Getting Comfy with Your Money

Chapter 2:
How Your Money Works

In this chapter, you will learn the basics of how your money works. As shown in the below model of personal finance, there are six parts that comprise everyone’s household finances:

  • Your Income
  • Your choices for Spending, Bills, Charging, Sinking Funds, and Savings

Let’s start by building this universal model of personal finance. Then we can examine the relationships that the model illustrates.

We begin with you. 

This book is all about you and the money that is such an important part of your life.

“Making money” is typically something you will do for much of your life by working some type of job or jobs. Doing a job requires that you learn how to do that job. You can prepare by going to school and/or training on the job.

Once you become proficient in your job, both you and your employer benefit: you get paid and your employer makes a profit on your work.

Gross vs. Net Income

The total income that you earn is your gross income. The money that you receive on payday is your net income: your gross income minus income taxes and any other deductions that may apply.

The taxes deducted from your gross income as well as the types of other deductions from your paycheck are beyond the scope of this book. Our concern is getting you comfortable with the money that you take home; your net income.

In this book, therefore, income refers to your net income, the money that you can spend any way you choose.

Using Your Income

The other side of the personal finance model is more complex. It shows the choices that you have for using your income both immediately and in the future.

Immediate uses of your money include:

Spending – using cash that you currently have.
Bills – making payments to a creditor or servicer.
Charging – going into debt that you intend to repay with money you expect to receive in the near future.

Your choices for future spending include:

Sinking Funds – money accumulated over a specified period of time in order to pay for something with cash at a future date.
Savings – your current income that you set aside to use in the future.

This almost completes the basic model of personal finance. Still missing is an element for planning which we will add later. For now, let’s look at the relationships that this model presents.

Relationships in the Model

While the model of personal finance applies to everyone, both sides of the model can apply to people differently.

For example, what you need to know in order to be able to do a job is specific to the job.

On the other side of the model, what you need to know to make good money choices is the same for everybody.

How you earn an income is one of the major life choices which can be very different for everyone. How you use and enjoy your income can also be different from one person to the next; however, what is true for everyone is how important it is for your current and future well-being that you learn how to make good money choices, just like you learned how to do your job well.

How much income you receive is normally determined by how many jobs you have and how well you do each job. This is another way the personal finance model can be different for everyone; the money you earn can depend on how well you prepare for and do your job.

This makes the income side of the model dependent on your efforts.

On the other hand, how well you enjoy the money you earn depends on your choices. How you choose to spend and save your income now will determine whether or not you enjoy your money.

The money choices that you make today can also determine how well you will enjoy retirement.

An added dimension to the personal finance model is differentiating between what you earn and what you spend.

In the model, the money that you receive, as you already know, is referred to as income.

On the flip side, the money that you spend or set aside for sinking funds and savings is called outgo.

Outgo that you spend includes cash purchases along with bill and credit card payments. Money that you set aside for sinking funds and savings is also considered outgo because the money is not available now: it has been put aside for use in the future.

A Safe Place for Your Money

There is normally a delay between your income and outgo during which your money sits idle. You need a place to keep the money that you have on hand, including the money you have put aside for sinking funds and savings. Your wallet, purse, bureau drawer, mattress or pocket do not usually qualify as a safe haven for your cash.

A checking account that you open at a bank or credit union is perfect for this purpose.

A checking account is a type of bank or credit union account that allows you to easily deposit and withdraw money for day-to-day transactions. This may include depositing checks and taking out cash from an ATM (automatic teller machine), by writing a check, or with a debit card (looks like a credit card, but, instead of borrowing, using a debit card immediately withdraws money from your checking account).

In addition to being a safe, convenient place to keep your money on hand, a checking account can be much more. Your checking account can also be the one place through which your money flows according to your complete spending and saving plan. And, by using a checking account, you are removed as the channel through which your income flows to outgo. The temptation to spend money just because there is readily spendable cash in your pocket is removed.

Personal Cash Flow

Personal cash flow is the movement of money into and out of your household. Put simply, cash flow represents all of the transactions in your checking account. When you have enough income to cover your outgo, you have a positive cash flow. Your cash flow is negative when you spend more than you receive.

The health of your household finances depends on the way your money moves. Understanding how cash flows into and out of your checking account gives you the power to use your cash to your best advantage.

In this book, it is assumed that you have a checking account that you use exclusively for managing your household finances.

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