Actively Manage Your Debt Levels

This is the second article in my series, Conserving Money, designed to impart learnings from my experience with financial planning to my children.

Once you pay yourself first and start to grow your Rainy Day fund, you now have the challenge of managing the remainder of your income and putting it to work for you. For simplicity, the rest of your income splits into two, remaining parts: one pool targets your fixed obligations (debt) and the remainder becomes your discretionary income, aka spending money. How you manage these funds determines how quickly you travel the path toward financial freedom. Please come along as I show you how to calculate and manage the debt in your financial portfolio.

A separate Housing & Debt account secures your ability to cover housing (mortgage or rent) and other debt payments, like car loans, student loans, consolidation loans, credit cards, etc. These costs represent critical components you need to maintain, including shelter, transportation, education, and job training. These resources provide stability and create opportunities to earn future income to survive. If you are carrying a continual balance on credit cards, I include that here as well. All credit card balances should be able to be paid off within one year. Longer terms than that require evaluation for other funding or debt instruments.

The remainder of your income represents spending or discretionary funds to cover food, fun activities, gym memberships, utilities, phone, gas, etc. These activities are where the challenging work in the current time is done. How you manage these expenses will determine where your money gets spent and how much, if any, you will need to rely on credit cards. We will cover spending more thoroughly in future articles.

Split Up Your Income

I recommend setting up a specific account for Housing & Debt and a separate Spending account to manage your discretionary income. In all, you should have 3 accounts to organize and manage your income properly:

1. Saving (Rainy Day fund)
2. Housing & Debt
3. Spending

Once you have the 3 accounts established, split your income amongst the accounts, via direct deposit. The target amounts should be 5-10% of gross income to Savings, 40% to Housing & Debt, and the remainder to Spending. We already discussed Savings, so I will assume you are funding your rainy day goal. Our next step focuses on calculating and understanding your debt levels.

Calculate Your Debt

I stated above that you want to aim to put 40% of your income toward Housing & Debt. Your housing costs constitute 25% or less per month and the rest of your monthly debt payments should equal less than 15%. 40% of your income may sound low. However, when you factor in taxes, benefits, and retirement deductions from your paycheck, a higher debt ratio will squeeze your budget and may force you to borrow to cover needs in other areas. like living expenses.

To calculate your debt level, add up your:

• Rent/mortgage,
• Student Loans,
• Car Loans,
• Payday or installment loans, and
• Credit card carrying balance (divide total unpaid balance by 12)

Add up all the total from all loans and divide by your monthly gross income. If you are unsure of your monthly gross income, simply take your Hourly Wage x 167 hours, then insert into the calculation below:

TOTAL DEBT / MONTHLY GROSS INCOME = DEBT RATIO

Let’s Take a Look at an Example

A single individual generates a monthly income of $4,000. Per month, they pay $1000 rent, $200 in student loans, $350 on a car loan and rollover $2200 on their credit cards. Their monthly debt equals $1733. Divide that sum by the $4000 in income and their debt ratio = 43.3%.

Their housing allowance is right at 25%. The installment loans are also within tolerance, coming in at 13.8%. It is the revolving credit card balance that puts them over the target. If the debt being carried is higher than 40% of your income, you need to make adjustments or you will detour off the path to financial independence. Let’s take a look at what may be done.

I Have My Debt %, Now What?

My Number is Higher than 40%

If your number is higher than 40%, you need to manage your debt levels lower. Outside of raising your income level, you will need to attack your debt aggressively. You have several different options to lower your number to the target rate:

• Downsize your living arrangements. If you are >25% allocated for housing, you need start here. Chances are you should be able to find more economical housing, take on a roommate, or
• Consolidate loans to better rates and/or extend the term to longer maturity. If you have student loans, you likely have a series of loans with different terms, balances, and interest rates. The same thing goes for credit cards. A consolidation loan may help you simplify to one payment which fits your budget. The catch: Your maturity may get extended, so be ready for how to manage that situation. AND, you cannot use this to rationalize more debt or you will only worsen your debt situation.
• If your car is your problem, you will need to evaluate how much loan you have left and how much the vehicle is worth. If you are very early in a loan, it could make sense to sell you car and look for a cheaper alternative. Most cars may easily be driven 8-10 years and 150,000 miles or more. Managing your car situation is the easiest method to staying out of or getting into painful debt situations.
• Cut into your spending and use money saved to resolve debt. This is always an option. If you can cut spending by the amount over 40% and use those funds to pay off your highest interest or smallest balances, you can get your debt situation under control without big sacrifices.
• Cut back on savings. I put this last because it should be your last option. Using the money you should be saving and applying it toward debt will keep you treading water (and will eventually cause you to drown)

My Number is Less than 40%

This is where you want to be to have control over your financial future. Continue to fund 40% of your income into your Housing & Debt account. The money you accumulate into this account by keeping your debt below 40% will make the perfect starter for:

• Pay off all your credit card balances! These rates are astronomical and the worst offenders for keeping you in debt and insolvent.
• Paying off your vehicle early. Interest on a $20,000 car loan equals about $40 and the total payment will be around $450 per month.
• Getting ahead on student loans. Send extra payments in on the higher rate loans or single out the loans with a smaller balance to whittle them down and eventually pay them off.
• Making annual payments on insurance policies. Most insurance policies allow monthly payments but charge you a premium to do so. Paying the whole thing at one time will provide you a discount and save you from being charged for “processing” or “convenience’ fees.
• Preparing to replace your car. Have money accumulated for that time maintaining your current car is costing you more than a replacement. Buying your next car is cash is doable, especially if you buy one that is a few years old.
• Saving for a home. It’s not necessarily for everyone, but if you want a home, you will need to accumulate money in all three accounts, Saving, Housing & Debt, and Spending. It will likely be the most expensive investment you make and you want to be well prepared. The quickest way includes a healthy dose of slashing debt.

Less Debt = Greater Cash Flow

You want to get ahead of your debt to increase your cash flow. Less debt means your income can go further and it puts it to work for YOU! You will be less worried about paying bills each month, less nervous about unexpected repairs, less fearful about lost income, and much more confident in handling money and building wealth.

Debt can be a very effective tool for people that have accumulated a measure of wealth and use it to leverage what they have saved. For people that do not have savings and wealth accumulated, debt can be crushing and keep you on the brink of default for months or years at a time.

There are lots of resources online to educate and help you make decisions on the right level of debt for your personal situation. My goals is to bring attention to its importance to your financial health and urging you to perform the exercise. Once you complete the exercise and gain a firmer hand on your monetary resources, I have no doubt you will begin to repeat this exercise regularly to brighten your financial future.

This article is the second segment of a multi-part series designed to impart learnings from my experience with financial planning on to my children. I hope you may find usefulness in this information for yourself or someone in your circle.