Debt Coverage Ratios and Loan-to-Income Ratios

I recently explored Total Debt Service (TDS) and Gross Debt Service (GDS) ratios as key affordability measures in underwriting. These ratios help lenders gauge a borrower’s capacity to manage debt responsibly. However, TDS and GDS ratios alone may not provide a complete picture of financial stability. In this part, we’ll examine two additional metrics: Debt Coverage Ratios (DCR) and Loan-to-Income (LTI) ratios.

Debt Coverage Ratios are particularly valuable when assessing the risk of commercial lending or income-generating properties. The formula is straightforward:

DCR = (Net Operating Income / Total Debt Service)

A DCR greater than 1.0 indicates that the income generated by the property or business is sufficient to cover debt obligations. In practice, most lenders prefer a minimum DCR of 1.2 to 1.5, providing a cushion against fluctuations in income or unforeseen expenses. For higher-risk borrowers or volatile industries, even more conservative ratios may be required.

Loan-to-Income ratios, on the other hand, focus on the relationship between the borrower’s total loan amount and their gross income. This ratio is particularly relevant for consumer lending and mortgage underwriting. A typical guideline is to keep the LTI ratio below 3 to 4, although this can vary based on regional practices and economic conditions.

I expect to see LTI discussed more in the Canadian lending landscape as OSFI is considering moving to this measure.

Understanding the nuances between these ratios is important. DCR, often applied to commercial credit or rental properties, focuses on the ability to generate income to meet obligations. LTI, in contrast, highlights how leveraged a borrower is relative to their income, which is critical when assessing long-term sustainability.

As with TDS and GDS higher-income borrowers may be able to maintain higher LTI ratios without undue risk, as their disposable income and asset base provide a cushion. Lower-income borrowers, however, may face greater vulnerability even with lower ratios. Therefore, affordability ratios must be interpreted in context, considering the borrower’s overall financial profile and risk tolerance.