Do You Pass the Financial Stress Test?
published Jun 23rd 2016, 5:00 am, by Suzanne Woolley
The largest U.S. banks found out today if they passed one of the Federal Reserve’s annual stress tests. The goal is to be judged strong enough to weather the economic fallout from a major financial crisis like the one in 2008 that led to the tests.
How would your own finances hold up under stress? Most of us don’t evaluate them rigorously until we want a mortgage or auto loan or face a crisis. Running a quick personal finance version of the banks’ test now can pay dividends down the line and be a lifesaver when you’re in turmoil.
Five ways to see if you could withstand the stress:
Calculate your readiness
Try the calculator on the site of the financial education nonprofit Mpowered to get a quick idea of where you stand. It asks 20 questions, including whether you pay the minimum on your credit card bill each month, pay more than a third in housing costs, and have more than three months of living expenses saved. It doesn’t require plugging in many numbers or making tricky assumptions.
Figure out your debt-to-income ratio
In the spirit of the formula-heavy Federal Reserve stress tests, get your head around that ratio. It’s your monthly debt payments divided by your monthly pretax income, and it gives a big-picture view of your financial flexibility. Zillow.com is among the sites with a debt-to-income calculator.There is no one perfect number to strive for, although the lower, the better in most cases. While anyone looking for a loan will hear about certain magic ratios, such as the 33 percent or so that mortgage lenders look for these days, those ratios are nothing to aspire to, noted Michael Kitces, a partner at Pinnacle Advisory Group in Columbia, Md., who has a widely followed blog.
A bank’s goal, he said, is to find “the absolute maximum threshold of pain where you take on the most debt possible and can just ever so barely pay it back.” A lot of people get in trouble because they view the amount a lender says they qualify for not as a debt ceiling but as a spending target. “You should shoot for something materially less than what they’ll give you,” Kitces said.
A high debt-to-income ratio may be dangerous for one person and not for another. If a client makes $400,000 a year and has a 50 percent debt-to-income ratio and $200,000 in cash flow, Kitces said, it’s not something he’d be concerned about as a planner. For someone making $40,000 and just able to cover food and the most basic expenses, it’s a different story.
Stop being such a creep
In figuring out your debt-to-income ratio, you get a rough feel for your cash flow. Now separate out must-pay expenses—rent or mortgage, insurance premiums, electricity, phone, transportation, prescriptions—from the want-to-have spending. What if you lost your job? Knowing this number now will offer comfort. Or spur you to cut. As your salary has risen, you may have fallen victim to lifestyle creep. Spending less than you earn gives you an important buffer, and not just because it helps you add to savings and build an emergency reserve, Kitces said. “Free cash flow is the first line of defense,” he said, because in the case of an unexpected expense you just redirect that excess cash flow that you would ordinarily have added to savings.
Is it liquid?
It’s typical to find professionals in their 50s who have a lot of home equity and a lot in retirement accounts but not a lot outside of those, said Eleanor Blayney, the CFP Board consumer advocate. If a big cash need pops up, they can’t readily get at that retirement money without penalties for early withdrawal and other complications. What’s the total available equity you can tap by whatever means if you had to? That includes home equity, preferably by having a home equity line of credit set up in advance that you don’t really use. It also helps to know what it will set you back in penalties and other costs to tap an IRA or take a loan from a 401(k) as last resorts. This is where an emergency fund can save the day. Saving automatically is getting much easier and, in some cases, kind of entertaining. Financial technology company Digit uses an algorithm to analyze your spending and saving and whisks money out of your checking account when it judges you won’t miss it. Since Digit was launched in February 2015, it has saved users $125 million.
Qapital lets users set “if this, then that” rules to trigger automatic savings based on certain events in their everyday lives. The most popular trigger rule is similar to what micro-saving app Acorns does, in rounding up the amounts of your purchases and putting that into savings. Qapital takes a more aggressive approach than Acorns, rounding up to the next even number. A purchase of $2.50 gets rounded to $4.
A “guilty pleasure rule” lets you have $20 sent to savings every time, say, you visit your favorite macaron shop. You’ll either increase savings while enjoying sweets or you’ll eat fewer sweets. You can go the other way and have money put into savings every time you visit the gym or do something else virtuous.
How’s your insurance?
Insurance policies act as a sort of personal risk management tool. On top of homeowners and auto, you may want an umbrella policy, particularly as your income rises. It would cover almost anything that falls outside your homeowners and auto insurance, said certified financial planner Lisa LaMarche, of Milestone Wealth Advisors in Greenville, Del. “If you have teenage kids driving, friends of your kids over your house a lot, someone working at your house—they can sue you if something happens,” she said. These policies tend to be very inexpensive, maybe $200 or $300 a year for the first million dollars of coverage. And if you have a family, it’s smart to get term-life insurance while you’re young, said Nola Kulig, of Kulig Financial Advisors in Longmeadow, Mass. It’s far cheaper than a whole-life policy, and you can get it for up to 30 years. A policy that covers you through your most financially vulnerable years, such as when you’re raising children and paying off a mortgage, is a good protective move. A disability policy to replace a portion of your income can also be a big help, but these policies can be quite expensive if they’re not part of a big group plan. Most large employers offer basic disability coverage, and if you opt to pay the premiums yourself, rather than have your company cover them, it can make financial sense. Since it’s a group policy, premiums will likely be low and add up to much less than the dollar figure for that 25 percent, 28 percent, 33 percent, or more in income taxes that would be taken out of a disability check if your employer paid the premiums. If you’re self-employed, you can likely get an inexpensive disability policy through a professional association. LaMarche, a CPA, said she got her “shockingly inexpensive” coverage through the American Institute of Certified Public Accountants. After you’ve done all this, or even read all this, the last step is to congratulate yourself. By stress-testing and planning, you are increasing the odds that you won’t wind up in need of a bailout.
To contact the author of this story: Suzanne Woolley in New York at firstname.lastname@example.org To contact the editor responsible for this story: Peter Jeffrey at email@example.com
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