Definition of Personal Finance
Explanation
- Personal finance means finance for an individual person. The individual earns money either through business or a job. He wants to invest in such a way that his daily expenses are covered, and his long-term financial goals are also achieved.
- Long-term financial goals may include marriage expenses for children, educational expenses for children, retirement fund, dream project, 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 & financial goals in an appropriate manner.
Personal Finance Planning Process
The planning process of Personal Finance goes like this:
- The individual first needs to access where he stands today, i.e. understanding the current situation of his finances. He needs to basically prepares his current sources of finances & his current estimated liabilities, if any.
- In case a person has huge financial obligations, he should focus first on the paying the financial obligations first. Only after then he should strive for savings & retirement goals.
- Assuming that the individual has no obligation presently or he 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 purpose.
- As per the plan, he needs to allocate his funds into the respective areas for each frequency selected above.
- In case of a change in the investment environment, he needs to 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.
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A person does a job at a consultancy firm in the US. His monthly salary is $ 6500 as off now & the increment is due on July 1, 2020, with a bonus of one month 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 salary as an emergency fund every month. 20% of surplus amount as savings account deposit every month. The balance amount of surplus each month 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 & rationale investments.
Types of Personal Finance
- Basic savings is account is treated as a type of personal finance medium. Whenever you wish to withdraw a certain set of amounts, you can do so.
- Choosing the appropriate stock out of a list of stocks is necessary for an increase in 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 so as to take up an educational loan (such as a loan for CFA).
- Mortgages or loans may also be taken for leverage purpose to acquire a new asset.
Need for Personal Finance
In today’s situation of economic crisis all over the world, the personal-finance mediums have been the only source for survival when many individuals, who used to earn lakhs & crores through employment in a multi-sized organisation, have lost their job due to the pandemic situation. There cannot be a better reference than this for explaining why do we need to have personal finance at the top list of our priorities.
Principles of Personal Finance
Some of the basic principles of personal finance are as follows:
- The most important principle 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 the world of personal finance.
- Investments should be made in such a way that there are passive sources of income even if you haven’t worked till 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 detailed manner:
- Revenue: This is the starting of personal finance. Unless you have something, how can you invest it? So as to generate revenue, a person does business or provide 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 counter party expense. Thus, you need to prioritise the expenses. First & foremost, the operating expenses are to be settled so that these expenses do not lag behind in future. The common expenses incurred by any individual are rental expense, 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 ratio of savings to revenue. Savings can be reflected through retention of physical cash, the amount in a savings bank account, investment in money market instruments or any other very liquid instruments. You should never invest 10% of your savings. It is always suggested to keep an emergency fund ready in case of an uncertain situation.
- Investments: The amount allocated from savings is transferred to investments. By this, we mean to say the purchase of certain assets that will generate revenue. Investment carries a risk. Every risk has a certain return. Risk & return go hand in hand. Investment can be made in stocks, equities, real estates, mutual funds, etc. Investment is to be made as per the risk appetite of the individual. Thus, this is the most important area in personal finance.
- Insurance: Insurance means financial protection in case of an unforeseen situation in future. For this, a certain amount is paid frequently. Some of the famous insurances are life insurance, health insurance, stock insurance, etc. Some insurers also provide a benefit of savings through the premium amount.
Why is Personal Finance Importance?
Finance, i.e. money, is the ultimate goal for every business person out there. 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 so as to channelize this source of money. Thus, personal finance is necessary for any individual who wishes to earn more with the time.
Benefits
Some of the benefits are:
- You exactly know 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 retain 100% ownership in the business. Thus, your business is debt-free & runs completely on the business of the capacities inbuilt in the business.
- You are not answerable to any outsider for finances.
Disadvantages
Some of the disadvantages are:
- If you have invested the complete amount in the business, you may not have the emergency funds for your family needs in case of any emergency situation.
- Your personal 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 happens to be 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 obviously hire a person to manage or look for the financing needs of your business. Prudence is very important 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.
Recommended Articles
This is a guide to Personal Finance. Here we also discuss the definition and personal finance planning process along with benefits and disadvantages. You may also have a look at the following articles to learn more –
- Stocks vs Mutual Funds
- Book Profit
- Interest Rate Swap
- Derivative Types
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