In our last posting we began a dialogue about personal financial ratios. We used the Second Habit, ‘Begin with the End in Mind’” from Stephen Covey’s book, The Seven Habits of Highly Successful People. We then went on to say that like the Second Habit, “personal financial ratios are a goal to strive toward, a goal to be obtained.” The first step in working with personal financial ratios is to create a “spending plan.”
Unlike the term budget, a ‘spending plan’ emphasizes choice in spending decisions. It is a necessary building block for the future. Once the spending plan is completed it should be reviewed in light of the personal financial ratios. Objectively, if we give away 10 percent of gross income, save 10 percent of gross income, and pay taxes of 30 percent of gross income, then we should be creating our spending plans with a goal of living off of 50 percent of our gross income.
The Housing Expense Ratio is used by lenders to qualify a borrower for a mortgage. The ratio compares projected housing expenses to the borrower’s gross income. Housing expenses consist of: mortgage payments (principal and interest); property taxes; hazard insurance; and if applicable, mortgage insurance, and association fees.
A borrower should spend no more than 28 percent of gross income on these expenses. In our practice, we encourage our high-net-worth clients to keep the ratio at 15 percent or less. This ratio is also called the PITI ratio (principal, interest, taxes, and insurance) or the Front-End Ratio.
The Debt-to-Income Ratio is also used by lenders to qualify a borrower for credit, as well as for a mortgage. The ratio compares the borrower’s total debt payments to their gross income. There is no true debt-to-income ratio. Rather, individual lenders have their own guidelines. In general, a lender will want the debt to income ratio to be 36 percent or less of the borrower’s gross income. This financial ratio is also called the Back-End ratio.
A major cause of the housing crisis and the resulting Recession of 2007-2009 was the callous disregard for these financial ratios by many lenders, the government, and consumers. As a result of government mandates and consumer recklessness, the three “Cs” of lending were thrown out the window: collateral, creditworthiness, and capacity. As a result, consumers were over leveraged, and the additional cash flow used to service their debt depleted their reserves.
Creating a spending plan and measuring your financial ratios has many rewards. The chief one is peace of mind: you have a plan and you are working toward the end in mind. Your consumer credit score will go up. And in our practice, clients who create a spending plan typically recover ten percent of their gross income because wasted spending is eliminated. It is truly amazing what may happen when one watches their financial ratios and has the end in mind.