5 Ways to Measure Your Financial Resilience
When putting together your personal financial plan, you’ll likely spend a lot of time thinking about your goals, risks, dreams, and fears. It’s a practical exercise, but it’s driven by much more than dollars and cents.
In doing all this thinking, one area that’s easy to overlook is resilience. Goals aside, what if the worst happened? How much can you withstand in your current financial situation? It’s not always an easy question to answer (nor does it tend to be pleasant to think about), but asking it can be an eye-opening experience.
Are you ready to reveal your own resilience? Read on for 5 ways to measure this important aspect of your financial future.
1. How diversified are your income streams?
One way to help build financial resilience is to have more than one source of income. For many, the primary income source is a job — but it doesn’t need to be the only one. Whether it’s a rental property, income from investments, freelancing work, a fully-developed side business, or something else entirely, finding new ways to make money could help you pad your savings and bolster your finances in times of trouble.
Choosing the right income streams for you is a matter of goals, skills, financial situation, and personal preferences, but with some creativity and effort it can be done. You might even find joy in growing a hobby into a paying job!
2. How secure are those income streams?
One of the ways that large banks measure their risks is through what’s known as risk-weighting. For example, if a bank owns a stock portfolio, it might only account for a percentage of its value for risk assessment purposes — just in case the portfolio declines significantly. In other words, you could say that risk-weighting looks at assets from a worst case scenario standpoint.
You can do a related exercise with your income sources. How secure are they? What is the risk that you’ll lose one of them, or that your income from a particular source will fall significantly?
It’s not exactly pleasant to think about the risk of being laid off or not being able to rent out that condo you invested in, but it is necessary. That’s because you can’t effectively manage risk until you understand it: the clearer you are on the risks you’re actually facing, the easier it will be to develop a plan to deal with them.
3. What’s your debt-to-income ratio?
Understanding your debt-to-income ratio can help you determine how resilient you are financially — and what you need to do to increase your resilience.
Your debt-to-income ratio is important because it shows you how much you’re obligated to spend each month on top of your basic living expenses. After all, if you were to lose your income, you’d still need to eat, and, unfortunately, you’d still need to service your debt.
To find your debt-to-income ratio, add up all your debt payments and divide by your monthly income. Banks and financial institutions typically use gross income when calculating this ratio, meaning that you would use your salary before taxes and other deductions — but if it makes more sense in your situation to use your net income, use that.
For example, if you devote $1,500 per month to your mortgage and another $1,000 to credit card bills and car payments, your total debt service comes to $2,500. With a gross income of $4,500, your debt-to-income ratio would be 55%.
Once you have the number in front of you, you can start asking some serious questions. How sustainable is this? Are the debts you’re paying for productive? For example, many people consider housing to be a productive asset, while personal expenditures on credit cards are not. What would you be able to save or use more productively if you didn’t have all that money going towards debt?
4. How much cash can you access in an emergency?
In addition to understanding how much debt you need to service on an ongoing basis, it’s helpful to know how much money you have available should the need arise. This could include your savings, a home equity line of credit, and other sources of financing.
While it’s generally not a good idea to use debt to finance living expenses, knowing what you have available and where can make it a little easier to prepare for and deal with emergencies. So, ask yourself: how much do you have saved for an emergency? More importantly, is it enough to mitigate the risks you’re facing?
Knowing what’s available and how it squares with your spending requirements can help steer you in the right direction towards building more savings or evaluating other options.
5. How much slack do you have in your budget?
Finally, now that you’ve looked at your budget from the perspective of income, debt, and savings, take a different angle: how much slack do you have — in other words, how much below your means are you living? Even if that extra padding doesn’t seem like much right now, consistently coming in under budget can reap huge benefits over time thanks to the power of compound interest.
But slack is about more than just savings: it’s about flexibility. If one month you need to buy a new timing belt for your car, slack is what makes the situation manageable and potentially less stressful. In fact, research shows that having slack in your budget can help you make better financial decisions! Less scarcity in your finances leads to clearer thinking, and that means a higher ability to weigh your options prudently and effectively.
So, if you don’t have it already, consider adjusting your budget to leave a little breathing room. It doesn’t have to be allocated anywhere specific, just let it accumulate. Even knowing that it’s there might help you gain some perspective and, possibly, a rising tide of good financial choices.
Like most things in life, resilience doesn’t necessarily show itself to the sound of blaring trumpets and fanfare. It shows itself in the little things — like that timing belt. While having a resilient financial plan can help in the major tragedies, it can also prove invaluable in the little inconveniences that we all face in our everyday lives. Slack is one part of that, along with a clear awareness of your present financial situation and of what you need to do to make your finances even stronger.