4 Steps to Managing Debt, Income and Savings

Sometimes it is easy for time to go by and we ignore our finances, hoping that any problems will go away and not wanting to see any potential for issues in the future, but this is not healthy. It could cost you now or later. You need to always be aware of your financial situation – not every minute of the day – but have a general idea as to where you stand and manage finance appropriately. Then you do need to take a closer look every few months or so, just to make sure that you are still in touch with managing debt, monthly savings and income are at.

You can do this by following the 4 steps that I outline here. It may seem like a lot at first, but when you’ve been through it once, you’ll find it gets easier.

One of the best ways to get an idea as to your financial position is to calculate your debt-to-income ratio. It sounds daunting, but it really isn’t. It is just a comparison between the debt that you have and your income. (In this case you don’t include your mortgage or rent payment in your debt.)

Let’s explain the calculation by means of an example:

Firstly, it is most appropriate to calculate this ratio on a monthly basis. So you need to determine your monthly income. This needs to be your income after all deductions (tax, medical etc.) i.e. what you take home at the end of the day. If your salary is not constant from month to month, take an average of your monthly salary over the last 12 months.

Remember that you must include all income. So if you have multiple sources of income – a job on the side, interest, rent, averages of bonuses etc; whatever comes into your pocket (minus the deductions).

Secondly you determine your total amount of debt.

Sum up all of your minimum monthly payments for all loans and credit that you have – exclude mortgage or rent payments; but include things like car payments, bank loans, credit accounts etc.

Now that you have these two figures, you can calculate your debt-to-income ratio:

Take you total monthly debt and divide it by your total monthly income.

You can make this a percentage by multiplying it by 100.

So, say the income that you take home each month is $3,000 and you pay $600 per month towards debt repayments, your debt-to-income ratio is 0.20 ($600 divided by $3,000) or 20%.

Why is this ratio really important?

This ratio is not only relevant as a benchmark, it is also helps you with managing debt and spending. If you are aware of your levels of debt and your income, you can:

• Be more discerning when it comes to making purchases
• Be informed when wanting to apply for further loans
• Prevent your debt from rising uncontrollably
• Avoid major problems with debt

Not only is your debt-to-income ratio important for you, but it is also something that lenders will consider when determining your credit status.

What should my debt-to-income ratio be?

It should be below 20%. The reasons?

• With a higher ratio you are going to find it more difficult to get further credit if you want it
• You won’t get the best terms and interest rates
• Most importantly, you don’t want to have troubles getting a loan in the case of an emergency.

If your debt-to-income ratio is above 20% now, work seriously on reducing it and keeping it low. If your ratio is below 16% you are doing OK, but always the lower the better, so don’t necessarily sit back on your laurels if you get to 15%.

To reduce this ratio and get out of personal debt you need to pay more than the minimum monthly amount on your debt repayments. This has the added bonus in that as you reduce debt, your interest rates will drop and you will have more money for other things.

Track Your Expenses

Now you need to determine on what you are spending your money.

You have three types of expenses:

• Fixed expenses – those which remain the same each month
• Varying expenses – those that differ from month to month
• Occasional expenses – those that happen every so often throughout the year

Let’s give some examples of each of these:

• Fixed Expenses: These will be monthly membership and subscriptions fees, bond repayments or rent, insurance, school fees etc. Don’t include anything that has already been deducted when you calculated your take-home salary.
• Varying Expenses: groceries, petrol, entertainment, miscellaneous items, clothing etc.
• Occasional expenses: vehicle and household maintenance, household appliance replacements, special occasions, licenses, vacations, unexpected medical costs etc. These usually occur only once or twice a year and are often rather large. You need to cater for these expenses and set aside a monthly saving for when they come around.

For the fixed and varying expenses, the best way of really seeing where your money is going is to record you expenditure for a month. Make a note of every dollar you spend – right down to parking and a small coffee. If you think you will battle to remember when you get home, carry a pen and small notepad around with you and jot down what you spend.

If a month truly seems impossible for you, try two weeks. It really is a worthwhile exercise as you’ll wake up to where you are in fact spending your hard-earned cash on things that are not a priority for you.

By the end of your data gathering period you’ll know what your fixed and varying expenses include.

When determining your monthly expenses it would be best to take an average of these expenses over a three month period.

For the occasional expenses, you need to look back over the last year and make a list of all expenses that were not regular. Estimate what these will be for the coming year and divide by 12 to get a monthly amount. This is what you need to set aside each month to cater for these expenses when they come around.

So your monthly income need is then your fixed and varying monthly expenses plus your savings for occasional requirements.

Now you come to the crucial question as to whether your income is enough for your needs. Take your monthly take-home income and subtract your monthly expenditure (including that saving for occasional needs). If the result is positive, you have money to spare – at least some of which you need to save. However, if the result is negative, you need to start cutting back or earning more.

Usually the former is easier (and quicker). The best thing to do is set up a budget. Now that you have all of the details of your income and your expenses, it will be a straightforward task. The easiest place to cut back is on your varying expenses. Perhaps you don’t need to buy lunch and can take a packed lunch with you to work.

If you were in the negative, you must continue to monitor your spending in detail to ensure that you are sticking to your goals and that you reductions are enough. Also keep a record of what you save as this makes the exercise more motivating.

The next step in the management of your finances is saving. This is extremely important for a number of reasons such as retirement, schooling, emergencies, loss of income and so on.

Experts say that you should have at least three months salary saved for “in case”. Once your income minus your expenses is positive, you need to put these extra funds away.

It’s best to setup a separate account for this money.

This may all seem like a huge undertaking, but it doesn’t need to be done every month – perhaps once or twice a year at most. The main thing is to know that you are on track with managing finances and just check up on that every so often. It is worth your while to know where you stand and to ensure that you have those savings for a rainy day.

Image credits: quaziefoto; alancleaver 2000