Unit 5 Personal Finance

1. Unit 5 Personal Finance

2. Saving and Investing A person has only 2 choices about what to do with after tax income. Spend it now or save for the future.

3. The opportunity cost of spending money is the interest you could have earned by putting it in some kind of financial investment.

4. 2 Types of Investment Financial Investment: refers to decisions by individuals and businesses to invest money in financial assets such as bank accounts, certificates of deposit, stocks, bonds and mutual funds that earn interest.

5. Real Investment: When businesses purchase factories, machinery, tools and equipment. This is the kind of investment we have talked about all semester.

6. Types of Financial Investments • Savings Accounts: accounts in banks that earn a small rate of interestbut on which checks cannot be written. • These are among the safest of all investments.

7. 2. Certificate of Deposit: depositorsloan money to a bank for a period of time and are paid back with interest. The time period can vary from 1 month to 5 years or more and will pay a little better than a savings account.

8. However, if you withdraw your money before the maturity date, you pay a penalty.

9. 3. Bonds: are issued by the government or by companies. You loan them your money for a period of time and are paid back with interest.

10. Bonds can be short term, paid over a few months or years or long term, which are repaid over decades. They are less risky than stocks

11. 4. Stocks: represent shares of ownership in a corporation. Owners receive a return in 2 ways: • The firm may pay dividends to its shareholders out of the profits that it earns. • investors may profit by selling their shares for more than they paid for them; this is called a capital gain.

12. Stock performance can be measured by looking at an index like the Dow Jones Industrial Average or the Standard & Poors500. • DJIA-a price-weighted average of 30 top stocks traded on the NYSE & NASDAQ • S&P 500-uses price changes of 500 representative stocks to indicate market performance

13. 5. Mutual Funds: a company sells stock in itself to individual investors and then invests the money it receives in stocks and bonds issued by other companies.

14. Investing in mutual funds automatically diversifies the investors portfolio and these funds are run by professional money managers.

15. 6. 401(K) Plan: a tax deferred investment and savings plan that acts as a personal pension fund for employees for retirement. (Roth IRA is not tax deferred…)

16. (401(k)) The employee contributes a certain amount each month into the plan which can be matched by some percentage by the employer. The fund grows, tax deferred, until retirement, at which time it is taxed.

17. 7. Individual Retirement Account (IRA): is another long term, tax deferred plan that a person can set up as part of a retirement plan. (Roth IRA is not tax deferred…)

18. Diversification: The spreading out of funds into different kinds of investments in order to minimize risk.

19. Based on the illustration, you would earn more in any of the three retirement plans than you would on basic savings because you would:

20. Types of Financial Institutions: • Banks: provide a safe means to store earnings. Offers direct deposit, check writing services, debit and credit cards, loans of all sorts, and other services.

21. Banks take the money deposited and loan out a portion of it to people who want to borrow. They charge a higher interest on the loans than they pay to the depositors in order to make a profit. (interest rate spread)

22. Credit Union: a nonprofit service cooperative owned by, & operated for, the benefit of its members and the members own and control the institution. Services provided are just like a bank

23. Savings & Loan: a depository institution that focuses on savings and home mortgage loans instead of providing other services. Investors will earn a higher savings rate but won’t have easy access

24. Payday Loan Company: give out small loans in return for a portion of a person’s upcoming paycheck. Interest rates can be extremely high.

25. Risk and Return Risk: describes a situation in which the outcome is uncertain and a range of results, potentially good and bad, is possible.

26. Return: the income or profit generated by an investment divided by the original cost of the investment. Example: If you put $100 in a bank account and receive $3 a the end of the year, then the rate of return is 3%. (3/100)

27. The greater the risk with an investment, the higher the rate of potential return.

28. Interest rate--the price paid or received for the use of another person’s money. It can be calculated in 2 basic ways… Simple interest or Compound Interest

29. Simple interest rate : is calculated only on the original loan amount, (principal). Example: Deposit Amt = $100, Interest rate = 5% (5% × $100 = $5) After year 1 the person would have $105. After year 2 the person would earn $110 ($105 + $5 = $110)

30. Compound interest rate: is earned not only on the principal but also on interest earned from previous periods. Example: Amount invested = $100, Interest rate = 5% ($100 x 5% = $5) Year 2 the person would earn $110.25 (5% × $105 = $5.25; $105 + $5.25 = $110.25)

31. Key is start saving early and be consistent. Compound interest can build considerably over time. It can be compounded monthly, quarterly, semi-annually, or annually To estimate how long it will take to double your investment…use rule of 70 (divide 70 by interest rate. Ex: 70/5=14 years)

32. http://www.econedlink.org/virtual-economics/?topic=Personal+Finance+Economicshttp://www.econedlink.org/virtual-economics/?topic=Personal+Finance+Economics http://investor.gov/tools/calculators/compound-interest-calculator#.Up_3nfRDtvo

33. Credit • Credit: the ability to borrow money. • Common forms of consumer credit are car loans, home mortgage loans and credit cards. • Businesses use credit regularly, either by borrowing from a bank or issuing corporate bonds.

34. The government also uses credit when it needs to borrow money to finance its budget deficit.

35. People who can borrow at a reasonable interest rate have good credit • those who can’t borrow at such rates are said to have bad credit. • Loans extended for longer periods involve higher interest rates to compensate for greater risk.

36. When comparing loans look at the annual percentage rate (APR) on the loan.

37. Short term credit people often use credit cards as a simple and convenient way of paying for purchases. • If a credit card balance is paid off each month, the borrower doesn’t pay any interest.

38. If the full balance is not paid each month, the borrower begins to accrue interest charges on the unpaid balance and the interest is accrued monthly. • Interest rates: • can be as high as 18% • can be fixed or variable

39. Credit Cards are unsecured loans, no collateral required therefore interest rates are higher • Bank loans are secured loans—collateral is required • Collateral: An asset of value put up against the loan in case of default.

40. Financial institutions look at a persons credit worthiness to decide whether or not to loan money • credit worthiness--an attempt to determine how well a person will be able to repay a loan. • based on annual income, • current debt level, • repayment history and • credit score

41. Credit Bureau’s collect individual credit information & sell it for a fee to banks, mortgage lenders, credit card companies and other financing companies.

42. Insurance • Insurance allows a person to pay to guard against a potentially disastrous event in the future. • If the negative event does occur, then the insurance will pay certain costs. • The price the insured pays for a policy is the premium…

43. Once a claim is filed the insured must first pay the deductible, then the insurance kicks in. • If a person wants a smaller premium, they can opt for a higher deductible, or vice versa.

44. Types of Insurance Health Insurance: provides payments to health-care providers if you are sick. The most common type is called a Health Maintenance Organization or HMO.

45. Life Insurance: provides a payment to your beneficiary if you die to help offset the loss of income. There are different types of life insurance but term life is the most affordable.

46. Auto Insurance: provides payments for damages caused in an auto accident. Ex. Liability, Collision, Theft, Car Rental, Comprehensive, No Fault This is typically the 1stkind of insurance needed by teenagers.

47. Homeowner’s insurance: pays for home repairs in case of fire or storm damage. Typical homeowners policies do not cover flood damage. If you are a renter, you should consider renters insurance.

48. Disability Insurance: covers workers who are injured and can’t work anymore. It provides a percentage of your lost income while you are out of work. There is both short term and long term disability, usually offered through the employer http://www.econedlink.org/interactives/EconEdLink-interactive-tool-player.php?iid=231&full

49. Human Capital: The combination of a person’s education, knowledge, experience, health, habits, training and talent.

50. A person who has acquired more human capital will be able to produce more. On an individual level, adding to one’s human capital boosts wages and income over your working lifetime.