After the financial crisis of 2008, the word “stress test” popped up on the radar. Regulators like the Federal Reserve and the European Central Bank started conducting high-profile stress tests of big banks to get an idea of how well these banks could handle economic stress.
When it comes to your own family finances, you should consider a stress test as well. Could your finances handle a financially stressful situation such as a job loss (or big cut in hours), major medical catastrophe, or a bigger-than-expected tax bill? You never know what might be around the corner, from the need to replace a major appliance in your home to an expensive car repair.
As you evaluate your situation, here are four things to consider when performing your personal financial stress test:
How much money do you have easy access to? If you needed to come up with money quickly, could you do it? I keep three weeks’ worth of expenses in a high-yield savings account. That way, if I need fast access to money, I can get to it immediately.
I have other assets available to me as well. My taxable investment account allows me to convert index ETF shares into cash in about seven days. With my savings account assets to tide me over until I can access other assets, I’m prepared for most financial problems.
Take a look at your own liquidity. Do you have easy access to cash reserves? What other assets do you have that can be quickly converted to cash–such as a Money Market account? Create a plan for accessing your money when you need it. Try to build at least three months’ worth of expenses (more is better) for emergency use.
Monthly debt obligations can get in the way of having enough financial freedom to meet a financial challenge. High levels of debt mean that you can’t turn to your credit as a resource if you must. A good rule of thumb to go by when considering your debt level is the 28/36 qualifying ratio. This says that no more than 28 percent of your monthly income should go toward your mortgage payment, and no more than 36 percent of your monthly income should go to total debt.
If you rent, you can still apply this rule of thumb. Just substitute your rent for your mortgage, and treat it, for these purposes, as a debt obligation. If you have a monthly income of $3,500, your housing payment should be no more than $980, and your other total debt payments shouldn’t exceed $280.
Keeping your debt level down helps you remain flexible. The more options you have in a financially stressful situation, the better off you’ll be.
Know What You Can Cut
Have you prioritized your expenses? You should understand which budgetary expenses are truly necessary, and which you can do without. That way, you don’t have to try to make hard choices when a financial setback crops up. Take a look at your most important expenses, and rate those above discretionary expenses. You know you have to pay your insurance premiums to retain asset protection, but you can probably cut your cable if a difficult situation arises.
Don’t forget to look into the realities of which expenses are needs and which are wants. You might need to buy groceries, but do non-essential foods slip into the cart? Review your receipts to see where you are spending your money, and then identify the first things to cut in the event of a financial setback. This process should also include such actions as putting a temporary halt on retirement account contributions (if the financial emergency is severe enough) and figuring out which bills you might be able to negotiate lower payments during a challenging time (skip unsecured credit bills rather than risk losing a home or a car).
Finally, take stock of your income diversity. Are there other ways to make more money? You can start a side gig right now to bring in an extra couple hundred dollars a month to reduce debt or boost your emergency fund. It’s also a good idea to recognize which items around the house you could sell for extra cash if needed. While you may not sell them now, knowing what they are, and being ready to leap into action, can make your choices a little easier.
You should also consider you as human capital. Do you have marketable skills that could transfer to a new job? Are you willing to work multiple jobs if you have to? Take stock of your options, and look for ways to ensure that you aren’t over-relying on a single source of income for your long-term financial well-being.
By Miranda Marquit, Staff Writer