You’re a busy person. This makes investing time into detailed financial and retirement planning extremely difficult. Unfortunately, you can’t afford not to or it can cost you big. That’s what makes personal finance ratios so powerful.
They provide guardrails for setting better financial goals, making decisions in quick, simple ways, and achieving financial success. For a personal finance ratio to be worthwhile, it should be easy to understand and remember.
With that in mind, I’ve compiled a list of the most important personal financial ratios that people have used for years to better manage their financial situation.
Retirement savings ratio: 25 x your annual income
When thinking about retirement planning, this is a quick way to figure out how much money you’ll need to retire, i.e. your retirement savings ratio. The theory here is that with 25 times your annual income saved, at retirement you can withdraw 4% annually.
That amount would be equivalent to your current income and help you maintain good financial health throughout your retirement.
Example of retirement savings ratio
- Annual Income: $50k
- Retirement Savings Needed: 25 x $50k = $1.25M
- 7% Annual Growth at Retirement: $87k
- 4% Annual Withdraw at Retirement = $50k
Monthly retirement contribution: 10% of your monthly income
So once you know how much you need to have at retirement, you’ll need to determine how much to save each month to get you there. Since your income typically goes up over the years, this number can fluctuate up and down a little depending on how you are tracking towards your retirement goals.
In the above example, if you saved 10% of $100k for 30 years and invested it at a 7% annual return, you’d have over $1M saved by retirement.
Tip for optimizing your retirement contributions
Make sure you check out how much your retirement investments are costing you. It doesn’t help to put 10% in if 3% is going towards expenses.
If you’re in a 401(k), you might not have much choice until you change jobs. You’re pretty much stuck with the mutual funds that are available in your workplace retirement plan.
But if your investments are in a Roth IRA, there’s no reason you can’t keep you can’t keep your expense ratio as low as possible.
Expense ratio: 1%
When it comes to your investments, there’s no reason you should be paying more than 1% for anything you invest in. And you want to ensure that if you’re paying a financial planner, you’re completely aware of the costs.
When it comes to your investments, there’s no reason you should be paying more than 1% for anything you invest in. Let’s compare this to some common expense ratios you’ll see out there:
- 2% & 20%: This is what hedge funds charge their high end clients. A 2% annual fee (regardless of whether the hedge fund earns money during the year), PLUS 20% of the profits. But let’s be honest. If your money was in a hedge fund, you wouldn’t be reading this article.
- .55%: This is the average mutual fund expense ratio, according to Vanguard.
- .10%: Average Vanguard mutual fund expense ratio
But 1% is the industry standard for working with a financial advisor. This should include the underlying investment fees (see the Vanguard fees above). But many times it does not, so you’ll want to check with your advisor.
Asset allocation ratio: Subtract your age from 120
As you get older, the stability of your investments becomes even more important because you don’t have as much time for things to recover if the markets take a dip. The best way to lessen your risk over time is to reduce the number of stocks in your portfolio and increase the number of bonds.
This asset ratio is valuable because it helps you figure out when and how much you should invest in stocks vs. bonds based on your age. That’s done by subtracting your age from 120.
The resulting number is the percentage of equities you should have in your portfolio. The remainder would go to bonds or other fixed-income instruments.
Example of asset allocation ratio
Let’s imagine you are 35 years old. Subtract 35 from 120, and you would have 85.
- 120 – 35 = 85% of your portfolio should be in equities.
- 100% – 85% = 15% of your portfolio should be in bonds and other fixed income investments.
Net Worth: Total Assets Minus Total Liabilities
Your net worth, also known as a balance sheet, is a great way to understand how much wealth you have. And tracking your net worth over time will enable you to track the progress your financial efforts have made. It’s pretty simple to calculate.
- First, you add up all your liquid assets and non-liquid assets. For most people, this would include checking, saving, investment accounts, real estate investments, as well as your home. This is your total assets.
- Second, add up your total debt obligations including your mortgage, credit cards, medical bills, student loans, personal loan, etc. If you owe money, include it here. Add all this up and you have your total debt or total liabilities.
- Finally, subtract what you owe from what you own, and that will give you your total net worth.
Safe withdrawal rate (SWR): 4%
This personal finance ratio is commonly debated, but has its roots in the financial planning industry. In 1994, William Bengen, a financial planner, published a study that concluded 4% was a safe withdrawal rate for the vast majority of investors entering retirement.
The SWR ratio measures how much you can “safely” withdraw from your investment accounts without drawing down on your principal. At that point, you are effectively living off just a percentage of your portfolio’s growth.
The SWR assumes that you are making similar withdrawals during good markets and bad markets. But either way, your portfolio should be resilient enough to support the same withdrawal percentage without long-term damage.
Example: If you have $1M in investments, assuming a safe withdraw rate of 4%, you could withdraw $40K every year without negatively impacting your portfolio.
Interestingly, William Bengen has since published new information that supports a 4.5% (tax-free) SWR, or a 4.1% (including tax) SWR during normal times, or an even higher SWR during periods of low inflation.
Passive income ratio: Income from passive investments / Total income
How much of your total net income comes from your effort, and how much comes from passive investments? When you’re in retirement, all of your income (or most of it, if you take on a side hustle) will be from passive investments.
But there’s no reason you can’t track your progress while you’re working. In this case, passive investments are your investment portfolio, rental properties, or “passive” side businesses like blogging, selling a product, or another side hustle.
Your total income should include your taxable income, plus income that is in your tax-deferred accounts, like IRAs or 401k plans. You should know what your income from passive sources is, and divide that by your total income.
This ratio allows you to understand how much of your income comes from your hustle, and how much comes from your investments.
Warren Buffett has a great quote about passive income that I’ve always found inspiring.
Basic liquidity ratio: Monthly expenses X 3 – 6 months of expenses
How much you need in your emergency fund can be subject to a lot of debate. But an emergency fund is a personal version of what companies call a basic liquidity ratio. In other words, how much cash do you have to keep paying the bills if your revenue stops?
Most financial planners and financial experts will tell their clients that they should have an emergency fund that’s large enough to pay for 3 to 6 months’ of fixed expenses. That allows for the household to address the vast majority of unexpected events, like a job loss. But what it really comes down to is your own comfort and risk tolerance.
But what if the emergency lasts longer than 6 months? The odds are that this falls under the category of life-changing event. If that’s the case, 6 months should be enough time to look at your entire life and make the big financial decisions, like:
- Do we need to sell the house?
- Do we move in with our parents?
- Does the non-working spouse get a job?
Please note: your emergency fund should be in cash assets or equivalent assets, like money market funds or savings accounts. This should be money that you can access quickly without having to liquidate anything. Even savings bonds have to be redeemed in order to be useful, so they shouldn’t be part of your emergency fund.
Example of Emergency Fund Ratio
$6000 in monthly expenses = $36,000 in emergency fund
Starter Emergency fund: ~$1K
Your resiliency fund is the first thing you save up money for when you’re getting out of debt. In the Dave Ramsey Baby Steps, this is Step 1, also called your “starter emergency fund”.
The main difference between the Dave Ramsey version is that your resiliency fund is always a stand-alone account and not part of your big emergency fund. This is so you have some flexibility for when something goes wrong with your budgeting. But the starter fund’s intent is for short-term problems, not the long-term problems that a true emergency fund would solve.
For example, a starter emergency fund would help you get through a credit card cycle of overspending (i.e. shopping for the holidays). The other emergency fund would help pay the bills while a spouse is in between jobs.
Savings rate: Total savings divided by total income – 10%
Saving for the future is crucial to your personal finances. So it makes sense to have a personal finance ratio to help you know how you’re doing.
Your savings rate is expressed as a percentage of your gross income are you putting away for the future. This might include retirement, but should also include other short-term goals, like college savings or saving up to buy a house.
Example of savings rate
If you earn $4,000 per month, and save $1,000, your savings rate is 25%.
Your savings rate should be at least 10% of your income. This is a ratio where more is better, so a 25% savings rate is better than a 10% savings rate. And people who save 50% of their income will likely do better than those who save 25%.
People who continuously have a high savings rate will achieve financial independence much more quickly than those with a low savings rate.
A best practice is to pay yourself first by having money automatically deducted from your paycheck, or directly deposited into your savings account.
The 50/30/20 rule
First coined by Elizabeth Warren, the 50/30/20 rule gives you a great way to determine how much your living expenses should be.
If you set aside 50% towards living expenses, 30% for discretionary spending, and save the other 20%, then your life should be in balance.
Living expenses might include:
- Housing (mortgage or rent)
Discretionary spending would include:
- Dining out
This framework can help you reach your savings goal.
Housing expenses – 25% of your income
Whether you’re buying a new home or renting an apartment, your monthly payments for housing expenses should never be more than 25% of your income. For mortgages, this should include your principal and interest, as well as your insurance payments and property taxes.
When you’re buying a home with a mortgage, your bank will look at your expenses to see whether you can afford the mortgage payments. If your expected housing expenses creep up past this metric, you might not be able to get the mortgage.
Cash flow: Monthly income minus monthly expenses
This is another simple but powerful personal finance ratio. Being able to identify how much cash flow you have is useful because it tells you exactly how much money you have available for debt repayment, or investing for your future. The higher your cash flow, the better off you are.
Calculating your monthly cash flow
- If your monthly income is $5,000
- And your monthly expenses are $4,000
- Your monthly cash flow is $1,000
That monthly cash flow can be used towards paying down debt, building your emergency fund, or establishing your savings.
Recommended Reading: If you’re interested in learning more about getting out of debt, budgeting, and planning for a retirement check out our complete guide to the basics of personal finance.
Life insurance ratio: 10 X your annual gross income
If you are the family’s primary breadwinner, your life insurance policy should be large enough to protect them in the case something happens to you. The standard rule of thumb is that a life insurance policy should represent 10 years of your current income.
Most employers offer group life insurance, but many people default to the minimum coverage. This often is around 1 year’s income, which is never enough to take care of a family that’s left behind. Before shopping around for your own policy, you should maximize the coverage available through your employer.
However, you should have your own policy as well. This will help protect you if you change employers, or if you lose your job.
Example of life insurance ratio
Let’s imagine that you earn $100,000 per year. Your employer offers group life insurance up to 2 times your income. You could take advantage of this, and still get outside insurance for $800,000.
Debt to Income Ratio: Monthly debt payments divided by monthly gross income
Also known as debt service ratio, your debt to income ratio (DTI) helps you understand how much of your income is going towards debt payments. This could be for a car loan, student loans, credit card debt, or a mortgage payment.
So if your gross monthly income is $5,000, and your debt repayments are $2,000 a month, your DTI ratio is 0.4, or 40%.
Another way to phrase it is for every dollar you bring home, 40% is going to service your debt. When you’re first starting off, or after you’ve bought your house, you’ll probably have a high debt levels, and a relatively high DTI.
As you continue to build wealth and your income increases over your career, your DTI will decrease over time.
Personal finance ratios are great tools in your financial planning toolbox. But keep in mind that they’re just a starting point, not a substitute for doing in-depth critical analysis. When making a big decision like buying a house or planning for retirement, you should make sure you’re properly planning.
Also, keep in mind, the most important personal finance ratios don’t help you if you don’t act upon what they are telling you. Think of them like you would a speedometer or fuel gauge in your car. All they can do is provide you information, but it’s up to you to decide to make the critical decisions.
If you liked this article, you should check out our other articles about how to manage your money!