How do you determine whether you're saving enough? When does debt become excessive? What is the recommended daily intake?
Because everyone's financial situation is unique, providing an exact cash figure as an answer to these questions is not useful. As an alternative, let me introduce you to the Golden Ratio for personal finance.
What’s a Golden Ratio? You may determine how you spend your money by using the Golden Ratio algorithm. Your three-digit "Golden Ratio" sums up the proportion of your gross revenue that goes to each of the following three categories:
The Past - Paying for things you bought/did in the past.
The Present - Funding your current lifestyle.
The Future - Accumulating to create future income.
A person with an annual income of $60,000 who saves $500 (the future) and $500 in debt payments (the past) would have a golden ratio of 10 | 80 | 10. 10% every dollar they earn is used to pay off debt, 80% goes toward the present through taxes, groceries, rent, and other expenses, and 10% is set aside for the future.
1. Past: Your debt-to-income
To calculate the past portion of your Golden Ratio, add up all of your monthly debt payments (principal and interest). Then divide this by your gross monthly income and multiply by 100.
For example, if you earn $6,000/month before taxes and pay $2,000/month toward your mortgage, credit cards, car loan, and any personal loans, then the past portion of your Golden Ratio would be 2,000/6,000 * 100 = 33.3, meaning that 33% of your income is directed toward paying off past purchases.
Many people want to exclude the principal on mortgages from this calculation, reasoning that this expense is more appropriately assigned to the “present” because it’s a current housing expense. I disagree for two reasons. First, you borrowed the full amount, and the principal you pay is a contractual debt obligation, not a monthly rent payment. Second, creditors include the entire mortgage payment (principal and interest) when considering your creditworthiness, so you should use the same debt/income ratio as they do.
How Much Debt Is Too Much?
Some debt is manageable. Overwhelming debt can be a poverty trap. Borrowing to invest in income-generating assets like real estate and career skills can put you in a better financial position in the long term. Home and school loans are considered “good debt” by creditors and don’t hurt your credit score nearly as much as other types of debt.
Borrowing to buy transient or intangible things (think: vacations, fine dining, cars, boats, TVs) usually weakens your financial position in the long run because you pay interest on things that you can’t resell at retail, let alone with interest. You’re effectively poorer at the end of the transaction than you were at the beginning. Therefore, consumer debt is treated as “bad debt” by creditors and drags your credit score down more than “good debt” does.
Regardless of the quality of your debt, you should aim to keep your total debt payments at or below 30% of your gross income. The ratio of your monthly debt payments/monthly gross income is also known as your debt/income ratio and is used by lenders and credit bureaus to determine your creditworthiness. As a rule, you want to keep your total debt obligations at or below 30% of your monthly pretax income.
However, if you find yourself overwhelmed by debt or if you simply want to pay off some or all your debt as quickly as possible, then by all means put more than 30% toward the past. It is only when your required debt payments reach 30% that you need to be concerned.
Bottom line: Keep the past portion of your Golden Ratio below 30.
2. Future: Your Savings Rate
The next calculation jumps to the future. To calculate the future portion of your Golden Ratio, add up all of your monthly savings contributions, divide this by your gross monthly income, and multiply by 100.
Building on the previous example, if you earn $6,000/month before taxes and save $1,000/month, then the future portion of your Golden Ratio would be 1,000/6,000 * 100 = 16.7, meaning that 16.7% of your income goes toward your future.
How much you should save depends on your goal and your time horizon (the number of years between today and your goal). You need to have at least a rough idea of both in order to know if you are saving anything close to “enough.”
There are many different views on how much a person needs to save to fund a secure retirement. Fidelity recommends having 10 times your desired retirement income saved in order to stop working at age 67. We’ll call this goal a 10x income multiple.
In the case of someone earning $60,000/year, they would need $600,000 to retire at age 67, using this rule of thumb. Someone who wants a $100,000/year lifestyle would need $1 million, and so on.
Some of us are aiming a bit higher. We want to save enough assets to live off the interest and not need to touch the principal. If you are aiming for this, then (based on the 4% rule, which is itself a subject of hot debate) your goal would be a 25x income multiple or higher.
I personally advise people to save at least 20% of their gross income. If that’s not possible, then start with what you can save and work your way up.
Saving anything is better than nothing, but a consistent 20% savings rate over time is, in my opinion, a sound rule of thumb.
3. Present: Your Consumption Rate
This takes us back to the present. This portion of your Golden Ratio is 100 - (Past + Future).
Using our previous example, if you earn $6,000/month, save $1,000/month, and pay $2,000/month in debt, then your Present = 100 - (33.3 + 16.7) = 50, meaning that 50% of your income is consumed by your present lifestyle.
You can think of this as your consumption rate or burn rate. Taxes, groceries, rent, gifts, and so on … if you didn’t save it, it is considered to be consumed. Period.
Adding It Up and Setting Goals
Let’s run through an example from beginning to end. For simplicity, imagine a person who earns $120,000 per year ($10,000 per month). Their monthly debt payments add up to $3,500, and they save a total of $1,500 per month.
1) Past = 3,500/10,000 * 100 = 35
2) Future = 1,500/10,000 * 100 = 15
3) Present = 100 - (35 + 15) = 50
Their Golden Ratio would then be: 35 | 50 | 15 (in Past | Present | Future order).
If this person is trying to grow their assets, they will need to make some changes. They can use these numbers to set goals for a healthier cash flow.
First, their past is greater than 30, so they could set a goal to reduce this to 30 as quickly as possible.
Second, their savings rate could be larger. Let’s assume they set a goal to have a Golden Ratio of 30 | 50 | 20 within two years. They can do this by refinancing high-interest debt and paying off debt and then putting the money saved on interest toward their savings.
How the Golden Ratio Makes Budgeting Easy
If your debt is healthy and you have achieved your savings goal, then you can spend the rest guilt-free! It doesn’t matter if you spend it on restaurants or holidays or clothes or model trains. If your past and future are in good shape, then you can skip all the itemizing and agonizing and just enjoy your life and your money.
This is where the Golden Ratio is powerful, in my opinion. It distils your cash flow into one very informative metric so you can know instantly if you are on or off track.
If you are on track, spend with impunity! If you are off track, you’ll know where to focus. If debt is the issue, look at refinancing high-interest-rate accounts and making a budget that is both satisfying and sustainable. If saving is the issue, the same strategies can help you find dollars to devote to your future.
If you want to estimate your own Golden Ratio, you can try our strategic partner; Morningstar’s Golden Ratio calculator.
Source: Morningstar Investment Management Europe Ltd.