Sometimes good financial advice can start out broad to address a goal. It may sound something like this; “Let’s try to increase the amount you are saving for retirement” or “We want to be careful with how much debt we take on”. Previously we’ve written about how our goals need to be measurable and this is no exception. So how do you measure progress towards some of the broadest financial goals? One answer is to lean on financial ratios for guidance.
In Part 2 of “Getting Your Financial House in Order”, we will be discussing several different financial ratios, how to calculate them, and how they affect you in the real world. This is another action you can take while at home and track over time to see your progress. Break out the calculator on your cell phone and let’s get started. (Read Part 1)
Your savings ratio, sometimes called savings rate, is the percentage of after-tax income not spent.
(After-tax income – Spending) / (After-tax income) = Savings Rate
If your annual household income, after taxes, was $100,000 and your spending for the year on essentials (mortgage, insurance, utilities, food, etc.) and discretionary purchases (eating out, movies, vacation, etc.) was $90,000, then your savings ratio would be $10,000 / $100,000 = 10%.
Doing this annually is most common, but you could also do it monthly. Knowing your savings ratio is important so you can get an idea of how much money left over you have to work with. Then you must prioritize where this money goes. For example, 5% might be going into your 401(k) and 5% might be going into an emergency fund or 5% could go into a Roth IRA, 2% into an HSA, and 3% into a 529 account. The where comes later, but the point is you can’t really prioritize until you know how much you have to work with. Over time reducing your debt payments and / or expenses will increase your savings ratio and give you more flexibility in tough times when you might need to cut back.
The Front-end Ratio, commonly known as the mortgage to income ratio, is the percentage of your gross monthly income that is spent on your mortgage payment. In this case your mortgage payment calculation consists of the principal, interest, property taxes, and mortgage insurance (PITI).
PITI / Gross Monthly Income = Front-end Ratio
Continuing on our previous example, someone with $120,000 of gross annual income (before taxes) would have monthly gross income of $10,000. If their mortgage payment consisted of $300 of principal, $900 of interest, $300 of taxes, and $120 of mortgage insurance, then their front-end ratio would be ($300+$900+$300+$120) / $10,000 = 16.2%. This number is important for two reasons.
First, lenders use it when you are considering borrowing money. A lenders standard maximum front-end ratio is 28% for most loans and 31% for FHA loans (although they have flexibility to go higher). FHA loans are government backed loans with lower down payments, usually 3.5%, and lower credit requirements. These tell you the upper limits for your front-end ratio, so you know what is possible.
Second, and more important, the front-end ratio can help guide you to not just what is possible, but what is responsible. Just because you can does not mean you should. When planning for a home purchase target a front-end ratio no higher than 20% – 25%. Since interest rates have been so low for years, following these guidelines have allowed people to buy more expensive homes than ever. Be careful when you evaluate what you can do vs. what you should do.
The back-end ratio is also known as your total debt-to-income ratio. This is a more holistic view of your current debt position and your ability to take on additional debt, like a mortgage. Car loans, student loans, personal loans, credit card payments, alimony, and homeowner association dues are included with your estimated mortgage to figure out how much you can afford.
Total Monthly Debt Payments / Gross Monthly Income = Back-end Ratio
Lenders also look at your back-end ratio, although the acceptable levels are higher. The standard limits with your back-end ratio are 36% on conventional loans and around 41% on FHA loans. For young home buyers with high student loan debt this can a big stumbling block.
Weighted Average Interest
The weighted average interest that you pay is simple the average interest rate percentage paid per dollar of debt. Each individual piece of outstanding debt you have has an interest rate and represents a certain percentage of your overall debt.
(Debt1% x IR1%) + (Debt2% x IR2%) + (Debt3% x IR3%) … = Weighted Average Interest
An example of this would be holding a mortgage for $200,000 at 4%, a car loan for $25,000 at 2%, and a student loan for $75,000 at 7%. First, we figure out what percentage of our total debt each one represents. The mortgage is roughly 67%, the car loan is about 8%, and the student loan is 25% of our total debt. Next, we input that into our formula (.67 x 4%) + (.07 x 2%) + (.25 x 7%), and it looks like (2.68) + (.14) + (1.75) = 4.57%. We can say on average, 4.57% interest is being charged on every dollar of debt outstanding.
All things considered a lower weighted average interest rate is better, but it can be confusing. If you were to take the snowball debt repayment plan (paying extra toward your smallest size debt first and then move on to the next smallest after the first is paid) your weighted average interest rate number would rise since the smallest debt has the lowest rate. Paying off debt is not bad, but it can inform us as to the most efficient way to pay it down. If you start with your highest interest rate debt first, then your weighted average interest number will always be decreasing over time.
Financial Ratios as Guideposts
Financial ratios, like most mathematical formulas, are not the defining measures of how to live your life. They are guides to help inform your decisions as you decide the best way to spend, or save, your money to maximize your happiness. As you know doing what is mathematically correct is not the same as what makes you feel the most secure. Paying off smaller debts or buying a little bigger house for a growing family may bring you enough security or happiness to be worth it. Everyone’s financial situation is unique, but these ratios provide measurable insight that everyone can apply along their own path.