Would You Pass a Financial Stress Test?

LendKey

In Managing MoneyLendKey

When was the last time you really took a close look at your finances? If it’s been a while, now might be a good time to reevaluate with a financial “stress test”. Generally, financial stress tests determine whether you’re financially secure enough to get through an emergency.

Of course, no two people have exactly the same financial background and circumstances, so there’s no “one-size-fits-all” method. Still, there are some general ways to assess and evaluate your financial health.

No matter what your situation, there are likely changes you can make to increase your financial security and enjoy greater peace of mind moving forward. As you continue reading, ask yourself the following questions:

Do You Have an Emergency Fund?

Having an emergency fund is not only wise but necessary in today’s volatile economy. However, there is a lot of misinformation out there regarding exactly how much a person should save in an emergency fund. Since the cost of living can vary by region, there is no magic number of dollars. Instead, aim to save a certain percentage of your income or a certain number of month’s worth of living expenses.

Ideally, your emergency fund should cover at least six months’ worth of your essential living expenses. This means if your basic expenses total $3,000 per month, your emergency fund should be sitting at $18,000 or more.

Take a look at your own emergency fund; do you have enough saved to cover six months’ worth of expenses if you needed to? If not, it’s time to start setting aside more. You can put more money in your emergency fund by:

  • Setting up automatic transfers from your checking account to your emergency savings account
  • Making sure your emergency fund is in its own high-yield savings account to maximize interest earnings
  • Putting aside a chunk of your next tax refund (if applicable)
  • Refinancing your student loans to free up money from reduced monthly student loan payments

Do You Stick to a Reasonable Budget?

As you assess your emergency fund, you may realize something else about your finances—that you aren’t sure what your monthly living expenses are. In this case, you might benefit from starting a budget and tracking how much money you actually need for essentials.

Having a budget (and sticking to it) is one of the best financial habits to adopt. No matter your debt and income, drafting a budget can make it easier to save money, pay off debt, and achieve other financial goals. It’s generally best practice to revisit your budget at least twice a year as your finances and needs change.

Coming up with a budget begins with gathering all your bank and credit card statements to see exactly how much money you’re bringing in versus how much you’re spending. If your income and/or spending vary significantly from month to month, then you should look at several months’ worth of statements to calculate averages. When calculating monthly expenses, factor in costs related to rent, groceries, transportation, entertainment, and childcare (if applicable).

Once you have determined your monthly expenses, subtract them from your monthly income. This number represents how much you have to delegate to saving, investing, and extra spending. If the money you have left over isn’t enough to achieve your saving and investing goals (including putting money into your emergency fund), it may be time to:

  • Cut back on inessentials, like weekly meal-delivery services or premium cable channels
  • Contact service providers (cell phone, cable, Internet, etc.) to negotiate a lower monthly bill
  • Look for ways to bring in additional income, like picking up a part-time job or monetizing a hobby
  • Use a free budgeting app or spreadsheet to track your income and spending

What’s Your Debt-to-Income Ratio?

Now that you know your monthly income and expenses, you can calculate your debt-to-income ratio.

Why does the debt-to-income ratio matter? Not only does it indicate your overall financial health, but it factors in anytime you take out a mortgage or apply for another line of credit.

Specifically, your debt-to-income ratio is a percentage determined by dividing all your monthly debt payments by your monthly gross income. For example, if your monthly debt payments total $1,000 and you consistently bring in $3,000 per month, your debt-to-income ratio is 33%.

This figure matters because if your ratio is too high, lenders will see you as a higher risk of defaulting on your loan. As a result, you may have a harder time getting approved for financing. Even if you are approved, you may end up with higher interest rates and other less-than-ideal loan terms. This remains true even if you otherwise have good credit and meet other loan eligibility requirements.

So, what’s an ideal debt-to-income ratio? Recommendations can vary a bit from one lender to the next, but you should generally aim for less than 43%.

If your ratio is higher than you’d like, there are some steps you can take to lower your debt-to-income ratio, such as:

  • Refinancing your student loans, which can free up money to pay them off faster
  • Applying for student loan forgiveness, if you’re eligible
  • Avoid taking on any additional debt, if possible
  • Using cash or a debit card for your expenses to avoid accruing credit card debt
  • Using a balance transfer to secure lower interest rates on credit card debt

Are You Eligible for Unemployment Benefits?

It’s crucial to have an unemployment plan, particularly in an economic downturn or recession. It’s important to understand your eligibility for unemployment benefits and how this would affect your finances.

If you’re a traditional W-2 employee, there’s a good chance you’d be entitled to unemployment benefits. If you’re laid off from your job or fired without cause, you should be eligible to collect. Exceptions may include at-will or seasonal employees.

However, if you’re an independent contractor, you’re considered self-employed and thus are not eligible to claim unemployment benefits. This makes it more important for self-employed workers to have a substantial emergency fund in-place.

If you would be eligible for unemployment benefits, figure out how much you’d receive monthly so you can adjust your budget accordingly. There are a number of free online calculators that can help you estimate your monthly benefits based on factors such as base period of unemployment, number of dependents, and income.

When budgeting based on unemployment benefits, be sure to factor in taxes as well. Depending on where you live, taxes may or may not be deducted from your unemployment payment at the time it hits your account. If taxes aren’t taken out right away, you should expect to be responsible for about 20% when it comes time to report your unemployment income and pay taxes in April.

Hopefully, you’ll never have to use unemployment benefits, but if you do, be sure to maximize them by:

  • Planning ahead of time and knowing how you would allocate your unemployment payments to your monthly expenses
  • Setting aside at least 20% to pay taxes on these benefits if they aren’t taken out beforehand
  • Finding out how long you’d be able to collect unemployment benefits before they would run out
  • Keeping an updated resume on-file so you can quickly apply for new employment opportunities if you lose your job
  • Taking advantage of continuing education and other professional growth opportunities to remain competitive in your field/industry

The Bottom Line: Would You Pass?

After answering these questions, you should have more clarity as to whether or not you’d pass a financial stress test. Hopefully, you’re feeling more confident about your finances and your ability to face unexpected financial setbacks, such as sudden unemployment. If you’re not thrilled with your results, there are plenty of ways to improve your financial wellness. Even though you hope not to be tested in real life, taking proactive steps to improve money management will allow you to enjoy a greater sense of financial security and peace of mind.



Please note that the information provided on this website is provided on a general basis and may not apply to your own specific individual needs, goals, financial position, experience, etc. LendKey does not guarantee that the information provided on any third-party website that LendKey offers a hyperlink to is up-to-date and accurate at the time you access it, and LendKey does not guarantee that information provided on such external websites (and this website) is best-suited for your particular circumstances. Therefore, you may want to consult with an expert (financial adviser, school financial aid office, etc.) before making financial decisions that may be discussed on this website.