Do Your Personal Finances Pass the Stress Test?
March 16th, 2015 by Ed Bannen
This week the Fed approved capital plans for banks such as Morgan Stanley, Wells Fargo, and Goldman Sachs Group, to boost their dividends and/or buy back more stock etc. This move comes after the Federal Reserve completed its “stress test” on them. These tests are examples of the government trying to improve transparency in the Finance industry, as well as evaluate risks. The Fed estimates if another bank crisis were to occur in the near future US Banks could lose as much as $490 billion as a result of bad loans.
The banks are not the only ones hit hard during the crisis, which is why it’s never a bad idea to take a look inward and evaluate yourself. So how would your personal finances hold up under a stress test? The Wall Street Journal put together some statistics that you should keep in mind when evaluating your finances:
- Debt-to-Income Ratio – should be averaging around 0.28 not including your mortgage. Now if you are a recent college graduate, go ahead and throw that number out the door! Your debt to income will be anywhere from 1 to 1.5. However, that is a problem for another time. Another general rule of thumb is household debt-to-household income of less than 36%, including mortgages.
- Discretionary Expenses –should be 2/3 of overall expense. Now I know people will struggle to define discretionary, no problem, I will help with that. “A discretionary expense is a cost which is not essential for the operation of a home or a business.” While that new pair of running shoes sounds essential, it is probably more important to have a roll of toilet paper and a bar of soap. The reasoning behind 2/3 of total expense is that you need to know what you can cut out of your life quickly if someone loses a job. So to conclude, spending more than 2 times your essentials is not advised.
- Emergency Saving – 3 to 9 months of expenses. Unless you are in a field where unemployment is almost zero; you should keep an emergency fund that would support you and your family for at least 3 months.
- Additional Income – What do you do in your free time? Could you be earning extra cash doing your hobby? Consider a backup plan to make extra money during a time of financial stress. A friend and I work in property management. We rent out homes and do basic repairs; we have no specialized knowledge. All we need are organization skills and a preferred list of plumbers, electricians and handyman for the tasks that are beyond basic.
- Total Assets – “Add up your emergency savings, the equity in your home and the balances in your retirement savings accounts to get your total assets. Then divide that number by your monthly expenses to figure out how many months you could live with no investment appreciation and no income until you have completely depleted those assets.” Here is where you need to think ‘how fast could I get my cash out of my assets.’ Investments in real estate take much longer to cash out than investments in stocks.
Now that you have the information, all that is left to do is make a plan and follow it!