August 2010


The loan-to-value ratio is very simple. It’s how much you owe on your house to how much it’s worth. Obviously, it’s never a good situation to be underwater on your home, but knowing this ratio can really put your home debt situation in perspective.

First you have to get a good estimate on the market value of your home. If you’ve bought it or refinanced recently, you should have that number handy. If not, look online for a website that gives estimated market values or a listing of recently sold properties in your area to fine comparable properties, such as zillow.com.

Once you settle on your home’s estimated market value, you’ll need your total mortgage principal. Also, if you have a home equity line of credit (HELOC), you’ll need that balance as well.

The loan-to-value ratio is the total mortgage and HELOC debt divided by the market value of the property. For a healthy financial situation, this percentage shouldn’t be more than 50%. Unfortunately, this is not very realistic in the current market. If it is a conventional mortgage, with 80% mortgaged and 20% down, the ratio is already taken well above the recommended maximum (assuming you buy the home at fair market value).

If you have a higher loan-to-value ratio, you may have too much debt, which can lead to issues in the long-run. If it is over 100%, you’re underwater. But there are steps you can take to significantly improve this ratio, especially if you have a significant HELOC balance that is increasing it. Look into including the debt in a debt rollup strategy.

If you plan on staying in your home for a long time, hopefully your property value will increase and your debt load will continue to decrease. It’s also important to know this ratio before deciding to refinance or take a HELOC out.

Next week’s post will be on Tuesday in observance of Labor Day. We hope everyone has a good holiday weekend!

The Forgotten Man by Amity Shlaes is a great look at the politics and economics of the years leading up to and during the Great Depression. It takes a critical view of the politians during this time, and their handling of the situations that arose, especially President Frankin Roosevelt.

The Great Depression had a huge impact on the political and economic scene in the United States, not only during those years, but today as well. The book goes into detail about many programs that came out of the Great Depression, some of which are still in tact today (most notably Social Security). It also tells about how much economic experimentation was actually going on, and what effect that had on the state of the country. This book is an interesting read, especially if you don’t have much background knowledge of what went on “behind the scenes” during this period.

While reading, a lot of parallels can be drawn between what was happening then and what is happening now on the political and economic scene. As quoted from the book:

“So many families were defaulting on their mortgages that [Roosevelt] was now contemplating a home version of Hoover’s debt moratorium, a national plan to prevent any more Americans from losing their homes. What he felt he needed was to buy time, and if stalling on the international monetary question helped that, he would do it.” (162).

Overall, The Forgotten Man was a worthwhile read. It definitely can put what’s happening today in perspective and give you a different view of the Great Depression.

Shlaes, Amity. The Forgotten Man. New York: Harper Perennial, 2007.

The back-end ratio, or total month debt ratio, is another debt tool that can help you to decide how much debt is too much in your financial situation.

Just like the front-end ratio, you will need your monthly mortgage payment, real estate taxes, homeowners insurance, and home equity line of credit (HELOC) minimum monthly payments (if you have one). Additionally, you will need the monthly payments you make to service your other debt (car loan/lease payments, student loans, credit cards, etc). You will be using the minimum monthly payments for each debt for the purposes of this ratio.

After adding all your monthly debt payments together, divide that total by your pre-tax monthly income. Here is an example:

Again, the back-end ratio is used by lenders to determine “safe” borrowing amounts. Conventional lenders use 36% and the Federal Housing Administration (FHA) uses 41% maximum percentage. Just as with the front-end ratio, the lower the better for you. In this example, while the front-end ratio was within conventional & FHA limits (though barely), the other debt pushes the ratio well above conventional and very close to FHA limits.

The back-end ratio has many applications, much more so than the front-end ratio that can only help you with housing related decisions. The back-end ratio can be used in any situation where there is potential for new debt. Also, if your ratio is too high, you know you will need to be more aggressive in a debt pay down plan. And, if your ratio is within the limits, it can help you decide how much you can really afford to pay for a new car, etc.

This ratio also can have a greater impact on a home buying or loss of job scenario than the front-end ratio. If you have a lot of additional debt bringing you above the back-end ratio, but your front-end ratio is within the limits, you still have a problem, especially if there is an income drop.

Our goal is to introduce you to some very simple ratios to help you more effectively manage and more importantly to eliminate your debt. Next time we will introduce you to another important debt ratio, loan-to-value.

Deciding how much debt is too much can be an important factor in determining what a healthy financial situation looks like for you. There are some simple ratios that can help you determine this. These ratios are often used by lenders to determine how much money you can borrow.

We know the term ratio sounds complex, but these are very simple to figure out using your current situation. We’ll start with the front-end ratio in today’s post.

Also known as the mortgage ratio, this will tell you how much of your income is being used up by housing expenses.

First, take your monthly mortgage payment, real estate taxes, homeowners insurance, and home equity line of credit (HELOC) minimum monthly payment (if you have one) and add them together. If you pay your taxes or insurance annually, take the most recent payments and divide them by 12 to get the monthly amount.

Once you total those expenses, divide it by your total monthly income (pre-tax). This will give you your front-end ratio.

Here is an example:

As we said, lenders often look to this ratio to determine “safe” borrowing amounts, especially when you’re trying to get a mortgage. Conventional mortgage lenders use 28% and Federal Housing Administration (FHA) uses 29% for a maximum front-end ratio. This means that if the house you want to buy puts you over those percentages, you won’t be very likely to get a loan (nor should you want to!) or may be forced into paying a higher interest rate. This incremental increase in interest may not seem large to you, but over a 30 year period could result in thousands of dollars of extra interest payments. In this example, the ratio is pushing the maximum recommended. Obviously, the lower your front-end ratio percentage is, the better off you are.

Knowing this ratio can help you in a few different situations. If you’re looking at buying a home, it can help you decide what price range to look in (mortgage) and what area to look in (taxes). If you have a drop in family income (especially due to the loss of a job) which doesn’t appear to be changing soon, it can help you evaluate if you can still afford to live in your current home. And if you are looking at taking out a HELOC, it can help you determine how much you can borrow without jeopardizing your debt load.

Next post will cover the back-end ratio, which will take into account any other debt that you have.

People who have been living with major debt may have a hard time facing the reality of their financial situation. They may not want to get organized because it would mean they have to look through their financial life piece by piece and actually see how much debt they have accumulated. It’s not an easy thing to do and it’s certainly not fun to tackle that debt. But it must be tackled.

It really won’t do anyone much good to try to better their financial life without dealing with the debt they may have. And there are many ways out there to deal with paying down debt.  Each way has its pros and cons, but if you do like one over the other, stick to it! The plan we like is the debt rollup (otherwise know as debt snowball). It’s simple and will allow you to tackle debt one at a time until they’re all wiped out (though you will pay more in interest over the long run).

The strategy is as follows:

  • Pay off the smallest debt that can be repaid in the shortest period of time first (based on the balance and the minimum payment). This will then provide additional cash that can be used to pay down other debt.
  • If more then one debt can be paid off in the same number of months, pay off the debt that has the highest interest rate first.
  • All other factors being the same, it is better to pay off debts with deductible interest, such as mortgage and home equity lines last.

Simply put: pay off the smallest balance first. Starting out, for each debt you have, pay the minimum balance. For the debt with the smallest balance, decide on an additional amount you can afford to pay monthly. Since hopefully you’ve already reviewed your cash flow, you should be able to decide on that dollar amount easily. Or, if you have been paying over the minimum on any of the debts, combine that extra amount and apply it toward the smallest debt. And don’t be discouraged!  Even if it’s only $5 extra a month, you’ll still be making progress. In the meantime, try and work down some of your expenses to increase that number later.

After the first balance is paid off, you have all that monthly payment to apply to the next debt’s minimum monthly payment. And you start again.

Below is a chart of a simple debt roll up.  Included in this example is the mortgage. You may or may not choose to pay off your mortgage early; there are legitimate cases for both sides, but for the purpose of showing this strategy, we’ll include it.

The key here is never to give up. This method will work, no matter how much debt you have. However, for it to work, it is very important to not create new debt!

Once you’ve figured out your personal financial surplus or deficit, it’s time to take a look at those numbers and improve on them.

Obviously, cutting expenses is not as important if you have a surplus than if you have a deficit. However, don’t discredit the idea just because you are making more than you spend. There may be expenses that can be easily cut, or even ones that you didn’t realize you had and don’t need. If you have a surplus, you should still do this exercise and cut spending where you can to make your financial situation even better!

If you are running a deficit, especially a large one (often funded by credit cards), all non-essential spending should be cut. And we’re not saying to never buy or do anything fun, but on a normal, everyday basis, any expense you can live without, cut. If you’re trying to clean up your financial life, sacrifices will need to be made to do so, especially in the short run.

You’ll probably need to review what non-essential spending is to you because it won’t be the same for everyone. What would be considered senseless spending to some people may be a big part of someone else’s lifestyle that would happily cut something else to keep it funded.

Debt is always a tricky subject when it comes to budgeting. If you have a lot of consumer debt, especially credit cards, you should first work out a debt reduction strategy so that you can have it built into your budget. Then, as you pay it down, and eventually off, more cash will be freed up, which can be used towards other things. The debt reduction strategy we favor will be covered in next week’s post.

Next, look at essential spending. There are always ways to decrease these as well, if you have the determination to. You can reduce utilities by being more conscious of your usage or negotiate a better deal for your cable or auto insurance. It never hurts to call a company and ask; there are often deals going on that you can take advantage of, especially with media companies. You can also save a lot by cutting back on dining out and being more conscious of what you buy at the grocery store.

Typically, you should work towards living at no more than 70% of your take home pay if you enjoy giving to charity (80% if not). Once you have trimmed your expenses down, take a look at how it adds up against your income. Keep in mind, if you’re paying down debt, you final budget may not hit this target. But, if you implement a debt reduction strategy, this will change as time goes by. Don’t be too disheartened if you can’t immediately get to 70% or below.

We won’t get into what to do with the extra 20-30% today. It may take some time to work out your budget. And as we said before, you shouldn’t stop enjoying life because you’ve cut expenses. Build an entertainment and hobby allowance into your budget, but just be sure to pick a reasonable number you can afford and don’t go overboard. It’ll be there if you want it, and you shouldn’t feel guilty about using it. And if you don’t use it, the extra will become part of your surplus.

Once you decide on your budget, be sure to stick to it! And, at the end of every year, you should perform zero-based budgeting. Review all your expenses again and make sure everything is still accurate. If some of your expenses have increased, make the necessary adjustments elsewhere. This should keep your expenses from getting off track.