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Debt-to-Income Ratio

The debt-to-income ratio (DTI) represents the percent of your income that goes toward paying debts, and the lower the number the better. DTI can be calculated in two different ways:

The front-end DTI ratio indicates the percent of your income that goes toward housing costs. For renters this is the rent amount and for homeowners this includes all payments associated with the house—mortgage payments, insurance premiums, property taxes, and homeowners’ association dues divided by your gross income. In general, lenders recommend a front-end ratio of 28 percent or less (see the sample below.)
The back-end DTI ratio indicates the percent of income that goes toward paying all recurring debt payments, including those covered by the front-end DTI as well as other debts, such as credit cards, car payments, student loan payments, child support, alimony, etc. In general, lenders recommend a back-end ratio of 36 percent or less.

If your ratios are a lot higher than the recommended amounts look for ways to lower them. For example, if your front-end DTI is above 30 percent, it’s a signal that your housing costs are too high for your current income level and you should try to increase your income or lower your housing expenses. Or, if your front-end DTI is okay but your back-end DTI is high (above 40 percent), it’s a signal that your loans and/or credit cards are taking up too much of your income, and you could possibly benefit from a debt-reduction plan.

Here’s an example of how to calculate the debt-to-income ratio:

Charles has a monthly gross income (the amount he earns before paying taxes or anything else) of $4,000. His total housing costs are $1,200 and his total monthly debt, including his housing costs are $1,700

SOURCE	Amount	Expenses / Income	Debt-to-Income Ratios
Monthly Gross Income	$4,000
Monthly Housing Costs	$1,200	1200 / 4000	Front-end DTI = 30%
Monthly Total Debt Payments	$1,700	1700 / 4000	Back-end DTI = 43%

Credit Utilization Ratio

Credit Utilization Ratios (CUR) – We used this term in an earlier article about credit scores and how they are calculated. The three major credit bureaus all factor in the amount of credit you have available and how much of that available credit you are utilizing or using. In most cases, this makes up about 30% of your total credit score so it is an important thing to keep up with.

To find out your credit utilization simply divide your credit card balance by your credit limit then multiply by 100. For example, if you have a total credit limit of $10,000 on all of your cards and your total balances on the cards are $1,000, you have a low CUR of 10%. This will increase your credit score and lenders will love you. If on the other hand, you have total balances of $8,000, you have a high CUR of 80%. This could not only hurt your credit score but lenders will be very leery of extending additional credit to you. In fact, having a CUR of greater than 30% can start to negatively affect your credit.

Also, be aware that car loans or a mortgages are calculated based your original loan. For example, if your original car loan was for $20,000 and your current balance is $10,000 then your CUR will be 50%, whereas if you owe $18,000 it will be 90%.

The credit bureaus tend to look at your CUR in two parts. First, it scores the credit utilization for each of your credit cards separately. Then, it calculates your overall credit utilization, that is, the total of all your credit card balances compared to your total credit limits. So before applying for more credit, get your balances as low as possible and allow yourself enough time for changes to be reflected in your credit score. Remember, creditors may not report changes immediately. ps!

Make Peace With Your Past: Write Your Money Autobiography

For better or worse, how we relate to money and possessions is often heavily influenced by our early life experiences and how money was handled in our homes growing up. One of the best ways to move beyond negative attitudes and beliefs about money, or to reinforce positive ones that we learned while growing up is to acknowledge their presence and how they impact the way we view and use money. Otherwise, we could easily spend our entire lives making decisions based on things we learned as a child that are no longer serving us in a positive way.

Writing your money autobiography is a great way to uncover the origins of your money beliefs and attitudes, and outline steps to counteract those you want to change. Start the process by taking time to reflect on the questions below. Answering them will provide you with some insights into the origins of your money beliefs. Then click here to download a FREE copy of Napoleon Hill’s original book, Think and Grow Rich to really get going in a positive direction.

Money autobiography questions to ponder:
General Family History

Growing up, who were your money management role models?
Who handled the money in your family?
How did they handle the money?
Was money discussed in your family?
Was money scarce or abundant?
How did your family discuss and express generosity?

Your Personal History

What are some of your earliest memories of money?
How is your money role like your mother’s?
How is your money role like your father’s?
What were the main money messages you received growing up? Did you follow them or rebel against them?
Growing up, did you feel rich, poor, or something in between?
What was the first money you recall earning? How did you earn it? How did you spend it?
What is your biggest money success and what did you learn from it?
What is your biggest money mistake and what did you learn from it?
When you picture yourself as rich, who do you see yourself as?
When you picture yourself as poor, who do you typically see yourself as?
How much money has passed through your hands in the past 10 years? 20 years?

Your Current Family Life

Who are your current money management role models?
Who handles the money in your family?
How do they handle money?
Is money easily discussed?
Is money scarce or abundant?
How does your family discuss and express generosity?
How much money do you anticipate will pass through your hands in the next 10 years? 20 years?

Summary points

- List your top three strengths relating to money:

- List top three weaknesses relating to money:

- If you are not where you want to be financially, what do you believe is keeping you from getting there?

Finally, take all of your ideas and write them down. Be sure to highlight the attitudes, strengths, and behaviors you want to keep as well as others you would like to change. Then consciously plan ways to get going in the direction that will work best for you. ps!

What’s Your Net Worth?

To chart a path to financial independence, you need to know where you are now.

The best tool to determine your starting point is a net worth statement. Your net worth is essentially a snapshot of your general financial condition at a given point in time. As you increase your net worth, your overall wealth base also increases so it is a good idea to set goals to increase your net worth each year.

Your net worth consists of everything you own minus everything you owe. To calculate your net worth, add up everything you own (assets) and subtract everything you owe (liabilities). The result is your net worth.

Assets include cash on hand (checking accounts, savings, certificates of deposit (CDs)) stocks, bonds, mutual funds, your house and cars, the cash value of life insurance policies, retirement plans, annuities, real estate and business interests, household furnishings, antiques, jewelry, coins, and artwork. In other words, anything of value you own that could be sold. When estimating the value of your assets, don’t worry if you don’t have the exact dollar amounts. Simply write down the amount you think you could reasonably sell each item for today or the ‘fair market value.’

Liabilities include outstanding loans (student, auto, installment), mortgages, credit cards, unpaid bills (medical, utilities, etc.), and taxes you owe (income tax, real estate taxes, etc.).

If you have more assets than liabilities, you have a positive net worth, and that’s a good thing. It means that you have a good base to start with. If on the other hand, your liabilities are greater than your assets, you have a negative net worth, and while that is not the best thing, it’s important to know so that you can determine areas you need to work on to grow your net worth and your wealth.

Once you complete your net worth statement, consider any changes that might be occurring in the next year that could impact it, and then project your net worth for the coming year. For example, paying off a current debt will decrease your liabilities and increase your overall net worth. After you factor in all of the possible changes, set a goal to increase your net worth, either by a specific dollar amount or a percentage and develop a plan to get there. This last step is important because it means that you are being proactive in managing your money and setting goals to increase your wealth.

Common ways to increase your net worth include increasing your savings, increasing the return on your investments, decreasing your debt, or a combination of these so look for ways to incorporate these strategies into your overall financial plan.

Remember, conducting a net worth analysis each year not only points out where you are but it gives you a consistent way to track your wealth as it grows! ps!

Click here to calculate your net worth

Building Wealth With IRAs

One of the easiest ways to increase your wealth is through the use of tax-deferred accounts. You do not pay taxes on tax-deferred investments while they are growing and, as a result, they grow faster. Employer sponsored retirement plans like 401(k)s are one example of tax-deferred accounts, and IRAs are another. While you may or may not have access to an employer sponsored retirement plan, everyone with earned income is eligible to set up an IRA.
IRAs are a type of account that you fund with your choice of investments. There are two basic types of IRAs: Traditional and Roth. Deciding which type of account to open can be a difficult decision and one answer does not fit all. Each type of IRA account can have very different financial consequences both now and in the future so get as much information as possible before you decide. Here are some IRA basics to help you decide which one is best for you:

Traditional IRAs
• There are no income limits for eligibility. Anyone with earned income can set up a traditional IRA.
• Depending on your income and your eligibility to participate in an employer sponsored retirement plan, your contributions may be tax deductible. In general, singles with incomes of less than $65,000 and couples filing jointly with incomes of less than $109,000 are eligible to deduct their contributions. Note: Income limits for couples increase to $176,000 if they are not eligible to participate in an employer sponsored plan.
• Contributions must stop at age 70 1/2.
• Withdrawals are required at age 70 1/2, and withdrawals before age 59 1/2 may incur a 10% penalty. Taxes are due in the year withdrawals are made.

Roth IRAs
• Eligibility to set up a Roth IRA is limited based on your income. They are available to single-filers earning less than $120,000 a year or couples earning less than $176,000 annually.
• You can make contributions beyond age 70 1/2 however your contributions are never tax deductible.
• There is no mandatory distribution age. Your contributions can remain in your account indefinitely.
• Principal contributions (money you put in) can be withdrawn at any time without penalty.
• Withdrawals (including principal and earnings) are 100% tax free if you follow the rules and regulations – a benefit that could mean thousands of dollars in future tax savings.
Choosing to invest in an IRA is not just a good idea, it can help your money grow faster, and save money on your taxes as well

Note: Contribution limits for both IRAs in 2011 is $5,000 and $6,000 for those over age 50. In the future, contribution limits will increase based on the rate of inflation. While you can split your contributions between the two types of IRAs, your total contribution in both types cannot exceed the current contribution limits.

Essential Planning: Documents to Prepare and Review

Estate planning is not just for the rich or older people. It’s for anyone who wants to make life easier for those they leave behind or those who must take care of them in the event that they are unable to care for themselves. In addition, proper planning can reduce or eliminate court and probate costs, taxes, and delays in processing your requests.

Here is a checklist of six common documents to prepare and items to review:

Prepare a will. At a minimum, your will should include any special requests regarding your final arrangements, a list of your assets and who you want them to go to, and the names of the individuals you want to be the guardians of any minor children. Be sure to follow the rules mandated by your state so that your will can withstand any challenges.
Prepare a living will. This document tells your doctors exactly what kind of care you do and do not want to receive if you’re terminally ill and/or incapacitated.
Prepare a durable power of attorney for health care and your finances. This document names the person who will make medical and financial decisions for you in case you are unable to do so.
Review the ownership of your assets. What type of assets do you have and how are they titled? There are three basic ways that you can own property: in your individual name, in joint names with others, and through contract rights. Whether or not a particular asset that you own at the time of your death will need to be probated will depend entirely upon how it is titled. So review your assets and determine if they are titled appropriately for your situation. If not, make changes now.
Review the beneficiaries on your retirement accounts and life insurance policies. Make sure that they list the people that you want them to go to. Unlike many other assets, these will go directly to the named beneficiaries at the time of your death so it is very important to keep these up to date.
Investigate whether a trust would be beneficial. Trusts are legal arrangements that let you put conditions on how and when your assets will be distributed upon your death. They also allow you to reduce your estate and gift taxes and to distribute assets to your heirs without the cost, delay, and publicity of the probate court, which administers wills. Some trusts even allow for greater protection of your assets from creditors and lawsuits.

Finally, discuss your estate plans with your heirs to help prevent future disputes and confusion. Keep originals of your important papers and instructions in a secure location, like a safety deposit box or leave them with your attorney. And keep a copy in a location that is easily accessible, like a filing cabinet. Then let people you trust, know where to find these documents in case of an emergency. ps!

Don’t Forget About the Power of Compounding

It’s easy to get busy or get caught up in all that’s going on today and forget about a basic tool that has worked since forever — compounding! Fortunes have been built with this simple concept, but it does take time and patience because it doesn’t happen overnight.

Here is a story to illustrate how the concept of compounding works:

This is a story about two students – Susan and Jason. At age 18 Susan invested $2,000 and she invested another $2,000 each year for three more years for a total of $8,000. Jason on the other hand, didn’t start investing until age 30 and he invested $2,000 each year for the next 35 years for a total of $70,000. Here is my question to you, “If they each earned 10% annually, at age 65, who has the most money?”

Almost without exception, people choses Jason. But the real answer is Susan and it is due to the power of compounding. (Check out the chart below to see a year by year account.) Basically, compounding is when your interest earns interest and the longer that has to work, the more your money grows. So even though Susan invested less she had more time for the power of compounding to work.

Click here to see the details of Susan and Jason’s investments

The moral of the story: Start investing as early as possible, even if you only have a small amount. For all those people who say “I will start investing when I pay off my bills or when I get a raise,” I point them to the story of Susan and Jason. Simply put, waiting costs you money.

P.S. – It’s rumored that Albert Einstein said that compounding was the 8^th wonder of the world. If this impressed Einstein, it’s probably a concept worth keeping top of mind when it comes to saving and investing. Check for yourself. Here is a link to the Compound Savings Calculator on Bankrate.com or use the Squeeze Simple Savings Calculator. See how your money can grow. ps!