The Basic Question: What is Personal Finance?
Personal Finance is a compound phrase. Starting with the noun, Finance is, roughly, how businesses should use debt and equity to generate income. Of course, that now introduces more nouns to define.
Debt, for businesses
Debt would be an obligation to give others some type of asset, usually but not always cash; the business is borrowing to buy something, with the idea that they can then sell their product at a price that can generate a profit even after paying the interest on their loans.
So Now What’s an Asset?
An asset would be anything that is expected to provide a future benefit to the business; for example, a computer would be used to facilitate communications, create the product being sold, etc.
What was that other word used to define finance? Equity!
Equity is the extent of assets that owners are entitled to after all debts are satisfied. Equity is the remaining value of a business’s assets, after paying back all loans. It’s the “net worth” of the business.
In the case of negative equity, that does mean the owners would have to contribute additional assets in order to satisfy all debts.
Digression on the phrase “Equities”
However, business commentators will talk about “equities”; typically, that is referencing the stocks (shares) that one can buy on the stock market. The phrase “equities” is used because those shares are ownership claims on a business’s net worth. People buy that with the expectation that those companies will generate future positive cash flows that will provide a return on investment. Owners sell such control of their businesses so that they can have greater assets to increase their income. Ideally, the infusion of cash allows the business to generate more income than they ever would have been able to from borrowing (debt) and using earned income (accumulated profits approximate the business’s equity)
We’ve Covered the Noun; Time for the Adjective: Personal
This time, it’s personal.
As established earlier, “Finance” as a practice and noun focuses on businesses; appending “personal” means using those same concepts but focused on how the individual can and should use debt and “self-financing” (equity in the form of previously accumulated income) to generate more income. Whether or not it’s good for an individual to operate their life like a business is for a separate article.
Right now, everyone has to generate income in order to stay alive; some people just have an easier time doing it because they happened to inherit quite a lot of assets, so they have no debt and high equity. A life of leisure still requires funding, typically from passive and investment income. Passive and investment income just happen to mean that the income is not generated by selling one’s own labor (and time) in exchange for compensation.
Net Worth vs Equity
When people are called “high net worth” individuals, it’s because they happen to have a much larger amount of assets that are not in some way supporting a large amount of debt. That is to say, the individual has a minimal amount of debt relative to their equity in their assets.
For example, people don’t receive title to their car (ownership of their car) until they finish paying off their car loan. In this situation, the individual with a car and no car loan has a high net worth in comparison to the individual with a car and a car loan.
In the reverse, negative net worth individuals have debts that exceed the value of everything they own.
As a side note, it is possible for a business to have negative equity; it is not a good sign for the business to have negative equity.
One-Sentence Takeaway
Personal finance is how individuals decide to borrow money and to spend their earned money to meet their needs and enjoy life; it’s both that simple and that complicated.