Planning Your Financial Future, 4eby: Boone, Kurtz & Hearth

An Overview of Personal Finance

Chapter 1

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The Meaning and Importance of Personal Finance

Can improve your standard of livingToday’s environment has impacted personal

finance over the years Sluggish growth in personal income

After adjusting for inflation and taxes, personal income growth has only been about 2% a year for the last two decades

Changes in the labor marketMost people starting jobs today will work at

numerous companies during their career(s) More options

Many more options available today in investments, retirement planning, banking, etc.

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Personal Financial Planning—A Lifelong Activity

No matter how old you are, you’ll have financial goals

What works when you’re 20, won’t necessarily work when you’re 40 In your 20s, your goals may be paying off

student loans or buying your first house In your 70s, your goal may be making

sure your retirement funds last your lifetime

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Personal Financial Toolbox

Once you graduate from college (and now have a ‘real’ job) Figure out your current financial

standing How much do you owe? What assets do you have?

Prepare an income statement and balance sheet Put yourself on a budget Insure yourself against financial ruin

Life, health, property

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Personal Financial Toolbox

Get your debts under control (if they’re not already) Pay off high-rate loans (or roll over into lower-

rate loans)Start saving for retirementSet up a regular savings program (pay

yourself) Have money automatically transferred from

checking to savings Treat this like a fixed expense

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Getting Professional Help

Many colleges & universities offer credit counseling

May use services of a CPA or professional investment advisor

Dozens of financial self-help booksOnline financial information is

availableIf you use a financial planner, make

sure they are qualified

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Web Links

http://www.moneycentral.com

http://www.quicken.com http://www.motleyfool.com

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A Personal Financial Management Model

A financial plan is a guide to help you reach your targeted future goals Step 1: Develop short and long-term goals

Influenced by your personal values & current financial situation

Step 2: Establish financial strategies Step 3: Put plan in action & monitor

performance

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General Themes Common to All Financial Plans

Maximizing income and wealth The amount of money you earn is a vital part of

any plan

Using money more effectively Spend (and save) your money wisely

Little things add up

Monitoring expenditures Use a budget to help control expenditures The more you know about loans, investments, etc.,

the more likely you are to make a good decision

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Pitfalls of Poor Financial Planning

Missed or late payments will be noticed Creditors may:

Repossess your property Garnish your wages Force you to file for personal bankruptcy

A bad credit record can last for years

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Setting Personal Goals

Your values will influence your financial goals What things in life are important to you?

Your financial goals are influenced by your current financial situation Prepare current financial statements

Review them to determine what you own, what you owe, & where you’re spending your money

Prepare a budget Prepare a list of short- and long-term goals

Make sure they are realistic and obtainable Write down your goals and periodically review

them

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Your Personal Financial Decisions

Career choice Most of your income comes from salaries/wages –

determines your lifestyle Basic money management

Prepare a budget Select the right bank Establish a regular savings plan

Credit management Don’t bite off more than you can chew Find a good credit card Learn how to compute interest charges/monthly payments Find out your credit history (report) Learn what to do if you get into trouble

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Your Personal Financial Decisions

Tax planning How can you reduce your taxes?

Effective buying Real estate, cars, etc.

Renting vs. owning

Insurance How much insurance should you have (if any)?

Life Health Property Disability Liability

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Your Personal Financial Decisions

Investment management Invest to increase your future wealth

Difficult to substantially increase future wealth without investing

Investments are risky, choices include: Mutual funds Stocks Bonds Options and futures Real estate Art Coins Metals (gold, silver, etc.)

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Financial Planning for Tomorrow

Planning for your children’s college education Becoming more and more expensive

Retirement planning How do you want to live your retirement? How much (if any) do you want to pass along

to your heirs? How long remains until you retire? Will Social Security be enough?

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External Factors

Government policy Changes to federal student loan

programs Will costs of student loans increase due to

loan consolidation limits? Social Security reform

Will it be privatized? Will benefits be reduced?

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External Factors

Economic conditions The business cycle

Shorter-term sequences of expansions and contractions (recession)

Typical business cycle has four stages: prosperity, decline, recession, and recovery

Gross domestic product Represents the total value of goods and services

produced by a nation’s economy Important determinant of personal income

Disposable personal income – what remains after income taxes

Discretionary personal income – what remains after all necessary living expenses have been paid

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External Factors

Unemployment rate The percentage of the workforce currently looking for a job

Inversely related to economic activity Inflation

Inflation decreases the purchasing power of the dollar Inflation has been about 3% in recent years Income sources with cost-of-living increases are tied to

inflation Interest rates

If you think interest rates are going to rise sharply, buy that house/car now instead of waiting

Interest rates are tied to inflation Nominal interest rates are those that you pay or receive,

whereas real interest rates are nominal rates less the rate of inflation

For instance, if a six-month CD pays a 5% nominal rate, but inflation is 2%, then you are earning a real rate of 3%

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External Factors

Government policy and economic activity Government influences economy

If taxes increase and government spending remains unchanged, economic growth will slow

Federal Reserve Board can increase or decrease the supply of money

Impacts interest rates, inflation, and economic growth

Recession/Expansion If you think a recession is in the near future,

save more now (in case you get laid off)

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Figure 1.5: Change in Real GDP

Source: Based on data from the Federal Reserve Board and the Statistical Abstract of the United States.

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Figure 1.6: Breakdown of Personal Income

Source: Based on data from the Federal Reserve Board and the Statistical Abstract of the United States.

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The Time Value of Money

Why money has time value Risk of not getting your money back Risk of inflation Opportunity cost

You have to give up something when you invest (you can’t use the money for something else)

Because money has time value you should expect to earn interest on an investment

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Future Value

Value at some point in the future of a current sum of money If you invest $1,000 in an account and it

earns 6%, after one year you will have $1,060 $1,000 × 0.06 = $60 interest + $1,000 beginning

amount After two years, the $1,000 investment would

be worth $1,060 × 0.06 = $63.60 interest + $1,060 =

$1,123.60 Or, $1,000 × 1.062 = $1,123.60

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Future Value

Compound interest Payment of interest on interest

Simple interest Interest on the original deposit only

Multiple cash flows An annuity is a series of cash

payments or receipts

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Present Value

The value today of a future sum of money A dollar received tomorrow is worth

less than a dollar today Finding present value is called

discounting