Measuring your Financial Health
How do you know if you’re financially healthy? Businesses use financial ratios to evaluate everything from operations to marketing to sales. They want to understand what makes their business tick and, more specifically, the areas they can improve. In personal finance, the same holds true. I constantly have clients ask me for a "grade" on their financial health. Some even ask for a grade on various parts of their financial life such as homeownership, debt, savings, retirement and investing.
With that in mind, here are 5 financial ratios that will help you grade your own financial health and find opportunities for improvement:
Monthly Savings (excluding retirement) / Monthly Take Home Pay > 5%
Monthly savings is the FUEL for your financial goals. After putting away for retirement, you should use at least 5% of your take home pay to apply to your emergency fund, paying off debt or just "get rich" money. If you don’t spend less than you make every month, the rest is irrelevant.
Remaining Mortgage Balance / Annual Gross Income < 2.5
If you’re a homeowner, this ratio will help you understand how stretched you may be with your mortgage. If you’re above 2.5, don’t panic but understand that your monthly payment is likely making a big dent in your budget (unless you’re in some crazy interest only or adjustable mortgage). You’ll need to cut in other areas to compensate. If you’re buying a home, try to stay below 2.5.
Outstanding Bad Debt (credit card, tax, 401(k) loans) / Monthly Take home Pay < 1
I hesitated putting this ratio on the list because I believe any high interest, unsecured debt (credit cards, tax debt, 401(K) loans, payday loans, etc.) should be paid off. Still, clients frequently ask “Should I be worried about my debt load?” This ratio is a simple way to look at your debt relative to your income. If you have more than 1x your monthly take home pay, make sure you have a clear plan to pay it off….soon.
Monthly contribution (including match) / Gross monthly income = 15%
After you have an emergency fund and paid off bad debt, you should target contributing 15% of gross monthly income to retirement. If your employer matches, you can include the vested portion of that contribution towards your 15%. You will need to adjust this number based on your current retirement balance – if you started saving late, time to contribute more; if you’re flush with cash, you can contribute less.
(Balance in equities / Total Retirement Balance) * 100 < Age
This is a classic asset allocation ratio based on your age. If you’re younger, you can take more risk (equities) because you have time for the money to grow. As you get older, you want to move your money to safer investments (cash, bonds, treasuries) assuming you will need it for retirement. If you have mutual funds, go to Morningstar.com, put your fund 5 letter ticker in the quote box and click "portfolio" to see how much of your money is in stocks vs. bonds/cash.
Remember, these are only a small set of the financial health ratios but should give you a birds-eye view of your status and opportunities for improvement.
What other financial ratios do you use to check your financial health? Which ratios are most helpful as you plan your financial path?