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Hey scholars, does your debt-to-income ratio make the grade?

A young CEO I know recently described entrepreneurship as akin to jumping off a cliff and building a plane on the way down. In other words, entrepreneurship is pretty risky but carries with it the potential of a huge payoff. With a new school year about to begin, that might be exactly what prospective students of higher education are feeling.

The average university tuition in Canada is now more than $5,000. After four years, Statistics Canada says a final bill of almost $60,000 can be expected after including books, housing, and other ancillary expenses. And tuition inflation historically has made the recent spike in food prices seem tepid, so that number might only be going up.

Part of that $60,000 you would have to pay for anyway. If you didn't enroll in post-secondary education, you'd still have to eat and find a place to live.

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Much of that cost is paid for through part-time and summer jobs, as well as help from family. Indeed, the average university graduate is carrying around $27,000 of debt upon graduation.

Statscan regularly reports on the average Canadian's debt-to-income ratio, and these days, every time they do, it makes it into the news. Everyone, including me, is finger-wagging about debt. That ratio has recently breached 150 per cent, meaning that for every dollar of after-tax income, we owe more than $1.50 in debt. That debt could be mortgages, vehicle loans, credit cards, lines of credit and, of course, student loans.

Of course, the danger of using averages like the 150 per cent is that it's a blunt instrument. It doesn't capture the reality of the picture for university students.

A new graduate with $27,000 in debt with a decent job in her field – and looking ahead to a first house, a car or perhaps even a wedding – would be extremely fortunate to carry the 150-per-cent ratio.

A humanities degree might net her a salary of $36,000 per year, but, after tax, that is closer to $30,000. That would put her at a debt-to-income ratio of 90 per cent, assuming the only debt she carried was her student loan. She could only take on $18,000 more debt before she hit an even 150-per-cent debt owed per after-tax dollar. So what's it going to be? A car or a wedding? Not both, and not a house.

The harsh reality is that debt is heaviest for young people, and a debt-to-income ratio well over 200 per cent is not abnormal. Most graduates don't buy a house the day after they graduate, as it takes time to build up a down payment. Fast-forward five years and the scene is not much better – hopefully the graduate has significantly paid down those student loans and has a spouse who's also working. After a few raises, perhaps her combined after-tax income is $72,000. At that rate, just to carry a $200,000 mortgage would mean a debt-to-income ratio of 278 per cent.

A recent report from TD Canada Trust says that it would take 15 years to pay off the average university student debt by making monthly payments of $260. That's a big cliff a new student is jumping from.

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If you are going to make the investment of post-secondary education, it doesn't have to be as risky as entrepreneurship. Before you jump, get the blueprint for that airplane you hope to build on the way down. That blueprint is available in the form of educating yourself about personal finance.

Run a surplus, avoid carrying balances on your credit cards, and focus on paying down debt aggressively. You'll be able to limit the turbulence on your flight, and ascend comfortably over time to a nice cruising altitude with your finances.

Freedom 15

The average debt of a university graduate in Canada is $27,747. Assuming an 8-per-cent annual fixed-interest rate, a monthly payment of $260 would pay off that debt, plus $19,181 of interest, in 15 years, for a total cost of $46,928. (Paying it off in only five years would save $13,393 in interest payments.)

Source: TD Canada Trust

What can be done about student debt levels? Personal finance columnist Rob Carrick will answer readers' student debt questions live on Wednesday at noon (ET). Click here to join the discussion.

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About the Author
Personal Finance columnist

Preet Banerjee is a consultant to the financial services industry. You can follow him on twitter at  @PreetBanerjee. You can find his conflict of interest disclosure on his website. More


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