Personal Finance
Principles of finance are applied at different levels for taking monetary decisions, right from the level of an individual to a nation’s economy. Application of these principles at the level of an individual or a family is the subject matter of personal finance.
Personal finance is primarily about how individuals obtain monetary resources and how they allocate them to various items of expenditure and save over a period of time. Personal finance is monetary planning and concerns budgeting and saving after giving due consideration to financial risks and life’s goals. During the course of planning one’s finances, one might have to consider financial products such as various types of bank accounts, investment and insurance products and/or retirement plans for future security, all the while taking into account the factor of income tax.
Personal Finance: Planning
Financial planning is crucial to personal finance. Financial is basically a continuous process that involves regular monitoring and periodic reassessment. It is basically a five step process that involves the following:
- Assessment: This is the easiest part which involves assessment of one’s personal financial situation. This is possible by going through financial statements such as income and expenditure statements and balance sheets. A balance sheet is a compilation of personal fixed and movable assets such as car, house, stocks, bank balance, jewelry etc and personal liabilities, which are the sums that one owes on account of mortgage, credit card debt and bank loan. Income and expenditure statement, on the other hand is a list of amounts earned and expenses incurred.
- Setting Goals: Goal setting is crucial to personal finance planning regardless of whether it is a short term goal of making a big ticket purchase or a long term goal of retiring at a particular age with a specific amount of money in bank.
- Plan Creation: This involves creating a plan that will help in accomplishing the goals you have set for yourself. Typically, this would involve either reducing your expenses or increasing income.
- Plan Execution: Executing a plan requires commitment and persistent determination. It may also require seeking help from financial planners for making investment decisions.
- Reevaluation: Things change and sometimes even goals change over time. Whatever plan one creates needs regular monitoring and reevaluation from time to time.
Typically, most people have goals such as paying off different types of debt, investing for paying cost of children’s education, saving for medical expenses and investing for retirement. Many people also have estate planning in mind so that their property can be passed on to their heirs.
Key Areas
As suggested by the Financial Planning Standards Board, individuals need to focus on the following key areas while planning their finances.
- Available Finances: This involves understating the available resources by assessing one’s net worth and total household cash flows. Net worth of an individual is the total of personal assets less all liabilities as of a given date. Household cash flows is the total of all expected income from all sources less expenses within a specified period, which could be a month, quarter or year whichever is convenient.
- Protection from Risks: Life often throws new challenges from time to time. There are risks such as liability, death, property risk, disability, long term health care and death. The risks that are not automatically taken care of require purchase of specific insurance policies to provide adequate protection from unforeseen risks. There are insurance products available for nearly every conceivable risk. However, it requires locating suitable insurance products after identify the risk/s one is exposed to.
- Tax Planning: Income tax is perhaps the largest expense for many households. Tax planning is not about evading taxes but finding ways and means to minimize it. Governments give adequate opportunities in shape of deductions and tax credits for saving income tax. As one’s income increases, so does the tax that one is required to pay. Understanding the many tax breaks available to individuals can have a significant impact on personal finance planning.
- Saving and Investments: This is actually the most important part of personal finance planning. Whatever amount is left over after paying the monthly bills needs to be invested in a way that it accumulates and grows so that whatever goals that have been set can be accomplished. Most people want to accumulate money to be able to make large purchases such as a car or house, setting up a business, paying for education and for retirement purposes.
- Retirement Plans: A retirement plan requires creating an investment after calculating the cost of living at retirement. This would typically involve taking advantage of structures allowed by the government such as IRA and retirement plans sponsored by employers.
- Estate Planning: This involves planning the distribution of wealth after death. Generally, there is a tax to pay on your net worth. Estate planning is about avoiding these taxes in a way that more assets are left for your heirs after payment of taxes. One may choose to leave assets to family, friends, trusts or charity.
Whatever goals that one may set for achieving requires estimation of what it will cost and the time when funds will be needed. The major hurdle that comes in the way is the inflation factor. Inflation is unavoidable and prices will inevitably increase over time. A financial planner takes into account the present cost, projected inflation rates and suggests how much money one needs to save and invest. To beat the inflation rate, one needs to invest in a way to get a higher return on investment. This may, however, involve exposing one’s investment portfolio to a variety of risks, making risk management an important factor in planning personal finances.
A common way of managing investment investments risks is creating a diversified portfolio with assets allocated across various asset classes. A well thought of asset allocation would involve investing majority of available investible funds in risk free investments such as bank deposits and treasury bonds and a small percentage (depending upon appetite for risk) in stocks and other high-risk-high-return financial instruments.