Understanding your personal finance numbers is essential for gaining control and setting realistic short- and long-term goals. By using some basic formulas, you can get a clear picture of your financial strengths and weaknesses, enabling better decisions about saving and managing debt.
Moreover, when applying for a home mortgage, lenders evaluate your financial situation using various ratios to determine interest rates. Familiarizing yourself with these typical lending ratios can help you secure the best mortgage or refinance offer.
Here are five key formulas to assess your financial health and optimize your finances:
- Cash Flow
Cash flow = monthly net (after-tax) income – monthly expenses Cash flow represents the amount left each month after covering your expenses, which you can use to reach financial goals like saving and debt reduction. It’s calculated by subtracting your monthly expenses from your take-home pay or after-tax income. For instance, if your net income is $4,000 and your monthly expenses total $3,500, your cash flow is $500. To increase your cash flow, consider ways to boost income, like starting a side hustle, or cutting expenses where possible. - Liquidity Ratio
Liquidity ratio = total cash / monthly expenses The liquidity ratio, or emergency fund ratio, indicates whether you have enough cash on hand to cover unforeseen expenses, such as job loss or significant unexpected costs. For example, if you have $30,000 in savings and your monthly expenses are $5,000, your liquidity ratio is six. This means you could cover expenses for six months without any income, relying on easily accessible funds. It’s recommended to maintain a liquidity ratio of at least three to six months’ worth of expenses. However, a higher ratio may be necessary if you’re self-employed, have high debt, or support several dependents. Conversely, an excessively high liquidity ratio might suggest that more of your cash should be invested for growth. - Savings Ratio
Savings ratio = monthly savings / monthly gross income The savings ratio measures the portion of your pre-tax income dedicated to long-term savings, such as retirement. For example, saving $500 from a $5,000 monthly income gives a savings ratio of 10%. A higher ratio increases your chances of achieving significant financial goals, like building a substantial retirement fund. While saving 10% to 15% of your gross income is a good rule of thumb, your personal goals may require adjusting this percentage. If you’re aiming for early retirement, planning for higher future expenses, or starting to save later in life, a savings ratio of 25% or more might be necessary. If your current savings amount is small, that’s still better than nothing. As your income grows, strive to increase your savings ratio. - Housing Ratio
Housing ratio = monthly housing costs / monthly gross income The housing ratio reflects the portion of your pre-tax income spent on housing costs, such as rent or a mortgage. A lower housing ratio indicates more affordable housing, leaving more income available for other financial goals. For example, if your rent is $1,500 and you earn $5,000 monthly, your housing ratio is 30%. This slightly exceeds the 28% threshold many lenders use when approving conventional mortgages, including costs like principal, interest, property taxes, and insurance. However, lenders may make exceptions for borrowers with excellent credit or substantial down payments, so always compare mortgage offers for the best terms. - Debt Ratio
Debt ratio = total monthly debt payments / monthly gross income The debt ratio shows how much of your income is allocated to regular debt payments, such as credit cards and loans. Keeping this ratio in check is crucial to avoid overwhelming debt that could hinder your ability to save. For instance, if your monthly mortgage is $1,500, an auto loan is $500, and a student loan is $500, your total debt payments are $2,500. With a gross income of $5,000, your debt ratio is 50%. Ideally, a lower ratio of 30% to 35% allows for more financial flexibility to save for short- and long-term needs. Mortgage lenders refer to this as the housing back-end ratio and typically prefer it to stay below 36%. A debt ratio above 43% can limit your loan options or result in higher interest rates, particularly when buying or refinancing a home.