There are very few people who can say they have no debts. Almost everyone has a mortgage, a loan or a credit card balance. Having debt is not necessarily a negative thing, as long as you are comfortably meeting repayments. The trouble comes when your debts start to outstrip your means to pay them back. If you are worried about how much debt you have accumulated, you can calculate your debt to credit ratio to assess your financial situation.
Calculating this ratio gives you a better understanding of your financial situation because it compares your monthly repayment commitments against your monthly income. There is more than one way to work out this ratio. Some people prefer to omit so called “good debts” from the calculation – these are debts such as a mortgage or a student loan. This is often the best way to make the calculation if you want to work out if you are overloading yourself with debt, as debts such as mortgages are unavoidable. If you want a more comprehensive picture of your finances, however, then it is best to consider both good and bad debt.
To work out your debt to credit ratio, make a list of all your debts then add in a figure for the monthly repayments. Tally up the repayments then divide your total by your monthly salary. To get your debt to income percentage, multiply this figure by 100. Ideally, if you are calculating the figure based purely on bad debt, this figure should be under 10 percent. If you are including mortgage payments then the number may be higher.
As an example, let’s assume that you spend $150 a month on an auto loan and $100 on paying off credit card debts. If your monthly salary was $1,000 then your ratio is 25 percent. Since this number is well above the recommended 10 percent limit for bad debt, it is an indication that you have overloaded your finances.
If you are using the ratio to assess your overall financial health and are including repayments such as student loans and a mortgage, then you are aiming for a ratio of less than 40 percent. If the percentage comes out higher than this, you should look for ways to lower your financial burden. A figure of less than 30 percent is considered excellent.
There are only two ways to reduce your ratio and those are to either increase your income or lower your debts. The first may be feasible if you can work overtime or take a second job. However, for most people, the only realistic option is to focus on reducing the debts.
To pay off your bad debt faster takes commitment. You should throw every spare penny you have at paying off your debts. This will temporarily increase your debt to credit percentage, but once you have cleared your bad debt your percentage will drop to zero.
A healthy debt to credit percentage is an integral part of financial security.