Personal Finance Chapter 1: Basics and the Time Value of Money

Personal Financial Planning

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

Opportunity Cost

What you give up by making a choice.

What are the main elements of every decision we make?

Spend

Save

Share

Spend

-For daily living expenses

-For major expenditures

-For recreational activities

Save

-For long-term financial security

Share

-For local and global assistance to those in need

The Financial Planning Process

1. Determine current financial situation

2. Develop your financial goals

3. Identify alternative courses of action

4. Evaluate alternatives

5. Create and implement your financial action plan

6. Review and revise the financial plan

Evaluate Alternatives

Consider

-life situation

-personal values

-economic factors

Assess

-risk

-time value of money (opportunity cost)

What are some of the risks associated with financial decisions?

-Inflation Risk

-Interest Rate Risk

-Income Risk

-Personal Risk

-Liquidity Risk

Inflation Risk

-Rising or falling (deflation) prices cause changes in buying power.

-Decide whether to buy something now or later. If you buy later, you may have to pay more.

Interest Rate Risk

-Changing interest rates affect your costs (when you borrow) and your benefits (when you save or invest).

-Borrowing at a low interest rate when interest rates are rising can be to your advantage. Variable rate loans may increase, resulting in higher payments. If you save when interest rates are dropping, you will earn a lower return with a six-month savings certificate than with a certificate having a longer maturity.

Income Risk

-The loss of a job may result from changes in consumer spending or expanded use of technology.

-Individuals who face the risk of unemployment need to save while employed or acquire skills they can use to obtain a different type of work.

Personal Risk

-Many factors can create a less than desirable situation. Purchasing a certain brand or from a certain store may create the risk of having to obtain repairs at an inconvenient location.

-Personal risk may also take the form of health risks, safety risks, or additional costs associated with various purchases or financial decisions.

Liquidity Risk

-Some savings and investments have potential for higher earnings. However, they may be more difficult to convert to cash or to sell without significant loss in value.

What are some common sources of financial planning information?

-Print and Media

-Digital Sources

-Financial Experts

-Financial Institutions

Print and Media

-Books

-Periodicals

-Newsletters

-Television, radio programs

Digital Sources

-Websites

-Blogs

-Phone apps

-Online videos

-Social media

Financial Experts

Seminar courses with:

-financial planners

-bankers, accountants

-insurance agents

-credit counselors

-tax preparers

Financial Institutions

Materials, websites from:

-credit unions

-banks

-investment,insurance, real estate companies

Why should you reevaluate your actions after making a personal financial decision?

Personal, social, and economic factors are always changing. It is important to keep you finances in line with these changes by assessing your financial decisions at least once a year.

Adult Life Cycle

The stages in the family situation and financial need of an adult.

Values

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

Security

A financial instrument that represents debt or equity.

Debt Securities

(Bonds) Represent money borrowed by companies or governments.

Equity Securities

(Stock) Represent ownership in a corporation.

Economics

The study of how wealth is created and distributed.

Trade Deficit

Affects the value of the nation's money and the cost of items being purchased by consumers.

Inflation

A rise in the general level of prices.

Rule of 72

To find out how fast prices (or your savings) will double, divide 72 by the annual inflation (or interest) rate.

Consumer Price Index (CPI)

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

Hidden Inflation

The cost of necessities (food, gas, health care) may rise at a higher rate than the cost of nonessential items.

Deflation

A decline in prices.

How do age, marital status, household size, employment situation, and other personal factors affect financial planning?

At different life stages, different needs arise which is why planning is different at every stage in life.

How might the uncertainty of inflation make personal financial planning difficult?

If one does not know how much something will cost the following year, one does not know how much needs to be saved.

What factors influence the level of interest rates?

Supply and Demand

Short-term Goals

Will be achieved within the next year

Intermediate Goals

Have the time frame from one to five years

Long-term Goals

Involve financial plans that are more than five years off

Consumable-product Goals

Usually occur on a periodic basis and involve items that are used up relatively quickly.

Durable-product Goals

Usually involve infrequently purchased, expensive items.

Intangible-purchase Goals

May relate to personal relationships, health, education, and leisure.

SMART

Specific

Measurable

Action-oriented

Realistic

Time-based

Time Value of Money

Increases in an amount of money as a result of interest earned.

Interst

Amount in savings * Annual interest rate * Time period

Future Value

The amount to which current savings will increase based on a certain interest rate and a certain time period; also referred to as compounding.

Present Value

The current value for a future amount based on a certain interest rate and a certain time period; also referred to as discounting.

Five Ways of Calculating Time Value of Money

1. Formula Calculation

2. Time Value of Money Tables

3. Financial Calculation

4. Spreadsheet Software

5. Websites and Apps

Annuity

A series of equal deposits or payments

How can you use future value and present value computations to measure the opportunity cost of a financial decision.

Calculating the future value allows you to see how much more money could be earned through saving.

Use the time value of money tables in Exhibit 1-8 to calculate the following:

a. The future value of $100 at 7% in 10 years.

b. The future value of $100 a year for six years earning 6%

c. The present value of $500 received in eight years with an interest rate of 8%

a) $196.70

b) $697.50

c) $270.00

What are the main components of personal financial planning?

1) Obtaining

2) Planning

3) Saving

4) Borrowing

5) Spending

6) Managing Risk

7) Investing

8) Retirement and Estate Planning

Liquidity

The ability to readily convert financial resources into cash without a loss in value.

Bankruptcy

The legal status of a person who is not able to pay debts owed.

Financial Plan

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

What is the purpose of a financial plan?

A financial plan provides the framework for what direction one needs to go with their finances.

Identify some common actions taken to achieve financial goals.

1) Using a well-conceived spending plan will help you stay within your income while you save and invest for the future. The main source of financial difficulties is overspending.

2) Having appropriate insurance protection will help you prevent financial disasters.

3) Becoming informed about tax and investment alternatives will help you expand your financial resources.