Let's talk about money ratios! It can be difficult to gauge the health of your personal finances. Especially when deciding how much to allocate towards wants versus needs, spending on credit, and figuring out how much debt is just too much.
One way to make quick determinations about your finances is to use money ratios. Money ratios provide rules of thumb to help you quickly evaluate your financial situation. Finance ratio formulas offer direct insight on how to improve your situation and plan for your future.
Top 7 essential money ratios for your finances
Using ratios with money helps you determine where you are financially and can help you achieve your money goals. Ease through your next money check-in with these 7 money ratios that every Clever Girl should know.
1. The 50/30/20 budgeting ratio
There are many budgeting methods to choose from. One of the most popular personal finance ratios used is the 50/30/20 budgeting ratio because it's pretty simple to use. This budgeting method is known as a percentage breakdown budget. So, the percentage breakdown of this budget is 50% needs, 30% wants, and 20% to savings.
For instance, the cost of your essentials should be less than 50% of your after-tax income. These are your basic essential living expenses that include housing and related expenses, transportation, food, and other must-have costs.
30% of your budget will be dedicated to your wants such as eating out, entertainment, designer handbags, etc. Last but not least, 20% will be allocated to savings.
Why the 50/30/20 ratio is important
This ratio highlights the importance of keeping the must-have costs at a level that allows you to consistently contribute to savings and invest for the long-term, with ample room for wants as well.
Essential costs that top 50% of your income, put your finances in a precarious position, with little room for error.
How to apply the 50/30/20 budget to your finances
First, to figure out this ratio, calculate your essential expenses as a percentage of your current after-tax income. An easy way to identify these essential costs is to include the costs you would still have to pay if you had a drop in income or became unemployed, including your minimum debt payments. Again, these will be your basic living expenses such as rent, food, and utilities.
A result of over 50%, calls for increasing your income, paying off debt obligations faster, reducing other fixed must-have costs or a combination of these.
2. Credit utilization rate money ratio
One of the most common finance ratio formulas used is the credit utilization rate ratio. This ratio is the sum of your revolving credit account balances to the total of all your credit account limits.
This tells you how much of the revolving credit available to you is being used. For example, if you own one credit card with a $10,000 credit limit and a current balance of $2,000, the utilization rate would be 20%.
$2,000/$10,000 x 100 = 20% Utilization
Why this money ratio is important
Credit utilization is a major factor in your FICO score, accounting for 30% of how your score is calculated. This means that the higher your credit utilization ratio is, the more negatively impacted your credit score will be. Even more important than the impact on your credit score, a high utilization could indicate that an unhealthy reliance on debt, along with high-interest costs on outstanding revolving debt.
How to apply it to your finances
Your credit utilization is a good ratio for gauging its effect on your credit score. The best approach to your revolving debt is to budget your spending on credit. Also, not carrying or adding to your balances, and paying off outstanding debts is beneficial. This way, your utilization is something you can be aware of while focusing on positive cash flow and avoiding ongoing revolving debt balances altogether.
3. Debt to starting salary ratio
The debt-to-starting salary ratio can be used to estimate the maximum amount, student loans to borrow for a particular degree program.
This ratio is a measure of the amount of student loan borrowed divided by the expected starting salary after graduation. As a rule of thumb, students should limit their debt-to-starting salary ratio to a value of 1 to repay the loans over a 10-year period.
Why applying this ratio is important
Calculating the exact ROI (return on investment) for a college degree may be difficult. So, the debt-to-salary ratio provides a simple guide for college students and their families to avoid over-borrowing.
When this rule is applied to borrowing, it’s easy for prospective students to understand that borrowing $60,000 for a degree that leads to an average starting salary of $27,000 does not make financial sense.
How to apply the debt-to-salary ratio to your finances
Limiting your debt-to-salary ratio to 1 when borrowing for a college education is a good guide. However, it is important to understand that the size of the monthly payments depends on the average interest rate on your student loans when using this ratio.
For instance, an undergraduate student with a debt-to-salary of 1 and total student loan debt of $27,000 at an annual interest rate of 3% can expect to make monthly payments of $259 (representing 11.5% of the gross starting salary) for 10 years.
That same student loan debt amount at 5% or 7% annual interest rates would result in monthly payments of $281 and $315, respectively, over the 10-year repayment period.
A more conservative debt-to-income ratio of 0.7, would be more appropriate and result in student loan payments under 10% of a borrower’s gross income.
4. Loan to value money ratio
The loan-to-value- ratio (LTV) is the measure of the mortgage on a property to its appraised value, expressed as a percentage. For example, 80% LTV on a $150,000 property is $120,000. Lenders use this ratio as a part of the mortgage approval process and for refinancing and home equity line of credit applications.
Why the loan to value ratio is important
As a potential buyer, the loan-to-value ratio can dictate whether you will pay additional costs, like private mortgage insurance (for an LTV of less than 80%). The LTV determines whether you can refinance a lower interest rate or access a home equity line of credit for existing homeowners.
For homeowners, the LTV also represents how much equity has built up in your home, i.e. how much of the mortgaged property you own.
How to apply the loan to value ratio to your finances
If you are a potential homebuyer, it’s critical to understand how different down payment options will affect the LTV of a home you purchase.
For example, to avoid PMI costs and get the best interest rate possible, a 20% down payment will be required. Keep in mind, too, that mortgage interest rates & PMI costs have inverse relationships to the size of your down payment.
Meaning the lower the down payment (and the higher the LTV) the higher the mortgage interest & PMI costs a home purchase.
The LTV of your home also factors into how soon PMI can be removed from your mortgage. It can increase when your home secures additional debt through home equity loans or lines of credit. It can also increase after a sharp drop in a property’s market value. This happened to many homes during the great recession.
The bottom line is the lower the LTV of your home the better because it can save you money.
5. Debt to income money ratio
The debt to income ratio is one of the finance formula ratios used by lenders to calculate how much you owe versus how much money you make. They add up your total debt and divide it by your monthly income to calculate your total debt to income ratio. They use this to determine your ability to repay loans.
Most lenders look for a DTI percentage below 35% total. This means that your monthly payments are under 35% of your income. It can also evaluate when your personal debt load approaches the danger zone.
Why debt to income is important
A high debt-to-income ratio can affect your ability to qualify for loans, prevent you from managing debt payments, and limit how much you can save and invest for your financial stability. It can also stand in the way of getting approved for a home loan, even with a high credit score and income.
How to apply the debt to income ratio to your finances
Use this ratio to identify how much of your income will repay debt with interest and motivate you to accelerate your debt pay off by increasing your income, cutting your expenses, or both.
6. The emergency fund ratio
This is one of the most important personal finance ratios you can do. The emergency fund money ratio is when you calculate 3-6 months of your basic living expenses to know how much you need to save for unexpected events such as a job loss. This way, you have enough money saved to cover your basic expenses such as housing, food, etc.
Why an emergency fund is important
An emergency fund is vital to your financial well-being because it prepares you for unexpected costs and prevents debt. It would save you from racking up credit card debt to pay for a vehicle repair or medical bill. Also, if you would lose your job, your emergency fund will float you until you could find another one.
How to apply the emergency fund ratio to your finances
The first step is to add up your monthly basic living expenses. Then you multiply that by 3-6 months for the total amount needed. For example, let's say your essential expenses are $1,200 a month. So you take $1,200 and multiply it by 3 or 6 for your total. Based on this amount, you should have $3,600-$7,200 saved in your emergency fund to cover your needs.
This may seem overwhelming at first, but if you break it down into smaller amounts, you will be able to eventually save up enough money. To get started, focus on your first $1,000 and grow from there!
7. Retirement savings money ratio
Everyone's retirement goals are different, but one thing we have in common is we all need a retirement savings plan. This ratio simplifies your savings plan by multiplying your income by 25. For example, if your annual income is $40,000 a year, you multiply that by 25, which equals one million dollars. Sounds steep, but you can make your money work for you and make this goal much more attainable with smart investing.
Why the retirement savings ratio is important
35% of Americans have no retirement savings at all! Not preparing and saving for retirement can mean a long hard life ahead. Working when you're older can be more difficult, which is why having enough savings is crucial to your financial future. Another issue is the increase in the cost of living, leaving a gap in retirement funds and monthly expenses.
The retirement savings ratio is one of the most important personal finance ratios you can utilize. Knowing how much you need for retirement can help you start investing your money and saving for a better future. Besides, who wants to work their whole life anyway when you could be living it up on a beach somewhere!
How to apply the retirement savings ratio to your finances
The first step to applying this ratio is multiplying your current income by 25. This will give you a total to work towards for your retirement savings plan. The second step is maximizing your investments and savings to ensure you are on track for the amount you need.
Be sure to diversify your portfolio to ensure you are investing your money the right way. Above all, keep in mind you need to regularly check in with your retirement accounts to ensure you are earning enough towards your retirement goal.
Use finance ratio formulas to manage your money wisely
Using ratios with money can help you keep your finances in check and manage your money better. Finance ratio formulas help you keep your debt to income low, plan for retirement, and stick to a budget so you can achieve your financial goals. Learn more about increasing your income and investing for your future with our Free financial courses and worksheets!