So, how do you actually know if you have too much financial debt?
Well, first you have to define financial debt: ‘Money that is owed‘… Yep, it’s that simple!
Most people only identify debt as loans or credit cards however, to truly capture all the money that is owed, we should be including everything that we haven’t paid cash for outright (something that we have an obligation to pay for in the future).
Some traditional examples include: Mortgages; Motor vehicle loans; Personal loans; Credit cards; Insurance; Etc.
Other ‘non-traditional’ examples include: Store credit; Payment plans; Phone / Internet / Pay TV plans that you are locked into; Rent that you are locked into; Partly paid subscriptions; Child support payments; Education fees; Etc.
Many people are shocked by the ‘non-traditional’ examples I have included above due to the fact that they don’t really think about what a debt actually is.
It is important to note that for Money Management, we often group some of the things above as ‘Expenses’ (which some are) however, we just need to be aware that they can also be classed as debts (if we owe money or have an obligation to make future payments for them).
The definitions themselves are nothing to lose sleep over but it is important to keep them in the back of your mind when you are deciding whether or not to upgrade to the latest mobile phone plan (with the newest mobile phone included), etc.
The next step on the road to uncovering whether you have too much financial debt is to review the actual amount your debt is costing you each month and, if you can continue to service that amount going forward.
Fortunately, there is a simple little debt analysis exercise you can perform to review your cost of debt compared to your income.
It’s called the ‘Cost of Debt to Income Ratio’ and is calculated as follows:
1. Monthly Cost of Debt (a)– List down all (that means ALL) the debts you have (refer to the examples listed above if you need to) and add up the gross amounts (with taxes included) that each one is costing you each month.
2. Net Monthly Income (b)– List down and add up all the net income that comes in each month (after tax).
3. Cost of Debt to Income Ratio (c)– Divide the ‘Monthly Cost of Debt’ by the ‘Net Monthly Income’ and multiply it by 100 (this will give you a percentage amount).
Here’s an Example:
1. Monthly Cost of Debt (These are the Gross Monthly Costs of various debts with the taxes included)
Home Loan: $1,840
Car Loan: $400
Credit Card: $120
Pay TV Plan: $77 (*Locked in for 24 Months)
*TOTAL MONTHLY COST OF DEBT: $2,587 (a)*
2. Net Monthly Income (These are the Net Monthly Income Amounts after taxes have been taken out)
1st Partner’s Main Occupation: $3,100
2nd Partner’s Main Occupation: $2,600
2nd Partner’s Additional Job: $1,200
*TOTAL NET MONTHLY INCOME: $6,900 (b)*
3. Cost of Debt to Income Ratio
Total Monthly Cost of Debt: $2,587 (a)
Divided By (Total Net Monthly Income): $6,900 (b)
Multiplied By: 100
Equals*(COST OF DEBT TO INCOME RATIO): 37.49% (c)*
So… The example above means this couple have a ‘Cost of Debt to Income Ratio’ of 37.49%… In other words… 37.49% of their net income is going into servicing their monthly debt obligations.
To put this into perspective, over one-third of their net income is going towards their debts before they have to pay for other expenses and entertainment costs each and every month.
Generally, the lower the ‘Cost of Debt to Income Ratio’ the better the financial situation and the following is a quick guide to the health of your debt vs. income levels.
Less than 36% = Good
37% – 40% = Getting Rather High (Be careful & keep an eye on debt levels)
41% – 49% = Real Financial Trouble is Looming
Above 50% = Extremely Dangerous Levels of Debt
Basically the more money that is tied up servicing debt each month, the less discretionary spending money that is available to pay for general expenses and entertainment.
This effectively means that your financial commitments are growing and your discretionary spending freedom is diminishing… This is when financial stress starts to creep in!
This can become even more of an issue if there is any uncertainty about the future of your current occupation.
Even though it is always a good idea to keep on top of your personal money management on an ongoing basis, when your ‘Cost of Debt to Income Ratio’ gets above the 40% mark, it’s time to get very serious and start actively taking an interest in your financial future by reducing your debt levels.
Nowadays, more and more people are approaching the 41% – 49% range which means that real financial trouble is looming and it is only a matter of time before financial hardship sets in!
As I’ve always said to people, it’s not rocket science and you don’t need any special degrees to perform debt analysis or manage your money, you just need to know the basics and take the initial step forward to act.
Once you have taken the time to sit down and actually look at where your money is being spent, it is relatively easy to plan for the future and keep track of your money going forward… You just need the right tools and resources!