Comprehensive University Study Notes on Personal Finance and Financial Planning
Personal Financial Planning: Foundations and Decision Making
Personal finance is defined as the many financial issues that can affect an individual.
Personal financial planning is the process of planning every aspect of your personal finances. This includes spending, borrowing or financing, and saving and investing to achieve the highest quality of life possible.
Key terms in personal finance include:
Bankruptcy: A legal process in which a court takes over some of the finances of a person who is unable to pay his or her bills.
Liquid asset: Something owned that can be rapidly converted to cash without a risk of significant loss; for example, cash or a savings account.
Opportunity cost: The cost of pursuing one option instead of another, expressed as the value of the activity you gave up.
The benefits of good financial decision-making include achieving life goals, avoiding common financial pitfalls, and attaining peace of mind through financial security.
The Seven Components of a Personal Financial Plan
A personal financial plan acts as a detailed road map or builder’s blueprint for wealth accumulation and emergency provision.
Component 1: A Plan for Your Budgeting and Taxes:
Budgeting involves forecasting future expenses and income to meet needs and wants.
Creating a budget includes four steps: (1) Determining net worth, (2) Establishing income, (3) Identifying expenses, (4) Considering tax impacts.
Net Worth Formula: .
Assets are items owned (cars, homes, collections), while liabilities are debts (loans, credit balances).
Equity refers to the specific amount of an asset that is owned after subtracting liabilities: .
Component 2: A Plan for Managing Your Liquidity:
Liquidity refers to how much readily available cash you have for immediate needs.
Managing liquidity involves money management (deciding how much cash to keep in reserve) and credit management (deciding how much credit to use to cover shortfalls).
Component 3: A Plan for Your Financing:
Financing is for major purchases like homes and cars.
Understanding payment terms, interest rates (price of borrowing), and creditworthiness (the likelihood of repayment) is essential.
Component 4: A Plan for Managing Your Risk:
Risk is the possibility of financial loss.
Insurance planning involves determining types and amounts of coverage needed to protect assets (house, car) and income (health, life, disability insurance).
Component 5: A Plan for Your Investing:
Excess funds should be invested in assets such as stocks, bonds, and mutual funds to earn more money.
Component 6: A Plan for Your Retirement:
Retirement planning involves determining annual savings needs and building wealth early to have the option to retire.
Component 7: A Plan for Communicating and Keeping Records:
Accurate record-keeping is necessary for taxes, calculating net worth, and helping heirs.
Financial Decision-Making and Cash Flow
Personal financial planning centers on cash flow: cash inflow (money received from sources like wages, allowances, or interest) and cash outflow (money spent on items like rent, utilities, and debt).
Step-by-Step Decision-Making Process:
Establish Your Financial Goals: Categorize as short-term (<1 year), intermediate-term (1–5 years), and long-term (>5 years). Goals must be realistic and achievable.
Evaluate Your Current Financial Position: Identify current income, expenses, assets, and debt.
Identify and Evaluate Options: Consider multiple paths to the same goal (e.g., working more hours vs. taking a student loan).
Pick the Best Plan: Based on risk tolerance (likelihood of loss vs. potential reward) and self-discipline.
Periodically Evaluate Your Plan: Monitor progress to ensure goals are on track.
Revise Your Plan as Necessary: Adjust for changes in circumstances or unachievable objectives.
Personal Financial Statements: Budgets and Balance Sheets
A personal cash flow statement records cash inflows and outflows to track money sources.
A budget is a forecast of future cash inflows and outflows, covering several months to a year.
Forecast Error: . High forecast errors indicate a need to adjust spending or increase income.
A personal balance sheet provides a summary of financial position at a specific point in time.
Liquid Assets: Cash or items easily converted to cash (checking/savings accounts).
Household Assets: Items typically owned (cars, houses, furniture) valued at market value (what they would be worth if sold today).
Investment Assets: Items acquired to make money (stocks, bonds, real estate).
Liabilities on the balance sheet:
Current Liabilities: Debts to be paid within one year (credit card balances).
Long-term Liabilities: Debts taking longer than one year to pay (student loans, mortgages).
Debt-to-Asset Ratio: Used by lenders to determine borrowing capacity. .
Careers, Education, and Income
Career choice affects lifetime income and job security. Higher education generally correlates with higher weekly earnings and lower unemployment rates.
Determining a Career Path: Identify interests and personality, screen for education requirements, job availability, and compensation.
Gaining Skills:
Apprenticeship: On-the-job training for specialized trades.
Internship: Temporary position providing exposure and training.
Certification: Official record of meeting training standards.
Accreditation: Recognition that a school or program meets professional standards.
Job Application Process: Involves filling out applications, preparing a résumé (snapshot of qualifications), writing cover letters, and interviewing.
The Principles of Taxation
Tax is money collected by governments to fund services like national defense, roads, and schools.
Types of Taxes:
Sales Taxes: Imposed by state and local governments on purchases.
Real Estate Taxes: Based on property value to fund local schools.
Payroll Taxes: Federal and state income taxes, plus FICA (Social Security and Medicare).
Federal Insurance Contributions Act (FICA):
Funds Social Security (payments to retirees/disabled) and Medicare (health care for elderly/disabled).
Social Security: 6.20% withholding (reduced to 4.20% for 2011–2012).
Medicare: 1.45% withholding with no income cap.
Filing Income Taxes:
Managed by the Internal Revenue Service (IRS).
Filing deadlines are typically April 15th.
Gross Income includes wages, interest, dividends, and capital gains (taxable gain from selling an asset for more than its purchase price).
Adjusted Gross Income (AGI) is gross income minus allowable amounts like student loan interest.
Standard Deduction is a fixed amount deducted to reduce tax liability. Itemized Deductions are specific expenses (mortgage interest, charity) used if the total exceeds the standard deduction.
Insuring Health and Life
Insurance is a financial product providing reimbursement for financial losses.
Health Insurance:
Policyholder: The person who buys the policy.
Premium: Regular payments for coverage.
Deductible: Amount paid by the policyholder before the insurance company pays.
Co-insurance (Co-pay): The share of costs for covered services paid by the insured.
HMOs (Health Maintenance Organizations) require a primary care physician (PCP) for referrals. PPOs (Preferred Provider Organizations) offer more flexibility at a higher cost.
Government Health Plans:
Medicare: For those 65+ or disabled.
Medicaid: For low-income individuals.
Life Insurance:
Beneficiary: Receives payment upon the policyholder’s death.
Term Insurance: Coverage for a 5–20 year period; no savings built.
Whole Life Insurance: Permanent coverage as long as premiums are paid; builds cash value.
Universal Life Insurance: Combines term and whole life features for more flexibility.
Key Legislation:
HIPAA (Health Insurance Portability and Accountability Act): Allows continuation of coverage when switching jobs.
COBRA (Consolidated Omnibus Budget Reconciliation Act): Allows continuation of coverage for 18 months after employment ends.
Economics and the Macro Environment
Economics is the study of choices made under limited resources.
Business Cycles: Pattern of shrinking and expansion in the economy.
Gross Domestic Product (GDP): Total dollar amount of final goods/services purchased in a nation in a given year.
Recession: A period of economic shrinkage. Depression: A severe recession.
Demographics: The study of human populations (e.g., "Graying of America" baby boomers born 1946–1964).
The worker-to-beneficiary ratio for Social Security was 16:1 in 1950 and is projected to be 2.1:1 by 2035.
Inflation: A sustained increase in the general level of prices, measured by the Consumer Price Index (CPI). Inflation reduces purchasing power.
Global Economy: The world where national economies interact. Globalization increases competition and outsourcing risks for low-skilled workers.
Credit Basics and Interest
Credit is money made available by a lender to a borrower to be repaid in the future with interest.
Types of Consumer Credit:
Noninstallment: Extended for a short term (e.g., 30 days, same as cash).
Installment credit: Specific purchases repaid monthly; includes principal (total amount outstanding) and interest.
Revolving open-ended credit: Borrowing up to a preset limit repeatedly (e.g., credit cards).
Credit Bureaus: Equifax, Experian, and TransUnion. They compile credit reports.
Credit Score: FICO score ranges from 300 to 850. Factors: Payment history (35%), Amounts owed (30%), Length of history (15%), New credit (10%), Types of credit used (10%).
VantageScore: Alternative system ranging from 501 to 990.
Identity Theft: Theft of personal info for financial gain. Tactics include shoulder surfing, skimming, phishing (online), and pharming (viral redirection).
Major Personal Loans: Housing, Education, and Vehicles
Personal loans are typically started at the time of purchase for specific assets.
Loan Contracts include the Annual Percentage Rate (APR), which factors in all financing costs.
Secured loan: Asset-pledged (collateral). Unsecured loan: No collateral (signature loan).
Housing:
Mortgage: Loan for a home where the house is collateral.
Fixed Rate Mortgage: Interest remains the same throughout the loan life.
Adjustable Rate Mortgage (ARM): Rate resets periodically based on economic conditions.
Home Equity Loan: Borrowing against the difference between a home's value and the mortgage balance.
Education:
Subsidized Federal Stafford Loans: Need-based; government pays interest while the student is in school.
Unsubsidized Stafford Loans: Not need-based; interest accrues immediately.
Perkins Loans: Lower interest for exceptional financial need.
Vehicles:
Leasing: A long-term rental agreement; lower payments but no ownership/equity.
Car Insurance components: Liability (property/bodily injury), which is often required by law.
Risk Management and Credit Cards
Credit limits are the maximum borrowable amounts. Overdraft protection allows exceeding limits for a fee.
Grace period: A 21-day minimum period where no interest is charged on new purchases if the balance is paid in full.
Debt Consolidation: Combining small accounts into one larger loan at a lower interest rate (e.g., using a home equity loan to pay credit card debt).
Risky Lending Alternatives:
Payday lending: Cash advances on post-dated checks with fees equivalent to triple-digit interest rates.
Pawnbroker: Loans based on collateral (firearms, jewelry) that can be sold if not redeemed.
Banking, The Federal Reserve, and Saving Methods
Depository Institutions: Commercial banks, savings banks, and credit unions (nonprofit, member-owned).
Federal Reserve System (The Fed): The nation’s central bank. Goals: economic growth, full employment, and price stability.
Monetary Policy: Adjusting the money supply to influence interest rates and the economy.
Fiat money: Money with value by government decree, not intrinsic worth.
Deposit Insurance: FDIC (banks) and NCUSIF (credit unions) insure up to $250,000 per depositor per institution.
Savings Accounts:
Demand Deposit: Funds in checking that can be withdrawn at any time.
Certificate of Deposit (CD): Contract specifying the time funds must stay in the bank and the interest rate earned.
Money Market Deposit Account (MMDA): Higher interest than NOW accounts with limited check-writing.
APY (Annual Percentage Yield): Actual interest earned on an annual basis accounting for compounding frequency.
Retirement and Planning for the Future
Retirement Options:
Defined-benefit plans (pension): Guarantee specific income; based on years worked and salary.
Defined-contribution plans: Employer contributes, but no guaranteed payout; employee assumes risk. Examples: 401(k) (for-profit) and 403(b) (nonprofit).
Vesting: The process of earning eligibility for employer benefits.
Individual Retirement Accounts (IRAs): Traditional (tax-deductible/deferred) or Roth (after-tax contributions/tax-free earnings).
Annuities: Financial products providing annual payments for a fixed period or life.
Time Value of Money: Money today is worth more than money tomorrow due to earning potential.
Compounding: Earning interest on the principal and previously earned interest.
Rule of 72: .
Portfolio Management: A portfolio is a collection of all investments.
Diversification: Investing in multiple asset classes to reduce risk.
Asset Allocation: Spreading investments among different categories (stocks, bonds, real estate).
Estate Planning: Determining how assets are distributed at death.
Will: Legal request for distribution; identifies guardians.
Intestate: Dying without a will, leaving the court to distribute the estate.
Trust: Legal mechanism to transfer assets and minimize tax liability.