At this time of year it is always advisable to take stock of the health of your finances. Last week, we looked at evaluating credit card debt and bringing the amount down over the next couple of months even as the holiday spending season barrels toward us. The aim, of course, is to not be overwhelmed by a mountain of credit card debt you can't seem to tunnel your way from under come the New Year.
But this is also the time of year to seize the opportunity to evaluate your overall financial health, not just credit card debt. If checking your credit card debt is like a quarterly medical check-up, then a deeper financial health assessment would be akin to a comprehensive annual executive medical profile. Both tests are necessary, but the executive profile casts a wider net, exposing more anomalies that don't necessarily show up in a regular check-up and bringing them to the surface. The executive profile is therefore critical, as it helps diagnose an issue that will affect your long-term physical health and hopefully head it off at the pass.
Diagnosing long-term financial health
Like the options on the checklist of an executive profile, there are different areas or metrics you'll need to evaluate to get a good idea of how healthy your finances are. This is something you are required to do if you want to embark on a wealth management journey.
So, in addition to knowing what your credit card debt is, you need to have a budget that you upgrade from time to time, figure out your net worth, gauge your credit score, focus on your savings, and later, know the status of your retirement fund. But one of the most important metrics you need to assess is your debt-to-income ratio. Many people don't do it because, frankly, it sounds too, well, 'mathsy'. Too hard. The word "ratio" brings back too many not-so-fond memories of algebra class. The good news is, though: it's not difficult. Think of it as simple maths, and this is what our focus will be on today.
What is the debt-to-income ratio?
The debt-to-income (DTI) ratio is, simply put, how your monthly debt obligations stack up against your monthly income.
So, what are your monthly obligations? The most common recurring monthly obligations include mortgage or rent payments; car payments; student loan payments; loan payments to friends/family members who lent you money or stood guaranty for down payments for you; child support payments; medical bills; and of course, the ubiquitous credit card payments that so many people incur.
Work out which of these debts recur each month for you and add them up. Then divide by your gross monthly income. (Remember the gross is the money you earn before taxes and other government obligations are taken out.) Work out the percentage the result is in relation to your monthly income. This is your DTI ratio.
What does the result say?
The lower your DTI ratio, the less risky you are to creditors. Generally, your DTI ratio should be below 30 per cent, meaning that if your debt obligations take up more than 30 per cent of your gross income, steps need to be taken to bring that rate within a manageable range.
So, for argument's sake, let's say Person X has a monthly debt of rent, car payment and student loan which add up to $50,000. Their gross income, for ease of calculation, is $100,000. This means their DTI ratio is 50 per cent. This is way too high. (Remember, expenses like grocery and so on are not counted as debt and don't factor in a DTI ratio.) So you can see that Person X is living in a state of denial and debt, and so, when they try to qualify for, say, a mortgage later on, will only experience disappointment and heartbreak since their DTI ratio is way more than a credit agency would recommend for a good credit score.
If your DTI ratio is above 30 per cent, you might need to assess whether the job you're in isn't paying you what it should be or whether you need to consider a part-time job or side hustle. A problematic DTI isn't only bad for your credit rating; it's simply bad for you because, unless you address it, you'll keep living from pay cheque to pay cheque and racking up credit card debt, wondering why you can't seem to make any headway in achieving your financial goals.
Knowing your credit card debt alone cannot truly tell you the real state of your financial well-being. One of the metrics used for an overall picture is a DTI ratio assessment. As you come closer to the end of the year, consider doing a DTI ratio assessment to get a more realistic idea of the true state of your financial health.