Debt is not typically looked at as a good thing in the world of personal finances, but the reality is that whether it’s using a credit card, or buying a house, managing debt is an important part of managing your overall finances. After all, there are only two things on our balance sheet: assets and liabilities. We put a lot of effort into managing the assets, but managing the liabilities column can be just as important for getting you and your family where you want to go.
Instead of just simplifying to debt is bad, let’s look at what types of debt people take on. The two forms of debt we will acquire are Secured and Unsecured debt. To tell them apart, ask yourself the simple question: “Is something backing this debt?”. Secured debt is asset based such as, a car loan or mortgage. Using secured debt skillfully can greatly improve one’s overall financial life. The dreadful unsecured debt includes private loans, student loans, and credit cards. These unsecured debts tend to have higher interest rates and carry a heavy burden on people’s finances.
In many cases debt seems to get away from us and collect very quickly, which, in turn, impedes our chances of financial growth. Having monthly bills on top of paying monthly debt cost, decreases your net income. This not only limits our financial flexibility but having a lot of debt impacts how easily we can acquire more debt for important future needs by throwing off our debt-to-income ratio. This ratio is a simple way that we can gauge how much debt we have and is what banks use to help decide to issue a person more debt.
For example. Let’s say Sam Spender has a monthly income of $10,000. His monthly bills are a $2,000 mortgage payment, $700 car payment, $ 800 student loan, and he has a $1500 credit card balance. Sam’s debt to income ratio is total income divided by total debt which is $10,000/$5000= 50%.
The example above shows how most banks look at debt-to-income or DTI for loan qualification and 50% is typically the most they will allow for preapproval. In this example Sam would have a hard time securing additional financing for any other needs or purchases.
Here’s a general rule-of-thumb breakdown from the Federal Reserve’s website of how your DTI will affect your ability to get additional financing:
- DTI is less than 36%: Your debt is likely manageable, relative to your income. You shouldn’t have trouble accessing new lines of credit.
- DTI is 36% to 42%: This level of debt could cause lenders concern, and you may have trouble borrowing money. Consider paying down what you owe.
- DTI is 43% to 50%: Paying off this level of debt may be difficult, and some creditors may decline any applications for more credit.
- DTI is over 50%: Paying down this level of debt will be difficult, and your borrowing options will be limited. Weigh different debt relief options, including bankruptcy, which may be the fastest and least damaging option.
Keeping an eye on your DTI before you apply for new debt can make the process much easier and take a lot of the nerves out of the process. Next time we’ll talk about how to manage your DTI with those different types of debt and look at the big picture of your debt to help you reach more of your financial goals.