“I wanna be a billionaire so f**kin’ bad
Buy all of the things I never had
I wanna be on the cover of Forbes magazine
Smiling next to Oprah and the Queen.”
First Verse of ” Wanna Be A Billionaire” Lyrics by Travie McCoy, sung and co-written with Bruno Mars
Don’t Have To Be A Billionaire
You do not have to be a billionaire to consider yourself to be financially successful. If you have a roof over your head, food on your plate, loving family and friends you are already in a fortunate class. Certain personal financial ratios may help you to evaluate your financial health. These quantifiable benchmarks can help you to develop better financial habits in savings, spending, retirement, investing and debt payoffs.
Financial metrics have some limitations. For example, debt-to-income will be different for people of different ages. At 30 years old when you are at the beginning of your working career, you are accumulating more debt and likely have low savings amount. However, by age 60-65, as you enter retirement years, the balance shifts to high savings and low-to-zero debt levels. For those who have unpredictable income, ratios may be difficult to assess without normalizing for volatility.
We zero in on a few of the most important financial ratios. For our post on 18 personal financial ratios where we look at array of money topics, go here.
There are qualitative factors, those you can’t calculate, that can help you measure your financial success.
Having money is not the only factor in our attaining success and happiness, is it?
Have An Emergency Fund That Can Absorb A Financial Shock
Having liquidity on hand for emergency purposes provides much needed peace of mind. Liquidity refers to your ability to easily convert assets into cash with little to no loss of principal. When you are liquid, you have the financial ability to pay for unexpected costs such as a loss of job, death in the family, or your roof is leaking.
Only 38% of Americans have an emergency fund, with 59% of American adults live paycheck-to-paycheck according to a recent Charles Schwab survey. It takes time to stash away money for unforeseen events such as a job loss. However, it should be a priority. Without it, you will be forced into borrowing.
Monetary assets are among the most liquid of assets. These assets includes cash, cash-equivalent securities or money markets, savings bonds, savings and checking accounts. Liquid assets can be used to support your fixed monthly expenses for 3-6 months. The larger the amount the more comfortable you will feel.
Liquidity Ratio = Monetary Assets/ Monthly Expenses
Your monetary assets should support your fixed monthly expenses such as groceries, rent or mortgage, utilities and car loan for 6 months. A ratio of 6 means that your monetary assets can pay for your basic needs of food, rent, utilities and car loan for the next 6 months, if necessary.
Emergency Fund Ratio
The liquidity ratio is linked very closely to the emergency fund. This is essentially a cash fund for emergencies in unforeseen events such as job loss, death in family, unexpected surgery or immediate house repair.
Emergency fund ratio works by using a targeted number of months that you believe is ample enough to support you through these unknowns. If you are looking for 6 months or higher (and this is highly recommended) to set aside in one fund that can be invested in a high yield savings account or in money markets, then:
Emergency Funds Ratio= 6*Monthly Expenses
This ratio will give you a targeted amount of monetary assets needed to be comfortable for the possible emergency. It takes time to accumulate money for these purposes. How long will it take depends on you and your ability to save.
Related Post: Why You Need An Emergency Fund
Net Worth Is A Key Benchmark
Your net worth, also known as net wealth, is a snapshot of your current financial position. How rich are you? It is calculated using total assets, that is, what you own less total liabilities, or what you owe. Hopefully, what you own is in excess of what you owe. I consider knowing what your net worth is to be an essential personal finance benchmark.
Net Worth Ratio
This is your personal balance sheet measuring your net wealth at a point in time. As you add to your assets, hopefully outpacing your liabilities, you will be getting wealthier. Calculating a net worth statement and updating it is important to do regularly.
Net Worth Ratio= Total Assets Less Total Liabilities
Your total assets are what you own at its current market value. Some assets, like art and antiques, are more difficult to calculate and may require a professional appraisal. Your total liabilities are what you owe based on your debt obligations, notably the balances on your credit card debt, mortgage, car loan and any other loans you have. The higher the positive number you have, the better off you are financially.
Targeted Net Worth Ratio (The Millionaire Next Door)
One of my favorite personal finance books, The Millionaire Next Door, is an oldie but goodie. I have read it at least twice and refer to it often when teaching my college students about money habits.
The more successful millionaires are profiled as prodigious accumulators of wealth (PAWs). They tended to not be extravagant or status seekers as commonly believed of millionaires. Instead, PAWs lived frugally, often buying used cars. As such, they accumulated and retained their wealth.
This ratio uses age as a factor in the calculation as some other ratios do.
Targeted Net Worth Ratio= Age x (Pretax Income/10)
Your targeted net worth provides you with an indication of what you should be worth after liabilities. As a 30 year old making $95,000 annually, your net worth should be $285,000. That amount is derived as 30 x (95000/10). It is a guidepost to help you reach your goals. Although somewhat arbitrary, it gives you some context of what could be achievable if your goal is financial flexibility.
These Ratios Are Linked To Our Age
There is a fundamental relationship between our income, debt and savings. These ratios (savings-to-income, debt-to-income and savings-rate-to-income) are closely linked to our age. In our early career years, we make lower salaries, borrow for a house and a car and make debt payments. Keep your debt burden at a manageable levels and save for 401 K retirement and Roth IRA.
When looking at savings, add your assets including cash and cash-equivalents, current market value of retirement savings, notably 401K and IRA balances, brokerage investment accounts, real estate investments, and current value of other business interests.
Your art, antiques, your car or primary home should not be included in the total for savings. Monetization of these assets are less predictable in terms of time. It is also harder to peg a reasonable value as they are usually less liquid than securities.
Savings-To-Income Ratio= Market Value of Savings/ Gross Income
At age 25 or 30, your ratio will be minimal, growing to a multiple of 3 or better when you are 45 years, and continue to grow to 10x-15x your pre-retirement income so you have a comfortable cushion for retirement.
A better way to look at whether your debt burden is too high is compare it to your gross income, that is, the amount you make.
Debt-To-Income Ratio = (Annual Debt Repayments/Gross Income) x 100
Typically, when you are age 30, when your salaries are at the low end of your career, you may be borrowing for a home and/or a car while still paying student loans. Your ratio should be no more than 36% of gross income. This ratio should decline as you command higher salaries and save more.
An alternative way to calculate Debt-To-Income ratio is looking at your total debt balances compared to your income.
For example, you owe $175,000 on your mortgage and $25,000 on your car loan. Your salary is $110,000, or (175,000 +25,000)/ $110,000 = 1.81. This is a fairly normal ratio for a 30 year old. As your salary rises and you pay off part or your loan, you should be at a ratio of 1 in your 40s. Target little to zero debt as you enter your 60s so you are debt free in retirement.
Savings Rate-To-Income Ratio
Savings should be one of the most important parts of your household’s financial goals. Adopt a “Pay Yourself First” attitude. Your monthly budget should call for savings to be at least 10% of gross income.
Savings Ratio = Savings/Gross Income
Savings refer to money in the bank, liquid funds, deposits, money markets and other liquid funds, such as your emergency fund. Gross income is your total source of income on your budget, and includes what you earn, side businesses, bonuses, dividends and interest income.
Your savings rate should be at least 10% of gross income. This is difficult to do when you first start to work. As your salary or what you make rises, it should get easier to put money away for savings. A healthy savings ratio of 20% would be a good target and allow you to put some of this money to pay down debt.
Personal Cost of Debt
Carrying too much debt relative to income is problematic. This ratio looks at your cost of debt influenced by your credit mix and FICO score. If you have high monthly credit card balances, then you probably have high cost of debt. Card companies notoriously charge high interest rates.
Also, your credit score matters. If you have a lower FICO score, that is, below 650 for example, lenders will see you as a risky borrower and charge higher interest rates. Reducing debt will help you to raise your credit score.
Pay Down High Cost Debt
In debt reduction plans, there are two types: Snowball Method (tackles the smallest debt first) and Avalanche Method (gets rid of the highest cost first). I prefer the Avalanche Method so that you can get rid of the highest cost of debt first. Try eliminating your credit card balances altogether by paying your bills in full.
Related Post: How To Pay Down Your Debt For Better Financial Health
Personal Cost of Debt = (Loan 1/Total Debt)x(Interest Rate for Loan 1) + (Loan 2/Total Debt)x(Interest Rate for Loan 2)
Debt Debt Amount Interest Rate % % of Total Debt Interest Rate x Weighting
Loan 1 $25,000 7.0% 42% 2.9%
Loan 2 $35,000 4.5% 58% 2.6%
Total $60,000 100% 5.5%
Your goal would be to reduce your higher cost debt, that is, loan 1. You would first target reducing the $25,000 loan outstanding. In considering net worth, you want your assets to be a larger amount than your liabilities. Your investments should be ideally earning returns above your cost of interest.
For example, stocks generate higher pretax returns of 9% over the long term, or 6%-7% aftertax returns. You therefore should look to carry debt at lower costs than stock returns.
This is very similar to how businesses look at borrowing capital for projects. They will pick plans that are expected to generate returns above their cost of capital. Your household is your business. You want to have higher returns in your investments than your borrowing.
Retirement Savings Ratio
There is a Chinese proverb: “Don’t wait until you’re thirsty to dig a well.”
Saving for your retirement should begin as early as possible so your nest egg can benefit from compound growth. As soon as you start your first job, you should take advantage of your employer’s sponsored retirement plans, usually a 401K, and begin contributing to your account. Save enough to earn your employer’s matched contribution. Open a Roth IRA plan.
Retirement Savings Ratio = 25 x Primary Income
If you make $100,000, your retirement savings should amount to $2.5 million. This ratio is also called the 25X Rule.
This ratio is complementary to the 4% Withdrawal Rule developed by William Bengen in his study, “Determining Withdrawal Rates Using Historical Data.” This means that you should be able to live during retirement by withdrawing 4% of $2.5 million in assets, or $100,000. It is not a coincidence that 25 x 4% equals 100%. The math at least works perfectly.
Bengen was a financial planner from MIT. His study said that if you withdraw 4% of your assets annually (his analysis pegged the number closer to 4.15%) your retirement savings could last 35 years. Use this as a guideline rather than something etched in stone. You need to figure out what kind of lifestyle you will have in retirement.
The 80% Rule
Some experts use the 80% rule as a rule of thumb for estimating what your income at retirement would be. If your final income before your retirement is $100,000 x 80% = $80,000.
This means that you should be able to live on $80,000 comfortably in retirement. The assumption is you may be able to eliminate some expenses associated with work such transportation and can take public transit.
If you use this $80,000 amount in conjunction with the 4% withdrawal rule, then $80,000/ 4%= $2 million. This lower amount (than the $2.5 million above) reflects the reduced lifestyle needs of a retired person.
Related Post: Saving For Retirement In Your 20s
Qualitative Measures of Being Financially Successful
Sometimes number crunching is just not enough especially for measuring your financial success. We embrace our lives differently. Making a million dollars a year may be a bad year for someone used to making eight figures in the past. Others may feel retiring by age 40 is their mark of success. Being a barber at the age of 108 years was a supreme achievement for Anthony Mancinelli.
What are the qualitative ways of being financially successful?
Being Financial Independent
Having a target of being financial independent means that you have enough savings and income to pay for your living expenses without being employed in a job you don’t want to have or be dependent on others.
You may support yourself through alternative sources of income like dividends, passive income and part or full time work you enjoy. It is a great mindset for those with many interests and don’t want to be tied down to a job you don’t like or non-flexible hours.
Debt-Free And Financially Flexible
You have paid off all your debt. The only debt you carry are monthly credit card payments and are able pay them in full. You have a financially flexible life, meaning you can meet your current and financial obligations and have savings. You are not living paycheck to paycheck. You have liquid savings in the event of an emergency.
Don’t Fight About Money With Your Spouse
You and your spouse are on the same page regarding your financial goals and communicate regularly to stay on track. You have a game plan for spending, savings and debt and are aligned for the most part. This is an ideal scenario and difficult to achieve regularly. It is up to both spouses to meet regularly to review their budget for the short term and assess long term goals.
Couples often fight about money issues. It will happen for most of us. Being honest and transparent to each other is really what counts. If you veer offtrack from your goals, review your plan together and make changes if needed. Don’t think shielding the other from potentially bad or embarrassing developments is the right thing to do.
Be open and proactive about financial problems that should be dealt with promptly. Avoid financial fidelity.
Passionate About Your Career Job
It is easier to increase your chances for financial success if you enjoy your job and career. Some people have had success in starting up several successful companies, or even starting up one great one after several failures. Apoorva Mehta, the founder of Instacart, the online personal shopper, reportedly had 20 failed startups before he successful built Instacart.
I have had success in very different career paths. When I was worked as an equity analyst, I enjoyed the quick pace and satisfaction of meeting with senior company management and communicating my research with institutional investors. I was passionate about my job. It was an exciting time for the telecom industry as digital Internet technologies created new products and services.
Now, as a professor, I love teaching and the “Aha” moment when students make connections in the classroom. When I feel I’ve made a difference, it is priceless.
Don’t Compare Your Financial Situation To Others
We often compare ourselves to others. It may give a point of reference to our peers which may not be a very complete picture. Obsessing over these comparisons is unproductive and may be stressful.
Social comparison bias is a human reaction. We allow ourselves to be influenced by comparing our financial achievements–income, net worth, our status, job title—to others. We negate different paths, personality traits and possibility that some inflation has been taking place.
A better comparison is to look at you are currently against the person you were in the past. What have you accomplished relative to what you anticipated in your plans? How do your results fit with your long term goals? That is a truer picture and will allow you to move forward with your next moves.
Enjoy Learning And Picking Up New Skills
To be successful, keep learning from your experiences and pick up new skills. Continue to challenge yourself with strengthening a weakness or adding a competence. Continue to evolve in your career, expand your skills, to manage people or learn a language. Not only will it keep you from being stymied, you will be more valuable at this job or elsewhere.
Financial ratios are useful as a starting point to understanding your financial health. They do not take the place of a good financial plan. Although they have limitations, like age specificity, these metrics can move you to the next goal post. Consider qualitative measures of what being financial success is. what we all want is to be able to say that we had a life well spent.
How do you measure your financial success? How does it coincide with your financial goals? Look at your financial plan relative to your goals regularly. What works for you? We would like to hear from you!
With a passion for investing and personal finance, I began The Cents of Money to help and teach others. My experience as an equity analyst, professor, and mom provide me with unique insights about money and wealth creation and a desire to share with you.