By Brendan M. Crews, Authorized Representative, AVMA LIFE
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 how much debt you take on.” However, to be effective, a goal needs to be measurable. So how do you measure progress towards some of the broadest financial goals like saving or spending? One answer is to lean on financial ratios for guidance. Break out the calculator on your cell phone and let’s review some of the most common.
Your savings ratio, sometimes called a 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 (i.e., mortgage, insurance, utilities, food, etc.) and discretionary purchases (i.e., eating out, movies, vacation, etc.) was $90,000, then your savings ratio would be $10,000 / $100,000 = 10%.
Calculating this rate annually is most common, but you can also do it monthly. Knowing your savings ratio is important so you can get an idea of how much money you have left once all your expenses are met. Next, you must prioritize where this money goes. For example, 5% might go into your 401(k) and 5% might go into an emergency fund. Or you may decide to put 5% into a Roth IRA, 2% into an HSA, and 3% into a 529 account. The “where” comes later; the first step is figuring out the “how much.”
Over time, reducing your debt payments and/or expenses will increase your savings ratio and give you more flexibility in times when you might need to cut back. The same result can by achieved by increasing your income. Regardless of how it happens, try to find a purpose for any new savings opportunities, before they get swept away by additional spending.
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 home payment. In this case, your home payment calculation consists of the principal, interest, property taxes, and mortgage insurance (PITI).
PITI / Gross Monthly Income = Front-end Ratio
For example, someone with a gross annual income (before taxes) of $120,000 would have gross monthly 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 apply to borrowing money. A lender’s 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 around 3.5%, and lower credit requirements. If your front-end ratio exceeds these limits, you are unlikely to be approved for a loan.
Second, and more important, the front-end ratio not only tells you what is possible, but what is responsible. Just because you can get a loan, does not mean you should. When planning for a home purchase, target a front-end ratio no higher than 20%–25%. And just because today’s low interest rates mean you can get approved for a larger loan to buy a more expensive house, doesn’t mean that is the right thing to do. Be careful when you evaluate what you can do versus what you should do.
The back-end ratio is also known as your total debt-to-income ratio. This number provides 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 when calculating how much you can afford.
Total Monthly Debt Payments / Gross Monthly Income = Back-end Ratio
Lenders also look at your back-end ratio, although acceptable levels are higher than with your front-end ratio. 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 ratio can a big stumbling block.
Weighted Average Interest
The weighted average interest that you pay is simply 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. Start with your student loans, which can come with a double-digit interest rate, then add in all other loans of varying amounts and interest rates.
(Debt1% x IR1) + (Debt2% x IR2) + (Debt3% x IR3) … = Weighted Average Interest
For example, let’s pick a recent graduate with an auto loan and two student loans: $20,000 at 5%, $25,000 at 6%, and $55,000 at 7%. This student’s total debt is $100,000. The first loan represents 20% of the total debt, the second loan 25%, and the third loan 55%. debt. Next, input those figures into our formula: (.20 x 5) + (.25 x 6) + (.55 x 7) = 6.35%. That means, on average, 6.35% interest is being charged on every dollar of this student’s outstanding debt.
All things considered, a lower weighted average interest rate is better. But sometimes it’s not that simple. If this student had a “snowball” debt repayment plan (paying extra toward the smallest debt first, and then move on to the next smallest after the first is paid), her weighted average interest rate would increase since the smallest debt has the lowest rate.
Paying off debt in any form is good, but knowing your weighted average interest rate helps you make better decisions and save money in the long run. If you pay off your highest interest rate debt first, your weighted average interest number will decrease over time – which means you will actually pay less in the long run.
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 determine 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.