These are the four rules of thumb that can help you understand your financial standing better.
· Savings and investment
You need to save or invest at least 20% of your income. If you are an employee and your EPF contributions are 23% or more, you should aim to save another 20% of your income to achieve a savings or investment rate of 40% or above.
The more you save and invest, the faster your journey towards financial freedom.
· Insurance costs
You should be spending 10% or less of your income to pay for life insurance premiums. If you’re single with no dependents, you should spend 5% or less on insurance.
While this is a rule of thumb, 5%-10% should be enough for life insurance premiums to adequately cover your risk management needs. Keep your insurance and investments separate.
· Giving and education
Giving such as to parents and charitable causes are good. Likewise, investing in your own growth and education is excellent too.
However, it is prudent that giving/education is not in excess to the point that you end up with cashflow problems.
A good gauge is that giving/education costs should be 10% or less of your total income.
Total spending of all expenses should not be more than 60% max of your total income.
If you are spending above 60% of your income on expenses, you are likely living in excess. You need to track your expenses in detail to see what unnecessary expenses you can cut.
It is not about lowering your quality of life but focusing on curbing the spending of your money on what does not bring you joy.
5 key financial ratios for personal finances
· Liquidity ratio
Your liquidity measures the number of months you are able to meet expenses from cash and cash equivalents i.e. fixed deposits, to other liquid investments i.e. shares, unit trusts, if you were to lose your job.
It is measured by total cash equivalents available divided by your total monthly expenses.
You should aim for a cash liquidity ratio of a minimum of six months of expenses.
If you include your cash and other liquid investments, you should aim for a liquidity ratio of 12 months and above.
Maintaining a level of liquidity is important to handle the unexpected.
· Savings ratio
Your savings ratio is the percentage of gross income set aside for future consumption.
Excluding your EPF savings, you should aim for a savings ratio of at least 20%. Including your EPF savings, you should aim for a savings ratio of 35% and above.
The more you save, the more you have to invest for your future financial freedom. These savings can be invested in various investment vehicles to create multiple streams of income.
· Asset liquidity ratio
An asset liquidity ratio is the percentage of cash or cash equivalents compared to total net worth. You should aim for an asset liquidity ratio of 20% and above.
If you include cash equivalents i.e. shares, unit trusts, other liquid paper assets, your asset liquidity ratio goal would be 50% and above.
Your liquid assets can be redeemed very quickly in case of an emergency.
· Debt to asset ratio
Your debt to asset ratio is the percentage of liabilities compared to total assets. It can be measured as total debt or total assets.
Excluding property mortgages (property loans), your debt to asset ratio should be 20% and below. If including your property mortgages, your debt to asset ratio should be 35% and below.
A debt to asset ratio is important to gauge how much of a risk you are taking on. If your debt to asset ratio is high, you are at a higher risk of being unable to pay off your debts.
Someone may appear to be rich with many assets but may actually be in poor financial health if they are carrying too much debt and risks.
· Debt service ratio
Your debt service ratio is the percentage of income available to meet debt repayment on all mortgage and consumer loans. It can be measured as total debt over income.
Excluding property mortgages (property loans), your debt service ratio should be 20% and below. If including your property mortgages, your debt service ratio should be 35% and below.
The difference between the debt service ratio and asset ratio is that the debt service ratio is measuring how much of your monthly income needs go towards repaying debt.
The debt service ratio is also important when applying for loans as it allows the lender to know whether they are able to pay back the loan.
This article first appeared in https://mypf.my
MyPF is on a mission to help simplify and grow Malaysians’ personal finances through financial education.