Understanding your finances comes down to understanding just a few key elements, definitions, and numbers that make up the sum total of your financial life.
Here are some things you’ll need to wrap your head around in order to get a good picture of your fiscal health:
Gross income vs. net income
Gross income: This is your total income before taxes and withholdings. If you are on a payroll as an employee of a company, your taxes and withholdings are taken out before you receive your check. This information is available to you on the paystub.
For this reason alone, budgeting can become a hazy picture because you’re not actually taking home the full amount. What you take home is called net income.
Net income: This is your gross income less taxes and withholdings. This is the actual amount you bring home.
Also called “burn rate.” This is the total expenditure over the course of a month, all the things you spend money on -- housing, food, clothing, transportation, utilities, etc.
This is one of the more important elements you’ll need to understand and to have control over. There are many ways to reduce spending, and by doing so, you can free up money for savings.
There are many different ways to save and just as many types of accounts and funds named for each kind. Here are some common savings vehicles that are worth knowing about and understanding:
A bank account with a low bank interest rate (currently the average savings account offers about 0.06% return, according to the FDIC).
This would be a 401(k) or an IRA fund, specifically for your retirement.
An account set aside especially for unforeseen events, such as extended unemployment or medical emergencies. Usually this would hold a predetermined number of months’ worth of expenses so that you can continue living uninterrupted by a major catastrophic event or emergency.
Home equity is a measure of how much of your home you actually own, based on its value, less the balance on your mortgage.
Equity = current market value - mortgage balance
It does not take into account the price you paid for the home, but rather the current market value. In other words, if someone were to buy it today, how much would they pay for it?
It is possible to have a negative home equity in the same way as net worth. If the housing market fell for example, as in 2007, a lot of home equity at the time was “upside-down.” One way to increase the value of your home is by making improvements to the home that increase the value by more than it cost to do the improvements.
Credit card balances are particularly important to keep track of, if not for any other reason than the fact that credit cards usually carry the highest interest rates. While some offer a 0% introductory rate, that rate is aptly named - it cranks up after the “introductory” time period and can climb as high as 35% or higher.
Typically credit cards carry a rate of between 7% and 36% in the United States. The rate you’re paying will affect the balance by adding debt to the balance. It would be worthwhile to investigate balance transferring to a low interest card if you find yourself paying a high interest rate on your credit cards.
Total assets - total liabilities = net worth
An equation that calculates a rather important number. Simply put, if you subtract all that you owe from all that you have, you will be left with how much you are worth.
Your assets are your property (cars, homes, etc.), savings, investments, and money in your bank account.
Liabilities are credit card debts, mortgage balance, auto loans, student loans etc.
It is possible to have a negative net worth if your liabilities exceed your assets, and unfortunately, this is more common that you may think. About 25% of American homes have a negative combined net worth.
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