Hey, friends, are you looking to improve your financial situation? If you’ve been following along, you’ll know that this is our third post on the hows and whys of Debt Reduction and Elimination. Part 1 can be found here, and part two, which discusses attitude rules for debt elimination, can be found by clicking on the preceding link.
Today we’ll discuss another vital part of debt reduction and elimination: assessing your financial situation.
How to Determine Your Financial Situation
If you’re truly serious about improving your financial situation, it’s crucial that you start with an assessment of where you’re currently at financially. Start by making two lists on a piece of paper or Excel spreadsheet. One list will be titled “assets”. This list will contain what you own. It could look somewhat like this:
401k with Vanguard $50, 194
Scotttrade Account $ 2, 604
Checking Account $ 237
Savings Account $ 780
2007 Honda Civic $ 5, 800
Total Assets $59,615
After that, you’ll make a list of your “Liabilities”. Liabilities are what you owe. This list could look somewhat like this:
Visa $5, 237
Sears $ 694
Car Loan $3, 790
Student Loans $9, 260
Total Liabilities $26, 375
Now it’s time to determine your “net worth”, which is, in essence, your assets minus your liabilities. In the above case, the person has a net worth of $33,240. However, if you take out the 401k balance, which should likely be considered as untouchable if possible, the net worth drops down to -$16,954. Now, don’t panic if you find yourself coming up with a negative number here, even if it’s a huge negative number. The reason for your assessment of your financial situation is so that you can determine what needs to be changed, and you can’t change anything if you don’t first know where you’re at.
Now that you have a clear picture of your assets and your liabilities, it’s time to make another list. A list that tells you what you owe, to whom you owe, and what the monthly payment is, the interest rate is and the balance is. Like this:
Lender For What Balance Owed Current Payment Current Interest Rate
ABC Bank Honda Civic $3,790 $250 5.65%
Capital One Mastercard $7,394 $150 15.99%
Chase Visa $5,237 $110 12.99%
Sears credit card $ 694 $35 21.99%
Sallie Mae student loan $9,260 $60 5.00%
Total balances/monthly payments: $26,375 $605
Now you know what you owe and to whom, and you know what you have for assets, or cash available. This mythical person doesn’t own a house, but if you did, you’d add housing costs/value in here too.
The next step in determining your financial situation is to determine your debt-to-income ratio. Your debt-to-income ratio is simply your total monthly payment divided by your income (Some use gross, some use net. Mortgage companies will use your gross income, but it’s a safer and more logical option to use your net income). So, if the debtor above made take home pay of $2, 000 a month, his/her debt-to-income ratio would be 32.5%.
There are many takes on what a “safe” debt-to-income ratio is, but the fact of the matter remains that the lower your debt-to-income ratio is, the better off financially you can be, provided you manage your money properly. Most mortgage companies will allow for a max of 43% debt-to-income (DTI) ratio when assessing qualification for a mortgage loan.
What Do You Spend?
A good next step to add into this process is to write down what you spend each month. This list will not only include the numbers relating to outstanding debt, but also the amounts you spend on other items such as transportation, phone, internet and energy costs, housing costs, grocery and entertainment costs, and so on. If you have never written a budget before, you might want to start by going back through last month’s expenditures and writing them down from information gained on your checking account statement or credit card, so that you have a rough idea of monthly spending.
So, at the end of this exercise, you should know roughly what you’re spending each month, the amount of your assets, the amount of your liabilities, and your debt to income ratio. In next month’s post on Debt Reduction and Elimination, we’ll discuss formulating a debt payoff plan. Won’t you join us?
Have you assessed your financial situation by determining your assets, liabilities and DTI? Were you surprised at the results? What dti would you be “comfortable” with in buying a new house?