Life is unpredictable. Unexpected change — whether a job loss, illness or other unforeseen event — can put pressure on your personal finances.
According to a report from the Pew Charitable Trusts, 55 percent of 7,800 households surveyed struggled to “make ends meet” following an expensive financial shock, and nearly half of them had not recovered six months later.
How well you survive a difficult financial situation may depend in part on whether you have assessed your financial health and taken appropriate action. Think of an assessment as a stress test, a method for determining your ability to withstand sudden financial pressure.
Your test results will reveal whether you could absorb a significant financial shock. It involves assessing current debt, spending and your ability to quickly generate cash or income.
Conduct your personal financial stress test by following these four steps.
CALCULATE YOUR DEBT-TO-INCOME RATIO
The ratio is your total monthly debt payments divided by your monthly pre-tax income. Include any recurring monthly debt. For instance, factor in minimum credit card payments, auto loans and student loans. Count your monthly mortgage payment of principal, interest, taxes and insurance.
Add up your monthly debt and divide it by your pre-tax monthly income. If, for instance, your total recurring monthly debt is $2,000 and your gross monthly income is $6,000, your debt-to-income ratio is 33 percent. To put that in perspective, the Consumer Financial Protection Bureau says a 43 percent debt-to-income ratio is the highest ratio you can have and still obtain a qualified mortgage. Lenders and others recommend you not exceed 36 percent.
A high debt-to-income ratio could suggest you’re spending to maintain a lifestyle greater than your income allows. A low ratio gives you advantages, such as an improved ability to qualify for a loan.
Pass the Test: If you have a high debt-to-income ratio, you’ll be less likely to absorb a financial shock because a large percentage of the money you make each month is going to continue to go back out the door. Lower your debt-to-income ratio by paying off debt where you can, and consider downsizing to things like a less expensive car or home. This not only will increase your ability to qualify for a loan, it also will help improve your personal financial health.
MAKE SURE YOU’RE DEDICATING THE RIGHT AMOUNT TO ESSENTIAL AND DISCRETIONARY EXPENSES
Essential expenses are what you pay for things like housing, food, loan debt and insurance. Discretionary expenses include costs for things like entertainment, clothing and personal care. Add them all up. How many of these expenses could you immediately cut back on if you needed money right away? The total dollar amount represents money that you can come up with in the event of sudden financial pressure.
A good rule of thumb to remember is 20/60/20. Budget 20 percent for discretionary expenses, 60 percent for essentials and 20 percent for saving and investing.
Pass the Test: When your budget is based on a rule like this, it typically means that you are setting yourself up to deal with a financial shock. Depending on how much you have saved or other factors, you may change the percentages for your situation. Try to avoid increasing your discretionary spending if your income rises or if you receive a financial bonus or gift. Maintain your existing lifestyle and save the extra money for a rainy day. You’ll gain some peace of mind and improve your liquidity.
ASSESS YOUR LIQUIDITY
Liquid assets are cash and assets that can be converted into cash quickly. These are typically savings accounts. Your retirement accounts, such as your 401(k), should not be considered liquid because this is money for retirement, not emergencies. In addition, you may incur penalties for early withdrawal.
Assess your liquidity to determine how much money you have that you are able to quickly access. If a financial emergency were to arise, tap your fund before borrowing money or paying bills late. In turn, you can avoid interest charges and late-payment fees.
Pass the Test: Build an emergency fund. As a general rule, create and maintain an emergency fund that contains an equivalent of six months of living expenses.
A serious accident or health issue could have devastating financial consequences. Your insurance policies could be a first line of defense. Take this time to review them for proper coverage.
Homeowners and auto insurance: Inadequate coverage can leave you open to tremendous financial risk, especially in the event of severe damage to your home or car.
Health insurance: According to HealthCare.gov, a three-day hospital stay for a person without health coverage comes with an average cost of $30,000.
Disability income insurance: If you couldn’t work, how would your family replace your lost income? Disability income insurance can help you make up for lost income. If you have employer-sponsored disability coverage, it may not be enough; consider augmenting it with an individual plan.
Life insurance: Look at how your family would be protected from financial burden if an income earner was to die unexpectedly.
Pass the Test: Review your insurance policies with two thoughts in mind: customization (choosing coverage options that fit your lifestyle); and coverage (making sure you have adequate coverage in order to minimize financial shock).
How well you survive a difficult financial situation may depend in part on whether you have assessed your financial health and taken appropriate action.
If you pass these tests, breathe easier knowing you’re prepared. You’re less likely to struggle should you ever encounter an expensive financial shock. If you have work ahead of you, that’s OK. At least you know where you stand, and you can follow the steps outlined here to strengthen your defenses.