chapter 1: the importance of personal finance

Chapter One

The Importance of Personal Finance

RCRE Personal Finance Web Site:

www.rce.rutgers.edu/money2000

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

Learning Objectives1. List the benefits of studying personal finance.

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

3. Understand the current economic environment

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

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

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


Financial Literacy

Financial literacy is knowledge of...• Facts• Concepts• Principles• Technological tools

...fundamental to being smart about money.


Financial Responsibility

Financial responsibility is being accountable for:

–Your financial decisions and

–Your own financial well-being.

“If it is to be, it is up to me”


Personal Financial Planning

What is it?

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

What steps are included in the financial planning process?


Financial Planning Benefits

• Financial planning helps you achieve:

– Financial Success – achievement of financial aspirations.

– Financial Security – being able to fulfill any needs and most wants.

– Wealth – an abundance of money and other financial resources.

– Financial Happiness – the satisfaction you feel about money matters.


Figure 1.1: Objectives and Steps in Personal Financial Success

See G&F- Page 6


Figure 1.2: The Building Blocks of Financial Success


Know the State of the Economy

• Expansion–– production high – unemployment low

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

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


Figure 1.3: Phases of the Business Cycle


Predict Future Directions of Prices and Inflation

• Inflation–Steady rise in the general level of prices (reduces purchasing power)

• Deflation–Falling prices.


How Inflation is Measured

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

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


Estimating Future Interest Rates

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

• You can forecast interest rates by paying attention to changes in the federal funds rate:

– the rate that banks charge one another on overnight loans (set by Federal Reserve)

– provides an early indication of Fed policy and trends for longer-term interest rates.


Opportunity Costs and Trade-offs in Decision Making

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

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

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


Income Taxes in Decision Making

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

– Six tax rates: 10%, 15%, 25%, 28%, 33%, 35%

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

• Tax-Sheltered (a.k.a., tax-deferred) Income–Income exempt from income taxes in the current year.


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


The Time Value of Money in Financial Decision Making

• The Time Value of Money compares:

– value in the future of a dollar received today (FV)

– value today of a dollar amount to be received in the future (PV)

• Key factors: time, interest, principal

• Annuity-a series of payments/deposits


Compound Interest

• Compound Interest–interest earned on interest.

• Compounding–the process of earning compound interest–is the best way to to build wealth over time.

Compound Interest Analogy:

Who Wants to Be a Millionaire? game show


Calculating Future Values

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

• Example: value of $1,000 invested at 8% for 4 years =$1,360.50

? Table A.1

FVF (8%, 4 years) = 1.3605

1,000 x 1.3605


Future Value of a Lump Sum: Mathematical Formula

• FV =What principal will grow to over time.

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

• Three ways to calculate time value of $:– Charts in the appendix of the book– Financial calculators– Mathematically (Finance I class will cover)


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

What does this chart tell you?


Key Financial Concept- The Rule of 72

• Calculates the number of years it takes for principal to double– Years = 72 divided by interest rate.– Example: 72 divided by 8% = 9 years

• Calculates the interest rate it takes for principal to double– Interest rate = 72 divided by number of years– Example: 72 divided by 10 years = 7.2%


Figure 1.6: The Rule of 72


Future Value of an Annuity

• What principal will grow to over time if a series of deposits are made (assumes same deposit amount each time period)

• Example: $2,000 annual deposits to Roth IRA at 8% interest for 40 years from age 22 to 62 = $518,113

Table A.3

FVOA (8%, 40 years) = 259.0565

2,000 x 259.0565


Present Value of a Lump Sum

• Present Value (PV)- Today’s value of an amount to be received at a future date.

• Example: Today’s value of a $25,000 inheritance to be received in 10 years, assuming the principal earns an 8% average annual return = $11,580

Table A.2

PVF (8%, 10 years) = .4632

25,000 x .4632


Present Value of an Annuity

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

• Example: The amount to have invested at retirement to provide $30,000 income per year for 20 years with a 7% return = $317,820

Table A.4

PVOA (7%, 20 years) = 10.5940

30,000 x 10.5940


Career-Related Money Decisions

Employee Benefits–Compensation for employment other than...– wages– salaries – commissions – other cash payments

What are some examples of employee benefits?


Employer-Sponsored Qualified Retirement Plans

• Savings plans that provide tax and other advantages, making it easy to save for retirement:– Federal tax-write-off for contribution– Tax-deferred investment earnings– Automatic payroll deduction for deposits– Sometimes, employer matching (especially 401(k)s)

• 401(k)s- Offered by private companies• 403(b)s- Offered by schools and non-profits• 457 plans- Offered by state/local government


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

• Start early to boost your retirement savings – Rule of 72: Early start = More doubling periods

• Plan to be a millionaire!

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

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


Golden Rules of Personal Finance

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

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

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

4. Take advantage of available employer benefits and opportunities to shelter income through a tax-deferred retirement savings program (e.g. 401(k) plan)

5. Develop expertise in financial matters

6. Remember that you are responsible for your own financial success.

chapter 1: the importance of personal finance

Documents

financial wellbeing

financial security

financial happiness

financial resources

financial planning process

financial decisions

time value of money

abundance of money