Time To Go On a Diet

I know that after the Thanksgiving holiday, I always want to go on a diet….and this year is no different. However, this year I am going to go on a different type of diet – the DEBT DIET!! I am going to go on this diet prior to the Christmas shopping season so I don’t end up with bulging credit card bills just aching to be paid right after the holiday.

A few months ago, I would not have had second thoughts about taking out my credit card and splurging for gifts during the holiday season. But now with the financial crisis as a backdrop in my thinking, I feel that too much credit is dangerous to my financial health. Just this morning as I read an article in the Wall Street Journal about how the "wealth effect" impacts our spending habits, I knew that most Americans were probably feeling the same way and were contemplating ways to curb their debt habits and reign in their spending.

So how can you go on a debt diet? The solution is very simple – spend less than you earn and trim expenses where you can. Then you just need to put this into practice. First, you will need to take an honest assessment of where you are now in terms of your debt to income ratio. One of the ways to calculate your financial health is the debt to income ratio. This is determined by adding up all your monthly debt payments and dividing by your total monthly income (after tax). It should look something like this:

Monthly mortgage payment or rent
Monthly car payment
Monthly student loan payment
Monthly revolving credit (furniture & appliance loans)
Monthly home equity loans
Monthly credit card payment
Monthly child support
Total Monthly Debt Payments

Monthly net income (pay after tax)
Any other income (bonuses, etc)

Most lenders will tell you that a debt to income ratio of 36% or lower is good but I suggest working to bring it down to 30%.

So for example, you are trying to figure out if you can afford a mortgage payment of $1500 per month, you would add up all your other monthly debt payment and the proposed mortgage payment of $1500 and divide this total by 36% to get a minimum monthly income number you would need to stay in a debt range that would be comfortable for the average person.

But remember that as your situation changes you will continually have to re-evaluate your debt and income situation. If you add on additional debt, you will have to recalculate your debt to income ratio and the same goes for any changes to your monthly income.

Credit and debt are very powerful tools that allow you to buy a house or send a child to college but too much debt can pose a serious problem to your financial health. Not only do you have to keep up with your debt payments but you lose the opportunity to use money to build wealth for the future. Just like any diet, part of the answer lies in making do with less. Painstakingly cut expenses and increase your credit card payments (if you have a balance) so that you can start preparing for your future.