Debt Management

Simple ratios can keep your financial ship afloat, says author


How can you tell at your age if your financial ship is headed toward open water or veering toward the rocks? Ratios, says ‘Retirement Roadmap’ columnist Charles Farrell

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Everybody wants to sail into that golden retirement sunset someday.

The problem is, we’re lousy navigators.

How can you tell at your age if your financial ship is headed toward open water or veering toward the rocks?

One word: ratios.

Charles Farrell, author,
‘Your Money Ratios’
Charles Farrell, 'Your Money Ratios' author

Photo credit: Bill Payton

Charles Farrell wrote “Your Money Ratios: 8 Simple Tools for Financial Security” Get Financially Nakedto help people of all ages chart their courses toward retirement.

Ratio examples include:

Mortgage to income ratio, which sets how much mortgage debt you could consider incurring

Education to average earnings ratio, which identifies how much debt you could reasonably incur to obtain a college or advanced degree.

Savings ratio, which pegs the savings you should set aside each year if you want to achieve other financial goals.

In his new book, “Your Money Ratios,” Denver investment adviser Charles Farrell expands on the themes of his “Retirement Road map” column for CBS Moneywatch to share the eight simple ratios he uses to help people of all ages chart a true course toward retirement.

How much should I have saved at my age? How much debt should I carry? How much should I be saving each year?

Farrell says the only way to answer these questions with any certainty is to view our personal financials the way corporations do: with ratios.

“‘Your Money Ratios’ takes the emotion out of saving for retirement,” Farrell says. “You simply follow the numbers consistently, year after year, and do your best to ignore what everyone else is doing or where the market goes … and over time, you are likely to reach your goals.”

You can test drive Farrell’s retirement ratios at his website. The purpose of “Your Money Ratios” is to help readers “make the transition from laborers to capitalists” and thereby retire in comfort. But many of us assumed we were already capitalists.

Charles Farrell: (laughs) Right, right. When I came up with this concept, I thought it might help if you frame all of your decisions with this core question: Is this going to help me convert the income I earn at my job into permanent wealth that I can live on? If it does, it’s probably leading you down the right path and if it doesn’t, then it may not be the right choice. It’s a good organizing principle because so few people understand that basic transformation that you have to make. Most fifth graders know what ratios are. Why do adults get nervous when confronted with them?

Farrell: Because ratios that salespeople use are designed to benefit them, not you. I tried to design a series of ratios that benefit the individual, to help you understand the fundamental relationships between your income and your savings, your debt, your capital, and how these very basic ratios have to change over time. These ratios give you a very clear, concrete goal. So much of the information out there unfortunately leads people down the wrong path. Even today, most mortgage lenders are going to qualify you for far more of a house than you probably should buy. Is buying too much house the biggest financial misstep most people make?

Farrell: I think so. In working with people for many years, when people run into financial difficulties, it’s almost always the house. Housing is a unique asset because it’s leveraged, so a 5 percent movement in the price of a house can wipe out all of your equity. Say you have $1 million in the stock market. If it falls by 5 percent, you still have $950,000, right? But if you have a $1 million house with a $950,000 mortgage on it, a 5 percent move wipes out 100 percent of your equity. With a leveraged asset, tiny valuation declines can wreak havoc on people’s finances. Which counters our unrealistic expectations about home appreciation.

Farrell: Right. For the most part, housing won’t really appreciate much more than the rate of wage growth over the long term, because if it did, then eventually the mortgage cost would eat up all of your income. If people think their housing is going to go up 10 percent a year, well, wages go up on average roughly 3 percent to 4 percent a year. So depending on the cycle, if housing costs were growing at 10 percent, after a short period of time, there’s absolutely no way that anyone could buy a home because the mortgage would cost more than 100 percent of your pay. Of course, if my book had come out in 2005, people would have said, “Why, that’s ridiculous!” You recommend that our mortgage payment should never exceed 15 percent of our monthly income. That’s a tough test for many to meet these days.

Farrell: If your mortgage is consuming 25 percent to 30 percent of your pay, it’s very likely that the smallest hiccup in your finances is going to send your life into a financial tailspin, because on top of that, people have auto debt, they have credit card debt. So when you add all of that up, it’s a debt burden that is not sustainable in the long run. Given the current economy, is it feasible for Americans to cut up their credit cards as you suggest?

Farrell: That’s probably not feasible. I think a lot of people unfortunately need to use credit card debt to finance the lifestyle they’re living. Credit cards, as unsecured debt, are a very convenient way to manage through those periods when you get in a bind: a cash crunch, a job change or illness. Now, there’s no problem using it as long as you use it properly. But when you get into carrying extensive balances over long periods of time, just the basic math shows that your investment return is never going to outpace the interest cost, so you’re really a net negative every time you carry the balance. They’re great for managing cash flow and emergency cash situations, but they’re not meant to be lifestyle enhancers the way the credit card companies want you to use them. Retirement ratios continue to fuel heated discussions. What’s your take?

Farrell: If you’re not a real high wage earner, say over $200,000 or so, I think it’s going to be tough for most people to get by on less than 70 percent of their pay (in retirement) because of the cost of health care. People think, oh, I have Medicare. But Medicare is by no means free. You also have the expense of trying to plan for or deal with long-term care, which currently is an uninsured benefit and can be very expensive. That can eat up a chunk of your monthly expenses every year consistently for a 25- or 30-year retirement. That’s the one thing that people tend to underestimate. Yes, there are people who can get by on 50 percent of their pay, or even 40 percent. But the bulk of American families are going to need much more. What’s the best way to steer toward retirement today?

Farrell: The No. 1 thing is, you have to be on track to be debt-free by whatever age you want to fully retire. If you can have everything paid off and you live in a home that you own, now we’re just talking about some lifestyle decisions above and beyond that. But there are ways that you can phase into retirement. Think about extending your retirement out a little bit. Work part-time. There are all kinds of things you can do if you get in front of it right now and you put yourself on a sustainable path. If you’re carrying a lot of debt, that’s when you’ll be very unlikely to be able to retire because you’ll have to pay the bank first. You raise the likelihood that you’ll run out of money if you retire with significant debt.

See related:QA with credit card and debt expert Amelia Warren Tyagi, QA with ‘Get Naked’ author Manisha Thakor

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