CTC tips: calculating debt

Calculating Debt

According to Nerd Wallet, the national average credit card debt is $15,607; the average mortgage debt is $153,500; and the average student loan debt is $32,656. Even if your debt isn’t as high as these averages, it can still wreak havoc on your finances.

Perhaps your debt payments are affordable. However, that doesn’t mean you’re in a financially healthy situation. Calculating your debt-to-income ratio (DTIR) can help you determine if you’re taking on too much debt. Your debt-to-income ratio is the percentage of your gross income that is tied up in debt. To calculate it, divide your monthly debt payments (mortgage/rent, student loan, credit card bills, etc.) by your monthly gross income and multiply it by 100 to get your DTIR as a percentage. So, if your monthly debt payment is $1,500 and your monthly gross income is $3,000, your debt-to-income ratio is 50% ($1,500/$3,000 x 100 = 50). Generally, anything over 36% is considered risky: a high DTIR will impair your ability to save and make it difficult to recover from a financial emergency.

Regardless of whether or not your DTIR is above 36%, total freedom from debt should be a financial goal. To start, make a list of all of your debt: their balances, interest rates, monthly payments, and due dates. Calculate how long it will take you to pay off your debts, and how much you will have paid in interest (you can find helpful calculators like this one online). Also note your annual and monthly income.

Making this list might seem like a small act, but it’s important to fully grasp the totality of your debt. Your debt can seem much more affordable when you’re only looking at your monthly payments; seeing the total numbers, especially compared to your annual and monthly income, can help you realize how big of a problem your debt is.

Risk and Return

Chart on Chalkboard

Risk and return – these are the basic concepts in the investing realm.  In order to achieve a greater return, the investor must be willing to take on greater risk.  We ask clients about their tolerance for risk, their ability to withstand the volatility and negative events that will come at some point. This is a tough one for any of us to answer or describe. No one wants to take undue risk with their hard-earned money, yet there is a fear of missing out on opportunities for gain.  It is important to understand as much as possible about the risks involved in investing, as, interestingly, understanding and being respectful of the risks creates a less risky scenario.

Howard Marks, the Chairman of Oaktree Capital Management LP, just this week put out a memo entitled Risk Revisited.  This is a detailed and interesting examination of risk that challenges some basic beliefs and reinforces others. A couple of the takeaways:

  • A widespread belief that “there is no risk” is the riskiest scenario.  When investors forget about risk and think there are only upside outcomes, peril awaits. Remember when real estate could never go down in value?  That tech stocks would only increase in value? Being risk conscious, performing extensive due diligence, being conservative in outlook and clear on the probability of outcomes is the better alternative.
  • The time to be conscious of risk is always. Given today’s low interest rate environment on the lower risk asset classes, we see money flowing into the more aggressive asset classes  as investors look for return wherever they can find it.  As prudent investors, we need to be even more so now as others leave caution behind. As Marks points out, we “move forward, but with caution,” emphasizing the caution side of the equation.
  • While we need to clearly examine the risks and control them to the extent possible, it is neither possible nor prudent to avoid all risk.  Marks makes clear that “risk avoidance usually goes hand-in-hand with return avoidance. While you shouldn’t expect to make money just for bearing risk, you also shouldn’t expect to make money without bearing risk.”

The study of risk reinforces that we cannot take all of the risk out of the equation. Outcomes are not predictable and the future is not knowable. We move forward with caution and with care.

How much credit card debt is too much?


credit card debt

Infogrpahic by Mint.com. Click to enlarge.

How much credit card debt is too much?

A few years ago, Mint asked people this question and published their results in an infographic (above). Almost half of the people who responded thought any credit card debt is too much. It’s not a surprising response: with the current average (i.e., not highest) credit card interest rate for someone with good credit at just over 17%, any amount of credit card debt can be expensive to pay off.

Thirteen percent thought anything over $5,000 was too much. At 17% interest and a 3% minimum monthly payment ($150/month), a $5,001 balance would take almost 4 years to pay off and a little over $1,800 would be paid in interest. Unfortunately, the average household credit card debt is more than $5,000 — $7,221 according to Nerdwallet. At a 17% interest rate, this could cost the cardholder almost $10,000 to repay.

So, what do you think? How much credit card debt is too much? Is it okay to carry a balance of a few hundred dollars? A thousand? Or is any credit card debt too much?

The behavior gap


In a recent article, Bloomberg writer and financial blogger Barry Ritholtz was discussing the significant difference between the returns that an investment earns, and the actual returns that investors get.  Here is an example:  As of 12/31/2013, the S&P 500 Index over the past 20 years returned on average 9.22% per year. The average equity investor earned just over half of that.

Financial Planner Carl Richards recognized this phenomenon and labeled it “the Behavior Gap.”  The gap is the return the investor didn’t capture and left on the table.  Carl Richards found that the gap was not due to poor investment choices, but by taking the wrong action at the wrong time.

A fundamental market principal is to buy low and sell high. It seems so basic and simple, but in reality, it is hard to do. People are not always rational when it comes to financial matters.  Think about the recent past.  When did everyone think about buying gold?  When gold was already up 60%.  When do we see the inflows into equity funds?  When equity funds are up significantly in value.  When the market goes down, we see worry and fear take over and people sell their holdings. In these very real scenarios, emotions are propelling investors to take action – action that results in buying high and selling low.  This is absolutely contrary to what is in our best interest.

There is talk of investment bubbles abounds in the media.  While we do not think that the equity market is overvalued, given where we are in the market, it would not be a surprise to see a correction. We are not predicting a correction or saying one is coming soon or very soon.  We simply recognize the market is not summer and sunshine all of the time.  There are those expected rainy days and cold seasons for which we should plan.

CTC tip: make IRA contributions early in the year

Calendar Planner

Waiting until the end of the year to contribute to your IRA limits your potential for growth.

A recent Money.com article reported that 70% of IRA contributions in 2013 were made near the contribution deadline. Waiting until then can cost an investor over $15,000 over 30 years: “assuming an investor contributes the maximum $5,500 annually for 30 years ($6,500 for those over age 50), and earns 4% after inflation, procrastinators will wind up with account balances $15,500 lower than someone who contributes as early as possible in a tax year.”

Year-end contributions miss out on months of growth. As such, putting $2,000 dollars into your IRA on January 1st is not the same as putting that same amount of money into your IRA on December 31st. If you contributed $2,000 into your IRA annually and receive a 5% return, here’s an example of how the timing of your contributions would affect growth:*

Years Invested Jan. 1st Contribution Dec. 31st Contribution Difference
5 $11,604.00 $11,051.00 $553.00
10 $26,414.00 $25,156.00 $1,258.00
15 $45,315.00 $43,157.00 $2,158.00
20 $69,439.00 $66,132.00 $3,307.00
25 $100,227.00 $95,454.00 $4,773.00
30 $139,522.00 $132,878.00 $6,644.00
35 $189,673.00 $180,641.00 $9,032.00
40 $253,680.00 $241,600.00 $12,080.00

As the Money.com article points out, people can have various reasons to wait until the end of the year to contribute to their IRA: some don’t have the money available to invest earlier in the year while others wait until they receive year-end bonuses. But whatever the reason may be, waiting can hurt their return.

Of course, contributing at the end of the year is better than not contributing at all. So regardless of when you’re contributing, you’re doing a great thing for your future. But if you are able, contribute early in the year — or regularly throughout the year —  instead of waiting until the end of the year to make the most of your investments.

Source: This Simple Move Can Boost Your Savings by Thousands of Dollars — Money.com

*Table taken from Kettley Concepts for Professionals (Kettley, 1999)