The Importance of Personal Finance

1
Chapter One

• The Importance of Personal Finance

2
Learning Objectives

• List the benefits of studying personal finance.
• Summarize the six key steps in successful
  personal financial planning.
  

3
Learning Objectives (continued)

• Understand the current economic environment and
  forecast the state of the economy, inflation, and
  interest rates over the next few years.
  
• Explain fundamental economic considerations that
  affect decision making in personal finance.

4
Learning Objectives (continued)

• Make use of time value of money calculations when
  making financial decisions.
  
• Recognize how employer-related money decisions
  can affect success in personal finance.

5
Financial Literacy

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

6
Financial Responsibility

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

7
Why You Should Study Personal Finance

• Personal financethe study of how people
• spend
• save
• protect
• invest their financial resources.

8
Personal Financial Planning

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

9
Financial Planning

• Financial Planning relates to
• Consumingspending on goods and services.
• Savingincome not spent on current consumption.
• Investingassets purchased to provide income from
  the asset itself.

10
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

11
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.

12
Figure 1.1 Objectives and Steps in Personal
Financial Success
13
Figure 1.2 The Building Blocks of Financial
Success
14
How the Economic Environment Will Affect Your
Personal Finances

• Forecastingpredicting, estimating, or
  calculating in advance.

15
Know the State of the Economy

• Economya system of managing the resources of a
  country, state, or community.
  
• Economic Growthincreasing production and
  consumption in the economy.
  
• Business/Economic CyclePattern of economic
  activity including
  
• expansion
• recession
• recovery

16
Know the State of the Economy (continued)

• Expansion
• production high
• unemployment low
• Recessiona recurring period of decline in
• total output
• income
• employment
• trade
• Recoveryproduction, employment, and retail sales
  begin to improve.

17
Figure 1.3 Phases of the Business Cycle
18
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.

19
Predict Future Directions of Prices and Inflation

• InflationSteady rise in the general level of
  prices.
  
• DeflationFalling prices.

20
How Inflation Affects Income and Consumption

• Purchasing PowerA measure of goods and services
  ones income will buy goes down during
  inflation.
  
• Personal incomes rarely keep up in times of high
  inflation.
  
• Real IncomeIncome measured in constant prices
  relative to some base time period goes down
  during inflation.

21
Percentage Change in Income Formula
22
Real Income Formula
23
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 ratethe rate of increase in
  prices of items purchased by a particular person.
  

24
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.

25
Opportunity Costs and Trade-offs in Decision
Making

• Opportunity CostValue 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.

26
Marginal Analysis in Decision Making

• UtilityThe ability of a good or service to
  satisfy a human want.
  
• Marginal UtilityExtra satisfaction from one more
  incremental unit of a good or service.
  
• Marginal CostAdditional cost of one more unit of
  some item.
  
• Compare the benefits of the additional options
  with the additional costs.

27
Income Taxes in Decision Making

• Marginal Tax RateTax rate at which your last
  dollar earned is taxed.
  
• Tax-Exempt IncomeIncome that is totally and
  permanently free of taxes.
  
• Tax-Sheltered IncomeIncome exempt from income
  taxes in the current year.
  

28
Figure 1.4. Tax-Sheltered Returns Are Greater
Than Taxable Returns
29
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.
  
• Interestthe price of money.

30
Compound Interest

• Compound Interestearning interest on interest.
• Compoundingearning compound interestis the best
  way to to build value over time.
  

31
Calculating Future Values

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

32
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.

33
Figure 1.5 Future Value of 10,000 with Interest
Compounded Annually
34
The Rule of 72

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

35
Figure 1.6 The Rule of 72
36
Future Value of an Annuity

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

37
Figure 1.7 Future Value of 2000 Annual
Investments
38
Present Value Calculations

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

39
Present Value of a Lump Sum

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

40
Present Value of an Annuity

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

41
Career-Related Money Decisions

• Employee BenefitCompensation for employment
  other than
  
• wages
• salaries
• commissions
• other cash payments

42
Employer-Sponsored Tax-Sheltered Spending Accounts

• Flexible Spending Arrangement (FSA)
• Health Savings Account (HSA)

43
Employer-Sponsored Qualified Retirement Plans

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

44
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.
  

45
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.

46
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.

47
Golden Rules of Personal Finance

• Pay yourself first by spending less than you
  earn.
  
• Stay up-to-date about current economic
  conditions.
  
• Use marginal and opportunity costs and time value
  of money calculations when making financial
  decisions.

48
Golden Rules of Personal Finance (continued)

• Map your financial future by establishing goals
  and realistic plans to achieve them.
  
• Take advantage of opportunities to tax-shelter
  some income through your employers benefits
  program, including fully funding your 401(k)
  retirement account.
• Develop expertise in financial matters and heed
  your own advice because you are responsible for
  your own financial success.