Personal finance

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Personal finance is the financial management that an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial risks and future life events.

Contents

When planning personal finances, the individual would take into account the suitability of various banking products (checking accounts, savings accounts, credit cards, and loans), insurance products (health insurance, disability insurance, life insurance, etc.), and investment products (bonds, stocks, real estate, etc.), as well as participation in and monitoring of income tax management and pensions.

History

Before a specialty in personal finance was developed, various disciplines which are closely related to it, such as family economics, and consumer economics, were taught in various colleges as part of home economics for over 100 years. [1]

The earliest known research in personal finance was done in 1920 by Hazel Kyrk. Her dissertation at University of Chicago laid the foundation of consumer economics and family economics. [1] Margaret Reid, a professor of Home Economics at the same university, is recognized as one of the pioneers in the study of consumer behavior and Household behavior. [1] [2]

In 1947, Herbert A. Simon, a Nobel laureate, suggested that a decision-maker did not always make the best financial decision because of limited educational resources and personal inclinations. [1] In 2009, Dan Ariely suggested the 2008 financial crisis showed that human beings do not always make rational financial decisions, and the market is not necessarily automated and corrective of any imbalances in the economy. [1] [3]

Research into personal finance is based on several theories, such as social exchange theory and andragogy (adult learning theory). Professional bodies such as American Association of Family and Consumer Sciences and the American Council on Consumer Interests started to play an important role in developing this field from the 1950s to the 1970s. The establishment of the Association for Financial Counseling and Planning Education (AFCPE) in 1984 at Iowa State University and the Academy of Financial Services (AFS) in 1985 marked an important milestone in personal finance history. Attendances of the two societies mainly come from faculty and graduates from business and home economics colleges. AFCPE started to offered several certifications for professionals in this field, such as Accredited Financial Counselor (AFC) and Certified Housing Counselor (CHC). Meanwhile, AFS cooperates with Certified Financial Planner (CFP Board). [1]

Before 1990, the study of personal finance received little attention from mainstream economists and business faculties. However, several American universities such as Brigham Young University, Iowa State University, and San Francisco State University started to offer financial educational programs in both undergraduate and graduate programs since the 1990s. These institutions published several works in journals such as The Journal of Financial Counseling and Planning and the Journal of Personal Finance.

As the concerns about consumers' financial capability increased during the early 2000s, various education programs emerged, catering to a broad audience or a specific group of people, such as youth and women. The educational programs are frequently known as "financial literacy". However, there was no standardized curriculum for personal finance education until after the 2008 financial crisis. The United States President's Advisory Council on Financial Capability was set up in 2008 to encourage financial literacy among the American people. It also stressed the importance of developing a standard in financial education. [1]

Personal finance principles

Individual situations vary significantly when it comes to income, wealth, and consumption requirements. Moreover, tax and financial regulations vary between countries, and market conditions change both geographically and over time. This means that advice for one person might not be appropriate for another. A financial advisor can offer personalized advice in complicated situations and for high-wealth individuals. Still, University of Chicago professor Harold Pollack and personal finance writer Helaine Olen argue that in the United States, good personal finance advice boils down to a few simple points: [4]

Personal financial planning process

The key component of personal finance is financial planning, a dynamic process requiring regular monitoring and re-evaluation. In general, it involves five steps: [5] [6]

  1. Assessment: A person's financial situation is assessed by compiling simplified versions of financial statements, including balance sheets and income statements. A personal balance sheet lists the values of personal assets (e.g., car, house, clothes, stocks, bank account, cryptocurrencies), along with personal liabilities (e.g., credit card debt, bank loan, mortgage). A personal income statement lists personal income and expenses.
  2. Goal setting: Multiple goals are expected, including short- and long-term goals. For example, a long-term goal would be to "retire at age 65 with a personal net worth of $1,000,000", while a short-term goal would be to "save up for a new computer in the next month." Setting financial goals helps to direct financial planning. Goal setting is done to meet specific financial requirements.
  3. Plan creation: The financial plan details how to accomplish the goals. It could include, for example, reducing unnecessary expenses, increasing employment income, or investing in the stock market.
  4. Execution: Execution of a financial plan often requires discipline and perseverance. Many people obtain assistance from professionals such as accountants, financial planners, investment advisers, and lawyers.
  5. Monitoring and reassessment: The financial plan is monitored for possible adjustments or reassessments as time passes.

Typical goals that most adults and young adults have are paying off credit card/student loan/housing/car loan debt, investing for retirement, investing for college costs for children, and paying medical expenses. [7]

Need for Personal Finance

There is a great need for people to understand and take control of their finances. These are some of the overarching reasons for it;

1. No formal education for personal finance [8] : Most countries have a formal education across most disciplines or areas of study.

This illustrates the need to learn personal finance from an early stage, [10] to differentiate between needs vs. wants [11] and plan accordingly.

2. Shortened employable age: Over the years, with the advent of automation [12] and changing needs; it has been witnessed across the globe that several jobs that require manual intervention or that are mechanical are increasingly becoming redundant.

These are some of the reasons why individuals should start planning for their retirement and systematically build on their retirement corpus, [16] hence the need for personal finance.

3. Increased life expectancy: [17] With the developments in healthcare, people today live till a much older age than their forefathers. The average life expectancy has changed, and people, even in developing economies, live much longer. The average life expectancy has gradually shifted from 60 to 81 [17] and upwards. Increased life expectancy coupled with a shorter employable age reinforces the need for a large enough retirement corpus and the importance of personal finance.

4. Rising medical expenses: [18] Medical expenses including cost of prescription medicine, hospital admission care and charges, nursing care, specialized care, geriatric care have all seen an exponential rise over the years. Many of these medical expenses are not covered through insurance policies that might either be private/individual insurance coverage or through federal or national insurance coverage.

These reasons illustrate the need to have medical, accidental, critical illness, life coverage insurance for oneself and one's family as well as the need for emergency corpus; [21] translating the immense need for personal finance.

Areas of focus

Critical areas of personal financial planning, as suggested by the Financial Planning Standards Board, are: [22]

  1. Financial position: is concerned with understanding the personal resources available by examining net worth and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under that person's control, minus all household liabilities, at one point. Household cash flow totals all the expected income sources within a year minus all expected expenses within the same year. From this analysis, the financial planner can determine to what degree and when the personal goals can be accomplished.
  2. Adequate protection: or insurance, the analysis of how to protect a household from unforeseen risks. These risks can be divided into liability, property, death, disability, health, and long-term care. Some wagers may be self-insurable, while most require an insurance contract. Determining how much insurance to get, at the most cost-effective terms, requires knowledge of the market for personal insurance. Business owners, professionals, athletes, and entertainers need specialized insurance professionals to protect themselves adequately. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be critical to the overall investment planning.
  3. Tax planning: typically, the income tax is the single largest expense in a household. Managing taxes is not a question of whether or not taxes will be paid but when and how much. The government gives many incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a progressive tax. As one's income grows, a higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax breaks when planning one's finances can significantly impact.
  4. Investment and accumulation goals: planning how to accumulate enough money for large purchases and life events is what most people consider financial planning. Significant reasons to get assets include purchasing a house or car, starting a business, paying for education expenses, and saving for retirement.
    Achieving these goals requires projecting their costs and when to withdraw funds. A significant risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to be invested in various investments. To overcome the rate of inflation, the investment portfolio has to get a higher rate of return, which typically will subject the portfolio to several risks. Managing these portfolio risks is often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation for stocks, bonds, cash, and alternative investments. The budget should also consider every investor's risk profile since risk attitudes vary from person to person.
    Depreciating Assets- One thing to consider with personal finance and net worth goals is depreciating assets. A depreciating asset is an asset that loses value over time or with use. A few examples would be the vehicle a person owns, boats, and capitalizes expenses. They add value to a person's life, but unlike other assets, they do not make money and should be a class of their own. In the business world, these are depreciated over time for tax and bookkeeping purposes because their useful life runs out. This is known as accumulated depreciation, and the asset will eventually need to be replaced.
  5. Retirement planning is understanding how much it costs to live at retirement and developing a plan to distribute assets to meet any income shortfall. Methods for retirement plans include taking advantage of government-allowed structures to manage tax liability, including individual (IRA) structures or employer-sponsored retirement plans.
  6. Estate planning involves planning to disposition one's assets after death. Typically, a tax is due to the state or federal government when one dies. Avoiding these taxes means more of one's assets will be distributed to their heirs. One can leave their assets to family, friends, or charitable groups.
  7. Delayed gratification: Delayed gratification, or deferred gratification, is the ability to resist the temptation for an immediate reward and wait for a later reward. This is thought to be an important consideration in the creation of personal wealth.
  8. Cash Management: It is the soul of financial planning, whether a person is an employee or planning for retirement. It is a must for every financial planner to know how much they spend before their retirement so that they can save a significant amount. This analysis is a wake-up call as many of us know our income, but very few track their expenses.
  9. Revisiting Written Financial Plan Regularly: Make monitoring a financial plan regularly a habit. An annual financial planning review with a professional keeps people well-positioned and informed about the required changes, if any, in personal needs or life circumstances. It would be best to be prepared for all the sudden curve balls life throws.
  10. Education Planning: With the growing interest in students' loans, having a proper financial plan in place is crucial. Parents often want to save for their kids but make the wrong decisions, adversely affecting the savings. We often observe that many parents give their kids expensive gifts or unintentionally endanger the opportunity to obtain the much-needed grant. Instead, one should make their kids prepare for the future and support them financially in their education.
  11. Real Estate Planning: Shelter is a basic human need, and as such, it is imperative that one understands how to obtain a place to live and at the same time maintain their financial security. Housing can be very complicated, with decisions regarding buying or renting, mortgages, insurance, taxes, utilities, maintenance, etc. Apartment or house? That question is crucial for any individual as each option has pros and cons.
    Buy or Rent: If a person chooses to buy a house, they can make a financial investment in a home and improve their credit score and history. Home ownership can make life more stable. The price of the house, including the down payment, monthly mortgage payment, repair and maintenance costs, HOA fees, utilities, insurance, property taxes, and other costs, are considerations. If renting a home is chosen, there is no need to worry about maintenance and no real estate taxes. Moving to a different location can also be easier. Expenses for renters may include electricity, water, internet, parking, and pet fees.
    Mortgages: When purchasing a home/real estate, it is essential to understand the options. Most people either go with a 15- or 30-year plan. The payment rate can be a fixed plan, a constant payment of the same amount over a certain period. The other is an ARM mortgage (Adjustable-Rate Mortgage). This rate can be adjusted and agreed upon to be changed in the given plan depending on mortgage rate fluctuations. Mortgage plans depend on a person's situation, and it is essential for potential borrowers to assess their credit score and financial status when contemplating plans.
    Location / Wants and Needs: When choosing a new home, it is essential to consider the location, along with the qualities that are desired and needed in a home. These variables can increase or decrease the price of an estate. Location-related considerations include a city or rural location, length of commute, the importance of quality public schools, level of safety, the amount of land, included amenities, proximity to family. Examples of variables that would affect the value of an estate include but are not limited to, the quality of school systems in that area, proximity to the community, shopping and entertainment/recreation, safety levels and crime rates of the neighborhood, amenities, and land size and surrounding developments. It is essential to keep all of this in mind when thinking about the future value of a home.

Education and tools

An example of personal budget planning software Budgetplanatm.JPG
An example of personal budget planning software

According to a survey done by Harris Interactive, 99% of the adults agreed that personal finance should be taught in schools. [23] Financial authorities and the American federal government had offered free educational materials online to the public. However, a Bank of America poll found that 42% of adults were discouraged. In comparison, 28% of adults thought that personal finance is difficult because of the vast amount of online information. As of 2015, 17 out of 50 states in the United States require high school students to study personal finance before graduation. [24] [25] The effectiveness of financial education on general audience is controversial. For example, a study by Bell, Gorin, and Hogarth (2009) stated that financial education graduates were more likely to use a formal spending plan. Financially educated high school students are more likely to have a savings account with regular savings, fewer overdrafts, and more likely to pay off their credit card balances. However, another study done by Cole and Shastry (Harvard Business School, 2009) found that there were no differences in saving behaviors of people in American states with financial literacy mandate enforced and the states without a literacy mandate. [1]

Kiplinger publishes magazines on personal finance. [26]

See also

Related Research Articles

Finance is the study and discipline of money, currency and capital assets. It is related to and distinct from economics, which is the study of the production, distribution, and consumption of goods and services. Based on the scope of financial activities in financial systems, the discipline can be divided into personal, corporate, and public finance.

<span class="mw-page-title-main">Pension</span> Retirement fund

A pension is a fund into which amounts are paid regularly during an individual's working career, and from which periodic payments are made to support the person's retirement from work. A pension may be:

<span class="mw-page-title-main">Saving</span> Income which is not immediately spent or otherwise used for consumption

Saving is income not spent, or deferred consumption. In economics, a broader definition is any income not used for immediate consumption. Saving also involves reducing expenditures, such as recurring costs.

<span class="mw-page-title-main">Actuarial science</span> Statistics applied to risk in insurance and other financial products

Actuarial science is the discipline that applies mathematical and statistical methods to assess risk in insurance, pension, finance, investment and other industries and professions. More generally, actuaries apply rigorous mathematics to model matters of uncertainty and life expectancy.

An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuition is an expense. Buying food, clothing, furniture, or an automobile is often referred to as an expense. An expense is a cost that is "paid" or "remitted", usually in exchange for something of value. Something that seems to cost a great deal is "expensive". Something that seems to cost little is "inexpensive". "Expenses of the table" are expenses for dining, refreshments, a feast, etc.

An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's earned income for the taxpayer's eventual benefit in old age. An individual retirement account is a type of individual retirement arrangement as described in IRS Publication 590, Individual Retirement Arrangements (IRAs). Other arrangements include employer-established benefit trusts and individual retirement annuities, by which a taxpayer purchases an annuity contract or an endowment contract from a life insurance company.

A 529 plan, also called a Qualified Tuition Program, is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary. In 2017, K–12 public, private, and religious school tuition were included as qualified expenses for 529 plans along with post-secondary education costs after passage of the Tax Cuts and Jobs Act.

A health savings account (HSA) is a tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a high-deductible health plan (HDHP). The funds contributed to an account are not subject to federal income tax at the time of deposit. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year to year if they are not spent. HSAs are owned by the individual, which differentiates them from company-owned Health Reimbursement Arrangements (HRA) that are an alternate tax-deductible source of funds paired with either high-deductible health plans or standard health plans.

Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. Examples of tax-advantaged accounts and investments include retirement plans, education savings accounts, medical savings accounts, and government bonds. Governments establish tax advantages to encourage private individuals to contribute money when it is considered to be in the public interest.

<span class="mw-page-title-main">Financial literacy</span> Able to make informed choices about money

Financial literacy is the possession of skills, knowledge, and behaviors that allow an individual to make informed decisions regarding money. Financial literacy, financial education and financial knowledge are used interchangeably. Financially unsophisticated individuals cannot plan financially because of their poor financial knowledge. Financially sophisticated individuals are good at financial calculations; for example they understand compound interest, which helps them to engage in low-credit borrowing. Most of the time, unsophisticated individuals pay high costs for their debt borrowing.

<span class="mw-page-title-main">Real estate investing</span> Buying and selling real estate for profit

Real estate investing involves the purchase, management and sale or rental of real estate for profit. Someone who actively or passively invests in real estate is called a real estate entrepreneur or a real estate investor. Some investors actively develop, improve or renovate properties to make more money from them.

The following outline is provided as an overview of and topical guide to finance:

Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, particularly for deferral of income taxes.

<span class="mw-page-title-main">Mortgage</span> Loan secured using real estate

A mortgage loan or simply mortgage, in civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any purpose while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".

A life annuity is an annuity, or series of payments at fixed intervals, paid while the purchaser is alive. The majority of life annuities are insurance products sold or issued by life insurance companies however substantial case law indicates that annuity products are not necessarily insurance products.

Retirement planning, in a financial context, refers to the allocation of savings or revenue for retirement. The goal of retirement planning is to achieve financial independence.

Asset location (AL) is a term used in personal finance to refer to how investors distribute their investments across savings vehicles including taxable accounts, tax-exempt accounts, tax-deferred accounts, trust accounts, variable life insurance policies, foundations, and onshore vs. offshore accounts.

<span class="mw-page-title-main">Asset</span> Economic resource, from which future economic benefits are expected

In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything that can be used to produce positive economic value. Assets represent value of ownership that can be converted into cash . The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.

At retirement, individuals stop working and no longer get employment earnings, and enter a phase of their lives, where they rely on the assets they have accumulated, to supply money for their spending needs for the rest of their lives. Retirement spend-down, or withdrawal rate, is the strategy a retiree follows to spend, decumulate or withdraw assets during retirement.

Property investment calculator is a term used to define an application that provides fundamental financial analysis underpinning the purchase, ownership, management, rental and/or sale of real estate for profit. Property investment calculators are typically driven by mathematical finance models and converted into source code. Key concepts that drive property investment calculators include returns, cash flow, affordability of financing, investment strategy, equity and risk management.

References

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  2. ↑ "Guide to the Margaret G. Reid Papers 1904–1990". The University of Chicago Library. 2010. Archived from the original on 3 July 2013. Retrieved 28 September 2015.
  3. ↑ Ariely, Dan (July 2009). "The End of Rational Economics". Harvard Business Review . Archived from the original on 10 November 2022. Retrieved 28 September 2015.
  4. ↑ "Can The Best Financial Tips Fit On An Index Card?". NPR . Archived from the original on 8 October 2020. Retrieved 5 April 2018.
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  6. ↑ "Creating a Personal Financial Plan" (PDF). Missouri State University. Archived from the original (PDF) on 17 September 2015. Retrieved 28 September 2015.
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  9. ↑ "More than half of U.S. high school students will take a personal finance class before graduation, following the passage of a new Pennsylvania law". cnbc.com. 16 December 2023. Retrieved 23 December 2023.
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  11. ↑ Dierksmeier, Claus (2013), "Wants vs. Needs", Humanistic Marketing, Palgrave Macmillan, doi:10.1057/9781137353290.0010, ISBN   978-1-137-35329-0
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  18. ↑ Wandel, William H. (June 1960). "Rising Medical Care Costs with Special Reference to Hospital Expenses". The Journal of Insurance. 27 (2): 65–68. doi:10.2307/250624. ISSN   1047-3483. JSTOR   250624.
  19. ↑ Sekhri, Neelam (2000). "Managed care: the US experience" (PDF). Bulletin of the World Health Organization. 78 (6): 830–44. PMC   2560791 . PMID   10916920. Archived (PDF) from the original on 10 April 2020. Retrieved 9 February 2020.
  20. ↑ Chaudhuri, Shubham. (2003). The effects of extending intellectual property rights protection to developing countries: a case study of the Indian pharmaceutical market. National Bureau of Economic Research. OCLC   249394911.
  21. ↑ "Personal Finance: The Allocation of Personal Wealth to Different Asset Classes", Pension Finance, John Wiley & Sons, Inc., 11 September 2015, pp. 67–76, doi:10.1002/9781119208945.ch2, ISBN   978-1-119-20894-5
  22. ↑ "Financial Planning Curriculum Framework". Financial Planning Standards Board. 2011. Archived from the original on 13 August 2021. Retrieved 23 August 2021.
  23. ↑ Kadlec, Dan (10 October 2013). "Why We Want—But Can't Have—Personal Finance in Schools". Time. Archived from the original on 6 October 2015. Retrieved 24 October 2015.
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  26. ↑ "10 Best Personal-Finance Tools to Better Manage Your Money". Kiplinger. Archived from the original on 5 September 2015. Retrieved 28 September 2015.

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