Face the numbers with personal financial 'stress test'

The nation's 19 biggest banks recently underwent "stress tests" ordered by the government to see how they would hold up if the economy deteriorated further.

Consumers should put themselves through a similar stress test to determine if their personal finances could withstand a job loss, a serious illness or any other unexpected event that would challenge their finances.

Such a test will tell you "am I recession-proofing myself from myself?" said Todd Mark, vice president of education at Consumer Credit Counseling Service of Greater Dallas, which developed a consumer financial stress test for The Dallas Morning News.

"What is my ability to cope with change if an external factor impacts me, if I lose a job, if my property value drops? How long would I financially be able to survive?"

The severe recession has so traumatized consumers that many may not want to put their finances under a microscope. But ignorance isn't bliss in the still-uncertain economy. In fact, it can set you up for a big fall.

"Most people approach their personal finances with their eyes shut and their fingers crossed," said Lynn Lawrance, a certified financial planner at Financial Network Investment Corp. in Dallas. "They believe only optimistic scenarios will prevail, things will somehow work out and that reality won't knock at their door."

Even though the results of your financial stress test may not be what you had hoped, it's crucial that you know where you stand so you can begin to fortify your finances.

"Think of a stress test as a life boat drill," Lawrance said. "How will you handle a leak in your boat? What would you do if you run out of fuel or you're blown way off course? Would you still be able to safely arrive at your destination? What can you do today to minimize the risk of these and other potentially serious events on your voyage?"

You need to stress-test the most critical assumptions of your financial situation, including:

- If you lost your job, how long would it take you to replace your income through a job search?

To find out, divide your current gross annual salary by $10,000 to determine how many months it would take you to replace your current income, Mark said. Mark said that formula is based on an estimate that for each $10,000 you make, it will take you one month to replace your salary.

- If you were laid off, would your emergency savings last as long as it would take to replace your income? And, if not, how much of a shortfall would there be?

To find out, divide your total emergency savings by your monthly expenses to determine how many months you can get by without income. Then subtract the number of months you're covered in savings from the number of months it would take you to replace 100 percent of your income to determine any potential income shortfall, Mark said.

Experts advise having savings equal to three to six months of expenses, but that's only a guideline. With today's economic uncertainty, it's wise to have more.

- If you carry a balance on credit cards and your credit card company raised your annual percentage rate or your mortgage reset to a higher rate, would you have enough to absorb those higher expenses?

If your credit card issuer cut your credit limit, would you have enough cash to pay for things that you would have bought on credit?

Would your credit score put you at risk for higher interest rates on your credit card and a lower credit limit?

- What is your debt-to-income ratio? It shows the ratio between your level of debt and your level of income.

To calculate, divide your total unsecured debt, such as credit cards, by your yearly gross income.

Mark advises having as little unsecured debt as possible. Mark said although your mortgage is part of your total debt load, he didn't use that as a factor in the formula because it's "healthy debt," which will lead to homeownership and home equity, vs. credit card debt, which is unhealthy because it doesn't help consumers achieve a financial goal.

Your total debt payments, including your mortgage, shouldn't exceed 36 percent of your annual gross income, said Gerri Detweiler, credit adviser for Credit.com, a credit education Web site.

Consumers with a high debt-to-income ratio and no emergency savings should make only the minimum payments on their credit cards and save the rest of the money, Mark said.

"They need to bill themselves every month, and that bill needs to be to the Bank of Me," he said.

"It's more critical to have that fallback position," Mark said, because there's no guarantee the credit line you have today is going be there tomorrow.

"I would much rather my cushion be cash in the bank rather than a credit line that I don't know whether it will be there a month later," Mark said.

Consumers who score low on the stress test, should not be discouraged.

"A low score on the test doesn't mean that they're destined for failure," Mark said. "It just means that their capacity to handle adversity is diminished. Their focus needs to be bolstering their financial strength so they can weather a storm."

TAKE THE TEST

The Consumer Credit Counseling Service of Greater Dallas has identified four factors that are key to determining your overall financial health and ability to cope if faced with financial hardship. To determine your financial stress test score, do the math for each factor and then find out how you score.

1. Enter yearly gross income.

2. Enter monthly net income.

3. Enter total monthly expenses (if needed, see CCCS budget sheet).

4. Enter total unsecured debt (credit cards, student loans, etc.)

5. Enter total amount of emergency savings.

6. Enter the dollar amount of any equity in your home.

7. Enter total retirement savings from company plans such as a 401(k) or any personal plans such as an IRA. Do not include any unvested dollars.

Factor One: Disposable income ratio. This factor shows your ability to absorb a drop in income or an increase in expenses. To calculate: Subtract monthly expenses from monthly income to determine disposable income or shortfall. Then divide your disposable income by monthly net income to determine your disposable income ratio.

Factor Two: Surviving on savings. This factor shows the amount of time you can survive on emergency savings without a job. To calculate: Divide your total emergency savings by monthly expenses to determine how many months you can get by without income.

Factor Three: Total spend-down. This factor shows how many months you could live before becoming completely broke. To calculate: Add your emergency savings to the amount of home equity and your total retirement savings to determine your total assets, then divide by your monthly expenses.

Factor Four: Debt-to-income ratio. This factor shows the ratio between your level of debt and your level of income. To calculate: Divide your total unsecured debt by yearly gross income.

STRESS TEST SCORING

Factor One: Disposable income ratio

25 percent or more = 25 points
15 to 24 percent = 20 points
10 to 14 percent = 15 points
5 to 9 percent = 5 points
4 percent or less = 0 points

Factor Two: Surviving on savings

Six or more months = 25 points
Three to five months = 20 points
Two months = 15 points
One month = 5 points
Zero months = 0 points

Factor Three: Total spend-down

More than 48 months = 25 points
36 to 48 months = 20 points
24 to 36 months = 15 points
12 to 24 months = 10 points
12 months or less = 0 points

Factor Four: Debt-to-income ratio

Less than 10 percent = 25 points
10 to 19 percent = 20 points
20 to 35 percent = 10 points
36 to 50 percent or more = 5 points
More than 50 percent = 0 points

FINAL TEST SCORE

Total the four categories to receive your financial stress test score.

0-25 points: Poor health - You are living dangerously and may already be in crisis.
25-50 points: Fair health - Any change or unplanned event could lead to financial crisis.
50-75 points: Good health - You have options to cope with change.
75-100 points: Excellent health - You are well prepared to handle adversity.

SOURCE: Consumer Credit Counseling Service of Greater Dallas

(c) 2009, The Dallas Morning News.

Distributed by McClatchy-Tribune Information Services.