Rate Yourself Using Debt-to-income Ratio

Rate Yourself Using Debt-to-income Ratio

By Linda Stern

WASHINGTON (Reuters) – If you were a company, what would the analysts be saying about you?

Most investors use financial ratios to grade the companies the average debt to income ratio by age buy and sell, but they rarely subject their own finances to the same rigorous reviews. Now, an investment adviser has suggested that his clients measure themselves against key ratios, too.

Charles Farrell, a Medina, Ohio, consultant, says that individuals can use these formulas to get a quick report on how they are doing.

“They can serve as an important tool, a guideline, to help convey to individuals how their income, savings and debt are related, and how those ratios must change over time,” he writes in an article in the January issue of the Journal of Financial Planning.

Of course, mortgage lenders have long used ratios to determine whether applicants are credit-worthy. Typically, they like to limit your housing expenses to 28 percent of your gross income, and your total debt payments to no more than 36 percent of your income.

To figure out if you’re within that range, add up what you spend in a month on your mortgage, home insurance and real estate taxes, and divide that figure by your monthly gross income. Your answer should be under .28.

Go back and add in your car payment, credit card payments and other debt payments to the first total, and divide again by your monthly gross salary. The answer should be under .36.

In his article, Farrell takes that formula further. He notes that a financially healthy family or individual will look different at different ages, and adjusts his ratios accordingly.

He based his ideal debt to income ratio formula on the goal of retirement at age 65 and assumes his clients will earn a 5 percent real rate of return on their investments and spend down about 5 percent of their savings every year in retirement.

Here are the numbers he believes healthy families should strive for.

— Savings. Farrell suggests that everyone, at every age, should save 12 percent of their income every year. In his charts and calculations, that figure doesn’t change. But the amount of savings accumulated, relative to household income, does change. He expects a 30-year-old to have 10 percent of their income amassed in savings, including retirement savings and other household savings. By age 35, that should be 90 percent.

Savings amassed at 40, 50 and 60 should be 1.7 times income, 3 times income, and 8.8 times income. Don’t include home equity in your savings for this calculation, unless you are committed to selling your home and moving to a cheaper place when you retire. Farrell assumes that you’ll withdraw 5 percent of your savings every year in retirement; if you’re going to be withdrawing more than that, you’ll have to save even more.

— Debt. Businesses calculate their debt-to-equity ratios by adding up everything they owe in long-term debt, and dividing it by the value of their stock. A healthy debt to income ratio corporate debt/equity ratio is usually between 0.5 and 2, depending on the kind of company it is.

The numbers for individuals and families are similar, but vary by age and use income, instead of equity, as the denominator.

Add up the mortgage, the student loans, the credit card balances and the remaining balance on the car loan. At age 30, you’ll have your highest levels of debt relative to your income, says Farrell. He pegs that number at 1.7, meaning that if you’re earning $50,000 at age 30, you should be $80,000 in debt.

That’s nice in theory, but it’s hard to imagine ever buying a first home without busting through Farrell’s formula.

As people age, they should reduce their debt-to-income ratio by paying down their mortgage and aggressively cutting auto and credit card debt. At age 45, debts should equal your annual salary. By retirement at age 65, those debts should be zero, he suggests.

Not everyone will measure up to his suggested ratios, but then not every company has optimum numbers, either.

The good news, for companies and for people, is that there’s always another quarter ahead for improving financial performance.

Cut debt, increase savings, and give yourself a new report card in April. Moving in the right direction is as important as getting the numbers right in the first place.

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