This post was written by Erica Gellerman, MBA, CPA, and founder of The Worth Project.
When it comes to money you’re doing your best each month. You save money where you can. You don’t buy too much. And you’re paying off debt. But how do you know if you’re really on the right track, financially? Is there any way to check in with your finances without having to open an overwhelming spreadsheet or get lost in an endless amount of financial jargon?
There sure is, and we’ve got you covered. Here are three easy ways to measure, and perhaps improve, your financial health:
Know Your Net Worth
When evaluating your financial health, calculating your net worth is a good place to start. Why? It gives you an easy way to get your full financial picture.
Your net worth is the difference between your assets and your liabilities. Said another way, it’s what you own, minus what you owe.
Calculating your net worth doesn’t need to be complicated. First, make a list of everything that you own (bank accounts, your home, retirement accounts, etc) and add it up to get the total. Next, make a list of everything that you owe (credit card debt, student loans, mortgage, etc) and add this up to get the total. Subtract what you owe from what you own. That number is your net worth.
For all of you homeowners out there, here’s where this calculation can get a little tricky. We are constantly told that our home is an asset. But if you have a mortgage, it’s also a liability. Let’s say you own a home worth $500,000 and your mortgage is $400,000. You’d include your $500,000 home in your list of assets (what you own), and your $400,000 mortgage in your list of liabilities (what you owe).
Income and budgets don’t factor into your net worth. It’s simply a way to see if right now you own more or owe more.
Improving your net worth
Ideally, you want to have a positive net worth. The higher the number, the better.
Looking at your own financial profile, don’t get discouraged if your net worth is negative. When I came out of school with six figures of student loan debt, my net worth was negative. It can be frustrating, but it’s just a measure of where you are right now and you can always make changes to improve your situation.
One option that may get your net worth moving in the right direction is improving your monthly cash flow.
Measure Your Cash Flow
Each month we have money coming in and going out; this is known as your cash flow. Your cash flow is going to tell you whether you’re living within your means or a little too large. It’s important because your net worth is dependent on your monthly cash flow. When your monthly cash flow is positive, you’re adding to your net worth. When it’s negative you’ll see your net worth fall.
A good goal to have is to have more money coming in than going out. It’s a simple concept, but not always easy to do.
Here’s how to measure your monthly cash flow:
What you earned minus what you spent = net cash flow
Experts usually recommend your net cash flow be at least 20% of what you earn each month. For example, if you earn $5,000 you’ll want to aim to have at least $1,000 in net cash flow remaining at the end of the month.
Improving your cash flow
Or, you can take a low-tech route and just sit down and write out how much you plan to spend and where you can cut back. The specific technique doesn’t matter; what does matter is that you know where your money is going.
Calculate Your Debt-To-Income Ratio
Your debt-to-income ratio (DTI) is important because it gives you an idea of whether you’ve taken on too much debt. It’s also a number that lenders often use to decide whether they can extend you more credit. If you’re trying to buy a home, this number is going to be especially important.
You can calculate your DTI ratio by taking your total monthly debt payments and dividing it by your monthly gross income (your income before taxes).
For example, let’s say you have a monthly gross income of $6,000. You have monthly debt payments of $950, which includes a student loan payment of $550, a car payment of $250, and a credit card payment of $150. Your monthly DTI is 16%.
Lenders like to see a lower DTI ratio because that gives them confidence that you can handle monthly debt payments. Most lenders won’t give you a mortgage if your DTI is over 43%.
If you are applying for a mortgage, the lender may include your estimated monthly mortgage payments in a DTI calculation. If you want to buy a home that would leave you with a $1,700 monthly mortgage payment, your new DTI would be 44%. That’s higher than most lenders would approve and you might have a difficult time finding a loan.
Improving your debt-to-income ratio
Knowing your DTI before you apply for a mortgage or other credit can help you figure out how to make your application as solid as possible. A couple of options that may strengthen your application are to pay off some lingering credit card debt or to request to borrow a lower amount of money.
Regardless of whether you’re planning to apply for more credit, keeping your DTI as low as possible means you’re creating a healthy financial future by not weighing yourself down with debt.