Understanding the numbers in your personal finances can help you take control and set reasonable short- and long-term goals. Some basic formulas can give you insight into your financial strengths and weaknesses and help you make better money decisions about issues like saving and how much debt to have.
In addition, if you apply for a home mortgage, lenders use various ratios to evaluate your financial situation and set interest rates. Understanding typical lending ratios can help you qualify for the best home purchase or refinance offer possible.
Here are five formulas to gauge your financial health and optimize your money.
1. Cash Flow
Cash flow = monthly net (after-tax) income – monthly expenses
Your cash flow shows how much money you have left over each month to reach your financial goals, like saving and paying down debt. It’s your take-home pay from a job or after-tax self-employment income, less your typical monthly expenses (fixed and variable).
For example, if your net income is $4,000 and your monthly expenses are $3,500, your cash flow is $500. If you want a higher cash flow, consider ways to earn more, such as starting a side hustle or cutting expenses when possible.
2. Liquidity Ratio
Liquidity ratio = total cash / monthly expenses
Your liquidity ratio, also known as the emergency fund ratio, indicates whether you have enough cash on hand. An emergency fund is essential for covering a hardship like losing your job or business income or having a significant unexpected expense.
For example, if you have $30,000 saved in a high-interest savings account and spend $5,000 monthly, your liquidity ratio is six. That tells you the number of months you could pay expenses without an income using funds easily converted into cash. You shouldn’t include non-liquid assets like your home or retirement accounts.
A general rule is maintaining a liquidity ratio of at least three to six. But if you’re self-employed, have high debt or support many dependents, you may need a ratio of 12 or more to be financially secure. However, a liquidity ratio that’s too high can mean you have too much cash and should invest more of it for growth.
3. Savings Ratio
Savings ratio = monthly savings / monthly gross income
Your savings ratio is a critical factor in your future financial security. It shows how much of your pre-tax income goes toward various savings vehicles for long-term needs, such as retirement.
For example, if you save $500 and earn $5,000 monthly, your savings ratio is 0.1 or 10%. The higher your savings ratio, the more likely you are to meet challenging financial goals like retiring with a healthy nest egg.
While a good rule is to save at least 10% to 15% of your gross income, you may need to save more or less depending on your financial situation and goals. For instance, if you want to retire early, spend significantly more in the future or get a late start saving, you may need a ratio of 0.25 or 25%.
However, if you can only save a smaller amount, that’s better than not saving. As you earn more, you can aim to boost your savings ratio over time.
4. Housing Ratio
Housing ratio = monthly housing costs / monthly gross income
Your housing ratio tells you how much of your pre-tax income goes toward rent or a home mortgage. A lower ratio means you have more affordable housing costs and more income to reach your financial goals. A reasonable housing ratio is also critical when qualifying for a home mortgage.
For example, if you pay $1,500 for rent and earn $5,000 monthly, your housing ratio is 0.3 or 30%. That exceeds 28%, a ratio that many lenders require to approve you for a conventional mortgage, including principal, interest, property taxes and insurance.
However, lenders can make ratio exceptions for borrowers with excellent credit or who make large down payments. So, always shop and compare mortgage offers for the best terms possible.
5. Debt Ratio
Debt ratio = total monthly debt payments / monthly gross income
The debt ratio shows how much of your income is used for regular debt payments, such as credit cards and home, auto, personal and student loans. It’s critical to monitor so you don’t take on too much debt that could jeopardize your ability to save.
For example, if you have a monthly mortgage of $1,500, an auto loan of $500 and a student loan of $500, your total debt is $2,500. If your gross income is $5,000, your debt ratio is 50%. A lower ratio of 30% to 35% would give you more financial breathing room to save for short- and long-term needs.
Mortgage lenders call this calculation the housing back-end ratio and prefer it not to exceed 36%. Having too much debt relative to your income, such as a ratio above 43%, can restrict your loan options or cause you to pay higher interest rates, especially when buying or refinancing a home.
