debt management

Are You Drowning in Debt?

Debt management can be a lifesaver if done swiftly, and with determination. Debt can be very tempting since it allows you to buy things immediately. It doesn’t matter if you don’t have the cash or ability to make the purchase otherwise.

But excessive personal debt may prevent you from reaching your financial goals.  At the very least, it will create a lot of unnecessary stress in your life, and make your objectives much more difficult to achieve.  Debt management problems are often created when individuals spend money they do not have and live a lifestyle they cannot afford.

Debt management issues can also arise if you do not have proper risk management in place. For example, a lack of health insurance can create a financial disaster in certain situations if you happen to unexpectedly fall ill.

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Once heavily in debt, it usually becomes difficult if not impossible to save much money for desirable goals. This can include establishing an emergency fund or saving for retirement. Instead, anything left over after paying the basic necessities must be applied to debt payments.

Debt Can Be A Useful Tool

Debt can be useful and convenient, but it can and often does get many of us into trouble.  Used wisely, it can be a great tool.  For example, very few individuals would ever be able to afford buying a home without borrowing money.  When you do borrow to purchase a home, go for a conventional fixed rate loan on a loan balance you can afford.  This way you can plan for the payment within your budget, and it won’t increase over time.

Debt can also be useful in the area of real estate or other investing niches.  It can be a very powerful tool in investing as long as it is used wisely.  It allows investors to use leverage to purchase a larger investment with less cash, which can amplify their cash on cash returns. This strategy works best when the investment generates consistent income which exceeds the cost to service the debt.

It is also ideal if the debt financed investment appreciates in value over time, so that the debt can be paid off completely with profit to spare when it is eventually sold.  Another benefit of using debt for business or investment purposes is that the interest paid is generally tax deductible.

Consumer Debt Should Be Avoided

However, debt can cause many problems when used to purchase consumer services or products which generally depreciate and do not generate any income to help pay the related interest cost of the debt.

Examples of such services and products include vacation travel, meals and entertainment, personal automobiles, electronics, clothing and accessories, and other personal material items. You see something you like and with the constant bombardment of credit card offers it is too easy to be tempted and fall into a debt trap.

Discipline is paramount in order to avoid getting in over your head. Debt which is backed by collateral does not generally carry very high interest costs. Examples include home and auto purchases.

The Pros and Cons of Credit Cards

However, shopping with credit cards and not paying off the balance monthly can create the worst type of debt possible. Credit card debt is not backed by any collateral, and therefore generally carries very high interest rates. To make matters worse, this “personal” interest is not tax deductible.

One positive of using credit cards is the reward points you can earn. But if you can’t be responsible and disciplined in paying off the balance every month within the grace period, the points are not worth it.

Also, you may use a credit card because you don’t like carrying around cash. Not to mention that cards are more recordkeeping friendly than cash or checks. To take advantage of these benefits, look into potentially using a debit card. This way you cannot spend more than you have in your account.

So how do I know if I need to apply debt management strategies?

Well, there are some obvious signs such as constant calls and letters from debt collectors.  Maybe you’ve maxed out credit cards and they get declined at the store.  Not being able to afford paying more than the minimum monthly required payment on your credit card balances could be another sign.  Alternatively, you may be struggling to make your mortgage payments.  It could be that you purchased more house than you can afford.  But before it gets to these more extreme levels, you can use some tactics which may allow you to see the problem and deal with it before it gets out of control.

Use Debt Ratios To Analyze Your Debt Levels

If you go to a bank to take out a loan such as a mortgage, the loan underwriter will generally use ratios to help determine if you qualify for a loan.  There are certain thresholds for each ratio which if exceeded generally indicate a relatively high credit risk. In other words, you’re not getting a loan.  So you too can utilize these benchmarks to help determine whether or not your debt load is out of control, or on its way there.

Consumer Debt Ratio

This ratio measures your total consumer debt payments as  a percentage of your net after tax income. Consumer debt includes everything other than mortgage debt on real estate.  So any minimum credit card debt payments, auto loan payments, and other such debt would be included in the numerator.  The denominator includes the total of any recurring earnings and other income such as rents, interest, or dividends after an adjustment for taxes.

You should strive to keep this ratio below ten percent.  Ideally, it should be closer to zero.  This is possible once you pay off all credit card debt, and maybe only have a car payment in the numerator of the ratio. When this ratio reaches between 15% to 20%, warning sirens should be going off in your head.  Once your consumer debt surpasses 20%, you likely need to take some quick action to reduce your debt levels.

Notice that for this ratio, the denominator is the net after tax income.  This is so because interest on consumer debt is not deductible.  For the two ratios below, gross income is used instead because they include non-consumer debt related payments which are tax-deductible such as mortgage interest and property taxes.

Example of Consumer Debt Ratio

As an example, let’s say that your monthly minimum credit card payments total to $250 and your auto loan payments are $200. Your gross monthly earnings are $1800, and you earn dividend income of $50.  Let’s say you are also in the 20% tax bracket.  This would leave you with net after tax income of $1480 (($1800 + $50) x (1 – 20%)).  So the consumer debt ratio would equal $450 divided by $1480, or about 30%.

This is above the 20% rule of thumb maximum that lenders use. You may think 30% is not bad, but keep in mind that this is only consumer debt.  You still likely have other major and more arguably more important expenses to pay such as those for utilities, food, your mortgage, property taxes, insurance, etc.

Payment to Income Ratio

This ratio is also called the housing expense ratio. It measures your PITI payments as a percentage of your recurring gross monthly income.  PITI represents your housing expenses, and stands for principal, interest, taxes, and insurance. This ratio should not exceed 28% of your gross recurring monthly income such as earnings, dividends, interest, rents, etc.

Even though property taxes and insurance are not debt payments, they are payments related to ownership of your home. As such, they are included in the ratio. The reason is that this ratio is used by mortgage lenders to measure how much house you can afford.

Example of Payment to Income Ratio

To illustrate, here is an example.  Let’s say your mortgage principal and interest payment is $900 per month.  You also pay $500 per month in property taxes, and $200 for insurance.  Your total PITI payments each month are $1600.  You also earn $2800 per month from your job, and $100 in interest from a savings account.  Your gross recurring monthly income is $2900 per month.  This results in a ratio of $1600 / $2900 or 55%.  So in this example you would be in bad shape as far as debt issues go.  You would need to cut your debt, increase your income, or both.

Debt to Income Ratio

A more comprehensive measure of debt is the debt to income ratio.  The ratio is total debt as a percentage of gross monthly recurring income.

The numerator includes payments for consumer debt plus the PITI payments for your home. It also includes student loan payments, child support, and alimony payments if any.  The denominator is gross recurring monthly income, same as with the housing expense ratio.

The debt to income ratio should not exceed 36%. If a bank will not give you a mortgage loan because this ratio is above 36%, then maybe you are drowning in debt.

Example of Debt to Income Ratio

In this example, let’s say you have minimum monthly credit card payments of $150.  Car payments are $200, and total PITI is $1200.  You also make total recurring gross monthly income of $3900. The ratio would equal $1,550 total debt payments divided by $5000 total income, or 31%.  In such a case, you are within reasonable debt levels.  However, it never hurts to pay down debt as much as possible regardless of the ratios.

Debt Management – What Steps Can I Take to Reduce Debt?

There are several steps you can take to reduce debt.

Reduce Your Expenses

In order to reduce debt, you must be able to allocate part of your earnings towards the debt principal balance. If you can’t do this, you need to list out your expenses, and cut whatever you reasonably can. This can be a very useful exercise, and you’d be surprised how much excess you can find.

Make More Money

Also try to increase your income if possible. You can request a raise at your present job or switch to a higher paying job. You can even look for a part-time job to supplement your full time position. Another alternative is to make a list of assets you can potentially sell.  Then apply the proceeds towards paying off your debt. You have to find a way to apply meaningful and consistent sums to your debt balances. Doing this will reduce them faster and save you interest.

Making The Minimum Payments Helps, But It’s Not Ideal

Try to consistently allocate a minimum of 10% of your monthly income towards any credit card debt principal balances. Pay off any credit card debt first. Make your minimum debt payments for all accounts.

This will preserve your credit score, avoid fees, and keep balances under control.  But it will take many years to pay off the balance by paying only the minimum. Not to mention all the extra interest you will be paying over that time.

Pay Off The Highest Interest Debt First

You likely will have more than one credit card account. If so, put extra funds saved towards paying down the accounts which are charging you the highest interest rate first.

Consider Downsizing Your Home or Car

You may also have to downsize your home or refinance your mortgage if advantageous.  Even your car may have to go at least temporarily.  Consider switching to a less expensive and more fuel efficient one. Mass transit can also be an option if it gets to that point.


So are you drowning in debt? Do you need to take debt management more seriously? If you see and experience the obvious signs listed above, then you know the answer. You may not have a need to even compute the debt ratios discussed. However, it helps to know just how bad it is in order to formulate a debt management plan of action. Alternatively, you may not be sure if trouble is lurking. Maybe you have the feeling like your debt is spiraling out of control. A more in depth analysis may be necessary to determine if more proactive debt management action is needed.

Either way, sit down with a pen and some paper, or in front of a spreadsheet on your computer. Sift through your records and compute the above ratios. You may be surprised at what you find. If you are in the danger zone with any of these ratios, things will probably only get worse. You should take decisive debt management action as indicated above. In the end though, it will all be worth it. You won’t have the stress of oversized debt balances hanging over your head.

If you think you need the professional debt management services, see Choosing a Credit Counselor from the Federal Trade Commission’s website.


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