Savings Ratio = Monthly Savings/After Tax Monthly Income Example = $500/$6,000 = 8% Rules of thumb for this ratio range from 5 to 10%. A negative savings ratio indicates that monthly cash outflows are greater than monthly cash inflows — a situation which cannot be sustained in the long term. Income Indexing. The purpose of this calculation is to evaluate the change that occurred in your annual income compared to the annual rate of inflation. Change in Income = (Current Annual Income/Prior Year Annual Income) – 100% Example: ($84,000/$81,000) = 103.7% – 100% = 3.7% In this case, the individual’s income went up by 3.7%. If annual inflation went up by 3%, then the increase in annual income exceeded the rate of inflation — that’s good news. On the other hand, if inflation went up by 5%, the individual’s increase in income did not keep pace with inflation. 8–4. DEBIT OR CREDIT? Resolving the issue of which card to use when paying monthly bills and making purchases depends upon your situation. Approximately one-third of all cardholders pay off their full credit card balance each month. If you are in this group, then you are better off paying your bills with your credit card. Why? By paying with your credit card, you are using someone else’s money to finance your monthly expenses on an interest free basis. If the card provides other benefits, such as airline miles or rebates, then you are also enhancing those benefits. For the approximately two-thirds of credit cardholders who carry a balance on their account, you are better off paying with your debit card. Why? By using your credit card to pay your monthly bills, you are increasing your debt — a situation which most of us should avoid. Sound financial management dictates that we not spend more then we have. Using a debit card is similar to paying in cash which is a strong motivator to live within your means. However, since your debit card provides a direct link to your checking account, there are some situations where it is safer to use a credit card. It is recommended that debit cards not be used in the following circumstances: a. Purchases made online or over the phone; b. Restaurant purchases; c. Recurring payments; or, d. Big ticket items (credit cards provide dispute rights if something goes wrong with the merchandise).
can be used to measure your financial health. Four common areas of evaluation are liquidity , solvency, savings, and income indexing. Liquidity. Liquid assets are your available cash plus other investment items that can be quickly converted to cash (i.e. money market mutual funds and short term Certificates of Deposit). This ratio provides an indication of your ability to pay your current expenses in the event of an unanticipated reduction in income. The analysis is usually done on a monthly basis. The formula looks like this: Liquidity Ratio = Liquid Assets/Monthly expenses Example: $6,000/$3,000 = 2 months In this case, the individual has sufficient reserves to pay his or her monthly bills for approximately 2 months. Normal rules of thumb for this ratio are 4 to 8 months of cash reserve. Solvency. Solvency ratios focus on the relationship between debt and personal income. They are often used by banks and mortgage lenders in evaluating applications for auto loans and home mortgages. Two of the more common ratios are: a. Debt Payment Ratio (aka Debt to Income) b. Mortgage Debt Ratio Debt Payment Ratio = Total Monthly Debt Payments/ Gross Monthly Income Example: $2,000/$6,000 = 33% Total monthly debt payments include the minimum payment for all types of debt including credit cards, student loans, auto loans, and home mortgages. Mortgage Debt Ratio = Monthly Mortgage Payment/ Gross Monthly Income Example: $1,500/$7,000 = 21% The monthly mortgage payment includes principle, interest, taxes, and insurance. Together, the debt payment ratio and the mortgage debt ratio measure your ability to pay your financial obligations. From a lender’s standpoint the lower these ratios are, the higher your credit worthiness. Normally lenders require that your debt to income ratio does not exceed 43%. On the mortgage side, lenders like to see a monthly mortgage payment that does not exceed 28% of gross monthly income. Savings. This ratio measures the percentage of your take home pay that you are able to save. The formula looks like this:
CHAPTER 8: PRINCIPLES OF FINANCIAL PLANNING
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