When clients contact me for the first time, one of the biggest challenges is trying to put debt into perspective. Adding up credit cards, lines of credit, over drafts and personal loans, is a good start but it doesn’t provide enough information for you to decide on what to do about your debt. In fact, it doesn’t really put your debt burden into perspective because it isn’t being compared to anything- your debt lacks context!
The Illusion of Managing Debt
Most people struggling with debt have become very good at shuffling credit around to maintain minimum monthly payments. Basically, one type of credit (line of credit) is being used to pay another form of credit like a credit card. Although this strategy works whilst credit is plentiful, it also changes your financial reality because it constructs the illusion of managing debt. Therefore, forming the belief that your debt isn’t a problem because you are making minimum monthly payments. What is a good rule of thumb to keep in mind is? If you can’t pay off your balance in full and on time every month, your debt is becoming a problem.
Consequences of Not Putting Debt into Perspective
What happens when you don’t put your debt into perspective? What happens when you don’t compare your debt to something concrete? You keep doing what you have always done; shifting balances between creditors, which gives the appearance you are managing debt. The reality is, you aren’t making a dent in the amount you actually owe and some creditors may even increase your interest rate! And, the biggest consequence is not having money to save for the future by building net worth through RRSP, TFSA and the like.
Putting it into Perspective: Debt-to-Income Ratio
One of the easiest ways to determine if you have too much debt in the form of credit cards, lines of credit, over drafts and personal loans, is to calculate your debt-to-income ratio. Essentially, the debt-to-income ratio is comparing your debt load to your net monthly income. Your income actually puts your debt burden into perspective because, unlike credit, it isn’t an unlimited resource. Your net monthly income is very limited and you only have so much available to meet your monthly debt burden and your needs of food and shelter.
You don’t need to be a mathematician to calculate your debt-to-income ratio. Below is a step-by-step formula to figuring it out.
- Add up all of your minimum MONTHLY debt payments such as
- Car payment(s)
- Mortgage payment or rent
- Credit card payments
- Lines of credit payments
- Identify your net monthly income
- Your total MONTHLY debt payments are divided by your NET MONTHLY INCOME
- The result will be a percentage
The equation looks like this:
$1200 (monthly debt payments) / $3000 (net monthly income)= .40 (40%)
What does this mean? 40% of net monthly income is going toward debt
Putting it into Context
Below is a chart that outlines what your ratio means.
|Debt-To-Income Ratio Categories|
|10% or less: Shouldnt have trouble getting loans. May qualify for lower rates|
|11% to 20%: Again, shouldnt have trouble getting loans. Time to be cautious and scale back if you are closer to 20%|
|21% to 35%: Although you may have trouble getting new credit cards, you are spending too much monthly income on debt payments. Time to develop a plan to reduce your debt burden.|
|36% to 50%: You may still qualify for CERTAIN LOANS, however, it will be at HIGHER RATES (because you are a risk for default). It is time to develop a plan to get out of debt. You may need to get aggressive by using a debt relief strategy because paying creditors back in full may not be realistic.|
|More than 50%: Very difficult to qualify for credit because you are deemed a high risk of default. You may also be insolvent.|
If you have a high debt burden, feel free to contact me.