If you want to achieve financial freedom, you need to have a firm grip on the concept of personal finance. This means managing your money to meet your needs in both the short- and long term. You need to understand how much money you have, how much you owe, and where your money is going. Here’s an overview of all the basics.
What Is Personal Finance?
Personal finance is a broad term that covers a lot of real estate. Number one, it means managing your money. It means making a budget and deciding where your money goes. How much are you saving for retirement? How much is going into short-term savings? What are you spending on groceries and car insurance? These are all essential aspects of personal finance.
Even more broadly, “personal finance” can also refer to the part of the financial services industry that provides services to individuals and families. Financial advisors, tax accountants, and stockbrokers all work in the personal finance business.
Ultimately, personal finance is about making sure you have enough money to meet all your personal goals. For example, let’s say you want to retire early, at age 55. That’s a common goal for many people, and it’s easy to understand why. However, you’d have to budget more for retirement savings than someone retiring at a normal age. If you have a good grasp of your personal finances, you can proactively save enough to meet that goal.
Among other things, personal finance includes:
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Income generation
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Budgeting
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Banking
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Mortgages and other loans
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Investments
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Retirement planning
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Tax and estate planning
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Insurance
The 3 Principles Of Personal Finance
When you study architecture, you don’t start by designing a skyscraper. You start with learning the basics – drafting, basic engineering, and other fundamentals. Along the same lines, personal finance starts with a few basic principles. The three principles of personal finance are prioritization, assessment, and restraint. If you can absorb and implement these core principles, you’ll be better prepared to manage your finances.
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Prioritization means focusing on what’s important. Go over your budget, see where your money is coming from, and focus on those things. For many people, this will mean an ordinary job, but it could also be a small business, investments, or other sources of income.
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Assessment means making an honest analysis of your finances. It can help to think of yourself and your family as if you were a business. A business has all kinds of costs, and a business owner needs to evaluate which costs are reasonable and which ones can be reduced. At the same time, you have to make an honest assessment of any potential investments. For example, you may have the opportunity to move your retirement investment to a different fund. You’d have to evaluate that fund compared to your current fund and determine if the move is worthwhile.
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Restraint means living within your means. There are people earning millions of dollars a year who end up penniless because they spent their money on Caribbean islands and warehouses full of classic cars. It doesn’t matter how much you’re earning if you’re spending more money than there is coming in. Even if you don’t earn very much, you can save for retirement and other goals by limiting your spending.
Why Is Personal Finance Important?
Personal finance is important because it puts you in control of your financial future. If you don’t understand what’s happening with your money, you won’t be able to plan and meet your goals. On the other hand, when you have a good understanding of your finances, you can save and spend your money in such a way that all your goals are achievable.
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What Are The 5 Aspects Of Personal Finance?
Generally speaking, personal finance falls into five different categories:
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Income
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Spending
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Savings
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Investing
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Protection
All five of these things are key to your financial situation. Let’s quickly go over all five.
Income
Your income is any kind of money you have coming in. This can be a wage or salary, investment income, rental income, Social Security, or any other type of earnings. Income is important because it’s where all your money comes from.
Spending
Spending is the opposite of income. It’s the money you spend on all of your expenses. Some of these are essential, like your mortgage, utilities, and grocery bill, and others are discretionary, like vacations, restaurant meals, and movie tickets.
Savings
Savings is money that you earn but don’t spend. Instead, the money goes into a savings account for future use. Savings are important for covering large expenses, whether a big vacation or an unexpected home repair.
Investing
Investing is similar to savings, in that you’re not spending your money on a tangible good or service. However, an investment is designed to provide you with additional income in the future. For example, you could put $1,000 under your mattress, and a year later, you’ll still have $1,000. If you put your $1,000 into an index fund that grows by 10%, you’ll have $1,100 – an earnings of $100.
Protection
Protection is the twin sister of investing. While investing is meant to grow your money, protection is designed to limit your losses. The most common form of protection is insurance. For instance, you spend money on homeowner’s insurance because you don’t want to lose your home’s entire value in the event of a fire.
8 Strategies For Better Personal Finance
You don’t have to be rich to have solid personal finances – it’s all about making the best use of your resources and allocating your money to your highest priorities first. Here are eight strategies that will lead you down the path to success.
Create Your Financial Goals For Yourself
Before you can do anything in life, you need to know why you’re doing it. The same is true for your personal finances. It’s tough to budget, save, or invest if you don’t have any ultimate goals. So set some short- and long-term goals. Maybe you want to retire early or retire to an exotic location in the long term. In the short term, you might want to improve your credit score or save up for a new car.
No matter what your goals are, it’s important to be realistic. For example, you’re not going to retire at age 30 unless you’re already wealthy. But if you set achievable goals, you’ll be well on your way.
Learn To Budget
Once you’ve outlined your goals, the next step is to develop a budget. To make a budget, start by tracking what you currently earn and spend. Write down all your monthly earnings in one column, and write down all your expenses in another. This will give you an idea of where your money is going, and it lets you identify opportunities to cut spending.
Next, draw up a new budget. Most financial advisors recommend using the 50/30/20 method.
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50% of your after-tax income goes towards necessary expenses. This means your rent, groceries, utilities, car insurance, and other essentials.
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30% goes to discretionary spending. This means movies, concerts, vacations, and other “fun” things. Charitable giving also falls into this category.
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20% goes to savings, investment, and paying off debt.
Finally, you need to stick to your budget. Continue tracking your income and expenses, and adjust your spending as needed to stay within your limits.
Start An Emergency Fund
If you don’t already have one, one of your first priorities should be to establish an emergency savings fund. An emergency fund is designed to cover major unexpected expenses. For example, you could draw on your emergency fund if your furnace broke down and you need a replacement right now.
An emergency fund can also be helpful if you unexpectedly lose your income. A general rule of thumb is that you should save enough money to cover three to six months of essential expenses. That might sound like a lot, but you can save a little at a time. Even if you only have a few hundred dollars to start with, it’s better than no savings at all.
Pay Off Your High-Interest Debts
Another major priority is getting out of debt. Many advisors even recommend doing this before you start saving for retirement. The reasoning is that accumulating interest is a constant dead weight on your finances. The faster you can get out of debt, the faster those interest payments will decrease. If you have a lot of debt, make a list of all your loans and the accompanying interest rates. Then, pay as much as you can towards the loans with the most interest, and make the minimum payments on the rest. Once the highest-interest loan is paid off, repeat the process with the next-highest-interest loan, and so on.
Student loans are particularly cumbersome because they can never be written off – not even in bankruptcy. The only way to get rid of that debt is to pay it off. Thankfully, there are programs available to help keep your payments down:
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Extended repayment makes the loan term longer. You’ll pay more in interest over time, but your monthly payments will be more manageable.
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Graduated repayment starts you out with a lower monthly payment, and slowly increases the payment amount over 10 years. This is helpful for new graduates, who expect to earn more as their career advances.
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Income-based repayment limits your monthly payment to 10% or 20% of your income, depending on how much you earn and whether you have any dependents.
Only Use Credit Cards Wisely
Credit cards can be an incredibly useful financial tool when used properly. When they’re not, they’re an easy way to rack up a lot of debt.
Credit cards exist for two reasons: to help you build credit and manage emergency expenses. That’s it. On the credit front, it helps to use your card for everyday purchases, as long as you don’t exceed 30% of your credit limit. Then, pay off the entire amount every month. You won’t owe any interest, and by making regular payments, you’ll grow your credit.
If worse comes to worst and you need to use your credit card for an emergency expense, you may not be able to pay off the entire balance. In that case, pay as much as you can afford every month until the balance is gone. Whatever you do, don’t just make the minimum payment. This can draw out your payments for years while racking up a ton of interest.
Monitor Your Credit Score
Use a free credit reporting service to keep tabs on your credit rating. This will let you track your progress and alert you to any issues, such as identity theft.
In the US, credit scores are based on the FICO system, which uses a set of weighted factors to determine your score. Here’s how it breaks down:
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Payment history – 35%
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Amount of debt – 30%
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Length of credit history – 15%
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Multiple credit types – 10%
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New credit – 10%
When you check your credit score, it will be a number between 300 to 850. Anything under 580 is considered bad credit, and from 580 to 669 is considered fair credit. If you’re over 670, your credit is good, and if you’re over 740, you’re considered a very good risk. Anything over 800 puts you among the top few percent of creditworthy individuals.
Maximize Your Tax Breaks
The American tax code is complicated to say the least. For this reason, many people just take the standard deduction rather than itemizing. This makes doing your taxes quick and painless, but for many people it also means you’re leaving a lot of money on the table.
This is particularly true if you spend a lot of money on business expenses. Let’s say you’re a small business owner, and a lot of your income goes right back into the company. If you save your receipts and itemize your taxes, you could end up with way more than the standard deduction. The same could be true if you’ve given large amounts of money to charity, or if you’re paying steep loans for graduate school.
Save For Retirement
Ultimately, personal finance is about ensuring your own financial stability, both now and in the future. And in the future, most of us would like to retire at some point. By saving for retirement, you’re doing a favor for a future version of yourself.
The key is to start saving as quickly as possible. The earlier you put money away, the more time it will have time to grow via compounding interest. If you work for an employer, you can even take advantage of matching funds. A lot of companies will match your 401(k) contributions dollar for dollar, up to a certain percentage of your paycheck.
How To Learn About Personal Finance
If you want to learn more about personal finance, there are plenty of resources. These include:
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You can take classes from a community college or adult education center.
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Visit your local library or your favorite bookseller.
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The U.S. Consumer Financial Protection Bureau has a variety of consumer resources. They provide information on everything from college loans to debt collection.
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Visit a licensed financial advisor, accountant, or another finance professional.
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See if your employer offers financial management assistance as one of your employee benefits.
Summary
Personal finance encompasses a wide variety of topics. But by understanding your finances, you’ll be better prepared to chart a course for your financial future. A good budget helps you live within your means, along with saving and investing. Using a credit card properly will help you build credit and avoid unnecessary interest payments. And by creating an emergency fund, you can avoid having to use that card in the first place.
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