FMST 201: Introduction to Financial Management

Core Principles of Money Management

• Definition: Money management is the comprehensive process of planning and controlling your income, expenses, investments, and savings specifically to achieve financial security.

• Influencing Factors: Perspectives on financial management are heavily influenced by individual personality, parental experiences, and the specific economic conditions that existed during an individual's formative years.

Interest Calculations: Simple vs. Compound

• Simple Interest: Simple interest calculates the interest rate based only on the original amount (principal) every year. This calculated interest is then added to the original amount at the end of the term.

• Compound Interest: Compound interest calculates the interest rate based on the original principal plus any interest that has already been earned in previous cycles.     - The interest earned is added to the principal to create a new, larger base amount for calculating the subsequent round of interest.

Budgeting and Cash Flow Management

• PYF Mentality: Individuals are encouraged to adopt a "Pay Yourself First" (PYF) approach to income distribution. This involves transferring a percentage of after-tax earnings directly to a savings account before any expenses are paid.

• The Balanced Budget: The initial goal of budgeting is to achieve a balanced budget, defined by the formula:
    $\text{Income} - \text{Expenses} = 0$

• Strategic Goal Setting: Once a budget is balanced, an individual should set short-term, medium-term, and long-term goals to enhance the effectiveness of saving money.

• Tracking Cash Flow: Cash flow should be tracked over a set period. Expenses are categorized as follows:     - Fixed Expenses: Costs that do not change (e.g., rent).     - Flexible Expenses: These involve external resources.     - Discretionary Expenses: Costs determined by personal decisions where the individual decides how much to spend.

• Timing and Scheduling: Effective cash flow management requires ensuring the timing and dollar amount of monthly expenses coincide with monthly paychecks. It may be necessary to shuffle payment due dates to prevent negative cash flow during the month.

The 50/30/20 Rule for After-Tax Income

• $50\%$ Essential Costs: This includes critical living expenses such as rent/mortgage, groceries, car expenses, and utilities.

• $30\%$ Needed/Discretionary Expenses: This includes costs like cell phone bills, internet service, and social activities.

• $20\%$ Savings: This allocation is dedicated to emergency funds, mid-term and long-term purchases, and retirement.

Prioritizing Expenses During Financial Hardship

When funds are low, personal expenses must be prioritized in the following order:

1. Rent or Mortgage payments.

2. Food and necessary supplies.

3. Utilities.

4. Expenses that facilitate earning income (e.g., car, cell phone, internet services).

5. Health insurance and healthcare expenses.

6. Minimum payments on other loans, specifically credit cards and student loans.

Retirement Accounts: 401(k)

• Overview: An employer-sponsored retirement savings plan.

• Tax Benefits: Contributing to a 401(k) reduces taxable income, leading to lower taxes during the contribution year.

• Taxation: Taxes are paid only when withdrawals are made.

• Withdrawal Rules:     - Standard withdrawals can begin at age $59\frac{1}{2}$.     - Early withdrawals (before $59\frac{1}{2}$) generally incur a $10\%$ penalty on the current amount.

• Management Considerations:     - It is vital to ensure funds are actively invested rather than sitting idle and collecting minimal interest.     - Expense Ratios (Fees): Account holders should monitor fees. The average percentage is $0.44\%$, with a typical range between $0.03\%$ and $1.0\%$. These fees are compounded over time.

Individual Retirement Accounts (IRA)

• Overview: These accounts are not employer-based; anyone with earned income can open one.

• Traditional IRA: Operates similarly to a 401(k) regarding income tax benefits and taxation upon withdrawal.

• Roth IRA:     - Contributions are taxed before being deposited into the account.     - Choosing a Roth IRA means paying taxes at the individual's current tax bracket.     - This is beneficial if the individual expects to be in a higher tax bracket at retirement age or expects tax rates to rise.

Exceptions to the $10\%$ Early Withdrawal Penalty

Certain circumstances allow for penalty-free distributions from retirement accounts:

• Birth or Adoption: Up to $\$5,000$ in penalty-free withdrawals is allowed per eligible birth or adoption.

• Military Reservists: Members called to active duty for at least $180$ days or an indefinite period.

• Financial Emergencies: One distribution per year up to $\$1,000$ for unforeseeable or immediate personal/family emergencies. This triggers income tax but can be repaid within $3$ years.

• Medical Expenses: Qualified expenses that exceed $7.5\%$ of Adjusted Gross Income (AGI).     - $\text{AGI} = \text{Income} - (\text{Itemized or Standardized Deductions})$

• Higher Education: Tuition, fees, room, and board for $12$ months of postsecondary education for the account holder, spouse, children, or dependents.

• Health Insurance while Unemployed: Available to those who have received unemployment insurance for $12$ consecutive weeks.

• First-time Home Purchase: Up to $\$10,000$ for a qualified principal residence.

The Stock Market and Investing

• Mechanism: The market involves investors buying, selling, and trading shares (ownership) of companies, bonds, and commodities.

• Corporate Utility: Companies raise money through the market to:     - Accelerate successful startups.     - Expand existing businesses.     - Consolidate operations and pay off debt.

• Investor Goal: Buying shares (providing capital for a company to increase profit) with the expectation of reaping financial benefits later by selling those shares.

• Economic Impact:     - Provides transparency for business practices.     - Funds technological and medical research and development (R&D).     - Promotes job creation and economic stability.     - Supports pension funds, which are significantly invested in the market to finance retirement, salaries, and projects.

Home Ownership: Conventional Loans

• Eligibility: Generally offered to those with good credit and strong financials. The average credit score requirement is $620$.

• Debt-to-Income (DTI) Ratio: A metric used by lenders to gauge the likelihood of repayment. It represents the percentage of monthly gross income spent on debt (credit cards, car loans, student loans).     - Front-end Ratio: $\frac{\text{Future Monthly Mortgage Payment}}{\text{Monthly Gross Income}}$. Target should be below $28\%$.     - Back-end Ratio: $\frac{\text{All Monthly Debt Payments} + \text{Mortgage Payment}}{\text{Monthly Gross Income}}$. Target should be below $36\%$.

• Thresholds: Maximum DTI for mortgage qualification is $43\%$. Loan approval is difficult if the back-end DTI is $50\%$ or higher.

Home Ownership: FHA, Freddie Mac, and Fannie Mae Loans

• Target Audience: Low-to-moderate-income families with average or below-average credit scores; popular with first-time homebuyers.

• Requirements: Credit scores typically between $580$ and $640$.

• Characteristics: These loans have more lenient credit requirements and lower down payments but come with more restrictions and higher interest rates.

Down Payments and Insurance (PMI/MIP)

• Standard Down Payment: $20\%$ of the house price.

• Private Mortgage Insurance (PMI): Required on Conventional Loans with less than a $20\%$ down payment.     - Costs range from $\$30$ to $\$70$ per $\$100,000$ borrowed.     - PMI can be cancelled upon request once $20\%$ equity is reached; it must be cancelled by the lender at $22\%$ ownership.

• Mortgage Insurance Premium (MIP): Required for FHA/Fannie Mae/Freddie Mac loans.     - Upfront MIP (UFMIP): $1.75\%$ of the loan amount (e.g., $\$2,625$ on a $\$150,000$ loan).     - Annual MIP: $0.45\%$ to $1.05\%$ of the loan, split into monthly installments.     - Duration: Remains for $11$ years if the down payment is between $10\%$ and $20\%$. Remains for the duration of the loan if the down payment is less than $10\%$.

Components of a Monthly Mortgage Payment

1. Principal: The original amount borrowed; payments reduce this balance to build equity.

2. Interest: The cost of borrowing, expressed as a percentage of the principal.

3. Taxes: Local property taxes based on assessed value.

4. Insurance: Homeowners' insurance to protect against damage or loss.

Closing Costs and Finalizing the Purchase

• Closing Costs: Fees paid to third parties (attorneys, lenders, title companies). Typically range from $3\%$ to $6\%$ of the loan amount.

• Maryland Specifics (2025): Average closing costs were between $\$14,000$ and $\$21,000$.     - Example Calculation: $\$300,000$ home, $20\%$ down ($\$60,000$), $\$240,000$ loan. Total cash needed: $\$60,000$ (down payment) + approximately $\$14,000$ to $\$21,000$ (closing costs) = $\$74,000$ to $\$81,000$.

• Loan Estimate: Lenders must provide this within $3$ business days of application. Multiple estimates within a $45$-day period count as only one hard credit inquiry.

• Strategies to Reduce Costs:     - Close at the end of the month to reduce accrued interest.     - Close near the end of the property tax year (In Maryland, the tax year is July 1st to June 30th).     - Shop around for title companies, insurers, inspectors, and appraisers.     - Request that the lender waive or reduce application, processing, or underwriting fees.