||Get Out of Debt Before Debt Takes It Out of You
Running up too much debt can foil the best
financial plans, so it pays to find out where you stand before you go
Without debt, it would be tough to buy a house or your
first car. Not many of us can rack up $100,000, $200,000, or more to
buy a house free and clear. With debt, you can definitely have too
much of a good thing. Mortgage payments, car payments, and credit
card minimum payments are due every month, no matter what. If you
borrow too much, you might not be able to save any money after buying
food, paying taxes, and making debt payments. When things get really
out of hand, you might end up borrowing money to buy food and that
will simply end badly. Even if lenders are willing to loan you more
money, it's a good idea to keep your debt load under
control. If you find out you're over the edge of
excessive debt, you can use common sense, discipline, and online
tools to get back on track.
Keeping Debt in Check
When you shop for a mortgage or a car loan, lenders typically check
your debt to income ratio to figure
much they're willing to lend to you. Credit card
companies, on the other hand, want you to run up balances on your
credit cards. With rates as high as 21 percent, they rake in the
dough when you maintain a balance. Paying only the minimum monthly
payment on a credit card can take years to pay off the balance, and
the interest you pay could end up being more than you borrowed in the
So, what are these guidelines that lenders follow?
- Mortgage debt to income ratio
Lenders typically limit
your monthly mortgage payment including
principal, interest, property taxes, and homeowners insurance to no
more than 30 percent of your gross monthly
income—that's your monthly income before
paying anything, including taxes and 401(k) contributions.
You can convince lenders to loan you more than that if you can show
that you've successfully handled a higher debt load.
However, it's a good idea to back your debt up with
higher savings so you can make your payments even if
you're out of work for a while.
- Total debt to income ratio
The limit for total monthly debt payments is no more than 36 to 38
percent of your gross monthly income. Total monthly debt includes
your mortgage payment, car payment, and other debt payments. Lenders
estimate your monthly credit card payment as 4 percent of any
Bringing Debt Back in Line
If your debt ratio is a little higher than the
lenders' guidelines, you can whittle it back down
with some minor adjustments to your spending. Often, you can get back
on track by putting your credit card in a drawer for a while. Studies
show that many people don't view credit card
purchases as spending real money. Try paying cash or writing checks
to bring your spending back to reality. You can also replace your
credit card with a debit card, so that you have to pay it off every
If you can only afford to pay the minimum on your credit cards each
month, you can resort to using cash advances on one card to pay
another, or mailing the wrong checks to creditors to buy some time.
At this point, you'll need stronger measures to get
back on track. Here are some techniques to reduce your debt as
quickly as possible with the minimal amount of pain:
Pay off debts with the highest interest rate first. For example, if
you carry a $5,000 balance on a credit card charging 20 percent
interest, pay as much as you can afford each month on that card,
while paying the minimum monthly payment on your 8 percent credit
card. When the 20 percent card is completely paid, use the monthly
payment you were making to start paying off the 8 percent card. When
that card is completely paid, apply the monthly payment to paying off
the 4 percent home equity loan.
After your debts are paid, you can apply the monthly payment
you're accustomed to dishing out now to savings.
Stop contributing to savings until your high-interest debt is paid
off. Paying off a 20 percent credit card interest by foregoing 1
percent on savings is like a guaranteed 19 percent return on your
money—which is a good return even for investing in the stock
If you carry a lot of debt, consider paying it off with
some—but not all—of your existing savings.
If things are really bad, you can even stop contributing to your
401(k). Because 401(k)s have other benefits, such as reducing your
taxable income and employer-matching, you should halt your 401(k)
contribution as a last resort.
If you want to know when you can start buying grande caramel skinny
lattes on your way to work again, you can prepare a more formal debt
reduction plan using the debt reduction calculator at
Before you go online, search your filing cabinet to figure out how
much you have in savings and identify the interest rate, outstanding
balance, minimum monthly payment, and your typical monthly payment
for each of your credit cards, mortgages, home equity loans, second
mortgages, car loans, any other installment loans, and other debt.
After you enter the information about your debts, the planner tells
you how long it will take and how much it will cost to pay off your
debt on your current schedule. If you want to apply savings toward
paying off your debt, select the Savings tab, type the amount of
savings you want to use, and click Save/Recalculate. To find out what
steps to take to make your plan happen, click Action Plan. The
planner includes common-sense tips such as stop charging to credit
cards, but also tells you how much to pay to each creditor each month
to optimize your monthly debt payments.
On the other hand, if lack of self-discipline got you into this mess
in the first place, you might want more help than the Quicken planner
can provide. Debt Counselors of America is a not-for-profit
organization that can help you for a small fee. You can download
their publications from http://www.dca.org or contact them to get
one-on-one help. Their One-Pay service includes working with
creditors to reduce monthly payments, late fees, and interest. You
make one monthly payment to DCA and they handle payments to your
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