Personal finance is basically individuals or families making decisions regarding their money using principles of financial economics and planning, to achieve certain financial goals in the future, taking into account their expected income and expenses. Individuals have to understand the principles, plan the decisions, and monitor the implementation, in order to achieve their personal financial goals successfully.
Time value of money
One of the most important principles of personal financial planning as in other types of financial planning is the principle of time value of money. This refers to difference in value of same amount of money at different periods. Value of amont of money received at present exceeds the same amount received in the future by the interest that can be earned during that period. Present or future value of streams of money can be ascertained using present value and future value formulas that includes the interest or discount rate.
Personal financial planning involves analyzing the individual’s financial position. As in corporate finance this involves preparing a balance sheet listing all liabilities and assets and a cash flow statement listing all income and expenses. An individual’s net worth can be arrived at by deducting his/her liabilities from assets. Net cash flow for a period can be arrived at by deducting expenses incurred from the income received during that period. Depending on the net cash flow future net worth may increase or decrease. Once the current position and the expected financial goals are known in detail, a personal finance strategy can be planned using detailed calculations in order to achieve the goals using available resources. This plan might detail investments to be made and their type, loans and mortgages to be obtained, taxes to be paid, insurance polices and pension accounts to be funded, expenses to be curbed etc. in each yearly period. Once the personal finance plan is finalized, it is implemented, monitored, and adjusted as circumstances change.
Financial life cycle
Depending on each individual’s stage in life appetite for risk and expected financial goals change. Modigliani and Brumberg (1954) created a model to explain stages of an individual’s financial life. Principles derived from the model can be used in creating personal finance plans. However, when creating a financial plan it must be borne in mind that financial instruments such as stocks, mutual funds, pension funds, banking services, and insurance etc. needed for the successful implementation of such plans are only available in developed counties.