One of the most important tasks within the financial planning process is measuring progress over time. Collecting this information helps determine the distance between a current financial planning position and one’s personal finance goals and objectives.
In order to accomplish this, financial planners use ratios derived from simple calculations.
Creating your financial planning statements beforehand will ensure that you have all of the information you need to calculate the following financial planning ratios. However keep in mind that these ratios are not an absolute pass or fail.
There are additional factors such as age, stage in the life cycle, economic environment, personal goal and family size that need to be considered when analyzing your financial planning ratios. The trends over time are the most important consideration.
Savings Rate Ratio
The long-term financial health of any individual and family depends on having a good savings rate. Calculating your savings ratio is simple. First determine how much money you saved over the last year. Next determine your income level in the same period, I suggest using after tax income (you can’t save what you don’t receive). Finally divide your annual savings by annual income.
So in essence, your savings ratio is how much money you save on an annual basis as a percentage of income. A healthy savings ratio is around 12-15%; of course the higher the better.
Housing Expense Ratio
For most of us, housing and all of the expense that come with it, is our largest expense. This is to be expected as our homes are our castles, its where we live, raise our children and lay our heads, you deserve to enjoy your home. However it’s also important that when we purchase a home we don’t get carried away.
One of the best ways to determine how much housing you can afford is by calculating your housing expense ratio. To calculate this ratio all you have to do is determine your total housing expenses (mortgage, rent, utilities, insurance, etc.) in a month and divide it by all of your total gross income for the same period. This ratio should be no more than 28%.
Debt to Income Ratio
This ratio is one that banks and mortgage companies use in order to determine one’s eligibility (default risk) for loans, specifically mortgages. It is because of this that this ratio (or the financials that it measures) is as important as your credit score.
The debt to income ratio measures the percentage of monthly income that goes towards paying expenses such as car loans, minimum credit card payments, student loans, mortgage payments and other non-discretionary expenses. To calculate your debt to income ratio, determine your monthly debt payments and divide it by your gross monthly income. A healthy debt to income ratio is no more than 36%.
These are the three personal finance ratios that I find to be the most critical. Remember that if you find that your ratios are not close to the recommended values, there is no need to panic. The best solution for this is to watch your financial planning ratio trends. Analyze your ratios on a month to month or year over year basis. If your ratios are not improving it might time to focus on your budget.