It’s January… which means it’s time to set yourself up for a successful, fruitful year. So for the next few weeks, we’re going to chat about the always important, sometimes confusing, often taboo world of PERSONAL FINANCES.
Now, don’t click away. I know you don’t want to talk about it, but we have to. Because step one to conquering your personal finances is understanding them.
Going forward, we’re going to chat about tips and tricks to make personal finances simpler. But tonight we’re going to start by DEFINING all of those scary, intimidating terms.
Primary Income Source
If you have a full or part-time job that covers most of your expenses, that’s your primary income source. It’s usually regular (we’ll talk about what to do if you have an irregular primary income source in another post) and is the easiest starting point to anchor your budget.
Auxiliary Income Source
This is additional income that supplements your primary income source. Do you babysit on the weekends? Walk dogs on the side? Sell jewelry on etsy? Those are auxiliary income sources. If you have considerable enough auxiliary income from a single source, you may want to consider forming an “LLC” to account for this income. But again, we’ll talk more about that in later episodes.
You can think of credit as a loan. Every time you swipe your credit card, the credit card company (Amex, Visa, MasterCard) is extending you a short term loan. You are betting that you will pay back that loan within your 30 day payment period, and the credit card company is betting that you won’t (so that they can collect interest payments).
There are many ways to use credit lines extended by credit card companies, but for our purposes (9 time out of 10) I would advise you not spend more on a credit card than your anticipated income in any given month.
Debt, simply, is the sum of all “loans” you have outstanding. It’s not always a bad thing! If you have a mortgage, took out student loans, or are financing your car, you have debt. Having debt, and paying it back in a timely manner, can improve your credit worthiness in the eyes of banks and credit card companies.
A credit score is a number, from 300 – 850, that rates your “credit worthiness”. Key factors impacting your credit score are things like:
-Length of time your accounts have been established (someone who has had a credit card for 10 years is more likely to receive credit than someone who has never had one).
-Credit Line : Credit Use ratio. Let’s say that you and I both have $1000 of credit card debt (credit used). If I have a $10,000 credit line and you have a $2000 credit line, that amount outstanding will impact our credit score in different ways. I like to shoot for an optimal ratio of 10:1.
-Timeliness of payments. Even if you don’t pay down your full balance each month, paying at least the minimum on time will keep from negatively impacting your credit score.
My first encounter with interest is a bit comical. I was 7 or so, and I was at a toy store and wanted to borrow $20 from my dad to buy something. I had my $20 at home to pay him back.
He said “sure, I’ll loan you the $20, but for every 10 minutes that the loan is outstanding you owe me $1”.
I took the deal, knowing the toy store was only about 10 minutes from our house. What I now know is that my cost of capital on that $20 loan was appx 5% (very high in our current financial climate, but not particularly high overall).
Interest is a fee paid by a borrower (me, in the toy store case) to a lender (my dad in the toy store case) for the use of that borrowed money. Typically, interest is calculated as a % of the principal (the borrowed money).
So if we take the above store, if my dad had said “I’ll loan you the $20, but for every 10 minutes that the loan is outstanding you owe me 10% COMPOUNDING” I would have run screaming in the other direction.
I jest, but compounding interest means the following:
0-10 Minutes : $20
10-20 Minutes: $22
20-30 Minutes: $24.20
30-40 Minutes: $26.62
40-50 Minutes: $29.28
50-60 Minutes: $32.31
So after an hour on that $20 loan, I would have had to pay almost 60% interest! Crazy!
It’s important to understand before entering into an interest agreement, what type of interest you are agreeing to.
Cash Flow Plan (or Cash Flow Statement)
A summary that shows total income and total expenses over a period of time. A Cash Flow Statement is typically used in accounting for a business, but we’re going to create one for the business of YOU.
Simple – a written cash flow plan. A budget takes into account two things: your income (over a certain period of time) and your expenses (over the same period of time). Ideally, your expenses will come in LOWER than your income.
An LLC, or Limited Liability Company, is a business structure that combines that pass-through taxation of a partnership (which means the business taxes are linked to the principal’s personal taxes) and the limited liability of a corporation (basically, if someone sues an LLC it is NOT tied to the principal’s personal assets).
In a real life scenario, let’s say that your run a dog walking business on the side. You walk dogs for 5 different families, and have 5 income streams.
You also put expenses through your dog walking business LLC.
You have some transportation expenses, you need to wear comfortable sneakers and warm clothes to walk these dogs (more company expenses) and you buy dog treats for all of your clients!
Let’s say that your dog walking income for the year is $1000, but you have $1500 in expenses. That $500 loss is deducted against YOUR PERSONAL INCOME as principal of the LLC.
That’s it. These are the main terms you’re going to need to understand going forward, and when we break it down together they’re easy!