Interest rates keep changing and in a rising interest rate environment, your EMIs can well increase beyond comfort. In the period immediately before the global financial crisis in 2008, domestic interest rates were on an upward trajectory.
You might have more than one loan running-two car loans, a housing loan, a second housing loan for that flat you invested in, and also perhaps an EMI for the latest smart phone. Ideally, you should have the liquidity to cover these monthly payments for at least the next few months. Even though you may be getting a monthly salary, unforeseen eventualities could impact regular income.
This is where evaluating your interest coverage ratio – which defines how much cash you have versus your total interest payment-can help.
For companies this ratio is calculated by dividing the annual earnings before interest and taxes by the annual interest expense. You could evaluate your personal interest coverage by deciding how much liquidity you want to create.
We ask clients to add up expenses and monthly interest payouts. The amount of liquidity to be kept aside depends on the certainty of income. If someone has stable income, then two to three times of expenses can be kept in some liquid form. But where entrepreneurs who face seasonality of income, six months to a year of expenses might have to be kept aside.
Add your cash in the bank plus any liquid investments like short-term fixed deposits or liquid fund investments and divide this by your pre-defined monthly interest payouts . An appropriate ratio can’t be predetermined; it will depend on your individual situation.