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♪ Got to sort of tell 'em ♪ Two destinations, one loyalty card. Visit yamava.com/palms to discover more. - Very focused show today. We're gonna cover three things. Number one, how big of an emergency fund do I need? Specifically, how would I figure that out in sitting for the CFP exam?

Number two, where should I keep it? And number three, what are the financial ratios that I should apply to my household to figure out if the household is running in a safe manner? (upbeat music) Welcome to the Radical Personal Finance Podcast. My name is Joshua Sheets and I'm your host.

This is episode 197. Gonna share with you some information that you will need if you're ever gonna sit for the CFP exam, but it's also applicable to, I don't know, what should I call us, normal people who aren't CFPs? (laughs) The point is, I'm gonna give you the technical answer today of how big of an emergency fund do I need with just a little bit of expansion for individuals.

(upbeat music) You're ultimately gonna have to be the person to decide for yourself how big of an emergency fund that you actually need. It's a very individual decision, but there is a little bit of technical formal guidance that we can give. Specifically, this is the technical formal guidance that you would need if you were sitting for the CFP exam.

And this way of thinking, I believe, you'll be able to find helpful to apply it to your life and think about the risk factors. According to the CFP board, their standards and their curriculum that they set out, or at least the way that you'll be tested on the exam, the way that you find an emergency fund is somewhere between three and six months worth of expenses.

And so you total up, if you are presented with something like a budget, you total up all of the fixed and variable expenses for a household, and you're going to either choose a three-month emergency fund or a six-month emergency fund. If you ever pay attention to common personal finance advice, you'll often hear this three to six months number tossed around.

Well, obviously, though, there's a big difference between three and six months. After all, six months of expenses is exactly double three months of expenses. So it's probably going to take you, if you're saving for this starting from zero, it may take you twice as much time to get to six months of expenses, which might delay your transitioning from building an emergency fund to pursuing other financial goals.

It might delay that for a period of time because you've got to save all this money. So how would you decide? Well, it's based upon the risk factors of income. And the key is you're going to look to figure out how many sources of income are there in a household.

If there are multiple sources of income into a household, then you probably have fewer risk factors of losing an income. If you and your spouse are both gainfully employed, both receiving an income, then it's possible that one of you will lose your job, but it's less likely that both of you will lose your job at the same time.

So therefore, it would probably be OK to have a slightly smaller emergency fund because even in the case of one job loss, you would have some savings, and then you would have one spouse continuing to work. So that's basically the approach that the CFP board recommends. And when you're sitting for the exam, if you're a prospective financial planner, you will always look and try to figure out how many sources of income there are into the household.

If you have a single wage earner, one individual person in a household, then you're automatically going to recommend a six-month emergency fund. Or if you have a married household, but only one spouse is earning income, then you're also going to automatically recommend a six-month emergency fund. In those cases, the concentration of risk in a single job is quite high, so you'll always transition to that six-month emergency fund.

However, if you have a single wage earner who has a second source of income of some type, in that case, you're going to go ahead and look to a three-month emergency fund, and that's the answer you're going to suggest on the CFP board exam. Or if you have a married household where both spouses are earning income, or if you have a married couple where only one spouse is working, but the other spouse has another form of income, for example, another spouse is receiving alimony payments, or perhaps one of the spouses or parties is very wealthy, has investment accounts that they're pulling money from, they're financially established and basically well-funded, or if there's a large trust fund providing income, rights of withdrawal, something like that, under those circumstances, then you're safe to go ahead and recommend the three-month fund.

It's as simple as that, and that's what you need if you're going to take the CFP board exam. That's what you need to remember. Now, if you are looking at this for your own personal financial planning, for your own household, just take this concept and extend it, and the importance is looking at how risky are my sources of cash flow.

The problem with the recommendation of three to six months is that it's necessarily vague because it's applying to a general population. It's okay if you make a choice to extend that out and you say, "I feel more comfortable "with a one-year emergency fund," or if you want to, I wouldn't go much below three months of expenses, but you can choose your own number.

But look at it with the same principle in mind and say, "What are the risks to our household "if we lose our income?" Now, what assets qualify as being useful for saving in an emergency fund? Number one, currency, cash, dollar bills, or whatever the currency of choice is in your environment.

That's obviously useful and applicable as being counted in the emergency fund. Any checking accounts, as long as you are not planning on funds that are normally used for day-to-day living expenses. So it'd be good to have emergency funds allocated into a different account, into a different checking account, or also some kind of savings account.

That would be good. Government money market accounts or CDs that have a short-term maturity, less than or equal to, if you're going by the official CFP board standards for trying to figure out when looking at a balance sheet, which of these accounts can I use as an emergency fund, less than or equal to 90 days, or a laddered CD program with maturities of less than or equal to six months?

So if you're a financial planning practitioner, look for those accounts, and those are the accounts that you can use if presented with a balance sheet. Those are the accounts that you can use to say that these are part of the emergency funds. Checking accounts, currency, savings accounts, government money market accounts, and CDs with a maturity of less than or equal to 90 days, or laddered CDs with a maturity of less than or equal to six months.

There are no other asset classes that will formally qualify. There are other assets that might be stable enough to be used as a portion of your savings accounts, but there are no other asset classes that will formally qualify for the purposes of the CFP board exam. Finally, let's talk for a moment about ratios.

These are some ratios that financial planning practitioners are tested on on the CFP board exam. There are also ratios that you should sit down and take a look at your own personal budget. These are the recommendations for the general population, so they're probably not as hardcore as many of you who are listening, but it's still a good way to test yourself and to make sure you're at least within the guidelines for the normal population.

The first ratio is what percentage of your income should your total housing expenses be? So housing expenses in this circumstance would be defined as either your mortgage payment, inclusive of principal, interest, taxes and insurance, or your rent payment. Either one of those would be fine, and that number should be either 28% or less of your total household budget.

So the way that you figure this out is take either your monthly-- excuse me, your annual mortgage. You could do it either on a monthly basis or on an annual basis. I'll do it on an annual basis here. But take your monthly payment and divide that into your gross income, your total amount of income, and for good financial health, that number should be 28% or less.

So as an example, let's say you have an income of just above median income, so call it $50,000 per year, and let's say that your monthly rent payments or your monthly principal, interest, taxes, and insurance payment, your total mortgage payment if you're escrowing taxes and insurance, your monthly payment is $1,000.

Take $1,000, multiply that times 12. That gives you your total annual expenditure. Then divide $12,000, divide that by $50,000 for your annual income, whatever your total gross annual income is, the amount of income before taxes and expenses. That will give you a percentage ratio. So in that example, it would be 24%.

If you were earning $50,000 per year household income and you're spending $1,000 a month on housing expenses, that would be 24%. That would be good health. Again, some of you will be far more extreme than this, some of you will not. But at least on the general population and specifically with regard to the CFP board exam, that number needs to be 28% or less of your gross income.

If your housing expenses are higher than that for you as an individual, consider why and consider making changes. It can start to be dangerous if your housing expenses are higher than that number in your monthly budget. Another number that the CFP board will test on is what should be the ratio of your total monthly debt payments as compared to gross income.

The number there that they've selected is your total monthly debt payments should be 36% or less of your gross income. So any debt payments at all, that can include mortgage, that can include consumer debt, car loans, student loans, any of those numbers should be 36% or less of your gross income.

So take your gross income, let's just use that $50,000 number again, and then simply choose 36% of that and that would be $18,000. So for a just over median income household, $1,500 a month should be the maximum amount of the total debt payments. The final ratio is what percentage of income should consumer debt be.

And in this case, the CFP board has chosen the number of 20% of net income. So here you would take your income after taxes and deductions and whatever that number is, at least the consumer debt should be at least less than 20%. And if you'll run those numbers, you can start to get an idea of where you stack up.

If your ratios are higher than those numbers, that should be a red flag for you. So if your housing expenses are higher than 28% of your gross income, or if your total monthly debt including housing expenses and consumer debt is greater than 36% of your gross income, or if your consumer debt is greater than 20% of your net income, that should be a big red flag and you should take steps to arrange that, to improve the situation because it puts a lot of stress on your budget, puts a lot of stress on the household, puts a lot of stress on your overall plan because the ratios are too high to give some wiggle room and some freedom.

And obviously, the lower you can get those numbers, the better. Finally, for CFP board students, make sure that you know how to calculate what we call a current ratio. Usually, you'll use the concept of ratios, liquidity ratios, and current ratios when looking at business calculations. But from time to time, you will see these applied to personal financial statements.

And you want to make sure that you know how to do a current ratio calculation. It's very simple. You take current assets and divide those by current liabilities. Current assets would be cash or cash equivalents, marketable securities, accounts receivable, and inventory. Obviously, that's the business definition applied over to personal financial planning, but I want to be precise with it.

And then current liabilities would be accounts payable, credit card debt, and taxes payable. We don't include long-term structured debts like mortgage payments in this number unless we are including the current amount. So for example, your mortgage payment is $1,500 and $1,500 is due. Then you would include that, but you wouldn't include the total balance of the mortgage here.

Take those current assets, divide it by the current liabilities, and that will give you a number. So as an example, let's say that you have $5,000 in a checking account, $10,000 in a money market account, that equals $15,000, and you have $3,000 of credit card debt. Take $15,000, divide it by $3,000, and you wind up with a number of 5.

That's the current ratio. Do not include in this number for assets. Don't include things like 401(k) accounts or other structured long-term deferred assets because the cost of turning them into cash is too high to calculate. They're not a current asset. They're not a cash or cash equivalent. The cost of converting them into money, into cash that you can spend, is too expensive.

They don't fit the definition. But that will give you a ratio. That ratio is going to be primarily useful for comparing among different households. Ratios are mostly meaningless on their own. If you're just running this for your own household, it's good for you to know, but you would need to be able to compare it to other households.

So this would be more useful for financial planners to compare households or it will be just a simple answer on the CFP board exam that you might need to know how to do. So my challenge to you is if you're a CFP board practitioner, go ahead and learn these, or if you're an individual, go ahead and calculate them.

And just check to make sure in the same way that knowing what the standard, say BMI or height and weight numbers are, that can be useful for your health to be able to judge that. But you have to take it with a grain of salt. So you take those generalized numbers, and if your numbers are out of the normal range, then look to try to figure out why your numbers are out of the normal range.

There may be a good reason for it, but be aware. It can be a red flag for you. Hopefully this is useful. I know it's just a short thing. This is a type of concept that you need to know for the CFP board exam, but it doesn't fit necessarily into a larger show, so that's why I've chosen to do it in a very simple scenario here.

Calculate the emergency funds, 3 months and 6 months. 6 months if you are a single wage earner in a household or have a household with one wage earner. 3 months if there are secondary sources of income. Run these ratios. Housing expense, 28% or less of your gross income. Total monthly debt, 36% or less of your gross income.

Consumer debt should be 20% or less of your net income. Calculate the current ratio with current assets divided by current liabilities. Thank you all so much for listening. If this is useful to you, I would be thrilled if you'd support the show. The show is provided to you free of charge thanks to the goodwill and financial support of the listeners of the show, a special group of listeners that we call the patrons.

If you would like to become a patron, please go to radicalpersonalfinance.com/patron. You can sign up at different levels and there are different incentives at each level for you. radicalpersonalfinance.com/patron. Thanks so much. Talk with you soon. ♪ ♪ ♪ ♪ ♪ ♪ Thank you for listening to today's show. Please subscribe to the podcast with our free mobile app so you don't miss a single episode.

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You can support the show with as little as a dollar a month or as much as you feel the content is worth. Details are at radicalpersonalfinance.com/patron. If you'd like to contact me personally, my email address is joshua@radicalpersonalfinance.com or connect with the show on Twitter @radicalpf and at facebook.com/radicalpersonalfinance. This show is intended to provide entertainment, education, and financial enlightenment, but your situation is unique and I cannot deliver any actionable advice without knowing anything about you.

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