Math for Grownups (24 page)

For some folks, any debt is too much. And others swear that the tax break makes having a mortgage worth it. Still others haven’t seen the light and are running up their credit card balances as if someone else is going to pick up the tab.

But no matter what your personal philosophy, there is such a thing as too much debt. And it’s not just older relatives and nosey neighbors who care. So does your mortgage lender and anyone else who is considering offering you a big loan.

These creditors consider something called your debt-to-income ratio, a simple number that compares the amount of debt you have with the amount of income you bring in.

And it really is simple:

Julian would like to sell his house and move into a smaller place, but he read somewhere that lenders pay attention to a borrower’s debt-to-income ratio. He decides to see whether he has anything to worry about.

First, Julian calculates his monthly debt. His obligations include a mortgage payment ($1,068), a car payment ($347), monthly college loan payments ($289), and monthly child support ($1,146).

$1,068
+
$347
+
$289
+
$1,146
=
$2,850

Now he needs to find his total monthly income. At his job he grosses $5,900 each month, and he also gets a monthly $250 check from stock dividends. Then there’s his yearly $12,000 bonus. He divides this by 12 to spread it out monthly: $12,000/12 = $1,000.

$5,900
+
$250
+
$1,000
=
$7,150

What is Julian’s debt-to-income ratio?

For obvious reasons, Julian wants his debt-to-income ratio to be as small as possible. How small? Lenders like to see it below 36%.

Julian decides he should put house hunting on hold. Mortgage lenders might be more interested once he pays off his car.

Most credit cards require a minimum monthly payment that must be paid every month. But here’s the thing: These payments are designed to benefit the credit card company, not the cardholder.

The minimum payment is calculated a number of different ways: from 1% of the interest for that period to 4ߝ5% of the total balance. If you pay only the minimum amount each month, you’ll be playing right into the credit card company’s hands—and shelling out way more interest than otherwise. Here’s how it works.

Big Sam hates debt. That’s why he’s royally peeved at his daughter, Lucy Belle, who came home from college with $6,000 charged on a credit card.

Lucy Belle assures her daddy that as long as she makes the minimum payments, she will be back in the black in no time. Big Sam shakes his head knowingly. And after making Lucy Belle shred the card in his home office, he sits her down for a quick lesson in minimum payments.

Lucy Belle’s credit card has 16% interest, and the minimum monthly payment is 2.5% of the balance. Big Sam shows her how to figure out her first minimum monthly payment:

$6,000 • 0.025
=
$150

“Well, that’s no big deal, Daddy,” Lucy Belle says, batting her eyelashes. “If I make the minimum payment every month, I’ll be done in 40 months!”

Big Sam realizes that she merely divided $6,000 by $150.

“That’s not gonna do it, sugar,” he says, shaking his head. Lucy Belle forgot about the interest. Her $150 payment includes some of the balance and a lot of interest. And every month, her minimum payment will go down—just so the credit card company can earn more money.

Because the interest rate is 16%, Lucy Belle will pay 1.333% interest each month. So in the first month, the amount she’s paying for interest is

$6,000 • 0.01333
=
$79.98

To find out how much of the $150 minimum is going to the balance, she subtracts

$150
–
$79.98
=
$70.02

Lucy Belle’s new balance is $6,000 – $70.02, or $5,929.98. And she can find the next month’s minimum payment from that.

$5,929.98 • 0.025
=
$148.25

Lucy Belle quickly figures out her new balance in the second month.

$5,929.98 • 0.01333
=
$79.05

$148.25
–
$79.05
=
$69.20

$5,929.98
–
$69.20
=
$5,860.78

“Oh,” she says with a little pout. “I guess I need to do somethin’ different, huh?”

“Lemme show you an easier way to figure this out,” Big Sam says.

He turns on his computer and pulls up an online credit card calculator. After plugging in the information, he clicks “Calculate,” and Lucy Belle gasps. If she makes only those enticingly low minimum payments, it’ll take her 254 months to pay off her balance.

“What if I make $150 payments every month?” Lucy Belle asks. “Not just the first month?”

Big Sam enters a fixed monthly payment of $150 into the online calculator. At that rate, it’ll take Lucy Belle 58 months to pay off the balance. Much better!

Just listen to the Federal Reserve chiefs address Congress. (You know, Alan Greenspan and Ben Bernanke, the guys the president puts in charge of the economy?) Economists and bean counters love using fancy words for ordinary ideas. Your personal finances are no exception.

Take credit cards as an example.

When you pay down a loan—whether it’s a credit card payment, a car payment, or a mortgage payment—you’re doing something called
amortization
. Simply put, you’re reducing the amount of the loan by making regular payments.

When there’s no interest, this is a very simple process. Just subtract the payment to find the new balance. And to figure out the number of payments you’ll make, just divide the balance by the payment.

Things get weird, though, when you have to pay interest. And that’s one of the reasons for all of the fine print on the back of your credit card statement.

Unless you’re paying your balance off each month, each time you make a payment on your credit card debt you’re paying principal and interest. And whether you’re making fixed or variable payments, these can be shown in an amortization schedule. This is a chart that outlines the amount of interest and principal you’re paying each month—and the new balance.

This is exactly what your bank would provide for you—if you were put into a time machine and sent back to the 1950s.

These days, using online calculators, you can customize an amortization schedule with your personal details. If you want to experiment with paying off your debt—by trying various monthly payment amounts—just search for an online credit card calculator. (Try search terms like “credit card calculator.”) These tools enable you to plug in different amounts and not get overwhelmed by the math.

Hurray for technology!

Ever wonder how people know they’re millionaires? Do they have a million bucks in the bank? Do they own a million-dollar house? Do their debts play a role at all?

The answer to all of these questions could be a simple
yes
. Or not. The issue is
net worth
—and this takes into account the amount of money in savings, what is invested, property, and, yes, debt. Net worth is calculated this way:

Net worth
=
assets
–
liabilities

Daddy Warbucks adds up all of his assets—including his three mansions, his dozens of cars, the money he has in the bank and invested on Wall Street, and even the value of his dad’s rare coin collection. The total is a whopping $3.7 million.

But he has liabilities, too. These are debts, including the balance on his mortgages, taxes, staff salaries, and Little Orphan Annie’s private school tuition. That total is $2.3 million.

So what is Daddy Warbucks’s net worth?

$3.7 million
–
$2.3 million
=
$1.4 million

Indeed, Daddy Warbucks is a millionaire. And that’s something to sing about.

But should net worth matter to you? Your year-to-year net worth could be a good indication of whether you’re staying ahead or getting behind, financially speaking. So checking this out every January, or even when you do your taxes, is a smart idea.

You may be putting in 60 hours a week at the office, but retirement is in your future. That can be either a thrilling prospect or a terrifying one.

With pensions practically nonexistent and the stability of Social Security in question, quitting your career to take up golf or sit around the house watching
The Golden Girls
reruns may not be a sure thing. It’s important to develop a retirement plan—and actually save for those golden years.

But how do you know how much you’ll need to retire comfortably? There is lots of advice out there, but one thing is for sure: Doing nothing is a bad idea.

Becky loves selling houses. She loves hunting down new properties and matching them with the perfect buyers. She loves crunching numbers and arranging flowers for open houses.

But Becky loves her grandchildren even more. She’d rather spend her days on the floor playing Barbie or playing soccer in the backyard.

So retirement has been on her mind a lot lately. Her dream is to give up her real estate license in favor of trips to the zoo with little Natalie, John, and Sarah. She just needs to know how to make that happen—and quick.

Becky has not neglected her retirement savings. She’ll draw a Social Security check, but it isn’t going to cover all of her monthly costs. That’s why she’s been diligently socking away a percentage of her commissions over the years. Her investment portfolio has a value of $186,000.

But is that enough to retire on? And if not, how much will she need to save before she can say goodbye to real estate?

She signed up for a retirement savings workshop at the local community college. And while there, she learned a few things:

1. She’ll need to estimate her retirement expenses and income.
   
2. The difference of those will be her monthly shortfall.
   
3. She should have about $15 to $20 in savings to cover each dollar of that shortfall.
   

The math isn’t so bad, she thinks.

The hard part is estimating her retirement expenses. When she retires, she’ll lose some expenses, such as the cost of commuting and lunches out. But she’ll also add a few items, such as increased health care expenses.

Luckily, Becky has been keeping a budget for years. She knows that her yearly expenses are $55,000. From that, she is able to list her yearly work expenses:

These are expenses she won’t have once she retires.