Creating an emergency fund is an important part of developing a budget that keeps you on the right financial path. With enough money set aside, you can stay on the right path, even when life takes a turn.
Understanding what an emergency fund ratio is can help you develop your own plan for covering unexpected expenses like car repairs or medical bills.
Without an emergency fund, you put yourself at risk of going deeper into debt when surprise expense pop up. You might be forced to use a credit card to cover a bill, or, worse, delay paying your bills. That can cause a lot of financial harm.
Importance of Emergency Fund Ratio
An emergency fund ratio helps you get a better understanding of how your emergency fund fits into your overall financial picture.
The emergency fund ratio is the proportion of your overall emergency savings compared to your total monthly obligations. So, if you have an emergency fund ratio that perfectly covers one month of expenses, your emergency fund ratio would be 1.
When you know how well your emergency fund is prepared to cover your expenses in the event of an emergency, you can plan whether you need to build more savings into your budget.
How to Calculate an Emergency Fund Ratio
To calculate how your emergency fund compares to your overall expenses, first total your average monthly expense. Include items that are considered necessities like:
- Monthly mortgage or rent payments
- Utilities bills
- Phone or Internet Service bills
- Credit card bills
- Any other loan payments
Then, divide your total monthly obligations by your total emergency fund savings.
Most financial advisors recommend you have at least three to six months’ worth of expenses saved to cover your necessary expenses. So, if something unexpected happens, like you lose your job, you’ll be able to continue to pay your bills on time while you look for your next source of income.
Other Key Ratios for Budgeting
Aside from an emergency fund debt ratio, you can turn to other key ratios for guidance creating your budget.
The debt-to-income ratio is a common ratio that can put the total debt you’re carrying into perspective. Lenders often use this ratio to help them determine whether you’d be a good borrower, or one who’s likely to repay your loan on time.
Even if you’ve proven you’ve managed your money well and paid your bills on time with good credit history, you can be denied a loan if your debt-to-income ratio is too high. That’s because the lender sees that you have a lot of financial obligations already.
To get your debt-to-income ratio, divide your total monthly payments toward debt by your total monthly income.
For example, consider that you have monthly payments of:
- $2,100 for a mortgage
- $125 for student loan debt
- $75 for credit card debt
- $250 for auto loan
Then, your total debt payments would be $2,550. (You don’t factor in expenses like monthly utilities bills, television bills, insurance, groceries or childcare.)
If your monthly income was $6,000, then your debt-to-income ratio would be 42.5% ($2,550 divided by $6,000).
What is a good debt-to-income ratio?
What makes a “good” debt-to-income ratio (DTI) is different for everyone. Ideally, of course, we’d all want our debt to be 0% of our total income – in other words, we don’t want any debt! Factors that affect our ideal DTI include lifestyle, financial goals, risk tolerance and job stability.
However, having some debt can be good to keep you on the path toward making major life steps. You may carry a student loan that helps you get the job you want, or you may carry a mortgage that has help you buy the house you live in. This kind of debt can help you in the long-run.
When you’re buying a home, many lenders use the 43% rule, which means they won’t approve you for a mortgage unless your debt-to-income ratio is below 43%. The Federal Housing Authority and U.S. Department of Veterans Affairs both use the 43% rule with approving their mortgages.
They want to make sure you have plenty of extra cash flow so that buying a house won’t be a strain.
Read also:
- Is $1,000 Enough for an Emergency Fund?
- What’s on a Traditional Income Statement?
- A Beginner’s Guide to Factor Investing
The Bottom Line
Knowing your emergency fund ratio is a great way to make sure your savings can meet your financial needs in a pinch. Calculate this metric at least annually so that you’ll know if you’re prepared to face an emergency without going broke.
Other key ratios, including the debt-to-income ratio, also play an important role in helping you manage your finances.
And remember, there’s no one-size-fits all recommended emergency fund. What’s ideal for you depends on your own situation.
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