Measuring Your Economic Wellness
This piece was written by Max Gulker, senior research fellow, and Ryan Smith, summer fellow.
You may be familiar with the common business practice of using financial ratios to assess financial performance. You can use this trick with your personal finances too. With just a few numbers, you can get a basic sense of your own economic and financial wellness, relative to what the experts recommend.
Financially healthy people are prepared to pay their bills on time, finance short-term emergencies, and have a healthy balance between short-term and long-term savings. The concepts of liquidity ratio, leverage ratio, and investment-assets-to-net-worth address these important areas:
- The leverage ratio (debt divided by total assets) shows an individual’s ability to pay their debts. A recommended maximum benchmark for this ratio is 36 percent, however, 50 percent is a more flexible benchmark for early-career individuals.
- The recommended benchmark for the liquidity ratio (cash and liquid savings divided by monthly income) is 2.5 or above, which means having enough cash to cover 2.5 months of payments in the event of an emergency or a job loss.
- The investment-assets-to-net-worth ratio shows how much people are saving and investing for the future. The established benchmark for the investment-assets-to-net worth ratio is at least 0.25. However, this ratio increases for most people as they get older, meaning a benchmark of 0.20 is more useful for early-career individuals.
Because numbers don’t always tell the whole story, economists like to include subjective measures of wellness along with hard data. We have identified a 10-item questionnaire released by the Consumer Financial Protection Bureau as a useful tool to capture peoples’ views about their finances. The questionnaire asks the degree to which you agree with statements like “I could handle a major unexpected expense” and “I can enjoy life because of the way I’m managing my money.”
As most of us know, information is only part of the recipe for change and must translate into changes in behavior. Not surprisingly, self-control problems are associated with higher borrowing, specifically on credit cards, and lower savings of income tax refunds. As we documented in a two-part blog post, human nature is such that it can be easy to under-save and overspend. But information like the ratios and questionnaire above can help us set goals and more easily put intentions into action.
Here at AIER, we’re developing tools and resources to help you evaluate and improve your economic wellness. With the right information and understanding, combined with a commitment to action, this initiative can help many people achieve greater financial and economic security.
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