Unit 5Personal Finance

Saving and Investing

A person has only 2 choices about what to do with after tax income.

Spend it now or save for the future.

The opportunity cost of spending money is the interest you could have earned by putting it in some kind of financial investment.

2 Types of Investment

Financial Investment: refers to decisions by individuals and businesses to invest money in financial assets such as bank accounts, certificates of deposit, stocks, bonds and mutual funds that earn interest.

Real Investment: When businesses purchase factories, machinery, tools and equipment. This is the kind of investment we have talked about all semester.

Types of Financial Investments

1. Savings Accounts: accounts in banks that earn a small rate of interest but on which checks cannot be written.

These are among the safest of all investments.

2. Certificate of Deposit: depositors loan money to a bank for a period of time and are paid back with interest. The time period can vary from 1 month to 5 years or more and will pay a little better than a savings account.

However, if you withdraw your money before the maturity date, you pay a penalty.

3. Bonds: are issued by the government or by companies. You loan them your money for a period of time and are paid back with interest.

Bonds can be short term, paid over a few months or years or long term, which are repaid over decades. They are less risky than stocks

4. Stocks: represent shares of ownership in a corporation. Owners receive a return in 2 ways:

• The firm may pay dividends to its shareholders out of the profits that it earns.

• investors may profit by selling their shares for more than they paid for them; this is called a capital gain.

Stock performance can be measured by looking at an index like the Dow Jones Industrial Average or the Standard & Poors 500.

• DJIA-a price-weighted average of 30 top stocks traded on the NYSE & NASDAQ

• S&P 500-uses price changes of 500 representative stocks to indicate market performance

5. Mutual Funds: a company sells stock in itself to individual investors and then invests the money it receives in stocks and bonds issued by other companies.

Investing in mutual funds automatically diversifies the investors portfolio and these funds are run by professional money managers.

6. 401(K) Plan: a tax deferred investment and savings plan that acts as a personal pension fund for employees for retirement.

(Roth IRA is not tax

deferred…)

(401(k)) The employee contributes a certain amount each month into the plan which can be matched by some percentage by the employer. The fund grows, tax deferred, until retirement, at which time it is taxed.

7. Individual Retirement Account (IRA): is another long term, tax deferred plan that a person can set up as part of a retirement plan.

(Roth IRA is not tax deferred…)

Diversification: The spreading out of funds into different kinds of investments in order to minimize risk.

a pay yearly taxes on savings.b invest more each year in the

retirement plans.c invest in the retirement

plans for a longer time.dreceive a higher rate of

return on the retirement plans.

Based on the illustration, you would earn more in any of the three retirement plans than you would on basic savings because you would:

Types of Financial Institutions:

Banks: provide a safe means to store earnings. Offers direct deposit, check writing services, debit and credit cards, loans of all sorts, and other services.

Banks take the money deposited and loan out a portion of it to people who want to borrow.

They charge a higher interest on the loans than they pay to the depositors in order to make a profit. (interest rate spread)

Credit Union: a nonprofit service cooperative owned by, & operated for, the benefit of its members and the members own and control the institution. Services provided are just like a bank

Savings & Loan: a depository institution that focuses on savings and home mortgage loans instead of providing other services. Investors will earn a higher savings rate but won’t have easy access

Payday Loan Company: give out small loans in return for a portion of a person’s upcoming paycheck. Interest rates can be extremely high.

Risk and Return

Risk: describes a situation in which the outcome is uncertain and a range of results, potentially good and bad, is possible.

Return: the income or profit generated by an investment divided by the original cost of the investment.

Example:If you put $100 in a bank account and receive $3 a the end of the year, then the rate of return is 3%. (3/100)

The greater the risk with an investment, the higher the rate of potential return.

Interest rate--the price paid or received for the use of another person’s money.

It can be calculated in 2 basic ways…

Simple interest or Compound Interest

Simple interest rate : is calculated only on the original loan amount, (principal).

Example: Deposit Amt = $100, Interest rate

= 5% (5% × $100 = $5)

After year 1 the person would have $105.

After year 2 the person would earn $110

($105 + $5 = $110)

Compound interest rate: is earned not only on the principal but also on interest earned from previous periods.

Example:

Amount invested = $100, Interest rate = 5%

($100 x 5% = $5)

Year 2 the person would earn $110.25(5% × $105 = $5.25; $105 + $5.25

= $110.25)

Key is start saving early and be consistent. Compound interest can build considerably over time.

It can be compounded monthly, quarterly, semi-annually, or annuallyTo estimate how long it will take to double your investment…use rule of 70 (divide 70 by interest rate. Ex: 70/5=14 years)

http://www.econedlink.org/virtual-economics/?topic=Personal+Finance+Economics

http://investor.gov/tools/calculators/compound-interest-calculator#.Up_3nfRDtvo

CreditCredit: the ability to borrow money.

• Common forms of consumer credit are car loans, home mortgage loans and credit cards.

• Businesses use credit regularly, either by borrowing from a bank or issuing corporate bonds.

The government also uses credit when it needs to borrow money to finance its budget deficit.

• People who can borrow at a reasonable interest rate have good credit

• those who can’t borrow at such rates are said to have bad credit.

• Loans extended for longer periods involve higher interest rates to compensate for greater risk.

When comparing loans look at the annual percentage rate (APR) on the loan.

• Short term credit people often use credit cards as a simple and convenient way of paying for purchases.

• If a credit card balance is paid off each month, the borrower doesn’t pay any interest.

If the full balance is not paid each month, the borrower begins to accrue interest charges on the unpaid balance and the interest is accrued monthly.Interest rates:

• can be as high as 18%

• can be fixed or variable

• Credit Cards are unsecured loans, no collateral required therefore interest rates are higher

• Bank loans are secured loans—collateral is required

• Collateral: An asset of value put up against the loan in case of default.

• Financial institutions look at a persons credit worthiness to decide whether or not to loan money

• credit worthiness--an attempt to determine how well a person will be able to repay a loan. based on annual income, current debt level, repayment history and credit score

• Credit Bureau’s collect individual credit information & sell it for a fee to banks, mortgage lenders, credit card companies and other financing companies. 

Insurance• Insurance allows a person to

pay to guard against a potentially disastrous event in the future.

• If the negative event does occur, then the insurance will pay certain costs.

The price the insured pays for a policy is the premium…

• Once a claim is filed the insured must first pay the deductible, then the insurance kicks in.

• If a person wants a smaller premium, they can opt for a higher deductible, or vice versa.

Types of Insurance1. Health Insurance:

provides payments to health-care providers if you are sick. The most common type is called a Health Maintenance Organization or HMO.

2. Life Insurance: provides a payment to your beneficiary if you die to help offset the loss of income. There are different types of life insurance but term life is the most affordable.

3. Auto Insurance: provides payments for damages caused in an auto accident.

Ex. Liability, Collision, Theft, Car Rental, Comprehensive, No Fault

This is typically the 1st kind of insurance needed by teenagers.

4. Homeowner’s insurance: pays for home repairs in case of fire or storm damage. Typical homeowners policies do not cover flood damage. If you are a renter, you should consider renters insurance.

5. Disability Insurance: covers workers who are injured and can’t work anymore. It provides a percentage of your lost income while you are out of work.

There is both short term and long term disability, usually offered through the employer

http://www.econedlink.org/interactives/EconEdLink-interactive-tool-player.php?iid=231&full

Human Capital:

The combination of a person’s education, knowledge, experience, health, habits, training and talent.

A person who has acquired more human capital will be able to produce more. On an individual level, adding to one’s human capital boosts wages and income over your working lifetime.

In general, the 2 factors that boost wages of a particular job are the demand for that service and the supply or training requirements needed for the job.

Example:

High demand/Low supply = high wages

Low demand/ High supply = low wages

Categories of Labor

Here is a common way to look at how workers are divided according to their skill level.

1. Unskilled: workers who work primarily with their hands (ditch diggers, fruit pickers and house cleaners) and earn the lowest wages.

2. Semi-Skilled: workers that operate machines that require a minimum amount of training such as lawn mowers, dishwashers or floor polishers.

3. Skilled: workers that operate complex equipment and perform tasks with little supervision (carpenters, typists, computer technicians and chefs).

4. Professional: workers with the highest level of knowledge based education and managerial skills such as doctors, lawyers, scientists and corporate executives.http://www.econedlink.org/interactives/EconEdLink-interactive-tool-player.php?iid=230&full

TaxesTaxes the necessary evil in

order for government to finance it’s various spending

programs.It has been said that the only fair tax is a tax on someone else.

Criteria for effective taxes

1. Equity: Fairness is subjective, but taxes are considered fairer if they have fewer loopholes– exceptions, deductions and exemptions.

2. Simple: Tax laws should be easy to understand.

3. Efficient: Taxes should be easy to administer and collect enough revenue for the government to operate on.

Types of Taxes

Generally, all taxes can be divided into one of three types.

ProgressiveRegressiveProportional

Figure 9.3

1.Progressive Tax: tax rate increases as income increases, meaning the wealthy pay a higher percentage of their earnings than people less well off.

Our federal income tax system is an example of a progressive tax.

You know a tax is progressive because the average tax rate increases as income increases.

Avg. tax rate = total tax paid ÷ total income

2. Regressive Tax: the tax rate decreases as income increases. This tax tends to hurt the poorer family more than the wealthy family.

An example of this tax is the state sales tax.

Ex. Poor family has $20,000 income and spends $15,000 on basic necessities with a 5% sales tax. The average tax rate is 3.75% Wealthy family has $100,000 income and spends $40,000 with a 5% sales tax. The average tax rate is 2%.

3. Proportional Tax: aka a flat tax, it does not change with respect to income. The tax rate remains constant as income increases.

Our FICA taxes which include social security and medicare are mostly proportional.

Ex. If the proportional tax is 15%, then everyone pays 15% regardless of whether they make $10,000 or $100,000.

Budgeting

Budgeting refers to drawing up a plan for how available funds will be spent. A typical approach is to write down the total income that you expect to have available to spend, and then to write down how you plan to spend it.

Budgeting helps you know where your income is going, which in turn helps you make more informed decisions.

Budgeting is aka money management since it involves clarifying decisions about how available income will be spent.http://www.econedlink.org/interactive

s/EconEdLink-interactive-tool-player.php?iid=232&full

THE END

Monthly deposits of $10 compounded monthly.