By: Roné Swanepoel
How do you know if you’re saving enough? How much debt is too much? What’s a healthy consumption rate? These are some common questions we might ask ourselves when evaluating our financial habits. Answering these questions with a specific rand amount isn’t necessarily helpful because everyone’s financial situation is so unique. Instead, I’d like to introduce you to the Golden Ratio for personal finance – a tool that will help you refresh your money maintenance.
This ratio provides a budgeting tool that skips all the investigating and lists and gets right to the heart of what you need to know: Is your cash management healthy? And more importantly, are you saving enough?
Determine your golden ratio
What’s a Golden Ratio? It’s a formula you can use to figure out how you spend your income. Your Golden Ratio is made up of three numbers, each one representing the percentage of your
gross (before tax) income that goes to:
The Past—Paying for things you bought/did in the past
The Present—Funding your current lifestyle
The Future—Accumulating to create future income
Someone earning R240 000 per year who saves R2 000 per month (the future) and has debt payments of R2 000 per month (the past) would have a Golden Ratio of 10 | 80 | 10. Ten percent of every rand they earn goes toward debt, 80% is consumed in the present through taxes, groceries, entertainment, and everything else, and 10% is saved for the future.
Past: Your debt/income
To calculate the past portion of your Golden Ratio, start by adding up all of your monthly debt payments (principal and interest). Then divide this by your gross (before-tax) monthly income and multiply it by 100. For example, if you earn R20 000 per month before taxes and pay R10 000 per month toward your mortgage, credit cards, car loan, or clothing accounts, then the past portion of your Golden Ratio would be 10 000/20 000 * 100 = 50, meaning that 50% of your income is directed toward paying off past purchases
How much debt is too much?
Some debt is manageable. Overwhelming debt can be a poverty trap. Borrowing to invest in income-generating assets like real estate and career skills can put you in a better financial position in the long term. Home and school loans are considered “good debt” by creditors and don’t hurt your credit score nearly as much as other types of debt.
Borrowing to buy momentary or intangible things (think: vacations, fine dining, cars, boats, TVs) usually weakens your financial position in the long run because you pay interest on things that you can’t resell at retail, let alone with interest. You’re effectively poorer at the end of the transaction than you were at the beginning. Therefore, consumer debt is treated as “bad debt” by creditors and drags your credit score down more than “good debt” does.
Regardless of the quality of your debt, you should aim to keep your total debt payments at or below 30% of your gross (before-tax) income.
Bottom line: Keep the past portion of your Golden Ratio below 30.
Future: Your savings rate
The next calculation jumps to the future. To calculate the future portion of your Golden Ratio, add up all of your monthly savings contributions, divide this by your gross monthly income, and multiply it by 100. Building on the previous example, if you earn R20 000 per month before taxes and save R3 000 per month, then the future portion of your Golden Ratio would be 3 000/20 000 * 100 = 15, meaning that 15% of your income goes toward your future.
How much should you save?
This depends on your goal and your time horizon (the number of years between today and your goal). You need to have at least a rough idea of both in order to know if you are saving anything close to “enough”, and working with a financial adviser to determine these goals is crucial for a bright financial future.
As a rule of thumb try to save at least 20% of your gross income. If that’s not possible, then start with what you can save and work your way up. Saving anything is better than nothing, but a consistent 20% savings rate over time is a sound rule of thumb.
Bottom line: Keep the future portion of your Golden Ratio above 20.
Present: Your Consumption Rate
This takes us back to the present. This portion of your Golden Ratio is 100 - (Past + Future). Using our previous example, if you earn R20 000 per month, save R3 000 per month, and pay R10 000 per month in debt, then your Present = 100 - (50 + 15) = 35, meaning that 35% of your income is consumed by your present lifestyle. You can think of this as your consumption rate or burn rate. Taxes, groceries, eating out, gifts, and so on … if you didn’t save it, it is considered to be consumed.
Adding it up and setting goals
Let’s run through an example from beginning to end. For simplicity, imagine a person who earns R120 000 per year (R10 000 per month). Their monthly debt payments add up to R3 500, and they save a total of R1 500 per month.
1) Past = 3 500/10 000 * 100 = 35
2) Future = 1 500/10 000 * 100 = 15
3) Present = 100 - (35 + 15) = 50
Their Golden Ratio would then be 35 | 50 | 15 (in Past | Present | Future order). If this individual is trying to grow their assets, they will need to make some changes. They can use these numbers to set goals for a healthier cash flow.
First, their past is greater than 30, so they could set a goal to reduce this to 30 as quickly as possible. Second, their savings rate could be larger. Let’s assume they set a goal to have a Golden Ratio of 30 | 50 | 20 over time by paying debt off quicker and ensuring a larger savings amount which can be achieved by working closely with their financial adviser. Remember “Rome was not built in a day” and these changes to our habits take time, but reminding yourself to focus on your spending and saving habits can greatly improve the probability of reaching your financial goals over the long term.
Conclusion
It is recommended that you review your spending, saving, and financial habits with your financial adviser at least once a year (barring any life-changing events that might take place in between, such as getting married, having a child, losing your income, etc.) to make sure you are sticking to your long-term financial goals. If you haven’t done so in a while, don’t lean into the temptation to bury your head in the sand and ignore the issues that might exist – the solution is often more simple than you think.
As spring comes to an end, let's focus not only on keeping our cupboards clean but also on our finances. Why not make a mental note to earmark the month of September as your annual reminder to tackle your money maintenance going forward and check in on your Golden Ratio?
* Swanepoel is the head of sales at Morningstar Investment Management SA
PERSONAL FINANCE