You’re a busy person. This makes investing time into detailed financial 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 and making decisions in quick, simple ways. 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 memorable and impactful examples that people have used for years to better manage their money.
1. Retirement savings ratio: 25 x your annual income
This is a quick way to figure out how much money you’ll need to retire. 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 assuming a 7% average annual return, you wouldn’t negatively impact your nest egg.
Check out the example below:
- Annual Income: $50k
- Retirement Savings Needed: 25 x $50k = $1.25M
- 7% Annual Growth at Retirement: $87k
- 4% Annual Withdraw at Retirement = $50k
2. Monthly retirement contribution: 15-25% your annual 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.
For the example above, if you saved 20% of $50k for 30 years, assuming a 7% average annual growth, you’d have over $1M saved by retirement. In that case, you may want to increase the % for a few years, or try to increase your income.
Tip: Make sure you check out how much your retirement investments are costing you. It doesn’t help to put 15% in if 3% is going towards expenses.
3. Asset allocation: Subtract your age from 120 (or 110)
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 rule is so 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 % of stocks you should have, with the rest going to bonds.
So let’s say you are in your mid-30’s:
- 120 – 35 = 85
- This means that 85% of your portfolio should be stocks, and 15% should be bonds.
Here’s a great video from the Motley Fool talking about this concept further.
4. How to calculate your net worth: Everything you own minus everything you owe
Understanding your net worth is a great way to cut through all the noise of your investments and debts, and find out how much your finances are truly worth. It’s super simple to calculate as well!
- 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. If you have other items that retain or increase their value, feel free to include them. This is your total assets.
- Second, add up your total debt including your mortgage, credit cards, medical bills, student loans, personal loans, etc. If you owe money, include it here. This is your total liability,
- Finally, subtract what you owe from what you own, and that will give you your net worth!
If you intend on monitoring this number frequently, I recommend using an app called Personal Capital that you can find more info about on my resources page.
5. Safe withdrawal rate (SWR): 3-4% annually
This is my favorite personal finance ratio because it because I aspire to retire sooner rather than later, so this number is crucial. The safe withdrawal rate is how much you can “safely” withdrawal 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, which hypothetically means you never have to work again!
Example: If you have $1M in investments, assuming a safe withdraw rate of 3%, you could withdraw $30K every year without negatively impacting your portfolio.
6. Passive income ratio: Gross income from salary vs. passive investments
Another thing to keep your eye on if early retirement sounds exciting is how much money you make from your day job vs. how much you make from passive investments. In this case, passive investments are investments such as dividend-paying stocks, rental properties, or “passive” side businesses like blogging or selling a product.
Warren Buffet has a great quote about passive income that I’ve always found inspiring.
7. Emergency fund ratio: Monthly expenses X 6 months
How much you need in your emergency fund can be subject to a lot of debate. What it really comes down to is your own comfort and risk tolerance.
I’m risk-averse, so for me and my family, we go with 6 months of expenses. There is nothing wrong with having less, though you’ll want at least 3 months.
Example: $6000 in monthly expenses = $36,000 in Emergency Fund
8. Resiliency 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 wiggle room for when something inevitably goes wrong with your budgeting, but it’s only a short term problem (weeks not months).
9. Savings ratio: How much you save divided by how much you made
Since saving for the future is such an important part of personal finances, it makes sense there would be a personal finance ratio to help you know how you’re doing. This personal finance ratio is expressed as what % of your gross income are you putting away for the future, including retirement and other shorter-term goals.
Example: If you earn $4k a month, and save/invest $1k of it, your savings rate is 25%.
Generally speaking, you should shoot for between a 15-25% savings rate. A best practice is to use a monthly budget to determine your spending before the month begins, and determine what you’ll have left for savings.
You can then begin paying yourself first a portion of that amount with every paycheck.
10. The 50/30/20 rule
First coined by Elizabeth Warren, the 50/30/20 rule gives you a great way to determine how much you should be spending and savings with 50% going to”needs”, 30% for “wants” and 20% for “savings”.
Check out this great infographic from The Balance for a simple overview.
11. Spending by category
In addition to the 50/30/20 rule, you can get even more tactical in your budgeting by following some simple category-based guidelines. This is particularly helpful if you are constructing a zero-based budget.
- Housing Expense: No more than 25% of your monthly take-home pay or risk becoming house poor!
- Utilities: Aim for 5%, and remember to turn off the lights when you’re not using them.
- Food: It’s easy to overspend here, so try to save money shopping for groceries. Aim for 10-20%
- Transportation: I’m a huge fan of buying cars with cash, but if you do take out a car loan make sure you aren’t spending over 10-20% of your income here, including insurance, gas, and maintenance.
- Clothing: 3-5% should cover most families since you don’t buy clothes every day, and they really should last you.
- Medical: This is a tough one since it’s oftentimes unavoidable. Do your best to keep it around 3%, but understand that this will fluctuate as needed.
- Personal & Discretionary: I consider this fun money. It can go towards whatever you want, but keep it around 5-10%.
- For Retirement and Savings goals: As I mentioned earlier, this should be around 15-25%.
- Debt Payments: The more you work to reduce your total liabilities the more cash flow you will have later. Pay as much as you can afford.
12. Cash flow: Monthly income minus monthly outgo
This is another simple but powerful personal finance rule. Being able to identify how much cash flow you have is useful because it tells you exactly how much money you have available to pay down debt, or invest for your future. The higher your cash flow, the better off you are.
- If your monthly income is $5K
- And your monthly outgo (expenses) is $4K
- Your monthly cash flow is $1K
13. Mortgage rule of thumb: Limit mortgage payment to 2.5X your income
This rule of thumb is useful in determining how much money you could spend on a house, but keep in mind it’s just one data point. You also need to make sure that your monthly housing expense doesn’t exceed 25% of your monthly income.
Example: If you make $50k a year, a $125K home isn’t out of the question, assuming the monthly mortgage payments are only 25% of your monthly income.
14. Housing expense as a percentage of income: 25%
As mentioned above, a solid financial planning ratio for housing cost is that it shouldn’t exceed 25% of your monthly income. Keep in mind, that is all in cost, i.e. principal, interest, property taxes, etc.
15. Life insurance ratio: 10 X your annual gross income
As a husband and parent, ensuring my family is always taken care of is a top priority for me. That’s why I believe parents should have term life insurance in place in case something happens. But how much is enough? The conventional wisdom is somewhere between 8-12x your annual gross income. I split the difference and go with 10x.
16. Debt to income: Monthly debt payments divided by monthly gross income
Your Debt To Income Ratio (DTI) is a valuable number to have because it tells you what % of your gross income is going to the service of debt. So if your gross monthly income is $5k, and your debt repayments are $2k 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.
There is no “ideal” DTI, though I’d recommend keeping it under 35% if possible. Ultimately, as you pay off debt, and eventually your mortgage, it will slowly go down until it’s 0%.
Personal finance ratios are great tools in your financial planning toolbox, but always keep in mind there are always exceptions, so make sure you are doing the proper ratio analysis. They are not a substitute for doing in-depth critical analysis for situations like buying a house or planning for retirement.
Also, keep in mind, they 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 slow down or fill up the tank.
What other personal finance ratios have you found useful for your own financial planning? Share them in the comments below!