Feeling like your finances are getting away from you? It could be time to take a personal stress test. And we’re not talking about the kind of stress that can be alleviated by a trip to therapy or some yoga. We’re talking about financial stress.
The Federal Reserve comes out with an annual stress test, which gauges how strong and prepared t
he United State’s major banks are. If banks fail the test, they aren’t allowed to dig into its capital to pay out profits to shareholders. Instead, the bank has to take a step back and collect itself, make a plan, and build. This test can also be applied to your personal finances. If you don’t pass the personal stress test, you know it’s time to sit down and reassess your financial plan. Below are three categories to test your financial strength by.
This is an important number because it will tell you exactly how much debt you have and how much of your income that debt is eating away. It might take an afternoon, but it’s worth knowing. First, add up all of your individual debts: credit cards, student loans, mortgage, and any others. Then divide this number by your gross income. The rule of thumb is to keep your debt-to-income ratio below 36%.
Sort all of your expenses into three categories: fixed (the things you have to pay no matter what); variable nondiscretionary (things like groceries or air conditioning, that you have some control over); and purely discretionary (expenses you control, such as gym memberships, vacations, entertainment, etc.). Your discretionary spending should make up a larger percentage of your spending, so that you are able to manipulate your spending and cut back where and when you please.
Everyone should have cash savings. At bare minimum, these savings should cover at least three months of your total living expenses. The savings account should not exist in investments such as securities, retirement accounts, certificates of deposit, and the like. This account needs to be liquid. The amount of savings a person needs depends on their individual financial situation. Your fixed expenses and whatever variable nondiscretionary expenses you can’t live without should all be accounted for when planning for how much you’ll need in this account.