Personal Finance Chapter 1

What is personal financial planning?

The process of managing your money to achieve personal economic satisfaction.

What are the main advantages of personal financial planning?

Better use and protection of financial resources, more control over finances, less excessive debt, improved relationships, and reduced financial worry.

What are the 6 steps of the financial planning process?

• Determine current financial situation

• Develop financial goals

• Identify alternative courses of action

• Evaluate alternatives

• Create and implement a financial action plan

• Review and revise the financial plan

What is Step 1 of the financial planning process?

Determine your current financial situation.

What should you evaluate when determining your current financial situation?

Income, savings, living expenses, and debts.

What financial records should you maintain?

Records of daily spending and lists of assets and debt balances.

What is Step 2 of the financial planning process?

Develop financial goals.

What should you consider when developing financial goals?

Your feelings about money, financial priorities, needs versus wants, and your specific situation.

What is Step 3 of the financial planning process?

Identify alternative courses of action.

What are four possible courses of action?

Continue the same action, expand the current situation, change the current situation, or take a new course of action.

Why can doing nothing be risky?

Choosing to do nothing is still a financial decision and may have negative consequences.

What is Step 4 of the financial planning process?

Evaluate your alternatives.

What is opportunity cost?

What you give up when you make a choice.

Can opportunity cost involve more than money?

Yes. It can include money, time, effort, health, and lost opportunities.

What types of risk should be considered in financial decisions?

Inflation risk, interest rate risk, income risk, personal risk, and liquidity risk.

What is inflation risk?

The risk that rising prices will reduce your buying power.

What is interest rate risk?

The risk that changing interest rates will affect borrowing costs or returns on savings and investments.

What is income risk?

The risk of losing income, such as through unemployment.

What is personal risk?

The possibility of financial losses due to health, safety, purchases, or other personal circumstances.

What is liquidity risk?

The risk that an investment may be difficult to convert into cash without losing significant value.

How can financial risk be reduced?

Gather relevant information from media sources, financial institutions, and financial specialists.

What is Step 5 of the financial planning process?

Create and implement your financial action plan.

What are examples of actions in a financial action plan?

Increasing savings, reducing spending, increasing income, or planning for taxes.

What is Step 6 of the financial planning process?

Review and revise your financial plan.

How often should a complete financial plan be reviewed?

At least once a year.

Why might a financial plan need more frequent review?

Because personal, social, and economic conditions can change.

What is the adult life cycle?

The stages of family and financial needs during adult life that influence financial activities and decisions.

What life situations can affect financial decisions?

Marital status, household size, employment, graduation, career changes, children, retirement, and other major events.

What are values?

Ideas and principles that a person considers correct, desirable, and important.

How does money flow through the financial system?

From providers of funds to users of funds through financial intermediaries and financial markets.

Who are providers of funds?

Savers and investors.

Who are users of funds?

Borrowers and spenders.

What are examples of financial intermediaries?

Banks, credit unions, insurance companies, investment companies, and other financial institutions.

What are examples of financial markets?

Stock markets, bond markets, money markets, and commodity markets.

What is economics?

The study of how wealth is created and distributed.

What major forces help determine prices?

Supply and demand.

What are two major responsibilities of the Federal Reserve?

Maintaining an adequate money supply and influencing borrowing, interest rates, and government securities transactions.

How can the global economy affect personal finance?

Through international competition, exports and imports, foreign investment, exchange values, and the prices consumers pay.

What is inflation?

A rise in the general level of prices.

What is the Rule of 72?

Divide 72 by the annual inflation or interest rate to estimate how many years it takes prices or money to double.

If inflation is 4%, approximately how long will it take prices to double?

18 years.
72 ÷ 4 = 18.

What is the Consumer Price Index (CPI)?

A measure of the average change in prices consumers pay for a basket of goods and services.

What is deflation?

A decline in prices.

What is consumer spending?

The total demand for goods and services in the economy.

Why is consumer spending important?

It influences employment opportunities and potential income.

What do interest rates represent?

The cost of money.

What influences interest rates?

Supply and demand.

What are the three time categories for financial goals?

Short-term, intermediate, and long-term.

What is a short-term financial goal?

A goal to be achieved within the next year.

What is an intermediate financial goal?

A goal to be achieved within one to five years.

What is a long-term financial goal?

A goal that takes more than five years.

Why should long-term goals be coordinated with shorter-term goals?

Because short- and intermediate-term goals can help support achievement of long-term goals.

What are the three financial-need goal categories?

Consumable-product goals, durable-product goals, and intangible-purchase goals.

What does SMART stand for in financial goal setting?

Specific, Measurable, Action-oriented, Realistic, and Time-based.

What does Specific mean in SMART goals?

Know exactly what the goal is so you can create a plan.

What does Measurable mean?

The goal should include a specific amount or other measurable target.

What does Action-oriented mean?

Identify the financial activities you will take to achieve the goal.

What does Realistic mean?

The goal should fit your income and life situation.

What does Time-based mean?

Identify a specific time frame for achieving the goal.

What is a personal opportunity cost?

The personal resource you give up to obtain something you consider more desirable.

What are examples of personal resources?

Health, abilities, knowledge, time, and effort.

What is the time value of money?

An increase in an amount of money as a result of interest earned.

Why can saving money today provide more money tomorrow?

Because saved or invested money can earn interest.

What is one opportunity cost of spending money today?

The interest that money could have earned if it had been saved or invested.

What three amounts are needed to calculate the time value of money?

Principal, interest rate, and time period.

What is principal?

The amount of money saved or invested.

What is the interest rate?

The annual percentage earned on savings or charged for borrowing.

What is the time period?

The length of time money is deposited or invested.

What is the formula for simple interest?

Principal × Annual Interest Rate × Time = Interest

How much interest does $500 earn at 6% for 6 months?

$15

Calculation:
$500 × 0.06 × 0.5 = $15

What is the total value of $500 after earning $15 in interest?

$515.

What is future value?

The amount current savings will grow to based on an interest rate and time period.

What is compounding?

Earning interest on previously earned interest.

Why does compound interest grow money faster?

Because interest is earned on both the original deposit and previously earned interest.

What happens to $100 invested at 4% for one year?

It grows to $104.

What is present value?

The current value of a future amount based on a certain interest rate and time period.

What is another term for calculating present value?

Discounting.

Is present value greater than or less than future value?

Present value is less than the future value.

Can present value be calculated for multiple deposits?

Yes. It can be calculated for a single amount or a series of deposits.

What are the major components of personal financial planning?

Obtaining, planning, saving, borrowing, purchasing, managing risk, investing, and retirement/estate planning.

What is a financial plan?

A formalized report that summarizes your current financial situation, analyzes your financial needs, and recommends future financial activities.

Who can create a financial plan?

You can create it yourself, work with a financial planner, or use money-management software.

What is one important financial habit?

Track your spending and create a spending plan that allows you to live within your income.

Why is insurance important in a financial plan?

It helps protect against major financial losses or disasters.

Why should you learn about taxes and investments?

To help expand and better manage your financial resources.