Personal Finance encompasses all personal decisions related to financial undertaken by a person or household. Personal Finance typically refers to budgeting, saving, investing, insurance, debt & loans, and retirement planning.
Unfortunately, personal finance is not adequately taught in school. Therefore, most people are ill-prepared when suddenly forced to make financial decisions at 18, 22, 25, and beyond.
How Important Is Personal Finance?
Personal Finance is the difference between building wealth and security vs. scarcity and poverty. There are people who make good incomes but, due to poor personal financial habits, they wind up destitute. The stereotypical example being the high-paid athlete who loses it all or the well paid corporate worker who accrues debt to maintain the appearance of wealth. Poor financial habits can undue all the hard work and income you make.
In short, personal finance is one of the most important skills you can learn.
Sadly, the majority of Americans are not taught how to properly manage their finances. The total household debt hit another all-time high with both mortgage debt & non-mortgage debt increasing.
As of mid-2022, over $16 Trillion in total household debt is outstanding across 130 million households. More concerning is the nearly $4.5 Trillion in non-mortgage debts. This equates to nearly $35,000 in non-mortgage debt per US household.
The non-mortgage debt is made up of credit cards, auto loans, and student loans. Since many households have zero non-mortgage debt, this means a significant portion of the population has $50k, $100k, or more bad debt.
Understanding Personal Finance can help you escape the debt hole and start to grow your wealth.
5 Categories of Personal Finance
The foundations of personal finance can be broken down into 5 main categories:
- Income
- Spending
- Savings
- Investing
- Protection
Each of the 5 personal finance categories are a building block that builds up your wealth and security.
Income – The Financial Starting Line
Income is your starting line for personal finance. It encompasses all the cash inflow you receive in a given period. Your salary, side income / income from gigs, wage, dividends & interest on investments, and any other cashflow are considered for your starting income.
In personal finance, you allocate your income to cover your spending, savings, investments, and protection. Therefore, the more income you have, the bigger the pie you get to allocate from.
[Professor B.T. Effer – “We always advocate for increasing income first and foremost. There is no limit on the money you can make. And adding an additional income stream is the quickest way to boost any personal finance goals”]
Spending – The Financial Stumbling Block
If Income is your financial starting line, then Spending is the first hurdle. Most people stumble in managing their spending and budget. This makes them unable to complete the race to savings, investing, and protection.
Spending is all cash outflows for expenses. Rent or mortgage, food, utilities, entertainment, travel, clothes, etc. are all examples of spending.
Spending can be further broken down into ‘essential’ and ‘discretionary’ spending.
Essential spending covers the items necessary for life: reasonable rent/mortgage, minimum groceries, minimum payments on debt, etc. Essential items are setting a baseline cost of living.
Discretionary spending are all the extras in your budget: new iPhone, eating out, designer clothes, etc. The discretionary spending bucket is where costs can be cut to meet a budget.
Savings – Catching Yourself From Falling
Your savings consist of liquid money you can use to fill any unexpected holes in your budget. Think of this as an emergency fund.
You should be spending less than your income so you have extra money (a ‘surplus’). You save some of that surplus in a high-yield savings account as a rainy day fund.
Now if an unexpected life event comes up, you can avoid debt and can use your emergency fund. You can use this fund instead of taking on debt. Whether it is car troubles, temporary unemployment, or any other surprise cost, you have a buffer to catch you from falling.
However, to save up the recommended 3-12 months of expenses, you need to first spend less than your income. In short, you have to have money to save.
Investing – Getting You To The Finish
Investing is when you purchase assets to earn a return on your money. Most common is to invest in stocks, bonds, and/or real estate. The goal of investing is to grow your wealth over time as the assets appreciate in value or pay income in dividends, cash flow, or interest.
Investing can be complicated and scary, but with the invention of low cost, passive, ETFs it has become more accessible to everyone. You no longer need to pick stocks or pay high fees for a professional manager. You can buy ETFs, get broad exposure to the market, and be diversified.
When you invest, you do take on risk. The price of your asset can decrease and the value of your portfolio can be volatile. However, for the higher risks inherent in investing, you can expect a higher return. On average, US stocks have increased 10%+ per year over the last 50 years and more. This is compared to 2-4% return on your savings accounts.
Savings accounts typically don’t return much more than inflation, meaning your wealth doesn’t grow. Once you have secured an emergency fund, your excess income should be invested.
Protection – Preventative Measures
Lastly, protection refers to all the ways you can protect yourself & your family from any major unexpected events. Protection includes health insurance, life insurance, estate planning, wills & trusts, liability insurance, etc.
Protection is important as a major unexpected item can completely wipe out all your work budgeting, saving, and investing. Imagine you are at fault in a major car accident where you get extremely injured and spend months in a hospital. Between the healthcare costs, loss of income, and liability from the accidents (ie-other drivers suing you), you can easily be looking at over 7-figures of unexpected costs.
Strategies For Personal Finance
“The best time to set up a personal finance plan was at 18 years old. The second best time is now”
-Professor B.T. Effer
The earlier you set up a personal finance strategy the better, but it is never too late to start. A personal finance plan can help yourself & your family reach financial independence and security.
What Are The 10 Fundamental Personal Finance Principles?
There are 10 fundamental personal finance principles to follow in order to succeed. What are the basic steps to a personal finance strategy?
- Know your regular income and any variable compensation
- Create a budget
- Build an emergency fund
- Invest a high portion of your income
- Buy insurance
- Avoid unaffordable debts & lifestyle creep
- Understand & monitor your credit score
- Plan for your future
- Automate to remove emotions
- Add income streams
1) Know Your Income
Before you can do anything, you need to know your income. This may seem simple. But knowing how to read your paystub to determine how much you get paid, how much gets deducted, how much tax gets withheld, and how much you bring home, is vital.
Additionally, how much of your income is fixed and how much is variable? Do you make commissions/tips, and how do you plan for slow stretches? Do you get bonuses, or receive long-term incentives and what should you do with one-time large payouts?
Your variable pay introduces another wrinkle in your planning.
Knowing your income is a must before you can move on to any of the items in your financial plan.
2) Create A Budget
Budgets are a framework for how you will spend your income. When you are starting your personal financial journey, it is important to have a detailed budget. However, over time many people are able to move to a spending tracking system rather than a budget.
There are numerous starting frameworks you can use. The most commonly recommended starting budget framework is the 50/30/20 rule. This rule allocates your after-tax take home pay such that:
- 50% goes to living essentials: Rent/mortgage, utilities, minimum payment on debt, basic groceries, etc.
- 30% goes to discretionary expenses: clothes, dining out, entertainment, etc. This bucket is any spending that isn’t required for a basic standard of living
- 20% saving & investing: emergency savings, investing, extra debt payments, and insurance
There are numerous spend tracking apps available to help you monitor your spending.
Additionally, the 50/30/20 budget framework and similar guidelines are starting targets. The goal should be to save more than 20%. The more you can save the faster you can grow your wealth and reach financial independence.
3) Build An Emergency Fund
Emergency savings are liquid assets you keep for any unforeseen expenses. If you don’t have an emergency fund, then you may be forced to take on debt and pay high-interest in order to cover surprise costs.
It is recommended you keep 3-12 months of income in your emergency fund. The large range is due to differences in jobs, stage of life, and wealth. For example, if a portion of your pay is variable, you likely want a larger emergency fund for slow periods.
You want your emergency fund in a liquid, FDIC-insured, high-yield account so you can easily and quickly access it when you need to. You don’t want this money in investments where the value can change and it may not be as big as you want when you require it.
4) Invest
“Pay Yourself First” is a large shift in your mentality. But if you don’t invest, you make it nearly impossible to grow meaningful wealth. And the easiest way to hit a 20%+ savings rate is to take that money out of your income first and figure out how to live life with what’s left over.
Since you have built up an emergency fund, you can invest in less liquid and more volatile assets that will give you a higher return than your savings account. Stocks have historically returned 10%+ over sufficiently long periods of time. Investing with a long-term mindset allows for compounding of returns and a significant growth in your portfolio.
If you save just $5,000 a year for 40 years and purchase stocks with a 10% annual return, you wind up with nearly $2.5 million. However, if you take the same $5,000 a year for 40 years and put it in a savings account earning 2% you wind up with less than $500,000.
This is the power of compound interest and why you want to invest your money instead of keeping it all in savings.
In short, wealth is achieved by spending less than you make and investing it in assets with a high expected return.
5) Buy Insurance
Insurance is vital to your overall personal finance wellness. Auto, homeowners, liability, health, long-term care, and life insurance provide protection from major unexpected incidents.
Insurance is a double-edged sword as you pay expensive premiums and the best case is you never need to use it. But insurance isn’t there as a source of wealth growth, its sole purpose is protection.
If you cause a major car accident where you total your car (auto insurance), need to spend extended time in a hospital (health insurance), get sued (liability insurance), you can easily be faced with 7-figure bills. Insurance protects you from these low frequency and high severity (high cost) events.
Additionally, life insurance protects your loved ones in case you prematurely die. It is peace of mind that your dependents and family will be taken care if you are no longer there to provide for them.
You should budget for adequate insurance coverage.
6) Avoid Debt & Lifestyle Creep
Debt is a huge drain on your cash flow. You need to make payments each month and you incur interest costs on your balance. Just like investment returns compound to build your wealth, the interest on debt continually eats into your wealth. It is negative effect of compounding.
Even worse, money you are spending on paying down debt is money you aren’t investing and letting compound. This is called an opportunity cost. You may be paying 4% APR on a loan, but if the stock market goes up 10%, the true cost of that loan is closer to an opportunity cost of 14%. Since you could have used those loan payments and invested them.
Buying an expensive car is one of the most visible examples of both bad debt and lifestyle creep. You should always have a plan when buying a car, like the 20/4/10 rule to car buying.
Lifestyle creep is when you increase your expenditures as fast or faster than your income is going up. If you get a $10,000 raise, but your spending increases by $10,000 as well, you are not building wealth any faster despite your higher income.
Avoid both bad debts & lifestyle creep.
7) Understand & Monitor Your Credit Score
Your credit score is the primary measure used by lenders to determine your riskiness. A good credit score allows you to get the lowest rates on loans and the best offers on credit cards. Understanding how your credit score works and monitoring it for any adverse impacts can save you material amounts on interest.
Understanding your credit score is one of the foundational skills to know when looking to unfukt your finances.
There are many companies that calculate credit scores with the most popular being your FICO score. There is no cost to view your credit score as there are many services that will show you one of your scores. Many credit cards include free credit scores as a service. Also, everyone gets 1 free credit report a year under federal law.
Your FICO score is made up of 5 factors with different levels of importance:
- 35% Payment History
- 30% Amounts Outstanding
- 15% Credit History Length
- 10% Mix of Credit
- 10% New Credit
FICO scores range from 300 (poor) to 850 (very good). In general the range of scores and the strength of your credit are:
- Exceptional Credit: 800 to 850
- Very Good Credit: 740 to 799
- Good Credit: 670 to 739
- Fair Credit: 580 to 669
- Very Poor Credit: 300 to 579
Lastly, having little to no credit history can be even worse than having fair or poor credit. The easiest way to build credit history is to have a credit card that you put basic expenses like groceries on and then pay off every month.
8) Build A Future Plan
After covering the basics, you want to start preparing for the future. This includes estate planning (what happens to your assets after you pass), setting up a will & trusts, and having a living will & declaring who has power of attorney.
Most of these documents help your family if something unexpected happens to you. This is part of having all your financial affairs in order and saving your spouse, children, and/or family a lot of time and expenses if you become ill, incapacitated, or die.
9) Automate!!!
The more you automate your finances, the less likely you are to deviate from your plan. Things like setting up automatic payroll deductions to your 401k and HSA guarantees you hit your savings targets. Having separate accounts for paying your essential expenses vs non-essential discretionary expenses decreases the chance you spend this months rent on drinks Saturday night.
In short, once you have a strong personal finance plan, the more you automate the easier it is you follow through on the plan.
10) Additional Income Streams
The last item on the list could be one of the most important as adding income streams is one of the best ways to improve your financial situation. There is only so many expenses you can cut from your budget, however there is no limit to the income you can add.
One of the simplest ways to improve your financials is to add income streams. This can be gig work, a side business, a part time job, rental properties (which are not passive) or a combination of them all.
When you set your personal financial plan, adding a second or third income source can help fill any gaps or speed up your savings & wealth growth.
Personal Finance FAQs
Below are a handful of common questions about personal finance.
Personal finance is all the decisions, knowledge, and frameworks used to manage your finances, minimize debt, and grow wealth. When you understand personal finance you have control over your spending, adhere to a budget, have emergency savings, and invest to grow your portfolio.
Some common guidelines for personal finance are:
1) Don’t spend more than you make
2) Save at least 20% of your after-tax take home pay
3) Spend less than 25% of your monthly gross income on a mortgage. For Example, you get $10,000 a month your mortgage, taxes, homeowners insurance, PMI, etc should be $2,500 or less
4) Spend less than 10% of your gross annual income on the purchase of a car and your monthly car payment should be less than 10% of your monthly income
5) 50/30/20 Rule is a framework that says 50% of your budget should go to essential expenses, 30% to non-essential discretionary spending, and 20% to your saving & investing
The 5 fundamental pieces of personal finance are: Income, Spending, Investing, Saving, and Protection.
1) Income is how much money you make
2) Spending is your cost of living expenses
3) Saving is your emergency fund
4) Investing is the assets you purchase to grow wealth
5) Protection are the ancillary items that cover you for major unexpected expenses (ie-Insurance and estate planning)
Making intelligent financial decisions will help you grow wealth and live a financially secure life. The fundamental pieces of personal finance are core to living within your means, saving & investing, and protecting your loved ones.
Personal Finance is not covered in most schools, therefore nearly everyone needs to learn it on their own. Since students start taking out massive loans at 18 for college, the sooner you can learn the basics of personal finance the better your future.
The Final Word – What Is Personal Finance
Personal finance covers a wide range of products, techniques, and decisions that help you manage your money.
The better you get at managing your finances, the sooner you can start growing your wealth.
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