Knowing the basics of personal finance is crucial to living a good life. Taking charge of your money is critical for personal success, so it pays to understand how to master money well and use it to accomplish your goals. From savings to budgeting to investing, there are many important elements to master when it comes to personal finance.
With the basics of banking, you learned about financial institutions and the different accounts and services available. In this article, I want you to understand the basics of personal finance. These are fundamental money concepts that have revolutionized the way I manage money.
In order to manage your money well, you first have to earn it. Earning income can come in many forms, from a full-time job to a small business, creative gigs, and passive income. We all have one main income source but it’s a good idea to have multiple streams of income so that if one source dries up, you always have others.
In addition to your primary source, which for most people is a job, it helps to have a way to earn additional funds on the side. Some people moonlight as freelance graphic designers or work as dog walkers on the weekend. How you earn is unimportant, but the key is to ensure that you have continuous income.
Making a budget is the difference between always knowing what your money is doing and wondering where it all went at the end of the month. A budget helps you to see where you are spending and where you need to either cut expenses or increase your savings. The first step in budgeting is to write down each monthly expense and compare that to your monthly income.
Ideally, you should be consistently spending less than you earn. Create categories for regular expenses that occur each month (rent, car payment, cell phone, etc.) and those that occur periodically (gifts, taxes, fees). Your budget helps you to get a handle on what you’re spending each month.
Building an emergency fund is one of the most important elements of personal finance because it acts as an insurance policy for your earnings. If you have budgeted your money down to the penny, what happens if you have an unexpected emergency expense? Your dog swallows a toy and the vet is charging $2,000 to remove it. Your car needs new brakes and it will cost $500 to replace them.
By having an emergency fund, you can cover unexpected expenses without touching your budget items. Your emergency fund will include 6 to 9 months of living expenses. Ideally, it should be held in a place that you don’t have daily access to, but can access quickly in an emergency.
Other important basics of personal finance include saving, investing, and credit.
In addition to your emergency fund, having a savings account allows you to accomplish certain short and mid-term financial goals. Goals that are typically between 1-5 years. Saving up for large purchases like a down payment on a house, a new car or a small business can take years so developing a savings plan is key.
Savings accounts are also useful for short-term financial goals like buying holiday gifts, replacing furniture or getting a medical procedure. Include your savings as a regular expense in your budget and pay into each month the same way you pay for your cell phone bill, rent or car insurance.
An investment account will not only provide you with a place to “park” your money but a way for it to grow. Investment accounts offer ways for your money to grow either through interest, dividends, or growth of share price. Allowing your funds to grow over time with automated and consistent investing can help you passively grow wealth.
One of the most critical, yet misunderstood concepts in personal finance is interest and how it can either help or hurt you. Interest is like rent paid on your money. When you save money in an interest-bearing account, the bank essentially pays you each month to keep your money there.
How much rent you earn depends on the interest rate that the bank is paying. Basic savings accounts typically pay the least amount of interest, while other savings type accounts may pay a bit more. And the more cash and the higher the interest, the more you earn. The key is to let it sit and let compound interest work its magic.
Conversely, paying interest can quickly add up, causing you to pay much more than your initial investment. When you purchase a car and pay 5% interest each month, you’re paying for the cost of the car plus the additional interest each month. The longer it takes for you to pay off the car, the more you end up paying for it. The key to avoiding this is to pay off debts–especially high-interest debts–as quickly as possible.
Your credit score is your virtual “report card” of how well you’re doing with financing. It shows potential creditors how much of a “risk” you are when it comes to lending, and it makes all of the difference in the amount of interest you pay for loans. If you are planning to buy a car, your credit score will hold a lot of weight, so it pays to stay on top of your credit and understand how the scoring system works.
Credit scores are largely determined by your history of on-time payments to your creditors, the length of time you have managed credit, and the type of credit you use. Your credit score will determine how much money you may be able to borrow to achieve other financial goals like buying a home.
Consider that a person with a low credit score will pay as much as $100 more a month for a car loan than a person with a high credit score. Over the life of a five-year loan, that adds up to $6,000 in interest payments alone. This $6,000 is money that is not available for your emergency fund, long-term savings, or investing. If you had saved that extra $100 a month in your investment account in a stock plan (stocks traditionally earn about 7% interest annually), you would have more than $7,500 at the end of the 5-year car loan.
Low credit scores mean that you pay more for loans, may have to pay higher deposits for certain items, or be denied credit outright. Check your credit annually to make sure you are headed in the right direction.
You’ve just completed the basics of personal finance. Want to learn more? Get familiar with the first stage on the financial wellness roadmap: financial literacy.