What is Personal Finance? Definition, Examples & Tips for Success

Personal finance is a fundamental part of everyone’s lives, and yet it’s a loaded topic for many people. Here’s what you need to know.

Updated: September 20, 2023

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Personal finance is a fundamental part of everyone’s lives, and yet it’s a loaded topic for many people. Money talk can be intimidating and confusing. Even the definition of “personal finance” can feel a little murky sometimes. But understanding it can be the key to unlocking some of your biggest financial goals — from buying a home to having kids to retiring early. 

So what exactly is personal finance? And how can you leverage it to make sound financial decisions? Here’s what you need to know. 

Personal finance definition 

Personal finance is personal money management. It refers to an individual’s strategies and habits for earning, spending, saving, and investing. Personal finance also encompasses various aspects of financial decision-making. Budgeting, saving for retirement, debt repayment, and purchasing insurance all fall under the personal finance umbrella. 

The fundamentals of personal finance

Developing financial literacy, i.e., knowledge and skills about managing money, can help you take control of your cash flow. While financial management is a pretty broad topic, there are a few areas of personal finance that are especially important to understand. Here are the basics. 

Earning an income 

Regular income provides financial security. It’s reassuring to know that if an emergency happens, you’ll be able to cover basic financial needs like housing, food, utilities, transportation, and healthcare. Maintaining a strong income is also the most reliable way to grow your net worth and reach your financial goals quickly. That could include saving for retirement, purchasing a home, funding your or your children’s education, or starting a business. 

The primary sources of income for most people include:

  • Employment:  Most individuals work for a company or organization and receive a regular paycheck in exchange for their services. Self-employment, freelancing, and gig work are also viable ways to generate income. The Occupational Outlook Handbook lists the average income and job outlook for most occupations.

  • Investments: You can also generate income from investments, such as stocks, bonds, or mutual funds. These can provide additional streams of revenue through dividends, interest, or capital gains.

  • Passive income: Passive income refers to earnings derived from sources that require minimal effort or time, such as rental properties, royalties from creative works, or income generated from online businesses. 

To manage your income effectively, it’s also important to understand the difference between disposable and discretionary income. 

  • Disposable income: This is what’s left after taxes have been deducted from your paycheck. It’s the money you have available to save, spend, or invest.

  • Discretionary income: This is the money you have after taking care of essential expenses, including housing, food, and transportation. It can be saved or invested, or used for non-essential spending. 

Budgeting 

Budgeting is the process of setting aside portions of your income for different spending categories. A good budget acts as a financial blueprint to make sure you’re effectively managing your money and maintaining a steady cash flow. While there is no one-size-fits-all approach to budgeting, here are some basic steps: 

  1. List your income and expenses: First determine your total income from all sources. Then, track your expenses for a month to understand where your money is currently going. You can do this using an Excel spreadsheet.

  2. Categorize your expenses: Next, lump your expenses into different spending categories. These might include:

    • Housing

    • Utilities

    • Groceries

    • Transportation, including car payments and gas

    • Eating out

    • Entertainment and hobbies

    • Debt repayments

    • Savings or contributions to a retirement account, like a 401(k) or IRA

  3. Follow the 50/30/20 rule: Now it’s time to take a look at your actual spending and determine whether or not it matches your values and goals. One popular budgeting guideline is the 50/30/20 rule. This rule encourages you to spend:

    • 50% of your after-tax income on needs (like housing, utilities, groceries, and transportation)

    • 30% on wants (like eating out, entertainment, and hobbies)

    • 20% on savings, retirement contributions, and debt repayment

  4. Adjust based on your financial goals: Your budget should align with your goals and desires. If you have a specific savings target — such as a down payment on a house or a chunk of debt you’d like to pay off — you may want to reconfigure your budget to hit your goal within a reasonable timeframe.

  5. Pay yourself first: It can be tough to prioritize saving over spending. To stay disciplined, set aside a portion of each paycheck for savings or investments before you allocate funds to other categories. Treat savings as a fixed expense and automate regular contributions to your savings accounts.

  6. Review and adjust regularly: Your income, life circumstances, and goals will change over time. Be sure to monitor your budget regularly and adjust as needed. 

Saving and investing

Here are some popular vehicles for storing extra funds and making that money work for you.

  • Emergency savings: Building an emergency fund should be a top priority, no matter what stage of life you’re in. Aim to have three to six months’ worth of living expenses socked away in a savings account. This will provide a financial safety net in case of unexpected events like job loss, medical emergencies, or major repairs. High-yield savings accounts offer competitive interest rates, which can help you earn money from your savings when they’re not in use. 

  • Checking accounts: Use this type of account for essential day-to-day transactions, such as paying bills and storing accessible cash. Most checking accounts come with debit cards and ATM access. 

  • Savings accounts: This type of bank account allows you to set aside money for short-term financial goals. Unlike high-yield savings accounts, traditional savings accounts tend to earn only a nominal amount of interest.

  • Investment accounts: For long-term financial planning — such as building wealth or retirement savings — consider opening an investment account. Options include: 

    • Individual brokerage accounts

    • Employer-sponsored retirement plans like 401(k)s,

    • Individual retirement accounts, including traditional and Roth IRAs

  • College savings: A 529 college savings plan offers tax advantages and can be used to cover qualified education expenses, such as tuition, books, and room and board. 

  • Certificates of Deposit (CDs): CDs offer savers a fixed interest rate for locking their money into an account for a specific period of time. CDs generally offer higher interest rates than regular savings accounts, but may have penalties for early withdrawal. 

So, how much should you allocate toward each type of account? Here are some general guidelines:

  • Emergency savings: Aim to save three to six months’ of living expenses. 

  • Investments: Consider investing 10 to 15% of your income in stocks and bonds, or in opportunities beyond Wall Street, like real estate. A financial advisor can help you decide the best way to invest your money.

  • College savings: Determine how much you’ll need to save and start early to take advantage of compounding growth.

  • Homeownership: Aim to save at least 20% of a home’s cost as a down payment. Otherwise, you may have to buy Private Mortgage Insurance.

Borrowing

Borrowing money can help you reach your financial goals, but you should never take on debt lightly. For one thing, debts will show up on your credit report, the official record of your borrowing history. Too much debt can have a negative impact on your credit score, which could affect your ability to open other lines of credit in the future. 

That said, not all debt is bad debt. Here are some common types: 

  • Mortgage: A loan used to purchase a home, typically repaid over 15 to 30 years

  • Student loans: Loans that fund education expenses. They can either be federal loans or come from private lenders.

  • Credit cards: A revolving line of credit that allows individuals to make everyday purchases. Credit card debt is typically subject to high interest charges if not paid in full each month.

  • Auto loans: Loans used to purchase a vehicle.

  • Personal loans: A type of unsecured loan that can be used for various purposes, such as debt consolidation, home improvements, or emergency expenses.

  • Home Equity Line of Credit (HELOC): A line of credit that allows individuals to borrow against the equity they hold in their homes.

  • Small business loans: Loans used to start or expand a small business. 

Conversely, paying off your debts can boost your credit score. When repaying debt, consider these general rules:

  1. Refinance when possible: Refinancing your student loans or mortgage can potentially save you money by getting you a lower interest rate.

  2. Manage your credit utilization: Aim to utilize less than 30% of your total credit limit. This can help you maintain a healthy credit score and keep your debt manageable.

  3. Make regular payments: Even if you’re focused on paying down one type of debt, continue to make on-time minimum payments on all your debts in the meantime.

  4. Debt repayment strategies: There are different approaches to debt repayment, such as the Snowball Method (paying off smaller debts first) or the Avalanche method (paying off debts with the highest interest rates first). Choose the strategy that most appeals to you.

  5. Stay motivated: Debt repayment can be tedious. Keep yourself engaged by finding an accountability buddy, listening to financial education podcasts, and keeping your financial goals in mind. 

Insurance coverage

Insuring yourself against financial emergencies is an important component of smart money management. Some common types of insurance include: 

  • Life insurance: Life insurance provides financial protection for your dependents in the event of your death. There are primarily two types of life insurance. Term life insurance provides coverage for a specific term, such as 10, 20, or 30 years. Whole life insurance provides coverage for your entire life. A financial planner or estate planning lawyer can help you choose the right type for you.

  • Auto insurance: Auto or car insurance provides coverage for property damage, bodily injury, and other liabilities related to vehicles. 

  • Home insurance: This protects your home and belongings against damages or losses caused by fire, theft, or natural disasters. 

  • Disability insurance: Disability insurance replaces your income if you are unable to work due to a disability or illness. 

  • Long-Term Care Insurance: This covers the cost of services like nursing homes, assisted living facilities, or professional caregivers. These aren’t usually covered by health insurance. 

Taxes

Staying informed about tax laws and regulations can help you minimize your tax burden. Here are some key points to understand:

  • Income tax: This is typically the largest portion of an individual’s tax burden. It’s often calculated based on a percentage of your taxable income. 

  • Tax deductions and credits: Deductions are items you can subtract from your taxable income. These may include charitable contributions and certain business expenses. Tax credits, on the other hand, are items you can subtract directly from your tax bill. These can save you even more money. Examples include the Child Tax Credit and energy-efficient home credits

  • Tax-advantaged accounts: Retirement accounts, Health Savings Accounts (HSAs), and education savings accounts let you make contributions that may be tax deductible or allowed to grow tax-free. 

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Disclaimer: This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.

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