6 Personal Finance Ratios You Need To Know

 

6 Personal Finance Ratios You Need To                                        Know 

These simple equations can help you make better financial decisions and grow your wealth — even if you're not a math wizard.

Want to measure your financial health?

Personal finance ratios, as well their closely-related cousin “rules of thumb,” are a great starting point.

In a matter of seconds, you can benchmark your current financial situation and habits to make better decisions about your financial future. 

But when it comes to measuring your personal financial health, ratios don’t tell the whole story.

In this post, we’ll take a look at a few important numbers, dates, rules of thumb and ratios that can help your improve your financial decision-making. 

The Two Financial Milestones You Should Track

 Two of the major financial milestones in your life are the date you become debt-free and the date you reach financial independence (when your investments can cover your living expenses for the rest of your life).

Tracking these dates is powerful because they take your entire financial picture into account — including your current assets, liabilities, income and expenses — giving you one number that shows exactly how you’re doing. 

Note: For getting out of debt, track the number of months it takes to become debt-free outside your mortgage. For financial independence, track your expected age to reach your goal.

With these numbers in hand, you can make financial decisions with one simple question in mind:

Will this increase or decrease my target date?

How To Calculate Your Debt Payoff Date

Tracking the number of months it will take to become debt-free should be the first thing you do on your journey to financial independence. 

But most people avoid looking at this number. Which means they never gain clarity into what they should do. 

Calculate Your Financial Independent Date

The rule of thumb for reaching financial independence is that you need to save 25X your annual expenses. For example, to live on $40,000 a year, you’d need $1 million.

Traditionally, this is outside of any other income sources (such as social security, work from part - time jobs, etc…).

While you’ll want to calculate your target financial independence date, the 25X rule of thumb is quite helpful in decision-making. 

For Example, say you have a taste for luxury cars. This may increase your expenses by $200 a month or $2,400 a year (compared to what you’d pay for a non-luxury car). You can afford it, so no big deal, right?

Well, just know that to keep this up in retirement you’ll have to save an additional $60,000.

It’s a good mental exercise to go through your expenses this way. Take a monthly expense and calculate it by 25X; that’s how much more you’ll need to save to continue to afford this expense.

Helpful Personal Finance Ratios

The Most Important Financial Ratio

What’s the most important financial ratio — the one financial ratio I always make sure to check?

My savings ratio.

This is easy to calculate:

Savings Ratio = How Much You Saved ÷ How Much You Made

For those starting out, it’s better to track this number on a monthly basis. The formula looks like this:

Savings Ratio = How Much You Saved This Month ÷ Your Monthly Income

It’s also important to define what “saving” is. My preference is to count only savings I invest.

 What’s the ideal number you should aim for? Some experts say 10%. Others say 20%.

My preference? Don’t worry about the perfect savings ratio today. Instead, start to track this number.

Then, aim to increase it. If you increase it by 1% every three months, in four years you’ll be saving 16% more than you are today.

2. Expense Ratios Of Investments

A study by the Center for American Progress found that the average 401 K plan charges a 1 percent fee. 

Another study by the ICI found the average mutual fund expense fee is 0.63 percent.

Why are these numbers important?

Look at this example, from the Department of Labour (as relayed by Nerd Wallet):

Assume that you are an employee with 35 years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.

That’s why it’s important to know about any and all fees. But they’re called hidden fees for a reason: because they’re hard to find.

3. The Emergency Fund Formula

How big is your emergency fund?

To find out, take your:

Cash on Hand ÷ Monthly Expenses = Emergency Fund

The general rule of thumb is that you want an emergency fund of at least three months but no more than six months.

An emergency fund that’s too small puts you at risk of not being able to deal with a financial setback. But an emergency fund that’s too big means you’re losing money to opportunity cost.

However, instead of worrying about rules of thumb, it’s better to answer this question:

How much cash do you need to feel comfortable and sleep well at night?

In a study titled “How Your Bank Balance Buys Happiness", researchers found:

“Having readily accessible sources of cash is of unique importance to life satisfaction, above and beyond raw earnings, investments, or indebtedness.”

Everyone is unique. My preference is to have as little as possible. I’ve gone with an emergency fund as low as one month. However, I’m a personal finance geek who likes to optimize everything.

Others may not be able to sleep well at night with just one month of savings tucked away. Instead, they may prefer six months (or even 12 months).

One tip to help you calculate your ideal emergency fund is to imagine your financial doomsday.

For Example, answer the following question:

What would I do today if I lost my income, the value of my home cratered, and my portfolio dropped by half?

By thinking through your actions in this scenario, you’ll get a clearer perspective on the role an emergency fund would play in your life.

4. The 28/36 Rule

The first thing you need to know about the 28/36 rule is that it’s not a rule used in financial planning. Instead, it’s a rule lenders use to determine how much debt you can “afford.”

The rule states that you shouldn’t spend more than 28% of your monthly gross income on housing (which includes principal, interest, taxes and insurance). Then, your total debt payments (housing + all other debt) should not exceed 36% of your income.

It’s important to look at this ratio from both a lender’s and consumer’s perspective.

For lenders, the purpose of the 28/36 rule is to determine the largest amount of debt a person can have.

In other words, the formula identifies the largest amount of debt banks think you can manage with a reasonable chance of paying it back. Remember, they want to loan you the most they can, as this maximizes the bank’s bottom line (but not your finances).

So what’s a better way to determine how much house you can actually afford?

5. How To Determine Your Asset Allocation

A general rule of thumb for asset allocation is:

Stock Allocation = 100 – Your Age

Specifically, one should invest in a percentage of stocks equal to 100 minus their age, with a bond allocation making up the remaining balance.

For example, a 40-year-old investor would invest in 60% stocks and 40% bonds.

While one can argue this advice is outdated (I would agree), it still holds some value as a starting point.

There’s clearly a misunderstanding of asset allocation among investors both young and old.

As for this formula being outdated: we have better models today to maximize return and minimize risk. Nonetheless, the ratio teaches an important concept, which is that your investing strategy should get more conservative as you age.

Final Thoughts

Peter Drucker famously said, “What gets measured, gets managed.”

Another quote of Drucker’s that’s not nearly as famous but just as true is, “There is nothing so useless as doing efficiently that which should not be done at all.”

In other words, it’s not just about tracking your personal finances: it’s also about tracking the right things and using that information to make informed and intelligent decisions that improve your life.