Do you know what your debt to income ratio is? It is probably one of the most important personal financial ratios around and is one factor in determining your credit rating, the interest rates you pay, and directly effects how much discretionary money you have to spend.
Personal Savings Ratio
Personal Savings Ratio = Monthly savings / Disposable Monthly Income
The ratio of current period's cash surplus to the current period's income after taxes. The current savings rate for Americans is 6.2% of disposable income, it was 17.3% in 1975. For most Americans, saving 10% of their income is not possible.
Most money experts believe individuals should be saving between 10% to 20% of monthly income.
Consumer Debt Ratio
Consumer Debt Ratio = Consumer Debt Payments / Monthly After-tax Income
This is the ratio of monthly consumer debt payments to monthly (after tax) income. Add credit card payments, auto loan payments, and department store account payments and divide by your after-tax income.
Consumer debt payments should not exceed 20% of your monthly take home pay.
Debt to Net Worth Ratio
Debt to Net Worth Ratio = Total Debt / Net Worth
Debt to Net Worth Ratio is a ratio that can help illuminate your financial health.
Before we can calculate Debt to Net Worth, we need to take a look at how net worth is calculated. Net Worth is calculated by taking total assets and subtracting total debts. Assets include your home, vehicles, bank accounts, 401k, IRAs, other investments, home furnishings, collections, clothing, etc.
Total debts include things like your mortgage, car loans, credit cards, student loans, home equity loans, etc. Subtracting your total debts from your assets gives you your net worth.
Next, take your total debt and divide by your net worth to arrive at your Debt to Net Worth Ratio.
This ratio is a snapshot of your financial health as it relates to debt and will change over time. As you increase your savings, assets, and investments, your Debt to Net Worth Ratio will decease.
Total Debt Service Ratio – TDS
Total Debt Service Ratio = Monthly Debt Payments / Gross Monthly Income
The TDS or Debt to Income (DTI) ratio gives lenders an indication of whether a borrower has the income necessary to cover all monthly debt obligations in addition to a mortgage payment.
TDS ratio is calculated by taking mortgage, credit cards, student loans, court ordered obligations, and other debt payments and dividing by gross monthly income.
Lenders typically will not give a qualified mortgage to a borrower with a TDS that exceeds 43% of gross income.
Gross Debt Service Ratio – GDS
Gross Debt Service Ratio = Monthly Housing Costs / Gross Monthly Income
The Gross Debt Service Ratio is a key ratio used by lenders during the underwriting process to determine how much a borrower can afford to borrow.
You can calculate your GDS by taking your total monthly housing costs and dividing by your monthly income. To calculate monthly housing costs add mortgage payments, utilities, insurance, taxes, and HOA fees.
Lenders generally require a GDS Ratio of 28% or less.
Liquidity Ratio (Emergency Fund)
Liquidity Ratio = Cash Equivalent Assets / Monthly Expenses
The liquidity ratio is one of the most important ratios of financial health because it shows the number of months an individual or family can meet current monthly expenses by tapping into cash assets ( e.g. in cases of job loss or disability). Cash equivalent assets include checking and savings accounts, savings bonds, CDs and other short-term liquid investments with maturities of 3 months or less at date of purchase.
Liquidity Ratio is calculated by taking cash equivalent assets and dividing by monthly expenses.
Most financial experts agree that individuals should maintain and emergency fund sufficient to cover 3-6 months of household expenses.
So now what? I already know I am not saving enough but what can I do?
Increase Your Income
- Concentrate first on your current job. Size up the opportunities for advancement in your current place of employment. A good place to start is the job postings. Are most of the jobs listed in areas you lack the qualifications for? If so, you may need to go back to school to acquire those skills or start looking elsewhere. This is where your networking skills can help you land a position before it is even posted so continue attending happy hour with colleagues and making your boss look good.
- Look for ways to increase your income leveraging the skills you already have. Do you have a hobby like photography that you could parlay into a part-time income?
- Be creative in looking for ways to make money. Check out Creative Ways to Make Money Online.
Lower Your Expenses
- Cutting discretionary spending is the quickest way to increase monthly cash flow. Itemize where you are spending your money and prioritize needs versus wants. Go for the easiest cuts first to gain success and then be sure to get family members to buy into the plan. A successful financial plan must start with clear goals, a realistic way to get there, and a way to monitor your progress. Use a free service like Personal Capital to keep track of your finances.
- Lower your debt payments. Refinancing a mortgage should be at the top of your list as long as you plan on staying in your home for the next 5 years and can reduce your interest rate by at least 1.5%. To get the best rates you should have a FICO Score of 740 or higher. For every 20 point drop in your score expect to pay .5% more in fees. Take advantage of balance transfer offers from credit card companies to pay off higher interest cards. Be sure to destroy the old card and do not make purchases on the new card since you will most likely pay a much higher interest rate on purchases.
- Have junior pay for his own car insurance. As more families find children returning home after college, it makes sense that they should share in the household expenses.
- Be creative in looking for ways to save money. Use coupons, rent from RedBox, delay that trip to Europe.
How about you? Do you know what your liquidity ratio is or have advice about how to improve it?