5 Tips for Passing a Personal-Finance Stress Test

Your household finances might be humming along just fine. But would they be able to withstand an unforeseen medical bill or sudden reduction in paid working hours? How about a job loss, furlough or unexpected tax assessment?

As the Federal Reserve prepares to announce the results of this year’s stress tests on the nation’s largest banks Wednesday, we offer the following five stress tests for your own finances.

#1: Debt-to-Income Ratio

Divide your debts, including credit cards, student-loan and car-loan balances, and your mortgage, by your pretax earnings. That will give you your debt-to-income ratio.

Sheryl Garrett, the founder of the Garrett Planning Network, says a good rule of thumb is to have a personal debt-to-income ratio of less than 28%, not counting mortgages, or household debt-to-household income of less than 36%, including mortgages.

A higher ratio is a warning that you have too much debt relative to your income and you either have to lower your debt or raise your income, or both.

#2: Discretionary Expenses

It’s important to know what your discretionary expenses are and how quickly you can cut back on them in times of stress.

Start by sorting all your expenses into three categories: fixed, which are those payments you have to make regardless of circumstances; variable nondiscretionary, which are expenses such as groceries or air-conditioning bills over which you can exercise some level of control; and purely discretionary expenses such as gym memberships and vacations.

Discretionary expenses should make up a greater percentage of your overall expenses than your fixed expenses, says Eleanor Blayney, consumer advocate for the CFP Board in Washington, giving you room to defer, cut back or eliminate.

“Figure out what you could live without or whittle down quickly,” she says.

#3: Emergency Savings

Financial planners tell clients to reserve enough cash in savings or other easily liquidated accounts to cover three to nine months of expenses—with three months being the bare minimum.

This stash will be the first place you turn for help because it is readily available. Getting at it shouldn’t require selling securities or taking an early-withdrawal penalty from a retirement account or certificate of deposit.

The greater your obligations, the more emergency cash you should have squirreled away, planners say. A single mother with a mortgage would want several months if not more than a year of cash to cover expenses, for example. A freshly graduated single person who has no student debt and who is renting an apartment might need only three months’ worth.

The National Foundation for Credit Counseling offers a program called “Sharpen Your Financial Focus” that has free online questionnaires for people to use in figuring out their own plans.

#4: Additional Income

Consider your options for generating additional income in a period of stress, says Bruce McClary, a spokesman for the National Foundation for Credit Counseling.

Wages or tips from a second part-time job or proceeds from selling personal possessions could raise enough to float you through a financially strapped period without spending down your emergency savings too quickly.

#5: Total Assets

If banks are evaluated by the liquidity and quality of their balance sheets and their ability to weather a run on their deposits, consumers could be evaluated by the liquidity and quality of their assets and how well they could withstand an immediate call by all their creditors, Ms. Blayney says.

Add up your emergency savings, the equity in your home and the balances in your retirement savings accounts to get your total assets. Then divide that number by your monthly expenses to figure out how many months you could live with no investment appreciation and no income until you have completely depleted those assets.

Take two people, each with a net worth of $1 million. The first person has securities and cash accounts, the second has her money tied up in real estate. Which one could pay the bills more quickly with less of a discount to convert assets to cash?

“You need to look at the liquidity of the net worth and the quality of it,” she says.

Corrections & Amplifications

To calculate debt-to-income ratio, divide your debts by pretax earnings. An earlier version of this post incorrectly said the ratio was obtained by dividing pretax earnings by debts.