Savvy Formulas to Understand and Plan Your Personal Finances

  • Master these simple ratios to get total control of your personal finances.
  • Live better and sleep easier with these planning tools — here’s how to use them.

How do you know if you have too much debt?

First, start by examining your debt to income ratios. Then apply some common sense to your situation. Let’s do both of those things right now.

Lenders (especially mortgage lenders) look at two specific ratios to determine your credit worthiness. The first is the so-called “front-end ratio.” The second is the “back-end ratio.” Both of these ratios are figured on the basis of gross monthly income (income before considering taxes).

The front-end ratio is the percentage of your housing expenses compared to gross income. Housing expenses are made up of your monthly mortgage payment, including principal and interest plus real estate taxes and homeowner’s insurance. The total of these expenses should not exceed 28 percent of your gross monthly income. To calculate the ratio, simply divide your housing expenses by your gross income. Under no circumstance should you get into a home loan if this percentage is higher than 28. The willingness of some lenders to go to 33% was one factor in the real estate crash of 2008.

These Formulas Will Help You Take Control of Your Life

The back-end ratio is the percentage of your total debt (including mortgage debt) compared to gross income. Your total debt includes car loans, child support and alimony, credit card bills, student loans, department store credit, etc. To calculate the back-end ratio, simply divide the sum of all your debts by your gross income. If that ratio is more than 36 percent of your gross income, you clearly are carrying too much debt.

Many people got themselves into trouble with debt because they confused the idea of qualifying for a loan as meaning the same as being able to afford a loan. These are two very different things. If your total debt ratio is less than 36 percent, you might well qualify for a loan. But if your other monthly expenses are substantial, you may nevertheless be unable to afford the loan.

Therefore, you must take into consideration other recurring expenses such as groceries, auto insurance, child and health care costs, taxes, etc. For example, suppose your auto insurance is unusually high because of accidents or tickets. A potential lender might not know that and therefore the lender might qualify you for a loan. But just because you have a new loan payment does not mean your auto insurance bill will automatically be reduced so you can make the loan payment.

Tax Debt Can Be a Real Pain

One of the biggest indicators that you have too much debt is that you can’t pay your taxes. If you have withheld money from the IRS or your state tax bureau to pay other expenses, you are asking for a major league problem. Now is the time to face the fact that your debt has gone too far and you need to get on top of it fast.

Unlike other creditors, the IRS and state taxing agencies have profound collection powers that usually can be executed without a court order. The IRS, for example, can file tax liens and execute wage and bank levies without ever darkening the door of a courtroom. These problems have to be taken seriously to be resolved.

Home Equity Loans Aren’t Always the Best Option

Unfortunately, many “financial advisors” suggest that people fund various spending activities with their home equity through home equity lines of credit (HELOCs). The argument is that if you’re going to spend (or borrow) the money anyway, better to use a home equity line since the interest on such a loan is tax deductible.

Sadly, as many people found out the hard way, that’s only partially true. There are legal limits on the amount you can borrow against your home while maintaining its interest tax deductibility. I’ve met too many tax and financial professionals who do not understand these limits.

Because of the importance of – and lack of understanding about – the legal limits on borrowing home equity, I include a thorough discussion of the issue in my new book, How to Eliminate Taxes on Debt Forgiveness: A Step-by-Step Guide to Preventing and Recovering Taxes on Cancellation of Debt. To order your copy now, call 800-346-6829.

Daniel J. Pilla is a Feature Writer for Independent Living and is nationally regarded as an expert in IRS procedures. Through his more than 4,000 media appearances and the sale of his many books, including How to Get Tax Amnesty, more than 3 million people have found relief from a tax debt they were unable to pay or received sound solutions to tax-related difficulties. Dan is an official tax consultant to the National Commission on Restructuring the IRS and the National Taxpayers Union.