Analyzing our personal financial data involves many ratios but today I will discuss three very important ones: the Emergency Ratio, the Housing Ratio, and the Debt Ratio. These three ratios are related to short-term savings and investments and assist in the evaluation of your emergency fund, income spent on housing, and income spent on debt and housing together. Using these ratios can help you evaluate your ability to meet short-term obligations and also how well you are managing your overall debt level.
I use these three ratios in my daily life as a roadmap to follow so I remain on track to meet my financial goals. Whenever I evaluate my finances, I begin with these ratios and remind myself that I need to remain within specific parameters to help ensure my overall financial health and independence.
The Emergency Savings Ratio: [i]According to Fundamentals of Financial Planning by Michael A. Dalton, the benchmark used to calculate an adequate emergency ratio is between 3 to 6 times your monthly non-discretionary cash outflows. Non-discretionary cash flows are those expenses that must be met regardless of loss of income, for example, your car payment, mortgage, electricity bill, etc. These bills still have to be paid if you lose your job. The role of this ratio is to evaluate your family’s safety nest egg in the event there is a loss of income. The best way to identify this number is by simply adding all of your non-discretionary monthly expenses and multiplying by 3 to 6; this will give you the amount you should have set aside for emergencies only.
The Housing Ratio: [i]Fundamentals of Financial Planning by Michael. A. Dalton suggests that your mortgage payment, including principal, interest, taxes, and homeowner’s insurance (PITI), should not exceed 28% of your gross pay. In order to calculate this percentage, you must divide your total PITI by your monthly gross pay (before taxes). For example, with a gross salary of $50,000/year and a PITI of $1000/month, the housing ratio would be calculated as follows:
$50,000/12 = $4167 monthly gross pay
$1000/$4167 = 24% housing ratio
In the above example we have a 24% housing ratio, which is below our 28% threshold. We have accomplished our goal and stayed within the guidelines successfully!
The Debt Ratio: The Housing and Debt ratio includes the total paid in housing (PITI) plus any additional debt payments. [i]The benchmark followed by Michael A. Dalton in Fundamentals of Financial Planning is a suggested maximum of 36% gross pay. Additional debt would include any recurring debt payments such as credit cards, car payments, student loans, etc. Let’s review a quick example to examine the debt ratio.
$50,000/12= $4167 monthly gross pay
PITI = $1000/month
Additional Debt Payments = $500/month
($1000+$500 = $1500)/$4167 = 36%
The above example gives us exactly a 36% debt ratio, which is the suggested maximum we like to see, according to the benchmark discussed earlier.
Understanding the significance of the ratios discussed above may encourage you to apply them to your family’s budget and help you stay the course toward financial independence. Additionally, knowing that your family’s immediate needs are covered for several months in a time of need may help you sleep better at night.
Feel free to contact Katherine Sojo with any questions by phone 305.448.8882 ext. 243 or email: KSojo@ek-ff.com
[i] Michael A. Dalton Joseph M. Gillice, Thomas P. Langdon, Fundamentals of Financial Planning (2011), Second Edition, Page 59.