What’s in a number? A number standing alone is meaningless. Especially in personal finance. Something like $10,000 without comparing it to other factors is surrounding the number is just an amount of money. If that $10,000 is buying someone’s car outright with cash for someone who makes $30,000 a year, it’s a significant amount to that person. That same $10,000 paid as a down payment on someone’s $250,000 Bugatti sports car who is making $5,000,000 per year is less significant in that person’s personal finance. That $10,000 is hardly anything compared to the $5,000,000 annual income. But someone who’s buying a $100,000 car outright with cash for someone making $300,000 per year, the financial impact is exactly the same as the first person buying the $10,000 car in the first example. The ratio is what matters in these examples.
We started to touched on Ratios a little bit in the last Post with Warren Buffet’s house. In that example we were comparing his home’s value to his net worth as a percentage. His house is really a very, very small part of his net worth. This post will look at important financial ratios that banks, landlords, and many other people who try to manage personal finance.
Financial Ratios Everyone Should Know, Wallet Hacks and Millionaire Mob are just a few sites that give some ratios. The first is the most basic. Then each one after that give some more ratios to understand. I give you those three so that you can dig in at your own time and at your own pace.
Since several of the readers have asked about buying a house in the near future, we’ll cover a few ratios for buying a house. I first heard of a ratio for buying a house when I purchased my first house. During the application process, the loan officer informed me that I could get a loan for up to 28% of my income for the house. But there was a caveat. The total of all my debt could not be more than 32% of my income. Since I was an Average person, I had more than 4% (32% – 28%) in consumer debt. This limited my first home to less than the standard 28%. I don’t remember exactly what the numbers were at the time. The point is that I had a lot of credit card debt and it effected my loan to buy my house. That was one of the earliest wake up calls that I may be in trouble. So, I started tracking these ratios periodically.
I’ve never really thought about that ratio for several years now. While writing for this Blog, I’ve noticed these ratios have changed! They haven’t changed for the better either. The newer ratios are 28% for your house and 36% for the total debt ratio. While that may seem better, it’s not. This is not in your best interest at all. Here’s why I don’t agree with the ratio.
The 28/36 ratio allows for 4% more than the old ratio. That’s a 100% (4% to 8%) increase in consumer deb! So what they are doing is allowing you to charge more depreciating assets! They haven’t increased from 28% for the generally appreciating asset called your house. Not that I’m a fan of financing to the maximum, but the above shows where the banks interests are focused. What they did was basically allowed for the Average consumer to borrow more money for the highest interest rate category. That means they make more money and you lose more money to interest.
So, you loose the flexibility to use that second 4% that you could put towards an emergency fund, for food, or for investing. You are also loosing the opportunity cost of that 4% compounded over the years if you invest it in your retirement. That’s worth you seriously considering before you decide to max out how much you can borrow on a house and credit cards. Let me say it again: That’s worth you seriously considering before you decide to max out how much you can borrow on a house and credit cards. The old 28/32 ratio was hard enough to recover. The 28/36 ratio would be much harder. So, don’t be Average and max out your credit. Live below your means and invest the remainder in your future.
By now, most of you by now have read about how much credit can cost you. You know to avoid it on depreciating assets. Assets that don’t appreciate in value or provide income should never be financed. So, when buying a house, don’t forget that wasting money on depreciating assets can really mess up your chances to minimize your interest costs. Remember all numbers in relation to your objectives of financial independence. Don’t get caught up in the Average American dream of owning a house at the expense of your financial future.
Maxing out your credit to purchase a house will significantly hinder your ability to save for your future. It will strap you for cash and for emergencies if you don’t have those in place before you finance a house. So, before you even consider buying a house make sure you have a fully funded emergency fund and an appropriate down payment.
Why is the down payment of 20% or more stressed by so many financial people? Because of two major reasons. Fist, it shows the mortgage company that you have skin in the game. You have 20% equity, so the bank has less risk. You are more likely to pay on time and not walk away leaving the bank with a house. They are not in the house buying business. They reward you for this by giving you a favorable interest rate. So, you’ll be financing less and at a lower interest rate. Over the life of your loan, the reduced financed amount and the lower interest rate will be a significantly less amount you pay to the banks.
Secondly, you won’t have to pay for Private Mortgage Insurance or PMI. PMI is insurance that the bank makes you pay for to insure that they actually get the money back that they lent you. That’s right, they make you pay insurance for them! You get absolutely no value for this either. So, you are losing money here too. In most instances, 20% down will eliminate this PMI. PMI increases with the cost of your house. More expensive house will require a more expensive PMI payment. So, just save at least until you get the 20% down to avoid throwing this money away by paying for the bank’s insurance for your home loan. Don’t do it. If you can’t afford this 20% down, wait until you can.
So, don’t be Average. Learn your financial ratios so you get a better picture of your major purchases such as a house.