The average household has more than $8,000 in credit card debt. Scary? Maybe you don’t think so, but to put it into perspective, an $8,000 balance at a rate of 18 percent interest (today’s average) will take more than 25 years to repay and cost more than $24,000 if you only make the minimum payment!
Is $8,000 too much? It depends; one good indicator is to look at your debt-to-income ratio. A debt-to-income ratio is a number, often expressed as a percentage, showing how much of your monthly income goes towards debt payments. These debt payments may include “necessary” debt such as your mortgage and student loans, and “unnecessary” debt such as credit cards and personal loans.
Unnecessary debt payments are a good indicator of overspending or living beyond your means. While many of us would like to keep up with Joneses, some of us just aren’t able to and run the risk of financial disaster by creating unnecessary debt, like taking on personal loans and high interest rate credit cards to make up the difference.
It is also possible to even have too much good debt, like a house that is too expensive or car payments beyond your auto budget. While having a roof over your head and a car to drive are both necessary, it is important to take into consideration your big financial picture and what is really affordable for you.
Calculating Your Debt-to-Income Ratio
To calculate your debt-to-income ratio and determine whether you are relying on debt too heavily, you will need to gather some information:
Step 1: Gather all of your pay stubs from your income sources.
Step 2: Gather all of your monthly statements from your credit cards, mortgage, personal loans and car loans.
Step 3: Add up all of your income and divide that number by 12.
Step 4: Add up all of your monthly debt payments.
Step 5: Take that figure and divide it by your previously calculated monthly income from step 3.
Voila! This number is your debt-to-income ratio.
For example: Monthly debt payments of $1,400.00 / total monthly income of $3500.00 = 0.4 or 40 percent debt-to-income. You can also use this loan calculator and simply punch in the numbers without having to do the math.
Determining Whether You Have Too Much Debt
So is a 40 percent debt-to-income ratio good? Unfortunately, not really. Here are the ratio guidelines:
- 30 percent and below: A ratio of 30 percent or less may score you the best rates on future loans.
- 30 to 36 percent: You are likely able to handle this debt load and still obtain decent rates.
- 36 to 40 percent: You run the risk of damaging your credit score.
- 40 percent and above: If your debt-to-income ratio is 40 percent or more this may signal financial disaster. With this debt load, an unexpected expense like divorce, a medical emergency or unemployment could send you into a tailspin.
Other Signs Your Debt Is Too High
So your debt to income ratio wasn’t convincing enough? Here are some more indicators of too much debt:
- You have trouble making the minimum payments on credit cards
- Payments to creditors are late
- Last month was a toss up between paying your mortgage or buying groceries
- You constantly transfer balances from card to card or tap into your home equity to pay off debts
- You use your credit card to purchase groceries, gas and make your car payments
- Your phone rings off the hook from bill collectors
How to Reduce Debt Now
If any of these apply to you, you may have a problem. Taking steps immediately to improve your finances can help you stay out of debt and you can start by creating a budget. A budget is a great way to manage your finances–if you find you are in the red, it’s time to trim expenses from your budget. Learn to live within your means and if you struggle to do so, seek additional debt relief options.
You can also try a do-it-yourself repayment schedule–a debt payment calculator can get you started. Simply enter your debts and calculate interest to come up with an amount you are comfortable with paying each month that also enables you to pay down your debt the quickest. Making minimum payments alone will get you nowhere fast.
Finally, consider seeking help. There are many options when it comes to debt relief. You just need to find the one that’s right for you! A Debt Management Plan (DMP) helps you work with your creditors to restructure your unsecured debt. Through a DMP, you make one monthly payment to the service and they pay your creditors. Companies that offer credit counseling do not loan you money but instead negotiate with your current creditors to secure you lower monthly payments, reduced interest rates and eliminated late fees.
If a DMP does not fit into your budget, you may also consider a Debt Settlement Plan (DSP). Debt settlement is usually less expensive than a DMP and works toward negotiating with a creditor to accept a lesser amount than what is owed, as opposed to only lowering interest rates.
There are a few questions you should ask before signing up for a Debt Relief Plan so be sure to do your homework before committing to a service. By taking charge of your debt now, you can improve your financial picture, avoid stress and start planning for your financial future.
This guest post is written by Suzanne Cramer, a certified credit counselor working in the Ask the Expert forums as a coach and a Social Media Specialist for CareOne. Suzanne writes for the Divorce, Debt and Finances and A Straight Talk on Debt blogs. Follow Suzanne on Twitter where she shares the latest debt industry news and tips to keep your finances in check with her @ADivorcedMom and @AskCareOne accounts.
