Carrying debt can eat into your income and keep you from meeting your financial goals. From owning a house to early retirement, and a whirlwind trip to Europe to owning a boat, it is impossible to see your financial future in a positive light when you are unable to save due to debt. You have to consider your finances constantly and focus on the ultimate goal of earnings either staying in your bank account or growing with a particular goal in mind. The key is to set financial priorities so your day to day expenses are always covered and you can ultimately build up your savings. By setting financial priorities, you can focus on saving for your future to meet your financial goals. Here’s how to measure your debt risk so you can manage your finances wisely.

Measuring Your Debt-to-Income Ratio

Most people are unaware of just how much money is going towards repaying debt. Your debt-to-income ratio allows you to keep track of this important number so you always know when you are paying too much towards debt.

This number is important because it shows you the relationship between your monthly income and how much money you owe. It also shows you how much trouble you are in financially. Your debt should never be more than 30% of your income. By assessing this number on a regular basis, you can spot when debt is rising, and make an effort to avoid using credit cards or applying for further loans that will lead to financial woes.

Your debt-to-income ratio equals the monthly total spent on debt repayment divided by your total monthly household income.

Don’t forget to include any additional income you might receive such as child support, tips, or part-time work, as well as anything from the government. Your debt includes:

• Credit card payments
• Car payments
• Student loans
• Bank loans
• Mortgage payment or rent

Measuring Your Coverage Ratio

This number is very important, as it will show you how long you will be able to cover your expenses without using credit. Depending on credit now, means you will be in trouble should you have a financial emergency. We advise having at least two to six months of savings to cover your living expenses should you lose your job. These funds also allow you to cover unexpected expenses such as major home or car repairs.

You must consider all of the earnings coming into your home and even how much credit you have available should you need to use it. Your coverage ratio equals liquid assets divided by total monthly expenses.

Your liquid assets are the funds you can access as cash, such as your savings and chequing account. Although you might have other assets, such as long-term investments or even your home, they do not provide immediate cash so are not considered liquid.

Measuring Your Current Ratio

This is a scary number, as it will give you an often startling view of how long it will take before you start to default on your payments should you lose your source of income. This can be a real eye-opener. It’s an important number because once you are unable to make payments, your life will become very difficult. You can even face the possibility of losing your home, car, etc. if you default on payments.

You should never be lower than 50%, as this provides you with six months of resources to cover your payments.

Your current ratio equals liquid and saleable assets divided by one year’s total debt payments.

In this case, you can include all of your assets such as your home and long-term investments.

Measuring Your Demand Debt Ratio

Not everyone will have to worry about this ratio as not everyone has “demand debt”. It is called demand debt because the terms allow the lender to demand payment when they see fit. This debt doesn’t have a fixed payment plan. The loans that are considered demand debt include lines of credit, home equity lines of credit, credit card debt, and payday loans. Fixed loans, on the other hand, are loans where you are expected to make a set payment by a set date, which would be your mortgage or car loan for example.

This is an important number, as it tells you if you will be able to rid yourself of the debt should the lender come calling. Your demand debt ratio equals liquid and saleable assets divided by total demand debt.

As above, you can include both your liquid and saleable assets. To put things in perspective, if you have a demand debt ratio of 50%, this means you only have half the money needed to repay your demand debt.

How to Use Your Debt Ratios

Once you calculate all of your debt ratios, you can begin to take better control of your finances. If you are sitting pretty, make it your goal to keep it that way. The less debt you carry, the better off you will be and the closer you can get to your financial goals.

Your goal should always be to reduce debt and increase savings, so you are always able to handle your expenses even in the case of job loss. If you have an unstable job, own your own business, or are self-employed and your measurements show you at higher risk, then do everything you can to increase your emergency funds. This means having an effective plan to pay down debt and avoid carrying further debt in the future.

In the case of high demand debt, your goal should be to set the highest possible monthly payment towards paying it off. This type of debt tends to be extremely expensive to carry due to interest rates, and it also puts you in more danger of default. If you are just paying the interest every month, you will never pay off the money owed and it will cost you thousands or even hundreds of thousands of dollars without putting a dent in your balance.

Your worst-case scenario is getting into the habit of requiring payday loans or using credit cards and lines of credit to pay off existing debt and cover your monthly expenses.

Before you get into a situation where debt is bogging you down, speak to a Licensed Insolvency Trustee at Charles Advisory Services. Our team can help eliminate debt and get you back onto a healthy path towards financial freedom. Call (416) 915-9007 or contact us here.