Updated July 14, 2023
Definition of Personal Finance
Personal finance refers to managing the way money is earned, the quantum of earned money to be spent & the quantum of money to be saved (i.e., managing the financial activities of a person) as per the choice & preference of the person considering the budgets, risk appetite, mortgage rates and planning for a future financial goal.
Explanation
- Personal finance means finance for a person. The individual earns money either through business or a job. He wants to invest to cover his daily expenses and achieve his long-term financial goals.
- Long-term financial goals may include marriage expenses for children, educational expenses for children, retirement funds, dream projects, buying a house, high net worth, etc. The goals can differ according to each personal preference.
- He needs to have the guidance of some financial expert to cover his financial needs & goals appropriately.
Personal Finance Planning Process
The planning process of personal finance goes like this:
- The individual first needs to assess where he stands today, i.e., understanding his finances. He needs to prepare his current sources of finances & his current estimated liabilities, if any.
- If a person has substantial financial obligations, he should focus first on paying the financial obligations first. Only after then should he strive for savings & retirement goals.
- Assuming that the individual has no obligation presently or has managed to pay his obligations, he needs to define a financial goal for the future.
- He then needs to choose the alternatives available for investment purposes.
- As per the plan, he must allocate his funds to the respective areas for each frequency selected above.
- In case of a change in the investment environment, he must churn his portfolio accordingly.
Examples of Personal Finance (With Excel Template)
Let’s take an example to understand the calculation of personal finance in a better manner.
A person does a job at a consultancy firm in the US. His monthly salary is $ 6500 as of now & the increment is due on July 1, 2020, with a bonus of one month’s pay in Oct 2020. Thus, after collecting all information, we have prepared a monthly budget for his revenues, expenses, savings, etc. (all amounts in US $)
| Particulars | Jan-20 | Feb-20 | Mar-20 | Apr-20 | May-20 | Jun-20 | Jul-20 | Aug-20 | Sep-20 | Oct-20 | Nov-20 | Dec-20 |
| Revenues | ||||||||||||
| Salary | 6,500 | 6,500 | 6,500 | 6,500 | 6,500 | 6,500 | 7,800 | 7,800 | 7,800 | 7,800 | 7,800 | 7,800 |
| Expected Bonus | – | – | – | 5,000 | – | – | – | – | – | 7,800 | – | – |
| Other Income | – | 500 | – | 500 | 500 | 1,000 | – | – | – | – | 500 | – |
| Total Income | 6,500 | 7,000 | 6,500 | 12,000 | 7,000 | 7,500 | 7,800 | 7,800 | 7,800 | 15,600 | 8,300 | 7,800 |
| Expenses | ||||||||||||
| Rent | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 | 1,700 |
| Food and Groceries | 800 | 800 | 800 | 800 | 800 | 800 | 800 | 800 | 800 | 800 | 800 | 800 |
| Entertainment | 400 | 400 | 400 | 400 | 400 | 400 | 400 | 400 | 400 | 400 | 400 | 400 |
| Childcare | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 |
| Personal Clothing | – | – | 500 | – | – | 500 | – | – | 1,000 | – | – | 1,500 |
| Other Expenses | 200 | 1,000 | 800 | 700 | 500 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 |
| Total Expenses | 4,100 | 4,900 | 5,200 | 4,600 | 4,400 | 5,400 | 4,900 | 4,900 | 5,900 | 4,900 | 4,900 | 6,400 |
| Surplus (Deficit) | 2,400 | 2,100 | 1,300 | 7,400 | 2,600 | 2,100 | 2,900 | 2,900 | 1,900 | 10,700 | 3,400 | 1,400 |
| Cumulative Savings | 2,400 | 4,500 | 5,800 | 13,200 | 15,800 | 17,900 | 20,800 | 23,700 | 25,600 | 36,300 | 39,700 | 41,100 |
Further, the funds are to be allocated as follows:
| Emergency Fund | 650 | 650 | 650 | 650 | 650 | 650 | 780 | 780 | 780 | 780 | 780 | 780 |
| Savings Account | 480 | 420 | 260 | 1,480 | 520 | 420 | 580 | 580 | 380 | 2,140 | 680 | 280 |
| Investments | 1,270 | 1,030 | 390 | 5,270 | 1,430 | 1,030 | 1,540 | 1,540 | 740 | 7,780 | 1,940 | 340 |
| Total Allocation of monthly surplus | 2,400 | 2,100 | 1,300 | 7,400 | 2,600 | 2,100 | 2,900 | 2,900 | 1,900 | 10,700 | 3,400 | 1,400 |
Explanation
- We have assumed 10% of our salary as an emergency fund every month. 20% of the surplus amount as a savings account deposit every month. Each month, the surplus balance is transferred to the investment account for various investments.
- As you observe at the end of the year, the total is as follows:
| Emergency fund | 8,580 |
| Savings Account | 8,220 |
| Investments | 24,300 |
| Total | 41,100 |
- Thus, the person is financially independent at the end of the year due to prudent expenses & rational investments.
Types of Personal Finance
- An essential savings account is treated as a type of personal finance medium. You can do so whenever you wish to withdraw specific amounts.
- Choosing the appropriate stock from a list of stocks is necessary to increase return on investment. This is also terms as a means of personal finance.
- If an individual wants to excel in human capital, he can avail of mortgages or loans to take up an educational loan (such as a loan for CFA).
- Mortgages or loans may also be taken for leverage purposes to acquire a new asset.
Need for Personal Finance
In today’s economic crisis worldwide, personal-finance mediums have been the only source of survival when many individuals, who used to earn lakhs & crores through employment in a multi-sized organization, have lost their job due to the pandemic. There cannot be a better reference than this for explaining why we need to have personal finance at the top list of priorities.
Principles of Personal Finance
Some of the basic principles of personal finance are as follows:
- The most crucial focus in personal finance is savings. The more you save, the more funds you have for disposal. Savings gives you an ultimate level of confidence in routine business dealings.
- Personal finance works best only after we have set the priorities for the spending pattern since resources are limited.
- Save yourself from making unrequired or luxurious spending (such as buying an expensive car, watch, etc.). That means there is no space for “show-offs” in personal finance.
- Investments should be made so that there are passive sources of income even if you haven’t worked to date.
- Gaining after every experience is very important in this field. Financial education is necessary to excel in the field of personal finance.
Areas of Personal Finance
Let’s discuss each area of personal finance in a little more detailed manner:
- Revenue: This is the start of personal finance. Unless you have something, how can you invest it? To generate revenue, a person does business or provides a reputed service. This business helps him get earned. The most common sources of revenue include salary for employment, bonus, dividend income, pension income, interest income, etc.
- Expenses: Every revenue has a counterparty expense. Thus, you need to prioritize the expenses. First & foremost, the operating expenses are to be settled so that these expenses do not lag in the future. The ordinary expenses incurred by any individual are rental expenses, EMIs, welfare expenses, personal expenses, travel expenses, entertainment, taxes, etc. However, one may choose to pay the expenses through a credit card & take the benefit of an interest-free credit period.
- Savings: All revenues less all expenses equals savings. This is the net amount retained at your disposal. This amount is compared to the revenue & one can understand the savings ratio to revenue. Savings can be reflected through the retention of physical cash, the amount in a savings bank account, investment in money market instruments, or other very liquid instruments. You should never invest 10% of your savings. It is always suggested to keep an emergency fund ready in an uncertain situation.
- Investments: The amount allocated from savings is transferred to investments. By this, we mean purchasing certain assets that will generate revenue. Investment carries a risk. Every risk has an inevitable return. Risk & return go hand in hand. Investment can be made in stocks, equities, real estate, mutual funds, etc. Investment is to be made as per the risk appetite of the individual. Thus, this is the most critical area in personal finance.
- Insurance: Insurance means financial protection in case of an unforeseen situation. For this, a certain amount is paid frequently. Some famous insurances are life, health, and stock insurance. Some insurers also provide the benefit of savings through the premium amount.
Why is Personal Finance Importance?
Finance, i.e., money, is the ultimate goal for every business person. Accumulation of money is given much more important than earning money. Personal finance comes into play as to how to manage this accumulated money. Investment ideas & other investment vehicles are necessary to channel this money source. Thus, personal finance is essential for any individual who wishes to earn more with time.
Benefits
Some of the benefits are:
- You know precisely the quantum of money you have retained. Thus, there is no need to look for other sources of finance.
- Leverage is a doubles-sized sword. One who does not know how to handle this sword should ideally invest the money in business from personal finances & not from loans.
- Since you had invested the entire amount in the business, you retained 100% ownership. Thus, your business is debt-free & runs entirely on the business of the capacities inbuilt into the company.
- You are not answerable to any outsider for finances.
Disadvantages
Some of the disadvantages are:
- If you have invested the entire amount in the business, you may not have the emergency funds for your family’s needs in case of any emergency.
- Your expenses are reduced & you will think about spending less as always.
- Non-availability of the source of finance in case any extra funds are required since no credit image is created.
- No leverage leads to the slow growth of the business.
- By chance, the business is a loss-making venture; you lose your money.
Conclusion
In today’s world, personal finance has become very important for the survival of the business & self. You can hire a person to manage or look for the financing needs of your business. Prudence is critical in the selection of appropriate sources of finances. Even though there are many disadvantages to personal finances, it is always suggested to remain debt-free.
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This is a guide to Personal Finance. Here we also discuss the definition, personal finance planning process, and its benefits and disadvantages. You may also have a look at the following articles to learn more –
