Understanding Debt Load
The sum total of all the money you owe is what's commonly known as your debt load. To determine whether your load is more than you can afford, you'll want to calculate your debt/income ratio by comparing the amount you owe to the amount you earn.
Follow these four simple steps:
- Calculate all your monthly debt payments. If you don't have fixed monthly payments, you can estimate your monthly payments as 4 percent of the total amount you owe.
- Take your gross annual wages and divide them by 12 – that's your monthly income.
- Take your monthly payments total and divide it by your monthly income.
- Move the decimal point two digits to the right to make it a percentage – that's your debt/income ratio.
A debt/income ratio of 10 percent or less means that your finances are exceptionally healthy, and ratios within a range of 10 to 20 percent represent good credit, but at 20 percent or above, it's time to assess your debt load. Creditors will be less likely to give a loan to someone with such a high debt/income ratio and creditors that do tend to charge higher interest rates.
Another way to gauge your financial health is to calculate your net worth, which is the total value of your personal finances.
Assets – Liabilities = Net Worth
- Assets – Everything that you own, which may include your house, car, furniture – anything that's worth money.
- Liabilities – Everything that you owe, which may include your mortgage, credit card balance, interest, student loans and loans from family and friends.
Prioritizing Loans
Though one size doesn't fit all when it comes to debt, there are two ways to manage your loans. Consider the implications of your financial situation before choosing a method – then stick with it.
- Debt Snowball Method – This method of paying off loans works by prioritizing debts based on their size. By paying off smaller loans first, you'll be able to pay off several loans earlier on, and your payments "snowball" as you're psychologically rewarded. Many people feel more motivated to pay off loans if they can see visible progress.
- Debt Avalanche Method – Paying off debt through the debt avalanche method means first making the minimum payment on each debt, then using any remaining money to start paying off the debt that has the highest interest rate. Once you've paid off your highest interest rate debt, tackle the debt with the next highest interest. Using this method can result in paying off debt more quickly while reducing overall interest rates.