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:
Assets
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:
Liabilities
Mastercard ? ? ? ? ? ? ? ? ? ? ? ? ? ?? $7,394
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?
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Wise Dollar
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Great post, Laurie! Getting on track financially is really important before you can do much else. It not only helps you get out of debt you have but it also helps you keep from getting into more debt.
Thanks, Natalie, and I completely agree!! If you don’t know the specifics of your current situation, you won’t have much luck creating a better one.
I think that something (even though I am a financial professional) that I didn’t think about much was my debt to income ratio. It can be very deceptive for people and you need to find a DTI that level that gives you flexibility and doesn’t hold you hostage to making a particular salary otherwise you will end up trapped by your debts.
DTI has been crucial for us to monitor, as it gives us another way to monitor our progress when it seems like the numbers are going down slowly. It’s been great for us to start keeping track of debt repayment in this way.
Nice work Laurie! This is a very important step to get control of your debt. If you don’t know where you are financially, how do you know where to go?
Thanks, Grayson, and I totally agree. It’s so hard to formulate any kind of a plan if you don’t know where you’re starting off.
It is always important to look at your total financial picture and determine whether there are assets you might use to meet family obligations, etc. Great post, Laurie! 🙂
Hi Alicia!! Thanks for the comment – I wholeheartedly agree. 🙂
Knowing your debt / income ratio is important because it influences the interest rate you can get on your mortgage. It’s a very important ratio for a lender to know how feasible it is for you to honor your debts.
I agree, Deb!
We went through this process several years ago and what we found was shocking! It really makes a huge difference to know where you’re at financially.
It sure does. When we went through it for the first time, it was quite traumatizing, but man, was it worth it!
Awareness is huge, whether you’ve got a $500k net worth or a negative net worth! Once you establish where you are it’s also very motivating to track your net worth growth every few months. Great post Laurie!
Thanks, FI pilgrim! Yes, assessing our financial life changed it for the better indeed!
It seems so basic now, but actually sitting down and doing this is exactly what a lot of folks need to do!
Tell me, Anne! “We were them” until a year and a half ago, and I don’t know how we ever lived without a proper picture of our financials.
Great post Laurie. It’s crazy to think how many of us in PF Blogger land take this kind of stuff for granted, but how many people aren’t on the wagon yet. Hopefully this gets a few more there!
Yeah, I know. Even though we’re only a year and a half in, I often still forget that there are many, many people and families sitting where we were before we started this journey.
Thanks for this Laurie! I must admit I have avoided working out my net worth. It seems very scary to do that. We are on track with getting our consumer debt paid off but we do have mortgages which causes me headaches when I think about them. I should really sit down and work out our net worth and debt to income ratio.
You guys are doing so well, Hayley: I’ll bet your net worth isn’t nearly as scary as you think it’s going to be. 🙂
This was a great post explaining how to determine your net worth. I have come up negative for a few years now, but as long as the number is getting smaller, it is progress.
SO true, Michelle! Any progress is good progress – keep up the awesome work. 🙂
Great breakdown, Laurie. I think people tend to get really overwhelmed by trying to determine what financial situation is.
I think so too, Liz. Sometimes, as a PF blogger, I forget that many people still haven’t started on this road to financial well-being and are starting from the beginning, just as we were at one point.