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AOF Principles of Finance

Lesson 2Introduction to Finance

Student Resources

Resource Description

Student Resource 2.1 Reading: Am I Financially Literate?

Student Resource 2.2 Key Word Prediction: Time Value of Money

Student Resource 2.3 Reading: Time Value of Money

Student Resource 2.4 Notes: Financial Services Industry

Student Resource 2.5 Reading: Financial Services Industry

Student Resource 2.6 Letter-Writing Frame: Letter to the US Secretary of the Treasury

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AOF Principles of FinanceLesson 2 Introduction to Finance

Student Resource 2.1

Reading: Am I Financially Literate?Have you ever heard someone say, “If I had a million dollars, all my problems would be over”? Many people think that having more money would make life easier. But consider Lady Gaga. She is a millionaire many times over, but back in 2009, she was bankrupt from overspending on her Monster Ball concert tour. How did that happen? It all starts with a lack of financial literacy.

At its simplest, the term finance means the management of money. Financial literacy describes the knowledge and skills we need in order to manage our finances effectively.

“That’s fine,” you might be thinking, “for people who have money. But it doesn’t matter to me.”

Don’t sell yourself short! On average, teens in the United States spend a total of $259 billion dollars of their own money per year. No wonder advertising companies are continually trying to market to teens. They have the money to spend. However, according to a recent nationwide survey, on average, high school seniors answered only 52.4% of questions about personal finance and economics correctly.1 With these statistics in hand, you’re probably not surprised at the newspaper headline that read, “They like to spend it, but young people don’t know much about how money works.”

What Is Financial Literacy?Financial literacy is important for everyone—millionaires and people who make minimum wage, kids and adults. Being financially literate enables you to plan for your future, attain your financial goals, and make sound fiscal decisions that can affect your overall well-being. Without financial education and good money management skills, it doesn’t matter how much money you make, you can still end up with no money to pay your bills or pursue your dreams.

Financial literacy is more than just having a job and earning a paycheck. It’s about what you do with your money once it’s in your hands. To be financially literate, you need to think about questions like these:

How much money do I bring in?

Where does it go?

Do I have a budget? Do I stick to it?

How much do I spend?

How much do I save?

Do I invest?

Do I borrow money? Take out loans? Use credit?

Feeling confident about answering these questions wisely is a goal of financial literacy.

Why Does It Matter?Financial literacy also gives you the tools to survive in the world. As you grow up and earn more money, you will have to make choices about banks, insurance, investments, student loans, or mortgages. What do you choose and whom do you trust? Learning about finance can help you to become a confident and competent consumer, allowing you to take advantage of the wide variety of financial products that are available.

1 Bernanke, “Financial Literacy,” http://www.federalreserve.gov/newsevents/testimony/Bernanke20060523a.htm.


http://www.federalreserve.gov/newsevents/testimony/Bernanke20060523a.htm


Becoming financially literate also means thinking about your behavior. Every time you spend money you are making a choice. We are living in an era where we are encouraged to overspend. It’s important to differentiate between your needs and your wants.

Needs: things you can’t live without

Wants: things you would like to have

For example, you need food, clothes, and a place to live. You might want to eat all your meals in a restaurant, wear designer clothes, and live in a big fancy house. Needs can also include things like transportation (to get to work or school), whereas wants often include entertainment (downloading new music or buying a new video game).

Every time you make a purchase, stop and think, “Do I really need this?” Choosing to change your spending habits can lead to more cash in your pocket and a larger bank account! Remember, financial literacy is not only about having the right education and understanding specific financial concepts but also about taking the appropriate steps to change any irresponsible monetary behaviors.

Financial literacy can help you plan for the things you want, such as buying a car, paying for college, buying a home, or funding retirement. You might plan to be a professional athlete, earning millions every year. You might want to be an artist and money might not be very important to you. You might want to be a business executive, a scientist, a computer programmer, or a social worker—no matter what you want to do for a job or where you want to live, knowing how to handle your money will help you succeed.




Key Word Prediction: Time Value of MoneyStudent Name: Date:

Directions: Look through Student Resource 2.3, Reading: Time Value of Money, and identify any words that are new to you. Write the words down in the My Word column below. Then take your best guess at what each word means and write that in the My Definition column. Once you have done that, read Student Resource 2.3 and write down how the reading defines each term in the Text Definition column.

My Word My Definition Text Definition




Reading: Time Value of Money

What Is the Time Value of Money?The time value of money refers to the idea that a dollar in hand today is worth more than a dollar in the future. In other words, money available now is worth more than the same amount in the future. How can this be?

Any amount of money is worth more the sooner it is received based on its potential to earn interest. Interest is a payment made in exchange for using money over time. If you borrow money from a bank, you pay the bank interest; if you lend the bank money, it pays you interest. The actual trade-off between money now and money later depends on the rate of interest you can earn by saving and/or investing.

For example, let’s say you were given the option to receive $1,000 today or $1,000 next year. Does it really matter when you receive it? Yes. The time value of money implies that if you received the money today, you could invest it (let’s assume at a 5% interest rate) and in one year it would be worth $1,050.

Moreover, if you receive the money now, you are taking advantage of the opportunities that you have to use your money. Aside from earning interest on your money, you could also use the money to pay off any outstanding debt, potentially avoiding some high interest charges. So what you do with your money can save you money by getting you out of debt.

Future ValueFuture value refers to the value of an investment at some point in the future. Essentially, the value of the money you have now is not the same as it will be in the future. Future value is the amount of money to which an investment can grow, at a certain interest rate, for a certain period of time in the future.

For example, given a 5% interest rate over a one-year period, the future value of $1,000 would be $1,050.

An ExampleEvery Friday after work Charlene Munson purchases a lottery ticket from the local convenience store. Every Friday she hopes that her string of chosen numbers will randomly be selected, entitling her to the jackpot. Finally, after eight long years of diligently playing the lottery, the current Fantasy 5 numbers are revealed: 7, 22, 18, 6, and 30! She screams in delight. She has just won $380,000.

Her state’s lottery quickly informs her of her choices:

The “take it now option” (also known as the cash option) allows Charlene to receive approximately 50% of the winning amount now, minus taxes.

The payment option allows her to receive the winnings over the next 20 years ($19,000 per year), of course minus taxes. (Lottery officials claim that by offering this option they are helping you to manage your money.)

By reducing the immediate cash payout amount and encouraging its winners to receive the money in annual installments spread out over a long period of time, it is obvious that the lottery understands the time value of money!

Most economists would agree that Charlene should take the money now. Even though she’s receiving about 50% less right off the top, she still has time on her side. If she takes the money in installments over



the next 20 years, the final check that she receives will be worth far less than it is worth today. Furthermore, she can take her earnings and pay off high-interest debt or invest it!

Simple Interest and Compound InterestSimple interest and compound interest refer to the interest that you earn on your money.

Simple interest is paid when the interest is not reinvested each interest period. Looking back at your $1,000 investment, with simple interest, you would have $1,050 after the first year; $1,100 after the second year; $1,150 after the third; and so on. With simple interest, the 5% interest that you earn is paid each year only on your initial $1,000 deposit.

However, if you are paid compound interest, things look even better. The process of compounding refers to earning interest on your interest. Let’s say that you leave the $1,050 in the bank for another year with the same 5% interest and the interest is compounded. In two years the future value of your initial investment would be $1,102.50. Leave it in for another year and after three years, you would have $1,157.63. You are essentially reinvesting the interest. As Benjamin Franklin pointed out, “Money makes money. And the money that money makes, makes more money.

Comparison of Interest Earned on $1,000 Initial Investment

Simple Interest 5% Compound Interest 5%

Invest Interest Total Invest Interest Total

1,000.00 50.00 1,050.00 Year 1 1,000.00 50.00 1,050.00

1,000.00 50.00 1,100.00 Year 2 1,050.00 52.50 1,102.50

1,000.00 50.00 1,150.00 Year 3 1,102.50 55.13 1,157.63

1,000.00 50.00 1,200.00 Year 4 1,157.63 57.88 1,215.51

1,000.00 50.00 1,250.00 Year 5 1,215.51 60.78 1,276.28

1,000.00 50.00 1,300.00 Year 6 1,276.28 63.81 1,340.10

1,000.00 50.00 1,350.00 Year 7 1,340.10 67.00 1,407.10

1,000.00 50.00 1,400.00 Year 8 1,407.10 70.36 1,477.46

1,000.00 50.00 1,450.00 Year 9 1,477.46 73.87 1,551.33

1,000.00 50.00 1,500.00 Year 10 1,551.33 77.57 1,628.90

Over 10 years, compound interest earned $128.90 more, which is 13% of the initial investment.




Notes: Financial Services IndustryStudent Name: Date:

Directions: As you view the presentation Financial Services Industry, complete this graphic organizer.




Banks

Thrifts and credit unions

Insurance companies

Alternative financial services



Reading: Financial Services Industry

The financial services industry includes many different institutions that manage money. People and businesses need these institutions for many reasons. We use them when we deposit our paychecks or borrow money to buy a house. People may need financial help when a disaster strikes, like an accident, a death, or a hurricane. Financial services companies also assist people with investing and growing their money. The finance industry plays an important role in our country’s economy—and the world’s economy. This industry is also important to each of us, young and old alike, because the industry can support us all on the road to financial independence.



Financial services is a broad term used to refer to the services provided by the finance industry. It is also the term used to describe organizations that deal with the management of money. The financial services industry is one of the largest industries in the world.

Financial services institutions may:

• Hold and protect people’s money (for example, in a bank account)

• Lend money to people (through loans, mortgages, credit cards)

• Help people make more money (for example, through investments)

• Protect people from being financially hurt by unfortunate events (through insurance)



Financial institutions provide financial services to their customers. Banks, credit unions, savings and loans associations, and insurance companies are some of the most common financial services institutions. Other types include:

• Advisory services

• Credit card companies

• Investment banks

• Stock brokerages

• Money transfer companies (such as Western Union)

These institutions keep money flowing through the economy as they move money from people to businesses or investors to companies.

Financial institutions are heavily regulated by the government. Several agencies supervise these institutions, including:

• The Federal Reserve Board (FRB)

• The Comptroller of the Currency (OCC)

• The Federal Deposit Insurance Corporation (FDIC)

• The National Credit Union Administration (NCUA)

• The Consumer Financial Protection Bureau (CFPB)

People have to trust the financial system, so the government regulates this industry carefully.



Savings and checking accounts are by far the most common. A savings account is a place to keep your money. The bank gives you interest for keeping the money in the account.

Checking accounts allow you to write checks against the money in the account. There are some checking accounts that will even offer interest based on the balance of the account.

ATM and debit cards are linked to your checking or savings account and allow you to withdraw cash as well as make purchases. Both ATM and debit cards are convenient, because you don’t have to go to the bank to get cash out. You can buy milk at the grocery store and get $20 cash as well. This money is immediately deducted from your checking account.

Financial services institutions will also lend money through loans or credit cards. This means you use the bank’s money, but then you pay them back―with interest.

Investment opportunities are an important service offered by the financial services industry. Investments include:

• Money market accounts

• Certificates of deposit

• Mutual funds

• Securities



Banks are one of most commonly used financial institutions. You can put your money in a bank, borrow money from a bank, and use a bank to take care of other financial matters.

When you put your money into a bank, the bank lends that money out for a profit. Banks profit from the difference between the interest rates paid and those charged. To give a very simple example, if you deposit $100 in an account that pays 5%, or $5, the bank can use your money to make a loan to someone else and charge, say, 8% interest, or $8. The bank has now made $3 on the transactions. Everyone wins—you earn interest on your money; the bank makes a profit; and the borrower is able to procure needed funds to buy a car or start a business.

The most common services that banks offer are depository (meaning, you can put or deposit your money into an account) and lending services (when you borrow money, such as through personal, commercial, and mortgage loans). Banks offer credit cards, ATM and debit cards, electronic fund transfer services, currency exchange, safe deposit boxes, and investment and trust services. Banks also keep your money safe while allowing for withdrawals of your money when needed—the FDIC insures bank deposits up to $250,000 (per depositor, per bank, per account category) in any FDIC-insured bank account.



Banks, thrifts, and credit unions—the three main types of financial institutions where you can deposit your money—started out being very different. Over the years, they have become more similar, but each still has its own specialty.

Thrifts, also known as savings and loan associations, are financial institutions that specialize in mortgage loans and depository services, especially loans for single-family homes and other residential properties. They are referred to as thrifts because they originally offered only savings accounts (thrifty people are good at saving money).

Credit unions are financial institutions formed by a group of people that have a common tie. For example, credit unions have been established based on profession, geographical region, and so on. Many large organizations form their own credit unions. For example, Deere Employees Credit Union serves John Deere employees, retirees, and their families. Credit unions offer many of the same services as banks, but they are nonprofit organizations. They don’t have to pay federal taxes, so they can usually offer better interest rates.

The National Credit Union Administration is an independent federal agency that oversees credit unions. It regulates and supervises credit unions (much like the FDIC does for banks) and insures deposits through the National Credit Union Share Insurance Fund.



Insurance is a form of risk management. It protects your finances if you, your family, or your business experience unexpected events such as death, natural disasters, theft, accidents, and much more. To get insurance, you have to pay a fee to the insurance company. This fee is called a premium. Depending on the insurance, you might pay your premium in monthly installments, every three months (quarterly), or once a year. In return, the insurance company pays your bills if you are in an accident, your house is flooded, or some other unforeseen event happens. In other words, insurance protects you from risk.

There are many different types of insurance available. Each kind protects you from a different type of risk: for example, you can’t use car insurance to help you if you fall off your bike and break a leg. Some of the most common are life, business, auto, home, health, property, disability, and casualty. Casualty insurance is for covering losses resulting from injuries to people. Other types of insurance range from earthquake or flood insurance to vacation or pet insurance.

Before purchasing insurance, make sure to research the company. Some insurance companies are more stable and reliable than others. The stability and strength of the insurance company is very important, since a premium paid to the insurance company provides coverage for losses at some future date.

Some insurance companies also offer typical banking services like mortgages and auto loans.



In addition to the mainstream and traditional financial services companies already discussed, there are also alternative businesses that are a part of the financial services industry. While many people use banks, credit unions, and other traditional financial institutions to meet their needs, there are lots of people who use alternative financial services companies. These types of companies include check-cashing outlets, payday lenders, money-transfer stores, and pawnshops. They all facilitate monetary transactions in different ways.

Convenience is the key for these services. Although they give you money quickly, they charge you a lot in order to get it. The fees and rates that are charged for these services can be much higher than those charged at a local bank or credit union.



The financial services industry is important to the overall well-being of the economy. It helps people manage and invest their money. It makes it possible for people to spend their money or invest it today and pay their debts off in the future, which encourages the economy to grow. The economy grows because the money we deposit or invest gets loaned to other people so they can buy homes, start businesses, go to college, and meet other financial goals. The financial services industry makes life easier and more convenient with ATM, debit, and credit card services. People can bank online now and even use their cell phones and other electronic devices for money transactions! Finally, this industry allows people to make necessary purchases to cope with life’s financial challenges.




Letter-Writing Frame: Letter to the US Secretary of the Treasury

Directions: Use the following guide to help you organize your letter to the US treasury secretary about the importance of financial literacy. Once you have completed this guide, copy the information onto a blank piece of paper or type your letter using word processing software. Make sure that you clearly understand the assessment requirements before beginning your letter.

Date:

Dear Mr. (or Madam) Secretary,

I am currently enrolled in a Principles of Finance class at (name of school). I am writing to you today… [Clearly explain your purpose for the letter. Draw from your notes, readings, discussions, and/or presentation.]

There are many reasons why financial education is important. To begin…[Write your first reason here. Remember to include at least one accurate fact (taken from the readings, notes, or presentation) that effectively supports one of your claims regarding the importance of financial literacy.]

Secondly/Furthermore/Also…[Write your second reason here.]



Thirdly/Lastly/Finally…[Write your third reason here.]

In conclusion, after giving this topic much thought, one way to increase the financial literacy levels of our teens is to…[Write down your suggestion for the treasury secretary.]

Thank you for your time, and I hope that you can consider my suggestion.

Sincerely,

(Your Name)

Before you turn in your letter, make sure it meets or exceeds the following assessment criteria:

The letter includes three detailed reasons why financial literacy is important.

The letter includes at least one accurate fact (taken from the readings, notes, or presentation) that effectively supports one of your claims regarding the importance of financial literacy.

The letter provides a realistic and/or appropriate solution to improve the financial literacy levels of our youth.

The letter is neat and legible, and uses proper spelling and grammar.


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