Chapter One

The Importance of Personal Finance

Learning Objectives

1. List the benefits of studying personal finance.

2. Summarize the six key steps in successful personal financial planning.

Learning Objectives (continued)

3. Understand the current economic environment and forecast the state of the economy, inflation, and interest rates over the next few years.

4. Explain fundamental economic considerations that affect decision making in personal finance.

Learning Objectives (continued)

5. Make use of time value of money calculations when making financial decisions.

6. Recognize how employer-related money decisions can affect success in personal finance.

Financial Literacy

• Financial literacy is knowledge of:– facts– concepts– principles– technological tools – that are fundamental to being smart about– money.

Financial Responsibility

• Financial responsibility is being accountable for:– your financial decisions and– your own financial well-being.

Why You Should Study Personal Finance

• Personal finance–the study of how people – spend – save – protect– invest their financial resources.

Personal Financial Planning

• Personal financial planning is the development and implementation of long-range plans to achieve financial success.

Financial Planning

• Financial Planning relates to:– Consuming–spending on goods and

services.– Saving–income not spent on current

consumption.– Investing–assets purchased to provide

income from the asset itself.

Financial Planning (continued)

• Financial planning helps you manage your level of living– what you actually experience financially

• In order to attain your standard of living.– where you would like to be financially

Financial Planning (continued)

• Financial planning helps you achieve– Financial Success – achievement of

financial aspirations.– Financial Security – being able to fulfill any

needs and most wants.– Wealth – an abundance of money and

other financial resources.– Financial Happiness – the satisfaction you

feel about money matters.

Figure 1.1: Objectives and Steps in Personal Financial Success

Figure 1.2: The Building Blocks of Financial Success

How the Economic Environment Will Affect Your Personal Finances

• Forecasting–predicting, estimating, or calculating in advance.

Know the State of the Economy

• Economy–a system of managing the resources of a country, state, or community.

• Economic Growth–increasing production and consumption in the economy.

• Business/Economic Cycle–Pattern of economic activity including:– expansion – recession– recovery

Know the State of the Economy (continued)

• Expansion–– production high – unemployment low

• Recession–a recurring period of decline in:– total output– income– employment– trade

• Recovery–production, employment, and retail sales begin to improve.

Figure 1.3: Phases of the Business Cycle

Predict Future Directions for the Economy

• Gross Domestic Product (GDP)–Value of all goods and services produced in the U.S.

• Index of Leading Economic Indicators (LEI)–Composite index suggesting the future direction of the U.S. economy.

Predict Future Directions of Prices and Inflation

• Inflation–Steady rise in the general level of prices.

• Deflation–Falling prices.

How Inflation Affects Income and Consumption

• Purchasing Power–A measure of goods and services one’s income will buy goes down during inflation.

• Personal incomes rarely keep up in times of high inflation.

• Real Income–Income measured in constant prices relative to some base time period goes down during inflation.

Percentage Change in Income Formula

100yearlast income nominal

yearlast income nominal - raiseafter income nominal change Percentage

Real Income Formula

rateinflation previous0.1

raiseafter income nominal income Real

How Inflation is Measured

• Consumer Price Index (CPI)–broad measure of changes in the prices of all goods and services purchased for consumption by urban house holds.

• Personal inflation rate–the rate of increase in prices of items purchased by a particular person.

Estimating Future Interest Rates

• Long-term interest rates are generally higher than short-term interest rates.

• You can forecast interest rates by paying attention to changes in the federal funds rate:– the rate that banks charge one another on

overnight loans.– provides an early indication of Fed policy

and trends for longer-term interest rates.

Opportunity Costs and Trade-offs in Decision Making

• Opportunity Cost–Value of the next best alternative that must be foregone.

• Opportunity cost reflects the best alternative of what one could have done instead of choosing to spend, save, or invest money.

• Trade-offs occur when you give up one thing for another.

Marginal Analysis in Decision Making

• Utility–The ability of a good or service to satisfy a human want.

• Marginal Utility–Extra satisfaction from one more incremental unit of a good or service.

• Marginal Cost–Additional cost of one more unit of some item.– Compare the benefits of the additional

options with the additional costs.

Income Taxes in Decision Making

• Marginal Tax Rate–Tax rate at which your last dollar earned is taxed.

• Tax-Exempt Income–Income that is totally and permanently free of taxes.

• Tax-Sheltered Income–Income exempt from income taxes in the current year.

Figure 1.4.: Tax-Sheltered Returns Are Greater Than Taxable Returns

The Time Value of Money in Decision Making

• Time Value of Money compares:– amounts to be received in the future with

dollar amounts received today – or dollar amounts received today with

dollar amounts to be received in the future.

• Interest–the price of money.

Compound Interest

• Compound Interest–earning interest on interest.

• Compounding–earning compound interest–is the best way to to build value over time.

Calculating Future Values

• Future Value (FV)–Value of an asset at the end of a particular time period.

?

Future Value of a Lump Sum

• What the principal will grow to over time.

• Formula:– FV = (Present Value) (i +1.0)n where,– i = the interest rate– n = the number of time periods.

Figure 1.5: Future Value of $10,000 with Interest Compounded Annually

The Rule of 72

• Rule of 72–Calculates the number of years it takes for principal to double.– Years = 72 divided by interest rate.

Figure 1.6: The Rule of 72

Future Value of an Annuity

• What the principal will grow to over time if a series of deposits are made.

Figure 1.7: Future Value of $2000 Annual Investments

Present Value Calculations

• Present/Discounted Value–Current value of an asset that will be received in the future.

Present Value of a Lump Sum

• Present value of an amount to be received in the future.

Present Value of an Annuity

• Present value of a stream of payments to be received in the future.

Career-Related Money Decisions

• Employee Benefit–Compensation for employment other than– wages– salaries – commissions – other cash payments

Employer-Sponsored Tax-Sheltered Spending Accounts

• Flexible Spending Arrangement (FSA)

• Health Savings Account (HSA)

Employer-Sponsored Qualified Retirement Plans

• Plans that give tax advantages, making it easier to save for retirement; e.g. a 401(k).

First Advantage: Tax-Deductible Contributions

• The amounts you and your employer contribute into the account is not included in your taxable income for the year contributed.

Second Advantage: Tax-Deferred Growth

• The investment earning off of the funds in your account are not subject to income tax during the year they are earned.

• Taxes will be paid when the earnings are withdrawn.

• All employer-based plans will have the second advantage. Most will also have the first.

How To Maximize the Benefits from a Tax-Sheltered Retirement Plan

• Start early to boost your retirement.

• Plan to be a millionaire.

• Saving just 1 percent more of your pay makes a big difference.

• Never make a hardship withdrawal from a tax-sheltered retirement plan.

Golden Rules of Personal Finance

1. Pay yourself first by spending less than you earn.

2. Stay up-to-date about current economic conditions.

3. Use marginal and opportunity costs and time value of money calculations when making financial decisions.

Golden Rules of Personal Finance (continued)

4. Map your financial future by establishing goals and realistic plans to achieve them.

5. Take advantage of opportunities to tax-shelter some income through your employer’s benefits program, including fully funding your 401(k) retirement account.

6. Develop expertise in financial matters and heed your own advice because you are responsible for your own financial success.