The best way to measure your financial security is by calculating your debt-to-cash ratio. Having a lot of debt lowers your financial security. Whereas having a lot of cash increases your financial security.
The lower your debt-to-cash ratio, the strong your financial security and vice versa. Using debt to buy a house that is appreciating in value is great. But using debt to buy a house when it is depreciating could cause problems if you don’t have enough cash on hand.
Your Debt-To-Cash Ratio
One of the reasons why I want to rebuild my cash reserves back over $100,000 is because of financial risk. With two rental mortgages to pay and no steady job, having less than $100,000 feels irresponsible. Further, I’ve got two young kids to take care of.
Theoretically, I could lose all my tenants and therefore have to shoulder both mortgage payments on my own. In such a scenario, because of property taxes, an HOA fee, maintenance, and mortgage payments, $100,000 would be exhausted in 12 months.
Going off a gut feeling to determine how much cash to have is OK. But it would be nice to formalize a debt-to-cash ratio to see at what level debt is too much.
Because of excessive debt, way too many people got their heads blown off during the last financial crisis.
Today, we once again see plenty of people borrowing from their home equity to buy things they don’t need. It’s so funny how quickly we forget about the risk of having too much debt!
Although the economy is recovering from the pandemic, reaching herd immunity is nowhere near certain.
Debt As A Necessary Evil To Build Wealth
The only reason why I take on debt is to leverage up on potentially appreciating assets like San Francisco real estate. So far, so good as the labor market is robust in the Bay Area, and the bubble in tech hasn’t popped, yet. Big tech is winning big during the pandemic. Remember, despite the dotcom meltdown and financial crisis, rents still went up.
I will never knowingly take on debt to buy a depreciating asset. Neither should you. Because of the interest you must pay, to do so is like giving yourself a double uppercut.
In event of a bad investment or downturn in the economy, too much debt can crush your finances. This post will discuss what levels I think are simply too much.
Cash is used as the denominator so we can measure financial risk. It’s all fine and dandy to have equity as the denominator, but when shit hits the fan, your equity could disappear in a nanosecond. Having cash is the true safety net. Do not count on equity!
Measuring Financial Risk And Security
Here are various ways to measure your financial security. We’ll go through each one to the come up with an appropriate debt-to-cash ratio.
No Debt Or Net Cash Position
You’re living as financially risk-free as possible. If you can cover your basic living expenses, you will likely never face financial calamity. Depending on your assets, it’s important to have health, auto, property, and excess liability insurance.
Having no debt or having cash that exceeds your debt is an excellent position to be in by the time you are retired or no longer earning active income. No debt is better than a net cash position.
100% Debt / Cash Ratio
Every dollar of debt is matched by a dollar of savings e.g. $100,000 mortgage and $100,000 in a money market account. You will also likely never experience financial distress because you will probably never have to fire sale an asset due to a liquidity crunch.
A 100% Debt / Equity ratio is risk-neutral. Shore up your financial security by developing as many income streams as possible.
200% – 500% Debt / Cash Ratio
An example is a $500,000 mortgage + $50,000 in student loans and $150,000 in cash. Such levels should be supported by secure income that has a high probability of growing over time.
You should also have a plan to continue working for at least 10 years. The higher the debt level, the longer you should plan to work and the more income streams you should have.
600% – 1,000% Debt / Cash Ratio
You may have just purchased a home and exhausted all your funds e.g. a $140,000 downpayment has left you with just $50,000 in the bank and a $500,000 mortgage (1,000% Debt / Cash).
This is generally a short term situation as you rapidly rebuild your cash hoard, and more slowly grow your income. You might want to pick up a side gig like driving for Uber. Be good to your parents! It’s important to do everything possible to grow your balance sheet.
1,000%+ Debt / Cash Ratio
With more than 10 times more debt than cash, you are at real risk of financial insolvency if anything should happen to your income.
Your income must either be extremely high (new medical doctor making $200,000+ with lots of student loans who decides to buy a house), or something is wrong with the management of your finances, e.g. took out a HELOC to spend on depreciating assets, massive credit card debt, etc.
Your number one financial goal is to pay down debt as quickly as possible while guarding against running out of cash should something unfortunate happen. Spending must go on lock down mode. Find ways to sell things you don’t use.
You might even want to start a website to keep your debt payoff motivation high. There are hundreds of debt bloggers out there who’ve achieved fantastic results thanks to their community’s encourage.
Variables To Reduce Insolvency Risk And Boost Financial Security
My debt-to-cash ratio is about 500%. In other words, I’m nowhere near a safe level for someone who no longer has a job. Entrepreneurship is risky business and Google could banish Financial Samurai and my other websites from their search rankings tomorrow!
A high debt-to-cash ratio is why I’ve been hustling to earn more money through corporate consulting clients so I can pay off one of a rental property mortgage early. With the volatility in the stock market, I’m even more motivated to raise cash in order to have buying ammunition.
My plan is to bring my Debt / Cash ratio down to 200% in 10 years, and down to 100% in 20 years before the age of 60. With the purchase of my fourth property in 2014, at 38, I’m no longer in the hyper asset accumulation phase unless I can win an attractive low ball deal. Making money selling a product online is more enjoyable than managing property at this stage of my life.
I would feel very comfortable having one dollar in savings match one dollar in debt. Even in true retirement, when due to arthritis, my fingers can no longer type.
So long as I can make a combined $300,000 AGI a year through business income and passive income, having a ~$750,000 primary mortgage balance is ideal at today’s interest rates. A 2.625% interest rate is a relatively low hurdle for my investments to overcome. Further, the $300K income:$750K mortgage ratio is relatively conservative.
Besides the level of income that may help lessen the risk of a high Debt / Cash ratio, the absolute level of cash is also an important variable as well. You may have $2 million in debt that costs $53,000 a year in interest to service. But if you have $1 million in cash, you’ll be solvent for the next 20 months, assuming no other income is received.
The Ideal Maximum Debt-To-Cash Ratio By Age
There’s no one size fits all Debt-to-Cash ratio because everybody’s risk tolerance and income generating abilities are different. But if I am to think logically about the necessities of debt to gain a college education and buy a home, here are the recommended Debt / Cash ratios by age.
The idea behind these ratios is to provide guidance for a typical person who goes through a typical arc of accumulating debt in the first half of his/her career. Then paying down debt in the second half of his/her career.
With the goal of being debt free by retirement. Cash should not include stocks, bonds, real estate, or any investments that do not guarantee 100% principal.
During boom times, you want to be leveraged with as much debt as you can comfortably handle invested in appreciating assets. During downturns, the reverse is true.
The goal is to not have to ever sell anything during a downturn due to a liquidity crunch. Many people who held onto their stocks and real estate between 2008-2011 are doing just fine now. It’s those who had to liquidate out of fear, a margin call, or a job loss who ultimately got hurt.
Before we die, it would be nice to have zero debt. This way, there’s one less organization to deal with when dispersing our wealth to family members and organizations we care about. But if you can’t get to zero debt before death, then try your best to get to a 100% debt-to-cash ratio by retirement.
Related Post: Pay Down Debt Or Invest? Implement FS-DAIR
Refinance Your Debt
If you have a lot of debt, it’s good to take advantage of all-time low interest rates and refinance your debt lower. Check out Credible, my favorite lending marketplace where qualified lenders compete for you business.
Personally, I refinanced to a 2.5% 7/1 ARM recently. As a result, I’m now saving thousands of dollars a year in interest. I also got a new 7/1 ARM for a new home purchase with no fees, thanks to Credible Mortgage.
Manage Your Finances In One Place
One of the best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize your money.
Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts to manage my finances on an Excel spreadsheet. Now, I can just log into Personal Capital to see how all my accounts are doing. I can also see how much I’m spending and saving every month through their cash flow tool.
The best feature is their Portfolio Fee Analyzer, which runs your investment portfolio(s) through its software in a click of a button to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was hemorrhaging! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up.
Finally, they recently launched their amazing Retirement Planning Calculator that pulls in your real data and runs a Monte Carlo simulation to give you deep insights into your financial future. Personal Capital is free, and less than one minute to sign up. It’s one of the most valuable tools I’ve found to help achieve financial freedom.