Imagine that you’re planning a road trip to Chicago. How would you get there? What’s your estimated time of arrival? Your answers to these questions will depend on the answer to another question: where are you now?
Essentially, all financial goals are a desire to get from point A to point B. But before you can figure out how to get to point B, you need to figure out where point A is. This requires a review of your current financial state, as well as an honest look at your spending and saving habits.
There will likely be things that you won’t be happy with, and that’s okay. In fact, that might be healthy for you: being content with poor money habits can keep you trapped in bad financial situations. So if you’re not happy with any part of your current financial situation, use that as motivation to get out of it!
So how do you figure out where you are right now? Start with these three things:
A net worth statement
Simply put, a net worth statement is the total of all your assets (financial accounts, real estate, investments, etc.) minus your debts (student and car loans, mortgage, credit card debt, etc.). This will give you a snapshot of your current financial state.
Your cash flow is a report that shows your income versus your expenses and spending. Ideally, you want to have a positive cash flow: if you don’t you’re losing money. Choose a period of time to track the money you make and the money you spend (e.g., create a monthly cash flow report for three straight months). Include bills, debt payments, groceries — everything.
It’s very important to know where your money goes; you can only make changes to or improve the things you know.
Debt-to-income ratio (DTIR)
Your debt to income ratio is your monthly debt payments divided by your gross monthly income. In other words, it shows you how much of your gross income is already claimed by debt. There are two good reasons to calculate your DTIR: firstly, lenders are interested in your debt-to-income ratio. If your DTIR is 30% or less, they are more likely to lend you money at a decent interest rate. If you are planning on borrowing money for a mortgage, for example, calculating your DTIR can help you determine if it’s safe to take on more debt without first reducing your current debt.
Secondly, your debt-to-income ratio can show you just how much your debt is costing you. The individual payments may seem affordable, but if your DTIR reveals that debt is consuming half of your gross income, it can explain some or perhaps even all of your financial troubles.
So where are you now?
Once you have your financial goal, you have to figure out a way to get there. But even before that, you have to know where you’re coming from. Use the above tools to establish your current financial situation so you can create a more accurate and effective financial plan.