Personal finance chapter 12 investing in stocks vocabulary answers

This page intentionally left blank

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.