Calculating Your Personal Profits and Losses

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Taking a Close Look at Your Spending Patterns
Now that you have a new perspective on your installment- and revolving-loan debt and have identified your expenses as either reducible or not, look at your expenditures once more and try to spot patterns. Sort them every which way – by month, by year, by store, by category. (Yes, this is much easier if you're using software.)

For example, is the total you spent on gifts higher than you wish, even though each item seemed to be of a manageable price at the time you bought it? This is information that might help you keep a big-picture perspective when shopping for an acquaintance's bridal gift. Do you still love all of the shoes you bought last year enough to justify their prices? If so, you're validated; if not, you'll now find shopping at discount stores even more appealing.

Tip
As I've said before, don't let guilt get in the way of your progress here. If you're dismayed to see what you spent last year or last month, don't dwell on the past: Use that information to make positive changes going forward. Now that you can see all of last year's decisions together at one time and compare them to one another, you finally have the information you need to make your best choices – information you didn't have before, so it's no wonder you couldn't make those best choices in the past. Now you can!

Do You Live Beyond Your Means?
That's a loaded question, and a tricky one, too, because there are many opinions regarding exactly what "your means" are. When the question is being asked by a lender considering granting you a mortgage, lease, or credit card, he or she will answer it at least partially by calculating your debt-to-income ratio.

Basically, this calculation tells a lender how much money you'll have left to pay his or her loan after you've paid for everything you're already committed to. It would be impossible to catalog here all of the methods lenders use for determining your debt-to-income ratio: The very definition of what constitutes income and debt varies from lender to lender.

For the purpose of organizing your finances, these definitions are quite simple: Income is any money you can expect to receive on a regular basis (for example, your take-home pay and child support or alimony payments you receive if they arrive reliably), and debt is anything you are committed to paying (installment loans such as a mortgage, revolving loans such as credit card payments, and child support or alimony that you pay). Debt does not include expenses such as utilities or groceries; these are living expenses – not loans. Add up your monthly debt payments, divide by your monthly net income, and you have your debt-to-income ratio. The figure below shows the simplest way to calculate your debt-to-income ratio, which tells you how much of a financial safety net you currently have. Keep in mind that this figure is useful for your information, but it probably won't match what a lender would calculate if you applied for a loan.

Experts tend to agree that you can breathe easy with a debt-to-income ratio below 10% and that you're still fairly safe up to 20%. Knowing your debt-to-income ratio can help you to make prudent choices when you're in the market for a new home or vehicle. Having already calculated this ratio your way, you can make a more informed choice if a lender uses her own method of calculating your debt-to-income ratio and offers you more money than you know you can afford. Remember, lenders often allow you to take on more debt than you should. It's up to you to set prudent limits for yourself.