Debt. Nobody's fond of it, and is it any wonder why? Debt can crush you, financially. And think of how quickly debt can snowball on you: Student loans! Credit card payments! Mortgages! Yikes.
Reality is, most everyone carries some amount of debt. But how much is too much? And how can you tell if you're using too much of your income to pay off your debts?
Look At Your Debt-To-Income Ratio
"Debt-To-Income Ratio" might sound scary, but it's actually pretty simple: Just divide your debt by your annual income.
For example, if your income is $60,000, but you owe $30,000 in debt, your Debt-to-Income ratio would be 50%. Not good! Lenders prefer seeing DTIs of 30% or below because it's a better indicator that you can afford to actually make debt payments and may get you a lower interest rate for your loans.
Conversely, a DTI of 50% or higher will likely result in higher interest rates.
Aside from your DTI, what other indicators can you look at?
If you answered 'yes' to any of these questions, you should take a serious look at what you can do to adjust your budget. (For ideas, see my article on "I Need a Budget! Where Do I Start? ".)
- Do you usually only make the minimum payments on your credit cards?
- Have you been denied credit?
- Do you have a savings account that you only rarely make deposits into?
Non-Credit Card Debts Should Come First
If you have a fixed debt (such as a car loan) and credit card debt, focus on the fixed debt.
With fixed debt, your payments are scheduled for a certain amount of time (such as with a car loan). This means you can easily tell when you'll pay off the entire debt. And once it's gone, it's gone.
The thing with credit cards? They're revolving debt. This means, you pay it down. And then, you charge it back up again. It's inevitable. It can sneak up on you. And because of this, it can be much more difficult to manage.
If you have money enough to make a double payment on either a fixed loan or a credit card payment--always make the double payment on the fixed loan.
Pay Off Your Credit Cards, Smartly
If you have multiple credit cards with multiple balances outstanding--in and of itself, another warning sign!--figure out how much you can allocate, total, to repayment in a month.
Next, determine the interest rates for each of your credit cards.
Pay as much as you can on the card with the highest interest rate, leaving just enough to make the minimum payment on the other cards.
Follow this routine until the first card is paid off, then move on to the card with the next highest rate, and so on.
If you have a card with 0% interest, and you have enough room on it, transfer balances from your higher-interest cards to the 0% card. If you don't have a card with 0% interest, you may want to sign up for a credit card with an introductory 0% offer so you can consolidate your credit card debt on that one card.
To Save Or Not To Save
Some people say it's better to save than to pay down your debts.
I think that's half right.
Savings accounts typically pay a very low interest rate, and what you do accumulate is taxable.
Compare that with a typical credit card interest rate, which can be 10%, 15%, 19% or more.
Looking at it this way, a dollar used to repay debt today is more valuable than a dollar saved--except when it comes to retirement.
If you can save into a tax-deferred account (a 401k or an IRA), do it. No second thoughts. In fact, this should be your #1 priority after food, clothes, and making at least minimum payments on your outstanding loans.
Have a question for CallCaroline? Email her at firstname.lastname@example.org.
CallCaroline can balance a budget, but she's not a professional financier. Please use your best judgment on whether or not to follow her specific advice.