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| Columns |
| Your Personal Finance |
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by
Thomas Munthali, 23 July 2006
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04:14:00
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Are your debt levels healthy?
One day, I was going through the music archives in our humble abode and came across one of my wife’s favourite songs, ‘Achimwene musaope ngongole, mukaopa ngongole mudzagona ndi njala’.
It then struck my mind to write something on how one can know if s/he is having too much debt or is within the limits. If it is too much, how does one force his way out?
To begin with, one should only avoid debt when it is having negative externalities on the individual’s life (both private and social). Borrowing solely for consumption, in my opinion, is a fool’s option but borrowing for productive purposes is a wise person’s best way of stealing from fools.
My advice for those who wish to get out of debt is to first do the following:
—Assess your financial situation
—Analyse whether you are borrowing to consume or produce more
—Be ready to seek help when you need it
—Always make sure you have a rationalised budget and cut unnecessary costs
—Whenever possible, avoid credit
Now each of the pieces of advice above warrants a full discussion of its own. However, let us start today by finding out how one can assess their financial situation.
Getting out of debt and staying out of debt is simple. All it takes is spending less than you earn, but although the solution is simple, putting it into practice is hard for many people. The first step is assessing where you are right now.
Businesses regularly calculate key ratios that indicate their financial health, and so should you. Two of the most basic personal finance calculations are the net worth and the Debt to Income ratio. Don’t be scared with the terms, you will find them very easy to grasp.
Firstly, let us look at the net worth. Net worth is the difference between all the things of value that you own (assets), and all the debts you owe (liabilities). In financial terms, your net worth is your assets minus your liabilities.
If you have more assets than liabilities, you have a positive net worth. This is a good thing. If you have more liabilities than assets, you have a negative net worth. This is not such a good thing, but it’s information you need to know. For a general idea of what your net worth should be, based on your age and income, the authors of “The Millionaire Next Door” recommend that you multiply your annual income times your age and divide by ten.
While the results are interesting, take this information with a grain of salt, since it’s simply an average and doesn’t take specific personal situations into account.
Calculating your net worth is fairly simple in concept. First, list the things of value that you own, starting with:
—Cash and cash equivalents, such as money in your pillow, bank deposits, money that friends ( and possibly enemies) owe you
—Investments, such as stocks, bonds, mutual funds
—Real estate, including your home, if you own it, and any other real estate or personal property such as wheelbarrows, cars, bicycles
—Household goods such as furnishings, jewellery, antique. Use the estimated fair market value, which may be more or less than what you paid for the item. Fair market value is “the price a willing, rational, and knowledgeable buyer would pay.” For cars, use the blue book value.
When you’ve listed everything you can think of, total your assets.
Next, list your liabilities, or amounts you owe others, starting with your
—Loans, including your lobola balances, if you have a wife from the north or lower shire, student loans, bank loans, car loans
—Taxes owed, such as city rates
—Any miscellaneous amounts that you owe others e.g. credit with your local bar.
When you’ve listed everything you can think of, total your liabilities.
Now subtract your liabilities from your assets. Is the number positive (you have more assets than liabilities)? If so, give yourself a pat on the back and start planning on how to increase your net worth. If the number is negative (more liabilities than assets), don’t despair, for we will be discussing how to have financial health in our subsequent discussions.
Secondly, is calculating your Debt to Income Ratio, which is your total debt payments compared to how much money you earn and tells you if you’re carrying too much debt. Your Debt to Income Ratio is nothing other than your Total Monthly Debt Payments divided by Total Monthly Income.
Most lenders will tell you that a 36 percent or lower debt to income ratio is good. In reality, it’s difficult to apply a one-size-fits-all formula to everybody. Your personal situation, such as number of dependants, unusual expenses, and spending habits will affect how much debt you can reasonably handle, but as a general guideline, it’s universally assumed that anything over 36 percent would be uncomfortable for the average person.
The Debt to Income Ratio is a very important measure and should act as your financial barometer. Deborah Fowles, a financial planning expert, points out that if your debt to income ratio is:
-Less than 30 percent, then that’s an Excellent for you!
-30 percent to 36 percent: Good. You won’t have any problem with lenders, but work to bring it down below 30 percent.
-36 percent to 40 percent: Borderline. Some lenders will still give you ‘katapila’ but you may struggle to make your payments.
-40 percent or higher: Red flag. Your credit situation requires attention.
-Feedback: tbmunthali@yahoo.co.uk |
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