It is easy to get caught up in life and lose sight of the details. We live busy lives. Whether you are raising a family or approaching retirement, one can unintentionally veer off-track. Often it is our financial health that can suffer.
When the unexpected happens (which it often does) the impact can feel devastating. Having a strong balance sheet can soften the blow. Our personal balance sheet is a barometer of our financial strength and it also provides very important clues about risk and financial vulnerability.
Recently, there was a WSJ story (Sept 20, 2020) about a middle-class working couple in NY. The wife, a practicing attorney recently lost her job due to Covid and they were struggling to pay a monthly debt load of approximately $5,230 on just her husband’s income (we don’t know their individual incomes, but their joint gross income was $175,000 annually). Of course hindsight is 20/20, but it makes sense to use these anecdotal tales to perform our own “safety” checks. Let’s start with the balance sheet.
What is a personal balance sheet?
The balance sheet is also called a net worth statement. It has three sections. The first section lists all assets (what you own) from cash and savings to retirement accounts, homes, and automobiles. The second section, liabilities (which is debt and monies owed), are listed. The difference between the two sections is Net Worth.
Now that you know your net worth, it is also important to understand the readiness or “liquidity” of your balance sheet. Liquidity means ready cash (checking and savings) as well as taxable (non IRA or non-401K) investment accounts. They are considered liquid because these accounts are easily accessed and can be used for living and debt expenses if something unexpected happens. If you have to sell a security, there may be a capital gains tax levied but no tax penalty.
If you find yourself in need of tapping into a retirement account, this would mean paying income tax on the amount you withdraw, potentially paying a tax penalty if you are under 59 ½ years old, and it also disrupts the compounding of your retirement assets.
Liquid is to be distinguished from “illiquid”. Real estate and business equity are considered illiquid because the selling time and process to turn that asset into cash tends to be much longer. It could be months (even years) before cash can be realized from the sale. Hence, having liquidity is important. We recommend 6-12 months of living expenses.
How much is too much debt?
Taking on debt has become standard practice in the United States. For many young people borrowing to go to college is the norm. In our August blog, College Planning, we learned that almost 70% of college students borrow money. Many graduate with $30,000 or more of student loan debt. As young people build their lives, the opportunity to take on more debt is always present. Mounting credit card debt can be a culprit as well as sexy car ads promising affordable monthly payments for buying or leasing new cars.
The next thing we do is buy a house. Real estate in Chicago and most other big cities is very expensive.
When you study the balance sheets of our younger up-and-comers it is not unusual to see student debt,
car loans/leases, credit card debt, and mortgage debt. It is very easy for the debt-to-income ratio to creep up. You have heard the expression “house rich and cash poor”. This is not a good position to be in. Ideally, lenders like to see 28% of debt to income or 36% which includes monthly expenses on top of credit payments.
What is the right ratio for you? Every situation is different. That is why it is important to have an emergency fund.
For our couple above, we calculated their debt-to-income ratio by dividing their total monthly credit payments by their total monthly gross income (before taxes and deductions). In this case, $5,230 divided by $14,500 is a debt-to-income ratio of 36%. Not bad if the $175,000 in annual income can be maintained. Cut their income by 50% (she is a foreclosure attorney and he is a CFO) and a debt ratio of 36% quickly becomes 72%. The harsh reality of a catastrophic event like Covid 19 is crippling. What can we learn from this painful reality?
Why is a strong personal balance sheet important?
There are many reasons a strong balance sheet is important and I’m sure you can add your own personal reasons to this list. From a purely financial perspective, the balance sheet is the best way to objectively review financial health and measure growth over time. The benefits from a strong balance sheet include:
Reviewing the balance sheet is an easy way to keep an eye on your cash and debt. Is it growing or shrinking? How much liquidity do you have? Is liquidity growing or shrinking? Do you need to save more?
Over time, the goal is for the left column (assets) to grow and the right column (debt) to shrink as you pay it down, allowing your net worth to grow. Why is this important? When disaster strikes (job loss, illness, etc.), it is the liquid portion of your balance sheet that will soften or absorb the blow. If necessary, can you liquidate an account if you lose your job to keep up with the payments? Having manageable debt costs (can you take care of it on one income) can prevent the worst from happening.
Peace of mind
There is nothing as worrisome as uncertainty and the only thing we can count on in life is uncertainty. A strong balance sheet sails the choppy seas of life without capsizing one's life. It allows you not to worry. We call it the “sleep at night” factor.
A strong balance sheet provides “choice” to people. You have options. Our couple in the WSJ unintentionally sacrificed their options as they increased their debt.
Lenders like strong balance sheets, as do most companies that extend credit. People with strong balance sheets are rewarded with loans that have better rates and terms.
Steps for building a strong personal balance sheet
In Morgan Housel’s book, The Psychology of Money, he writes about key financial principles that, if followed, help consumers build strong balance sheets. One important concept underlying all of these principles is understanding how your behavior directly impacts the ability to build and preserve wealth. Are you a saver? Thrifty? Frugal? Or are you a spender? Spontaneous? Generous? Shopping is a guilty pleasure or therapeutic? You know where this is going.
Understanding your relationship and behavior with money is the key to accomplishing a healthy net worth. It isn’t reasonable to expect behavior to change overnight but, with a good plan, baby steps are possible. Before you know it, change is occurring and good financial health is possible.
Jenifer Aronson is the Founder of Mosaic Fi.