Unit 5

Personal Finance

Saving and Investing

Generally, 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 holding money for spending purposes is the interest you could have earned by putting the money 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 Account: these are 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: this is where you 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 loans 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 versus long term, which are repaid over decades.

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

Stocks are riskier than bonds. Stock prices can be measured by looking at an index like the Dow Jones Industrial Average or the S & P 500.

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

The employee contributes a certain amount each month into the plan which is then matched by some percentage by the employer. The fund grows tax deferred until retirement at which time it is taxed. This allows for a bigger nest egg.

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

Diversification: The spreading out of funds into different kinds of investments in order to minimize risk. The idea is not to put all your eggs in one basket.

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.

d receive 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 InstitutionsBanks: provide a safe means to store

earnings. Banks offer direct deposit, check writing services, debit and credit cards, loans of all sorts, as well as other services. Banks take the money deposited and loan out a portion of it to people who want to borrow. By charging interest on the loans banks are able to make a profit. The interest on the loans is always more than the interest paid out to depositors for their money. Otherwise, banks could not earn a profit. This is called the interest rate spread.

Credit Union: provide services similar to a bank; the main difference is that a credit union only provides these services to its members, and these members own and control the institution. Since the credit union exists for the benefit of its members, it can offer better rates on loans or savings accounts.

Savings & Loan: instead of providing a wealth of services, a savings and loan takes deposits and concentrates on two areas: namely savings and mortgage loans. Depositors won’t have as easy access to their money as in a bank, but they will earn a higher savings rate.

Payday Loan Company: these companies 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: of an investment is calculated as the income or profit generated by that investment divided by the original cost of the investment.

Ex. If you put $100 in a bank account and receive $3 a the end of the year, then the rate of return is 3%.

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

Simple vs. Compound Interest

The interest rate is the price paid or received for the use of another person’s money. This interest rate can be calculated in 2 basic ways.

The simple interest rate is where interest is calculated only on the original loan amount, also called the principal.

Ex. Loan amount = $100, Interest rate = 5% 5% × $100 = $5 After 1 year the person would have $105. After the 2nd year, the person would earn $105 + $5 = $110

The compound interest rate is where interest is earned not only on the principal but also on interest earned from previous periods.

Ex. Same example as above In the 2nd year, the person would earn 5% × $105 = $5.25, so the total earned would be $105 + $5.25 = $110.25

The compound interest is greater than the simple interest. The current difference is only 25¢, but compound interest can build up significantly over a long period of time.

Rule of 70

.

The key to compounding is to start saving early and be consistent.

Interest can be compounded monthly quarterly, semi-annually, or annually.

Albert Einstein is quoted as saying, "The most powerful force in the universe is compound interest."

How much is a penny compounded daily for a month?

Monthly deposits of $10 compounded monthly.

CreditCredit: refers to the ability to borrow money. Some forms of credit commonly used by consumers are car loans, home mortgage loans and credit cards. Businesses also 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 are said to have good credit, while 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, one should look at the annual percentage rate (APR) on the loan.

For short term credit people often use credit cards as a simple and convenient way of paying for purchases. The advantage is that if a credit card is used and the balance is paid off each month, the borrower doesn’t pay any interest. However, 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 as high as 18% are not uncommon, and the rate can be fixed or variable depending on the card.

Interest rates are higher on credit cards than on bank loans because they are an unsecured loan. The borrower doesn’t have to put up any collateral in case of default. With a bank loan collateral would be required.Collateral: An asset of value put up against the loan in case of default.

When financial institutions decide to loan you money they look at your credit worthiness which is an attempt to determine how well you’ll be able to repay a loan.

Here are the 3 main factors they consider:

1. Annual Income

2. Amount of current debt you have

3. Timeliness of repaying your loans

What is a Credit Bureau?An agency that researches and collects individual credit information and sells it for a fee to creditors so they can make a decision on granting loans. Typical clients include banks, mortgage lenders, credit card companies and other financing companies. Also commonly referred to as consumer reporting agency or credit reporting agency.

InsuranceIn general, all forms of insurance allow a person to pay a small amount of money today, called a premium, in order to guard against a potentially disastrous event in the future. If the negative event does occur, then the insurance will pay certain costs.

When a claim is filed the insured must first pay the deductible before the insurance starts to pay. If people want a smaller premium, they can opt for a higher deductible, or vice versa.

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

Life Insurance: provides a payment toyour 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.

Auto Insurance: provides payments for damages caused in an auto accident. This is typically the 1st kind of insurance needed by teenagers.

Ex. Liability Collision Theft Car Rental Comprehensive No Fault

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.

Disability Insurance: covers workers who are injured and can’t work anymore. The insurance 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.

Human Capital

This refers to 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: these are workers who work primarily with their hands including ditch diggers, fruit pickers and house cleaners. These workers earn the lowest wages.

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

3. Skilled: these workers can operate complex equipment and perform tasks with little supervision. Examples include carpenters, typists, computer technicians and chefs.

4. Professional: these workers have the highest level of knowledge based education and managerial skills such as doctors, lawyers, scientists and corporate executives.

TaxesTaxes will always be

necessary 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: the 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: also known as a flat tax, a proportional tax 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 sometimes called money management since it involves clarifying decisions about how available income will be spent.