Have you ever stopped to think what an out-of-control financial issue could do to your life? You need to do this because a serious financial problem could totally disrupt your life, leaving you in a mess that could take years to fix.
Are you carrying too much debt?
Debt call kill your financial life because what it means is that you’re borrowing from tomorrow to pay for today. Then when tomorrow rolls around it’s likely you’ll have to borrow again and again until you’ll feel as if you’ve fallen into debt hell.
How can you tell if you’re carrying too much debt? There’s a simple formula called the debt-to-income ratio. To determine yours just add up all your fixed monthly obligations – your loan payments, credit card payments, rent or mortgage and so on. Next, add up all your income. If you earn bonuses or commissions in addition to a salary, be sure to include them. If it’s a yearly bonus or if you always get a nice, fat Christmas check from Aunt Jane, divide this by 12 and add 1/12th of that to your monthly income.
Now, divide your monthly fixed obligations by your monthly income to get your debt-to-income ratio. As an example of this, suppose your monthly income is $5,000 and you have $2,000 in fixed monthly expenses. In this case, your debt-to-income ratio would be 40%, which most experts say is too high. In fact, your ratio should be 30% or less and the more less the better.
Of course, you may not have to compute your debt-to-income ratio to learn if you’re carrying too much debt. If you always run out of money before your next paycheck, if you have creditors or debt collectors calling and dunning you for payments or if your credit card bill has gotten so high it could reach the stratosphere, you already know you’re carrying too much debt.
Do you understand compound interest?
One of the reasons you’re having a problem with debt might be that you don’t understand compound interest and how it’s hurting you.
According to the online encyclopedia Wikipedia “Compound interest arises when interest is added to the principal of a loan, so that, from that moment on, the interest that has been added also earns interest. This addition of interest to the principal is called compounding.”
Here’s a real world example of how this works against you.
Let’s say you have $1,000 in credit card debt at an interest rate of 19% and your minimum monthly payment is $30. In this case it would take you four years to pay off the loan and it would cost you $432 just in interest charges. The reason for this is because that $30 minimum monthly payment would not even pay off all of your interest charge for the month and practically none of your balance. So every month you made that minimum payment, you would be paying interest on interest – hence the four years required to pay off the loan.
Have an emergency fund
If you don’t have an emergency fund you’re just asking for trouble. We guarantee that you will have a financial emergency sometime in the next couple of years. It might be your car’s transmission going bad, getting laid off at work or having a serious illness. If you don’t have an emergency fund, guess what you’ll have to do? You’ll have to borrow to pay for it – which will mean more debt piled on top of the debt you already have. The financial experts we respect say you that should have the equivalent of six months of living expenses salted away to carry you through any emergency. If you feel you’ll just never be able to save that much, try for the equivalent of three months of living expenses as this would help you through most emergency situations.
Here comes that dreaded B word – budget. If you don’t have one you need to get busy and start creating one. There are two ways to do this – the easy and the hard way. The hard way is to keep all your receipts for 30 days. Then get out your checking account statement. Make a list of all your spending for that month and divide into two columns – “fixed expenses” and “variable” expenses. The fixed ones are those we discussed in an earlier paragraph – your rent or mortgage payment, auto loan payment, credit card payments and so on. Your variable expenses are everything else, including food, entertainment, transportation, clothing, eating out, your utility bill, etc.
Now, add up the two numbers. Can you now see why you’ re having a problem with debt? It’s probably because your expenses outweigh your total income – and maybe by a substantial amount.
Use an app
The easier way to create a budget is to get an app like Mint.com. It has two great features. First, it’s free. And second, it’s easy to use.
To create an account in Mint all you do is type in the numbers of your checking and savings accounts, credit cards, loans and investments (if appropriate). Mint will then gather up all your information and present it to you in one simple, easy-to-understand picture. Mint will know about your past spending because it will have the information from your credit cards and checking account(s). Mint will even organize your spending into categories. You create a budget by setting spending limits in each category. Any time you exceed your spending limit in a category, Mint will send you an alert via email.
Why easier is better
The problem with the “harder” way to budget is that it can be tough to track your spending accurately so you may end up overspending. By the time you sit down to write out what you spent that day you could think you had spent $80 on groceries when you really spent $95. Ditto how much you spent for lunch or hanging out with friends after work. You might even forget to write down your spending for several days, which could tear your budget to shreds.
In comparison if you use an app such as Mint.com or Page Once you will have an accurate record of your spending and will know exactly where you need to make cuts.
Get out an axe
If you truly want to get your debt under control you’ll need to take an axe to your spending. Your goal should be to reduce your spending to the point where it’s at least 20% less than your income. Most people find that food, clothing and entertainment are the easiest categories to cut back on. You will need to continue tracking your spending – manually or with Mint, Mvelopes or You Need A Budget (YNAB) so you will know how you’re doing vs. your goals.
Use a Snowball
One good way to get your debts under control and paid off is by using the “snowball” strategy. This is where you focus on paying off the debt that has the lowest balance first while continuing to make the minimum payments on your other debts. Once you have that debt paid off, you will have more money available to begin paying off the debt with the second lowest balance and so on. This strategy was developed by the personal finances expert Dave Ramsey and has helped thousands of people become debt free. Here’s a short video where Dave explains more about debt and snowballing.
As an alternate to this you could begin by paying off the debt that has the highest interest rate first. There are other experts who believe this is a better alternative because it’s the debt that’s costing you the most.