During my CFP® studies, I had to learn the suggested “savings and debt ratios”. I thought this would be particularly relevant to anyone who is just getting started saving or getting out of debt. So, here goes!
In general, there are three debt-to-income ratios: consumer debt, housing debt, and total debt. These ratios are used to determine, in part, how you’re doing financially. As part of taking financial inventory, you’ll want to know your debt ratios. Note that some ratios compare monthly payments to gross income (before taxes) whereas others compare to net income (take-home pay).
Consumer Debt Ratio
Definition: Your consumer debt ratio is your debt other than housing and student loans, i.e. your credit cards, auto loans, and medical debt.
Percentage: Generally, your consumer debt ratio should not exceed 20% of net income. An “excellent” consumer debt ratio is 10% or less.
Calculation: To determine your consumer debt ratio, divide your monthly debt payments by your monthly take home pay.
Housing Debt Ratio
Definition: Your housing ratio is your housing debt, including principle, interest, taxes, and insurance (PITI). For renters, housing includes rent and insurance.
Percentage: Your housing ratio should be under 28% of gross income.
Calculation: To figure out your housing ratio, divide your PITI by your monthly gross income.
Total Debt Ratio
Definition: Your total debt ratio combines your consumer debt and housing debt, along with any other debts, including personal loans, student loans, etc.
Percentage: The recommended total debt ratio is under 36% of gross income.
Calculation: To determine your total debt ratio, divide your total debt payments by your gross monthly income.
Now, let’s take a look at the emergency fund savings and total savings recommendations. (Because what you save for retirement is based on a number of personal factors, there is no general retirement savings percentage, so you won’t find that here.)
Definition: Your emergency fund is a savings account that you can easily access in case of an emergency (e.g., job loss, car accident, injury, etc.). It’s your financial “cushion”.
Percentage: The recommendation here is to have between 3 and 6 months of expenses saved in an emergency fund. Whether you’re on the 3 month end of things or the 6 month end depends on your specific situation. One factor is whether you have one or two incomes in your household. The more incomes, the more fewer months you’ll need saved.
Calculation: To determine what “3 to 6 months” of expenses looks like, figure out what it costs to live for 1 month and multiply that by 3 and 6. Somewhere in between those numbers is the suggested emergency fund amount. Note, that you don’t include any of your taxes, retirement, or other automatic withdraws from your paycheck in your monthly expenses here. Only add up what you’d have to pay if you lost your job (housing costs, utilities, loans, groceries, gas, etc.).
Total Monthly Savings
Definition: Your total savings is what you put into savings, investments, and retirement every month.
Percentage: Generally, for a young professional who starts saving before age 32, saving between 10-12% of your gross income is recommended. For people who start saving when they’re older, this percentage jumps to the 15-20% range. But this is just based purely on a general recommendation. Determining what you should contribute to retirement varies greatly based on your income, tax bracket, investments, and a number of other things.
Calculation: To calculate your monthly savings, multiply your gross monthly income (i.e. before tax income) by .12 to see what you should be saving monthly at 12%. For example, someone earning $5,000 pre-tax, would want to save $600 / month, split between her savings and retirement (5,000 x .12 = 600) using this guideline.
Here’s a recap of the 5 savings and debt ratios from above:
- Consumer debt: < 20% of net income
- Housing debt: < 28% of gross income
- Total debt: < 36% of gross income
- Emergency fund: 3-6 months of non-discretionary expenses
- Total savings: 10-12% gross income if you started saving before age 32.
If you’re interested in calculating your savings and debt ratios electronically / digitally, then I recommend using an online tool like Personal Capital. You can use this website to organize and track your overall financial health.