Tag Archives: Debt to Income Ratio

Analyzing Personal Finances with Ratios

Financial ratios are a common tool to measure the financial health of a company.  The price-to-earnings (P/E ratio) is a ratio that is commonly referenced by the financial media.  The P/E ratio is a quick measurement for valuing a company that measures the current share price to its per-share earnings.  A company that has a high P/E ratio is normally linked to a stock that investors have high expectations for growth.  The average P/E ratio of the market is in the 25 times earnings range. A value stock will have a low P/E ratio.  Ford (F) comes to mind because it has a P/E ratio of 5.

Another common ratio is EBITDA ratio.  This is giving me a flashback to Accounting 101.  The EBITDA ratio measures revenue with earnings.  EBITDA stands for earnings before interest, taxes, depreciation, and amortization.  It is believed by many financial managers that EBITDA determines the true financial health of a business.

For a business to be successful, its management needs to take stock of its financial health.  For an individual or household to be financially successful, they too should take a deep dive and look at their metrics.  Are there financial ratios that are relevant to personal finance?

There are many different aspects to being successful in personal finance.  There are, however, far fewer variables when it comes to personal finance than the financial management of a corporation.  With that, there are far fewer ratios to measure.

What should an individual investor measure to determine if their personal finances are healthy?  For a business to be successful, it needs revenue.  On the personal finance side, income is needed.  Too much debt is negative for both businesses as well as for an individual.  One sign of a healthy company is that it has many assets on its balance sheet.  That is also true for individuals and the foundation of acquiring many assets starts with having a high savings rate.

Income

Income is what drives your personal finances.  Income is a key factor for those who are working to earn a paycheck.  It is equally important for retirees who require income-producing investments to sustain their standard of living.

To save money, income is needed.  How much should people be saving?  In the 1980’s, Americans were saving 10% on average.  That percentage has decreased over the decades.  American’s are, however, trying to get their savings back on track.  They are currently saving more than 5% on average.

While saving 10% is better than the current rate, it is not as high as it should be.  In the Richest Man in Babylon, a savings rate of 10% was suggested.  I do not know the average lifespan from 5,000 years ago, but I know that it was not as long as people are living today.

To find out if you are saving enough, the saving-to-income ratio is a helpful tool.  To determine the saving-to-income ratio, divide household savings by the average household income.  Savings include everything that is in a 401K, IRA, brokerage account, savings account, and checking.  Real estate holdings such as your house should not be used.  Income includes all earnings from a job, business, and side-gigs.

For example, Sarah is a 25-year-old math teacher.  She has $20,000 in total savings.  Her salary as a school teacher is $40,000 per year.  Sarah would have a saving-to-income ratio of 0.5.  Sarah would have a high savings-to-income ratio for age.

A good savings-to-income ratio for the average 30-year-old person would be 0.1.  The saving-to-income should increase with age.  At mid-career, a person should have a 1.7 savings-to-income ratio by age 40.  At age 50, with retirement in sight, the savings-to-income ratio should be at 4.5.  If a person is still employed at age 60, the savings-to-income rate should be in the 8.8 range.

Debt

The second factor consider is to measure debt.  As a member of the financial independence community, I view all debt as bad.  For a more mainstream approach to measuring debt, the debt-to-income ratio is a good measure.

Start with total debt.  Include both good and bad debts.  Calculate the totals for the monthly student loan, credit card payments, mortgage payments, and any other outstanding debt that you might pay every month.  Next, calculate the total monthly income.  To determine debt-to-income ratio: total monthly debt/income.

For example, Jim has $2,000 in monthly debt payments.  His household income is $10,000.  That would equal a Debt/Income Ratio of 0.2.  That would be considered a reasonable amount of debt.

A household should never exceed a Debt/Income Ratio of 0.36.  Anything above 0.37 is considered the danger zone.  It is considered the danger zone because of that ratio measures if there is enough household income to cover monthly debts and other obligations.  When the ratio of 0.36% is exceeded, there is less money to cover other expenses as well as for savings.

Savings

The last ratio is an important ratio for retirement planning.  Every personal finance blog, forum, and publication states that people need to be saving more for retirement.  How much exactly should people be saving?

The Saving Rate-to-Income Ratio is a helpful tool to determine how much a person should save for retirement.  An employer match on a 401K plan should be counted.  If an employee contributes 8% of their salary to their 401K and the employer provides a 4% match, the Savings Rate-to-income would equal 12%.

A good starting rate for a young employee who wants to retire early (younger than age 65) would want to start at 12% and try to increase their Savings Rate-to-Income Ratio by 1% per year.  If an employee is satisfied with a more traditional age of 65, the 12% rate should be adequate if it is followed for 40 or more years of employment.

That 12% does not include interest, dividends, or capital gains.  It does not include Social Security withholdings.  The 12% Savings Rate-to-Income also does not include any contributions that an employee makes to a defined benefit plan.

Conclusion

Financial ratios are a useful tool to measure and track how healthy a household’s personal finances are.    With financial ratios, they do not tell the whole story.  They should be used as a helpful tool.  They are useful to gain a snapshot to determine if income is sufficient, debt is at a manageable level, and if savings are high enough to cover future living expenses.

When you calculate the income, debt, and savings ratios, the results might be eye-opening.  If these ratios reflect that your personal finances are not as healthy as you thought, the good news is that they can be improved.  As you work to earn more, pay down debt, or save more, your efforts will be reflected in the ratios.  A 45-year-old should have better ratios than a new college graduate.

Calculate these ratios every six months.  A good time to run them is when you review your asset allocation.  These ratios are for tracking the progress you are making.  As you work to make improvements, your efforts will be reflected in these metrics.

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Debt: Reaching Step Zero

The first step in correcting a problem is to admit that there is a problem.  Prior to admitting that there is a problem, there is another step.  That is when a person reaches their breaking point and cannot go on living the way that they are living.  That is often referred to as step zero.  Step zero is when a person says to themselves “this crap has to stop”.  It is the breaking point.  It is the point where a person becomes willing to take corrective action.  They become willing to try a different approach of living because of a psychic change.

Have you reached the point where you realized that your way of managing money is not working?  Are you spending more than you earn?  Does all of your earnings go towards paying bills?  Do you have creditors calling you who want to be paid?  Do you have to borrow money when an emergency occurs?  Do you find yourself spending money that you do not have in order to keep up with your friends, neighbors, or relatives?  Do you feel broke even though you work hard and earn a good income?  Do you contribute any money to your retirement savings accounts?

Have you reached step zero? Do you want to change how you manage your finances?  Do you want to take control of your life?  Do you want to break away from the bondage of debt?  Are you at a point where you are totally dissatisfied with how you are living because of debt?

The good news is that there is hope.  It can get better.  It is all up to you.  It is based on your willingness to change.

Now that you have admitted that your way of managing your finances does not work, how should you start the mending process?

Measuring the Damage

Start by measuring the damage that you created.  Before you can move forward, do an analysis of what you owe.  My favorite tool to assess debt is the debt-to-income ratio.

To calculate your Debt-to-Income Ratio, see the formula below:

Debt-to-Income Ratio = Monthly Debt Payments/Monthly Income x 100

Example: $1000 in Monthly Debt Payments/$3000 in Monthly Income x 100 = DTI of 33%

What is considered a bad DTI Ratio?

If your DTI Ratio is higher than 36%, you are in the danger zone.  The higher your DTI Ratio is, the less money you have to cover your living expenses.  A healthy DTI Ratio is less than 16%.

Where to Start

After you know your DTI Ratio, it is time to start paying down that debt.  Start with paying off all of your bad debt.  Pay off all of your payday loans, credit cards, and auto loans.  Next, start to pay down your student loans, mortgage, and business loans if they exist.

Stop the Bleeding

Stop buying stuff you do not need on credit.  Identify what you need and only pay cash for those needs.  A few examples of needs are food, clothing, medical supplies, transportation costs, and housing expenses. Wants are fancy cell phones, cable TV, designer clothes, eating at restaurants, or any other expense that is not required to live.

Income

If you are part of a dual-income household, learn to live off of one salary.  Use the higher of the two salaries to pay for all of the household living expenses.  Use the lower of the two salaries to pay down debt.  After your debt is paid off, you can start to focus on saving money.

Get a second job.  Find a side gig to earn money to pay down debt.  If you spend your free time working, you will be less likely to spend money on stuff you do not need.

Create a budget.  A budget is a plan that allows you to break down where your earnings will be allocated based on a percentage.  For example, 25% for housing, 11% for transportation, 20% to pay off bad debts.  Once you have a budget established, all you need to do is follow it.

Recreation

Even though you have debt, you still have to live your life and have fun.  Find ways to enjoy what your local community has to offer.  Instead of going to high priced movies or amusement parks, go to local parks or free museums.  Instead of going to a high priced gym, exercise outside by walking.  Instead of going on a luxurious vacation, take a staycation.

Guilt & Shame

There is no use in feeling bad about having debt.  You have identified the problem.  Now is the time to move ahead and to make positive changes.  Having ill feelings is not a solution.

Focus on the positive and on everything that is possible once your debt is under control.  Try to take small steps and to monitor your progress.  Don’t strive for perfection.  If you have a slip, don’t beat yourself up.  Pick yourself back up and keep striving for progress.

Conclusion

Debt is similar to hiking.  Once you walk 5 miles into the woods, you have to walk 5 miles to get out.  Now that you have decided that a change is needed, it is up to you.  At this point, there is no use in looking for someone or something to blame for your debt.  You cannot change the past.  You can just pick up what is left and apply a solution.  If you learn from the situation, it was not a waste.  As you move forward, you can also use it to help other people who are struggling with their own financial issues.

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You Can Live Debt Free

Do you dream of living debt free?  As long as a person has debt, they are working for someone else.  Unfortunately that someone else is a bank.  The ticket to be debt free is to change how you are managing your finances.

Today, debt is as American as apple pie with trillions owed in mortgages, auto loans, and credit cards. Household debt in 2017 stands at $12.35 trillion.  It is only slightly lower than the 2008 figure of $12.68 trillion. The average American household owes a little above $28,535 in auto loan debts, $172,086 in mortgage debt, and $16,000 in credit card debts.

Considering those statistics,  Americans have too much debt.  To improve their financial future, debt needs to be managed more prudently.  To become debt free, people need to be educated that debt makes them a slave to creditors.  The answer is based on becoming willing to change, finding a solution, and following it up with action. 

How to be Debt Free

Most people have similar financial goals.  Most of these goals are about achieving a better quality of life.  More specific goals include becoming debt-free, savings more money, improving personal relationships, and building a secure financial future for their family. 

Of course, everybody who is in debt wants to be out of debt.  They also want to break the cycle that keeps them going back into debt.  The majority of people never learned how to be debt- free.  In high school, students learn how to cook in Home Economics, but are not taught how to balance checkbooks, save money, and invest for their future.

High-interest credit cards are one of the key factors driving people to excessive debt levels.  Wouldn’t you rather pay yourself instead of paying creditors high-interest rates?  It is possible when you implement a couple of simple practices.  By learning a new way to manage money, you will have a brighter financial future.

Steps to Reducing Debt

One option is to consider debt consolidation if you owe money to many different creditors.  This approach allows you to combined many different credit cards or loans into one simple payment.  It also helps to reduce the pressure from collection agencies if you have delinquent debts.   

While it may seem complicated now, reducing debt is quite easy and is the first step in achieving financial freedom. All you need to do is make a few small adjustments to what you are currently doing. Doing this will help shed off the debt holding you hostage to these creditors.  It might also let you pay off your debt much quicker than you thought and prevent you from going back into debt.  Just imagine how much control you will have in your life when you stop paying creditors high-interest rates just to use their money.

Imagine enjoying life instead of joining the more than 70 percent of Americans that are unhappy with their jobs because they feel disengaged, unappreciated, and overworked.  It is time you learn how to manage your finances.  Do you want long-term financial stability?  Today is a great day to change.

The Debt Snowball Strategy

The debt snowball strategy is perhaps the oldest practice for getting yourself out of debt.  It is a simple plan and it works. This popular strategy is based on ranking your current debts based on interest rates.  Focus on paying off your high-interest debts like credit cards or payday loans.  Next, pay down auto loans and student debt.  Last focus on mortgage debt.  As soon as you pay off a high-interest debt, add the same payment amount to the next loan, and continue the process until you are finally out of debt.

To find extra money to pay down debt, you have to drastically cut expenses.  This includes cutting off excessive spending on items like coffee, dining out, and vacations.  All of the money you save must be applied to deb.

This approach also requires you to stop funding retirement accounts.  Only contribute enough to capture the match that your employer contributes.  You do not want to miss out on free money.  Once your Debt-to-Income Ratio is brought down to 25%, you should start ramping up the amount that you contribute to retirement accounts.  

To calculate your Debt-to-Income Ratio, see the formula below:

Debt-to-Income Ratio = Monthly Debt Payments/Monthly Income x 100

Example: $1000 in Monthly Debt Payments/$4000 in Monthly Income x 100 = DTI Ratio of 25%

When you combine the money that you have from reducing expenses with what you were contributing to retirement accounts, you will soon realize that you can make double monthly payments high-interestst debt as you make minimum payments to other loans. 

Advantages: The snowball debt strategy works as people can free up money and pay off their debts once they follow the plan. It is also a good way of strategically reaching your desired debt-free lifestyle.

Disadvantages: The strategy requires that you reduce your contributions to your retirement accounts and sacrifice the quality of life to pay off debt. It also has a very low success rate because most people are unwilling to give up the small pleasures of life for years.

Create an Emergency Plan

When you take all that money every month and sink it into paying debts, you will be making a noticeable step towards achieving a debt-free life. However, when you run into a financial emergency or hardship, the first place you will want to turn to is to use credit cards and loans. 

Rather than using all your available money for paying debts, work on saving up three months of living expenses in an emergency fund.  Start by putting $25-$50 per week to the side.  keep this money in a checking or savings account.  By having an emergency fund, it will prevent you from using credit cards and going into debt.  Whenever you require money for an unforeseen expense, you just withdraw the funds from your bank.

Write and Follow a Plan

Write a financial plan.  Stick to your plan and use it as a guide.  Let it guide you to escape debt. It might be hard at first.  You are modifying your lifestyle.  Change is not easy, but it is necessary to make progress in your financial life.  Your written plan should spell out the steps above and include additional layers including investments, insurance, and education to make the most of the opportunities that you will be able to take advantage of after you pay off your debt.

Conclusion

While this sounds simple, it is not easy.  This is common sense information that you might have heard before.  Your debt reduction plan is your ticket to becoming debt free and it will also increase your retirement dollars. The best time to get started on this life-changing financial adventure is now.