Getting out of debt isn't as hard as it seems. All you have to do is spend less than you earn. This is easier said than done for a lot of people because credit has become so easy to get and our culture is so focused on consumption and excess that it really requires a lifestyle change. A lot of times people just try to keep up with their friends or want to appear desirable to a potential mate. We are marketed to constantly with ads telling us that if we just buy this new product we will be happy and all of our dreams will come true. It is an endless spiral to self-destruction really.
Though our Government tells us that we have to go out and "buy things" to keep our economy going, the actual truth is that most of this consumption and perceived wealth in America is an illusion. People think they are wealthy because they have nice clothes or a nice car or a big house. Do they really own any of it? Almost all of it is backed by debt. It isn't really wealth at all. You are "renting" all of those material things and can keep them as long as you keep making payments.
When people can no longer borrow to keep this false economy inflated we hit a recession and people scale back or file for bankruptcy. We of course look at this as the end of the world and our Government packages up more goodies to bribe us into continuing this consumption of excess to get the "economy moving again". But the reality is that we SHOULD scale back (as individuals and the Government) to pay off our debt, become fiscally sound, and being to accumulate wealth once again.
They call it a "business cycle" to make is sound official as if it should always happen but if we were to keep our debt manageable we would never get into this mess and there would be no business cycle. Part of this is due to the American culture of excess, but a large part of it is due to the spending policies of the Government that seems to have credit card of their own with no limit. The monetary policies of the Federal Reserve also create business cycles through the manipulation of the interest rates and money supply.
But aside from talking about the reasons, let's talk about a solution shall we?
Businesses often calculate ratios to judge their financial health and you can do the same. Here are two of the most basic personal finance calculations:
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Net Worth - this is a value of your current financial health. It tells you what you are worth by taking into account all of your debt and your assets.
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Debt to Income Ratio - this is a value that compares your total debt payments to the money you earn. This value can help you determine if you have too much debt.
There are different Debt to Income calculations. Some include your mortgage or rent and some others don't include that information. The method used by most mortgage lenders includes your mortgage or rent payments in your debt to income ratio. You should really shoot for a ratio lower than the standard guidelines because most people that do fall within the "acceptable" range struggle with payments. Keep in mind that their range simply judges risk. They couldn't care less about your quality of life. Mortgage companies want you to pile on as MUCH DEBT AS POSSIBLE while being able to just barely keep your head above water each month. They don't want you to default on the loan but also don't want to miss out on the opportunity to make more money on the interest of a higher loan amount.
Calculate Your Debt to Income Ratio
Monthly mortgage payment (including property taxes and insurance) or rent
Monthly home equity line of credit or loan payment
Monthly car payments
Monthly revolving credit payments (furniture, appliance loans, etc.)
Monthly student loan payments
Monthly minimum credit card payments times two
Other monthly loan amounts
Monthly child support payments
TOTAL MONTHLY DEBT PAYMENTS
Monthly net (take-home) pay
Annual bonuses and overtime, divided by 12
Other annual income, divided by 12
TOTAL MONTHLY INCOME
Total Monthly Debt Payments Divided by Total Monthly Income = Debt to Income Ratio
Evaluate Your Debt to Income Ratio
36% or lower is a good debt to income ratio for most lenders but it is hard to use a single number to fit everyone. Other criteria such as the number of dependents you have, your spending habits, or other unusual expenses can affect the amount of debt you can handle.
Financial Health Score
If your debt to income ratio is:
Less than 30%: Excellent!
30% to 36%: Good. You probably won't have any problem with lenders but you should try to get it down to under 30%.
36% to 40%: On The Edge. You are a lender's dream but not in the good way. You will likely struggle to make payments and you probably won't get a very big loan, but because your debt ratio is so high, it is possible that the lender can use this as an excuse to increase the interest rates they charge you and you'll probably take it. They will make even more money off you.
40% or higher: Red flag. Nearly half of your income is going to pay debt. You are in a dangerous situation.