Personal finance, by definition, is the application of the principles of finance to the monetary decisions of an individual or family unit. It addresses the ways in which individuals or families obtain, budget, save, and spend monetary resources over time, taking into account various financial risks and future life events.
The Principles of Finance defined:
Finance is the set of activities dealing with the management of funds. More specifically, it is the decision of collection and use of funds. It is a branch of economics that studies the management of money and other assets.
Finance is also the science and art of determining if the funds of an organization are being used properly.
In fact, when you get right down to it, there are three broad types of income you can generate:
1. Earned Income
2. Portfolio Income
3. Passive Income
Any money you ever make (other than maybe winning the lottery or receiving an inheritance) will fall into one of these income categories. And each income category has its own set of benefits and drawbacks.
Earned Income
Earned income is any income that is generated by working. Your salary or money made from hourly employment (regardless of whether that salary or hourly income came from working for someone else or from your own “consulting”) is considered earned income.
Some activities that generate earned income include:
* Working a job
* Owning a small business
* Consulting
* Gambling
* Any other activity that pays based on time/effort spent
While earned income is the most common mechanism for making money, its obvious downside is that once you stop working, you stop making money. Additionally, because the amount of money that is made through earned income is directly proportional to the time and effort you spend working, it’s difficult for someone to make more earned income without either learning a new (or more valuable) skill or working longer hours. Additionally, earned income is taxed at a higher rate than any other type of income.
One huge benefit of earned income over the other income types is that you generally don’t need any startup capital in order to make earned income, which explains why most people rely on earned income from the start of their working life. In fact, earned income is a great way to start your investing career, as it allows you to save up cash that will help you generate the other two types of income…
Portfolio Income
Portfolio income is any income generated by selling an investment at a higher price than you paid for it. Some people refer to portfolio income as “capital gains,” because that’s how the money is taxed by the federal government.
Some activities that generate portfolio income include:
* Trading (buying/selling) Paper Assets — Paper assets refer to things like stocks, bonds, mutual funds, ETFs, CDs, T-bills, currencies or other types of futures/derivatives. Stock market investing is the most common generator of portfolio income
* Buying and Selling Real Estate (specifically the profit from the sale)
* Buying and Selling of any other Assets — Antiques or cars, for example, or other types of collectibles that have appreciated in value
Portfolio income certainly has some advantages over earned income. Once you have the knowledge and experience to generate portfolio income on a consistent basis, you can continually reap the benefits (compound your return) by reinvesting after each sale. Additionally, any portfolio assets held long-term are generally taxed at a lower rate.
Passive Income
Passive income is money you get from assets you have purchased or created. For example, if you were to buy a house and rent it out for more money than it costs you to pay your mortgage and other expenses, the profit you make would be considered passive income.
Some activities that generate passive income include:
* Rental Income from Real Estate
* Business Income (assuming it’s not earned based on amount of time/effort spent — that would be Earned Income)
* Creating and Selling Intellectual Property — Books, Patents, Internet Content, etc
* Affiliate or Multi-Level Marketing
* Dividends
There are some major benefits to passive income over the other two types of income:
* Passive income is generally recurring income; once the investment is made, and assuming it is a good investment, the income will continue to come in month-after-month or year-after-year, with little additional work by you. This means that you can essentially “retire” and still continue to grow your net worth.
* Investments that generate passive income usually allow the owners active control over the investment. For example, if you owned an apartment building or a corporation, you would have say in the day-to-day operations that would ultimately impact the success of your investment.
* Passive income investments often allow for the most favorable tax treatment. Corporations can use profits to invest in other passive investments (real estate, for example), and take tax deductions in the process. And real estate can be “traded” for larger real estate, with taxes deferred indefinitely.
* Because it is generally possible to closely approximate the return (or at least the risk) you can expect from passive investments, these investments can often be funded using borrowed money. For example, a good business plan can attract angel funding or venture capital money. And real estate can often be acquired with a small down payment (20% or less in some cases) with the majority of the money borrowed
As you might suspect from the above overview, many people consider passive income the holy grail of investing, and the key to long-term wealth.
