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Financial Ratios & Wealth Building

Learn how you “CAN” use financial ratios to build wealth by taking Conscious Action Now…

 

In this discussion TheWealthIncreaser.com will look at a myriad of financial ratios that can lead you closer to the success that you desire.  With 2017 coming to an end and a new year only days away, it is the desire of TheWealthIncreaser.com that this page will serve as an inspiration for you to do more in 2018.  OK, here we go–hopefully TheWealthIncreaser.com won’t bore you too much and you can use the following paragraphs to achieve more in 2018 and beyond!

 

Rule of 72 Ratio:

 

Dollar Amount Invested/ Interest Rate

1,000 / 7% = 14.3 or just over 14 years to turn $1,000 into $2,000

1,000 / 14% = 7.1 or just over 7 years to turn $1,000 into $2,000

 

Relevance:

Relevance:

Lets you know what percentage of your assets are liquid (cash, certificates of deposits, money market etc versus stocks, bonds, mutual funds, home equity etc.) so that you can plan your lifestyle accordingly.

 

Credit Ratio:

 

Credit Owed / Available Credit or Credit Balance ÷ Credit Limit = Credit Ratio, for example

 

500/40,000 = .0125 or 1.25% very low ratio–good

30,000 / 40,000 .75 or 75% very high ratio–bad

 

To further drive it home, if you had a $5,000 credit limit and held a $2,000 balance, your credit ratio would look like this for one creditor:

 

2,000 ÷ 5,000 = .4, or 40%

 

If you had a $25,000 credit limit with all of your credit cards and monthly installment payments and held a $12,000 balance, your credit ratio would look like this for all of your creditors:

 

12,000 ÷ 25,000 = .48 or 48%

 

Relevance: The lower your credit ratio the better as lenders use the credit ratio to grant you more credit or provide you credit at the best rates based in large part on how you use credit and your payment history.  See the chart below to determine your current risk level!

 

Credit Ratio                                      Risk      
< 30%                                                Low (ideal)
30-49%                                              Medium
50-75%                                              High
76% or more                                    Very High

 

The types of credit available include: Revolving Credit, Installment Loans and Open Credit. 

 

Finance Company Accounts and Mortgage Loans will fall in the above categories, however realize that some lenders categorize them separately as well.

 

Debt to Income Ratio:

 

 Total Debt / Total Income

 

Also called Front End Ratio

 

Let’s say you have $10,000 in Gross Monthly Income (your income before any taxes or other deductions are taken out – your actual paycheck will likely be much less).

 

What can you afford as far as your home purchase is concerned?

 

x / 10,000 = .28

2.800 / 10,000 = .28 which is the maximum debt you could have on the front end (excludes housing payment)

X = 2,800  max on front end

 

You may not be approved for a mortgage loan in which the PITI payment exceeds $800 per month if you maxed out your front end ratio of 28 percent.  On the flip side, if you had zero outstanding balance you could possibly qualify for a loan up to $3,600 per month!

 

On the back end your maximum debt would be $3,600 calculated as follows:

x / 10,000

3,600 / 10,000  = .36 which is the maximum debt you could have on the back end (includes housing payment)

 

If you maxed out your credit on the front end (bills totaling $2,800 per month) you would only have $800 available for housing payment (includes principal, interest, taxes and insurance or PITI).  If you had bills greater than 10 months averaging $400 per month you would qualify for a loan up to $3,200 per month.

 

What that means in purchasing power or how much home you can afford based on this ratio depends on the current interest rates, the local property tax rate, the amount of your down payment, mortgage insurance, and homeowners insurance.  In other words, how you manage your finances and your particular market are the key factors that can lead to you purchasing the home of your dream.

 

The amount that you will be approved for will vary over time and across different locations as the market interest and where you are will play a factor.  However, always realize that high debt on the front end will bring down the amount of house you can afford based on the conventional ratio breakdown of 28% on the front end and 36% on the back end.

 

To further drive it home let’s look at another example, monthly debt in excess of one year divided by gross monthly income is your debt to income ratio or front end ratio!  If you earned 3,600 per month and had credit card and car payment totaling $800 your front end ratio would look like the following:

 

800/3,600 = .22.22 or 22% on the front end for conventional–good

 

1,300 / 3,600 = .36 or 36% which only leaves $500 per month available for housing payment on the back end for conventional–probably not enough for quality housing in most markets

 

Relevance:

The front end and back end ratios provides you the ratio that you need to determine the level of debt that you are carrying in relationship to your monthly income.  You don’t want to overextend yourself with debt and make life more difficult and painful while here on earth.  You must know how to manage your credit wisely and pay your debt in a timely manner.

You also don’t want to put yourself in position where you are house and/or car rich and cash poor–your life will be a bore!  Use these very telling and powerful ratios to make life as enjoyable as possible for you and your family while you are here on planet earth.

 

Housing and Debt to Income ratio:

 

Also called the back end ratio

 

Monthly debt in excess of one year plus expected housing payment (PITI)  divided by gross monthly income, for example

 

1,200/3,600 = .33 or 33%

 

To further drive it home, the back end ratio is the total debt to income ratio, which includes your housing debt AND other debt owed for at least the next 10 months or so, by you the borrower.

 

Back End Ratios may not exceed 36% in most cases.

 

Some Qualified Mortgages (FHA) may let the Back End Ratio be as high as 43%.

 

If you the buyer have $1,000 worth of other debt and monthly income of $4,800 (car loan, student loan, credit card, etc.), how much can you afford?

1,000 / 4,800  = 21.7%–Good on the front end ratio for conventional

 

2,000 / 4,800 = 41.6%–Not good on the back end for conventional but some lenders could possibly still make it happen for you

 

As far as FHA goes, you would qualify with both the front end  ratio 31% and the back end ratio 43% because both of your ratios are lower than those percentages (21.7% and 41.6% respectively).

 

When your other debt is taken into consideration, you the buyer(s) can afford a home with a PITI payment of $1,000 using and FHA loan and you would not qualify for a conventional loan according to the financial ratio guidelines.  However, you could possibly qualify for a conventional loan even with those ratios if a conventional lender worked with you to make it happen.

 

If you are like most buyers, going up to a 36% debt to income ratio is not comfortable!

 

A 43% back end ratio is even more difficult to handle, even for the most frugal purchaser(s).

 

However, a better school district and/or being closer to your job or family members may well be worth the trade off!  It all depends on what you value and your ability and willingness to put into place a process that allows you to know your cash flow position up front so that you can better plan for your living conditions in the future.

 

Do you have an adequate emergency fund and have you planned for your future in a comprehensive way?  By answering these questions you can get on a path toward making the best decision for you and your family.

 

If you like to eat out, entertain and save abundantly for your future you might determine that a 43% ratio is too high a price to pay at this time and you might postpone your home purchase until you could get more income coming in on a monthly basis or you paid off certain debt.  Your lifestyle and plans for your future will play A LARGE PART IN DETERMINING THE BEST APPROACH TO TAKE.

 

The temptation may be great and you may want to go for a 43% back end ratio. What would that look like with our current example?

 

You still would only qualify for a loan of $1,060 (2,160/4,800) unless FHA decided to allow you to go higher or you paid off some debt or increased your monthly income.

 

NOTE: When you decide to purchase your home where you will seek a loan, remember that Lenders will pull your credit reports and ask for 2-3 months of your past bank statements.

 

If there is a sudden, large amount of money added to any of your bank accounts, or if your credit card balances or car loan are paid off just prior to applying for a loan, this sends up a red flag and some lenders will be hesitant to offer you a loan without a reasonable explanation of why you took those actions.

 

Lenders may ask for a gift letter, indicating that the money does not have to be paid back, and may request a larger down payment, such as 10% instead of 3.5% or 5%.

 

It is wise for any buyer to get their financial accounts in shape “well before” applying for a mortgage loan so that they will not be disappointed! 

 

The critical back end ratio shows your ability to take on more debt (your new housing payment).

 

Mortgage lenders generally will not lend more than what would constitute 28% of a person’s monthly gross income before adding their monthly home payment to the back end.

 

If there is other debt, mortgage lenders will generally not originate a loan that causes a borrower’s total debt to income ratio to exceed 36% (mortgage plus other debt).

 

Conventional 28% front end and 36% back end, or

 

FHA 31% front end and 43% back end

 

Certain circumstances allow lenders to go higher…

 

Sales Price to List Price Ratio:

 

Sales price of a home divided by what the property listed for, for example

 

290,000 / 310,000 = .9355  or 94%

 

Relevance:

By calculating the ratio of sales price to list price of recent sales in your target market (the area where you plan on buying your home or listing your home for sale) you can get a better feel of what you should offer as purchase price, or if you are selling—the listing price:

 

Is it 90%? 95%? 103%?

 

By knowing that ratio you put yourself in position for a more realistic purchase price offer or sales price listing.

 

Loan to Value Ratio:

 

Loan amount / purchase price or refinance value

 

For example,

 

288,000 / 360,000 = .80 or 80%

 

You may also see CLTV or combined loan to value which simply means all of your outstanding loans (2nd mortgage, home equity loan etc.) divided by purchase price or refinance value

 

Relevance:

By knowing your loan to value ratio you understand immediately how much debt you are taking on from a percentage standpoint.  When you get to a certain equity position you may also be able to eliminate PMI or MIP from your monthly housing payment so it is important to know this number.

  

Investor Ratios

 

Return on Investment with Appreciation Ratio:

 

 Cash Flow before Tax + Principal Reduction + Tax Saved + Appreciation  / Cash Invested 

6,000 + 3,000 + 3,500 + 5,000 / 85,000 =  20.59%

 

Return on Investment without Appreciation Ratio:

 

Cash Flow before Tax + Principal Reduction + Tax Saved  / Cash Invested

6,000 +3,000 + 3,500 / 85,000 =  14.7%

 

The following ratios are used to Value Real Estate & the Relative Value Depends on Your Particular Market, therefore what is acceptable in one area may not be acceptable in another area, use with caution in mind.

 

Capitalization Rate Ratio:

 

Net Operating Income (from Schedule E or elsewhere) / Purchase Cost

30,000 / 390,000 = 7.7%

 Limitation: does not take into account financing

 

Cash on Cash Ratio:

 

Cash Flow before Tax / Cash Invested

6,000 / 85,000 = 7.1%

Is the strongest Method, it does take into account income, expenses and financing

 

Price per Square Foot Ratio:

 

Cost / Number of Square Feet = price per square feet

300,000 / 3,000 = $100 per square feet

Limitation: does not take into account income, expenses and financing

 

Price per Unit Ratio:

 

Cost / Number of Units = price per unit

300,000 / 4 unit quadplex = $75,000 per unit

Limitation: does not take into account income, expenses and financing

 

Gross Multiplier Ratio:

Cost / Gross Operating Income

300,000 / 50,000 = 6%

Limitation: does not take into account  expenses and financing

 

NOTE: the above numbers are rounded for illustrative purposes

 

Relevance:

 

For those who invest in rental property it is imperative that they understand the amount of CASH FLOW that they will receive (be sure to look at schedule E of the seller(s) tax return prior to purchase), they estimate the APPRECIATION that is expected or projected, they know the amount of PRINCIPAL REDUCTION that is expected at various intervals of the loan and they know the amount of DEPRECIATION (and how to break down the various elements of depreciation for their greatest benefit).  Always remember that you cannot depreciate land on rental properties.

 

By properly analyzing the rental property that you plan on purchasing and utilizing the appropriate ratios you CAN get a better appreciation (no pun intended) of the returns that you will or potentially can achieve based off of your purchase.

 

You can then know in the future if selling your property, refinancing your property, continuing to hold your property or doing a 1031 exchange will serve your best interest.  You also want to have an awareness of the tax implications at the time of purchase or preferably before you purchase so that you will have no future surprises.

 

Will you be taxed at ordinary income or capital gain rates?  What is your basis and what will you pay taxes on after depreciation.  You must understand that depreciation recapture will occur whether you take the depreciation—or you fail to do so.  Will you plan to avoid taxes in the future or will you just jump into your real estate investing career with no real plan of action as it relates to your tax implications that you will face at the time of your purchase, yearly and when and if you sell in the future?

 

Do you know about form 3115 and how you could possibly amend your tax return to get the depreciation that you overlooked if you currently own investment property and you failed to claim the depreciation?    By claiming the depreciation that you were entitled to you in essence put cash back in your pocket in a real way!  These are just some of the more pressing questions that you must ask–and answer on the front end if you are to maximize your rental property purchase.

 

Even if you purchase and quick turn properties for short term gains, you must realize that there will be tax implications (ordinary income rates if sold in less than a year and capital gain rates if sold after a year).  Whether you quick turn for a profit or buy and hold for cash flow and appreciation you must consider the combined tax implications at the federal as well as at the state level.

 

CONCLUSION

 

It is important that you use financial ratios (where and when appropriate) so that you can maximize your returns and minimize your mistakes during your lifetime.  By utilizing the above ratios among others–you can put yourself and your family on a positive path toward building wealth.

 

Always realize that there are many other financial ratios available at the corporate as well as personal level that may also be of benefit to you and your family.  In short, you don’t want to stop with what you have learned on this page.  Continue to pursue better ways that can lead you toward success in a more timely manner and use financial ratios where appropriate to help along the way.

 

All the best to applying financial ratios in a manner that will fill up your nest…

 

By taking Conscious Action Now–this page and site will show you how…

 

You CAN achieve lasting success–if you at this time make a conscious decision to give it your best…

 

By using the ratios appropriately you CAN put procrastination to rest…

 

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SEP-IRA versus SOLO 401k

 

Learn what the best choice is for your retirement future if you are a single employee at your company or you are a small company considering whether an SEP-IRA or a SOLO 401k is your best choice

 

If you operate a small company or you are a single person owner–you may be deciding among a number of retirement plans to stash away money for your retirement years.  Trying to decide the best option can be a daunting task for those who are new at facing retirement options or have recently opened a business for the first  time.

 

In this discussion TheWealthIncreaser.com will present ways that you can make this sometimes grueling decision—less grueling and help put you on a path to enjoying your retirement  in the manner that you desire and provide you with more clarity so that anxiety will not play a role in your life as you build wealth for yourself and your family.

 

It is the desire of TheWealthIncreaser.com that you will use this page as a guide so that you can experience joy on the inside that will lead to your retirement portfolio and your conscience experiencing a smoother ride!

 

Retirement Plan Options:

 

Depending on your line of work there could be many retirement options available to you.

 

Some of the more common include IRA’s (many versions), 401k’s, 403b’s, SIMPLE IRA Plans (Savings Incentive Match Plans for Employees), SEP Plans (Simplified Employee Pension), SARSEP Plans (Salary Reduction Simplified Employee Pension), Payroll Deduction IRAs, Thrift Plans, RRB Plan (Railroad retirement Benefits Plan), Traditional Pension such as Defined Benefit Plans, Money Purchase Plans, ESOPs (Employee Stock Ownership Plans), Government Plans, 457 Plans, 409A Non-qualified Deferred Compensation Plans and other profit sharing options.

 

If you desire a more in-depth understanding of the various retirement types or you feel that a SEP-IRA or a SOLO 401k is not right for you—consider going to the following links to learn more about the retirement account that may be a better choice for you.

 

https://www.irs.gov/retirement-plans/plan-sponsor/types-of-retirement-plans-1

http://www.realty-1-strategic-advisors.com/retirement-and-personal finance

 

If you are a small operator, depending on your yearly income—you could be choosing among a number of options but in the end the choice of which “Retirement Plan Option” is best for most and possibly you as well—normally comes down to the choice between an SEP-IRA versus SOLO 401k as they both allow you to maximize your contribution limits and control your investment options better than other plans.

 

However, as a practical matter it is important that you look at and  appropriately analyze all options available to you and not just base your decision on how you feel or think or based on what others are doing.

 

You must analyze all retirement options to see where you will benefit most from a revenue, savings, tax and goal oriented perspective.  After thorough analysis (and possible professional advice) you can select a retirement vehicle that serves your future goals and allow you to maximize your savings and tax advantages on an annual basis.

 

SEP-IRA

 

A SEP-IRA allows you to make contributions that are capped at 25% of your income after a reduction for self-employment taxes.  A SEP-IRA is used by those who have a small firm and solo entrepreneurs as well.

 

SEP IRA contributions for sole proprietors, on the other hand, are limited to 20% of your net self-employment income (business income minus half of your self-employment tax), up to a maximum contribution of $54,000 for 2017.

 

SEP Contribution Limits (including grandfathered SARSEPs) controls what an employer can contribute to an employee’s SEPIRA.  The amount cannot exceed the lesser of 25% of the employee’s compensation, or $53,000 (for 2015 and 2016, $54,000 for 2017).

 

Example: Lets say you are 52 years old and earned $60,000 in income after receiving your w-2 from your Limited Liability Corporation business in 2017.

 

Your total contributions would be capped at $15,000 for 2017!  

 

If you earned $144,000 your contributions would be capped at $36,000.

 

If you earned the maximum income for the year $270,000, your contributions to the SEP-IRA would be capped at $54,000.   The reason being that you have exceeded the contribution limit.

 

Can I make catch-up contributions to my SEP-IRA?

 

Because SEP IRA’s are funded by employer contributions only, catch up contributions  usually don’t apply because you as an owner (employer) would be making the contributions.

 

Catch-up contributions apply only to employee elective deferrals.

 

However, if you are permitted to make traditional IRA contributions to your SEP-IRA account, you may be able to make catch-up IRA contributions.

 

Compensation doesn’t include amounts deferred under a Section 125 cafeteria plan.

 

Compensation is limited to $270,000 in 2017 and $265,000 in 2015 and 2016.

  

SOLO 401k

 

A SOLO 401k allows you to stash away up to $18,000 in 2016 and 2017, or $24,000 in 2016 and 2017 if age 50 or over.

 

In addition, you can also use SOLO 401k’s to make ROTH 401k deferrals of after-tax money that you can withdraw tax free during your retirement years.

 

Solo 401(k), (also known as a Self Employed 401(k) or Individual 401(k)), is a 401(k) qualified retirement plan that was designed specifically for employers with no full-time employees other than the business owner(s) and their spouse(s).

 

A one-participant 401k also goes by other names, such as solo-k, Uni-k, one participant k and possibly other names as well as they are becoming more popular.

 

Although unknown by many in the general public a one-participant 401(k) has been around for a while (early 2000’s) and is basically a plan covering a business owner with no employees or just their spouse–and have the same rules and requirements of any 401(k) plan!

 

Contribution limits in a one-participant 401(k) plan

 

In a SOLO 401(k) plan the business owner (you) are both employee and employer.

 

You must always realize that contributions can be made to the plan in both capacities and you as the owner can contribute both:

 

  • Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit of $18,000 in 2016 and 2017, or $24,000 in 2016 and 2017 if age 50 or over; plus

 

  • Employer non-elective contributions up to 25% of compensation as defined by the plan

 

For self-employed individuals:

 

Total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $54,000 (for 2017; $53,000 for 2016)

 

Example: Lets say you are 52 years old and earned $60,000 in W-2 wages from your S Corporation in 2017.  You deferred $18,000 in regular elective deferrals plus $6,000 in catch-up contributions to the 401(k) plan.

 

Your business contributed 25% of your compensation to the plan, $15,000.

 

The total contributions to your plan for 2017  that would be allowed is $39,000 with your maximum contribution for the year being $60,000 “if” you earned $144,000 in 2017 ($144,000 * .25 plus $24,000).

 

This would be  the maximum that you could contribute to the plan for Tax Year 2017.

 

If you had income from other sources and you participated in another 401(k) plan–your deductions would not be allowed and you would have to take corrective action.  By reading this discussion you now know that your limits on elective deferrals are by person, not by plan–meaning once you reach the limit–that’s it!

 

In essence, you must consider “the limit” for “all elective deferrals that you makes during a year”–regardless of source to ensure that you don’t exceed the limits and have to take corrective action–that could get costly!

 

Contribution limits for self-employed individuals

 

You must make a special computation to figure the maximum amount of  non elective (25% of your earned income) and elective ($18,000 in 2016 and 2017, or $24,000 in 2016 and 2017 if age 50 or over) contributions that you can make for yourself.

 

When figuring the contribution, compensation is your “earned income,” which is defined as net earnings from self-employment after deducting both:

 

  • one-half of your self-employment tax, and

 

  • contributions for yourself.

 

Testing in a one-participant 401(k) plan

 

A business owner with no common-law employees doesn’t need to perform nondiscrimination testing for the plan, since there are no employees who could have received disparate benefits.

 

The no-testing advantage vanishes if the employer hires employees. No matter what the 401(k) plan is called by a plan provider, it must meet the rules of the Internal Revenue Code.

 

If you hire employees and they meet the plan eligibility requirements, you “must include them in the plan” and their elective deferrals will be subject to nondiscrimination testing (unless the 401(k) plan is a safe harbor plan or other plan exempt from testing).

 

A one-participant 401(k) plan is generally required to file an annual report on Form 5500-SF if it has $250,000 or more in assets at the end of the year.

 

If you are a one-participant plan with fewer assets you may be exempt from the annual filing requirement.

 

Alternatives to a one-participant SOLO 401(k) plan and SEP-IRA

 

Other possible plans for a single business owner that might work for you depending on your business revenue and future goals include:

 

SEP

IRA

ROTH IRA

 

Conclusion

 

With a SOLO 401k you could contribute up to $54,000 for 2017 with a $6,000 catch-up provision if you are over age 50 (maximum contribution $60,000).

If you desire to establish a SOLO 401k you can go to: http://www.kiplinger.com/article/retirement/T001-C001-S003-set-up-a-solo-401k-with-low-fees.html

 

If you had annual income of $250,000 with a SEP-IRA you could contribute up to $54,000 for 2017.

If you desire to establish a SEP IRA you can go to: https://www.irs.gov/retirement-plans/establishing-a-sep

 

Be sure to consider other factors as well such as your years in business, when you plan to exit, tax ramifications now–and in your future, setup fees and administration fees, your anticipated future income, company growth and other factors that may be unique to you or the business that you operate.

 

You can choose to use an SEP IRA or SOLO IRA  if you are a sole proprietor, LLC or Limited Liability Company, S Corporation and possibly other legal structures that meet the IRS guidelines.

 

As you might expect the SEP IRA was once cheaper to set up and administer, however  that has now changed as many brokerage companies offer low cost SOLO-IRA setup and administering.  In addition, you must look at more than just  setup costs and the administrative fees as those are just a small piece in the overall puzzle toward your retirement goals.

 

Always keep in mind that SEP IRA contributions for sole proprietors, on the other hand, are limited to 20% of your net self-employment income (business income minus half of your self-employment tax), up to a maximum contribution of $54,000 for 2017.

 

You may have more investment choices with a SEP IRA as opposed to a SOLO 401k.

 

With a SOLO 401k you have the 25% employer contribution amount (non-elective deferral) based on your income minus the self-employment taxes–plus the elective deferrals and catch-up provision that would allow you to save more annually than a SEP IRA generally–depending on your income.

 

With both plans you would have to pay taxes on withdrawals, however at that time you might be in a lower tax bracket.  Both plans allow you to use the power of compounding to help you reach your retirement number.

 

Early withdrawals or tapping into  the account by you will result in serious tax penalties and vary depending on your age, years of contributions and whether an exception may apply.

 

Investments and Withdrawals basically follow the same guidelines that the IRS has set for IRA’s and 401k’s in general!

 

If you know that you will come out of the gate making $150,000 the decision as to the best choice will be much clearer for you.  However, if you come out of the gates slow and steady with your income increasing steadily from a low amount such as $20,000 in year one–$40,000 in year two and a steady upward trend an IRA SEP may serve your best interests during your early years.

 

In the end “proper analysis” and not just going on what you hear or see others doing –or what you feel will work is the real key.  It is the hope of TheWealthIncreaser.com that this discussion has at least provided you a starting point toward making your retirement dreams come true.

 

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25% of compensation as defined by the plan