It can sometimes be confusing to figure out all the "appropriate" ratios for your finances. You may often hear terms such as "income to debt ratio" or "debt to savings ratio." Knowing what those terms means and how to apply them to your personal financial situation can be the difference between financial success and failure, especially if something happens unexpectedly and you need some quick cash.
What is Savings?
While this may seem like an elementary question, savings is the amount of money you have in the bank that you can easily access in times of need. Everyone should have a savings cushion for those unexpected emergencies that arise, such as car or home repairs. If you have at least some money in a savings account, you can prevent yourself from getting further into debt.
What is Debt?
Debt constitutes all the bills you pay every month that do not include utilities. Debt can be in the form of a mortgage, credit cards, personal or student loans or car payments. These bills need to be paid every month and usually have an interest rate attached. Interest is what you pay on top of the actual loan and can make the total amount you pay for something two or even three times the original amount.
What is the Ratio?
A ratio is a comparison between two items, such as your savings account and the amount of debt you have. Obviously, you want your savings number to be higher than your debt number. Figure your ratio by setting up the amount of money you pay to debts each month to the amount of money you put into savings each month. For example, if you pay $1,000 in debt payments and put $250 in savings, you would set up your ratio as a fraction of 1,000 over 250. Divide 1,000 by 250, and you will find that your ratio is 25 percent debt to savings, or 4:1. Ideally, you want your savings to be higher than the debt. However, if you have a lot of high interest debt you may want to concentrate on paying that off by paying more than the minimum payment each month and only putting a little bit into savings. Paying down your debt is always good in the long run.
How Much Savings?
One question many people have is how much money they should have in their savings account. This number will be different for every family, depending on the amount of money you make and the amount of debt you have. A good rule of thumb is to build up a savings account that will allow you to pay all of your bills for at least six months. Those six months allow you to keep your head above water should disaster strike in the form of an accident or loss of a job.
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