What Is Personal Finance, and Why Is It Important?

 

What Is Personal Finance?

Personal finance is a term that covers managing your money as well as saving and investing. It encompasses budgeting, banking, insurance, mortgages, investments, retirement, tax, and estate planning. The term often refers to the entire industry that provides financial services to individuals and households and advises them about financial and investment opportunities.

Individual goals and desires—and a plan to fulfill those needs within your financial constraints—also impact how you approach the above items. To make the most of your income and savings, it’s essential to become financially savvy—it will help you distinguish between good and bad advice and make intelligent financial decisions.

The Importance of Personal Finance

Personal finance is about meeting your personal financial goals. These goals could be anything—having enough for short-term financial needs, planning for retirement, or saving for your child’s college education. It depends on your income, spending, saving, investing, and personal protection (insurance and estate planning).

Not understanding how to manage finances or be financially disciplined has led Americans to accumulate enormous debt. In Q3 2024, the Federal Reserve Bank reported household debt had increased by $3.8 trillion since December 2019, prior to the recession. In addition, the following balances increased from the second quarter of 2024 to the third

Areas of Personal Finance

The five areas of personal finance are income, saving, spending, investing, and protection.

Income

Income is the starting point of personal finance. It is the entire amount of cash inflow that you receive and can allocate to expenses, savings, investments, and protection. Income is all the money you bring in. This includes salaries, wages, dividends, and other sources of cash inflow.

Spending

Spending is an outflow of cash and typically where the bulk of income goes. Spending is whatever an individual uses their income to buy. This includes rent, mortgage, groceries, hobbies, eating out, home furnishings, home repairs, travel, and entertainment.

Being able to manage spending is a critical aspect of personal finance. Individuals must ensure their spending is less than their income; otherwise, they won't have enough money to cover their expenses or will fall into debt. Debt can be devastating financially, particularly with the high interest rates credit cards charge.

Saving

Savings are the income left over after spending. Everyone should aim to have savings to cover large expenses or emergencies. However, this means not using all your income, which can be difficult. Regardless of the difficulty, everyone should strive to have at least a portion of savings to meet any fluctuations in income and spending—somewhere between three and 12 months of expenses.

Beyond that, cash idling in a savings account becomes wasteful because it loses purchasing power to inflation over time. Instead, cash not tied up in an emergency or spending account should be placed in something that will help it maintain its value or grow, such as investments.

Investing

Investing involves purchasing assets, usually stocks and bonds, to earn a return on the money invested. Investing aims to increase an individual's wealth beyond the amount they invested. Investing does come with risks, as not all assets appreciate and can incur a loss.

Investing can be difficult for those unfamiliar with it—it helps to dedicate some time to gain an understanding through reading and studying. If you don't have time, you might benefit from hiring a professional to help you invest your money.

Protection

Protection refers to the methods people take to protect themselves from unexpected events, such as illnesses or accidents, and as a means to preserve wealth. Protection includes life and health insurance and estate and retirement planning.

Personal Finance Services

Several financial planning services fall under one or more of the five areas. You're likely to find many businesses that provide these services to clients to help them plan and manage their finances. These services include:

• Wealth management
• Loans and debt
• Budgeting
• Retirement
• Taxes
• Risk management
• Estate planning
• Investments
• Insurance
• Credit cards
• Home and mortgage

Personal Finance Strategies

The sooner you start financial planning, the better, but it’s never too late to create financial goals to give yourself and your family financial security and freedom. Here are the best practices and tips for personal finance.

1. Know Your Income

It's all for nothing if you don't know how much you bring home after taxes and withholding. So before deciding anything, ensure you know exactly how much take-home pay you receive.

2. Devise a Budget

A budget is essential to living within your means and saving enough to meet your long-term goals. The 50/30/20 budgeting method offers a great framework. It breaks down like this:

• Fifty percent of your take-home pay or net income (after taxes) goes toward living essentials, such as rent, utilities, groceries, and transport.
• Thirty percent is allocated to discretionary expenses, such as dining out and shopping for clothes. Giving to charity can go here as well.
• Twenty percent goes toward the future—paying down debt and saving for retirement and emergencies.

It’s never been easier to manage money, thanks to a growing number of smartphone personal budgeting apps that put day-to-day finances in the palm of your hand. Here are just two examples:

• YNAB (You Need a Budget) helps you track and adjust your spending to control every dollar you spend.
• PocketGuard is available in both free and paid versions. It uses an algorithm to help you avoid overspending by analyzing your income, bills, goals, and budget.

3. Pay Yourself First

It’s important to “pay yourself first” to ensure money is set aside for unexpected expenses, such as medical bills, a significant car repair, day-to-day expenses if you get laid off, and more. The ideal safety net is three to 12 months of living expenses.

Financial experts generally recommend putting away 20% of each paycheck every month. Once you’ve filled up your emergency fund, don’t stop. Continue funneling the monthly 20% toward other financial goals, such as a retirement fund or a down payment on a home.

4. Limit and Reduce Debt

It sounds simple enough: Don't spend more than you earn to keep debt from getting out of hand. But, of course, most people have to borrow from time to time, and sometimes going into debt can be advantageous—for example, if it leads to acquiring an asset.

Taking out a mortgage to buy a house might be one such case. Still, leasing sometimes can be more economical than buying outright, whether renting a property, leasing a car, or even getting a subscription to computer software.

On the other hand, minimizing repayments (to interest only, for instance) can free up income to invest elsewhere or put into retirement savings while you’re young when your nest egg gets the maximum benefit from compounding interest. Some private and federal student loans are even eligible for a rate reduction if the borrower enrolls in auto pay.2

Student loans account for $1.61 trillion of consumer debt—if you have an outstanding student loan, you should prioritize it. There are myriad loan repayment plans and payment reduction strategies available. If you’re stuck with a high interest rate, paying off the principal faster can make sense.1

Flexible federal repayment programs worth checking out include:3

• Graduated repayment—progressively increases the monthly payment over 10 years
• Extended repayment—stretches out the loan over a period that can be as long as 25 years
• Income-driven repayment—limits payments to 10% to 20% of your income (based on your income and family size)

5. Only Borrow What You Can Repay

Credit cards can be major debt traps, but it’s unrealistic not to own any in the contemporary world. Furthermore, they have applications beyond buying things. They are crucial to establishing your credit rating and a great way to track spending, which can be a considerable budgeting aid.

Credit needs to be managed correctly, meaning you should pay off your entire balance every month or keep your credit utilization ratio at a minimum (that is, keep your account balances below 30% of your total available credit).4

Given the extraordinary rewards and incentives offered these days (such as cashback), it makes sense to charge as many purchases as possible—if you can pay your bills in full.

Using a debit card, which takes money directly from your bank account, is another way to ensure that you will not be paying for accumulated small purchases over an extended period with interest.

6. Monitor Your Credit Score

Credit cards are the primary vehicle through which your credit score is built and maintained, so watching credit spending goes hand in hand with monitoring your credit score. If you ever want to obtain a lease, mortgage, or any other type of financing, then you’ll need a solid credit report. There are a variety of credit scores available, but the most popular one is the FICO score.5

Factors that determine your FICO score include:6

• Payment history (35%)
• Amounts owed (30%)
• Length of credit history (15%)
• Credit mix (10%)
• New credit (10%)

FICO scores are calculated from 300 to 850. Here’s how your credit is rated:78

• Exceptional: 800 to 850
• Very good: 740 to 799
• Good: 670 to 739
• Fair: 580 to 669
• Poor: 579 and below

To pay bills, set up direct debiting where possible (so you never miss a payment) and subscribe to reporting agencies that provide regular credit score updates. In addition, you can detect and address mistakes or fraudulent activity by monitoring your credit report. Federal law allows you to obtain free credit reports once a year from the “Big Three” major credit bureaus: Equifax, Experian, and TransUnion.9

Reports can be obtained directly from each agency, or you can sign up at AnnualCreditReport.com, a federally authorized site sponsored by the Big Three.

Some credit card providers, such as Capital One, will provide customers with complimentary, regular credit score updates, but it may not be your FICO score. Instead, Capital One's CreditWise program offers your VantageScore.

7. Plan for Your Future

To protect the assets in your estate and ensure that your wishes are followed when you die, be sure you make a will and—depending on your needs—possibly set up one or more trusts. You also should look into insurance and find ways to reduce your premiums, if possible: auto, home, life, disability, and long-term care (LTC). Periodically review your policy to ensure it meets your family’s needs through life’s major milestones.

Other critical documents include a living will and a healthcare power of attorney. While not all of these documents directly affect you, all of them can save your next of kin considerable time and expense when you fall ill or become otherwise incapacitated.

Retirement may seem like a lifetime away, but it arrives much sooner than expected. Experts suggest that most people will need about 80% of their current salary in retirement. The younger you start, the more you benefit from what advisors call the magic of compounding interest—how small amounts grow over time.

8. Buy Insurance

As you age, it's natural for you to accumulate many of the same things your parents did—a family, home or apartment, belongings, and health issues. Insurance can be expensive if you wait too long to get it.

Healthcare, long-term care insurance, and life insurance all increase in cost the older you get. Additionally, you never know what life will send your way. If you're the sole breadwinner for the family, or you and your partner both work to make ends meet, a lot depends on your ability to work.

Insurance can cover most of the hospital bills as you age, leaving your hard-earned savings in your family's hands; medical expenses are one of the leading reasons for debt. If something happens to you, life insurance can give those you leave behind a buffer zone to deal with the loss and get back on their feet financially.

9. Maximize Tax Breaks

Due to an overly complex tax code, many people leave hundreds or even thousands of dollars sitting on the table every year. By maximizing your tax savings, you’ll free up money that can be invested in your reduction of past debts, enjoyment of the present, and plans for the future.

You should start saving receipts and tracking expenditures for all possible tax deductions and tax credits. Many office supply stores sell helpful “tax organizers” that have the main categories already labeled.

After you’re organized, you’ll want to focus on taking advantage of every tax deduction and credit available, as well as deciding between the two when necessary. In short, a tax deduction reduces the amount of income on which you are taxed, whereas a tax credit reduces the amount of tax that you owe. This means that a $1,000 tax credit will save you much more than a $1,000 deduction.13

10. Give Yourself a Break

Budgeting and planning can seem full of deprivations. Make sure you reward yourself now and then. Whether it’s a vacation, a purchase, or an occasional night on the town, you need to enjoy the fruits of your labor. Doing so gives you a taste of the financial independence you’re working so hard for.

Last but not least, don’t forget to delegate when needed. Even though you might be competent enough to do your own taxes or manage a portfolio of individual stocks, it doesn’t mean you should. Setting up an account at a brokerage and spending a few hundred dollars on a certified public accountant (CPA) or a financial planner—at least once—might be a good way to jump-start your planning.

Essential Skills for Financial Freedom

Personal finance is not just about numbers—it's about making informed choices today to create a secure and stress-free future. Here’s a step-by-step guide to building the essential skills every individual needs to take control of their money and achieve financial freedom.

1.Learn How to Budget Effectively

The foundation of personal finance is creating a realistic budget. Start by tracking your monthly income and all your expenses—both fixed (like rent and utilities) and variable (like dining out or shopping). Use the 50/30/20 rule as a guideline: 50% of income for needs, 30% for wants, and 20% for savings and debt repayment. Budgeting apps like YNAB or Mint can help automate this process and offer visual insights into your spending habits. The key is consistency—review and adjust your budget monthly to stay on track.

2.Build a Strong Saving Habit

Once you have a budget, prioritize saving money regularly. First, create an emergency fund that can cover at least 3–6 months of expenses to protect yourself against unexpected events like job loss or medical emergencies. Next, set up automated transfers to your savings account so you "pay yourself first." Consider keeping your savings in a high-yield savings account to earn more interest. For specific goals, such as a vacation or a car, create separate “sinking funds” to save gradually over time.

3.Manage and Eliminate Debt

Debt can derail your financial progress if not managed carefully. Begin by listing all your debts, including the total amount, interest rate, and minimum payment for each. Use strategies like the debt snowball (pay off smallest debts first for quick wins) or debt avalanche (target high-interest debts first to save money). Pay more than the minimum if you can, and avoid taking on new, unnecessary debt. Consider consolidating your loans if it reduces your interest rate and simplifies repayment.

4.Understand and Build Your Credit Score

Your credit score plays a crucial role in your financial life—it affects your ability to borrow money, rent an apartment, and even get a job. To build or maintain a good credit score, always pay bills on time, keep credit utilization below 30%, and avoid unnecessary credit inquiries. Check your credit reports annually through free services like AnnualCreditReport.com to spot and correct errors.

5.Start Investing Early

Investing helps your money grow faster than regular savings. Begin by understanding the basics: stocks, bonds, mutual funds, and ETFs. Open an investment account like a Roth IRA or brokerage account, and start small with low-cost index funds. Use the power of compound interest to grow your wealth over time. Investing regularly—even with modest amounts—is more impactful than waiting for the "perfect" time to start.

6.Set Clear Financial Goals

Without goals, it's hard to stay motivated. Define your short-term (e.g., buying a phone), medium-term (e.g., buying a car), and long-term (e.g., retirement) financial goals. Use the SMART criteria (Specific, Measurable, Achievable, Relevant, Time-bound) to make your goals actionable. Track your progress regularly and celebrate small wins to stay inspired.

 7.Learn the Basics of Taxes

Understanding how income tax works can save you money. Learn about different tax brackets, deductions, and credits. Know what documents you need for tax season (like W-2s, 1099s, or receipts for deductions). Use tax-filing software like TurboTax or consult a tax professional if your finances are complex. Also, take advantage of tax-advantaged accounts like 401(k) and IRAs to reduce your tax burden while saving for retirement.

8.Protect Your Finances with Insurance

Insurance is your financial safety net. At a minimum, everyone should have health insurance. Depending on your life situation, consider auto, home/renters, life, and disability insurance as well. Insurance helps prevent one unexpected event from wiping out years of financial progress. Choose coverage that suits your needs and avoid being under- or over-insured.

9.Plan for Retirement

It’s never too early to think about retirement. Take full advantage of employer-sponsored retirement plans (like 401(k)s), especially if they offer a matching contribution—that’s free money! Learn about Roth vs. Traditional IRAs, and begin contributing regularly, even in small amounts. The earlier you start, the more you benefit from compounding over time.

10.Continuously Improve Your Financial Literacy

The financial world changes constantly. Stay informed by reading personal finance blogs, watching YouTube channels, or listening to finance podcasts. Books like “The Total Money Makeover” by Dave Ramsey or “Rich Dad Poor Dad” by Robert Kiyosaki offer timeless lessons. The more you learn, the more confident and capable you’ll feel about making financial decisions.