The latest and greatest fad in personal finance is “balance sheet repair.” So, what is balance sheet repair, and does your balance sheet need to be repaired?
First, what is “balance sheet repair?” It’s one of those delightful phrases you hear bandied about when someone wants to sound smart and informed, but ends up being a little ambiguous. What balance sheet repair means is that debt is being reduced and that assets are being increased. So, if you pay off some of your credit cards and save some money in your emergency fund, then your repairing your balance sheet. The phrase also implies that you had an undesirably high level of debt or low level of savings in the past, but you’re fixing it now.
Perhaps you remember Balance Sheet Repair In Action, where I took a look at U.S. household debt reduction. Research suggests that, when household wealth decreases, household savings increases, which we’ve seen a lot of, these last few years.
So, how do you know if your balance sheet needs to be repaired? There are some long-standing rules of thumb for that. First, compare your debt payments to your gross income. This is called the debt-to-income ratio. It’s really easy – take a piece of paper and sum up your monthly debt payments. Then, compare the total of your payments over your monthly gross income, like this: $150 in debt payments over $2,500 in gross income per month.* That would mean 6% of your gross monthly pay goes to service your debt. Is that bad or good? The rule of thumb is that you debt-to-income ratio should be 28% or less. This rule comes from the mortgage industry, where conforming loans require that the debtor have a debt-to-income ration of 28% or better.
If you’re not happy with your numbers, how can you repair you balance sheet? There are two methods: increase assets or decrease liabilities. You can increase assets very reliably by saving more or increasing investment contributions. You can decrease your liabilities by paying them off (here are some suggestions for paying off your debts.)
Repairing your balance sheet takes time, but with diligence, persistence, and a little luck, you can get your finances in good order.
* Gross income is the amount you are paid before any taxes or deductions. It’s usually the top line on your pay stub.