The Building Blocks of Personal Finance
The purpose of this lesson is to:
• Give you a solid understanding of the building blocks of personal finance
• Teach you how they relate to your life and the things you do everyday
• Teach you how to think about them in a way that will make you more likely to make good financial decisions
With that out of the way, let’s get started.
Building Block 1: Your Income
What we mean by income is the money you make. More specifically, it is money given to you because you have committed your time, your labor, or your money to something. Let’s go into a little more detail.
There are basically 3 types of income:
• Earned Income
• Portfolio Income
• Passive Income
Earned Income
Earned income is any income you get based on the time or labor you spend doing something. Most people’s earned income consists of the salary they receive from working or the income they receive from consulting or working in their own business.
Portfolio Income
Portfolio income is income you get from selling something for more money than you paid for it. For most people, this applies to investments such as stocks, bonds, mutual funds, real estate, etc. and they are more commonly referred to as “capital gains.”
Passive Income
Passive income is income you don’t have to do anything (or do very little) for. This type of income mainly comes from renting out something you own (such as real estate or intellectual property) or business income you don’t have to put in time or work to collect (such as dividends or loan payments owed to you).
As you’ve probably gathered by now, these income types are quite different, as earned income requires you to continuously put in time or labor in exchange for getting money in return. For portfolio and passive income, you normally need to invest either your money or your time in something so that it can pay off in the future.
Think about the income streams you currently have and how much time and energy you have to put forth in order to receive those streams of income.
Then think about what you want your future income streams to look like. Remember that you can have a combination of the different income types at any given time and that you can save your earned income to be able to later generate the other income types that don’t require as much of your time.
Finally, think about how you can achieve your future income stream scenario.
Building Block 2: Your Expenses
Expenses are the money you spend or your cash outflows. Controlling your expenses is a major part of controlling your finances, and understanding the different types of expenses, knowing where your money goes, and being able to figure how to decrease your spending is the key to controlling your expenses.
There are 3 types of expenses:
• Debt Expenses
• Fixed Living Expenses
• Variable Living Expenses
Debt Expenses
Debt expenses are expenses you have because you hold debt. They consist of the monthly payments on the money you’ve borrowed. If you have a mortgage, your mortgage payment would be a debt expense. Same thing for a credit card payment. If you didn’t have the debt, you wouldn’t have the debt expenses.
When you pay debt expenses, part of the payment goes to pay down the amount you owe and part of the payment goes to pay interest to whoever lent you the money.
Fixed Living Expenses
Fixed living expenses are expenses where you know what amount you are going to have to pay and when. Some examples of these are rent, some utilities like cable and internet, and insurance premiums.
The good thing about fixed living expenses is that they make it easy to plan what your finances are going to look like in the future. Because they are scheduled payments for amounts known in advance, you can plan to make sure you either have enough income or enough saved up to pay them.
Variable Living Expenses
Variable living expenses are expenses where you don’t know how much you are going to have to pay. Some of these may be scheduled regularly like fixed expenses, but the amounts you have to pay tend to vary. This can include utilities such as electricity and water, groceries, retail purchases, gasoline, automobile expenses, dining, and entertainment.
Think about what you normally spend money on. Think about where the money you make goes. Does it mostly go toward paying off debt or does it go toward living expenses?
Reducing Expenses
Reducing debt expenses can be done in two ways.
For debt expenses where the payment varies based on the balance, you can pay down the balance, and that will reduce your payment for that debt.
You can also lower the payments on virtually every kind of debt expense by getting the interest rate lowered. This is usually done by negotiating with whoever lent you the money or by transferring your balance to somewhere that is willing to offer you a lower interest rate.
Like getting your interest rate lowered to reduce your debt expenses, reducing your fixed living expenses is normally also done through either negotiation with whoever it is you are paying or by taking your business elsewhere where you can get similar services for a lower price.
The easiest expenses of all to reduce, or at least the ones you have the most control over, are your variable living expenses. Reducing these basically involves looking at the expenses, figuring out where you can afford to cut back, and then simply not spending as much on those things.
Building Block 3: Your Assets
Assets are things you own that have value. In other words, they are things you would be able to sell and get money for.
There are 3 types of assets:
• Income-Generating
• Appreciating
• Depreciating
Income-Generating Assets
Income-generating assets are things you own that provide you with a stream of income. Some examples of these are real estate you’ve rented out, dividends from stocks you own, and interest payments from money you’ve lent. The stream of income could be for a fixed amount of time or it could be for as long as you own the asset.
The income you receive contributes to the overall value of this type of asset because whoever you would sell it to would then begin receiving the income.
Appreciating Assets
Appreciating assets do not provide income. Instead, they increase in value, or appreciate over time.
Appreciation is usually not guaranteed because it is ultimately based on supply of, and demand for, the asset. That being said, choosing the right assets to purchase and holding them for long periods of time before selling them generally increases the likelihood that the asset will have appreciated in value.
Some examples of appreciating assets can include real estate, stocks, mutual funds, businesses, and collectibles.
Depreciating Assets
Depreciating assets are assets that lose value as time passes. The most common example of this is an automobile, as very rarely are you able to sell a car for more than you paid for it. You can also think of most of the tangible items you buy as depreciating assets.
The path to wealth and financial freedom is one by which you acquire appreciating assets and income-generating assets and try to stay away from owning too many depreciating ones.
Think about the type of assets you have. This will include any money you have in any bank accounts, the value of any real estate you own, and the value of any investments you have.
Then think about the assets you want to own and how you can go about acquiring more income-generating and appreciating assets.
Building Block 4: Your Debts
Unless you’ve been living under a rock, chances are you know what debt is. Debt is money you’ve borrowed that you have to pay back with interest. However, there are different kinds of debt, and some are better for your finances than others. This block is a little more complicated than the others, but understanding the differences between different kinds of debt will help you choose the right ones to take on… so let’s dive in.
There are 8 main attributes a debt can have.
Debts can be:
• Revolving
• Amortizing
• Secured
• Unsecured
• Tax-Deductible
• Non Tax-Deductible
• High Interest
• Low Interest
Revolving debt basically means there is no time period by which you have to pay the debt back. If a friend lends you money and you agree to pay them back when you have the money to pay them back, that is revolving debt. Credit cards are also revolving debt because other than a small minimum monthly payment, there is no set schedule or number of years by which you have to pay the credit card back.
Amortizing debt is characterized by a fixed amount of time that the money is due back and almost always has a payment schedule. The payment schedule is set up so the lender gets paid back mostly interest toward the beginning of the schedule. This is done to protect the lender, as the borrower will owe the majority of the total loan amount until well into the schedule. Home mortgages and auto loans are examples of amortizing debts.
Secured debt means there is some form of collateral the lender can take from you if you default on the loan. Home mortgages and auto loans are also examples of secured debts because if you default, the lender can foreclose on your home or repossess your car.
Unsecured debt means the lender cannot take anything of yours if you default on the loan. Credit card debt is an example of unsecured debt.
Tax-deductible debt basically means you can take some of the interest you paid for the debt and deduct it from the amount of income taxes you owe at the end of the year.
Non tax-deductible means you can’t deduct from your taxes any of the interest you paid on the debt.
High interest debt is debt with an interest rate greater than 10%.
Low interest debt is debt with an interest rate lower than or equal to 10%.
What’s high and what’s low will probably vary depending on who you ask, but at Finavigation, we like to keep it simple and use 10%.
Once you understand these, you can get an idea of which attributes are more desirable when it comes to debt and which ones are not. It’s clearly better to not take on debt, but if you have to, here’s what you should know.
The ideal debt would be a revolving, unsecured, tax-deductible, low interest debt. However, we don’t think we’ve ever seen one of these debts.
The next best type of debt to take on would be amortizing, tax-deductible, low interest debt. Most home mortgages fall into this category.
The worst type of debt to take on would be amortizing, secured, non-tax deductible, high interest debt because you wouldn’t be chipping a significant portion of the balance away until later in the schedule, the lender would be able to take something away from you if you defaulted, you wouldn’t be able to deduct the interest from your taxes in the mean time, and you’d be paying a hefty amount of interest all the while. Again, we don’t think we’ve ever seen one of these, but theoretically you can get an idea of why they wouldn’t be favorable.
What’s ultimately good and bad is going to be a judgment call by you after considering what options are available to you. It may come down to a decision between credit card debt and a line of credit on your home. Credit cards have the advantage of being unsecured, but not being tax-deductible and having a relatively high interest rate. A line of credit on your home would be tax-deductible and low interest, but the lender would be able to foreclose on your home if you defaulted.
Think about the debts you currently have and try to classify them using the 8 attributes you’ve just learned about. Try to rank them from best to worst based on the attributes.
Tying It All Together
Now that you have an understanding of the building blocks, it’s time to think about them together and how financial decisions you make will touch on each one.
For example, if you take out a mortgage to buy a home, you are taking on amortizing, secured, tax-deductible, low interest debt to purchase what will probably be an appreciating asset over the long term. Pretty good financial decision, as long as the mortgage payments are affordable given your level of income and the rest of your expenses.
Another example, would be taking out an amortizing, secured, non-tax deductible, high interest loan to purchase a new car, which will be a depreciating asset over the long term. Not such a good financial decision, as you’re going to wind up paying way more for the car than it will be worth to you.
When you buy things, try to think about how each purchase is affecting the building blocks of your personal finances. If you do this, it will help you come to realizations you’ve never come to before and allow you to improve your financial decision-making skills.
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