Ratios are found everywhere – in recipes and personal finance; knowing them makes life easier.
Shorn of the fancy add-ons, the popular Indian comfort food khichdi is basically a ratio of rice and lentil – half a cup of each, boiled in four cups of water, and serves two people. The portion of lentil is sometimes more, but that varies with individual taste. Either way, it is still a ratio.
Ratios are important because even if you forget the exact recipe – do you add cumin? Onion? – some working knowledge of the ratio of the main ingredients will save the day for you. You or your guests won’t go hungry.
So it is with personal finance; if you follow a ‘money ratio’ – how much you spend under various heads from your income – and are disciplined about it, you will never be broke. In fact, it can help you build a sizeable retirement corpus.
What is money ratio?
Unlike the golden ratio, which is a mathematical fact, a money ratio is just a rule of the thumb that can be the starting point in bringing order to one’s personal finances. Money ratio can be of various types, such as:
- Budgeting ratio
- Emergency fund ratio
- Housing ratio
- Credit utilisation ratio
- Investing/retirement savings ratio
These ratios will help you evaluate your financial situation and offer an insight on how to improve it. Let us study each of them in detail for a better understanding.
This involves breaking down your take-home pay to a 20:30:50 ratio for different heads, though the allocations frequently differ from people to people. The underlying principle, however, is the same. You can customise your breakup as per your personal needs, but the following is a good starting point (the order is important):
- 20% saved (goals or retirement) or paying off personal debts
- 30% on housing (maximum amount; this is for rent or home loan EMIs)
- 50% on everything else
US Senator Elizabeth Warren, who is also a bankruptcy expert, and her daughter Amelia Warren Tyagi, a business executive, have backed this form of personal finance management in their book All Your Worth: The Ultimate Lifetime Money Plan.
Their allocations are, however, slightly different, whereby 50% of the income is allocated to ‘essential living’ (rent or mortgage, food and utilities such as electricity bills, Internet, phone etc); 20% to financial goals (i.e. investments), and 30% to personal expenses (dining out, holidays, fancy clothes etc). But the broad principle remains intact.
Why it is important: This ratio helps you save; 20% of your income saved (or invested, as per the Warrens’ plan) sets you on the road for financial success.
Emergency fund ratio
There is no standard emergency fund amount as such; one can never foretell the extent of the emergency or the financial requirement to meet it. Also, it can differ from people to people according to circumstances and way of living. But on an average, your emergency fund should be about six times your monthly income. You can always cut out frills such as eating out etc., but you will need money for housing.
Why it is important: An emergency fund is for tiding over a financial problem such as loss of job, an illness, or a major repair to your home. It improves financial security by creating a safety net of funds and reducing the need for high-interest debt options.
As mentioned earlier, the maximum amount earmarked for housing should be 30%, and this applies for both rent and home loan EMIs. If you think this is too much, know this: the thumb rule for housing is 30-35% in the West and 25-40% in India.
An EMI of 40% of the net monthly pay/ income is considered very risky, as it eats into such a large portion of the household resources; few lenders are likely to sanction a loan with an EMI this large. However, if your take-home is deemed to be in the higher income bracket, the EMI can be up to 35-40%.
Why it is important: Capping the EMI at 30% of the net income allows you to repay the loan comfortably; this limit is considered a ‘safe zone’, and assumes you are also paying rent along with the home loan EMI, which means saving is difficult at this point. (This happens when the house being purchased is under construction, where a delay can get upsetting).
Credit utilisation ratio
Credit card limit is the extent to which you can have a credit balance without attracting a penalty. Keeping the credit limit utilisation below 30% is considered healthy; banks will raise a red flag if this limit is breached and the borrower’s credit score will be affected adversely.
Why it is important: The easiest way to acquire a loan history is to use credit cards. If your spending is within accepted limits and dues are paid on time, you can hope for a CIBIL score of 750 or more, which is very good and qualifies you to seek other lines of credit if the need arises.
A debt-to-income (DTI) ratio, expressed as a percentage, is your total recurring monthly debt divided by your gross monthly income. A healthy DTI for someone with a monthly rent or mortgage payment should ideally range between 30% and 40%.
Why it is important: DTI helps lenders (including home loan lenders) gauge your ability to manage monthly payment and repay debts. So, if your monthly income is Rs 1 lakh, your debt repayments should be in the range of Rs 30,000-Rs 40,000; if your home loan EMI is this much, it means you should cut down on your credit card use drastically.
Financial fitness is as important as physical fitness; it is important you know how you utilise your money – that is, how you spend and save. This managing of personal finances is not a financial problem, it is a management issue. This is where a thorough knowledge of money ratios comes in, as money management boils down to how you control your expenses and savings. Set priorities according to these ratios; it will define your financial fitness.