I avoided my personal finances the way some men avoid commitment - - I got just close enough to cause damage before turning and running. However, by running away from my personal finances I was only harming myself. Once I learned that managing my money was not difficult if I knew the right numbers to use, I embraced my personal finances like a long lost friend.
The Five C's of Credit
You might think that I would stay away from credit to keep my personal finances healthy; however, by learning about credit I learned how to be financially stable. Knowing what elements lenders use to determine my credit-worthiness helped me know what areas I needed to concentrate on to become more financially stable. The five elements of credit that a lender checks before deciding whether to lend you money are:
- Capital - your assets
- Capacity - your ability to pay back debt
- Collateral - the assets you have pledged for debts
- Character - your trustworthiness
- Conditions - the financial climate
I cannot control the current financial conditions; however, I can control the other four elements of credit. By doing so, I improved my financial health.
Five financial ratios directly affect the above elements. Knowing these ratios and concentrating have having healthy numbers helped me monitor my financial health and being to improve it.
- Assets-to-debt ratio: This relates directly to the first credit element - - capital. This ratio is figured by dividing your total assets (house, car, personal items, etc.) by your total debts. Anything below a 1.0 means you owe more than you own and you are not financially solvent. Benefit to my financial health: I paid down debt to increase this ratio.
- Debt payments-to-take home pay ratio: This ratio measured my ability to pay my non-mortgage debts with my net income. It was simple to figure: my total monthly debt (not including my mortgage) divided by my net take home pay. Anything more than 20% meant I was using too much of my income on credit cards, personal loans, car loans, etc. Mine was 28% before I began to work on my finances - - it is now 21% so I still have work to do. Benefit to my financial health: I reduced my credit card bills to lower this ratio.
- Debt service-to-gross income ratio: I used this ratio to measure my total debt (including my mortgage) to my gross income to see if I was living beyond my means. I divided all of my monthly debts (not including utilities and living expenses) by my gross income. Anything over 36% is not advisable - mine was 29% so I was good.
- Basic liquidity ratio - I use this ratio to measure my ability to survive a financial disaster. To figure the ratio divide the amount of cash immediately available (checking account, savings account, etc.) by total monthly expenses (all bills and living expenses). The result is the number of months you can go without income and pay your bills. I read that financial advisors state I should have at least three months worth of funds in an emergency account - - mine was less than one. Benefit to my financial health: I have increased my savings thereby increasing my assets.
- Savings ratio: Divide monthly savings amount by monthly take home pay - - anything below 15% is too low. By not having sufficient savings, I could not cope with a financial emergency and I was not on tract to meet long-term financial goals. Benefit to my financial health: Seeing how low this ratio was encouraged me to allocate more money to savings.
It was scary at first to see how out of balance my finances were and to realize that I was living beyond my means. By using the ratios and concentrating on getting them within a healthy range, I was able to increase my financial health. Knowing the right numbers makes all the difference!
More from this contributor:
The Frugal Toad