Financial well-being is an abstract subject and it helps to have targets in mind when assessing your own financial well-being. The financial services industry is filled with rules of thumb and small snippets of advice that most people judge to be valuable. For example, you may be familiar with the so-called “4% rule” that’s peddled as an answer to how much of your retirement portfolio you can spend without having to worry about going broke. The true answers to the questions these rules of thumb are designed to simplify can be quite a bit more complicated, but they can provide a nice benchmark for you to gauge your financial health or progress towards your goals. With that in mind, I want to introduce you to 5 easy ratios to calculate that will inform you of your financial position.
1. Savings Ratio = Monthly Money Saved/Gross Monthly Income
There are exactly two things you can do with the money you’ve earned; spend it or save it. If we know how much money you’ve made, and how much you’ve saved, we can very quickly figure out the percentage of your income that you are saving. The bare minimum for this number is 10%. But the truth is saving and investing only 10% of your income is not going to get you anywhere very fast because it’s based on the assumption that retirement is your only financial goal; that’s not true for many people. The reality is, if you are a young person making an average monthly income, you should be shooting for 12-15%; if you have graduated to middle age and still have not accumulated substantial savings, you might want to start thinking about how you can save close to 15%-20% of your gross income. The logic is pretty straightforward here, the younger you are, the more time you have to let the market do the financial “heavy-lifting” for your portfolio’s growth; the older you are the less this is the case. The more goals you have that will require money in the future, the more you need to be setting aside today to make those future goals happen.
2. Emergency Ratio = Emergency Savings/Fixed Monthly Expenses
This one gets neglected by a lot of people I meet with. Many people are perpetually optimistic about our financial future; especially when we are younger. There’s always more time and more “road in the windshield and than rearview mirror” so-to-speak. But the reality is that even though your financial future may be bright, terrible things happen to good people every day whether they deserve it or not. The rule of thumb here is 3 to 6 months i.e. you want your Emergency Savings divided by your Fixed Monthly Expenses to be in the 3 to 6 ballpark. There is potentially a little wiggle room here if you have multiple streams of income or live in a multi-income household. The more diverse your income is, the less likely it is that one of them will leave you unable to meet your obligations; so if that applies to you, you can safely shoot for 3 months. On the other hand, if you are the breadwinner in your household and your entire income is dependent on one employer you should shoot for a ratio closer to 6 months. If you have far more than 3-6 months, great job! But be careful, having too much cash on hand may be hurting you more than helping you.
3. Front-end Ratio = Monthly Housing Costs/Gross Monthly Income
This is sometimes referred to as the “housing ratio” or “mortgage-to-income ratio.” Monthly housing costs include your mortgage payments, insurance, and taxes. The rule of thumb here is that you want to keep the percentage of housing costs at or below 28% of your gross monthly income. You may be thinking, “Wow, that sounds totally arbitrary; where does that number come from?” and I agree. This number comes from mortgage lenders. Banks rightly seek to protect themself from loan defaults. So from the risk departments of banks we get 28% (could be as much as 31% for some types of loans). If you can house yourself for less than 28% of your gross monthly income, you’ll be in even better position. If you’re pushing up against this level or are even above it, there are 2 things you can do: spend less on housing or make more money. Most people can’t just make more money on the drop of a hat, so consider ways to spend less on housing e.g. refinancing your mortgage to get a lower rate or get rid of that PMI. The best advice is to make sure you choose to live in a place that’s not going to eat up too much of your income to begin with, even if you have a bank or landlord willing to allow you.
4. Back-end Ratio = Housing Costs + All other debt payments/ Gross Monthly Income
This is the front-end ratio’s big ugly brother. You may hear it referred to as a “debt servicing ratio” or something similar. The calculation takes your mortgage payments along with the insurance and taxes due in your housing costs and adds to it all other debt obligations, e.g. auto loan payments, credit card payments, student loan payments, etc. The rule of thumb here is that you want to keep these payments at or below 36% of your gross monthly income. If you exceed this threshold, you’re not likely to comfortably meet your Savings Ratio which means you’re going to be treading water and losing precious time to build a portfolio. It also means that you are far likelier to default on one or more of your obligations if you have an emergency or unexpected expense.
5. Current Ratio = Current Assets/Current Liabilities
The word “Current” here means anything with a maturity of less than 1 year. On the assets side, this includes cash, CDs with less than 1 year of maturity, Money Market Funds, and the like. On the liabilities side, this includes things like credit card debt, outstanding bills, or any other debt due in one year or less. The interpretation of this ratio is how many times can you cover your current liabilities with the cash you have one hand. The rule of thumb here is that you want your current ratio to be greater than or equal to 1. The reason is pretty straightforward; you want to be able to pay off your bills at least 1 time in any given year. A current ratio greater than 1 just means you have more flexibility if your income dropped or you acquired more debt than expected.
These five ratios can act as a target for you to aim for when assessing your financial well-being. I work with my clients using ratios like these to assess their current situation and prioritize their goals. The core skill I bring to the table for my clients is taking raw ambitious goals and distilling actionable, bite-sized objectives for them to pursue. If you would like to work with me to improve your financial well-being, drop me a line in the form below!
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The National Foundation for Credit Counseling is a fantastic resource if you want to play around with hypothetical budgets. The best part is, it’s 100% free! I also, have written blog posts in the past about financial well-being, including non-financial steps you can take to improve your financial well-being.
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Erik Goodge is a CERTIFIED FINANCIAL PLANNER™ and the President of uVest Advisory Group. He holds a B.S. in Economics and Cognitive Science from the University of Evansville. Erik is a Marine Corps veteran of the Afghanistan campaign and Purple Heart recipient. He is from Evansville, Indiana, and currently lives in near-by Newburgh with his wife and daughter.