It's hard to go backward if you have no debt.
Peter Lynch said this in relation to businesses, but it could well be applied to your personal financial life.
There is always a cost to debt. The 24% per annum that the credit card outstanding costs you is a lot more than you will ever earn anywhere else. If you have a loan and you pay it off, there is an instant return there.
Debt can be crippling your retirement plans. It is not without reason that it is referred to as modern day slavery.
Sarah Newcomb, director of behavioural finance at Morningstar, suggests getting a reality check. Here are three easy exercises to undertake.
Check your Net Worth over time.
Add up the market value of everything you own, and then subtract the total of everything you owe. Whatever is left (even if it’s a negative number) is your net worth.
Think of it this way: If you had to pay off all your debts tomorrow, selling off assets to do so if necessary, how much would you have left over?
Watching how that number changes over time gives a simple indicator of whether you are moving forward or backward, financially.
Many people shy away from looking at their net worth because they know they won’t like what they see. Student loans, home loan, personal loan, credit card debt --- it can be very disconcerting. Yet, this vital sign gives you an indication of the level of financial freedom you have. If your debts overwhelm your assets, then financial independence will remain out of reach.
It is fine to have a negative net worth while you are in the beginning of your financial journey. And all debt is not bad; you do get tax benefits on home loans.
But in order to achieve financial independence, your assets will need to provide you enough income to sustainably cover your cost of living, including any debt payments.
Watch your change in net worth over time. Is it increasing? Good. If not, take a good hard look at your spending and debt and ask yourself if they are making you stronger or weaker overall.
Check your Debt-Income ratio
Similarly, the debt/income ratio is a measure of how much your debt load is weighing you down. Unlike net worth, your debt/income ratio is a measure of your monthly debt obligations compared with your income streams.
To estimate your DTI, simply add up all your monthly debt payments and subtract that from your pre-tax monthly income.
There are different schools of thought about what constitutes a good DTI, but if you can keep it below 30% that is great.
Quickly assess your financial situation
Put percentages when answering these questions to get a holistic view of your financial situation.
- How much are you paying your past? (Servicing debt)
- How much are you paying your current self? (Lifestyle)
- How much are you paying your future self? (Saving & Investing)
