Chapter 12 investing in stocks answers

Chapter Reflection & Application

Personal Finance

Vickie Bajtelsmit Colorado State University

with Linda Rastelli

Credits PUBLISHER Anne Smith

PROJECT EDITOR Beth Tripmacher

MARKETING MANAGER Jennifer Slomack

SENIOR EDITORIAL ASSISTANT Tiara Kelly

PRODUCTION MANAGER Kelly Tavares

PRODUCTION ASSISTANT Courtney Leshko

PROJECT MANAGER Shana Meyer

CREATIVE DIRECTOR Harry Nolan

COVER DESIGNER Hope Miller

COVER PHOTO © George Doyle/Getty Images

Wiley 200th Anniversary Logo designed by: Richard J. Pacifico

This book was set in Times New Roman by Techbooks and printed and bound by R.R. Donnelley. The cover was printed by R.R. Donnelley.

This book is printed on acid free paper. �

Copyright © 2008 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201) 748-6011, fax (201) 748-6008, website http://www.wiley.com/go/permissions.

To order books or for customer service please, call 1-800-CALL WILEY (225-5945).

ISBN-13 978-0-470-11123-9

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

www.copyright.com
http://www.wiley.com/go/permissions
This page intentionally left blank

VI APPENDIX—PERSONAL FINANCE WORKSHEETS

PREFACE College classrooms bring together learners from many backgrounds with a variety of aspirations. Although the students are in the same course, they are not necessarily on the same path. This diversity, cou- pled with the reality that these learners often have jobs, families, and other commitments, requires a flexibility that our nation’s higher edu- cation system is addressing. Distance learning, shorter course terms, chunked curriculum, new disciplines, evening courses, and certifica- tion programs are some of the approaches that colleges employ to reach as many students as possible and help them clarify and achieve their goals.

Wiley Pathways books, a new line of texts from John Wiley & Sons, Inc., are designed to help you address this diversity and the need for flexibility. These books focus on the fundamentals, identify core competencies and skills, and promote independent learning. The focus on the fundamentals helps students grasp the subject, bringing them all to the same basic understanding. These books use clear, everyday language, presented in an uncluttered format, making the content more accessible and the reading experience more pleasurable. The core competencies and practical skills focus help students suc- ceed in the classroom and beyond, whether in another course or in a professional setting. A variety of built-in learning resources promote independent learning and help instructors and students gauge stu- dents’ understanding of the content. These resources enable students to think critically about their new knowledge, and apply their skills in any situation.

Our goal with Wiley Pathways books—with its brief, inviting for- mat, clear language, and core competencies and skills focus—is to cel- ebrate the many students in your courses, respect their needs, and help you guide them on their way.

Wiley Pathways Pedagogy

To meet the needs of working college students, all Wiley Pathways texts explicitly use an outcomes and assessment-based pedagogy for the books: students will review what they have learned, acquire new information and skills, and apply their new knowledge and skills to real-life situations. Based on the recently updated categories of Bloom’s Taxonomy of Learning, Wiley Pathways Personal Finance presents key

topics in personal finance (the content) in easy-to-follow chapters. The text then prompts analysis, synthesis, and evaluation with a variety of learning aids and assessment tools. Students move efficiently from reviewing what they have learned, to acquiring new information and skills, to applying their new knowledge and skills to real-life scenarios.

With Wiley Pathways, students not only achieve academic mastery of personal finance topics, but they master real-world skills related to that content. The books help students become independent learners, giving them a distinct advantage in the field, whether they are starting out or seek to advance in their careers.

Organization, Depth and Breadth of the Text

▲ Modular format. Research on college students shows that they access information from textbooks in a non-linear way. Instructors also often wish to reorder textbook content to suit the needs of a particular class. Therefore, although Wiley Pathways Personal Finance proceeds logically from the basics to increasingly more challenging material, chapters are further organized into sections that are self-contained for maximum teaching and learning flexibility.

▲ Numeric system of headings. Wiley Pathways Personal Finance uses a numeric system for headings (for example, 2.3.4 identi- fies the fourth sub-section of section 3 of chapter 2). With this system, students and teachers can quickly and easily pinpoint topics in the table of contents and the text, keeping class time and study sessions focused.

▲ Core content. Topics in the text are organized into fifteen chapters.

Part I: The Personal Financial Planning Process

Chapter 1, Personal Financial Planning in Action, provides an overview of the five steps in the personal financial planning process and the elements of a comprehensive financial plan that are developed throughout the text. How to make effective financial decisions is also explained.

Chapter 2, Money Management Strategies and Skills, looks at ways to collect and organize your financial information. Students learn how to compile and use personal financial statements to evaluate their financial conditions. Simple financial ratios are presented to determine where you need to save or to better allocate money.

PREFACE vii

viii PREFACE

Chapter 3, Managing Your Taxes, examines the United States tax system. Students are helped to understand their federal tax returns, including tax brackets, tax credits and exemptions, and calculating taxable income. How to file a return and avoid common filing errors is presented. Finally, effective tax planning strategies are offered.

Part II: Managing Your Personal Finances

Chapter 4, Managing Your Cash and Savings, explains the objectives and rules of cash management. Students are helped to understand the basic differences between financial institutions, and given guidance in choosing a financial provider. Cash management products and services are detailed. Tips are provided on how to resolve cash management problems, including bounced checks, fraudulent activity, and obtain- ing emergency cash.

Chapter 5, Consumer Credit, helps students make wise credit card and consumer loan decisions. It examines the benefits and costs of consumer credit, including credit cards. How to apply for con- sumer credit and correcting credit mistakes are presented. How to avoid identify theft is explained, as well as other pitfalls of credit card usage.

Chapter 6, Using Consumer Loans, outlines the characteristics and types of consumer loans. Student loans are covered in detail, as well as how interest is calculated on consumer loans and the role of credit reporting agencies. How to improve your creditworthiness is studied, including the five C’s of credit. Managing your debt is explained, including how to reduce it, and as a last resort, filing for bankruptcy.

Chapter 7, Making Automobile and Housing Decisions, examines how to purchase and finance autos and homes. From determining how much you can afford to spend, to negotiating, to obtaining a mortgage or auto loan, all aspects of these important transactions are covered. Whether to lease or buy a car, mortgage financing, choosing a reputable real estate broker, and closing the real estate transaction are also part of this chapter.

Part III: Protecting Yourself with Insurance

Chapter 8, Insuring Your Home and Automobile, shows how to pro- tect your car and home after you have purchased them. It explains how insurance works, including risk pooling, indemnity, liability, exclusions and deductibles. Which risks are covered is discussed, as well as which types of homeowner’s and automobile coverages are available. Next, how to buy insurance, from finding agents to getting

PREFACE ix

quotes, is explained. Making insurance claims is included in this chapter.

Chapter 9, Health and Disability Insurance, reviews why health insurance is an important employee benefit and component of a sound financial plan. The types of health insurance are described, including employer-sponsored and government sponsored plans. Finally, planning for disability income needs is discussed, together with the importance of understanding your chances of becoming disabled at some point.

Chapter 10, Financial Planning with Life Insurance, describes why life insurance may be useful in your financial plan. Topics covered include how to determine your life insurance needs, what types of com- panies sell life insurance, types of policies, and important provisions in a life insurance contract.

Part IV: Managing Your Investments and Your Future

Chapter 11, Investment Basics, outlines clearly how to develop real- istic investment goals, as well as find the money for investing. Fac- tors that reduce investment risk and your investment alternatives are offered. The need for a consistent investment strategy and how to establish one is explored.

Chapter 12, Investing in Stocks and Bonds, explains equity and debt investing in brief detail. Common and preferred stock, how com- mon stock is classified, and buying and selling stock on exchanges are explained. Evaluating the performance of your stock is also pre- sented. Then the advantages and disadvantages of bond investing are explored, including how to buy and sell bonds.

Chapter 13, Investing in Mutual Funds, describes mutual funds and why they may be preferred by the individual investor. Included in the discussion are mutual fund investment classifications. How to select a fund and how to evaluate a fund’s performance are offered as well.

Chapter 14, Planning for Retirement, has information on estimat- ing retirement income needs and sources of retirement income. Described here are IRAs and how to avoid paying more taxes in retirement than you need to. Employee-sponsored and government sponsored benefits are included in the discussion. Finally, preparing for retirement payouts is covered.

Chapter 15, Preserving Your Estate, outlines reasons why you probably need a will, and why estate planning is important for every- one. The key components of estate plans are presented, and how to avoid estate and gift taxes. The types and formats of wills, including how to establish a valid will, is included.

x PREFACE

Pre-reading Learning Aids

Each chapter of Wiley Pathways Personal Finance features the follow- ing learning and study aids to activate students’ prior knowledge of the topics and orient them to the material.

▲ Pre-test. This pre-reading assessment tool in multiple-choice format not only introduces chapter material, but it also helps students anticipate the chapter’s learning outcomes. By focus- ing students’ attention on what they do not know, the self-test provides students with a benchmark against which they can measure their own progress. The pre-test is available online at www.wiley.com/college/bajtelsmit.

▲ What You’ll Learn in this Chapter. This bulleted list focuses on subject matter that will be taught. It tells students what they will be learning in this chapter and why it is significant for their careers. It will also help students understand why the chapter is important and how it relates to other chapters in the text.

▲ After Studying this Chapter, You’ll Be Able To. This list emphasizes capabilities and skills students will learn as a result of reading the chapter. It focuses on execution of subject matter that shows the relationship between what students will learn in the chapter and how the information learned will be applied in an on-the-job situation.

Within-text Learning Aids

The following learning aids are designed to encourage analysis and synthesis of the material, support the learning process, and ensure success during the evaluation phase:

▲ Introduction. This section orients the student by introducing the chapter and explaining its practical value and relevance to the book as a whole. Short summaries of chapter sections pre- view the topics to follow.

▲ “For Example” Boxes. Found within each chapter, these boxes tie section content to real-world examples, scenarios, and applications.

▲ Figures and tables. Line art and photos have been carefully chosen to be truly instructional rather than filler. Tables distill and present information in a way that is easy to identify, access, and understand, enhancing the focus of the text on essential ideas.

www.wiley.com/college/bajtelsmit
PREFACE xi

▲ Self-Check. Related to the “What You’ll Learn” bullets and found at the end of each section, this battery of short answer questions emphasizes student understanding of concepts and mastery of section content. Though the questions may either be discussed in class or studied by students outside of class, students should not go on before they can answer all ques- tions correctly.

▲ Key Terms and Glossary. To help students develop a profes- sional vocabulary, key terms are bolded in the introduction, summary, and when they first appear in the chapter. A com- plete list of key terms with brief definitions appears at the end of each chapter and again in a glossary at the end of the book. Knowledge of key terms is assessed by all assessment tools (see below).

▲ Summary. Each chapter concludes with a summary paragraph that reviews the major concepts in the chapter and links back to the “What You’ll Learn” list.

Evaluation and Assessment Tools

Each Wiley Pathways text consists of a variety of within-chapter and end-of-chapter assessment tools that test how well students have learned the material. These tools also encourage students to extend their learning into different scenarios and higher levels of under- standing and thinking. The following assessment tools appear in every chapter of Wiley Pathways Personal Finance:

▲ Summary Questions help students summarize the chapter’s main points by asking a series of multiple choice and true/false questions that emphasize student understanding of concepts and mastery of chapter content. Students should be able to answer all of the Summary Questions correctly before moving on.

▲ Applying this Chapter Questions drive home key ideas by asking students to synthesize and apply chapter concepts to new, real- life situations and scenarios. Asks student to practice using the material they have learned in contrived situations that help reinforce their understanding, and may throw light on impor- tant considerations, advantages, or drawbacks to a specific methodology.

▲ You Try It Questions are designed to extend students’ thinking, and so are ideal for discussion, writing assignments, or for use

xii PREFACE

as case studies. Using an open-ended format and sometimes based on Web sources, they encourage students to draw con- clusions using chapter material applied to real-world situations, which fosters both mastery and independent learning.

▲ Post-test should be taken after students have completed the chapter. It includes all of the questions in the pre-test, so that students can see how their learning has progressed and improved.

Instructor and Student Package

Wiley Pathways Personal Finance is available with the following teach- ing and learning supplements. All supplements are available online at the text’s Book Companion Web site, located at www.wiley.com/college/bajtelsmit.

▲ Instructor’s Resource Guide. Provides the following aids and supplements for teaching an Introduction to Personal Finance course: • Sample syllabus. A convenient template that instructors

may use for creating their own course syllabi. • Teaching suggestions. For each chapter, these include a

chapter summary, learning objectives, definitions of key terms, lecture notes, answers to select text question sets, and at least 3 suggestions for classroom activities, such as ideas for speakers to invite, videos to show, and other projects.

▲ PowerPoints. Key information is summarized in 15 to 20 PowerPoints per chapter. Instructors may use these in class or choose to share them with students for class presentations or to provide additional study support.

▲ Test Bank. One test per chapter, as well as a mid-term, and two finals: one cumulative, one non-cumulative. Each includes true/false, multiple choice, and open-ended questions. Answers and page references are provided for the true/false and multiple choice questions, and page references for the open-ended questions. Available in Microsoft Word and computerized formats.

www.wiley.com/college/bajtelsmit
PREFACE xiii

ACKNOWLEDGMENTS Taken together, the content, pedagogy, and assessment elements of Wiley Pathways Personal Finance offer the career-oriented student the most important aspects of personal finance as well as ways to develop the skills and capabilities that current and future employers seek in the individuals they hire and promote. Instructors will appreciate its practical focus, conciseness, and real-world emphasis. We would like to thank the reviewers for their feedback and suggestions during the text’s development. Their advice on how to shape Wiley Pathways Per- sonal Finance into a solid learning tool that meets both their needs and those of their busy students is deeply appreciated.

We would especially like to thank the following reviewers for their significant contributions: Robert Vaughn Diamond, American River College Christine Mooney, Queensborough Community College

This page intentionally left blank

BRIEF CONTENTS Part I: The Personal Financial Planning Process . . . . . . . . . . . . . . . . . . . 1

1. Personal Financial Planning in Action. . . . . . . . . . . . . . . . . . . . . . . . . 1

2. Money Management Strategies and Skills . . . . . . . . . . . . . . . . . . . . . 22

3. Managing Your Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

Part II: Managing Your Personal Finances . . . . . . . . . . . . . . . . . . . . . . . 75 4. Managing Your Cash and Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

5. Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

6. Using Consumer Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

7. Making Automobile and Housing Decisions . . . . . . . . . . . . . . . . . . 158

Part III: Protecting Yourself with Insurance. . . . . . . . . . . . . . . . . . . . . 190 8. Insuring Your Home and Automobile . . . . . . . . . . . . . . . . . . . . . . . 190

9. Health and Disability Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

10. Financial Planning with Life Insurance . . . . . . . . . . . . . . . . . . . . . 247

Part IV: Managing Your Investments and Your Future . . . . . . . . . . . . . 278 11. Investment Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278

12. Investing in Stocks and Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 307

13. Investing in Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351

14. Planning for Retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380

15. Preserving Your Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404

Endnotes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478

CONTENTS Part I: The Personal Financial Planning Process . . . . . . . . . . . . . . . . . . . . . . . . 1

1. Personal Financial Planning in Action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.1 The Personal Financial Planning Process . . . . . . . . . . . . . . . . . 2 1.1.1 Step 1: Analyze Your Current Financial Position . . . . 3 1.1.2 Step 2: Develop Short-term and Long-term

Financial Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 1.1.3 Step 3: Identify and Evaluate Alternative Strategies

for Achieving Your Goals . . . . . . . . . . . . . . . . . . . . . 4 1.1.4 Step 4: Implement a Plan for Achieving

Your Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 1.1.5 Step 5: Regularly Reevaluate and Revise Your

Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1.2 Factors That Influence Personal Financial Planning . . . . . . . . . 6 1.2.1 Changing Needs over the Life Cycle . . . . . . . . . . . . 6 1.2.2 Values and Attitudes . . . . . . . . . . . . . . . . . . . . . . . . 7 1.2.3 Life Situation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 1.2.4 General Economic Conditions . . . . . . . . . . . . . . . . . 8

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1.3 Elements of a Comprehensive Financial Plan . . . . . . . . . . . . . 12

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1.4 Making Effective Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . 13 1.4.1 Make Reasonable Assumptions . . . . . . . . . . . . . . . 13 1.4.2 Apply Marginal Reasoning . . . . . . . . . . . . . . . . . . . 14 1.4.3 Consider Opportunity Costs . . . . . . . . . . . . . . . . . 14 1.4.4 Use Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . 15

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2. Money Management Strategies and Skills . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

2.1 Collecting and Organizing Your Financial Information . . . . . 23 2.1.1 Why You Need to Save Bills and Documents . . . . . . 23

2.1.2 How Long You Should Save Documents . . . . . . . . 23 2.1.3 Where You Should Keep Documents . . . . . . . . . . . 24

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2.2 Using Personal Financial Statements . . . . . . . . . . . . . . . . . . . 25 2.2.1 Preparing a Personal Balance Sheet . . . . . . . . . . . . 25 2.2.2 Valuing Your Assets and Debts . . . . . . . . . . . . . . . . 26 2.2.3 Calculating Your Net Worth. . . . . . . . . . . . . . . . . . 28 2.2.4 Preparing a Personal Cash Flow Statement . . . . . . 29

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

2.3 Using Financial Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 2.3.1 Measuring Liquidity. . . . . . . . . . . . . . . . . . . . . . . . 33 2.3.2 Measuring Debt Usage . . . . . . . . . . . . . . . . . . . . . . 34 2.3.3 Measuring Savings . . . . . . . . . . . . . . . . . . . . . . . . . 36

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

3. Managing Your Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

3.1 The Basics of Federal Income Tax . . . . . . . . . . . . . . . . . . . . . 43 3.1.1 The Progressive U.S. Tax System . . . . . . . . . . . . . . 43 3.1.2 The Internal Revenue Service. . . . . . . . . . . . . . . . . 44 3.1.3 Tax Rate Schedules . . . . . . . . . . . . . . . . . . . . . . . . 45 3.1.4 Inflation Indexing of Tax Brackets . . . . . . . . . . . . . 47 3.1.5 The Marginal Tax Effect . . . . . . . . . . . . . . . . . . . . . 48

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

3.2 Calculating Taxable Income and Taxes Owed. . . . . . . . . . . . . 48 3.2.1 Reporting Income . . . . . . . . . . . . . . . . . . . . . . . . . 49 3.2.2 Adjusted Gross Income . . . . . . . . . . . . . . . . . . . . . 51 3.2.3 Standard vs. Itemized Deductions . . . . . . . . . . . . . 52 3.2.4 Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 3.2.5 Final Calculation of Taxes Owed . . . . . . . . . . . . . . 54 3.2.6 Paying Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

3.3 Filing Your Federal Tax Return . . . . . . . . . . . . . . . . . . . . . . . 58 3.3.1 Filing Status. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 3.3.2 Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 3.3.3 Age . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 3.3.4 When and Where to File Taxes . . . . . . . . . . . . . . . 60 3.3.5 IRS Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

CONTENTS xvii

3.3.6 The Most Common Filing Errors . . . . . . . . . . . . . . 61

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

3.4 Tax Planning Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 3.4.1 Tax Evasion vs. Tax Avoidance. . . . . . . . . . . . . . . . 63 3.4.2 Reducing Taxable Income . . . . . . . . . . . . . . . . . . . 64 3.4.3 Defering Taxable Income . . . . . . . . . . . . . . . . . . . . 65 3.4.4 Receiving Income That Is Subject to Lower

Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 3.4.5 Increasing Deductions and Exemptions

from Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 3.4.6 Maximizing Tax Credits . . . . . . . . . . . . . . . . . . . . . 67

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Part II: Managing Your Personal Finances . . . . . . . . . . . . . . . . . . . . . . . . 75

4. Managing Your Cash and Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

4.1 Objectives of Cash Management . . . . . . . . . . . . . . . . . . . . . . 76 4.1.1 Managing Transactions . . . . . . . . . . . . . . . . . . . . . 77 4.1.2 Preparing for Cash Emergencies . . . . . . . . . . . . . . 77 4.1.3 Making Temporary Investments. . . . . . . . . . . . . . . 78 4.1.4 How Much Should You Hold in Cash?. . . . . . . . . . 78

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

4.2 Rules of Effective Cash Management . . . . . . . . . . . . . . . . . . . 79 4.2.1 Balancing Your Checkbook Every Month. . . . . . . . 79 4.2.2 Paying Your Bills on Time . . . . . . . . . . . . . . . . . . . 80 4.2.3 Paying Yourself First . . . . . . . . . . . . . . . . . . . . . . . 80 4.2.4 Evaluating Alternative Accounts

and Providers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

4.3 Selecting a Financial Institution . . . . . . . . . . . . . . . . . . . . . . . 81 4.3.1 Depository Institutions . . . . . . . . . . . . . . . . . . . . . 81 4.3.2 Nondepository Institutions . . . . . . . . . . . . . . . . . . 84 4.3.3 Evaluating Financial Institutions . . . . . . . . . . . . . . 85

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

4.4 Cash Management Products and Services. . . . . . . . . . . . . . . . 86 4.4.1 Checking Accounts . . . . . . . . . . . . . . . . . . . . . . . . 87 4.4.2 Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . 88

xviii CONTENTS

CONTENTS xix

4.4.3 Savings Alternatives . . . . . . . . . . . . . . . . . . . . . . . . 89 4.4.4 Other Cash Management Products

and Services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 4.4.5 Evaluating Your Options . . . . . . . . . . . . . . . . . . . . 94

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

4.5 Resolving Cash Management Problems . . . . . . . . . . . . . . . . . 96 4.5.1 Bouncing a Check… . . . . . . . . . . . . . . . . . . . . . . . 96 4.5.2 Receiving a Bad Check…. . . . . . . . . . . . . . . . . . . . 97 4.5.3 Discovering Fraudulent Activity on

Your Account…. . . . . . . . . . . . . . . . . . . . . . . . . . . 97 4.5.4 Stopping Payment on a Check… . . . . . . . . . . . . . . 98 4.5.5 Getting Money in a Hurry… . . . . . . . . . . . . . . . . . 98

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

5. Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

5.1 What Is Consumer Credit?. . . . . . . . . . . . . . . . . . . . . . . . . . 107 5.1.1 Advantages of Consumer Credit . . . . . . . . . . . . . 108 5.1.2 Disadvantages of Consumer Credit . . . . . . . . . . . 109 5.1.3 Consumer Credit and the Economy. . . . . . . . . . . 109

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

5.2 Types of Consumer Credit . . . . . . . . . . . . . . . . . . . . . . . . . . 111

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

5.3 Applying for Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 5.3.1 The Five C’s of Credit . . . . . . . . . . . . . . . . . . . . . 113 5.3.2 If You Are Denied Credit . . . . . . . . . . . . . . . . . . . 115

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

5.4 Protecting Your Credit and Correcting Credit Mistakes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 5.4.1 Rights in Obtaining Credit. . . . . . . . . . . . . . . . . . 116 5.4.2 Credit Reporting . . . . . . . . . . . . . . . . . . . . . . . . . 116 5.4.3 Correcting Errors on a Credit Report . . . . . . . . . . 117 5.4.4 Billing Statements and Debt Collection . . . . . . . . 118

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118

5.5 Credit Cards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 5.5.1 Types of Cards and Contract Terms . . . . . . . . . . . 119 5.5.2 Choosing Cards Based on APR. . . . . . . . . . . . . . . 123

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

5.6 Advantages and Disadvantages of Credit Card Use. . . . . . . . 124 5.6.1 Advantages of Using Credit Cards . . . . . . . . . . . . 124 5.6.2 Disadvantages of Using Credit Cards . . . . . . . . . . 125

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133

6. Using Consumer Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

6.1 Characteristics of Consumer Loans . . . . . . . . . . . . . . . . . . . 135 6.1.1 Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 6.1.2 Payment Arrangements . . . . . . . . . . . . . . . . . . . . 136 6.1.3 Secured and Unsecured Loans . . . . . . . . . . . . . . . 136

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

6.2 Types of Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . . . . 137 6.2.1 Home Equity Loans . . . . . . . . . . . . . . . . . . . . . . . 137 6.2.2 Automobile Loans . . . . . . . . . . . . . . . . . . . . . . . . 139 6.2.3 Student Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

6.3 Sources of Consumer Loans . . . . . . . . . . . . . . . . . . . . . . . . . 142 6.3.1 Depository Institutions . . . . . . . . . . . . . . . . . . . . 142 6.3.2 Consumer and Sales Finance

Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 6.3.3 Other Sources of Consumer Loans. . . . . . . . . . . . 143

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144

6.4 Managing Your Debts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 6.4.1 Signs of Credit Trouble . . . . . . . . . . . . . . . . . . . . 145 6.4.2 Getting Out of Debt. . . . . . . . . . . . . . . . . . . . . . . 146

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

6.5 Declaring Personal Bankruptcy . . . . . . . . . . . . . . . . . . . . . . 149

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

xx CONTENTS

CONTENTS xxi

7. Making Automobile and Housing Decisions. . . . . . . . . . . . . . . . . . . . . . . . . . . 158

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

7.1 Buying a Motor Vehicle . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 7.1.1 Preparing to Shop . . . . . . . . . . . . . . . . . . . . . . . . 160 7.1.2 Evaluating Alternatives . . . . . . . . . . . . . . . . . . . . 162 7.1.3 Determining Purchase Price. . . . . . . . . . . . . . . . . 165 7.1.4 Resolving Consumer Complaints . . . . . . . . . . . . . 167

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

7.2 Automobile Financing Alternatives . . . . . . . . . . . . . . . . . . . 167 7.2.1 Basics of Leasing an Auto. . . . . . . . . . . . . . . . . . . 168 7.2.2 Important Lease Terminology . . . . . . . . . . . . . . . 168

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

7.3 The Housing Decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170 7.3.1 The Rent vs. Buy Decision . . . . . . . . . . . . . . . . . . 170 7.3.2 The Costs of Home Ownership . . . . . . . . . . . . . . 171

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

7.4 Buying a Home . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174 7.4.1 Choosing a Real Estate Broker . . . . . . . . . . . . . . . 174 7.4.2 Your Legal Relationship with a

Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

7.5 Mortgage Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 7.5.1 Types of Mortgages . . . . . . . . . . . . . . . . . . . . . . . 177 7.5.2 Factors Affecting Mortgage Payments. . . . . . . . . . 179 7.5.3 The Mortgage Application . . . . . . . . . . . . . . . . . . 181 7.5.4 Refinancing a Mortgage . . . . . . . . . . . . . . . . . . . . 181

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

7.6 Completing a Real Estate Transaction. . . . . . . . . . . . . . . . . . 183 7.6.1 The Closing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183 7.6.2 Closing Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189

Part III: Protecting Yourself with Insurance. . . . . . . . . . . . . . . . . . . . . . 190

8. Insuring Your Home and Automobile . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

8.1 How Insurance Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

8.1.1 Risk Pooling and Insurance . . . . . . . . . . . . . . . . . 191 8.1.2 Insurance Premiums . . . . . . . . . . . . . . . . . . . . . . 192 8.1.3 Insurance Policies and Terminology. . . . . . . . . . . 193

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194

8.2 Managing Homeowners’ and Renters’ Risk. . . . . . . . . . . . . . 194

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

8.3 Homeowner’s Insurance Policies . . . . . . . . . . . . . . . . . . . . . 197 8.3.1 Homeowner’s Insurance Forms and

Coverages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 8.3.2 Pricing of Homeowner’s Insurance. . . . . . . . . . . . 199

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202

8.4 Automobile Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202 8.4.1 Managing Automobile Risks . . . . . . . . . . . . . . . . 202 8.4.2 The Personal Automobile Policy (PAP). . . . . . . . . 204 8.4.3 No-Fault Auto Insurance . . . . . . . . . . . . . . . . . . . 205 8.4.4 Auto Insurance Premiums . . . . . . . . . . . . . . . . . . 207 8.4.5 What to Do If You Have an Auto Accident. . . . . . 208

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

8.5 Buying Insurance and Filing Claims. . . . . . . . . . . . . . . . . . . 209 8.5.1 Finding Agents and Insurers . . . . . . . . . . . . . . . . 209 8.5.2 Getting Price Quotes . . . . . . . . . . . . . . . . . . . . . . 210 8.5.3 Making a Claim on Your Insurance . . . . . . . . . . . 210

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

9. Health and Disability Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219

9.1 Employee Compensation and Health Insurance. . . . . . . . . . 219 9.1.1 Why Benefits Are Preferable to Cash

Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 9.1.2 Advantages of Group Insurance . . . . . . . . . . . . . . 220 9.1.3 Expected Health Costs. . . . . . . . . . . . . . . . . . . . . 221 9.1.4 National Trends in Health Costs . . . . . . . . . . . . . 222 9.1.5 Strategies for Controlling Health-Care Costs . . . . 224

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

9.2 Types of Health Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . 225 9.2.1 Fee-for-Service Plans . . . . . . . . . . . . . . . . . . . . . . 226 9.2.2 Managed-Care Plans . . . . . . . . . . . . . . . . . . . . . . 228 9.2.3 Consumer Choice Plans. . . . . . . . . . . . . . . . . . . . 230

xxii CONTENTS

CONTENTS xxiii

9.2.4 Government-Sponsored Plans . . . . . . . . . . . . . . . 230 9.2.5 Dealing with Special Circumstances. . . . . . . . . . . 234 9.2.6 Additional Types of Insurance . . . . . . . . . . . . . . . 235

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236

9.3 Planning for Disability Income Needs . . . . . . . . . . . . . . . . . 236 9.3.1 What Is Disability?. . . . . . . . . . . . . . . . . . . . . . . . 236 9.3.2 Sources of Disability Income . . . . . . . . . . . . . . . . 237

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246

10. Financial Planning with Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248

10.1 What Is Life Insurance? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248 10.1.1 How Life Insurance Works . . . . . . . . . . . . . . . . . 248 10.1.2 How Life Insurance Differs from

Other Insurance. . . . . . . . . . . . . . . . . . . . . . . . . . 249

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251

10.2 Determining Your Life Insurance Needs. . . . . . . . . . . . . . . . 251 10.2.1 What Are the Odds? . . . . . . . . . . . . . . . . . . . . . . 251 10.2.2 Why Buy Life Insurance? . . . . . . . . . . . . . . . . . . . 252 10.2.3 Factors That Affect Your Life Insurance Needs . . . 253 10.2.4 Approaches to Life Insurance Needs Analysis . . . 253

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258

10.3 Choosing Life Insurance Companies and Policies. . . . . . . . . 258 10.3.1 Term Life Insurance . . . . . . . . . . . . . . . . . . . . . . . 258 10.3.2 Permanent Life Insurance . . . . . . . . . . . . . . . . . . 260

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264

10.4 Buying Life Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264 10.4.1 Choosing an Insurer . . . . . . . . . . . . . . . . . . . . . . 265 10.4.2 Choosing an Agent . . . . . . . . . . . . . . . . . . . . . . . 265

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

10.5 Important Provisions in a Life Insurance Contract . . . . . . . . 267 10.5.1 Grace Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 10.5.2 Policy Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267 10.5.3 Incontestable Clause . . . . . . . . . . . . . . . . . . . . . . 268 10.5.4 Policyholder Dividends . . . . . . . . . . . . . . . . . . . . 268 10.5.5 Entire Contract Clause. . . . . . . . . . . . . . . . . . . . . 268 10.5.6 Nonforfeiture. . . . . . . . . . . . . . . . . . . . . . . . . . . . 268

10.5.7 Reinstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 10.5.8 Beneficiaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269 10.5.9 Suicide Clause . . . . . . . . . . . . . . . . . . . . . . . . . . . 270 10.5.10 Waiver of Premium . . . . . . . . . . . . . . . . . . . . . . . 270 10.5.11 Accelerated (or Living) Benefits . . . . . . . . . . . . . . 270 10.5.12 Accidental Death Benefit . . . . . . . . . . . . . . . . . . . 270 10.5.13 Guaranteed Purchase Option. . . . . . . . . . . . . . . . 271 10.5.14 Settlement Options . . . . . . . . . . . . . . . . . . . . . . . 271

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

Part IV: Managing Your Investments and Your Future . . . . . . . . . . . . . . . 278

11. Investment Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279

11.1 Developing Realistic Investment Goals. . . . . . . . . . . . . . . . . 279 11.1.1 Establishing a Firm Foundation. . . . . . . . . . . . . . 279 11.1.2 Investing to Meet Your Prioritized Goals . . . . . . . 280 11.1.3 Getting the Money to Invest . . . . . . . . . . . . . . . . 281

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284

11.2 Understanding Your Investment Alternatives . . . . . . . . . . . . 284 11.2.1 The Advantages and Disadvantages of Lending . . 284 11.2.2 The Advantages and Disadvantages of Owning . . 285 11.2.3 The Major Asset Classes. . . . . . . . . . . . . . . . . . . . 285

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289

11.3 Factors That Reduce Investment Risk . . . . . . . . . . . . . . . . . 289 11.3.1 The Risk/Return Trade-off . . . . . . . . . . . . . . . . . . 290 11.3.2 Measuring Risk and Return for Individual

Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290 11.3.3 Risk Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . 291 11.3.4 Reducing Risk in a Portfolio . . . . . . . . . . . . . . . . 293

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296

11.4 Establishing Your Investment Strategy . . . . . . . . . . . . . . . . . 297 11.4.1 Active vs. Passive Investing . . . . . . . . . . . . . . . . . 297 11.4.2 Passive Investing Strategies . . . . . . . . . . . . . . . . . 299

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

xxiv CONTENTS

CONTENTS xxv

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

12. Investing in Stocks and Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308

12.1 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 12.1.1 What Is Common Stock and Why Is

It Issued? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308 12.1.2 Stockholder Rights and Obligations. . . . . . . . . . . 309 12.1.3 The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . 311

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

12.2 Classification of Common Stock . . . . . . . . . . . . . . . . . . . . . 314 12.2.1 Income vs. Growth Stocks . . . . . . . . . . . . . . . . . . 314 12.2.2 Blue Chip Stocks . . . . . . . . . . . . . . . . . . . . . . . . . 314 12.2.3 Cyclical vs. Defensive Stocks . . . . . . . . . . . . . . . . 315 12.2.4 Industry and Sector Stocks . . . . . . . . . . . . . . . . . 315 12.2.5 Market Capitalization . . . . . . . . . . . . . . . . . . . . . 315

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

12.3 Buying and Selling Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . 317 12.3.1 Looking Up a Stock Price . . . . . . . . . . . . . . . . . . 317 12.3.2 Placing an Order . . . . . . . . . . . . . . . . . . . . . . . . . 317 12.3.3 Selling Long vs. Selling Short. . . . . . . . . . . . . . . . 320 12.3.4 Full-Service vs. Discount Brokerage Firms. . . . . . 320 12.3.5 Brokerage Accounts . . . . . . . . . . . . . . . . . . . . . . . 321

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

12.4 Stock Selection and Performance Evaluation . . . . . . . . . . . . 323 12.4.1 Measuring Expected Stock Returns . . . . . . . . . . . 323 12.4.2 Measuring Stock Risk . . . . . . . . . . . . . . . . . . . . . 324 12.4.3 Evaluating Portfolio Performance Against Stock

Indexes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328

12.5 Investing in Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328 12.5.1 Advantages of Owning Bonds . . . . . . . . . . . . . . . 328 12.5.2 Bond Terminology . . . . . . . . . . . . . . . . . . . . . . . . 329 12.5.3 The Bond Market. . . . . . . . . . . . . . . . . . . . . . . . . 332 12.5.4 Types of Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . 332 12.5.5 Classification of Bond by Characteristics . . . . . . . 334

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

12.6 Buying and Selling Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . 337 12.6.1 Bond Risk in a Diversified Portfolio . . . . . . . . . . . 338 12.6.2 Bond Investment Strategies . . . . . . . . . . . . . . . . . 338 12.6.3 A Bond Transaction . . . . . . . . . . . . . . . . . . . . . . . 339

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

12.7 Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

13. Investing in Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352

13.1 What is a Mutual Fund?. . . . . . . . . . . . . . . . . . . . . . . . . . . . 352 13.1.1 The Increasing Popularity of Mutual Funds . . . . . 353 13.1.2 The Advantages of Mutual Fund Investing. . . . . . 357 13.1.3 The Costs of Mutual Fund Investing . . . . . . . . . . 360

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

13.2 Mutual Fund Investment Classifications . . . . . . . . . . . . . . . 363 13.2.1 Classification by Investment Objective . . . . . . . . 363 13.2.2 Classification by Portfolio Composition . . . . . . . . 365

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367

13.3 Selecting and Evaluating Mutual Funds . . . . . . . . . . . . . . . . 367 13.3.1 Matching Fund Classification with

Investment Objective. . . . . . . . . . . . . . . . . . . . . . 367 13.3.2 Identifying Fund Alternatives . . . . . . . . . . . . . . . 370 13.3.3 Comparing Funds Based on Key Factors . . . . . . . 370 13.3.4 Determining How Many Funds to

Invest In . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371 13.3.5 The Mutual Fund Transaction . . . . . . . . . . . . . . . 371 13.3.6 Tracking Your Portfolio . . . . . . . . . . . . . . . . . . . . 373

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 377

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378

14. Planning for Retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381

14.1 Estimating Retirement Income Needs . . . . . . . . . . . . . . . . . 381 14.1.1 Determining Your Retirement Goals. . . . . . . . . . . 381 14.1.2 Determining Your Expenses in Retirement. . . . . . 384 14.1.3 Adjusting for Inflation . . . . . . . . . . . . . . . . . . . . . 385

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386

xxvi CONTENTS

CONTENTS xxvii

14.2 Sources of Retirement Income . . . . . . . . . . . . . . . . . . . . . . . 386 14.2.1 Estimating Your Benefits from

Employer-Sponsored Plans . . . . . . . . . . . . . . . . . 388 14.2.2 Estimating Your Social Security Benefits . . . . . . . 389 14.2.3 How Much Nest Egg Will Be Enough?. . . . . . . . . 393

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393

14.3 Personal Retirement Savings Options. . . . . . . . . . . . . . . . . . 394 14.3.1 Individual Retirement Accounts. . . . . . . . . . . . . . 394 14.3.2 Investing in Taxable Accounts . . . . . . . . . . . . . . . 396 14.3.3 Asset Allocation in Retirement Accounts . . . . . . . 396

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397

14.4 Preparing for Retirement Payouts. . . . . . . . . . . . . . . . . . . . . 397 14.4.1 Distributions from Retirement Accounts . . . . . . . 398 14.4.2 Tapping Your Home Equity . . . . . . . . . . . . . . . . . 398 14.4.3 What Happens if You Don’t Have Enough

Money to Retire? . . . . . . . . . . . . . . . . . . . . . . . . . 399

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403

15. Preserving Your Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405

15.1 What is Estate Planning? . . . . . . . . . . . . . . . . . . . . . . . . . . . 405 15.1.1 The Estate-Planning Process . . . . . . . . . . . . . . . . 405 15.1.2 What Happens if You Fail to Plan?. . . . . . . . . . . . 406 15.1.3 Estate Planning over the Life Cycle . . . . . . . . . . . 407

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408

15.2 Key Components of an Estate Plan. . . . . . . . . . . . . . . . . . . . 408 15.2.1 The Will . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 408 15.2.2 The Living Will or Durable Power

of Attorney . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409 15.2.3 The Letter of Last Instruction. . . . . . . . . . . . . . . . 410 15.2.4 Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411

15.3 Types and Formats of Wills . . . . . . . . . . . . . . . . . . . . . . . . . 411 15.3.1 Preparing a Valid Will . . . . . . . . . . . . . . . . . . . . . 412 15.3.2 Passing Property Outside a Will. . . . . . . . . . . . . . 416

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417

15.4 Estate and Gift Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417 15.4.1 Federal Gift Taxes . . . . . . . . . . . . . . . . . . . . . . . . 418 15.4.2 Federal Estate Taxes. . . . . . . . . . . . . . . . . . . . . . . 418

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421

15.5 Reducing Taxes Through Trusts and Gifts . . . . . . . . . . . . . . 421 15.5.1 When Are Trusts Useful? . . . . . . . . . . . . . . . . . . . 422 15.5.2 Revocable vs. Irrevocable Trusts. . . . . . . . . . . . . . 422 15.5.3 Living vs. Testamentary Trusts . . . . . . . . . . . . . . . 422 15.5.4 Charitable Trusts . . . . . . . . . . . . . . . . . . . . . . . . . 424 15.5.5 Gifting Alternatives . . . . . . . . . . . . . . . . . . . . . . . 425

Self-Check . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426

Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426

Summary Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428

Applying This Chapter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 429

You Try It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 431

Endnotes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432

Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 433

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478

xxviii CONTENTS

1 PERSONAL FINANCIAL PLANNING IN ACTION Developing a Personal Financial Plan

Starting Point

Go to www.wiley.com/college/bajtelsmit to assess your knowledge of developing a personal financial plan. Determine where you need to concentrate your effort.

What You’ll Learn in This Chapter ▲ Personal financial planning and decision-making strategies ▲ Factors that influence financial planning ▲ The stages of successful financial planning

After Studying This Chapter, You’ll Be Able To ▲ List the five steps in the personal financial planning process ▲ Examine the factors that influence personal financial planning decisions ▲ Begin to construct a comprehensive financial plan ▲ Consider opportunity costs and marginal effects in making personal finance

decisions

www.wiley.com/college/bajtelsmit
2 PERSONAL FINANCIAL PLANNING IN ACTION

INTRODUCTION Knowing how to manage your finances can help you be more successful in life. In this chapter, we first look at the five-step financial planning process and then the factors that influence it, and we discuss the elements of a comprehensive finan- cial plan. Finally, we explore strategies for making effective financial decisions. With this framework, you will be able to gain the tools for successful personal financial management.

1.1 The Personal Financial Planning Process

In your life, you’ve probably already faced some financial challenges. For example, maybe you’ve asked yourself one or more of the following questions:

▲ Should I take out a student loan to pay for college expenses? ▲ How can I get out from under my credit card debt? ▲ Can I afford to replace my car’s transmission? ▲ Where should I buy my auto insurance? ▲ Would graduate school be a good investment for me? ▲ How much should I contribute to my 401(k) retirement plan? ▲ Should I start a savings plan to fund my child’s college education? ▲ How do I decide among the employee benefit options that my employer

offers?

These questions are all related to personal finance—a specialized area of study that focuses on individual and household financial decisions, such as budgeting, saving, spending, insurance, and investments. Understanding these topics will help you in many ways. For example, you’ll make better decisions when you buy an auto, shop for a home mortgage, choose a career, and save for retirement. You may also be able to pay less in taxes and interest. Personal financial planning is the process of devel- oping and implementing an integrated, comprehensive plan designed to meet finan- cial goals, to improve financial well-being, and to prepare for financial emergencies.

The primary goal of personal financial planning is to develop and achieve financial goals, such as

▲ Buying a first home or a bigger home. ▲ Making a major consumer purchase. ▲ Supporting a growing family. ▲ Preparing financially for retirement.

People who have their finances in order gain important social and psychological benefits as well. Generally, they feel less stressed and experience improved

1.1 THE PERSONAL FINANCIAL PLANNING PROCESS 3

relationships with friends, family members, and coworkers. As many couples know, financial difficulties are a major contributor to marital problems. Most peo- ple also find that the self-sufficiency that eventually results from good financial planning improves their self-esteem.

In this section, we introduce the five-step personal financial planning process (see Figure 1-1) and examine each step in detail. It’s important as you read about the steps to recognize the circular flow of the planning process. Although you use the process to develop a personal financial plan, your plan won’t ever be a finished product; you’ll need to reevaluate and revise it continually as your life circumstances change. The process of personal financial planning is a lifelong activity.

1.1.1 Step 1: Analyze Your Current Financial Position

At the end of the month, many people struggle to meet their expenses. “Where did all the money go?” is a common lament. Before you can move forward with your financial plan, you need to determine where your money is coming from and where it is going.

Analyzing your current financial position requires that you take the following steps:

1. Collect and organize all your financial information. 2. Create personal financial statements. 3. Quantitatively evaluate your current financial position to establish a base-

line against which you can measure improvement in the future.

This last step may involve hard work for those who are “organizationally challenged.” Nevertheless, careful record keeping is vital to good financial planning, because it enables you to track actual expenditures and identify

Figure 1-1

The five-step financial planning process.

Step 5. Reevaluate and revise your plan as needed.

Step 1.

Analy ze your

current

finance s.

Step 2.

Develop goals.

Step 3. Identify and evaluate strategies to achieve

your goals.

Step 4.Establish andimplement your plan.

4 PERSONAL FINANCIAL PLANNING IN ACTION

small financial problems before they turn into big ones. In Chapter 2, we explain how to analyze your current finances to determine your financial condition.

1.1.2 Step 2: Develop Short-Term and Long-Term Financial Goals

Everyone has a personal conception of “success.” Have you thought about where you want to be 5 years from now? 10 years from now? For some, suc- cess may be defined in monetary terms and for others, in levels of personal satisfaction. However you define success, the second step in the personal finan- cial planning process requires that you identify and prioritize specific goals and objectives.

The process of setting goals should involve some introspective assessment of why you have the goals you have. For example, are your objectives focused on your own needs or the needs of others? Are your objectives related to pressures from family members or peers?

Keep in mind that short-term and long-term goals change over time and may be influenced by changes in economic circumstances.

1.1.3 Step 3: Identify and Evaluate Alternative Strategies for Achieving Your Goals

Although every person’s goals and objectives are unique to his or her circum- stances, the strategies for achieving them are similar from person to person. In general, in order to have more money available to meet current or future goals, you either have to reduce spending or increase earnings. Step 3 in the personal financial planning process requires that you identify alternative strategies for achieving goals and compare the costs and benefits of each.

1.1.4 Step 4: Implement a Plan for Achieving Your Goals

Using the information developed in step 3, you are now prepared to decide on the best strategies for achieving your goals so that you can implement your plan. How do you make such decisions? How do you know which strategies are the best ones for achieving your goals? You acquire fundamental knowl- edge and master analytical tools that help you to make effective personal finan- cial planning decisions. The result will be a personal financial plan that meets your basic household needs, builds wealth over time, and protects your income and assets.

1.1.5 Step 5: Regularly Reevaluate and Revise Your Plan

Many changes occur over the course of your life. Not only do changes in your personal circumstances (e.g., graduation, a new job, marriage, children) affect

1.1 THE PERSONAL FINANCIAL PLANNING PROCESS 5

your financial planning objectives and strategies, but economic conditions may necessitate revision of the plan as well. An effective financial plan must be adapt- able to changing circumstances. Thus, step 5 takes you continually back to steps 1 through 4.

1. Define personal finance and personal financial planning.

2. List the five steps of the personal financial planning process.

S E L F - C H E C K

FOR EXAMPLE

When Goals Must Change In 2006, Jack Naughton was employed as a superintendent for a large resi- dential construction firm. He and his wife lived comfortably on his $50,000 salary and felt lucky that he had been able to work his way up in the busi- ness, despite his lack of a college degree. They had recently stretched their finances to buy a larger house, and they planned to increase their retirement account contributions and to begin a college savings plan for their daughter.

Due to a real estate downturn, Jack was unexpectedly laid off from his job, and the Naughtons’ goals had to change drastically. Instead of retirement and college savings, their new goals were to pay their bills and find a new job for Jack. After his layoff, Jack found a new job but had to take a significant pay cut, and his earnings no longer covered the family’s expenses. To meet expenses, the Naughtons might use one or more of the following strategies:

▲ Mrs. Naughton could get a job. ▲ They could sell the house or possibly refinance it at a lower inter-

est rate to reduce their monthly mortgage payments. ▲ They could sell other assets. ▲ They could dip into savings. ▲ They could borrow money.

Each of these strategies has costs and benefits that must be carefully iden- tified and evaluated.

6 PERSONAL FINANCIAL PLANNING IN ACTION

1.2 Factors That Influence Personal Financial Planning

As you build your financial plan, you need to consider many factors that influ- ence your spending and saving behavior. Some are unique to you, such as where you are in your life cycle, your family composition, your values, and your attitudes. Others, such as inflation and interest rates, affect everyone to some extent. Both types of factors can be expected to change over time, so your plan needs to continually adapt to new circumstances.

1.2.1 Changing Needs over the Life Cycle

Your household goes through several phases over your life cycle, and your finan- cial situation changes as well. Figure 1-2 illustrates how a person’s income and wealth might change over the life cycle. There are many different types of family situations. Although everyone’s situation is unique, for everyone, there are significant differences in planning needs over the life cycle.

In general, your income level through your early 20s is lower than it is later, and your wealth may even be negative—that is, you may have more debts than assets at this point in your life. That’s because you’re making investments in your education that have not yet paid off.

Marriage, career development, the purchase of a home, and investments in your children’s education will likely occur from your late 20s through your 40s.

Figure 1-2

Household income and wealth over the life cycle.

1,000,000 Household wealth

800,000

600,000

400,000

200,000

�200,000

0

0 15 30 45 Age

60 75 90

Household income

1.2 FACTORS THAT INFLUENCE PERSONAL FINANCIAL PLANNING 7

During this time, your household will focus on setting goals, establishing savings, and protecting the family against unexpected negative events, such as premature death or job loss due to illness or disability. This is also the beginning of the wealth accumulation phase, which continues through your 50s to early 60s.

As retirement approaches, most people in their 50s and 60s pay closer atten- tion to meeting retirement income and health needs and preserving wealth for their heirs. The earlier you plan for these needs, the better off you are when you get to that stage in the life cycle. During your retirement period, which generally begins at age 65, you decumulate, or spend, your accumulated wealth. Your goals during retirement may include maintaining an active lifestyle, including travel and leisure activities, and having sufficient income throughout your retirement period.

1.2.2 Values and Attitudes

People have different money styles—different values and attitudes regarding money and its use. A person’s money style is generally the result of both learned behav- iors and inherent tendencies. For example, if you were raised in a household where money was tight and consumer purchases were made with careful deliberation, you might carry the money skills learned from your parents’ example into your adult life.

Whether your parents were spendthrifts or tightwads, however, your own genetic makeup also affects your personal money style. Individuals who are impulsive by nature often have difficulty controlling their spending, just as those with a tendency to orderliness are more likely to have their finances in order. Thus, both nature and nurture help to form your values and attitudes toward money. In fact, it is not uncommon to find that siblings raised in the same house- holds have very different money styles. We explain here what we mean by values and attitudes:

▲ Values are fundamental beliefs about what is important in life. What do you think is most important: family, friends, things, education, religious faith, financial success, fame, health, self-sufficiency? The weight you place on each influences the goals you set and the strategies you develop to achieve your goals.

▲ Attitudes are opinions and psychological differences between people that affect their decisions. Are you an optimist or a pessimist? conservative or liberal? Do you like to have everything planned out in advance or just go with the flow?

Of particular importance to financial planning is your attitude toward risk, or uncertainty: Are you a risk-taker, or do you tend to avoid risk? What if you already know that you have a problem with money? Is it possible to overcome your biological makeup and your learned values and attitudes? Of course! You must first recognize what your values and attitudes are, particularly where they

8 PERSONAL FINANCIAL PLANNING IN ACTION

may run counter to achieving your goals. If you are a spender, you may need to approach your budget differently than someone who is naturally inclined to be more conservative in spending. Similarly, if you are a natural risk taker, you may need to learn to be more cautious, like someone who tends to avoid risk.

1.2.3 Life Situation

Family composition and demographic characteristics—such as age, marital sta- tus, income, and wealth—significantly affect financial planning. Households with children, for example, tend to have higher expenses and therefore less ability to save during their child-rearing years.

Children’s college expenses can take a big bite out of family savings. Double- income couples, particularly those with no children, tend to be better off financially than singles. Those without children are also more able to focus on career goals and therefore can more quickly move up the employment ladder. However, the financial and social support provided by children to their parents in old age may eventually offset the increased earlier costs.

Also, education plays a critical role in financial success. College-educated people, particularly those with specialized skills (e.g., business, education, engi- neering), tend to receive higher starting salaries and larger wage increases over their careers. White-collar employees are also more likely to receive retirement plans and benefits packages.

Demographic factors such as gender, age, income, and education have also often been linked to risk attitudes. If you are male, childless, educated, and high income you are more likely to be a risk taker.

1.2.4 General Economic Conditions

A fundamental truth about the economy is that it is very unpredictable. Even experts cannot say with certainty what the future may hold. Nevertheless, some factors in the economy have a known influence on personal finances, and it’s important for you to recognize these factors and incorporate them into your financial planning decisions. Many economic factors affect financial planning. Some factors that are highly likely to affect your future are

▲ Inflation. ▲ Interest rates. ▲ Employment conditions. ▲ Political unrest and global issues.

Everyone has at one time or another heard an older person say, “When I was a kid, it was a lot less expensive to . . . .” Such statements describe the effects of inflation, or the change in general price levels over time. Occasionally, we have a negative inflation rate—that is, the prices of goods and services actually decline over

1.2 FACTORS THAT INFLUENCE PERSONAL FINANCIAL PLANNING 9

a given period. Generally, however, inflation refers to an increase in prices. As prices of goods and services go up, the spending power of your money goes down—a dollar will not purchase as much as it previously did.

Inflation affects nearly every aspect of your finances. Your grocery bills are probably higher this year than they were last year. You’re likely paying more for gasoline now than in the past. Your monthly rent will probably go up next year, too. As prices of goods get higher over time, you can maintain your standard of living only if your income after taxes also rises by the same amount. For your standard of living to improve, your income must rise at a rate faster than the inflation rate. Inflation affects your investments as well. If the costs of goods rise at a rate of 4 percent, but your savings account is paying only 3 percent, then you are actually losing spending power.

For the overall U.S. market, inflation is measured by the change in the consumer price index (CPI), reported monthly by the Bureau of Labor Statis- tics. The CPI tracks prices of a representative basket of more than 400 goods and services used by urban households, including food, housing, consumer goods, gasoline, and clothing.

Whereas the price of a college education has tripled since 1980, that of gaso- line has increased only 78 percent over the same period. Depending on various factors, you may experience a larger or smaller change in expenses than the price changes indicated by the CPI. For example, some areas of the country have higher rates of inflation than average, primarily because of higher fuel and hous- ing costs. Housing in areas of the country that are in high demand can be extremely costly. According to the National Association of Realtors, at the end of 2005, the median price of a home in Indianapolis, Indiana was only $122,000, whereas the median resale price in San Francisco, California, was $718,700.

A person also has different demands for goods and services at different stages in the life cycle. For example, health care costs, which have risen at a much faster rate than other elements of the CPI, are a bigger component of a retiree’s expenses— 12.6 percent of total household expenses, compared with only 2.5 percent for those under age 25 and 4 percent for households aged 35 to 44. Housing costs, in con- trast, have less importance for retirees because many retirees have paid off their home mortgages. Furthermore, inflation can be particularly problematic for people on fixed incomes. If your retirement income doesn’t increase over time, but your expenses do, your standard of living gradually declines.

Although inflation has averaged 4.8 percent per year since 1970, the annual rates of inflation have ranged from 1.2 to 13.3 percent. Over that same period, the federal minimum wage rate has increased from $1.60 to $5.15, the equiva- lent of only 3.6 percent per year. Similarly, the average wage for production workers in private industry has increased 4.3 percent. These statistics illustrate an important economic reality—wages don’t always keep up with prices—and this is particularly true during periods of high inflation. For example, in 1979, when inflation hit a high of 13.3 percent, production workers’ average wages

10 PERSONAL FINANCIAL PLANNING IN ACTION

that year increased only 8.5 percent. Because 8.5 percent probably seemed like a good raise at the time, it’s likely that the average worker didn’t realize that his or her standard of living had actually declined.

Interest rates also affect general economic conditions. The interest rate is a measure of your earnings, or return, on an investment When you borrow money, the interest rate is a cost to you. Interest is usually expressed as a percentage of the amount lent or borrowed. Interest rates can also be thought of as a cost of spending money today instead of saving for tomorrow. How much additional money will you need to get in the future to be willing to delay spending that money on goods and services you can enjoy right now? For example, if your roommate asks you to lend him $1,000 and promises to pay you back exactly one year from now, how much will you require that he pay you at that time? If you have to take the money out of a savings account that pays you 4 percent interest per year, you’ll probably want him to pay you at least the $1,000 plus 4 percent interest. But what if lending him the money means that you will have to forego a trip to Mexico over spring break? How much additional money in the future will it take to convince you to give up spending the money on the trip now?

What makes interest rates go up or down? Like the prices of goods and ser- vices, interest rates are driven by supply and demand. When there is a lot of demand for borrowing but not a lot of money available to borrow, interest rates go up. In recessions, when businesses do not need or want to invest in growth, the demand for borrowing is lower, and rates may go down.

Actions taken by the Federal Reserve Bank (referred to as “the Fed”)—the central bank that controls the money supply in the United States—affect the

FOR EXAMPLE

How the Fed Moves Interest Rates Between 2000 and 2003, the Federal Reserve several times took action to lower the federal funds rate—the rate that banks charge each other for short-term loans—in an attempt to stimulate the sluggish economy. By reducing the rate from 6.5 to 1.0 percent gradually over that time period, the Federal Reserve actions reduced short-term borrowing rates, which in turn resulted in lower commercial loan and mortgage loan rates. These actions helped to pull the coun- try out of the recession. In June 2004, the Fed reversed this trend and began to increase rates. In addition to actions by the Federal Reserve, inflation and other economic conditions cause interest rates to go up and down over time, and, through a series of increases over the next two years, brought the rate back up to 5.25 percent by October 2006 in order to keep inflation in check.

1.2 FACTORS THAT INFLUENCE PERSONAL FINANCIAL PLANNING 11

finances of the average person, although they may not be aware of what the Fed is doing. Sometimes the Fed takes actions to increase or decrease the supply of money in the economy in order to manipulate the rate of interest on short-term, low-risk borrowed funds. When these rates go up, it becomes more expensive for people to obtain credit, to finance their mortgages, and to use credit cards. This slows down the economy. Conversely, lower rates increase economic activ- ity by making it easier for people to obtain credit.

Although the ups and downs in interest rates tend to track each other, there are differences among interest rates on various types of loans at any given time. These differences are primarily due to differences in risk. For example, what is the chance that payments will not be made on time or that a loan will not be repaid? The higher the chances, the riskier the loan and the higher the rate charged by lenders. If the borrower does not pay the loan as agreed, does the lender have any way of recouping the loan? If not, the loan is riskier than it would otherwise be. Consumer loans and credit cards are riskier in that the borrower is an indi- vidual rather than a financial institution and might be unable to pay if his or her financial situation changes in the future. However, car loans have much lower rates than credit cards because the bank normally has the right to take back the car in the event of nonpayment. The riskier the investment or loan, the higher the interest rate because the lender or investor must be compensated for the risk of not being repaid.

Your personal finances are also affected by cyclical business and employment conditions, known as the economic cycle, or the historical pattern of ups and downs common to the U.S. economy:

▲ A low point in the cycle is called a recession (or, in the extreme, a depression), and is characterized by reduced business investment and high unemployment rates.

▲ Economic expansion periods are characterized by increased business investment and employment opportunities.

FOR EXAMPLE

Boom and Bust in Silicon Valley During the technology boom of the 1990s, even undistinguished computer science majors had multiple job offers at graduation and were constantly bombarded by headhunters trying to entice them to different jobs for better pay and benefits. A few years later, new graduates in these fields were happy to get any job at all. Widespread layoffs at technology firms meant that new graduates were competing in the job market with individuals who had many more years of experience.

12 PERSONAL FINANCIAL PLANNING IN ACTION

In times of growth and low unemployment, salaries tend to rise more quickly, and there are better opportunities for advancement. Your future will be less sen- sitive to changes in employment conditions if you choose an area of study that is likely to have continuing strong demand over time. You can also minimize the risk of layoff by keeping your skills up-to-date.

Political and global factors can also affect your personal finances. For some time following September 11, 2001, the looming threat of terrorism had a neg- ative impact on the U.S. economy. The stock market, which had already seen substantial declines from its high of the previous year, continued to plummet, losing more than 20 percent of its value from September 2001 to September 2002; unemployment increased rapidly; and governmental spending on home- land security cut into state budgets.

1. Define inflation, CPI, interest rate, and federal funds rate.

2. List the personal factors that affect financial planning.

3. What is a low point in the business cycle called?

S E L F - C H E C K

1.3 Elements of a Comprehensive Financial Plan

There are four stages in developing a comprehensive financial plan, all of which are covered in various sections in this book:

1. Establishing a firm foundation: The first step to success in your per- sonal finances is to establish the necessary foundations, including an understanding of the personal financial planning process, the necessary tools, and the tax effects of your financial decisions.

2. Securing basic needs: The second step is to secure your basic needs. This step includes meeting your consumption and housing needs, setting aside funds for financial emergencies, protecting your assets with insur- ance, establishing a career path, and making educated employee benefits decisions.

3. Building wealth: After you have secured your basic needs, you can begin to think about wealth building to meet future needs, such as retirement and college funding. With financial security comes the need to protect your wealth.

1.4 MAKING EFFECTIVE DECISIONS 13

4. Protecting wealth and dependents: The final stage in the process of developing a comprehensive financial plan includes the protective elements of life insurance, long term care insurance, and estate planning.

1. What are the basic needs you need to meet after you have a finan- cial foundation?

2. What are four stages of a comprehensive financial plan?

S E L F - C H E C K

1.4 Making Effective Decisions

As you work on your financial plan, you need to make many important decisions. After you identify your goals, you need to make decisions about consumption, savings, and investment alternatives. These decisions can more effectively help you achieve your goals if you use these decision-making strategies:

▲ Base your decisions on reasonable assumptions: Don’t be unreasonably optimistic about your finances.

▲ Apply marginal reasoning: Marginal refers to the change in outcome or the additional benefit that will result from the decision you make.

▲ Consider opportunity costs: An opportunity cost is a measure of what you have to give up in order to take a particular action.

▲ Use sensitivity analysis: A sensitivity analysis asks the question “What effect would it have on my personal finances if my assumptions turned out to be wrong?”

Let’s look at each of these strategies in more detail.

1.4.1 Making Reasonable Assumptions

Most financial decisions require you to forecast, or predict, future events and economic circumstances: What will your needs be 5 or 10 or even 20 years from now? What will your family circumstances require from you financially? When will you retire? How long will you live? Which investments will perform best over time? What will the rate of inflation be in the future? What rate will you earn on your investments? What kinds of risks will you face?

Life is, of course, unpredictable. But even if you don’t know an outcome for certain, you can still use the information available to you to come up with a rea- sonable assumption. This is a critical component of successful decision making.

14 PERSONAL FINANCIAL PLANNING IN ACTION

FOR EXAMPLE

Retirement Squeeze Karen and Luke Amato were planning to retire in 2001, when both would reach the age of 65. They had invested all their retirement funds in the stock market over the 1990s, accumulating a total portfolio of about $1.5 million by the time the market reached its peak, an amount they thought would be more than adequate to meet their expected retirement needs. Unfortunately, one year later, they had to reconsider their plans because the value of their retirement nest egg had fallen by more than one-third, to less than $1 mil- lion. Although the Amatos might have limited their losses by moving their money to safer investments earlier, they, like many other investors, had unre- alistically clung to the hope that the stock market would recover. In fact, they were lucky—some investors experienced much larger losses. If they had applied more realistic assumptions, based on a longer-term history of stock market returns, the Amatos and others might have avoided such extreme losses and been able to retire as they had planned.

One of the biggest mistakes people make in their finances is that they are too optimistic in their assumptions. During the 1990s, the stock market enjoyed a long period of strong growth. Investors who had never experienced a market downturn actually thought that stocks would continue to earn such high rates of return indefinitely. Unreasonably optimistic investors eventually lost a large percentage of their investment portfolios when the market declined.

1.4.2 Applying Marginal Reasoning

In choosing among potential strategies to achieve your financial goals, it is important to apply marginal reasoning. The term marginal refers to the change in outcome, or the additional benefit, that will result from the decision you make.

Suppose you and your spouse share a car and you’re considering buying a second car. In applying marginal analysis, you need to consider only the addi- tional benefits that the second car brings and not the general benefits of having a car in the first place. Similarly, if you’re choosing between two possible cars, you need to consider how much extra benefit you would get from the more expensive of the two and balance that against the extra cost.

1.4.3 Considering Opportunity Costs

Every financial decision you make has an opportunity cost. An opportunity cost is a measure of what you have to give up in order to take a particular action. Opportunity costs can be personal costs, such as time and effort, but they are often financial costs, such as lost dollars or return on investment.

1.4 MAKING EFFECTIVE DECISIONS 15

As explained in Section 1.2.4, your spending decisions often involve a trade- off because if you spend money, you are giving up the interest you could have earned on the money if you had invested it instead. When you invest, your money earns interest. If you leave your money invested for long periods of time, your money earns compound interest, or interest on interest. So, if you earn 10 percent interest on $1000 for one year, you will have $1100 at the end of the year. But if you leave the interest in the account, you will earn the 10 percent interest on the entire $1,100, so your interest the second year will be $110. This allows it to grow faster and is often referred to as the time value of money. The opportunity cost of missing out on earning compound interest is an important component of financial decision making.

For example, suppose you’re faced with the decision of whether to take money from savings for your college education or to work while attending school to earn the money. If you choose to take money from savings, you give up what you could have earned on that investment—this is your opportunity cost. But if you otherwise would have to work 30 hours per week while you attend school, the lost investment earnings might be small relative to the personal costs you would incur—less time and energy to apply to your studies and extracurricular activities. Evaluating opportunity costs carefully results in better decisions.

1.4.4 Using Sensitivity Analysis

Suppose you are deciding on the purchase of a new home. Although the loan payment will be a bit of a stretch for you the first year, you anticipate that you

FOR EXAMPLE

The Power of Compound Interest Marie receives a tax refund of $3,000. She wants to use the money for a college fund for her daughter who is three years old. If she invests this in an account that earns 5% interest and leaves it to earn compound interest for 15 years, she can calculate the amount she will have at the end using the equation: Future value � Present Value � (1 � r)n. So, in fifteen years, Marie will have $6,237 � $3,000 � (1.05)15. As a shortcut to fig- uring out how much difference interest will make to your decisions, you can use Figure 1-3. Find the column for the interest rate you expect to earn on your investment and look down to the number in the row corre- sponding to the number of years you plan to leave the money invested. That number is the amount you can multiply times your original investment to determine how much it will grow to. If Marie could earn 8 percent on her investment, the multiplier from the table is 3.17, so her $3,000 will grow to $3,000 � 3.17 � $9,510.

16 PERSONAL FINANCIAL PLANNING IN ACTION

Figure 1-3

Future Value Multipliers

will get a good raise next year, which will make the payment affordable. But what if this assumption is wrong—what if you do not get the raise or, even worse, are laid off from your job?

Sensitivity analysis asks the question “What effect would it have on my personal finances if my assumptions turned out to be wrong?” By considering how the outcome might change with changes in other uncertain variables, you can reduce the risk that your plan will have an adverse impact on your finances.

Psychology research has shown that people exhibit different decision-making styles, many of which result in less-than-optimal outcomes. Even if you are nat- urally inclined to make decisions in a different way, you can still learn to apply the strategies and tools discussed in this chapter in order to make more effec- tive decisions.

1. List the decision-making strategies available to you for financial planning.

2. Define opportunity cost and sensitivity analysis.

S E L F - C H E C K

Years Interest Rate Earned on Investment

Invested 3% 4% 5% 6% 7% 8% 9% 10%

1 1.03 1.04 1.05 1.06 1.07 1.08 1.09 1.10 2 1.06 1.08 1.10 1.12 1.14 1.17 1.19 1.21 3 1.09 1.12 1.16 1.19 1.23 1.26 1.30 1.33 4 1.13 1.17 1.22 1.26 1.31 1.36 1.41 1.46 5 1.16 1.22 1.28 1.34 1.40 1.47 1.54 1.61 6 1.19 1.27 1.34 1.42 1.50 1.59 1.68 1.77 7 1.23 1.32 1.41 1.50 1.61 1.71 1.83 1.95 8 1.27 1.37 1.48 1.59 1.72 1.85 1.99 2.14 9 1.30 1.42 1.55 1.69 1.84 2.00 2.17 2.36

10 1.34 1.48 1.63 1.79 1.97 2.16 2.37 2.59 15 1.56 1.80 2.08 2.40 2.76 3.17 3.64 4.18 20 1.81 2.19 2.65 3.21 3.87 4.66 5.60 6.73 25 2.09 2.67 3.39 4.29 5.43 6.85 8.62 10.83 30 2.43 3.24 4.32 5.74 7.61 10.06 13.27 17.45

KEY TERMS 17

SUMMARY Personal financial planning can mean the difference between financial success in your life and problems down the road. The five-step planning process is a con- tinuous cycle that helps you assess your position and get to where you want to be. Personal factors as well as general economic factors influence the planning process. The stages of a plan include laying a foundation, securing basic needs, building wealth, and protecting wealth and dependents.

KEY TERMS Attitudes Opinions and psychological differences between peo-

ple that affect their decisions.

Consumer price A U.S. government index that tracks prices of a index (CPI) representative basket of goods and services.

Economic cycle A pattern of ups and downs experienced by the U.S. economy.

Expansion Periods characterized by increased business invest- ment and employment opportunities.

Federal Reserve Bank The central bank that controls the money supply in the United States.

Federal funds rate The rate banks charge each other for short-term loans.

Inflation The change in general price levels over time.

Interest rate A cost of money, expressed as a percentage.

Marginal reasoning A strategy that takes into account the change in out- come or additional benefit resulting from a decision.

Opportunity cost What you have to give up in order to do something.

Personal finance A specialized area of study that focuses on individual and household financial decisions, such as budgeting, saving, spending, insurance, and investments.

Personal financial The process of developing and implementing an planning integrated, comprehensive plan designed to meet

financial goals, to improve financial well-being, and to prepare for financial emergencies.

Recession A low point in the business cycle.

Sensitivity analysis Consideration of how an outcome changes with changes in other variables.

Values Fundamental beliefs about what is important in life.

18 PERSONAL FINANCIAL PLANNING IN ACTION

ASSESS YOUR UNDERSTANDING

Go to www.wiley.com/college/bajtelsmit to assess your knowledge of developing your personal financial plan. Measure your learning by comparing pre-test and post-test results.

Summary Questions

1. Which of the following is not normally considered an area of personal finance?

(a) budgeting (b) investments (c) choice of a career (d) choice of a marriage partner

2. Personal financial planning skills are applicable only in the early years of a person’s life. True or false?

3. Which of the following is the best definition of personal finance?

(a) the study of individual and household financial decisions (b) the study of individual investment planning (c) the study of personal wealth (d) the study of personal money management

4. Which of the following is not one of the steps in the personal financial planning process?

(a) developing short-term and long-term financial goals (b) identifying and evaluating alternative strategies for achieving goals (c) implementing a plan for achieving goals (d) determining the appropriate risk level of a participant

5. An effective financial plan should be inflexible in order to achieve the goals set. True or false?

6. A person’s fundamental beliefs concerning what is important in life are referred to as:

(a) values. (b) attitudes. (c) opinions. (d) judgments.

7. For a person’s standard of living to improve, his or her:

(a) income must be above the average standard of living. (b) expenses must decrease.

www.wiley.com/college/bajtelsmit
APPLYING THIS CHAPTER 19

(c) assets must rise in value faster than his or her expenses (d) income must rise faster than the inflation rate.

8. For the overall U.S. market, inflation is measured by the change in the: (a) producer price index. (b) consumer price index. (c) gross domestic product. (d) wholesale price index.

9. You are considering adding a wood shop to your home. You enjoy wood- working and could make items for sale. In considering this addition, you look only at the extra cost of the shop and the potential benefits of hav- ing the shop. This is an example of: (a) opportunity cost decision making. (b) sensitivity analysis. (c) marginal analysis. (d) reasonable assumptions.

10. When a person begins to spend his or her accumulated wealth, this is known as the distribution phase. True or false?

11. You decide to take a part-time job to help with your college expenses. The hours available for study are thus reduced. The reduction in study hours would be your: (a) fixed cost. (b) direct cost. (c) variable cost. (d) opportunity cost.

Applying This Chapter

1. Name three benefits of having a better understanding of personal finance.

2. Explain how your financial planning needs are likely to change over your life cycle.

3. Under what circumstances might the Federal Reserve take action to increase short-term interest rates?

4. Identify where each of the following fits into a comprehensive financial plan: career development, checking and savings accounts, stock investing, retirement planning, and life insurance.

5. Sanjay, an engineer at a major technology firm, earns $50,000 per year. He thinks that having an MBA degree will increase his chances of being promoted to a management position. He is trying to decide whether to

20 PERSONAL FINANCIAL PLANNING IN ACTION

enroll in a part-time evening program that will take two years or in a one-year full-time MBA program. Identify the factors that Sanjay should consider in making this decision. What are the opportunity costs of each alternative?

6. How can marginal reasoning be applied to the analysis of Sanjay’s situa- tion in Question 5?

And Then There Were Three Kenny and Ellen are married during their senior year in college. They plan and save $3,000 for a honeymoon trip to Europe after graduation. They both have offers for jobs that begin in July. Two months before gradua- tion, they discover that Ellen is pregnant.

1. Should they change their honeymoon plans?

2. Explain why they should reevaluate their honeymoon decision based on the change in their life circumstances.

3. If they invest the $3,000 instead of spending it, how much will it be worth in 10 years if they earn 7 percent per year on their invest- ment. (Hint: Use Figure 1-3)

What Happens if the Car Breaks Down? Miranda is a single mother of two, struggling to make ends meet. Her salary of $40,000, after taxes and child- care expenses, doesn’t go very far. Miranda is a careful budgeter, and she has been setting aside $40 per month for Christmas presents for her kids. By October, she is proud to have $400 in her savings account. But disaster strikes: Her car breaks down, and the mechanic tells her the cost of fixing it will be $350.

1. What are Miranda’s options?

2. Taking Miranda’s situation into consideration, at what stage is she in her comprehensive financial plan? Which elements do you think she needs to focus on in the short term (one year or less)? Which elements should she focus on over the next five years?

21

YOU TRY IT

2 MONEY MANAGEMENT STRATEGIES AND SKILLS Putting Your Financial House in Order

Starting Point

Go to www.wiley.com/college/bajtelsmit to assess your knowledge of money management strategies and skills. Determine where you need to concentrate your effort.

What You’ll Learn in This Chapter ▲ Document organization, storage, and safekeeping ▲ How to use personal balance sheets ▲ How to calculate personal financial ratios

After Studying This Chapter, You’ll Be Able To ▲ Develop a system for organizing and maintaining your financial records ▲ Calculate your net worth by using a personal balance sheet ▲ Summarize your current inflows and outflows of cash by using a personal

cash flow statement ▲ Use personal financial ratios to evaluate your current financial position

www.wiley.com/college/bajtelsmit
2.1 COLLECTING AND ORGANIZING YOUR FINANCIAL INFORMATION 23

INTRODUCTION The skills taught in this chapter provide the foundation for successful money management. You’ll learn to organize and maintain your financial records and how to use personal financial statements to see how you’re doing financially. You’ll also learn how to calculate the financial ratios that determine your cred- itworthiness and how much you are saving. These tools will help you on your road to financial success.

2.1 Collecting and Organizing Your Financial Information

Although some people love to file and organize, most people do not. The older you get, the more stuff you accumulate, and it doesn’t take long for a small pile of paperwork to grow to fill several file cabinets. The earlier you develop a sys- tem for organizing your financial records, the easier it is to maintain order as your life becomes more complex. The Personal Financial Planner that can be found in the Appendix and online includes a worksheet to help you get started organizing your records.

2.1.1 Why You Need to Save Bills and Documents

The first rule of organization is that there should be a particular purpose for everything you save and file. Although this list is not exhaustive, some possible reasons for keeping particular documents are

▲ Paying bills. ▲ Tracking your budget. ▲ Preparing for tax reports. ▲ Making investment decisions. ▲ Making insurance or warranty claims. ▲ Ensuring prompt access to essential records.

2.1.2 How Long You Should Save Documents

Of course, you need not keep all your documents forever. How long you should save each item depends on what you will use it for. Documents necessary for bill paying and budgeting have only short-term usefulness. Thus you need to save receipts for ATM withdrawals and deposits and for cash or credit purchases only until you receive a statement verifying that your account was correctly charged. You should keep bills for utilities, car expenses, and other irregular expenses that are not tax deductible for a full year so that you can accurately report the costs in your budget and personal cash flow statements.

24 MONEY MANAGEMENT STRATEGIES AND SKILLS

You should file any documents that support tax deductions with your tax records. Although most Internal Revenue Service (IRS) audits occur within three years of the filing of a return, they can also occur later, so it’s generally recom- mended that you keep tax records for seven years to be safe. The IRS audits about 1 out of every 174 returns, and most audits occur in the first year fol- lowing filing. Audits in later years are usually the result of irregularities discov- ered in auditing earlier returns.

2.1.3 Where You Should Keep Documents

You can keep your personal financial documents anywhere, as long as you can easily access them when necessary. A system of file folders kept in a file cabinet or box is effective for most people. Although computer filing is also a possibil- ity, most bills still exist on paper, so even if you can use your computer for some filing purposes, you still need to store paper copies as well.

You should keep important personal documents and valuables, particularly those that are difficult to replace—passports, birth and marriage certificates, Social Security cards, stock certificates, wills, and deeds—in a safe deposit box or fireproof lockbox. A safe deposit box is a secure private storage area (usually a small locking drawer) maintained at a remote location, often at a financial insti- tution’s place of business. A lockbox, which is a fireproof keyed safe that you keep in your home, is not as secure as a safe deposit box because it’s usually movable, and any thieves that break into your house are likely to look for it right away. The primary purpose of a lockbox is to prevent loss or damage to the documents in the event of a fire.

If you use your home computer for managing your finances, you should be sure to regularly back up the information on a disk and store that disk in a separate location, such as a friend’s house, your place of employment, or a safe deposit box. You need to ensure that your electronic records will be safe in the event of theft, fire, electrical outage, or water damage. The best way to do this is to back up your records immediately whenever you make any major changes to the files, such as when you pay bills or revise your budget.

1. Explain the difference between a lockbox and a safe deposit box.

2. List the types of information you should store.

S E L F - C H E C K

2.2 USING PERSONAL FINANCIAL STATEMENTS 25

2.2 Using Personal Financial Statements

After you’ve collected and organized your financial information, you can use it to begin evaluating your financial condition. Personal financial statements summarize your financial information in a way that makes it easy to see where you stand and to plan for where you want to be in the future. Just as compa- nies make regular reports on their financial status to their shareholders, you should make a financial report to yourself.

Others might request the information contained in your personal finan- cial statements (e.g., financial companies considering your application for a loan, organizations evaluating your qualifications for a scholarship, financial advisors helping you with your personal financial plan). In this section, you’ll learn how to develop a personal balance sheet to estimate your financial net worth and a personal cash flow statement to evaluate your cash inflows and outflows.

2.2.1 Preparing a Personal Balance Sheet

How much are you worth today? In other words, how wealthy are you? This calculation is a good starting point for financial planning. A personal balance sheet is a financial statement that details the value of everything you own and subtracts what you owe to others to arrive at your net worth, or the amount of wealth you would have left after paying all your outstanding debts. A personal balance sheet shows your assets and debts:

▲ Assets are the things you own. Assets include liquid assets (such as cash), personal property, real estate, and investments.

▲ Debts, or liabilities, are the amounts you owe. Debts include both short-term obligations, such as unpaid bills and credit card debt, and long-term debts, such as student loans, car loans, and home mortgages.

To prepare a personal balance sheet, you start by making a list of everything you own, beginning with the most liquid assets—cash and near-cash assets that can easily be converted to cash without loss of value—and ending with the least liquid. Checking and savings accounts are examples of liquid assets; your auto- mobile and home are not liquid because it would take time to sell them, and you would incur transaction costs such as advertising fees and commissions. If you needed cash in a hurry, you would probably also have to discount the price to make a quick sale.

The next step in constructing your personal balance sheet is to make a list of your debts. As with your assets, you start with short-term debts, such as cur- rently unpaid bills, and end with long-term debts, such as your student loans and home mortgage.

26 MONEY MANAGEMENT STRATEGIES AND SKILLS

FOR EXAMPLE

A Personal Balance Sheet Danelle, a senior at a large university in the Midwest, is graduating with a biology major. She says, “I’m also getting a teaching certificate so that I can be a high school biology teacher. My parents helped out with my first two years, but now I’m supporting myself with a part-time job, financial aid, and student loans. Although I think I’m in pretty good financial shape, I know I need to get better organized. My biggest problem is that I’m so busy— with my schoolwork and job responsibilities, it’s sometimes hard to even find the time to pay my bills. To be totally honest, I also have a tendency to avoid financial matters because I’ve never particularly liked math. One of my financial downfalls is that I love to shop for clothes and can’t resist a good sale. So my credit card balances have increased. I’m a little nervous about how I’ll be able to pay them off, especially since I’ll have to start pay- ing my student loan once I graduate.”

This section walks through how to create a balance sheet that itemizes Danelle’s assets and debts, as shown in Figure 2-1. You can create your own personal balance sheet by using the worksheet provided in the Personal Financial Planner.

2.2.2 Valuing Your Assets and Debts

How do you go about assigning a dollar value to each asset and debt? Your most recent bank statements give you the value of your checking and savings accounts. For other assets, you can try to estimate the market value, or the price you could sell them for today.

The market value is not the same as what you paid for an asset. For exam- ple, if you just bought a new car, you won’t be able to sell it now for what you paid for it. Similarly, the market value of your stereo system is much lower than what you paid for the system, even if it’s practically new. In contrast, you might own some assets that have much higher market values than what you paid for them. A first-edition comic book that you paid $1 for 10 years ago may be worth $100 today. Also, normally, real estate increases in value over time, so your home probably has a higher market value now than when you purchased it.

For some of your assets, such as your car, there may be a corresponding debt. If you have outstanding debt on your car, you enter the market value of your vehicle on the asset side of your balance sheet and the loan balance on the debt side. Notice that Danelle has entered $5,000 as the value of her car and $3,000 as the remaining balance on her car loan. If you lease a car, your pay- ment obligations are a debt, but you don’t own the car, so you shouldn’t include

2.2 USING PERSONAL FINANCIAL STATEMENTS 27

Figure 2-1

Danelle Washington’s personal balance sheet.

Danelle Washington’s Personal Balance Sheet, December 31, 2004

Assets

Checking accounts $ 500 Savings accounts 1,000 Money market accounts Cash value of life insurance

Total Liquid Assets $ 1,500

Home furnishings 1,200 Jewelry/art collectibles 500 Clothing/personal assets 3,000 Market value of automobiles 5,000

Total Personal Property $ 9,700

Market value of investments (stocks, bonds, mutual funds)

Employer-sponsored retirement plan Individual Retirement Accounts (IRAs) Other retirement savings College savings plan Other savings or investments

Total Investment Assets

Market value of home Market value of investment real estate

Total Real Property

TOTAL ASSETS $11,200

Debts

Rent or mortgage payment $ 500 Utillities and other bills 130 Credit card minimum payments 150

Total Current Bills $ 780

Credit card balances 1. Master Card 4,200 2. JCPenney 1,000

Personal Loans Car loans 3,000 Alimony/child support owed Taxes owed (above withholding)

Total Short-Term Debts $ 8,200

Student loans 18,000 Home mortgage balance Home equity loan Other real estate loans Other investment loans and liabilities

Total Long-Term Debt $ 18,000

TOTAL DEBTS $ 26,980

Net Worth � Assets � Debts �$15,780

List the values of your liquid assets (Chapter 5), household goods, and automobiles (Chapter 8).

List the market value of assets, investments, and real property (Chapters 8, 11–15).

List your short-term and long- term debts (Chapter 6–8).

Calculate your net worth by subtracting total debts from total assets.

28 MONEY MANAGEMENT STRATEGIES AND SKILLS

it as an asset. You can estimate the market value of your car by using a current automotive blue book, available in book form at most bookstores and libraries or online (e.g., www.edmunds.com). In some cases, your car’s value may actually be less than what you still owe in car payments.

Although real property, including homes and other real estate, is not very liquid, it may be your largest investment. Real estate values are determined by the values of comparable properties in the area, so if you just enter what you paid for a property on your balance sheet, you will be understating your actual wealth. If you don’t know of a recent sale of a similar property, you can con- sult a real estate professional to help determine the value of your home or other real estate investment. In general, real estate values increase over time, so you need to update this information regularly. Because Danelle is renting an apartment with some friends from school, she doesn’t own any assets in this category.

An insurance policy is counted as an asset only if it’s a policy that accumu- lates cash value over time. If you cancel an insurance policy that has a cash sur- render value, the insurer returns that amount of money to you. Because this is an available source of cash, you should count it as an asset. Homeowner’s, auto, and health insurance (discussed in Chapters 8 and 9) don’t accumulate cash value, but some types of disability and life insurance policies (discussed in Chap- ters 9 and 10, respectively) may have cash value. This value is determined by the contract terms and is generally much smaller than the face value of the pol- icy. In some cases, insurance policies also allow you to borrow against the cash value. If you have borrowed from one or more of your policies, you need to include the amount owed as a debt on your personal balance sheet. Danelle doesn’t have any cash value insurance.

2.2.3 Calculating Your Net Worth

After you enter all the required information on your personal balance sheet, you can calculate your net worth by using the following equation:

Net worth � Total assets � Total debts

Notice in Figure 2-1 that Danelle’s net worth is negative $15,780. What does this mean? If Danelle sold all her assets and used the money to repay her debts, she would still owe $15,780. In contrast, if your net worth is positive, it repre- sents how much you would have left over after paying everything. Your net worth is thus a measure of your wealth.

There is no “magic number” that represents the ideal amount of net worth because it depends on an individual’s life cycle stage and personal goals. How- ever, in general, the larger your net worth, the better off you are financially.

What if you have negative net worth like Danelle? If you’re like most stu- dents, you’re in the accumulation phase of your life cycle. You’re developing

2.2 USING PERSONAL FINANCIAL STATEMENTS 29

skills and abilities that will lead to greater income and wealth in the future. You may have student loans and car loans but little in the way of financial investments. This situation is not overly troubling at such an early stage of life. However, if it continues indefinitely, it will eventually result in insolvency, which is the inability to pay debts as they come due. Insolvency can lead to bankruptcy.

It’s not uncommon for an individual’s net worth to decline due to an unex- pected change in life circumstances, such as an extended illness, the death of a spouse, or a divorce. One of the purposes of developing and evaluating personal financial statements is to identify ways to improve your situation so that you can be better prepared for such problems. As you proceed through the financial plan- ning process, you should keep this in mind and conscientiously attempt to reduce your debt and increase your assets over time.

2.2.4 Preparing a Personal Cash Flow Statement

Your net worth is highly related to your spending and saving behavior. If you consistently spend more than you earn, you’ll end up financing the extra con- sumption through borrowing. In contrast, if you’re a regular saver, you’ll accu- mulate more assets over time.

On average, Americans spend more than they earn and have very low savings rates. Not surprisingly, average household debt continues to rise over time. This problem has been exacerbated over the past few years, as increasing home values and low mortgage rates have encouraged many home- owners to access home equity lines of credit to pay for vacations and other non-investment expenses. When this happens, total debt goes up, and net worth declines, as you will see when you look at credit in more detail in Chapters 5 and 6.

A personal cash flow statement is a financial statement used to evaluate the relationship between your income and expenditures. Whereas your personal balance sheet is like a snapshot of your finances at a certain point in time, your personal cash flow statement shows inflows and outflows of cash over a period of time, often one month or one year.

You use a personal cash flow statement to carefully itemize the amounts of money that come into your household from various sources as well as all the money that goes out over the same period of time. You can utilize a worksheet such to record your cash inflows and outflows; for example, Figure 2-2 shows Danelle Washington’s personal cash flow statement for 2004. A blank worksheet is included in your Personal Financial Planner; an alternative is to use the work- sheets provided with a personal finance software package, such as Microsoft Money or Quicken.

When should you record cash flows? You prepare a cash flow statement on a “cash basis,” which means you record cash flows when they are received or

30 MONEY MANAGEMENT STRATEGIES AND SKILLS

Figure 2-2

Danelle Washington’s Personal Cash Flow Statement, 2004

Cash Inflows

January 1 to December 31,

Monthly 2004

Salary/wage income (gross) $792 $9,500 Interest/dividend income Other income (self employment) Rental income (after expenses) Cash from sale or assets Student loans 500 6,000 Scholarships 108 1,300 Other income Gifts 17 200

Total Cash Inflows $1,417 $17,000

Cash Outflows

January 1 to December 31,

Monthly 2004

Income and payroll taxes $71 $852 Groceries 171 2,052 Housing

Mortgage or rent 300 3,600 Property tax & insurance Maintenance/repairs

Utilities Heating 40 480 Electric 25 300 Water and sewer Cable/phone/satellite 15 180

Car loan payments 113 1,356 Car maintenance/gas 80 960 Credit card payments 125 1,500 Other loan payments Other taxes Insurance

Life Health 42 504 Auto 67 804 Disability Other insurance

Clothing 25 300 Gifts 30 360 Other consumables (TV’s, etc.) Child-care expenses Sports-related expenses 13 156 Health club dues Uninsured medical expenses 17 204 Education 333 3,996 Vacations/travel 25 300 Entertainment 84 1,008 Alimony/child support Charitable contributions Required pension contributions Magazine subscriptions/books Other payments/expenses

Total Cash Outflows $1,576 $18,912

Net Cash Flow � Cash Inflows � Cash Outflows � �$159 �$1,912

Danelle Washington’s personal cash flow statement.

2.2 USING PERSONAL FINANCIAL STATEMENTS 31

paid. Thus, if you receive a bill on January 5 but don’t pay it until February 1, you record it as an expense in February, not in January. If certain amounts are deposited directly to or withdrawn directly from your checking account, such as paycheck deposits or car payments, you record them when they occur.

Identifying Your Cash Inflows

You should include as cash inflows all amounts of money you receive during the period of time in question. You include any income you earn from a job—wages, salaries, tips, and commission. Other sources of income may include

▲ Scholarships. ▲ Cash allowances or gifts from your parents or others. ▲ Proceeds from the sale of assets. ▲ Alimony or child support. ▲ Government benefits, such as welfare, unemployment, or Social Security. ▲ Investment earnings (i.e., income from dividends and interest). ▲ Gambling winnings.

Notice that Danelle records her annual gross income—that is, income before taxes and expenses—and records the taxes she paid during the year as cash out- flows. Last year, she earned $9,500 from a part-time job and received a $1,300 scholarship and gifts of $200. She also took out a student loan in the amount of $6,000. Her total cash inflows are therefore $17,000 for the year.

Detailing Your Expenditures

Whereas income is generally easy to identify and calculate, expenditures are more difficult to track accurately. You can probably easily determine the big fixed expenses—expenses that are a constant dollar amount each period, such as rent and car loan payments. But few people do a good job of keeping track of their variable expenses, which vary in amount from period to period, such as gro- cery bills and gas money, even though these can be a big portion of their total cash outflows.

You can see that on Danelle’s personal cash flow statement, $2,052 for gro- ceries was one of her largest annual expenditures, exceeded only by her rent, at $3,600, and her college expenses, at $3,996.

Small daily expenditures, such as money for parking meters or candy bars from vending machines, are especially easy to overlook, but often these expen- ditures can make the difference between achieving your financial goals and not achieving them. Even if you just buy a latté at the coffee shop every weekday afternoon on the way home from school or work, the seemingly small cost of $3 per day adds up to $780 per year—enough to take a nice vacation or to add to your investment portfolio.

32 MONEY MANAGEMENT STRATEGIES AND SKILLS

If you spend money primarily by writing checks and using a debit card, it’s a little easier to track your cash outflows because your bank statement and check register are useful sources of information. Alternatively, you can track your expenditures on a daily basis in a spending log in which you record all your cash outflows for a month or longer. Your Personal Financial Planner includes a spending log worksheet that you can use for this purpose. At the end of the time period you have chosen, you can then total the amounts entered in your spending log to put into your personal cash flow statement. You need to do this for at least a month to be sure that you’ve included even the irreg- ular cash outflows.

You should be careful not to alter your normal spending behavior tem- porarily simply because you’re recording everything. Suppose, for example, that you never realized how much money you spent on lattés until you began keep- ing your spending log. Even if you plan to reduce your latté spending, you need to incorporate this expense in your log so you can more realistically evaluate your current finances. If you quit your latté habit during your spending log period and decided to allocate the $780 per year to savings, what if you “fell off the wagon” and returned to your prior spending behavior? At this stage, it’s better to be brutally honest and record all spending, regardless of whether you plan to make changes.

Calculating and Evaluating Net Cash Flow

After you enter and total your cash inflows and outflows on the personal cash flow statement, you can calculate your net cash flow. Danelle calculates hers as follows:

Net cash flow � Total cash inflows � Total cash outflows

� $17,000 � $18,912 � �$1,912

Based on Danelle’s personal cash flow statement, which shows a negative net cash flow, she has been spending more than her income during the past year. How did this happen? Her personal balance sheet gives some clues: Danelle has credit card debt totaling $5,200 and total student loan debt of $18,000. Because the personal balance sheet is cumulative, this amount represents debt she has accumulated over time, not just in the past year. For example, we know that she received $6,000 from a student loan this year, which means she must already have had $12,000 in student loan debt at the beginning of the year.

In addition to taking on more student loan debt, Danelle spent $1,912 more than she earned last year, so these expenditures must have been made using credit cards. The increased debt resulted in a decline in her net worth.

As you can see, Danelle’s income and spending habits have had a big effect on her overall financial picture. We might be tempted to explain Danelle’s financial

2.3 USING FINANCIAL RATIOS 33

position by pointing to her low income. However, an interesting economic truth is that those who have more tend to spend more. If you’re struggling to make it on a student’s budget, you likely eat ramen noodles at least once a week and make do with your current wardrobe. If you’re a movie star earning millions of dollars each year, you probably have more than one extravagant home, entertain lavishly, and buy only designer clothes. But just because you have high income doesn’t mean that your finances are in good shape. Many seemingly well-off people have gone bankrupt.

1. Define net worth, liquid assets, market value, and fixed expenses.

2. List some of your variable expenses.

3. What type of statement helps you track your spending?

S E L F - C H E C K

2.3 Using Financial Ratios

Financial ratios provide another important tool for evaluating your financial condition. You can calculate your financial ratios from the information you’ve collected on your personal financial statements, compare your ratios to recom- mended targets, and track your ratios over time as a measure of your progress toward achieving your financial goals. In this section, we examine ratios designed to measure three aspects of your finances:

▲ Liquidity. ▲ Debt management. ▲ Adequacy of savings.

The individual ratios and their calculations are explained in this section using Danelle Washington’s financial information from Figures 2-1 and 2-2.

2.3.1 Measuring Liquidity

If you experience a total loss of income, if you’re temporarily disabled or laid off, you might need to meet your expenses without having your regular income. The liquidity ratio tells you how many months you could pay your monthly expenses from your liquid assets. This ratio is calculated as follows:

Liquidity ratio � Liquid assets/Monthly expenses

34 MONEY MANAGEMENT STRATEGIES AND SKILLS

2.3.2 Measuring Debt Usage

Everywhere we turn, it seems there’s someone inviting us to borrow money to buy something today instead of waiting until we’ve saved enough to pay cash. Small wonder that one of the biggest financial problems U.S. households face is that they have too much debt.

If your money style is to spend impulsively or if you tend to avoid financial matters altogether, you may already understand the problems associated with monthly payments on credit cards. Although debt is not inherently bad, pay- ments made to lenders include interest charges and fees—funds that could be better used to build your financial wealth. You can use your personal financial statements to assess your debt management. Financial institutions such as banks and mortgage companies use a variety of debt ratios when they evaluate you for mortgage or car loans. We discuss three ratios in this section:

▲ The debt ratio. ▲ The debt payment ratio. ▲ The mortgage debt service ratio.

These are the ratios that financial institutions most commonly use in their mort- gage lending process.

The debt ratio measures the percentage of your total assets that you’ve financed with debt. It is calculated as follows:

Debt ratio � Total debt/Total assets

FOR EXAMPLE

What if Danelle Loses Her Scholarship? Danelle has liquid assets equal to $1,500, the total value of her checking and savings accounts (refer to Figure 2-1). Her annual expenses, from the cash flow statement in Figure 2-2, are $18,912, and her monthly expenses total $1,576. Thus, Danelle’s liquidity ratio (rounded to one decimal place) is

$1,500/$1,576 � 1.0

This means that Danelle could meet her expenses for only one month with- out her regular income sources. Financial planners often recommend that you have liquid assets sufficient to cover your expenses for three to six months, so liquidity is a concern for Danelle, particularly at the end of the school year, when she has depleted her student loan and scholarship funds. However, a low liquidity ratio does not necessarily imply that she needs to increase her allocation of funds to liquid assets. She may have other sources of funds that can be tapped in an emergency, such as family loans or credit cards.

2.3 USING FINANCIAL RATIOS 35

As your credit card balances increase, so does your debt ratio because credit card purchases are usually for consumer goods that add little—if any—value to your assets. For example, suppose you use a credit card to pay for dinner and a movie for you and your significant other. This causes your debts to increase by, say, $50, but your assets don’t increase at all. The end result is that your debt ratio goes up. However, the debt ratio generally declines as you get older because your financial assets and home equity increase in value.

The debt payment ratio estimates the percentage of your after-tax income that goes to paying required monthly minimum debt payments of all types, including mortgage loans, student loans, car loans, and credit card payments. The debt payment ratio is calculated as follows:

Debt payment ratio � Total monthly debt payments/After-tax monthly income

Note that we use after-tax income in the denominator of the equation because the purpose is to assess ability to pay. As you can see in Figure 2-2, Danelle’s monthly after-tax income is $1,346 (calculated as monthly gross income of $1,417 less $71 in income and payroll taxes). Her monthly debt payments total $238 per month ($125 for credit cards plus $113 for her car loan). Using this information, we can calculate Danelle’s debt payment ratio as follows:

$238/$1,346 � 0.177, or 17.7 percent

Bank lenders commonly require that total debt payments not exceed 33 per- cent to 38 percent of gross income, which implies that the debt payment ratio (based on after-tax income) could be even higher. By that measure, Danelle’s 17.7 percent debt payment ratio is not very high, but she will have to begin paying her student loan a few months after graduation, so the ratio is likely to rise in the near future. In addition, this ratio tends to understate Danelle’s actual financial obligations because it doesn’t include her required monthly rent payments.

For most individuals, housing costs, either rent or mortgage payments, are the largest monthly expenditure. The total monthly cost of a mortgage, includ- ing the principal and interest paid to the lender, property taxes paid to the local municipality, and homeowner’s insurance, is called the mortgage debt service. Mortgage lenders commonly require that borrowers make a single monthly pay- ment to cover all these expenses. The mortgage debt service ratio, which mea- sures the percentage of your gross income that you pay out in mortgage debt service alone, is calculated as follows:

Mortgage debt service ratio � (Principal � Interest � Taxes � Insurance) /Gross monthly income

Both the debt payment ratio and the mortgage debt service ratio measure your ability to pay your financial obligations. In determining your creditworthi- ness, lenders commonly compare these or similar ratios to maximum values. For example, a mortgage lender might require that your total debt payments be no

36 MONEY MANAGEMENT STRATEGIES AND SKILLS

more than 35 percent of your gross income or that your total mortgage-related expenses be no more than 25 percent of your gross income.

2.3.3 Measuring Savings

You can assess how well you’re implementing your savings goals by tracking your savings ratio over time. The savings ratio measures the percentage of your after- tax income that is being allocated to savings and is calculated as follows:

Savings ratio � Monthly savings/After-tax monthly income

Because the amount you have available for savings is what’s left over from your income after you’ve paid all your expenses and taxes, it’s quite possible to have negative savings. This happens whenever your cash outflows exceed your cash inflows. In that case, your savings ratio is negative as well. Danelle Washington’s savings ratio is

�$159/$1,346 � �11.8 percent

Because her negative savings ratio implies that, rather than saving, Danelle is accumulating more debt, this financial situation cannot continue for long. As she begins to develop her personal financial goals, Danelle will probably want to include goals related to improving some of the financial ratios described here. Financial advisors commonly recommend that households target at least a 10 percent savings ratio and that they attempt to increase this ratio over time.

SUMMARY It’s important that you develop a system for organizing and maintaining your finan- cial records. You can use a personal balance sheet to figure out your net worth, which is the total value of your assets minus the total value of your debts. You can summarize your current inflows and outflows of cash by using a personal cash flow statement. This financial statement helps you calculate net cash flow. Personal finan- cial ratios can help you evaluate your current financial position, based on your per- sonal balance sheet and cash flow statements. By comparing your ratios over time, you can track your progress toward achieving your financial goals.

1. Define gross income.

2. What financial ratios measure your ability to pay your debt?

3. Where does the information for ratios come from?

S E L F - C H E C K

KEY TERMS 37

KEY TERMS Assets Everything you own, including liquid assets,

real and personal property, and investments.

Debt payment ratio A financial ratio that measures the percent- age of disposable income required to make debt payments.

Debt ratio Total debt divided by total assets.

Debts Everything you owe to others, including unpaid bills, credit card balances, car loans, student loans, and mortgages. Also known as liabilities.

Fixed expenses Expenses that are a constant dollar amount each period.

Gross income Income before taxes and expenses.

Insolvency The inability to pay debts as they come due.

Liquid assets Cash and near-cash assets that can be easily converted to cash without loss of value.