updated - January 25, 2021 Monday EST
Good financial health can be directly translated to having financial resiliency. This means covering daily basic needs and preparing for unexpected emergencies, even if a loss of income is experienced.
Having healthy finances, however, is far less common than it should be. According to Forbes, 78% of Americans are living paycheck to paycheck. Living this way eats away limited income and damages credit.
Things got worse after the economic downturn caused by the coronavirus crisis. However, this pandemic has been highlighting several lessons in life, including paying attention to one's financial health. For starters, here are five factors that make up financial health.
Great financial health requires good credit. Credit measures one's financial stability and credit management. Having a good credit score means you can easily take out loans whenever you want or need to, usually with the best interest rates available.
A good credit score is anywhere between a 670-739 FICO® rating or 661-780 VantageScore rating. What determines credit score? Below are eight factors that are taken into account when determining credit ratings:
Credit utilization rate
Length of credit history
Types, number, and age of credit accounts in use
Public records (e.g., such as bankruptcy)
Number of inquiries reflected on your credit report
On the other hand, you should know how bad credit scores affect borrowing. Below are some ways a bad credit score has a negative impact when you're borrowing.
Loan approval can be difficult and generally takes longer.
When approved, you'll get more restrictive terms, higher rates, and higher insurance premiums.
Renting apartments, getting a security clearance, subscribing to mobile phone services, and, even worse, finding a job can be troublesome.
That said, it's not the end of the world if your credit score isn't exactly as what you want it to be. Additionally, before extending your credit or offering you a loan, lenders also consider your credit report and debt-to-income ratio.
Your debt health is primarily based on your debt-to-income (DTI) ratio. It's the percentage of your monthly gross income paid to your monthly debts. Putting it in another way, this is how you calculate a DTI ratio:
DTI % = Gross Monthly Debt Payments ÷ Gross Monthly Income
A low DTI ratio, which indicates an even distribution between your income and debt, is a good debt health indicator. To achieve a low DTI ratio, avoid being in a lifestyle inflation phenomenon, in which you spend more than you can afford.
Moreover, relying on high credit card limits can be a double-edged sword. While it allows you to make large purchases even without cash, you might also get stuck in a spiral of growing debt repayments that can exhaust your entire monthly income.
Setting aside funds to get through unexpected expenses is another way to make your financial condition healthy. If you have a stable job, your emergency savings should cover at least 3-6 months' worth of your living expenses (or more if possible). It's advisable to double this amount if you're either a contract worker or self-employed.
The unemployment rate has skyrocketed due to the coronavirus pandemic, making the current crisis almost as bad as the Great Depression. Consequently, many people are losing financial stability due to income loss. These situations are where emergency backup would come in handy.
Getting a retirement plan can also make your personal financing healthy. This doesn't only secure your financing during your golden years but also improves your credit. If you solely rely on your Social Security, you'll typically have limited access to credit. However, with a retirement plan, you will enjoy more credit options and a better credit score.
It's advised to spare at least 10% to 15% of your pre-tax income for your retirement. However, keep in mind that even with a retirement plan, you can't afford not having a job if you still have large amounts of debt or struggles in paying current bills. Ideally, your financial situation should be stable before you decide to retire.
Ramping up your savings (i.e., emergency funds, retirement plans, and insurance) can indirectly improve your credit score. Also, keeping up with bills and minimizing debts will be much easier if you have extra funds in your accounts. Since your credit is good, your debt is regulated, and you have more savings, leading to better financial health.
The more you'll invest in financial backups, the better. In fact, dealing with unexpected car accidents, home fire, or medical expenses without good insurance can bankrupt you. It's always better to be cautious and prepared than to be regretful later. Make sure to have health, living, auto, and life insurances in case of emergencies.
In brief, your financial health is in good shape if you have a good credit score, low DTI ratio, emergency funds, a retirement plan, and insurances. It's also important to distinguish your needs and wants, stick to your budget, and cut spending to save more. That way, you won't have to stress and worry about your financial needs during these trying times.
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