chapter 1: understanding personal finance personal finance

Chapter 1:Understanding Personal Finance

Personal Finance

Copyright ©Houghton Mifflin Company. All rights reserved. 1 - 2

Learning Objectives

1. Use the building blocs to achieving financial success.

2. Understand how the economy affects your personal financial

success.

3. Apply economic principles when making financial decisions.

4. Perform time value of money calculations.

5. Make smart decisions about your employee benefits.

6. Identify the professional qualifications of providers of

financial advice.

Financial Literacy

•Financial literacy is knowledge of:

– Facts

– Concepts

– Principles

– Technological tools

…that are fundamentalto being smartabout money.

The Building Blocks of Your Financial Success

Class Discussion Question #1

•How do you make yourself feel financially happy?

Possible Answers

• Invest money in a retirement fund

• Put money away in a savings account

• Pay off debt early (house, credit card,car note, etc.)

• Avoid relying too much on credit to make purchases

• Avoid impulse buying

• Don’t collect things that you don’t need

The Economy and Business Cycles

• The economy grows and contracts over time:

– Expansion

– Peak

– Contraction

– Trough

Economy: System of managing the resources of a country, state, or community.

Economic Growth: Increasing production and consumption in the economy.

Business Cycle Phases


The Future Direction of the Economy?

• Track the Gross Domestic Product

• Track the Employment Report

• Track the Index of Leading Economic Indicators

• Track the Consumer Confidence Index


Inflation• Inflation: Steady rise in the general

level of prices.

• How does inflation affect income and consumption?

• How inflation is measured:

– Consumer Price Index (or CPI)

– Personal Inflation Rate

Think Like an Economist

• Opportunity Cost: Cost of decision measured by the value of the next best alternative.


Think Like an Economist

• Marginal Utility/Cost: Usefulness or cost of the next increment of something.

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


FAQ in Personal Finance

• What will an investment (or a series of investments) be worth after a period of time?

• How much savings will I have for retirement?

• This question asks for a future value.


Calculating Future Values• Future Value (FV): Valuation of an

asset projected to the end of a particular time period in the future.

• Savings/Compounding: Interest earned on interest from multiple periods

– Ex: “How much will I have in 10 years if I invest $1,000 at 8% interest?”

$1,000 Principle Amount

x(1.08)10 Interest Rate (annual)

$2,158.93 Investment Value

Future Value of $1 After a Given Number of Periods

Periods 4% 7% 8% 10%

1 1.0400 1.0700 1.0800 1.1000

2 1.0816 1.1449 1.1664 1.2100

3 1.1249 1.2250 1.2597 1.3310

4 1.1699 1.3108 1.3605 1.4641

5 1.2167 1.4026 1.4693 1.6105

10 1.4802 1.9672 2.1589 2.5937

Appendix A-1


Calculating Future Values

• Future value of a lump sumFuture Value (FV) = P(1 + r)tEx: “How much will I have in 10 years if I invest $100 at 10% interest?” $100(1.10)10 = $259.37

• Future value of an annuityFuture Value (FV) = P(1 + r)t + P(1 + r)t + P(1 + r)t . . .

Ex: “How much will I have if I invest $100 at the end of each year for 3 yrs at 10% interest?” = $100(1.10)0 + $100(1.10)1 + $100(1.10)2 = $100 + $110 + $121 = $331 FV in 3 years !

– Rule of 72: An approximate interest rate earned based upon the time it will take for an investment to double is determined by:

72 r r = interest rate earned, so:

Ex: If doubling period is 8 years, the interest rate is72/8 = 9 %

Rule of 72 Illustrated

Rule of 72: Reveals number of years it takes for the principle amount invested to double in value.

Future Value of $10,000


FAQ in Personal Finance

• How much has to be put away today (or as a series of investments) to provide some dollar amount in the future?

• This question asks for a present value.


Calculating Present Values• Present value of a lump sum – “How much do I need

to save today to have $259.37 in 10 years if I can earn a 10% return?”Present Value (PV) = FV

(1+r)tEx: $259.37 future value discounted at 10% for 10 years = $259.37 = $100 needed today (1.10)10

r = discount rate measures the present or future value of $1 received at time period (t)

t = time period of investment

• Present value of an annuity – “How much do I need to save today to be able to withdraw $4,000 each year for the next 3 years if I can earn a 10% return?” – A fixed stream of cash flows at the end of each period over time.

• PV = Pmt =PV of $4,000 received each year for (1+r)t 3 years at 10% interest: $4,000 + $4,000 + $4,000 = $9,947.41 (1.10)1(1.10)2 (1.10)3


Smart Money Decisions at Work• Flexible benefit plans offer tax-free money

• Flexible Benefit (Cafeteria) Plan• Making decisions about employer-sponsored health

care plans

• High-Deductible Health Care Plan

• Health Savings Accounts (or HSAs)• Making decisions about employer’s Flexible

Spending Accounts

• Pretax Dollars: Money income that has not been taxed by the government.


Smart Money Decisions at Work

• Making decisions about… – Participating in employer life, disability, and

long-term care insurance plans

– Participating in your employer’s retirement (or tax-sheltered retirement) plan

Tax-Sheltered Returns

• Assumes $2,000 Annual Contribution and 8% Return


Employer Retirement Plans

• First advantage: tax-deductible contributions

• Second advantage: employer’s matching contributions

• Third advantage: tax-deferred growth

• Fourth advantage: starting early really pays off

Starting to Save Early Versus Starting Late at 9%

Earlier Later

Age $ Value Age $ Value

23 $ 3,000 23 $ 0

31 6,000 31 3,000

39 12,000 39 6,000

47 24,000 47 12,000

55 48,000 55 24,000

63 $96,000 63 $48,000

Professional Financial Planning Advice

• A true financial planner should be able to analyze a family’s total needs in such areas as:

– investments

– taxes

– insurance

– education goals

– retirement



• Appropriate professional designations and credentials for planners:– Certified Financial Planner (CFP)– Chartered Financial Consultant (CFC)– Certified Public Accountant (CPA)– Accredited Financial Counselor (AFC)– Mutual Fund Chartered Counselor (MFCC)– Registered Investment Advisor (RIA)



• How financial planners are compensated:– Commission-only financial planners/brokers

– Fee-based financial planner/brokers

– Fee-offset financial planners/brokers

– Fee-only financial planners


Top 3 Financial Challenges in Personal Finance

People are challenged to build and maintain financial well being when they:

1. Think only about money matters when faced with a financial problem.

2. Spend more than they earns.

3. Get financial advice from amateurs.


Good Money Habits in Personal Finance

• Spend significantly less than you make and save using pay-yourself-first.

• Stay up-to-date with current economic conditions and the knowledge to manage your personal finances.

• When making financial decisions, use marginal and opportunity costs and time value of money calculations.

• Establish financial goals and take actions to achieve them.


Good Money Habits in Personal Finance

• Take advantage of tax sheltering through your employer’s benefits program.

• Believe in compounding by allowing your money to earn interest on top of the principal and other accrued interest.

• Keep debt under control.

• Take responsibility for managing your own financial success.

Questions ?

chapter 1: understanding personal finance personal finance

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