Every year the Federal Reserve conducts financial stress tests on the nation’s major banks. The test determines how well a bank would stand up to major setbacks, such as a significant drop in the unemployment rate, a stock market crash or a collapse in oil prices. At the conclusion of the test, the Fed determines whether a bank has failed or passed. Sometimes a bank passes, but it has to fix issues that the Fed has raised.
How would you score if a financial stress test was conducted on your personal finances? Would you pass or fail? Or are there aspects of your personal finances that need to be fixed so that you would be able to cope should stress be placed on your finances?
The comparison is not all that far-fetched as the stresses that would be placed on banks in times of economic turmoil are similar in many ways to stresses that we all could face in our personal circumstances. The financial stress on a bank posed by a significant drop in the unemployment rate, for example, might translate to you losing your job.
Here are questions that you might ask yourself to conduct your own financial stress test on your personal finances.
How close to the edge are you living?
Add up the regular expenses that you incur each month. Average out aspects such as your utility bills, which might rise or fall according to the seasons, and reduce to monthly amounts those payments that you make only every six months or a year, such as insurance bills.
If you pay your credit cards in full each month, there is no reason to include them as you would have recorded the amounts already in your list of spending. But if the amounts you pay on your credit cards represent previous debt, you will need to include them as separate items. If you pay only the minimum amounts on your credit cards each month, write down those amounts, but realize that they could increase should you spend more on your cards.
Once you have calculated your monthly expenses, compare the total with the amount of after-tax income you receive each month from salaries, investments or other sources. Exclude deductions from your salary by your employer. This amount should be the actual amount of money you have to spend each month.
The difference between income and expenses will determine how much money, if any, you have over each month for spending on emergencies, such as unexpected fixes for your car, health bills should you or members of your family become ill, or unanticipated home repairs. Write down that amount.
Whether you pass this aspect of the financial stress test depends on the amount of money you have written down. If you are living so close to the edge that you cannot afford an unexpected expense of any amount, you will have failed the financial stress test. For the rest, the amount you have written down represents the degree to which you have passed the test; a low amount is a barely passing grade.
If you feel the amount you have available is inadequate, you need to start setting aside an amount each month to meet those out-of-the-blue events. Avoid spending any surplus income you might have on items you do not really need. Place the money in a savings account and let it build up each month so that an adequate amount is available should you need it.
How much debt are you carrying?
For this calculation, you will determine your gross, or pre-tax income. Include bonuses, overtime, tips and investment income.
Our next step is to determine how much of that is debt. From that, we will calculate your debt-to-income ratio.
To determine your monthly debt, add up all loan payments you make, such as car payments, student loans and credit card payments. Do not include your credit card payments if you pay off your balance in full every month; we are concerned here only with the amount of debt you are carrying.
If you pay only the minimum amount on your credit card each month, include the amount you pay, not the full amount of your credit card debt. Similarly, if you pay off only some of your credit card debt include that amount. For example, should your total credit card debt be $4,000, but you pay only $200 a month on that, use only the $200 in your calculation.
Now that you have determined your total loan payments each month, divide your income by this amount and multiply that by 100. Say your total income is $5,000 a month and your total debts are $1,500. Your debt-to-income ratio is 30 percent.
Generally, the lower your debt-to-income ratio, the better it is. Many financial professionals use 35 percent as an acceptable ceiling. A percentage of 20 percent or below is considered to be ideal.
If your debt-to-income ratio is above, say, 40 percent, you will fail the financial stress test. A bank is unlikely to lend you money, but you should not take on more debt, even should you be able to secure a loan from some source. A figure between 36 percent and 40 percent puts you close to failing the stress test. Do all you can to reduce your debt.
What if you lose your job?
Clearly, if you lose your job you will lose a large piece of your income and it will be a major stress on your finances. You might be able to receive unemployment benefits or you might have some income from investments or other sources, such as your spouse’s income.
For our financial stress test in this regard, calculate how much you will lose in after-tax income if you lose your job. Deduct it from your overall income and re-calculate the amount on which you would have to survive. You will have to supplement this amount from another source. If your debt-to-income limit enables it, you might be able to borrow money, such as on a home equity loan if you own your house.
Clearly, you will fail this aspect of the financial stress test if you cannot come out financially should you lose the income from your job. If you have sufficient savings to survive losing your job for at least three months and preferably six months, you pass this aspect of the stress test. The answer is to build up your savings so that you can draw on them during the time you are unemployed.
Are your savings liquid?
In your previous calculation, you might have included savings on which you can draw in emergencies. The next part of the financial stress test is to determine whether those savings are liquid. In other words: Will you be able to draw on those savings immediately or will you have to wait for a relatively long period of time before you can do so?
The obvious example of illiquid savings is an investment in property. Even in a buoyant real estate market, it can take up to three months from deciding to sell your property to receiving the money in your bank account. Not only that but the price you obtain for the sale might not be as high as you expected.
It often happens that the time you need the money because you are suffering is a time when others are suffering, too, so that the buyers for your property are not readily available and you have to drop your price until you are able to sell.
Of course, it is a good idea to invest in valuable real estate. To pass our financial stress test, however, you should not consider it a readily available source of money in an emergency.
The same can be said of retirement accounts. If you draw on your money in a 401(k) plan, for example, you might be subject to early withdrawal penalties and you will reduce the amount you will have available in retirement.
Savings in stock or mutual funds generally are liquid, meaning you can sell at any time. But you might have to sell at a time when the market is down and the income you receive therefore will be lower.
Make sure your emergency savings are in a place where you can access the money immediately and where it is less subject to the vagaries of market forces. The degree of liquidity of your savings will determine whether you pass this test.
Are you adequately insured?
It is important to insure yourself adequately against major expenses that can occur. In most cases, you will be required to have house and auto insurance, but check out other insurance, such as disability insurance. That could be offered by your employer. If you are not covered, you might want to pay the premiums yourself.
An umbrella insurance policy, in addition to your homeowners and car insurance, can protect you and your family against all kinds of expenses that might suddenly arise through no fault of your own.
If you have adequate insurance, you pass this aspect of the financial stress test. If not, perhaps it is time to consider obtaining it.