Section A: Personal Financial Management Personal Financial Management
The first section of this unit deals with personal financial planning. The second deals with forecasting and financial planning for a business.
Your financial management skills are critical to your financial success. Your financial situation directly impacts your credibility with lenders, your qualification for financing, and your ability to operate your household effectively.
This module presents techniques to help you record and analyze your personal financial information.
After reviewing this module you should be able to:
People who are under financial stress generally go through a series of stages as shown in Table 1.
Sound financial planning is necessary to control your spending.
Table 1: Stages of Financial Stress
|Degree of Financial Stress|
In order to remain financially sound, you should work within a budget.
A budget lists all your sources of income and all your expenses. Once you are aware of income and expenses, you will be able to quickly determine your financial situation.
When calculating your income, you will need to consider the following:
1. Gross Income: Gross income is the total income that you earn before deductions are taken off.
2. Net Income: This is the total income that you take home after all deductions have been taken off. In other words, this is your take home pay.
3. Other Incomes: Other income could include income from the following:
Every household budget should include many categories for expenses. Most problems arise when all expense categories are not considered and are left to crop up at the most inopportune times.
Expenses should be listed and prioritized. Which of the bills should you pay first?
Household expenses typically include the following:
Mortgage/Rent and Taxes
A mortgage is a conveyance of land as security for a debt. This means that we arrange a loan by offering our home as security and make payments over a period of time.
If you miss a payment, you are in fact jeopardizing your home by allowing the lender an opportunity to exercise one of its legal remedies.
Power of Sale gives the mortgage company the right to sell your home to realize the safe return of its investment. You will have the opportunity to rectify the situation before action is taken. However, if you are three months in arrears for example, and then action is taken, your troubles may be too far along to recover from.
Having more than one mortgage is not uncommon. A second mortgage is often used to consolidate debts and lower monthly payments. This is accomplished by the fact that mortgage interest rates are usually much lower than credit card and loan rates.
A mortgage may also be spread out over a greater number of years, effectively reducing the monthly payments over a longer amortization period.
Table 2 shows a method you can use to calculate the percentage of your monthly income required to cover your mortgage/rent payments and taxes.
Table 2: Percentage of Income for Mortgage and Taxes
|Percentage of Income Required to Pay Mortgage and Taxes|
|Monthly mortgage payment||$650.00|
|Monthly taxes (divide yearly amount by 12 months)||$100.00|
|Multiply TOTAL by 100||$750.00 X 100 = $75,000.00|
|% required to pay mortgage and taxes divide by monthly net income||$75,000 = 30%
|30% of the net income is required to pay the mortgage and taxes.|
If 40% to 50% of your monthly net income is used to pay the mortgage and taxes this usually results in a stressful situation as more is being paid for rent/mortgage than can realistically be afforded without giving up some other needs.
An acceptable result is 42% or less.
Car Loans, Bank Loans, Credit Cards and Credit Lines
When preparing your budget, you will need to list your credit card minimum payments, credit line payments and bank loan payments.
Determine your annual cost for insurance for your home and vehicle(s) and divide by 12 months.
Life Insurance and Retirement Savings Plans
Life insurance and retirement savings plans are very useful and important in your overall financial plan.
Auto Repairs and Home Repairs
Go through any receipts for the past year or two and determine an average cost throughout the twelve month period and divide by 12 months.
Try to determine how much money you must spend in a twelve month period on gifts. Birthdays, Christmas, anniversaries and such have a way of adding up.
How much do you spend each week? Whatever the amount, multiply it by 52 weeks and divide by 12 months to determine your monthly expenditure.
Gasoline and Oil
This section of your budget includes the day to day expenses of operating your vehicle(s).
Calculate what you spend each week on miscellaneous items such as club memberships, entry fees to arena, magazines, flowers, maintenance items, church donations, other charitable donations, etc. Multiply your weekly spending by 52 and divide by 12.
Gross Debt Service Ratio (G.D.S.)
Banks often calculate your debt service ratio to determine your financial status before lending you money.
You can calculate your gross debt service ratio using the following steps:
1. Calculate gross monthly income from all sources
Your gross monthly income is your income before any source deductions such as income tax and C.P.P. are removed.
Add to your gross monthly income your net profit realized from other sources of income that you may have.
2. Calculate total rent or mortgage payments and add it to your monthly taxes
Your taxes may be billed quarterly and listed as yearly.
Take the total amount and divide by 12 or by 4, whichever applies, to realize the taxes that would represent one month’s payment.
3. Calculate Gross Debt Service Ratio
Add your mortgage plus taxes, then multiply by 100.
Divide this number by your gross monthly income.
Gross Debt Service Ratio =
(mortgage/rent + taxes) x 100 / gross income for same time period
Table 3 gives sample calculation of debt service ratio.
|Calculation of Gross Debt Service Ratio</b|
Gross monthly income
Monthly mortgage and taxes
Gross Debt Service Ratio =
Therefore, 30% of total income is required to service these two monthly expenses.
900 X 100
Interpretation of Debt Service Ratio
If your gross debt service ratio is:
1. Less than 30
You are doing very well in this area and are certainly not trying to live beyond your means.
2. Greater than 30 but less than 40
You are still doing okay, but you are going to have to try to hold it there and not make any moves that will increase it.
Most banks in Canada will not lend a mortgage where a gross debt service ratio is greater than 33%.
There are a number of other mortgage lending institutions that will allow this ratio to be as high as 37% and even in some case, 40%.
3. 45 or greater
This is a danger zone. You should determine exactly why your mortgage and tax payments are so high and what measures can be taken to lower your gross debt service ratio.
If you are locked into a mortgage interest rate that is higher than the current offered rate, try to calculate exactly how much your payments would be lowered if a lower interest rate was applied.
Determine if it is to your benefit to pay any possible discharge penalty and the cost of legal fees incurred by re-negotiating your mortgage.
If you are able to obtain a new lower rate for five years, the difference in payments may very well off set the fees charged to you and result in an improved credit situation.
Total Debt Service Ratio (T.D.S.)
This is a similar calculation to the gross debt service ratio, but includes your monthly credit card and loan payments as well.
mortgage + taxes + all credit card and loan payments x 100
your gross monthly income
If this ratio works out to less than 40, then you are financially responsible.
If your number climbs to 50+, you are definitely skating on very thin ice.
Click on Worksheet 6.1 (Word Document) to calculate your Gross and Total Debt Service ratios.
Analysis of your Current Existing Finances
It is important to be completely honest with yourself when contemplating your new budget.
Your analysis starts with a calculation of your total net income. Then you can determine how much you should spend on your expenses.
Table 4 suggests some acceptable figures for expenses based as a percentage of your net income. You can agree with the figures suggested or re-arrange them to suit your own situation.
For example, you may place a great deal of importance on your home and your car. You may not care about dining out or partying each weekend. Therefore, you will increase the mortgage, taxes and car loan allowance by reducing your spending allowance.
Only you can decide how to disburse your income. Once your budget is set, it is important to try to live with it and modify it as slightly as is possible. It is worthwhile taking the time now to think about a reasonable budget.
Table 4: Breakdown of Expenses
|Expenses as a Percentage of Net Income</b|
|Mortgage/rent and taxes||30%|
|Gasoline, oil and maintenance||20%|
|Loan and credit card payments||15%|
Notice that clothing and kids’ activities have not been listed in Table 4. How many other expenditures should you include?
When setting your budget, prioritize your expenses. This will help you determine which expenses are more important and which ones you might be able to cut back on in order to balance your budget.
If you are having financial difficulties, refinancing your mortgage might be an appropriate solution. A mortgage interest rate is usually found to be less than that of a personal loan.
A loan is amortized over three to five years and may carry a higher interest rate of as much as four or five percent. The higher rate and shorter amortization period result in a higher payment.
A home may be amortized by mortgage for as much as twenty five years. A mortgage can be paid back over a twenty five year period whereas a car for example, would need to be financed over a much shorter period, usually five years or less. Table 5 compares a bank loan and a mortgage.
The down side to taking out a mortgage is that it may never be repaid unless you make some provision to discharge the debt in the future.
One way of accomplishing this is to consider renewing the larger amount when your existing first mortgage opens up. Hopefully, your home will increase over the years by enough to swallow up the smaller debt that you have just added. Such action should not be taken lightly. You should seek all possible solutions first.
Table 5: Refinancing
|Bank Loan Compared to Mortgage|
Bank loan of $8,000 – 4 Year Repayment, 12% Interest
Monthly payment = $210 per month (from an amortization schedule)
Total payments = $10,080 ($8,000 + $2,080 interest)
Mortgage of $8,000 – 20 Years remaining on existing mortgage, 9% interest
Monthly payment of $71 added to existing monthly mortgage payment.
Therefore, a mortgage offers a savings of $139.00 per month, but you pay a total of $17,040 ($71 x 20 x 12) or $8,000 plus $9,040 interest.
Table 6 shows a typical household budget for a couple called Harold and Cindy.
Harold and Cindy are a prime example of a couple that are just getting by for now. Yet on a credit application their G.D.S. = 18 and their T.D.S. = 21.6 which are both allowable ratios as far as the bankers are concerned. In their case, more credit would be allowed.
How can these people attain some extra buying power so that they accomplish an emergency fund and some modest savings?
Less could be spent on groceries for example, by using coupons and shopping carefully. One hundred dollars per week may be within reason and by doing so, they would add $140.00 per month to their cash flow.
They could eliminate their credit card payments altogether by adding their debt to the mortgage, or perhaps by arranging a small second mortgage to accomplish the cancellation of the credit cards and lines. In order to be effective credit cards use would have to be managed carefully. People tend to spend more when using credit cards.
Table 6: Household Budget Analysis
|HAROLD AND CINDY CASH
ANYWHERE IN CANADA
HOUSEHOLD BUDGET AND ANALYSIS
|Harold works for an industry and earns approximately $48,000.00 gross annual income. His net income each month (take home pay) is $2,500.00 and they have no “other” incomes to bring into the household.|
|% OF INCOME||PRIORITY||EXPENSE||BALANCE|
|1||Cookie Jar Expenses||25||0|
A $6,000.00 increase in their first mortgage or in the addition of a second mortgage would create a monthly payment of approximately $53 at 9% interest over 20 years. Even though this would increase their debt load, that debt is spread out (amortized) over many more years. The result is a lower payment and a monthly savings of $97. They will however, end up paying more interest in the long run.
While it is true that their mortgage amount is increased, a period of inflation will more than make up the difference as their home should become more and more valuable each year.
Positive Cash Flow
Positive cash flow is when you have money remaining after your budget requirements are met.
If you have established a good sound financial plan, then you hopefully have a few dollars that are left over each month.
What should you do with the extra cash? Fifteen dollars per week does not sound like a lot of cash, however it represents $65.00 per month and if simply left to accumulate, it becomes $780.00 in a year’s time.
Registered Retirement Savings Plans (RRSP)
RRSPs let you take advantage of saving cash for your retirement and reducing your current income that you pay tax on. RRSPs are available in monthly payment plans that can be directly removed from your bank account automatically. You will pay income tax on your contributions and the income you earn on them only when you withdraw this money from your RRSP at the income tax rate you pay at that time. Therefore, funds should be left to accumulate tax free until you retire and are in a lower tax bracket. Then you can set up an annuity to withdraw the funds in monthly payments.
Reconciling Your Cheque Book Register
It can be very embarrassing and expensive when a cheque is not honoured due to insufficient funds. Try to keep your chequebook balance up to date so that you know exactly what the current balance of funds within your bank account is at all times.
Each month, when you receive the Statement of Account from your bank, balance your account. Make this a habit.
It is reasonable to assume that your larger, more expensive items will wear out over time and need to be replaced. You should include into your budget, some provision for this natural occurrence.
Your car, refrigerator, television and furniture are all items that eventually will require replacement.
Depreciation is a category that you should include just above your savings and you may even want to consider it for a spot ahead of spending. While this is not a do or die category, in the event of a worn out refrigerator and a thousand dollar replacement cost, such a fund would be welcomed.
Click on Worksheet 6.2 (Word Document) to analyze your current financial status and plan for the future.