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This article comes with a big, fat warning in bold: please remember that this is my blog and I do share my opinion. This should never be interpreted as advice. Just that we are all clear about the difference, opinions are freely bestowed and should be critically assessed; advice is offered by qualified professionals and you pay for it. You should critically assess advice as well, but then this is only my opinion!
I did promise to share with you the steps I went through when faced with a big, scary debt. First, I asked you to search for the funny feeling and symptoms that can be an early warning that you have debt. Then led you, step by step, through working out your numbers. Today, I am going to tell you that working out you numbers was very well done but on its own it means very little. Numbers are absolutes and as such are not very useful when we have to make up our minds and decide on a course of action – action rests with judgement, and judgement comes from comparison. Simply put
to decide how to tackle your debt you need to work out some ratios.
There are many ratios that you need to work out to be able to take charge of your personal finance but three are particularly important when deciding on how to tackle debt: (a) net worth to debt; (b) annual income to consumer debt; and (c) monthly income to expenses. Let me address these in turn.
Net worth to consumer debt
I know that there have been voices claiming that ‘net worth’ is a deceptive measure of wealth and financial health. To a degree I would agree but mainly in that the value of your worth is insufficient to decide on action – one needs to work out also the structure of their net worth. I believe, for instance, that in the UK we share a particular structure where almost all our wealth is in real estate and pensions; this leaves little scope for making our existing wealth to work for us. But I am digressing. What matters here is that, imperfect as it may be, the value of your net wealth is important piece in the debt busting puzzle.
Calculating one’s net wealth (or worth) is, at the general level, easy. One has to use the following formula:
(Assets + Cash and savings + Non-income generating possessions + Retirement Assets) – Liabilities = Net Wealth
Specifying these categories further (and yes I do remember that assets, liabilities and possessions were discussed already):
Assets (all that brings money in your pocket) include the following:
- rental properties;
- shares, bonds and mutual funds; and
- cash value of life insurance
Assets can also include passive income stream generators like monetised websites, intellectual property rights (commercial patents, books, music etc.) but these will vary from case to case and are difficult to specify.
Cash and savings: please include all money in current accounts, saving accounts, ISAs etc.
Non-income generating possessions are:
- The house one lives in;
- Other real estate that does not generate income (like second homes, summer houses, gardens, land for private use etc.);
- Furniture and equipment;
- Recreational vehicles (caravan, boat etc.);
- Jewellery; and
- Art and collectibles
Retirement assets include:
- Employee pension fund; and
- Private pension fund(s);
- Credit card debt;
- Current unpaid bills;
Did you get all that? Well, there is an easier way to do this – you can find a useful tool here.
Once you have know what you are worth, calculate what percentage of your net worth is your consumer debt. In my opinion (and experience) anything lower than 20% can be managed with relative ease. Anything, between 20% and 40% will be stretching. Anything above 40% will need drastic measures (there is a case I know of where the option was to sell the family home, for instance).
Why is this relevant, you may ask? Because having £100K debt is such a large number that most will see it as impossible to deal with; realising that this is 5% of your net worth make it a problem (and remember, if there is no solution there is no problem).
Annual income to consumer debt
To be able to further scope the size of the problem, which will indicate the possible course of action, you need to work out the ratio between your annual income and your consumer debt. Base on observation and experience, my opinion on this one is that:
- If you consumer debt is equal to or less than 50% of your annual income* it is relatively straight forward problem to deal with and paying it off will need relatively minor adjustments to your finances and budgeting.
- If your consumer debt is up to 100% of your annual income paying it off can be a serious problem and it may need some re-adjustments. For instance, if your debt is on credit cards you may need to look at consolidation loan over a long(er) time.
- If your consumer debt is over 100% of your annual income it is very serious and you may need specialised help and may need to look at other options (e.g. Debt Management Plan (DMP), IVA or even bankruptcy).
* Annual income before tax.
Monthly income to expenses
Working out the previous two ratios is important strategically – this knowledge will help you decide on a course of action. Working out the ratio between your monthly income and expenses is important operationally and will help you decide on what to do day to day.
This is straight forward and here I’ll use ‘the only chart you will ever need’. Here it is:
Dealing with debt debt, and even in record time, you need to watch the space between monthly income (after tax) and monthly expenditure. To be able to make additional debt payments there has to be positive difference now; to be able to increase debt payment you will need to either increase your income or to reduce your spending. Ideally both with emphasis on income.
A debt repayment strategy that can’t fail; I know because we used it!
Next time I’ll be telling you about the sequence of actions when dealing with debt.