Personal Finance

Personal Finance Planning

The process of meeting your life goals through the management of your finances.

Personal Financial Planning Process

1. Establish Foundation: Acquire knowledge, tools and objectives

2. Secure Basic Needs: Secure cash flow, housing, emergency funds

3. Build Wealth: Saving and investing

4. Protect Finances: Insurance and real estate planning

Marginal Reasoning

Evaluating if doing a little bit more is worth it by only considering what changes as a direct result of your choice.

Sunk Cost

A past, irreversible loss that should not influence current marginal reasoning ("Don't cry over spilt milk").

Sensitivity Analysis

Anticipating the financial impact on your plan if your assumptions turn out to be wrong.

Financial Position (Personal Balance Sheet)

Calculated as Assets (what you own) minus Liabilities (what you owe).

Financial Performance (Personal Cash Flow Statement)

Shows what is happening with your money over a specific period (monthly/yearly).

Human Capital

Your ability to earn and save money; considered your biggest and most powerful asset.

Discounting

The opposite of compounding; bringing a future value back to its Present Value (e.g., $100 received in 4 years discounted at 5% = $100 / (1.05)^4).

Compounding

Growing money forward into the future (e.g., $100 invested at 5% for 4 years = $100 x (1.05)^4).

Means you earn returns on original investment as well as previous interest earned. Creates accelerating growth over time.

Time Value Money

The concept that a dollar today is worth more than a dollar tomorrow due to opportunity cost, risk, inflation and human impatience.

Three factors:

Size (how big the amount of money is), Timing (how long before you receive it), and Risk (the discount/compounding rate used).

Inflation

The economic factor that causes money to lose purchasing power over time (e.g., $100 from 1966 only has about $6.16 in buying power today).

Affects the discount rate. Higher inflation means money buys fewer goods and services.

Human Capital Derivatives

A financial contract where someone receives money today in exchange for part of their future income.

Example:

• Anastasia receives $50,000 now

• Investor receives 10% of her income for 10 years

Cost and Benefits of HuCaDs

Benefit

• provides money immediately

• helps finance education and business opportunities

Cost

• You give up part of future income

• Difficult to accurately estimate future earnings

Factors that determine Human Capital Value

• Expected Income

• Wage Growth

• Working life remaining

• Discount Rate

• Risk

• Inflation

Estimating Human Capital Value

HC = PV(Year 1 income) + PV(Year 2 income) + PV(Year 3 income)

Present Value

How much future money is worth today.

Present Value is discounted Future Value

Present Value = Future Value / (1 + Discount Rate)^t

Future Value

What money today will be worth in the future.

FV = PV(1 + r)^t

r = interest rate

t = number of years

Rule of 72

A quick approximation to estimate the years it takes for something to double.

Years = 72 / Interest rate

Example 8%: 72 / 8 = 9 years to double

CPI

Measures the general increase in prices over time by measuring the prices of a basket of goods over time.

Nominal Value

Actual dollar amount that is not adjusted for inflation.

Example Movie Ticket:

1996 = $7.26

2023 = $16.96

Real Value

Value that is adjusted for inflation. Allows for a fair comparison across different years.

Example Movie Ticket:

2023 ticket $16.96 → 1996 real value of $8.42

Therefore, movies only slightly more expensive after accounting for inflation.

Winners of Inflation

• Borrowers: loans are repaid with dollars that are worth less

• People whose wage rises faster than inflation: purchasing power increases

Losers of Inflation

• People holding cash: loses purchasing power over time due to inflation

• Lenders: Loan repayments are worth less over time

Predictors of Wellbeing

Satisfaction in the domains of work, health, relationships, and finances (individuals differ in importance given to each).

Personal Cash Flow Statement

Records Income and Expenses/Outgoings to calculate a Surplus. Expenses are categorised as Fixed or Variable.

Fixed Expenses

Committed expenses that cannot easily be changed in the short run (e.g., loan repayments, utilities, study fees, insurance)

Variable Expenses

Expenses that can be changed or controlled in the short run (e.g., food, clothing, utilities, car fuel/servicing, extra super contributions, entertainment, travel).

Personal Balance Sheet

Records Assets, Liabilities, and calculates Net Worth (Total Assets - Total Liabilities).

Net Worth Ratio

(Net Worth / Total Assets) × 100
Meaning: Indicates the percentage of acquired assets you own outright vs. what lenders own. Changes over the lifecycle (can be negative when young).

Limitations of Net Worth Ratio

May hide information: doesn't show capacity to handle shocks, and you don't have to own an asset to get services from it (e.g., leasing a house/car).

FU (Emergency) Fund

Extra funds saved so that if you need to move away from unpleasant or dangerous situations, you can do it without wondering how you will make ends meet. Credit cards are NOT emergency funds.

Liquid Assets

Assets that convert to cash quickly with minimum loss of value. They provide options in "bad times" (financial shocks).

Liquidity Ratio

(Liquid Assets / Current Debt) × 100
Meaning: Shows the percentage of short-term debts covered by short-term (liquid) assets.

Basic Liquidity Ratio

Liquid Assets / Monthly Expenses (excluding super/savings)
Meaning: Shows the number of months you can cover expenses if there is no income. Recommended buffer is typically 3 to 6 months.

Building Financial Resilience

1. Increase income where possible

2. Spend according a plan

3. Build an emergency fund

4. Prepare contingency plan

5. Avoid relying on expensive debt

Savings Ratio

(Savings / Net Income) × 100
Meaning: Dictated by life-cycle stage (may be low/negative for young or older couples). Savings includes surplus plus extra super contributions.

Savings Goal Approach (Kitces)

Starting with a savings goal is going at it backwards; one should start from a spending lifestyle first, not a savings target, to avoid "Lifestyle Creep."

Debt Ratio

(Total Debt / Disposable Income) × 100
Meaning: Measures overall debt burden. RBA refers to loans >400% as high (considers buffers). Can also be measured as Total Debt / Total Assets.

Debt Service Ratio

(Annual Debt Payments / Disposable Income) × 100
Meaning: Measures ability to service debt. RBA estimates 1-in-5 to 1-in-4 borrowers have a DSR > 30% after interest rate increases.

Role of Setting Goals in Behaviour

Behavior change is significantly related to setting goals. Specificity is important, and monitoring by others makes success more likely. Whether goal is stated as behavior or long-term outcome didn't matter.

Downsides of Focusing on Goals

Overprescribing goal setting can have systematic side effects (e.g., narrow focus, unethical behavior, risk-taking).

Checking if a Goal is Real

Consider: Approval/support from others, importance to you/family, confidence in knowledge/budgeting, achievable with available resources, achievable within timeframe.

Planning Fallacy

A tendency to underestimate the time, costs, and risks of future actions, and overestimate benefits. Results in time/cost overruns and benefit shortfalls.

Action Plan

A self-regulatory strategy that, once a goal is decided, specifies required actions and how to handle potential obstacles. Detailed action plans help overcome procrastination.

Implementation Plan

Specifies the what, why, when, and how of the planned action, and how to handle identified obstacles.

Coping Plan

An "if-then" automatic strategy to handle obstacles or slow progress (e.g., "If progress is slow, then I will focus on the benefits I am gaining").

Good Financial Habits

Can take a very long time to form. Missing one opportunity to perform the behavior does not materially affect the habit formation process (hiccups happen).

Strengthening Goal Commitment

Review implementation plans, justify your strategy, tell somebody, and make it public.

Active Financial Planning Strategies

Pay Yourself First, Automate savings/actions, Talk to others.

Debt

Total amount of money a person or organisation owes to others. Debts can result from credit cards, loans, unpaid bills, or other borrowing arrangements.

Credit

The ability to borrow from a lender (such as bank or financial institution) with the promise of repaying it later.

Loan

Enables a borrower to receive a fixed amount of money and agree to repay it over time according to a schedule, usually with interest.

Interest

The cost of borrowing money. It is the amount a borrower pays to the lender for the use of borrowed funds

Primary Purpose of Debt

• It allows you to shift cash from future to present.

• It is the bargain that: value of debt today is greater than value of the future payments you make on it

HECS/HELP Loan

A type of debt borrowed from the government to pay for education. It is different because it does not accrue traditional interest (like credit cards/personal loans), but it is still considered debt by APRA.

Income Contingent Debt

Debt where repayments depend on your income (e.g., HECS/HELP: if income is low you repay nothing; if income rises, you repay more).

Goldilocks Debt Level

The "just-right" spot of debt that fits your personal financial plan. Too little debt might hinder human capital investment when young; too much debt creates risk and impacts wellbeing.

Secured Loan

A loan where security (an asset) is offered by the borrower. The lender takes less risk, so it usually has a lower interest rate. If the borrower fails to pay, the lender can sell the secured asset. (e.g., home mortgage).

Unsecured Loan

A loan where no asset is pledged. The lender takes more risk, resulting in higher interest rates, and they are generally for smaller amounts. (e.g., credit card, BNPL, payday loans).

Payday Loan

A type of unsecured loan letting you borrow up to $2,000 (16 days to 1 year to repay). Known for high fees rather than interest (e.g., borrowing $2,000 over 1 year can cost $3,360 total).

Credit Provider Responsibilities

Under the National Consumer Credit Protection Act 2009, they must: make reasonable inquiries about your financial situation, take steps to verify it, and ensure the contract is 'not unsuitable' for you.

Credit Suitability Checks

Credit cards: Ability to repay credit limit within 3 years.
Home loans: Ability to service loan if interest rate increases by +3% (APRA requirement).
Small Amount Credit Contracts: Repayments ≤ 10% of disposable income.

Consumer Awareness of Lenders

Lenders aim to make a profit (not charities), may be optimistically biased on your suitability, don't necessarily consider your best interests, and govts sometimes encourage lending (e.g., BNPL in Covid).

Credit Provider Licensing

Credit providers must have an Australian Credit Licence. Some retailers are exempt, but the actual credit provider behind them must be licensed.

Credit Guide

A document from a credit provider containing their licence number, contact details, fees/charges, and details of your right to complain or access their External Dispute Resolution Scheme (EDR).

Cooling Off Period

A set time after signing a contract where you can cancel without heavy penalty. Generally does not exist for credit/loans. Exceptions include gym memberships, door-to-door/phone sales, retirement villages, and unsolicited sales (10 days). It does NOT apply to cars (in WA) or houses.

Credit Contract

Must be in writing. Common fees include: monthly account fees, late/missed payment fees, over-limit fees, and establishment fees.

Co-Borrowers

New partners or joint owners who are both legally responsible for the joint debt (common with joint home mortgages).

Guarantor

A person who guarantees a loan and must pay the entire loan if the borrower cannot. Doing this can stop the guarantor from getting a loan themselves and could result in a bad credit report.

Loan Size (TVM)

Loan size is a Time Value of Money question. If money is more expensive (higher interest rates/higher risk), you get a smaller loan for the same repayment capacity.

PV and FV in Loans

Present Value is the amount you borrow

Future Value is the amount you repay

Interest Calculation (Days)

For short terms: Interest = Principal × (Rate/100) × (Days/365). In Australia, assume 365 days unless otherwise stated.

Simple/Flat Interest Loan

Interest is calculated on the original principal for the entire term. Total Repayment = Principal + (Principal × Rate × Years).

(Note: a flat rate is NOT the same as a fixed rate).

Reducing Balance (Amortized) Loan

Interest is charged only on the outstanding balance. As the balance falls, the interest falls, meaning more of each repayment goes toward the principal. It almost always costs less in total than a flat-interest loan.

Loan Feature Relationships

Shorter loan term: Higher repayments, but lower total repaid.

Higher interest rate: Higher repayments, and higher total repaid.

Debt Repayment Behavior

People often split extra repayments evenly across debts rather than paying off the most expensive debt first, which is mathematically suboptimal.

Cost of Debt

Not just interest; includes fees, penalties, and transaction costs. Lenders "package" debt to look attractive (e.g., hiding high fees behind 0% interest).

Small Amount Credit Contract Fees

May not charge interest, but have an Establishment fee (up to 20% of loan), Account keeping fee (up to 4% per month), and a total repayment limit of 200% of the loan. Short-term rates equate to massive annual rates (e.g., 24% over 4 weeks ≈ 312% p.a.).

“Interest-Free” Loan

They are not cost-free. Often include high monthly account fees (e.g., $10.95/mo = $131.40/yr) and high revert interest rates if not paid in time. Effective p.a. rate can be very high due to fixed fees on small balances.

Buy Now Pay Later (Afterpay)

Makes money from merchant fees (retailers) and late fees, not interest.

Debt Diversification

Having multiple separate debts, which can be costly due to varying high interest rates, fixed transaction costs/fees (fixed fees hurt more on small loans), and the time/effort required to manage them.

Refinance

Renegotiating a single debt (e.g., asking your bank to change terms on your home loan or switching to a bank with a better rate).

Consolidate

Combining multiple debts into one new single loan (e.g., paying out credit cards and car loans with a new mortgage).

Smart Consolidation

Consolidation to reduce total repayments, not just monthly repayments. Extending the loan term might lower monthly payments but increase the total cost of the debt.

Leverage

The term used to describe the amount of debt, because debt magnifies effects (gains and losses).

Managing Debt (Shocks)

You must contemplate "what ifs" (e.g., loss of income, interest rate increases) because debt makes shocks tougher to handle. Plan to make additional payments to buffer against risks.

Risk

Exists because future outcomes are uncertain. You might have a car accident, lose your house or lose your job.

Binary Outcome

Something either does or doesn’t happen.

Continuous Outcome

Result of risk can take many different values such as investment can be various percentages.

Standard Deviation

Measures how much outcomes vary around the mean.

Small SD = Outcomes are predictable.

Large SD = Outcomes are unpredictable.

Prospect Theory

The idea that people tend to feel losses more strongly than gains of that equivalent amount

Gain $100 → Feels Good

Lose $100 → Feels Much Worse

Speculative Risk

There is probability of gain or loss

Pure Risk

There is only probability of loss

Risk Management Process

1. Identification - Identify risks you are exposed to

2. Evaluation - Potential size and consequences of losses

3. Management - Choose what to do about risk

4. Review - Regularly reassess your situation and whether strategy works

Insurance

You pay a certain cost in exchange for protection against a potentially very large uncertain loss.

• Health Insurance

• Pet Insurance

• Car Insurance

Insurance Excess

The amount you must cover yourself in an insurance claim. You cause $5000 of damage, you only pay $500 while insurance covers the rest.

Principle of Utmost Good Faith

The insured has a duty to take reasonable care not to make a misrepresentation or mislead the insurer. Failure to meet this duty may void a contract or reduce insurer liability upon a subsequent claim.

Income Tax

Taxes on income such as wages, capital gains, dividends and interest

Indirect Tax

Tax on spending or transactions, such as GST, sales taxes, excise taxes and stamp duties.