Staying on the path to financial independence can be easy with the use of simple ratios as a basis for making financial decisions. Often, people are overwhelmed by the complexity of financial calculations. Sophisticated financial planning uses software to assist with these complexities. However, these simple ratios can give guidance when you don’t have the time or expertise to run the software. They cover a broad range of topics and should not be used for precise planning. They will help you quickly make decisions regarding retirement, insurance, investing, savings, and debt management. There are certainly others but here are those used most frequently.
Additionally, one of the major obstacles that people face in staying on the path to financial independence is the inability to think in real dollars. That is, inflation adjusted dollars. Using ratios can offset that bias as well.
What’s your retirement number?
The common rule of thumb in retirement distribution planning is that a 4% inflation adjusted withdrawal from a portfolio should last the duration of an average retirement. Using that assumption, to find a retirement number, simply divide your take home pay by 4%. There are lots of additional factors to consider but this gives a ballpark number that is easy to calculate.
Example: John makes $80,000 per year but after taxes, deductions, and retirement contributions, he takes home $4300 per month. Annualized that is $51,600. $51,600 divided by 4% and his retirement number is $1,290,000.
How much life insurance should I have?
This number is very similar to the retirement number. Essentially, if you are replacing your income at retirement with your assets, then you should not have life insurance needs at retirement. You may choose to have life insurance for estate planning strategies, planning giving, or other special situations but replacing your income is typically the reason we need life insurance. If you have replaced your income at retirement, you probably don’t need additional insurance. So, a simple way to consider how much insurance is to take your retirement number (calculated above) and subtract out your current liquid assets.
Example: John from previous example has $350,000 in savings. He needs $940,000 in life insurance to protect his family ($1,290,000 retirement number minus $350,000 in current liquid assets.
What rate should I be saving for retirement?
It is simple to understand that the longer you wait to start saving, the higher the rate of saving you’ll need. It is difficult to know exactly the correct rate of savings. It is also difficult for people to think beyond their paycheck dollars and think in terms of a percentage of income. This simple ratio can keep you on track. Your savings rate should be your age minus 10 years. Two examples:
John, 20 years old, saves 10% (age – 10) of his salary until age 67 at 6% growth rate. If he makes $25,000 per year, he should have $638,911 which should replace his income in retirement.
Jane, 40 years old, saves 30% (age – 10) of her salary until age 67 at 6% growth rate. If she makes $50,000 per year, she should have $1,012,922 which should replace her income in retirement.
Of course, if you wait too late to start savings, you may not be able to replace your income entirely.
How much debt should I have?
This is another quick and easy answer. Your total debt payments should not exceed 33% of your income and your mortgage should be no more than 28%. You can use these ratios to decide on how much house you can afford or whether you can afford a new car. Here’s an example:
Barbara makes $50,000 per year which means that her mortgage payments should be no more than $14,000 per year (28% of $50,000) and she can only afford to have another $2,500 in debt payments to bring her total debt ratio to 33% of income ($16,500). That means, if she is looking at a new car, the payments cannot exceed $208.33 per month.
Although it’s possible to get credit beyond these limits, staying in line with these numbers will allow your credit availability to grow as you earn more and pay down old debt. It is a healthy way to use credit to grow your assets and lifestyle without putting your path to financial independence at risk.
How much should I keep in cash?
For a household with a single wage earner, six months of take home pay is the amount of emergency fund that should be achieved. It is three months for a household with two wage earners. This ratio prevents a household from having to go into debt when they have a short term financial emergency such as job loss. It also prevents them from taking assets out of their long term investments such as a retirement account. This number can be reduced if there is short term disability insurance involved but you should always have some in the emergency fund.
Once you have reached your emergency fund number, you should use additional money to pay off debt at faster rate, increase your retirement savings, or start other savings and investing plans. Keeping too much in cash becomes an opportunity cost since those dollars can be invested to earn higher rates of return without jeopardizing your financial security.
Considering other factors:
Although these simple ratios are good for quick financial decisions, they should not be the sole source of financial advice and should not be relied upon completely. Taxes are a good example of a factor that should be considered that could change the effectiveness of these ratios. In addition to taxes, there are many other factors why a particular ratio may not be appropriate and you must be mindful when making financial decisions.
In Summary:
It doesn’t take a college degree in finance to become financially savvy and secure. These five simple ratios can help determine the right amount of emergency savings, retirement assets, and life insurance someone may need. They can also determine the amount of debt they can handle and at what rate they should savings on their path to financial independence.