Author: Paw Paw

Just a normal guy trying to live the best life I can.

012, Financial Ratios, It’s all About the Numbers

Paw Paw

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.

011, Enough Already

Paw Paw

How much is enough?  Since a home and vehicles can be such a large part of your expenses, especially when you are young, let’s address that first. You surely don’t need the excessive stuff above. You may want it, but you don’t need it.

How much house is enough? Warren Buffet is a extremely rich guy. If you don’t know him, take a few minutes on google and check him out. He lives in house that’s .001 Percent of his Net Worth. Think about that for a second to let it sink in. For some perspective, if your net worth was $1,000,000 your house would be $10 ($1,000,000 X .00001). Yep, that’s ten dollars. The $10 represents how difficult it would be to purchase the house from your cash or investments. This house he bought in the 1950s is an insignificant part of his wealth. He could afford a way more expensive house if he wanted. He’s said he’s happy where he lives. If he felt he could be happier in another house, he would move. But he’s content. There’s no need for him to spend any more to chase a bigger house to keep up with others. He has what he needs and wants.

Granted, he’s worth $60-80 billion, so he’d need a massive house to even begin to approach 1% of his net worth. But that’s not the point necessarily. When you have enough, you don’t need more. When you are content, you don’t need more. When you are happy, you don’t need more. That’s my point.

You’ve often heard things like “your home is your biggest investment”. While your house is an appreciating asset, it doesn’t generate any income. Money is tied up in your house where you can’t spend it or truly invest it. Practically, that means that if your home is your biggest investment, more than half of your net worth isn’t going to generate income. Having that much of your net worth inaccessible and tied up means that you can’t spend it. It also means that it’s not generating income. So, you’ll have to work longer to build assets that can actually generate cash either now or in retirement. That’s the classic house rich, money poor scenario. You have an expensive house, but you don’t have much money for other things like properly investing for your future. Being house rich can severely limit your flexibility to get ahead financially.

This is really amplified when you are young. Your young years can have the most impact on your wealth in retirement when you invest efficiently. When you neglect your retirement in your early years, it’s much harder to catch up due to the time that has passed. The compounding interest from these early years really help to build up an investment nest egg of investments to carry you through your retirement years. Don’t become house rich and cash poor.

Here’s a great article looking at home ownership in total. Avoid the Dream House Trap. It talks about how an expensive house can strap you with large expenses. Those expenses, if not properly balanced against your income, will be felt financially a lot more. It will limit your ability to have flexibility to properly invest in other income generating assets to help you through retirement. The Average people in America frequently overlook how a house can trap you in the rat race just to stay afloat.

You need a roof over your head to shelter yourself from the elements. People do live in grass huts, modest homes and mansions. They all provide the basic requirements of shelter to keep you alive. People are also happy in each of those examples. Each example is also more costly. Grass huts are cheap, modest homes are reasonable, and mansions are extremely expensive. So, choose your housing carefully without overestimating your needs.

Next, let’s talk about cars.  We’ve touched on those before.  This is likely the second biggest expense that can cost lots of money if not done smartly. Since I’ve been into Choose FI a lot lately, here is an article about new cars and here’s a podcast if you listen to those.  The bottom line is that your transportation costs can eat up quite a bit of your income.

Over the course of your, at least 40 years of driving, decisions you make can literally cost you hundreds of thousands of dollars if you are not wise in your choices.  Those hundreds of thousands of dollars can either boost your income during retirement or drag you down.  The choice is yours. If you haven’t read my article about the brand new car I bought, please go back and read my post.  Buying a new car was not a good financial move for me.

You do need transportation. Most will drive cars or trucks versus mopeds or bicycles. Just as in houses, the choices vary widely. They will impact your finances one way or another. Make well informed decision on how your choices will impact your finances. A cheap used car can get you from point A to point B just as well as a brand new high dollar sports car. So, it’s truly up to you which path you choose. Choose wisely and position yourself for success in retirement.

These two major expenses can make or break your finances in the long run. They are the Big Rocks. So, make wise decisions based on facts and solid information that will meet your financial goals. Don’t overestimate your needs and max out your wants. Find the sweet spot that can work for you. If you have to have the cat’s pajamas, you’ll pay more for things at the expense of your financial security in your later years.

Make finding contentment a goal with whatever you have.