3 Numbers that can help you budget
Determining whether you're saving sufficiently or if your debt has reached excessive levels is a unique journey for each individual. Precise financial numbers can be futile as answers, given the diverse nature of personal finances. Instead, let me introduce you to a tool that can offer valuable insights – the Golden Ratio for personal finance.
The Golden Ratio: A Holistic Approach
The Golden Ratio algorithm offers a comprehensive view of your financial distribution. This three-digit ratio represents the proportion of your gross income allocated to three crucial aspects:
The Past: Allocations for past purchases or debt payments.
The Present: Funds designated for your current lifestyle.
The Future: Resources directed towards accumulating for your future income.
For instance, if someone earning $60,000 annually allocates $500 each for future savings and debt payments, their Golden Ratio would be 10 | 80 | 10. This signifies that 10% of their income addresses debt, 80% caters to current expenses, and 10% is saved for the future.
1. Past: Debt-to-Income Ratio
To calculate the past portion of your Golden Ratio, add up your monthly debt payments (including principal and interest), then divide by your gross monthly income and multiply by 100. This provides insight into how much of your earnings are directed towards past financial commitments.
For example, if your monthly income is $6,000 before taxes and your debt payments amount to $2,000 (mortgage, credit cards, loans), your past portion of the Golden Ratio would be 2,000/6,000 * 100 = 33.3, indicating that 33% of your income goes towards past obligations.
Debt Tolerance: A Guiding Threshold
The sustainability of debt hinges on its manageability. While certain debts like home and education loans can be beneficial, it's essential to avoid overwhelming debt. Generally, your total debt payments should remain within 30% of your gross income. This ratio, known as your debt-to-income ratio, is a crucial gauge used by lenders and credit bureaus to assess your creditworthiness.
2. Future: Savings Rate
The future portion of your Golden Ratio involves your monthly savings contributions. Calculate this by adding your monthly savings and dividing by your gross monthly income, then multiplying by 100. This figure showcases the percentage of your income dedicated to future financial growth.
For instance, if you earn $6,000 monthly before taxes and save $1,000, your future portion of the Golden Ratio would be 1,000/6,000 * 100 = 16.7, signifying that 16.7% of your income is earmarked for future endeavors.
Setting Savings Goals
The adequate amount to save varies based on your objectives and time horizon. Advisors recommend aiming for 10 times your desired retirement income as a savings goal. This could mean accumulating $600,000 if you aim to retire at 67 with an annual income of $60,000. The "4% rule" is also used to estimate retirement savings needs, suggesting a 25 times income multiple for those aiming to live off interest.
3. Present: Consumption Rate
Your present portion of the Golden Ratio is calculated by subtracting the sum of past and future portions from 100. It represents the percentage of your income utilized for your current lifestyle.
For example, if you earn $6,000 monthly, allocate $2,000 for debt payments, and save $1,000, your present portion would be 100 - (33.3 + 16.7) = 50, signifying that 50% of your income supports your present expenses.
Balancing Your Golden Ratio
By understanding and optimizing your Golden Ratio, you can foster a balanced financial life. If your past, present, and future allocations are in equilibrium, you can confidently enjoy your life without undue stress. However, if adjustments are required, you'll have clear insights into where to focus – be it reducing debt or enhancing savings.
The Golden Ratio simplifies budgeting, providing an instant snapshot of your financial health. If you're on track, enjoy your finances responsibly. If not, focus on refining the corresponding aspects to achieve your financial goals. To estimate your own Golden Ratio, you can use Morningstar's Golden Ratio calculator.
Source: Morningstar Investment Management Europe Ltd.
