Reducing debt usually isn’t a high priority for people until they have already gotten into trouble with overspending. Using a few basic guidelines, and debt calculations, can help you see when your debt load is getting into the danger zone.
First off, creditors use budgeting guidelines when reviewing and approving credit. If your debt exceeds the financial communities recommended guidelines, then you have a higher risk of credit applications being denied.
Getting, and keeping, your debt in line with recommended budgeting guidelines, is an important step in reducing debt. Use the following recommended budgeting guidelines (the same ones used by Financial Institutions) to review the items in your budget:
- Housing 35% – Mortgage or rent, taxes, repairs, improvements, insurance, and utilities;
- Transportation 20% – Monthly payments, gas, oil, repairs, insurance, parking & public transportation;
- Debt 15% – Credit cards, personal loans, student loans & other debt payments;
- All other expenses 20% – Food, insurance, prescriptions, doctor & dentist bills, clothing & personal;
- Investments & Savings 10% – Stocks, bonds, cash reserves, retirement, rental real estate, art, etc.
Debt Income Ratios
The second step is calculating your debt income ratio. Once you know what your ratio is, you will understand just how important debt load is to your overall financial picture. Your debt income ratio is the percent of your monthly take-home pay that goes to paying debts.
You calculate it by taking the amount needed to repay debts each month, including rent or mortgage, and divide by your take-home pay (your net pay after taxes). Remember, this is “Debt” ratio, so only include actual debt repayment in the calculation.
Credit To Debt Ratio
Just because you pay off a credit card is no reason to close your account. One little known fact about the Credit to Debt Ratio is the reverse effect it has on your credit score. If you pay off a credit card, and close the account, you are actually negatively impacting your credit score.
The reason for this negative effect is in the calculation of the Credit to Debt Ratio itself. This ratio is the relationship of your debt total vs. your credit limit.
You calculate it by dividing the total credit limit of all credit cards and loan accounts by the total of the actual debt (spent total). Now, if you pay off a credit card, you are reducing the actual debt, which is great, but, if you close the account, you are also dramatically reducing the credit limit you have, and usually by a higher percentage than you are reducing debt.
Pay Yourself First
Essential to long-term financial success, and protecting your future, is paying yourself first. While this may seem easy to do, it happens to be the last thing most people do, instead of first.
Debts and other financial obligations, money for entertainment, and other spending always seem to take a higher priority. All I can say is, STOP! Think about it, if you aren’t worth being paid first, then who is? Always put something away in your savings, and leave it alone. It doesn’t matter if it’s only $5 a week, just do it!
Snowball The Credit Cards
Last, but not least, is making extra payments, not just the minimum payments, on your credit cards. You have probably already seen this method to reducing debt many times, but it just can’t be stressed enough.
Paying just $10 extra a month on a credit card, above the minimum required payment, can cut your repayment term in half, if not more! So, squeeze out that extra payment, however small, every month, and take advantage of the compounding effect of snowballing your way to reducing debt.
The Power of Financial Knowledge
Remember, you don’t have to be a financial whiz to understand what’s going on with your credit and debt. Just a few simple calculations, and an eye on the future, will go a long way to help you succeed financially and keep your debt under control. Be safe, be smart, do the maths!
About the author:
Debs is the editor of DebtSteps.com where you can get the answers you need about debt relief, consolidation, credit counselling and more. Subscribe to the free newsletter and discussion list and get free money management worksheets in pdf and spreadsheet format