What Is Personal Finance and Why Does It Matter?
What Exactly Is Personal Finance?
Personal finance refers to money management, as well as saving and investing. Budgeting, banking, insurance, mortgages, investments, and retirement, tax, and estate planning are all included. The word frequently refers to the entire industry that provides financial services to individuals and households, as well as financial and investment advice.
Individual goals and ambitions, as well as a plan to meet those needs within your budgetary limits, influence how you approach the issues listed above. To make the most of your earnings and resources, you must become financially savvy—this will enable you to distinguish between good and bad advice and make sound financial decisions.
Personal finance is concerned with achieving personal financial objectives. These objectives could be anything from having enough money for immediate necessities to planning for retirement or saving for your child's college tuition. It is determined by your income, spending habits, savings, investments, and personal protection (insurance and estate planning).
Americans have accumulated massive debt due to a lack of understanding of financial management and financial discipline. Household debt had risen by $2 trillion between December 2019 in August 2022. Furthermore, the following balances increased from the first to the second quarters of 2022:1
- Credit card balances have increased by $46 billion.
- Auto loans increased by $33 billion.
- Consumer loans and store cards have increased by $25 billion.
- Non-housing totals increased by $103 billion.
- Mortgages have increased by $207 billion.
Student loan debt has remained stable at around $1.59 trillion.
Americans are taking on an increasing amount of debt to finance purchases, making personal money management more important than ever, especially as inflation eats away at purchasing power and prices rise.
Personal finance is divided into five categories: income, savings, expenditure, investing, and protection.
Income
The beginning point for personal finance is income. It is the total amount of money you receive and can put towards expenses, savings, investments, and protection. Income is the total amount of money you bring in. Salaries, wages, dividends, and other forms of income intake are all included.
Spending is a monetary outflow that often consumes the majority of income. Spending is anything that a person buys with their money. Rent, mortgage, groceries, hobbies, eating out, home furnishings, house repairs, travel, and entertainment are all included.
Personal finance requires the ability to manage one's expenses. Individuals must guarantee that their expenditure is less than their income; otherwise, they will run out of money or go into debt. Debt may be financially catastrophic, especially with the high-interest rates charged by credit cards.
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Savings are the funds that remain after expenditure. Everyone should strive to save money for significant bills or emergencies. However, this requires not spending all of your money, which might be challenging. Regardless of the difficulty, everyone should endeavor to have enough savings to cover any variations in income and spending—between three and twelve months of costs.
Beyond that, cash sitting in a savings account is a waste because it loses purchasing value over time due to inflation. Instead, cash that is not in an emergency or spending account should be invested in something that will help it retain or grow in value.
Investing entails purchasing assets, most commonly stocks and bonds, to gain a return on the money invested. Investing seeks to grow an individual's wealth above and beyond the amount invested. Investing is risky since not all assets appreciate and some may lose money.
Investing can be tough for individuals who are inexperienced with it; it is beneficial to devote some time to learning about it by reading and studying. If you don't have the time, you can benefit from hiring an expert to assist you with your investment.
Protection refers to the steps people take to safeguard themselves against unforeseen events such as sickness or accidents, as well as to preserve riches. Life and health insurance, as well as estate and retirement planning, are all forms of protection.
A variety of financial planning services fit into one or more of the five categories. There are likely to be numerous firms that offer these services to clients to help them plan and manage their finances. Among these services are:
- Asset Management
- Debt and Loans
- Budgeting
- Retirement
- Taxes
- Risk Control
- Estate Administration
- Investments
- Insurance
- Charge Cards
- Mortgage and Home
The sooner you begin financial planning, the better, but it is never too late to set financial objectives to provide financial security and freedom for yourself and your family. Here are the top personal finance habits and tips.
According to the 2022 Investopedia Financial Literacy Survey, which polled 4,000 adults, the majority of Americans are concerned about personal finance basics, retirement funding, and crypto investing.
1. Understand Your Earnings
It's pointless if you don't know how much money you take home after taxes and withholding. So, before you make any decisions, be sure you know exactly how much take-home cash you receive.
2. Create a Budget
A budget is necessary for living within your means and saving enough for long-term goals. The 50/30/20 budgeting strategy provides an excellent structure. It is broken down as follows:
- Fifty percent of your take-home pay or net income (after taxes) is spent on living expenses like rent, utilities, groceries, and transportation.
- Thirty percent is set aside for discretionary spending such as dining out and clothing shopping. Donations to charities can also be made here.
- Twenty percent is allocated to the future—debt repayment and savings for retirement and emergencies.
Money management has never been easier, thanks to an increasing number of smartphone personal budgeting apps that put day-to-day finances in the palm of your hand. Here are only a couple of examples:
- YNAB (You Need a Budget) assists you in tracking and adjusting your expenditure to control every dollar you spend.2
- Mint centralizes cash flow, budgeting, credit cards, bills, and investment tracking. It automatically updates and categorizes your financial data as new information arrives, ensuring that you are always aware of your financial situation. The software will even provide personalized tips and advice.
3. First and foremost, pay yourself.
It is critical to "pay yourself first" to ensure that money is set aside for unforeseen expenses such as medical bills, major auto repairs, day-to-day expenses if you are laid off, and more. Three to twelve months of living expenditures is the ideal safety net.
Financial experts normally advise saving 20% of each salary each month. Don't stop saving if you've exhausted your emergency money. Continue allocating 20% of your monthly income to other financial goals, such as a retirement fund or a down payment on a home.
4. Debt Limitation and Reduction
To prevent debt from spiraling out of control, don't spend more than you earn. Of course, most people must borrow from time to time, and going into debt can occasionally be advantageous—for example, if it leads to the acquisition of an asset. Taking out a mortgage to buy a property is one example. Still, whether renting a home, leasing a car, or acquiring a computer software subscription, leasing can be more cost-effective than buying outright.
Reducing repayments (to interest only, for example) can free up cash to invest elsewhere or put into retirement savings while you're young when your nest egg benefits the most from compounding interest. Some private and federal loans may even qualify for a rate reduction if the borrower enrolls in automatic payments.
Student loans account for $1.59 trillion in consumer debt—if you have one, you should prioritize it. There are numerous loan repayment options and payment reduction strategies to choose from. Paying off the debt sooner may make sense if you're stuck with a high-interest rate.
Among the flexible government repayment programs worth investigating are:
- Graduated repayment—the monthly payment is gradually increased over 10 years.
- Extended repayment—the loan is spread out over up to 25 years.
- Income-driven repayment—payments are limited to 10% to 15% of your income (depending on your income and family size).
5. Borrow only what you can afford to repay.
Credit cards can be significant financial traps, but in today's environment, it's unrealistic not to have one. Furthermore, they have applications other than purchasing goods. They are essential for creating your credit score and are an excellent way to track expenditures, which can be a significant budgeting aid.
Credit should be managed properly, which means paying off your entire bill every month or keeping your credit usage ratio low (that is, keeping your account balances below 30% of your total available credit).
Given the incredible rewards and incentives available these days (such as cashback), it makes sense to charge as many goods as possible—as long as you can pay your bills in full.
Credit card debt should be avoided at all costs, and payments should be paid on time. Paying bills late or, worse, missing payments is one of the quickest ways to destroy your credit score.
Using a debit card, which deducts funds directly from your bank account, is another option to avoid paying interest on little transactions made over a long period.
6. Keep an eye on your credit score.
Credit cards are the major means by which your credit score is developed and maintained, thus keeping track of your credit spending goes hand in hand with keeping track of your credit score. A good credit report is required if you ever want to receive a lease, mortgage, or any other sort of finance. There are several credit ratings available, but the FICO score is the most widely used.6
Your FICO score is determined by the following factors:
- Payment record (35%).
- Owed amounts (30%)
- Credit history length (15%)
- Credit mix (ten percent)
- Additional credit (10%)
FICO scores range between 300 and 850. Here's how your credit score is calculated:7
- Excellent: 800 to 850
- Excellent: 740 to 799
- Excellent: 670 to 739
- Average: 580 to 669
- Very poor: 300–579
Set up direct debiting where possible to avoid missing payments and subscribe to credit reporting companies that provide regular credit score updates. Furthermore, by checking your credit report, you can detect and remedy errors or fraudulent activities. Federal law permits you to get free credit reports from the "Big Three" credit bureaus once a year: Equifax, Experian, and TransUnion.8
Reports are available directly from each agency, or you can sign up for them at AnnualCreditReport.com, a federally authorized site hosted by the Big Three.
Some credit card companies, such as Capital One, will give consumers free credit score updates regularly, but it may not be your FICO score. All of the aforementioned provide your VantageScore.
7. Make a Future Plan
Make a will and, depending on your needs, set up one or more trusts to protect the assets in your estate and ensure that your desires are carried out after you die. You should also check into insurance and, if possible, discover ways to minimize your premiums: auto, home, life, disability, and long-term care (LTC). Review your policy regularly to ensure it matches your family's needs as life's significant milestones approach.
A living will and a healthcare power of attorney are also important documents. While not all of these documents directly touch you, they can all save your next of kin time and money if you become ill or otherwise incapacitated.
Retirement may appear to be a lifetime away, yet it comes far sooner than anticipated. According to experts, most people will require approximately 80% of their present wage in retirement. The earlier you begin, the more you profit from what financial experts refer to as the "magic of compounding interest," or how little amounts rise over time.11
Setting money aside for retirement now not only permits it to grow over time, but can also reduce your current income taxes if the funds are placed in a tax-advantaged plan, such as an IRA, 401(k), or 403(b).
If your workplace has a 401(k) or 403(b) plan, begin contributing right away, especially if your employer matches your contribution. You are wasting money by not doing so. If your workplace offers both, take the time to grasp the differences between a Roth 401(k) and a standard 401(k).
Investing is only one aspect of retirement preparation. Other solutions include deferring Social Security benefits for as long as feasible (which is prudent for most people) and converting a term life insurance policy to a permanent life insurance policy.
8. Purchase Insurance
It's natural for you to accumulate many of the same things your parents did as you become older: a family, home or apartment, goods, and health difficulties. Insurance might be costly if you wait too long to obtain it. Health care, long-term care insurance, and life insurance all cost more as you get older. Furthermore, you never know what life will throw at you. If you are the family's single breadwinner or if you and your partner both work to make ends meet, your capacity to work is critical.
Insurance can cover the majority of your hospital bills as you age, leaving your hard-earned savings in the hands of your family; medical expenses are one of the leading causes of debt.12 If something happens to you, life insurance can provide a buffer zone for those you leave behind to deal with the loss and get back on their feet financially.
9. Increase Your Tax Breaks
Every year, many people lose hundreds or even thousands of dollars due to an unnecessarily complex tax structure. By optimizing your tax savings, you will free up funds that can be invested in debt reduction, present enjoyment, and future objectives.
Begin keeping receipts and documenting expenses for any available tax deductions and credits. Many office supply companies sell useful "tax organizers" with pre-labeled primary sections.
After you've structured yourself, you'll want to concentrate on taking advantage of every available tax deduction and credit, as well as picking between the two when appropriate. In short, a tax deduction lowers the amount of income taxed, but a tax credit lowers the amount of tax owed. This means that a $1,000 tax credit saves you far more than a $1,000 deductible.
10. Allow Yourself a Break
Budgeting and planning often appear to be fraught with constraints. Make sure to treat yourself now and again. You must enjoy the results of your labor, whether it is a vacation, a purchase, or an occasional night out. This provides you with a taste of the financial independence you've been striving for.
Last, but not least, remember to delegate when necessary. Even if you are capable of doing your taxes or managing a portfolio of individual equities, this does not imply you should. Setting up a brokerage account and spending a few hundred dollars on a certified public accountant (CPA) or a financial planner—at least once—might be an excellent approach to get your planning started.
The key to putting your money back on track is to use the talents you already have. It's also essential to know that the ideas that contribute to company and career success equally apply to personal money management. Finance prioritizing, cost-benefit analysis, and expenditure restraint are three essential abilities.
- Finance Prioritization: This implies that you can examine your finances to see what keeps the money coming in and stay focused on those activities.
- Evaluating the Costs and Benefits: This critical ability stops professionals from being overburdened. Ambitious people are always thinking of new ways to make money, whether it's through a side business or an investment. While taking a chance has its place and time, treating your finances like a company requires taking a step back and honestly examining the prospective costs and advantages of any new endeavor.
- Spending Restriction: The final big-picture skill of successful business management that must be applied to personal finances is spending restraint. Financial advisers frequently meet with wealthy people who continue to spend more than they make. Earning $250,000 per year won't get you very far if you spend $275,000 per year. It is critical to learn to delay spending on non-wealth-building items until you have met your monthly savings or debt reduction targets.
Personal Finance Training
Personal finance is not one of the most popular subjects taught in schools. Many college degrees involve some financial education, but it isn't aimed at individuals, so most of us will have to receive our personal finance education from our parents (if we're lucky) or learn it on our own.
Fortunately, you don't need to spend a lot of money to learn how to handle it better. Everything you need to know is available for free online and in library books. Almost all media outlets provide personal money advice regularly.
Blogs on the Internet
Reading personal finance blog is an excellent place to begin learning about personal money. Instead of getting general advice from personal finance publications, you'll understand exactly which problems real people experience and how they deal with them.
Mr. Money Mustache has hundreds of posts full of insights on escaping the rat race and retiring early by making unconventional lifestyle choices.13 CentSai guides you through a plethora of financial decisions through first-person accounts.14 Million Mile Secrets and The Points Guy each teach you how to travel for a fraction of the retail price using credit card rewards. These sites frequently connect to other blogs, so as you read, you will discover new sites.1516
Of course, we can't help but brag about ourselves in this category. Investopedia provides an abundance of free personal financial education. Start with our specific sections on budgeting, home purchasing, and retirement planning—or any of the thousands of other articles in our personal finance department. Don't forget to subscribe to Investopedia newsletters and listen to "The Investopedia Express with Caleb Silver," our weekly podcast.
Within the Library
If you don't already have a library card, you may need to go in person to get one, but after that, you may check out personal finance audiobooks and e-books online without leaving your house. Your local library may have copies of the following best sellers: I Will Teach You to Be Rich, The Millionaire Next Door, Your Money or Your Life, and Rich Dad Poor Dad. Audiobooks are also available for personal finance classics such as Personal Finance for Dummies, The Total Money Makeover, The Little Book of Common Sense Investing, and Think and Grow Rich.
Online Courses for Free
Try one of these free digital personal finance courses if you like the structure of lectures and quizzes:
- The Morningstar Investing Classroom allows both new and seasoned investors to learn about stocks, ETFs, bonds, and portfolios. Some of the courses available include "Stocks Versus Other Investments," "Methods for Investing in Mutual Funds," "Determining Your Asset Mix," and "Introduction to Government Bonds." Each course lasts approximately 10 minutes and is followed by a quiz to ensure that you understand the lesson.
- EdX is a Harvard University and Massachusetts Institute of Technology online learning platform. It provides at least three personal finance courses: "How to Save Money: Making Smart Financial Decisions" from UC Berkeley, "Personal Finance" from Purdue University, and "Finance for Everyone: Smart Tools for Decision-Making" from the University of Michigan. These classes will teach you how credit works, what types of insurance you should have, how to maximize your retirement savings, how to read your credit report, and how to calculate the time value of money.
- "Planning for a Secure Retirement" is a Purdue University online course. It's divided into ten main modules, each with four to six sub-modules covering topics like Social Security, 401(k) and 403(b) plans, and IRAs. You'll discover your risk tolerance, consider the type of retirement lifestyle you want, and calculate your retirement expenses.
- "Personal Finance" is a free online video course available through iTunes from Missouri State University. This introductory course is appropriate for those who wish to learn about personal financial statements and budgets, how to utilize consumer credit sensibly, and how to make automobile and home decisions.
Podcasts
If you don't have much free time, personal finance podcasts are an excellent method to learn how to manage your money. You may listen to professional advice on becoming more financially secure while getting dressed in the morning, exercising, going to work, running errands, or preparing for bed. In addition to "The Investopedia Express with Caleb Silver," you might find the following useful:
- The Dave Ramsey Show is a call-in show that you can listen to whenever you want using your preferred podcast app. You'll learn about actual people's financial troubles and how a multimillionaire who was once broke himself recommends resolving them.
- Freakonomics Radio and NPR's Planet Money make economics fun by explaining real-world occurrences including "how we got from mealy, nasty apples to apples that taste delicious," the Wells Fargo fake-accounts crisis, and whether we should still use cash.
- American Public Media's Marketplace helps make sense of what's going on in the business and economic worlds.
- Farnoosh Torabi's So Money blends interviews with successful business people, expert guidance, and personal finance queries from listeners.
The most essential thing is to identify resources that suit your learning style and are fascinating and engaging to you. If one blog, book, course, or podcast is boring or difficult to grasp, try another until you find something that works for you.
Education should not end once you have mastered the fundamentals. The economy is constantly changing, and new financial tools, such as the budgeting applications discussed earlier, are constantly being produced. Find resources you love and trust, and continue to hone your financial skills as you approach retirement and beyond.