Measuring the Ability to Repay: The Residual Income Ratio

Measuring the Ability to Repay: The Residual Income Ratio Which of these observations about consumer indebtedness is correct? The answer depends largely on the method used to measure consumer debt. Total dollar debt is one measure. Ratio analyses are also popular. Most ratios normally compare total debt outstanding with consumer financial assets or personal disposable income, or they compare debt service payments with disposable income. Each approach is discussed below, and the conclusion is drawn that debt service-to-income ratios are preferred. The rationale for dividing expenses into required and discretionary categories and using residual income to compare to debt repayments is then presented. Finally, two examples of the use of the ratio are provided. RATIO ANALYSIS OF HOUSEHOLD DEBT SERVICE CAPACITY The limited literature on measuring household debt capacity is confounded by the lack of consistency in terminology. General agreement exists in the use of the term gross income, but consistency breaks down beyond that point. While some authors talk about discretionary income, others refer to take-home pay, and still others call this disposable income (Block et al. 1988; Garman and Forgue 1988; Kapoor et al. 1988; Van Arsdale 1982). More confusing still is the failure of authors to define exactly what they mean by their terminologies, implying by this failure that a standard definition exists. For example, what is discretionary income? Most authors imply that it is the income over which the household has discretion in making purchase decisions (Van Arsdale 1982), but because there are degrees of discretion, one author's definition of discretionary income may be quite different from another's (Cole 1988). Definitions of debt have similar problems. While standard definitions exist for installment and noninstallment debt, the treatment of debt by government data bases at the macro level has led to inconsistencies when terms are used in developing household analysis (Toal 1986). For example, some definitions include mortgage debt in debt capacity analysis, while others do not (Amling and Droms 1982; Apilado and Morehart 1980; Bailard et al. 1986; Barngrover et al. 1981; Cole 1988; Garman and Forgue 1988; Lang and Gillespie 1981). A related problem is the treatment of installment lease obligations. For practical purposes, at the household level these obligations are very similar to household debt. However, the current literature treats these obligations as regular household expenditures rather than as debt. Thus, definitional problems compound analytical problems in attempt to establish an individual household's ability to repay their debt obligations. The terms used in this paper are defined in Table 1. Table : TABLE 1 Definitions of Terms Debt I. Total Debt: all financial obligations accrued by a household. This figure includes the principal only (the amount owed) and not the interest on the amount borrowed. A. Mortgage debt: real estate is used as collateral for the obligation. B. Consumer debt: nonmortgage debt. 1. installment debt: borrowers can repay in two or more periods. 2. noninstallment debt: borrower must repay the entire credit balance in one period, i.e., travel and entertainment credit card charges. II. Debt Service and Lease Payments: the payment of the interest charges plus, in most cases, Some payment toward reducing the principal on consumer debt, and the payment on a long-term lease agreement. Payments are usually monthly. A. Mortgage payments: repayments on real estate loans. B. Installment debt payments: repayments on a debt where an interest charge is made and more than one payment is required. C. Credit convenience payments: repayments of credit card debt where credit is used as an alternative for cash. …