I saw a tweet a while back that got me thinking:
It got me thinking about ratios and rules of thumb. I thought it would be fun to do a post about two related, but slightly different ratios and see if we could come up with any useful rules of thumb:
- Your Investment to Payment Ratio and
- Your Investment to Interest Ratio
Let’s take them one at a time and see how implementing the proper ratios can help you build wealth.
Investment to Payment Ratio
This ratio is the amount of money you invest in a given month compared to the minimum required payments on all of your debts. So let’s say you make $20K a month, have a $3500 P&I payment on your house, a $1500 per month student loan payment, a $20 credit card payment, and a $480 per month car payment. That’s a total of $5500 in payments. Let’s say you’re saving $2,000 a month. That would make your investment to payment ratio:
$2,000/$5,500 = 0.36
That seems pretty low to me. What would be good? Well, I think it’s a good idea to keep this ratio above 1, at least for a high income professional. That’s going to require some sacrifice and discipline though. What does a ratio of 1 look like? It looks about like this. Again, let’s assume that same $20K a month gross income. Let’s say you’re putting 20% toward retirement and 5% toward college, so you’re investing $5K. You kept your student loans down ($1,000/month) and bought a less expensive house ($2500/month) and avoided car payments and credit cards. What’s your ratio now?
$5000/$3500 = 1.43
Keeping that above 1 doesn’t seem that hard does it?
Investment to Interest Ratio
This ratio is the amount of money you invest in a given month compared to the interest you’re paying for all of your debts. So if you have a $200K student loan at 6%, the monthly interest would be about $1,000. The interest on a $500,000, 4% mortgage is $1,667. Maybe the interest on cars and credit cards is $100. Total interest is $2,767. If you’re saving $2K, your ratio is 0.72. If you’re saving $4K, it’s 1.45. As you make more or increase your savings rate and pay off your debt, that ratio improves. When you pay off all your debts, it becomes infinite.
I think a ratio of < 0.5 is poor, 0.5 – 2 is fair 2-5 is a good ratio, 5-10 is very good, and > 10 is excellent.
I like this ratio a little better in that it rewards you for doing things that minimize the interest paid, like taking a shorter loan term, running the interest rate risk yourself with a variable rate, or refinancing to a lower rate. The ratio also improves as your overall financial situation improves and your debt burden drops. But otherwise, it suffers from the same problems as the other rule of thumb.
What About Extra Payments?
I was asked about whether extra debt payments above and beyond what is required should count on the investment side of the ratios. My response was, “If you have to ask, you probably have too much debt!” But I like the idea of counting them because not only does making extra payments decrease interest and shorten the term of the loan, but it also increases your net worth just like investing does. So if you’re investing $4K and paying $4K on the loans like a good little WCI-following, living-like-a-resident young attending, you could have a ratio of 4 or better and climbing.
What do you think? What’s your investment to payment ratio? What about your investment to interest ratio? Do you think it’s a useful number for a typical attending in the accumulation phase to make? Why or why not?