One of the most important skills that a person can have in today's society is a solid understanding of personal finance. You'd never know it by looking at your school curriculum though: I know I never once took a course in personal finance in school. It wasn't until after I finished my formal education that the I realized the importance of understanding how to manage my money. So I've decided to consolidate the knowledge I've accumulated during my personal research in the hope that you might find it as useful as I have.
I think the easiest way to start this series off is with a broad overview of some of the main concepts in personal finance and what better way than with the help of a diagram?
I've broken things down into two main categories: the stuff we want to focus on making higher and the stuff we want to focus on making lower. Let's start by taking a look at the good stuff!
Income is one of the most familiar concepts in personal finance. Income is the money that we receive from some outside source. The most common example of an income source is a pay cheque. Every two weeks most of us get a cheque from our employer as compensation for the amount of work we have done over the two week period. There are also some other sources of income such as investment income: interest, dividends and capital gains. I'll discuss the differences between various sources of income later on in this series.
The other thing to remember about income is that it is subject to income tax. That means that the government requires us to pay them a portion of each dollar we earn. This a commonly overlooked area of personal finance but there are some basic tax reduction strategies that can save you a bundle come tax time. I'll talk more about taxes later.
The second area of personal finance that falls in the "good stuff" category is assets. Assets are the things that we own that are worth money. We accumulate assets when we invest the money we get from our income. Some common examples of assets are:
Some assets are better in the long run than others. A car, although an asset, significantly decreases in value over time. After 10 years it is not uncommon for a car initially worth $25,000 to be worth only a few thousand dollars. A house typically has a much more stable value and often increases in value over time. Also, in some cases, assets can generate income for us. I'll talk about some of the differences between various types of assets later.
Now on to the bad stuff. Expenses are the things that you spend your money on. Most of us spend money on food, utilities, entertainment, clothing, etc. Each month we get bills for our expenses and we need to use money from our income to pay for them. I like to think of expenses as "negative income." I find it helps me to remember that by limiting my expenses I'm increasing my effective income. I'll talk more about expenses in a future installment in this series on personal finance.
Finally we have the concept of liabilities. In much the same way I like to think of expenses as "negative income," I like to think of liabilities as "negative assets." Liabilities are things that we have that we need to give back to other people. Some common sources of liability are:
A lot of times, a liability will tend to offset an asset that we have. This is true with a mortgage or a car loan. Liabilities can also be a significant source of expenses. Interest payments on loans and credit card debt can add up very quickly and really eat into our income over time.
Liabilities are not always bad though. Sometimes a loan can allow us to invest in something that will put us in a better financial position in the future. This is what is commonly called "good debt." Yes, it does exist and once you know how to find it, it can be a useful tool in your quest for financial independence.
So that is a basic overview of some of the key concepts in personal finance: We've gone over the "good stuff" -- income and assets -- as well as the "bad stuff" -- expenses and liabilities. We've also talked about the importance of remembering the effects of income taxes when it comes to assessing our finances. This gives us a nice starting point for discussing these topics in more depth in future articles.
I hope you found this useful and please let me know what you think by commenting below.
This article is part of the Personal Finance 101 series.