Tips & Advice

Debt to Income Ratio

The ratio is calculated by dividing the amount of debt payments per month by the monthly gross income  .

 

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Credit Cards | Affordable Debt | Making Minimum Payments |  Debt Relief Options

  Credit Cards

A "credit card" offers immediate access to services and merchandise to consumers who may or may not be able to make the full payment at once. Credit cards allow consumers the flexibility and leverage to make purchases with the promise of paying later. When used properly, credit is an ideal financial tool. Today's consumer can benefit significantly from the convenience of credit. Credit cards offer such benefits as frequent-flyer miles and cash-back bonuses, and are especially useful for large purchases, emergency situations, identification, reservations, and protection from fraud.

When used foolishly, credit can cost a lot of money in interest and fees. Unfortunately, millions of consumers misuse credit cards beyond their financial means. The misuse of credit results in costly interest payments and late fees, impulse buying, overextended lifestyles, and unnecessary stress such as harassing telephone calls from collectors. This can also hurt an individual's credit rating, which ultimately hinders their ability to purchase homes or cars, and also endangers their future financial stability.

Credit card holders also mistake cash advances through credit cards as free money. In fact, consumers must pay back the cash advance amount at a typically high interest rate, as well as a cash advance fee. For example, an individual who takes a cash advance of $500 will ultimately pay back more than $600 within one year, if all payments are made on time. (If any payment is late, late fees or higher interest rates may also be applied.) People sometimes take out cash advances in order to pay off existing credit card balances. This is nothing more than a temporary solution to credit woes. In reality, this method of paying bills is one of the worst financial decisions a consumer can make, as it compounds the problem. In the end, the borrower will end up paying off the new debt at a higher interest rate, thereby losing even more money.

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Affordable Debt

Learning the Debt-to-Income Ratio is very important. The ratio is calculated by dividing the amount of debt payments per month (excluding mortgage or rent) by the monthly gross income. For example, the debt-to-income ratio is 20% for someone who earns $2500 per month and pays $500 per month in credit card and loan payments (500/2500 = .20 or 20%). As a general rule of thumb, a personal debt-to-income ratio of less than 20% is considered safe. A ratio higher than 20% may be a sign of future financial trouble. Ideally, individuals will carry little debt so that their income can be saved, invested, or spent on something of lasting value, rather than spending their disposable income on interest and late fees.

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Making Minimum Payments

Consumers often mistakenly believe that making a minimum payment on a credit card is a reasonable financial move. In reality, minimum payments make only a very small dent, if any, into the original amount borrowed, which is called the principal. For example, Consumer A has $5000 in debt on a credit card that carries a 24 percent interest rate. If the creditor requires only a minimum monthly payment of 2.5 percent, or $125, only $25 would be applied to the principal. At that rate, it would take nearly 18 years, and cost over $21,000 in interest alone, for the individual to pay off this $5000 debt.

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Debt Relief Options

One option is to contact a Consumer Credit Counseling Agency, like AAA Cook County Consolidation. Agencies can identify the consumer's problem through a budget analysis. Then attempt to negotiate payments and lower interest rates to come up with a comfortable payment that will satisfy both parties.

There are instances, though when individuals may wish to consider borrowing more money to consolidate their debts into one payment. An example is an unsecured debt consolidation loan, which pays off your creditors in full, and then you are required to pay off the loan amount at a fixed rate to the Consolidation Loan Company. However, since you are borrowing more money to pay off your current bills, you are never really getting out of debt. Once your original credit card balances are paid off, you still owe the same amount of money to your loan company.

Another possibility that comes with some danger is a home equity, or secured, loan. What many people fail to realize is that by taking a second mortgage or home equity loan to pay off credit card debt, families may be putting their home at risk. The home serves as collateral to secure the loan, and can therefore be taken away if they default on their payments.

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