At the beginning of the New Year, resolutions are made for self-improvement. It’s time to get healthy and tighten the belt. And, I mean tighten the belt in more ways than one. The New Year is also the time to get your financial house in order by managing your debt.
The debt conversation is one I have with every type of client. For the young adults who are taking on student loans for college, I warn about overborrowing to support a lifestyle. Likewise, I warn empty nesters who want to travel and see the world that it is often not the best use of money once the children are “off the payroll.”
When looking at personal debt, nearly everyone wants to know what the ideal debt-to-income ratio is. Evaluate what you have coming in, such as, your income, royalties or rents, dividends, and interest compared to your obligations, such as, your mortgage, loans, credit cards, student loans, car payments, etc. Divide your monthly obligations by what you have coming in each month. Generally, you want to be around 28 percent to 36percent. Of course, to change that debt-to-income ratio, you must either lower your debt or increase your income.
You’ll often see mortgage lenders placing a lot of emphasis on your debt-to-income ratio when they are considering you for a loan. They generally like to see a debt-to-income around 28 percent when applying for a mortgage. But just because you can go up to 36 percent debt-to-income, doesn’t mean you should. Unfortunately, this practice often results in consumers being pre-approved for loans that are much more than they can actually afford on a monthly basis. Your debt-to-income may show that you can afford a $1,200 mortgage payment, but as most homeowners quickly learn, that is not the end of their housing costs. There are utilities, insurance, lawn maintenance, and repairs that come with a home. Nearly every homeowner has a “horror” story of having to replace a major appliance, a hot water heater, and an HVAC unit within three months of ownership!
I also see many investors with a “Depression” mentality — where all debt is bad, and they will do everything they can to never have debt. When it comes to credit cards, I would agree. Credit cards can charge up to 36 percent annual percentage rate on balances. However, I view mortgages as more of a grey area. In the past several years, you could have refinanced your home loan and have a mortgage at 3.75 percent annual percentage rate. Therefore, you have to wonder if it is smart to take money out of savings or the stock market to pay off a mortgage? In my opinion, not really. I believe an investor can still earn more in the stock market than he or she would save on interest by paying down the mortgage early.
Even if you can improve your debt-to-income ratio by making more money and spending less, you still need to pay down debt you have accrued. Luckily, there are several ways to do it. You can start by paying off the smallest balance first and then begin on the next smallest debt; therefore, you see the number of outstanding balances decreasing. Another method is to begin paying down the highest interest rate first to save as much on the interest payments as you can. The method that works best is the one that keeps you motivated to continue paying down your debt.