What is Personal Finance?
Personal finance comprises investment, budgeting, savings, risk allocation, mortgages, and personal banking. It is financial management pertaining to an individual or household. It focuses on individual financial objectives. Achieving financial goals requires some level of financial literacy—knowledge of tax laws, investment opportunities, interest rates, etc.
Financial growth at the individual level involves reducing debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state., reducing credit card reliance, avoiding impulsive buys, and long-term planning. Everyone needs to save up for retirement and emergencies. In addition, individuals must possess knowledge of credit scores to maintain their creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan..
Table of contents
- Personal finance deals with an individual or household’s income, spending, and savings.
- The five fundamental focus areas of personal finance are income, spending, savings, investing, and protection.
- Understanding a country’s tax system can help individuals save a lot of money. This requires proper tax planning. Tax avoidance is a legal method of saving money by paying fewer taxes—by claiming various tax deductions and credits.
Basics of Personal Finance Explained
Personal finance can be understood as the art of managing money. It deals with an individual’s or household’s earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments., savings, and expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.—based on needs and preferences. Individuals who plan their finances have a better shot at reaching their financial goals. Even with limited earnings, they can afford a decent standard of living and future financial security.
Everyone should possess basic finance know-how. But, in the end, finance boils down to personal discipline and control over unnecessary expenses. Further, everyone needs to learn the difference between needs and wants. Once individuals narrow down on a financial goal, they can start saving. In addition, they can invest in suitable opportunities and create multiple sources of income.
Foundation of Personal Finance
The following areas act as the foundation for personal finance:
- Income: It refers to the cash inflow or earnings made by individuals or families—salary, wages, commission, bonus, pension, rent, profit, dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity., etc.
- Spending: It refers to incurred monthly expenses—rent, travel, utilities, mortgage payments, taxes, and leisure.
- Savings: It refers to money that is left after expenses and investments.
- Investing: For financial growth, individuals invest in profitable assets—securities, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period., mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc, and fixed deposits. Investments require proper analysis of potential risks and returns.
- Protection: Insurance offers financial security to individuals—health insurance, motor insurance, life insurance, product insurance, etc.
The principles of personal finance are as follows.
- Prioritization: Decide your priorities before spending—segregate all the unavoidable expenses from the ones that can wait.
- Assessment: Before investing, analyze the costs and benefits of each financial product, investment opportunity, or business idea.
- Restraint: The 30-day savings rule is highly recommended. Before spending your money on something you want but don’t need, stop and think for 30 days. This financial technique protects individuals from impulse buying.
- Knowledge: Develop an interest in financial management—better knowledge of finance and markets lead to better decision-making.
Financial planningFinancial PlanningFinancial planning is a structured approach to understanding your current and future financial goals and then taking the necessary measures to accomplish them. Because this does not begin and end in a specific time frame, it is referred to as an ongoing process. at the individual level comprises the following:
- Retirement Planning
- Estate Planning
- Tax PlanningTax PlanningTax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities.
Personal Finance Tips
Following are some strategies for efficient personal finance management:
- Allocate a personal finance budget. Further, break it down into—necessary expenses, savings, and investments.
- Credit cards may seem bliss, but they can very well end up being a curse. Use them only for emergencies.
- Keep track of your credit score—a poor credit report will result in expensive or no loans for the future. Timely payment of installments is highly recommended.
- Individuals must restrict their borrowings through mortgages and credit cards.
- Always save something for emergencies—a reserve of three to six months of earnings should be set apart.
- Tax planning should be done in advance. Tax avoidanceTax AvoidanceTax avoidance is the process of reducing the income tax liability of an individual or firm by adopting the lawful methods. The taxpayers can claim exemptions and deductions as allowed under the nation's tax provisions. Such as investments in municipal bonds and deductions for business loss. is a legal method of saving money by paying fewer taxes—by claiming various tax deductions and credits.
- Everyone needs long-term financial planning for the future. Pension plansPension PlansA pension plan is a retirement plan where the employer makes a guaranteed payment to the employee once they retire. Every month, the employee receives a specified income post-retirement derived from earnings on its employer’s investments. and long-term investment plans provide constant and periodic returns post-retirement.
Let us consider a fictional example to understand the practical application of personal finance.
Arthur and Brendan work in XYZ Bank as Probation Officers. In a month, they earn $4000 each. Both are married and have a child. While Arthur is keen on personal finance, Brendan does not plan his finances. Thus, for a family of 3, their spendings are as follows:
|Expenses||Arthur ($)||Brendan ($)|
Note: Miscellaneous expenses include outings, leisure, and entertainment.
From the above table, it is evident that Brendan spent $100 more than he’s earning using his credit card. This is on top of the $200 debt repayment for past borrowings. Also, he does not have any savings or investments. Clearly, Brendan had no financial planning.
On the contrary, Arthur plans, budgets, and tracks his finances. As a result, he invests $100 and saves $200 every month. The differences between planned and unplanned finances add up over time.
Frequently Asked Questions (FAQs)
Following are the various ways through which an individual or household generates income:
• Salary/Business/Professional income;
• Rental income from leasing or renting premises;
• Interest received on savings or fixed deposit account;
• Dividends and interests received on other investments like securities, bonds, and debentures;
• Accumulated savings;
• Proceeds from mortgage loans;
• Borrowing from peers and family members.
The rule applies to purchases that an individual wants but does not really need. So, the 30-day rule recommends waiting 30 days before spending. After 30 days of pondering, if the individual still fancies, they can go ahead with the purchase. This financial management technique protects individuals from impulse buying.
How to plan your finance?
Personal finance planning involves the following steps:
• Making a budget of income and expenses;
• Deciding a financial goal;
• Listing out the inevitable expenses:
• Limiting unnecessary spending;
• Investing in suitable opportunities;
• Retirement planning:
• Insurance Saving for emergencies.
This has been a guide to What is Personal Finance & its Meaning. Here we discuss personal finance budget, planning, examples types, principles, and strategies. You can learn more about it from the following articles –