Do’s and Don’ts While Your Loan is Being Underwritten

Do’s and Don’ts While Your Loan is Being Underwritten

Have you ever wondered how much debt you can accumulate – so much debt that you can never get out of debt?

Actually, this is the wrong question to ask. The question you should ask yourself is, “Do I have the disposable income to make more than the minimum payments on my existing debt?

The key to getting out of debt is to pay more than the minimum payment each month – and to do this, you need unallocated disposable income.

Income allocation – what it means

No matter how much your household income, you can find general guidelines on how to allocate it. These allocations are based on percentages – meaning, you can easily apply them no matter how much you earn.

The bullet points below shows a simple income allocation based on three basic categories. For this chart, allocation is assumed based on net, or after tax, income:

  • Essentials – In this category is shelter (rent or mortgage), food, transportation (gas, public transportation, etc.), and utilities (gas, water, electricity). Because these are essentials, they get the bulk of your income allocation or 50%.
  • Necessary – In this category are those items that are necessary, but not essential, such as insurance (home, auto, medical, etc.), savings, loan payments (i.e. vehicle, short-term loans), and childcare. For this category, allocation is 30% of after-tax income.
  • Disposable – In this category are those things that can seem essential, but are really “nice to haves” and thus are considered part of the “disposable income” allocation, including, clothing, phone plans, gym memberships, Internet and cable, eating out, vacations, home improvements, etc. For this category, allocate 20%.

As you can see, more than half your income is already spoken for with regard to the “essential” and “necessary” items of life. Which brings us to the “disposable income” category – where you have the most play.

It’s here that the question, “Do I have too much debt?” can be answered. Let’s look at two scenarios.

Scenario #1: $150K Household Income

For a couple earning $150K a year, $15K in debt might not be that big of a deal. Because it’s easy to work with round numbers, let’s break down their income this way:

Monthly income after tax: $9,000
($150,000/12 = $12,500 x 28% tax bracket = $3500 in taxes)

And, let’s say they have a $2,500 a month mortgage and $15,270 in debt, which is the average household amount, according to data found on Nerd Wallet.

Plugging these numbers into MSN Money’s Debt Calculator shows that their debt payments, not including mortgage, represent $305 or 3.4% of their disposable income.

The Debt Calculator deems this debt scenario “reasonable.”

In fact, by paying more than double on their debt, or $750 each month, this couple can pay off that debt in 24 months – according to MSN Money’s handy Debt Payoff Calculator.

We can conclude then, that if this couple doesn’t add to their debt, they have savings, and they continue working, their $15K in debt isn’t “too much” for them to handle.

Scenario #2: $51,371 Household Income

The U.S. median household income for 2010, according to the Census Bureau, was $51,371. Using this income, plus the same formula from Scenario #1, we get:

Monthly income after tax: $3,638
($51,371/12 = $4,280 x 15% tax bracket = $642 in taxes)

Let’s say this couple has a mortgage of $1500 a month and they have the average $15,270 in debt.

As the Debt Calculator shows, this couple’s debt payments of $305 a month are 8.4% of their disposable income. Coupled with their mortgage, this couple may have trouble meeting their financial obligations.

If they pay only the minimum payments, it will take this couple five years to pay off their credit card debt – assuming they don’t add to it – according to the Debt Payoff Calculator.

Amount of unallocated disposable income is key to paying off debt

While both of these calculators are good at helping you do the math with regard to debt, what they don’t do is help you see why having too much debt can tip you over the edge of a deep dark financial hole.

When you begin allocating more and more of your disposable income to finance credit card debt, you then begin cutting back on the “Necessary” and “Essential” categories in order to meet expenses.

Savings usually is the first to go. When you stop saving, you lose the ability to meet unexpected financial obligations with cash.

For example, if your car breaks down, you don’t have the cash to pay for this expense – so you put it on your credit card. Or, you just had a really hard day: your boss yelled at you and traffic was bad and by the time you get home, you’re dead tired so you call out for pizza – which goes right on your credit card because you lack cash.

These expenses add to your debt, which increases your monthly payment, which decreases the amount of disposable cash you have each month – and the vicious cycle repeats.

Over time, you have so much debt you have no way of paying it off. The hole just keeps getting deeper and deeper.

If you must carry a credit card balance, my advice is to ensure your debt, excluding mortgage, is no more than 10% to 15% of your after-tax income.
If you believe like you have too much debt, you can get help from American Consumer Credit Card Counseling, a non-profit organization that works with consumers to manage and pay off debt.

Or, if you you’ve been considering a refi in order to free up cash, give us a call. One of our loan officers will be happy to discuss your options with you.