Budgeting, saving, and credit
Personal finance applies financial principles to everyday life. This lesson is educational and general, not personal financial advice; consider a qualified adviser for your situation.
Budgeting
A budget tracks income and planned spending. A popular guideline, the 50/30/20 rule popularised by Elizabeth Warren and Amelia Warren Tyagi, suggests about 50% of after-tax income for needs, 30% for wants, and 20% for saving and debt repayment. Tracking actual spending often reveals surprising leaks.
Emergency funds
An emergency fund covers unexpected costs, such as car repairs, medical bills, or job loss, without resorting to high-cost debt. Many financial educators suggest building three to six months of essential expenses in an accessible savings account, starting with a smaller target if that feels out of reach.
Paying yourself first
Automatically transferring a set amount to savings when paid, before spending, makes saving consistent. Thanks to compounding, regular saving started early can grow substantially over decades.
How credit works
Credit lets people borrow and repay later, with interest. Credit cards carry high interest rates, often over 20% APR in the US in recent years; paying the full balance each month avoids interest. Making only minimum payments on a large balance can take many years and cost far more than the original purchases.
Credit scores
In the US, FICO scores range from 300 to 850 and are based mainly on payment history, amounts owed (credit utilisation), length of credit history, new credit, and credit mix. Higher scores lower borrowing costs. Paying on time and keeping balances well below credit limits help build good credit.
Good and bad debt
Borrowing can be useful when it finances things that build long-term value, such as education or a home bought within one's means, at reasonable rates. High-interest debt for consumption, such as carrying credit card balances or payday loans, can trap people in cycles of debt. Paying off high-interest debt is often one of the best guaranteed 'returns' available.
Debt repayment strategies
The avalanche method pays off the highest-interest debt first, minimising total interest. The snowball method pays off the smallest balance first, providing quick wins that help motivation. Both work if people stick with them; consolidating debts at a lower rate can also help.
Worked example
Someone owes 3,000 dollars on a credit card at 24% APR (2% a month) and pays only 90 dollars a month. Most of the early payment goes to interest (60 dollars in the first month), so it takes about 4.6 years to pay off, with roughly 2,000 dollars in interest. Paying 200 dollars a month clears it in about 18 months with roughly 600 dollars of interest.
Key takeaways
Budgets track income and spending; the 50/30/20 rule is one guideline. Emergency funds of several months' expenses protect against shocks. Paying yourself first makes saving automatic. Credit card interest is high; pay balances in full when possible. FICO scores (300-850) depend mainly on payment history and utilisation. High-interest consumer debt is costly; avalanche and snowball methods help repay debt.
Flashcard
Plan for income and spending
Check your understanding
Which debt repayment method minimises total interest paid?