6.1 Personal finance
Earnings, expenses, and savings
Personal finance refers to the money that a person earns, spends, saves, and borrows.
- A person’s net earnings refers to money being received, usually via a work salary, after taxes are deducted.
- Expenses refers to money a person spends on items like rent, food, or fun.
- Savings refers to money being put into an account for future use.
Savings are important for unexpected expenses or temporary loss of earnings. Spending all that a person earns is known as living check to check.
6.1.1: Monthly personal finances.Start2x speed
Housing, food, fun, …
To bank account, …
Jo’s monthly personal finances
Val’s monthly personal finances
Previous savings keyboard_arrow_upCaptions
- Personal finance starts with net earnings: The money a person receives (say monthly), after subtracting income taxes. Jo may earn $5000 before taxes, but $3500 after taxes.
- Expenses are the money a person spends on things like housing, food, or fun. Jo’s monthly expenses are $3000 per month.
- Ideally, expenses are less than earnings, so monthly a person can put money into savings: Money for future use. Jo can put $3500 – $3000 = $500/month into savings.
- Many people spend all that is earned (or more). Val’s net earnings are $3500, but expenses are $3500 yielding no monthly savings.
- Savings help handle unexpected situations. Jo’s $500 per month provides a buffer to pay for a car repair, and later for a temporary job loss.
6.1.2: Earnings, expenses, and savings.
Lee’s gross salary is $6000 per month, but federal and state income tax totals about 30%. What is Lee’s net earnings per month?$4200$5200
Ji’s net earnings are $4000 per month. Ji’s expenses total $3500 per month. How much can Ji save per month?$0$500
If Kay saves $500 per month, how much total savings will Kay have after 1 year?$3000$6000
At some point, Kay has $3000 in savings. Kay’s air conditioner breaks, requiring a $1000 repair. How much will Kay have in savings after the repair?$1000$2000
At some point, Kay has $8,000 in savings. Kay unexpectedly loses her job. Kay’s monthly expenses (rent, food, etc.) total $2,500. Kay finds a new job in 2 months. How much is left in Kay’s savings?$3000$5000
Saving some money each month can lead to substantial total savings over time. If Kay saves $800 per month for 5 years, how much total savings will Kay have?$48,000$5000
Savings have the added benefit of collecting interest. If Kay puts $10,000 into an account that earns 5% interest per year, about how much will be in that account after 10 years, even if Kay stops putting new savings into that account?$10,500$15,000
Suppose Kay starts with $10,000, and contributes $800 per month for 10 years, into an account earning 5% interest each year. About how much will Kay’s account have after 10 years?$50,000$137,000Feedback?
Emergency fund: At least 3-6 months of expenses in savings.
Common financial advice is to have at least 3-6 months of expenses as savings, as suggested by Vanguard, Wells Fargo, and Nerd Wallet.
A person without savings need not panic. Saving a bit each month soon adds up to having at least some emergency savings (and some is better than none).
(True story) Frank worked at a large company that paid employees every two weeks. A glitch prevented checks for one pay period, which was corrected by doubling the next period’s paycheck. Some employees living check-to-check had to borrow money for those two weeks to pay for food, car, rent, etc. Those people had to scramble, and pay interest on those loans, creating stress and loss of money. People with previous savings may have grumbled but had no serious issues.
The pressure to spend
People are literally bombarded with messages to spend money. A typical American sees several thousand advertisements every day, encouraging the person to spend money. And, people see the results of other people spending money: other people driving nice cars, making house upgrades, eating out, or posting about vacations, which all can increase pressure to spend. Advertisers also focus on kids, not only to get kids to spend (or nag their parents to spend), but also to develop an attitude of buying and attachment to brands into adulthood, leading to numerous unhealthy outcomes.
Companies seeking people’s money have a key theme: You deserve this (whatever “this” may be). But, financial advisors point out that people also deserve peace of mind, aided by sufficient savings, and low expenses. Other contributors to peace of mind include a strong network of family or friends to fall back on. Thus, a key principal in personal finance is:
Recognize the external pressures to spend, and resist.
This Saturday Night Live video humorously encourages people not to spend money they don’t have.
To save, a person’s expenses must be less than net earnings. A first step is to list monthly expenses. Then, if expenses are near (or exceed) net earnings, a person might create a budget: A plan for how money will be spent.
A commonly-advised budget is an 80/20 budget: Of monthly net earnings, spend no more than 80%, putting at least 20% to savings. This website (nerdwallet.com) describes budgeting and has an online planning tool. To save, a person might have to reduce expenses. The largest expenses are most important to reduce first. Below is a simplified example.
6.1.3: Budget example.Start2x speed
- Andi determines net earnings to be $4000. Next, Andi determines expenses. Housing is $1500 per month for rent, plus $200 per month for utilities (electricity, gas, water).
- Andi drives 1,000 miles/month; an estimate is $0.50 per mile, which considers gas, maintenance, and cost of the car. So 1,000 × $0.50 = $500. Rideshares add $100.
- Andi pays $300/month for health insurance, and also $1200 every 6 months for auto insurance, which is ($1200)/(6 months) = ($200)/(1 month).
- Andi adds expenses for food, media (Netflix, cell phone, home internet), and so on. Andi estimates where not sure, like about $5/day for coffee/snacks = $150/month.
- Andi adds other expenses (not shown), for total expenses of $4,000. Andi can save $4,000 – $4,000 = $0 per month. Ouch. Andi lives check to check.
- To save 20% of net earnings ($4,000 × 0.20 = $800), Andi reduces expenses. Andi gets a roommate who pays $500, so Andi’s rent expense drops from $1,500 to $1,000.
- Andi arranges to work from home once a week, reducing driving costs from $500 to $400. Andi switches health plans, dropping payments from $300 to $200.
- Andi’s expenses decrease from $4,000 to $3,300. Andi can now save $700 each month, nearly reaching the 20% goal of $800.
Consider the budget example above.
To follow common advice of saving 20% of net earnings per month, how much should Andi strive to save each month?$800$1000
In the original budget, how much is the most costly single expense for Andi?$1000$1500
By how much did getting a roommate reduce rent expense for Andi?$200$500
What was the next most costly expense for Andi?DrivingGroceries
The next most costly expense for Andi was groceries. By how much did Andi reduce that cost?$0$100
By how much did Andi reduce the health insurance expense?$100$200
If Andi focused on reducing coffee/snacks and reduced those by 1/3rd, what percent of the $800 savings would have been achieved?6%30%
Did Andi achieve the $800 per month savings goal?YesNo
Some expenses are not monthly and not regular, like occasional vacations. A person can estimate the yearly cost of such expenses, and then divide by 12 to add that cost in the budget analysis. If Andi takes a few trips a year that total about $1200, how much should Andi add for monthly expenses?$100$600Feedback?
Cable TV, and are you poor?
(True story) To save money, Frank and his wife went without cable TV the first 18 years of marriage. Frank’s 10-year-old son Eric was on a soccer team. At a restaurant, another player, 10-year old Brad, discovered Eric didn’t have cable TV at home. Brad looked perplexed. Eventually, Brad asked Frank: “Do you have a job?” Yes, Frank replied. “Does the job pay good?” Yes, pretty good, Frank replied. “So…I don’t understand…Why don’t you guys have cable…Are you poor?”
Saving money can mean giving up things that folks consider standard today, like the nice car, the big house, or the latest electronics. But people quickly adapt to such simpler choices, and go on living happy lives. Frank’s kids are grown now, and turned out just fine — yes, even without cable TV.
Living check to check
Living check to check is common in the U.S., with some estimates saying nearly half of Americans live check to check and have fewer than 3 months of emergency savings. This article has tips on avoiding living check to check, including tracking expenses, automating savings via automated bank transfers, and keeping savings in accounts that are hard to access. The article ends by suggesting being patient with oneself, as switching to a savings mindset may take some time.
Good and bad debt
Debt refers to money owed by a borrower to a lender. Interest is a percent paid by a borrower to a lender each year. Ex: At 10% interest, a person borrowing $10,000 pays about $1000 in interest each year.
While people generally would like to avoid debt, some advisors treat certain debts as “good” if such debts lead to gains. Other debts are considered “bad”, where a person gains little but ends up paying a lot in interest.
6.1.5: Good and bad debt.Start2x speed
College degree may yield better paying job (and job satisfaction)
Replaces rent, builds equity, home value may increase
Bachelors degree: $17k/yr more
After 20 years: 20 × $17k =
$340k more earnings
Loan: $2,000/mo (roughly equals rent)
After 20 years:
+ $150k value
Often to buy items a person can’t afford
$10k debt at 15% interest
After 20 years:
Financed item (car, furniture, …)
- Some loans may be “good debt”. A $20,000 student loan may enable a degree that earns $17k more per year, so $340k more over 20 years.
- A home loan’s interest may roughly equal rent, yet after 20 years a homeowner may have $200k equity, and the resale value may have increased by $150k too.
- Some loans are widely considered “bad debt”. Credit card debt, or financing (cars, furniture, …), are often used to buy items a person can’t actually afford.
- If a person buys $10,000 of items on a credit card with 15% interest and then just pays interest, after 20 years the interest totals $30k. The loan company wins.
(Note: Because so many Americans have excessive debt, some advisors say that no debt is good. The authors of this material don’t agree, but understand, and encourage great discipline with debt).
6.1.6: Good and bad debt.
Match the gain/loss over 20 years with the scenario.
Assume student loans are 6% interest and paid back in 10 years. (See this loan interest calculator).
Mouse: Drag/drop. Refresh the page if unable to drag and drop.
- Gain of $150k of equity + $500k resale value increase
- Gain of $400k additional earnings
- Loss of $10,000 in interest
- Loss of $30k in interest plus loss of $100k.
Getting a degree requiring a $30k student loan but yielding $20k increased annual earnings.
Choosing a costlier school requiring a $100k student loan but without increased annual earnings.
Buying a $300,000 home with a 30-year loan at 4% interest where the monthly mortgage is the same as rent.
Taking out a $10,000 credit card debt at 15% interest and making the minimum payments.ResetFeedback?
Student loan debt.
Student loan debt has risen steeply in the past decades, due largely to tuition increases after colleges lost state funding from the 2008 financial recession. 40 million U.S. adults have student loan debt — about 1/5 of all adults. 70% of students graduate college with student loan debt, and those students average $37,000 of debt in 2019, compared to $17,000 in 2005. One concern is such debt delays buying a home, so young adults are less able to build wealth through home equity and rising home values. Sources: CNBC story, Federal Reserve Bank of New York.
The story of two college graduates: One saved, the other didn’t
(Mostly true story: The story below is loosely based on two real people that Frank knows). Jay and Tom each graduated college about 10 years ago and both started around $50k annual net earnings. Jay started spending all his annual net earnings, while Tom enjoyed spending some but saved a lot. After 10 years, both have similar living arrangements (similar housing, car, electronics, etc.) but financially Jay has no savings and is quite stressed, while Tom has a net worth of over $300k and is quite comfortable.
6.1.7: Tom and Jay’s different saving mentality led to dramatically different financial situations after 10 years.Start2x speed
Year after college
- Tom and Jay graduated college 10 years ago, and both got good jobs with net earnings of about $50k per year. But Tom and Jay’s spending after college differed greatly.
- Jay moved from his parents’ home to a pricey apartment, commuted far, leased a sports car, and more. Jay’s expenses equaled his net earnings.
- Tom kept expenses low for 3 years, staying with parents, driving a used car, and commuting short. He spent $20k/yr, but still saved $30k/yr, put in a 6% mutual fund.
- Starting year 4, Tom spent more, moving out, getting a new car, and more. But Tom still saved the standard 20%. In 10 years, Tom had nearly a quarter million dollars.
6.1.8: The very different after-college spending of Tom and Jay.
Consider the example above.
After 3 years of saving $30k per year, Tom had how much in his mutual fund?$90k$100k
How much was Tom’s account worth after 10 years?$100k$225k
The example above didn’t mention that after 3 years, Tom had enough for a down payment to buy a $200k condo, which went up in value about 5% per year. After 7 years, about how much did Tom’s condo value increase?$10k$70k
How much did Jay have saved after 10 years?$0$50k
Tom’s situation is even better than stated. He invested money with a friend who was having great success “flipping” houses: Spending about $250k to buy and remodel a home, then selling for about $350k within a year. Tom invested $50k for one such home. What was Tom’s return after the flip?4%40%
Jay’s situation is not unresolvable. If Jay starts saving 20% of net earnings of $50k, what is Jay’s savings after 5 years?$10k$50kFeedback?
Money saving tips.
Below are a few tips, large and small, on saving money:
- Housing: Housing is a big fraction, so give housing a big focus. Things that help early in one’s career: living with parents, having roommates, or renting/buying a modest place.
- Driving: Remember that driving is more expensive than most people think. Things that help: Living close to school/work if possible, driving/keeping a used car as long as possible, buying instead of leasing.
- Utilities: Focusing on the high-cost utilities (like perhaps phone or electricity), and the big contributors to those (like the contract or heating/cooling) , may be wise. (In contrast, many people cause disruption/stress over items with little cost impact).
- Shopping: Stores are designed to get you to spend more than you intended. A disciplined shopper creates a list, and sticks to the list, perhaps allowing only a small amount of “impulse” buying. When grocery shopping, avoid shopping hungry. Consider thrift stores like a Goodwill store or Salvation Army store for clothes and household items; such stores sell used items donated by people.
- Buying: Americans like to buy things, on Amazon, in stores, and more. But many people have little savings or have much debt. So a piece of general advice: Stop buying so much stuff. Get out of that habit. Many people can be quite happy (even happier) with a lot less material things.
- Vacations/weekend activities: Vacations and activities need not be expensive. Many activities are cheap or free, and quite enjoyable: Hiking, camping, visiting family or friends, going to museums, etc.
- Mark Cuban (a billionaire famous for the TV show Shark Tank) gives great advice in this 3-min video. Mark gives 9 rules, starting with: Live like a student, don’t use credit cards, and save 6 months income. His last rule: Be nice.
Saving: You’ll win some, you’ll lose some.
When people pay closer attention to money being spent, some get frustrated at failed savings attempts. A person may drive to a store to stock up on a discounted item only to be frustrated at the item being sold out. Upon checking out of a hotel, a person may learn that a much cheaper price was available next door. Forgetting to turn off the air conditioner while gone for a weekend, getting a parking ticket, paying to get a dog’s wound stitched up — all these “losses” can really frustrate a person and cause strife among spouses or family members. To avoid such frustration, some people just decide to not pay attention to such money matters — and some would say there are indeed some benefits to that approach.
However, when focusing on saving, the key is to recognize that nobody will ever save optimally. As the saying goes: You’ll win some, you’ll lose some. So when you do on occasion “lose”, a person might take comfort in knowing that at least by trying, a person is saving more than otherwise. A healthy “Oh well, we gave it a shot” attitude can help keep a person happy and the person’s family relationships strong, while still building at least some savings.
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