Teacher Guide (Oct 6)

High School Course
Teachers Guide
State of California
Department of
Real Estate
Financial Literacy 101
2011 California Department of Real Estate

This project is a result of a partnership by and between Sacramento Charter High School
("SCHS"), and the National Association of Real Estate Brokers-Investment Division,
Inc., a HUD Housing Counseling Agency NID-HCA ("NID-HCA") and the State of
California Department of Real Estate.
State of California Department of Real Estate

First Printing: 2011

Disclaimer: The views and opinions expressed in this text do not necessarily reflect the
official policy or position of any agency of the State of California. Examples of analysis
performed within this article are only examples. Assumptions made within the analysis
are not reflective of the position of any State of California entity.
For inquiries, please contact:
State of California Department of Real Estate
Dionne Young Faulk, Financial Literacy Chairperson
320 w. 4
th
Street, Suite 350
Los Angeles, CA 90013
Web site: www.dre.ca.gov

Acknowledgements
This Financial Literacy High School course is provided by the California Department of
Real Estate (DRE) in partnership with Sacramento Charter High School ("SCHS"), and
the National Association of Real Estate Brokers-Investment Division, Inc., a HUD
Housing Counseling Agency NID-HCA ("NID-HCA"). Its production and distribution is
part of the DRE Financial Literacy Outreach Program initiative enacted under the vision
of former Real Estate Commissioner Jeff Davi. The California Department of Real
Estate is committed to a very important and strategic outreach effort critical to promoting
an understanding for all Californians of real estate financial transactions including but not
limited to purchasing a first home, renting and refinancing an existing mortgage.
California experienced a challenging financial impact caused in part by the lack of
consumer knowledge and a thorough understanding regarding the financial commitment
required for homeownership and the complexity of real estate transactions and financing.
Knowledge is power. The DRE believes that by educating all Californians--from young
adults to senior citizens--with the power of real estate knowledge, they will have greater
understanding in their real estate transactions and financing and be less likely to be
victimized by real estate fraud.

The California Department of Real Estate is dedicated to developing and implementing
an innovative real estate financial literacy program that provides important and relevant
information and resources with a specific focus based upon emerging needs.

The following are those very key people involved in the success of this high school
course:
The California Department of Real Estate
Jeff Davi, Former Real Estate Commissioner, California Department of
Real Estate
Barbara Bigby, Chief Deputy Commissioner, California Department of
Real Estate
Dionne Young Faulk, Managing Deputy Commissioner and Financial
Literacy Outreach Program Chairperson, California Department of Real
Estate
Jacqueline Carlisle, Executive Director, NID-Housing Counseling
Agency
Will Jarrell, Principal, Sacramento Charter High School
Barbara Favila, Instructor, Sacramento Charter High School
California Department of Real Estate Financial Literacy Outreach Task
Force
TableofContents
PART1StudyGuide
Chapter1
FinancialLiteracy:TheIntroduction
1
WhatIsFinance?
WhyIsFinancialLiteracyImportant?
WhatWillYouLearn?
WhatIstheFinancialEnvironmentYouLivein?
HowDoYouPlanforYourFinancialFuture?
WhatCanYouDoWhenYouDontHaveEnoughMoney?
WhatDoYouNeedtoKnowAboutGoingtoCollege?
WhatShouldYouDoWhenYouHaveExcessMoney?
CanYouAffordtoBuyaHouse?
4
4
4
4
4
4
5
Chapter2
TheFinancialSystemintheU.S.
6
TheU.S.DollarandtheFederalReserve
TheBankingIndustry
TypesofBankAccounts
RateofReturn
Privileges,RestrictionsandFees
Safety
ManagingYourBankAccount
9
9
10
10
12
Chapter3
FinancialPlanningandBudgeting
15
ShortTermBudgeting
Income
Expenses
ContingenciesandSavings
TheBottomLine
PeriodicReview
ExampleofShortTermBudget
LongTermBudgeting
TheTimeValueofMoney
16
16
16
18
19
19
19
21
22
Chapter4
BorrowingandConsumerCredit
26
UsingConsumerCredit
TypesofConsumerCredit
FactorsCreditorsConsider
WhatIsaFICOScore?
WhyIsCreditScoreImportant?
PaymentsofClosedEndCredit
HowDoesGoodCreditHelpYouSaveMoney?
26
27
28
29
29
30
31
Chapter5
FinancialDecisionMakinginCollege
34
PlanningforCollege
BenefitsofAttendingCollege
CostsofAttendingCollege
UsingCreditCards
FeaturesofCreditCards
IdentityTheft
RentinganApartment
LocationandBuildingFeatures
LeaseTerms
Insurance
34
34
35
36
37
38
38
39
39
40
Chapter6
SavingandInvesting
41
PopularInvestmentVehicles
BankAccounts
Bonds
Stocks
RealEstate
MutualFunds
TaxImplications
WhatTypesofTaxesAreYouRequiredtoPay?
HowDoTaxesAffectYourFinancialGoals?
42
42
43
44
45
46
46
47
47

Chapter7
BuyingYourFirstHome
50
HomeOwnership
HomeBuyingProcess
HomeFinancing
TypesofMortgages
MonthlyMortgagePayment
CostofMortgages
51
52
53
53
54
54
PART2Glossary
PART3PowerPointSlides
PART4ExcelSpreadsheetModels
PART5Appendices
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GU UI ID DE E
Chapter1FinancialLiteracy:TheIntroduction
STUDENTLEARNINGOBJECTIVES
Inthischapter,youwilllearn:
Themeaningoffinanceandwhyitisimportant
Thefinancialconceptsanddecisionmakingskillsyouwilllearninthiscourse
KEYTERMS
Finance
RateofReturn
Investment
Risk
WHATISFINANCE?
Financialliteracyistheabilitytounderstandfinance.Itisaboutdevelopingtheknowledgeand
skillsthatwillallowyoutomakebetterfinancialdecisions.Thefirststeptowardfinancial
literacyistounderstandthemeaningoffinance.Youhaveprobablyheardoftheterm(ora
variantofit,suchasfinancialandfinancing)alot.Forexample,TVnewsreportsonthe
financialcrisisandhowthathasaffectedtheeconomy;inTVcommercials,automakersoffer
specialfinancingof0%APRtocarbuyers;andyourguidancecounselormayhavetoldyouthat
financeisoneofthemostpopularmajorsincollege.
Whatexactlydoesfinancemean?Herearesomedefinitionsfromauthoritativesources:
Finance,theprocessofraisingfundsorcapitalforanykindofexpenditure.Consumers,
businessfirms,andgovernmentsoftendonothavethefundsavailabletomake
expenditures,paytheirdebts,orcompleteothertransactionsandmustborroworsell
equitytoobtainthemoneytheyneedtoconducttheiroperations.Saversandinvestors,on
theotherhand,accumulatefundswhichcouldearninterestordividendsifputto
productiveuse.Thesesavingsmayaccumulateintheformofsavingsdeposits,savingsand
loanshares,orpensionandinsuranceclaims;whenloanedoutatinterestorinvestedin
equityshares,theyprovideasourceofinvestmentfunds.Financeistheprocessof
channelingthesefundsintheformofcredit,loans,orinvestedcapitaltothoseeconomic
entitiesthatmostneedthemorcanputthemtothemostproductiveuse.
BritannicaEncyclopedia
1
1. Moneyorotherliquidresourcesofagovernment,business,group,orindividual:
Finances
2. Thesystemthatincludesthecirculationofmoney,thegrantingofcredit,themakingof
investments,andtheprovisionofbankingfacilities
3. Thescienceorstudyofthemanagementoffunds
4. Theobtainingoffundsorcapital:Financing
MerriamWebsterDictionary
Theseformaldefinitionssoundcomplicatedandmayevenbealittlebitconfusing.They
probablywouldnothelparegularpersoncomprehendwhatfinanceis,andwhyunderstanding
itissoimportant.Amuchsimplerwaytodescribefinanceisthatitisasubjectthatdealswith
money.Thedownsideofusingsuchasimpledefinitionisthatyoumayunderestimatethe
complexityoffinanceandhavethefalsesensethatmakingfinancialdecisionsiseasy.Because
financeisnotjustaboutspendingmoney(whichmostpeopleareverygoodat)butisabout
managingmoney,youmayneedhelptobecomefinanciallyliterate.Ontheotherhand,finance
isnotrocketscience,soallyouneedisbasicmath,logicalthinkinganddisciplineinorderto
makesoundfinancialdecisions.Theexamplebelowhelpsillustratesomeofthefactorsthat
shouldbetakenintoaccountwhenmakingfinancialdecisions.
Considerthissimplequestion:$100and$105,whichisbetter?Theimmediateresponseby
mostpeoplewouldbe$105,ofcourse.However,theanswerisnotthatstraightforwardand
mayrequireyoutotakeseveralfactorsintoconsideration.First,arewecomparing100US
Dollarswith105USDollars?Iftherearedifferentcurrenciesinvolved(forexample,theUS
DollarandtheCanadianDollar),theanswerwouldbeaffected.Whentheeconomicconditions
change,oneUSDollarmaybeworthmoreorlessthanoneCanadianDollar.Ifwefocusonthe
USDollaronly,thenthenextfactortobeconsiderediswhetheryourereceivingorpayingthe
amounts.Allrationalpeoplewouldchoosetoreceivemore,butprefertopayless.Now
supposeyourchoicesaretoreceiveeitherUS$100orUS$105.Thenthethirdfactoriswhen
youexpecttoreceivethemoney.Thesooneryougetthemoney,thesooneryoucanspendit,
orsaveitinabankaccountandstartearninginterest.Asaresult,$100todaymaybeabetter
choicethan$105tobereceivedthreeyearsfromnow.Tomakethetwoalternativesmore
comparable,letsassumeyouexpecttoreceiveeitheramountinUSDollarsayearfromnow,
whichoneisbetter?Theanswermaydependonwhopromisestopayyoutheamount.Most
peoplewouldchoose$100promisedbysomeonetheytrust,insteadof$105fromsomeone
theybarelyknow.Thisistheconceptofrisk,whichdealswithuncertaintiesinthefuture.This
exampledemonstratesthatfinanceisasubjectthatdealswiththeconceptsofmoney,time,
riskandhowtheyareinterrelated.
2
DOTHEMATH
Rateofreturnisaveryimportantmeasureoftheprofitabilityofaninvestmentopportunity.It
iscalculatedastheratioofhowmuchyouearnontheinvestmenttohowmuchyoupayforthe
investment.Mathematically,therateofreturncanbecomputedbasedonaninvestments
valuenowanditsvalueattimeofpurchase:
Rotc o rcturn = _
Ioluc now -Ioluc ot timc o purcbosc
Ioluc ot timc o purcbosc
]
Calculatetherateofreturnonthefollowinginvestmentopportunities:
Youpaid$20forastockanditisworth$22now.
Aninvestorboughtabondfor$980anditsvaluehasincreasedto$1,035.
Jasonpurchasedahousefor$300,000,andthehouseisnowworth$314,580.
WHYISFINANCIALLITERACYIMPORTANT?
Overthecourseofyourlife,howmuchmoneydoyouthinkyouaregoingtoearn?Tensof
thousands?Hundredsofthousands?Formostpeople,thetotalamountofmoneyyouearn
fromthefirstjobyougetafterfinishingcollegetothetimeyouretirewillbeover$1million.
Theaverageannualsalaryforcollegegraduatesisabout$45,000.Assumethatyoustartyour
careerattheageof22andneverreceivearaise(whichishighlyunlikely,butletsbe
conservativeintheestimation).Ifyouretireattheageof65,thetotalamountyouwillearn
overthe43yearperiodwillbe$1,935,000,nearly$2million.Withanannualincreaseofonly
1%,yourtotalearningswillexceed$2.4million.Doyouknowhowtomanagemillionsof
dollars?Itsoundslikesuchahugeamountthatyouwouldneverneedtoworryaboutrunning
outofmoney,right?Unfortunately,ifyoudonthandleyourfinancesproperly,thisseemingly
unlimitedamountwillnotbeenough.
DavidEdwardsfromKentuckywasthePowerballjackpotwinnerinAugust2001andtookhome
$27millionincash.InaninterviewwithCNN,hesaidhewasgoingtobesmartwithhismoney.
Sixyearslater,Edwardswasevictedfromhis$1.2millionhomeinFlorida;shortlythereafter,he
wasevictedfromastorageunithewaslivingin.Ashisentirewinningshadbeenblown,
Edwardssaidthatwinningthelotterywasacurse,notablessing.Whatdoyouthinkyoucan
learnfromastorylikethis?
WEBEXERCISE
SearchontheInternettofindtheaveragesalaryforahighschoolgraduate,acollegegraduate,
andonewithamastersdegree.
Howmuchmoremoneycanyouearnovera40yearcareerifyougotocollege?
Howmuchmorecanyouearnifyoureceiveamastersdegree?
3
WHATWILLYOULEARN?
Thepurposeofthiscourseistohelpyoudevelopabasicunderstandingoffinanceand
recognizesomeofthefinancialdecisionsyoumayencounterinyourlife.Wewillusemany
practicalexamplesandshowyouthecontrastbetweenmakingtherightandwrongdecisions.
Someofthefinancialconceptsandskillsyoulearninthiscoursewillhelpyoumakebetter
decisionsimmediately;othersmaybemoreapplicableinthelongrun,benefitingyouduring
yourcollegeyearsandbeyond.Hereisalistofthetopicsyouwilllearn:
Whatisthefinancialenvironmentyoulivein?
Chapter2describesthefinancialsystemintheU.S.ItdiscussestherolesoftheFederalReserve
systemaswellasthefunctionsofthebankingindustry.Youwilllearnthedifferentfinancial
institutionsyousaveyourmoneywith,andthevarioustypesofaccountsyoucanchoosefrom.
Thischapteralsotalksaboutthefactorsyoushouldconsiderwhencomparingdifferentbank
accounts.
Howdoyouplanforyourfinancialfuture?
Chapter3focusesonbudgeting,specifically,makingaplanthatconsidersthemoneyyouwill
bringinandthemoneyyouwillspend.Youwilllearnhowtoprepareashorttermbudget(for
example,monthly)ofincomeandexpenses.Thischapterwillalsoteachyouhowtoplanfor
longertermgoals,suchasgoingtocollege,buyingyourfirsthouse,andsavingforretirement.
Animportantlessoninthistopicistoknowhowyourshorttermplansmayaffectyourchance
toaccomplishthelongtermgoals.
Whatcanyoudowhenyoudonthaveenoughmoney?
Sometimesyoumaynothaveenoughmoneytopayforwhatyouneed(notwhatyouwant),for
example,acar,ahouseoracollegeeducation.Whatcanyoudointhissituation?Withthe
financialsystemintheU.S.,youcanborrowthemoneyneededfromafinancialinstitution.
Chapter4helpsyouunderstandwhereandhowyoucangetaloan,aswellasthecostof
varioustypesofloans.Italsotalksaboutthefactorslendersconsider,especiallytheborrowers
credit,whendecidingwhetheraloanapplicationshouldbeapprovedorrejected.
Whatdoyouneedtoknowaboutgoingtocollege?
Manyofyouhavealreadymadeupyourmindaboutattendingcollege.Ifnot,Chapter5may
assistyouinmakingthedecisionasittalksaboutthecostsandpotentialbenefitsofgettinga
collegedegree.Thechapteralsodiscussessomeofthefinancialdecisionscollegestudents
needtomake,includinggettingacreditcard,managingyourcredit,andselectinganapartment
andsigningalease.
Whatshouldyoudowhenyouhaveexcessmoney?
Afterfinishingcollege,mostpeoplegetafulltimejobandstartacareer.Atthisstageinyour
life,yourincomeislikelytoexceedyourtotalexpenses(includingyourcurrentconsumption
andthepaymentsonloansyouveborrowed).Chapter6helpsyouidentifythenumerousways
tosave/investyourmoney.Eachinvestmentopportunityhasitsownuniquecharacteristics,
suchaspotentialreturn,risk,taximplications,etc.Youwilllearnthebasicsofinvestingand
howtoplanforyourretirement.
4
CanYouAffordtoBuyaHouse?
BuyingahouseisthebiggestinvestmentdecisioninthelivesofmostAmericans.Chapter7
teachesyouwhatyouneedtoconsiderwhenchoosingbetweenrentinganapartmentand
purchasingyourownhome(whichcouldbeasinglefamilydetachedhouse,atownhome,ora
condominium).Italsodiscussesthedifferenttypesofmortgagesthatareavailabletoyoufor
yourhomepurchaseandothertypesofhomeownershipexpensesyouneedtoconsider.
KEYTERMSTOREMEMBER
Finance
Asubjectthatdealswiththeconceptsofmoney,time,riskandhowtheyareinterrelated.
Investment
Anassetoritemthatispurchasedwiththehopethatitwillgenerateincomeorincreasein
value.
RateofReturn
Themoneyyouearnonaninvestment,statedasapercentage.Calculatedasthe(ValueNow
minustheValueattheTimeofPurchase)dividedbytheValueattheTimeofPurchase.
Risk
Thedegreeofuncertaintyoftherateofreturnonaninvestment.
Chapter2TheFinancialSystemintheU.S.
ThefinancialsystemintheU.S.andtheroleoftheFederalReserve
Varioustypesoffinancialinstitutionsthatprovideservicestoindividuals
Differenttypesofbankaccountsandhowtochooseamongthem
KEYTERMS
TheFederalReserveSystem
CommercialBank
CreditUnion
SavingsandLoanAssociations
AnnualPercentageYield(APY)
CheckingAccount
SavingsAccount
Compounding
Weliveinaneconomythathasoneofthemostdeveloped,advancedfinancialsystemsinthe
world.Everyoneenjoystheconvenienceprovidedbythesystemonadailybasis,butwe
seldomthinkabouttheimportanceofit.Whatwouldourdailylivesbelikeifthefinancial
systemwetakeforgranteddidnotexist?Imagineaworldwithnobanksorotherfinancial
institutions;nochecksorcreditcards;noATM.Peoplemustusecashtobuyeverything,from
groceries,tocarsorevenhouses.Ifyoudonthaveenoughofyourownmoneytobuyahouse,
theonlysourcesforborrowingarepeopleyouknow,suchasyourparents,relativesand
friends.Ifyourmonthlyincomeisgreaterthanyourcurrentspending,youneedtostorethe
excesscashinasafetyboxorhideitunderamattress,butyoucantsavethemoneyinabank
toearninterest.
Sowhatisthefinancialsystem?Inabroadersense,thefinancialsystemcoverseverythingthat
facilitatesthetransferofmoney(capital,funds).Componentsofthesystemincludebankswith
whichyousavemoneyorfromwhichyouborrowmoney;creditcardcompaniesthatprovide
youtheconvenienceofnothavingtocarryalotofcash;governmentagenciesthatregulateand
monitortheoperationsofthosefinancialinstitutions;andstockandbondmarketswhere
individualsandinstitutionsinvesttheirfunds,amongothers.Inthischapter,wewillfocuson
thesectorthatismostrelevanttoindividualsmakingfinancialdecisions:thebankingindustry.
THEU.S.DOLLARANDTHEFEDERALRESERVE
Asdiscussedinthepreviouschapter,financeisthesubjectthatdealswithmoney.Soletsstart
byexaminingthemoneyweuse.TheConstitutionoftheUnitedStatesofAmericastatesthat
6
TheCongressshallhavethepowertocoinmoney.Asaresult,theCongresscreatedthe
U.S.Mintin1792inPhiladelphiatoproducecoinsrepresentingtheofficialU.S.currency.The
Mintsfirstproductionwascoppercents,anditlateralsoissuedsilverandgoldcoinsaswell.In
1861,duetoashortageofpreciousmetals,theDepartmentofTreasurybeganprintingpaper
money(notes).Today,theBureauofEngravingandPrintingisresponsibleforproducingpaper
currencywhiletheU.S.Mintisresponsibleforproducingcoinage.Bothgovernmentagencies
arepartoftheU.S.DepartmentofTreasury.
In2010,theBureauofEngravingandPrintingprintedabout6.4millionnoteswithatotalvalue
ofnearly$400billion.Duringthesametime,theU.S.Mintproducedapproximately$6.4billion
worthofcoins.Mostofthenewproductions(about95%)wereusedtoreplacenotesandcoins
alreadyincirculation.Asoftheendof2010,approximately$942billionofpapercurrencyand
$40billionofcoinswereincirculation.
WEBEXERCISE
TakeavirtualtourofHowCoinsAreMadeattheU.S.Mintswebsite
(http://www.usmint.gov/mint_tours/).
GothewebsiteoftheBureauofEngravingandPrinting(www.moneyfactory.gov)tolearn
thenewfeaturesoftheredesigned$100note.
AfterpapernotesandcoinsareproducedbytheDepartmentofTreasury,theyaredeliveredto
theFederalReserve(theFed)beforebeingreleasedtothepublic.WhytheFederalReserve?
BecauseitisthecentralbankoftheUnitedStates,anditisresponsibleforcontrollingthe
nationsmoneysupply.Whenanindividualneedsmoney,hecanborrowfromabank;whena
bankneedsmoney,itcanborrowfromtheFederalReserve.Therefore,youmayconsiderthe
Fedasabankersbank.TheFederalReservewasfoundedbyCongressin1913withthe
primaryresponsibilityofmaintainingasafeandstablemonetaryandfinancialsystem.Overthe
yearsitsrolehasexpanded.Currently,theFederalReservesdutiesfallintofourgeneralareas:
1)conductingthenationsmonetarypolicy,2)supervisingandregulatingbankinginstitutions,
3)maintainingthestabilityofthefinancialsystem,and4)providingservicestofinancial
institutionsandtheU.S.government.
TheFederalReservesystemconsistsoftheBoardofGovernors(inWashingtonD.C.)andtwelve
regionalFederalReserveBanks.TheBoardandtheReserveBankssharetheresponsibilityof
implementingthegovernmentseconomicandfinancialpolicy.TheFederalReserveoperates
withintheoverallobjectivesestablishedbythegovernment;however,itsdecisionsdonothave
toberatifiedbythePresidentoranyoneelseintheexecutivebranchofthegovernment.The
systemissubjecttooversightbytheU.S.Congress.ThechairmanoftheBoardisappointedby
thePresidentandconfirmedbytheSenate.Becauseofthepositionsstronginfluenceonthe
largesteconomyintheworld,theFederalReservechairmanisoftenconsideredoneofthe
mostpowerfulpeopleintheworld.
7
WEBEXERCISE
OneoftheFederalReservescurrentresponsibilitiesisconsumereducation.Gotothe
FederalReservewebsite(http://www.federalreserve.gov)andfindthebrochuresthatare
designedtohelpconsumerslearnaboutanddealwithfinancialissues.
Identifythe10mostpowerfulpeopleintheworldandfindoutwhytheyaresopowerful.
THEBANKINGINDUSTRY
OneoftheFederalReservefunctionsissupervisingandregulatingbankinginstitutions.Itis
importanttounderstandwhatbanksare,whattheydo,andhowtheyaffectindividualslike
you.HaveyouseenthescenesinWesternmovieswherebanditsrobabank?Didyouwonder
whatthedifferencesarebetweenbanksinthe19
th
centuryandthoseoftoday?Traditionally,a
bankistheplacewherepeoplesavetheirsurplusincome.Asavergivesuptherightof
spendingthemoneynow;inexchange,shegetsmoremoneybacklater(principalplusinterest).
Asthebankcollectssavingsfrommanyindividuals,itusesthemoneytomakeloanstothose
whoneedmoremoneythantheycurrentlyearn.Whenmakingaloan,thebankchargesan
interestrate.Thebankusesthedifferencebetweentherateitcollectsfromborrowersandthe
rateitpaystosavers(thisiscalledaspread)tocoveritsexpensesofdoingbusinessandto
makeaprofit.
Today,thebusinessofcollectingdepositsandmakingloanscontinuestobeoneofthemajor
functionsofthebankingindustry;however,thetermbankisbeingusedinamuchbroader
sense.Forexample,investmentbanksarefinancialinstitutionsthathelpcorporationsand
governmentsraisecapitalbydesigningandmarketingsecurities(suchasstocks,bonds,and
otherderivativesecurities);mortgagebanksarethosethatspecializeinfacilitatingrealestate
transactionsbybringingborrowersandlenderstogether.Althoughtheyarecalledbanks,you
cantopenachecking/savingsaccountwithaninvestmentbankoramortgagebankbecause
theydonotacceptdeposits.Sowhatkindofbankdoyouopenanaccountwith?Banksthat
performthetraditionalfunctionsofcollectingdepositsandlendingarereferredtoas
commercialbanks.Inearly2011,thefivelargestcommercialbanksintheU.S.wereChase,
BankofAmerica,Citi,WellsFargo,andUSBank.Youcanprobablyfindthebranchofficesof
some,ifnotall,ofthesebanksinyourneighborhood.Aninterestingfeatureoftheselarge
banksisthattheyhaveevolvedintolargefinancialconglomeratesthatdomuchmorethanjust
compilingsavingsandmakingloans.Eachofthemhasoperationsincommercialbanking,
investmentbanking,mortgagebanking,aswellasmanyotherfinancialactivities.
Inadditiontocommercialbanks,severalothertypesoffinancialinstitutionsalsoprovidesimilar
servicestoindividualsandbusinessesthatneedtosaveorborrowmoney.Examplesinclude
creditunions,savingsandloanassociations,andmutualsavingsbanks.Sincetheyrelyon
depositsfromsaversastheprimarysourceofraisingcapital,theseinstitutionsarereferredto
asdepositoryinstitutions.Thefollowingtablesummarizessomeofthecharacteristicsthat
traditionallydifferentiatethevarioustypesofdepositoryinstitutions.Itsimportanttonote
thatallofthemhaveexpandedtheirservices,sothedifferenceshavebecomeblurred.
8
FinancialInstitutionsthatCollectDepositsandMakeLoans
TypeofInstitution KeyServicesandOwnership
CommercialBanks
Provideafullrangeoffinancialservices,including
checking,savings,businesslendingandmortgageloans
Ownedbyshareholders
SavingsandLoanAssociations Specializemainlyinsavingsaccountsandhomemortgage
loans
Ownedbyshareholders
MutualSavingsBanks Specializemainlyinsavingsaccountsandhomemortgage
loans
Ownedbydepositors
CreditUnions Providevariousfinancialservices
Ownedbymembershavingacommonbond,suchas
work,churchorcommunityaffiliation
TYPESOFBANKACCOUNTS
Manypeopleareamazedandconfusedbythemanydifferenttypesofaccountsavailableata
bankwhentheytrytoopentheirfirstbankaccount.Checking,saving,certificateofdeposit,
moneymarket,etc.Whichoneisthebest?Theanswerdependsonyourfinancialsituation,
suchashowmuchmoneyyouhaveandwhenyouwillneedthemoney.Somebankaccounts
haveaminimumbalancerequirement,requiringyoutohaveatleastacertainamountof
moneyinthebankatalltimes.Ifyourbalancedropsbelowtherequirement,youarechargeda
fee.Otheraccountsallowyouwritealimitednumberofcheckseachmonth.Ifyouneedto
writemorechecks,feeswillbecharged.Certainaccountsdonotallowyoutowithdrawmoney
untilaspecificdate.Ifyouneedthemoneybeforethatdate,youhavetopayafee.Why
wouldanyoneacceptthoserestrictionsastheymaypotentiallycostextramoney?Because
thoseaccountsmaypayahigherinterestrate.Likemostfinancialdecisions,selectingthetype
ofbankaccountthatisrightforyouinvolvesatradeoff.Herearesomeofthefactorsyou
shouldconsider.
RateofReturn
Theonefactoreveryonetakesintoconsiderationwhenselectinganaccountistheinterestrate.
Theideaseemsquitesimple:thehigher,thebetter.However,simplycomparingthenominal
interestratesmayleadtothewrongdecision.Anotherkeyfactortotakeintoaccountishow
oftentheinterestiscalculated.Asinterestearnedinthepreviousperiodcanalsoearninterest
inthecurrentperiod(thatis,interestoninterest,orcompounding),themorefrequently
interestiscalculated,themoremoneyyouwillhaveinyouraccount,giventhesameinterest
rateandtimeperiod.Supposeyouhave$100inasavingsaccountandtheinterestrateis6%.
Ifinterestiscalculatedannually,youwillhave$106afteroneyear.Ifinterestiscalculated
9
monthly,eachtimeitiscalculated,youearn0.5%(6%12).Asaresult,youwillhave$106.17
attheendoftheyear.Youeffectivelyearna6.17%rateofreturnovertheyear.
Becausemostconsumersdonotknowhowtocalculatetheeffectiverateofreturnbyfactoring
inthecompoundingfrequency,thelawsrequirebankstodiscloseannualpercentageyield
(APY)soeveryonecanmeaningfullycomparethedifferentoptions.APYisdefinedasthe
percentagerateexpressingthetotalamountofinterestthatwouldbereceivedona$100
depositbasedonthenominalinterestrateandthefrequencyofcompounding.Thenumber
reflectshowmuchinterestanaccountcanearnandshouldbethebasisforcomparison.
DOTHEMATH
Howisannualpercentageyield(APY)determined?Ifyouknowtheannualinterestrate(i)and
thecompoundingfrequency(m),theAPYcanbecalculatedwiththisformula:
AP = _1 +
i
m
]
m
-1
Nowcomparethefollowingthreealternatives.WhichonehasthehighestAPY?
Anaccountwitha10.50%interestrateandannualcompounding
Anaccountwitha10.25%interestrateandmonthlycompounding
Anaccountwitha10.00%interestrateanddailycompounding
Privileges,RestrictionsandFees
Asmentionedbefore,somebankaccountshaverestrictionssuchasminimumbalance
requirement,orlimitedcheckwriting.Someaccountschargefeesforcertainactivities,suchas
ATMfees,onlinebankingfees,andbouncedchecks.Manybanksalsoofferprivilegestovarious
typesofaccounts.Forexample,somesavingsaccountsallowyoutowritealimitednumberof
checks;somebankswaivetheminimumbalancerequirementifyousetupdirectdepositfor
yourpaychecks(thatis,yourwagesareelectronicallydepositedintoyouraccountdirectlyfrom
youremployer);someinstitutionsreimbursethefeeyouarechargedwhenusingtheATMof
anotherbank.YoumaybeenticedtodobusinesswithabankthatpayshigherAPYthanits
competitors,butitisveryimportantthatyoualsoconsideralltheprivileges,restrictionsand
potentialfees.A$3feeyoupayattheATMmaycompletelyoffsettheadditionalinterestyou
earnoverthewholeyearwithaslightlyhigherAPY.
Safety
Duringeconomicrecessions,youmayhearthenewsofbanksgoingoutofbusiness.What
wouldhappentoyourmoneyifthebankyoudepositedmoneywithfiledforbankruptcy?Most
banksandsavingsinstitutionsareinsuredbyagenciesthatareaffiliatedwiththefederal
government.IfthebankisinsuredbytheFederalDepositInsuranceCorporation(FDIC),your
depositsofupto$250,000areprotected.
10
WEBEXERCISE
Gotothewebsitesoftwodepositoryinstitutions(acommercialbankandacreditunion)that
havebranchofficesinyourlocalareatofindinformationabouttheirsavingsaccounts.
Comparetheirannualpercentageyield,minimumbalance,potentialfees,andother
restrictions.
Mostofthedepositoryinstitutionsofferavarietyofaccounts,includingchecking,savings,
moneymarket,andcertificatesofdeposit.Supposeyouhavesomemoneytosave,whichtype
ofaccountisbestforyou?Thetablebelowsummarizessomeofthekeycharacteristicsof
varioustypesofaccounts.
TypesofBankAccountYouCanUsetoSaveMoney
TypeofAccount Characteristics
CheckingAccounts Thesearethemostflexibleaccounts.Youmakedepositsto
theaccount,andwritecheckstopayyourbillsormake
purchases.Youhaveconvenient,frequentaccesstoyour
money.Mostbanksallowyoutowithdrawcashormake
depositsusinganautomatedtellermachine(ATM).Many
alsoissuedebitcardssoyoucanpurchaseproductsand
servicesatbusinessesthatdonotacceptpersonalchecks.
Regularcheckingaccountsdonotpayinterest.Thosethat
dopayinteresttypicallyhavemuchlowerAPYthanother
typesofaccount.
SavingsAccounts Thesearesimilartocheckingaccounts,buthavemore
restrictions.Savingsaccountstypicallyallowyoutomake
withdrawals,butwithouttheconvenienceofusingchecks(or
onlyalimitednumberofchecks).Ifyouhavebothchecking
andsavingsaccountswiththesamebank,yourATMcard
maybelinkedtoboth.Asavingsaccountmayhaveahigher
minimumbalancerequirementthanacheckingaccount.
Allsavingsaccountspayinterestandtherateofreturnis
typicallyhigherthaninterestearningcheckingaccounts.
MoneyMarketAccounts Comparedwithcheckingandsavingsaccounts,these
accountstypicallyhavehigheraminimumbalance
requirementandotherrestrictions.Theymayallowasmall
numberofchecksandmoneytransferseachmonth.
Themainbenefitofmoneymarketaccountsisthefavorable
rateofreturn.Theyieldisbasedonmarketinterestrates,so
itmayfluctuateovertime.
11
CertificatesofDeposit(CDs) Theseaccountsrequireyoutokeepyourmoneywiththe
bankforaspecificperiodoftime.Youdonothaveaccessto
yourmoneyuntiltheendoftheperiod,thatis,thematurity.
CDtermsrangefromafewdaystoseveralyears.Sometimes
thebankmayallowyoutowithdrawmoneybeforematurity,
butapenaltyisoftencharged.
Inexchangefortheinflexibility,youreceiveaguaranteed
yieldthatistypicallyhigherthanothertypesofaccounts.
MANAGINGYOURBANKACCOUNT
Anessentialpartofmanagingyourfinancesisknowinghowmuchmoneyyouhave,howmuch
moneyyouearn,andhowmuchmoneyyoucanspend.Asaresult,knowingthebalanceof
yourbankaccountisveryimportant.Traditionally,peoplemanuallyrecordeachtransaction,
forexample,deposits,withdrawalsandcheckswritten,inordertokeeptrackofthebalance.
Manycheckbookshavepagesoftemplatesinwhichonejustfillsinthetransaction.Thatiswhy
thisactivityisoftenreferredtoasbalancingyourcheckbook.
Intheexamplebelow,Juliehad$102.50inhercheckingaccountatthebeginning.OnAugust
10,shedepositedherpaycheckof$235.20.Aftertheamountiscredited(thatis,added),her
accountbalancebecame$337.70.Thenextday,Juliewroteacheckof$15(check#120)topay
forpizza,soshedebited(thatis,subtracted)theamountfromheraccount.OnAugust14,she
usedanothercheck(#121)andalsowithdrew$20fromanATM.Afterthesetwotransactions,
heraccountbalancewas$89.80.Onethingpeopleoftenforgetisthefeestheymayhave
incurredintransactions.IfJuliewaschargedafeewhentakingcashoutoftheATM,that
amountneedstobedebitedfromtheaccountaswell;otherwise,herrecordwouldnotbe
consistentwiththemonthlystatementpreparedbythebank.Anotherpotentialreasonfor
inconsistentrecordsisthatpeopleforgettoincludepurchasesusingadebitcard,especially
whentheydontkeepthereceipts.Withoutknowingexactlyhowmuchmoneyshehasinher
account,Juliemightwriteacheckforanamountexceedingherbalanceandconsequentlyhad
topayaheftyfeeforthebouncedcheck.

12
Today,manyfinancialinstitutionsofferonlinebanking,soyoucankeeptrackofallthe
transactionsandyourbalancebyloggingintoyouraccountonacomputerorevenfromyour
smartphone.Additionally,youcantransferfunds,paybills,orapplyforaloanonline.Some
banksevenallowyoutocreateabudgetandcompareitwithyouractualspending.Withallthe
newtechnologyandtools,managingyourfinanceshasbecomemucheasier.Nevertheless,the
keytoasoundfinancialfutureisstillcarefulplanninganddiscipline.
WEBEXERCISE
Manybanksnowencouragetheircustomerstouseonlinebanking.GotothewebsiteofBank
ofAmerica(http://www.bankofamerica.com/onlinebanking/?context=en)andclickonthe
ViewDemobuttontolearnabouthowthesystemworks.
KEYTERMSTOREMEMBER
TheFederalReserveSystem
ThecentralbankoftheUS,establishedin1913.ItisgovernedbytheBoardofGovernors
locatedinWashington,D.C.andincludes12regionalFederalReserveBanks.Thesystemis
authorizedtoimplementthegovernmentseconomicandfinancialpolicyaswellastoregulate
thebankingindustry.
AnnualPercentageYield(APY)
TheAPYistheinterestrateactuallyearnedorpaidinoneyear,takingintoaccounttheeffectof
compounding.TheAPYiscalculatedbytakingoneplustheperiodicrateandraisingittothe
numberofperiodsinayear.
CommercialBank
Bankthatoffersabroadrangeofdepositaccounts,includingchecking,savingsandtime
deposits,andextendsloanstoindividualsandbusinesses.
CreditUnion
Anotforprofitinstitutionthatoffersfinancialservices,similartothoseofferedbya
commercialbank,toitsmembers.
SavingsandLoanAssociations
Afinancialinstitutionthatacceptssavingsdepositsandinveststhebulkofthefundsreceived
intomortgages.
CheckingAccount
Adepositaccountatafinancialinstitutionthatallowstheholdertowritechecksagainst
depositedfunds.
13
SavingsAccount
Adepositaccountatafinancialinstitutionthatpaysinterest,butcannotbewithdrawnbycheck
writing.
Compounding
Theprocessofaccumulatingthetimevalueofmoneyforwardintime.Forexample,interest
earnedinoneperiodearnsadditionalinterestduringeachsubsequenttimeperiod.

14
Chapter3FinancialPlanningandBudgeting
Themeaningofbudgetingandhowtoprepareashorttermbudget
Thepurposeoflongtermbudgeting
Thedifferencebetweenshorttermandlongtermfinancialplanning
Thebasicsofthetimevalueofmoney
KEYTERMS
Budget
Income
Surplus
Needs
TimeValueofMoney
Expense
Deficit
Wants
Asdiscussedinthelastchapter,animportantsteptowardasoundfinancialfutureiskeeping
trackofyourmoney.Youneedtoknowhowmuchmoneyyouveearned,howmuchyouve
spent,andhowmuchyoucurrentlyhave.Thenextstepistodrawaroadmapforthefuture,
thatis,preparingabudget.Abudgetisaplanoffinancialactivitiesthatconsidersthemoney
youexpecttobringin(calledcashinflow)andthemoneyyouaregoingtospend(calledcash
outflow).Ifthemoneycominginexceedsthemoneygoingoutduringacertainperiodoftime,
youhaveasurplus;otherwise,youhaveadeficit.
WhenaTVbroadcastersaysthatthefederalgovernmentbudgetinthenextfiscalyearhasa
deficitof$1.1trillion,thatmeanstheamountofmoneythefederalgovernmentexpectsto
bringin(mainlyfromtaxrevenues)is$1.1trillionlessthantheamountitplanstospend.Why
isitsuchabigdeal?Becausetheshortageofmoneyhastocomefromsomewhere,orthe
governmentneedstoreduceitsspending.Thegovernmenthastwomainoptionstobringin
moremoney:raisingtaxesorborrowing.Eitherway,taxpayers(includingbothbusinessesand
individuals)eventuallyhavetopayforit.Whileweoftenhearaboutbudgetissuesrelatedto
thegovernment,theconceptofbudgetcanbeappliedtoindividuals,familiesandbusinessesas
well.Ateenagermaywanttoknowwhetherhewillbeabletoaffordanewvideogamewhen
itisreleased;afamilymayneedtofigureouthowitcansaveforavacation;andacorporation
mayneedtodecidehowitshouldraisefundsforamajorexpansion.Preparingadetailedplan
forfuturefinancialactivitieshelpsyou:1)avoidoverspending;2)assessyourabilitytoreach
certaingoals;3)identifynecessaryadjustmentsinyourfinancialhabits;and4)prepareyoufor
financialemergencies.
15
WEBEXERCISE
SearchontheInternettofindthefederalbudgetforthecurrentfiscalyear.Howmuch
totalrevenuedoesthefederalgovernmentexpecttoreceive?Howmuchtotal
expendituresdoesitplantospend?Doesithaveasurplusoradeficitfortheyear?
Findthesameinformationforthestategovernment.
Therearedifferenttypesofbudgeting.Abudgetmayfocusonarelativelyshortperiodoftime,
suchasafamilysmonthlybudgetandthegovernmentsannualbudget.Ontheotherhand,a
budgetmaybedevelopedforthelongrun.Forinstance,anindividualmaybesavingmoneyfor
thepurchaseofherfirsthouseinfiveyears,orplanningforherretirementinthirtyyears.This
chapterteachesyouhowtoprepareashorttermbudget.Youwillalsolearnhowtheresultof
shorttermbudgetingmayaffectyourlongtermfinancialplanning.Anessentialconceptfor
financialdecisionmaking,calledthetimevalueofmoney,isintroducedinthelastsectionof
thechapter.
SHORTTERMBUDGETING
Themostcommontypeofbudgetinginpersonalfinanceisthepreparationofamonthly
budget.Toprepareamonthlybudget,youneedtoknowhowmuchyouearn/receive(thatis,
yourincome)andhowmuchyouspend(expenses)inthemonth.Thefirststepistogatherall
theinformationaboutyourincomeandexpensesinrecentmonths.Forexample,yourpaystubs
showhowmuchyouearnedandhowmuchtaxesweredeductedfromyourincome;bank
accountstatementslistallthechecksyoudeposited,checksyouwrote,andcashwithdrawals
youmade;andcreditcardstatementsitemizeallthecharges.Becausesomeincomeand
expenseitemsmayvaryfromtimetotime,youneedtoestimatewhatisthetypicalamountfor
budgetingpurposes.
Income
Forateenager,theregularincomesourcesmayincludewagesfromaparttimejob,an
allowancefromparents,andinterestearnedonasavingsaccount.Someofyoumayalsohave
othertypesofincomethatoccurlessfrequently,suchasgiftsforspecialoccasions(birthdays,
Christmas,etc.)andearningsfrombabysitting.Forafamily,theparentssalaries/wagesmaybe
theprimarysourceofincome,buttheymayalsoreceiveinvestmentincome,orbonuses,
amongothers.Inthesampleworksheetthatfollows,severalincomesourcesarelisted.Thisby
nomeanssuggeststhatthosearetheonlysources,oreveryoneshouldhaveincomefromeach
ofthesources.Lineitemscanalwaysbeaddedtoordeletedfromthetemplate.
Expenses
Afterestimatingtheamountofmoneyyouwillbringin,thenextstepistodeterminehowthe
moneywillbespent.Youshouldstartwithallexpensesthatoccuronaregularbasis.First,you
mayneedtopaytaxesonsomeofyourincome(wagesbutnotallowance).Ifthewagesinthe
incomesectionarealreadytheaftertaxamount,thenyoudontneedtosubtractthetax
paymentagain.Othertypicalexpensesmayincludeeducation,housing,foodand
16
M Mo on nt th hl ly yB Bu ud dg ge et tW Wo or rk ks sh he ee et t
Category BudgetedAmount ActualAmount Difference
Income
Wages
Allowance
Interest
(Others)
(Others)
TotalIncome

Expenses
Taxes
Education
Housing
Food
Transportation
Healthcare
Entertainment
Personal
Debt
Charity
(Others)
(Others)
(Others)
TotalExpenses

Contingencies
Savings
Surplus/Deficit

17
transportation.Theitemsintheworksheetarebroadcategories,andyoumaywanttoadd
subcategorieswhenpreparingyourownbudget.Forexample,expensesforeducationmay
includetuitionandfees,books,schoolsuppliesandfieldtrips.Intermsoftransportation,ifyou
ownacar,youmayneedtoconsidercarpayments(ifyouhaveacarloan),insuranceand
gasoline;ifyoutakeabustoschool/work,thecostofbusfaresshouldbeincluded.Someof
youmayhaveotherpaymentsthatoccuronaregularbasisandareofaconstantamount,such
asacellphonebill,membershipduestoclubs,etc.
Afterregularexpenseitems,youshouldalsoconsiderdiscretionaryspending,likeshopping
(clothes,shoes,etc.),dining(pizzas,snacks,etc.)andentertainment(movies,videogames,
etc.).Theseexpensesmayfluctuateperiodically,butyouneedtoestimatetheamountyou
spendinatypicalmonth.
Forfamilies,thelistofexpensesislongerandtheamountsaretypicallyhigher.Inadditionto
taxesandtransportation,otherregularexpensesmayincludehousing(mortgagepayment,
rent,and/orhomeownerassociationdues),utilities(electricity,water,gas,trashremoval,etc.),
groceries,andinsurance(health,lifeandproperty).Therearealsodiscretionaryitemsafamily
needstoconsiderinitsmonthlybudgeting.
Acommonmistakeinpreparingshorttermbudgetingisthatyouforgettoincludeexpenses
thatoccurlessfrequently.Forexample,acarregistrationfeeisbilledtotheowneronceayear.
Ifyoudontcalculatetheaverageamountpermonthandallocateittoeachmonth,youwill
underestimatetheoverallcostofowningacar,andconsequently,mayhaveahugecash
shortfallinthemonthwhenthefeeisdue.Forfamilies,backtoschoolandholidayshopping
areoftenoverlookedifthebudgetisnotbeingpreparedatatimewhenthoseexpensesoccur.
Asaresult,afamilythatnormallyhasabalancedbudgetmayhaveahardtimemeetingits
financialneedsduringcertainperiodsoftimeinayear.
ContingenciesandSavings
Afterderivingtotalincomeandanticipatedexpenses,mostpeoplesubtracttheexpensesfrom
theincometoseethebottomline.Iftheresultispositive(thatmeansincomeisgreaterthan
expenses),theywouldfeelcomfortablewiththeirfinancialsituation.This,however,isthebare
minimumofanacceptablefinancialposition.Theexpenseslistedinthebudgetsofarareall
anticipateditems.Whatifsomethingunexpectedhappens?Supposeyourcarbreaksdown
andthecostofrepairis$800.Withcarinsurance,youdontneedtopayfortheentireamount
butarestillresponsibleforthedeductibleof$500.Howshouldexpenseslikethisbetakeninto
accountinthebudgetingprocess?Forafamilybudget,themostcriticalfactorisprobablya
medicalemergency.Studieshaveshownthatover60percentofbankruptciesintheU.S.were
linkedtomedicalexpenses,eventhoughmostofthosewhofiledbankruptcyhadhealth
insurance.Howshouldyoudealwithsuchunexpectedexpenditures?Thesolutionistoset
asideacertainamountofmoneyforarainyday.Ateenagershouldprobablykeep10to15
percentofhis/hermonthlyincomeforemergencysituations.Incontrast,financialadvisers
recommendthatfamiliesshouldmaintainanemergencyfundofthreetosixmonthsofliving
expensesforunexpectedfinancialdifficulties.
18
Ifyourincomeisjustenoughtocovertheplannedexpensesandthecontingency,youwontbe
abletosavemoneyonaregularbasis.Toaccomplishyourlongtermfinancialgoals(whichwill
bediscussedlaterinthischapter),youneedtosavemoneyandletthemoneyworkforyou
overtime.Asaresult,settingasavingstargetisanecessarypartofthebudgetingprocessas
well.
TheBottomLine
Nowyoucansubtractalltheexpenses,thecontingency,andthesavingsfromyouincome.If
youhaveleftovermoney,youcanalwayssavemorethantheplannedamount.Oryoumay
choosetoindulgeyourselfonceinawhilebydiningoutorbuyingnewclothes.Whatshould
youdoifyourincomeisnotenough?Thisiswhenthebudgetingprocessreallyhelps.You
needtoreviewtheexpensesandprioritizethem.Itsveryimportantthatyouunderstandthe
differencesbetweenwhatyouneedandwhatyouwant.Weoftenhearpeoplesaythings
likeIneedanewpairofshoes.Ifthepersonsshoesarefallingapartand,asaresult,he/she
cantgotoschoolorwork,thenewpairofshoesarewhathe/sheneeds.Butifthereasonis
thatthenewshoesbettermatchanoutfithe/shejustbought,thenthepurchaseiswhat
he/shewants.Youaresupposedtospendmoneyonwhatyouneedfirst,andonlybuywhat
youwantifyoucanaffordtomakethepurchase.
WEBEXERCISE
Averyimportantsteptowardbalancingyourbudgetisunderstandinghowtocontrolyour
spending.TherearemanyexcellentresourcesontheInternetthathelpyoudevelopbetter
spendinghabits.Forexample,youcangotoSmartAboutMoney.org
(www.smartaboutmoney.org)andsearchfortipsoncontrollingspendingandunderstanding
needsvs.wants.
PeriodicReview
Afterabudgetisprepared,youneedtohavethedisciplinetofollowit.Itisimportanttoreview
thebudgetonaregularbasisandcompareitwithyouractualincomeandexpenses.Ifwhat
youhadplannedandwhatactuallyhappenedisverydifferent,youneedtoinvestigatewhether
itisatemporarysituation/isolatedcase,oritislikelytobepermanent.Ifitisthelatter,either
thebudgetneedstoberevisedorthewayyouspendyourmoneyshouldbeadjusted.
ExampleofShortTermBudget
Nowletspreparethemonthlybudgetfortwoteenagers:AlanandCharlie.Alanhasapart
timejobatafastfoodrestaurantandearnsabout$320eachmonth.Healsomowsthelawnat
severalhousesintheneighborhood,makinganaverageof$70amonth.Intermsofexpenses,
Alanneedstopayforlunchesatschoolandgasolineforhiscar,whichaverageabout$120and
$75eachmonth,respectively.Alanrecentlystartedlearningkarate;heandhisparentssplitthe
monthlycostof$60forthesport.Heestimatesthathespendsapproximately$70onactivities
suchasgoingtomovies,rentingvideogamesandhangingoutwithfriends.Alansetsaside10%
ofhismonthlyincomeforunanticipatedexpensesandplanstosaveatleast$50eachmonth.If
theresanyleftover,itwouldbeaddedtohissavingsaccount.
19
CharlieworksatthesamerestaurantandmakesaboutthesameamountofmoneyasAlan.
Additionally,hereceivesa$30weeklyallowancefromhisparents.Asaresult,Charlies
monthlyincomeisapproximately$440.WhileCharliemakesmoremoneythanAlaneach
month,healsospendsmuchmore.Ondayswhenhedoesntwork,Charlielikestobuya
smoothieonthewayhome;hismonthlyexpenseonfoodandbeverageisthus$40higherthan
Alans,eventhoughtheyspendaboutthesameamountattheschoolcafeteriaeachday.They
alsopayacomparableamountongasoline.Charliesparentsgothimacellphoneandpayfor
thebasicplan;however,heisresponsibleforanyoveragecharge.Hepaysabout$50each
monthfortheadditionalairtime.Charlieplaysmanysports;sincehisparentspayforallsport
relatedcosts,theseexpensesareexcludedfromhisbudget.Inadditiontospending$100each
monthonentertainment,Charliepaysabout$35formusicandgamedownloads.
ThetablebelowcomparesAlanandCharliesbudgets.Atfirstglance,bothAlanandCharlieare
inprettygoodfinancialsituationastheyhaveamonthlysurplusof$6and$20,respectively.
OnemayevenconcludethatCharlieisinabettershape.However,furtherinvestigationofthe
detailstellsadifferentstory.InCharliesbudget,hedoesnotconsideranyemergencyfunds,so
anunexpectedexpensecouldwipeouthissavingsoverseveralmonths.Alan,ontheother
hand,notonlyallocatesmoneyforemergenciesbutalsosetsaminimumsavingtarget.Asa
result,hecansave$56everymonth,orpossiblyevenmoreifthecontingencyfundsarenot
fullyutilized.
ComparisonofAlanandCharliesMonthlyBudgets
Alan Charlie
Income
Wages 320 320
Allowance 120
OtherIncome 70
TotalIncome 390 440

Expenses
Food 120 160
Transportation 75 75
Entertainment 70 135
Sports 30
CellPhone 50
TotalExpenses 295 420

Contingency 39
Savings 50
Surplus/Deficit
6 20
20
WEBEXERCISE
GotoSmartAboutMoney.org(www.smartaboutmoney.org)andclickontheresourcelibrary
linktolookfortipsonimprovingthebottomlineofyourbudget.
LONGTERMBUDGETING
Thepurposeoflongtermbudgeting(orplanning)istohelpyoufigureoutif,andhow,youcan
achieveafinancialgoalinthefuture.Itbasicallycombinestheresultsofyourshortterm
budgetoveranextendedperiodoftime.Whileitiscalledlongtermbudgeting,thisprocess
canbeappliedtoavarietyoftimehorizons.Forexample,ateenagerhasputtogetheraweekly
budgetbasedonhisallowanceandregularspendingandbelieveshecansave$15eachweek.
Heisreallyinterestedinanewvideogamethatcosts$75.Hisbudgetindicatesthatitwilltake
fiveweeksforhimtosaveenoughmoneyforthegame.Meanwhile,ifhewantstobuythe
gamewhenitisreleasedinthreeweeks,heneedstosave$10moreeachweek.
Thesameprocesscanbeappliedtoamultiyear(orevenmultidecade)period.Considera
youngcouplecontemplatingthepurchaseoftheirfirsthouseinfiveyears.Theirmonthly
budgetgivesthemanideahowmuchtheycansaveoverfiveyearsandhowmuchhousingthey
canafford,giventhetypesoffinancingavailable.Ifthecouplehasaspecificpricingtarget,the
longtermbudgetingprocesscanhelpthemdeterminehowlongitwilltakeforthemtoreach
thegoal.Anothercommonapplicationoflongtermbudgetingisretirementplanning.Witha
monthlybudgetandanestimateofannualsavings,onecanprojectwhenhe/shecanretire,or
whatkindsofcurrentsacrificeshe/sheneedstomakeinordertoretireatacertainage.Anin
depthanalysisofhomepurchasesandretirementplanningwillbediscussedinlaterchapters.
Onemajordifferencebetweenshorttermandlongtermbudgetingisthatyoushouldtakethe
timevalueofmoneyintoaccountwhenplanningforthelongrun.Whatisthetimevalueof
money?Itmeansonedollartodayisworthmorethanonedollarinthefuture.Todaysone
dollarcanbesavedorinvested,andconsequentlyearnarateofreturnforyou.Overtime,the
moneyyousavewillgrow.Asaresult,timewillhelpyoureachyourfinancialgoal.Remember
Alan,whosavesabout$56eachmonth($50targetsavingand$6surplus)?Supposeheis
savingmoneyforthedownpaymentonanewcar,howlongwillittakeforhimtoaccumulate
$2,000towardthepurchase?Withoutconsideringanyinteresthecanearn,itwilltakenearly
threeyearsforhimtoreachthegoal.Butwithanannualinterestrateof3.5%onhissavings,
Alancanreachthegoaltwomonthsfaster.
Themathematicsinvolvedinthetimevalueofmoneyisdiscussedinmoredetailinthenext
section.Afewexampleswillbeusedtoillustratehowthetimevalueofmoneymayaffectyour
longtermfinancialplanning.
21
TIMEVALUEOFMONEY
Thetimevalueofmoneyisoneofthemostimportantfinancialconcepts.Itcansimplybe
describedasonedollartodayisworthmorethanonedollarinthefuture.Thisisbecause
moneysavedinabankaccountcanearninterestandmoneyinvestedinthestockmarketmay
earnarateofreturn.Asaresult,moneygrowsandcancreatemorevalueovertime.
Thetimevalueofmoneyhasveryimportantimplicationsforyourlongtermbudget.For
example,ifyousave$500eachyear,thetotalamountsavedwouldbe$10,000over20years.
However,ifthemoneyisdepositedinabankaccountthatpaysinterest,the$500savedinthe
firstyearwillearninterestduringthefollowing19years,the$500savedinthesecondyearwill
earninterestduringtheremaining18years,andsoonandsoforth.Furthermore,theinterest
receivedinanearlieryearwillearnmoreinterestlateron.Sohowmuchmoneywillyouhave
attheendofYear20?Thisanswerdependsontheinterestrateonthebankaccountandhow
ofteninterestiscalculated(similartotheannualpercentageyieldconceptdiscussedinChapter
2).Withanannualpercentageyieldof3%,thetotalamountofmoneyinyouraccountwill
reach$13,435,about34%morethantheamountyouactuallydeposited.
Bythesametoken,thetimevalueofmoneycanmakeiteasierforyoutoreachyourfinancial
destination.Supposeyourgoalistoaccumulate$1millionin40years.Howmuchdoyouneed
tosaveeachyear?Withoutearninganyinterest,youwillhavetosave$25,000peryear.In
contrast,ifthemoneyissavedinthebankaccountandearns3%ayear,yourannualdeposit
amountbecomesonly$13,262,nearlyhalfoftheamountwithoutearninginterest.Suppose
themoneyisinvestedinthestockmarketand,onaverage,earnsan8%rateofreturneach
year;thenyouwouldonlyneedtosaveapproximately$3,860eachyear.Thisdramaticchange
isattributablecompletelytothetimevalueofmoney.
Sincetheideaistoallowmoneytoearnmoremoneyforyou,thesooneryouputthemoneyto
work,themoreyoucanearnovertime.Therefore,ifyousavemoneyonamonthlybasis,
insteadofwaitinguntiltheendoftheyear,theamountyouneedtodepositwillbeevenlower
asthemoneycanstartworkingforyousooner.Giventhesame8%annualreturninthestock
market,theamountyouhavetosaveeverymonthinordertoachievethegoalisonly$286.50
(orapproximately$3,438ayear).Doyouthinkthegoalofbecomingamillionaireis
achievable?
Theexamplesabovedemonstratehowthetimevalueofmoneymayaffectyourlongterm
financialplans.Nowletslearnthemathematicsinvolvedintheanalysis.Thebasicformulais:
FI
n
= PI (1 +i)
n
Intheequation,FV
n
(whichstandsforfuturevalue)istheamountofmoneyyoullhaveinthe
accountinnyears.PV(thatispresentvalue)ishowmuchyouhaveintheaccountnow,andiis
theannualinterestrate.Forexample,tofindtheamountofmoneyyouwillhavebysaving
$100inabankaccountwith4%interestratefor3years,youcanmanuallycompute1uu
(1 +u.u4)
3
,orusetoolssuchasafinancialcalculatororspreadsheetsoftware,suchas
MicrosoftExcel.Theansweris$112.49.Howfastyourmoneywillgrowovertimedependson
22
theinterestrate.Theexhibitbelowcomparesthefuturevalueof$100depositedtodayin
accountswithdifferentinterestrates.
FutureValueof$100DepositedToday
DOTHEMATH
Usethetimevalueofmoneyequationtoanswerthefollowingquestions:
Howmuchmoneywillyouhavein10yearsifyoudeposit$420inanaccountearninga3.2%
interestrate?
Howmuchwill$1becomein50yearsifitiscompoundedat10%annually?
Youjustdeposited$200ata6%interestrate.Howmuchinterestwillyouearnoverthree
years?
Thesameequationcanalsobeusedtosolvedifferentkindsofproblems.Forexample,tofind
outhowmuchmoneyyouneedtodepositinanaccountwitha5%interestrateinorderto
have$200infiveyears,yousolveforPV.Thatis:
PI =
FI
n
(1 +i)
n
GiventhatFV=200,i=0.05andn=5,theansweris$156.71.Youcanalsousetheequationto
solveforunknownsuchasiorn.Forexample,howlongdoesittaketodoubleyourmoneyin
thebankaccountwitha10%annualrateofreturn?Inthiscase,youneedtoentervaluesfor
PV(whichcanbeanynumber),FV(whichistwiceasmuchasPV)andi,andsolveforn.
100
200
300
400
500
600
700
800
1 2 3 4 5 6 7 8 9 1011121314151617181920
A
c
c
o
u
n
t
B
a
l
a
n
c
e
(
$
)
NumberofYears
0%
3%
6%
10%
23
DOTHEMATH
Howmuchdoyouneedtodepositintoanaccountwitha7%interestrateinorderto
accumulate$1,000infiveyears?
Givenanannualinterestrateof6%,whatisthepresentvalueof$30,000in25years?
Sometimes,thesituationmayrequireyoutousetheequationmultipletimes.Theexampleof
saving$500eachyearover20yearscanbecalculatedusingtheequation20times.Thefirst
depositwillbeintheaccountearninginterestfor19years,thatisSuu (1 +u.uS)
19
;the
secondonefor18years,Suu (1 +u.uS)
18
;andthelastoneisdepositedin20years,soit
doesntearnanyinterest.Whenyouaddthe20futurevaluestogether,theresultisthetotal
amountyouwillhaveafter20years.Themathematicalformulaforcalculatingthefuturevalue
ofastreamofevencashflows(eachwiththeamountofPMT)is:
FI
n
= PHI
(1 +i)
n
-1
i

IfyouuseafinancialcalculatororExceltosolvetheproblem,youdontneedtoworryabout
memorizingtheformulaorfindingtheanswermanually.However,itisveryimportantthatyou
understandtherationalebehindtheequationandhowitcanbeappliedinfinancialdecision
making.
DOTHEMATH
Usetheequationabovetosolvethesetwoproblemsandcompareyourresultswiththe
examplesdiscussedatthebeginningofthissection.
Youplantosave$500ayear.Iftheinterestrateonyoursavingsaccountis3%,howmuch
moneywillyouhavein20years?
Howmuchdoyouneedtosaveeachyearintoanaccountwitha3%interestrateinorderto
accumulate$1millionin40years?
Similartofindingthefuturevalue(FV)ofacashflowstream,youcanalsocalculatethepresent
value(PV)ofthecashflowstream.ThismeansthattheseriesofcashflowsofPMTineach
periodovertimehasthesamevalueasaonetimecashflowofPVtoday.Mathematically,the
formulais:
PI = PHI
1 -
1
(1 +i)
n
i

Thisformulawillbeusedinlaterchapterstodealwithloansthatarerepaidwithconstant
paymentsoveraspecifiedperiodoftime.
24
KEYTERMSTOREMEMBER
Budget
Adetailedscheduleoffinancialactivitythatpertainstoincomeandexpensesexpectedduringa
specificperiodinthefuture.
Surplus
Theamountofincomethatremainsaftersubtractingallexpenses.
Deficit
Theamountbywhichspendingexceedsincomeoveraperiodoftime.
Income
Moneyearnedthroughemploymentorinvestment.
Expense
Aparticularpaymentofmoney.
Needs
Thingsyoumusthaveinordertosurviveormeettheminimumlivingstandards.
Wants
Discretionaryexpensesthatmaybedelayedorsubstitutedwithoutaffectingyourabilityto
survive.
TimeValueofMoney
Theideathatadollartodayisworthmorethanadollarinthefuture.

25
Chapter4BorrowingandConsumerCredit
Themeaningofcreditandtheprosandconsofusingcredit
Varioustypesofconsumercredit
Thekeyfactorsthataffectyouropportunitytoborrowmoney
Howtocalculatethemonthlypaymentofaloan
KEYTERMS
Credit
OpenEndCredit
Default
4Cs
Amortization
ConsumerCredit
ClosedEndCredit
LineofCredit
FICOScore
AnnualPercentageRate(APR)
Overthecourseofyourlife,therecouldbemanyoccasionswhenyouneedtopayforcertain
expendituresbutdonthaveenoughmoneytomakethepayment.Considerthefinancial
challengesJohnencountered.Johnisaresponsibleyoungmanwhohasbeenveryvigilantwith
hisfinancessincehewasateenagerandalwaysmakessurethathedoesntoverspend.When
hewasacceptedtoauniversitythatwashistopchoiceandofferedascholarshipthatwould
coverpartofthetuitionandfees,heneededmoneytopayfortherestofthetuitionaswellas
otherlivingexpensesduringthefouryearperiod.Aftergraduatingfromcollege,Johnfounda
newjobandneededacartogotoworkeveryday.Hehadsavedsomemoneyfromaparttime
jobincollege,butitwasnotenoughtopayfortheentirepurchaseprice.Afewyearslater,
Johnandhiswifewereexpectingtheirfirstchild.Theyneededmorespacethantheone
bedroomapartmenttheyhadbeenrenting.Theywouldliketobuyacondoinaneighborhood
withexcellentschoolquality,butthepricewasoutoftheirreach.HowcouldJohndealwith
thesesituationswherehejustdidnothaveenoughmoneyatthetimewhenmoneywas
needed?ThankstothefinancialsystemthatyoulearnedaboutinChapter2,Johnwasableto
borrowmoneyforthoseexpenditures.Inthischapter,wewilldiscussvarioustypesof
consumercreditandfactorsthatmayaffectyourabilitytogetaloan.
USINGCONSUMERCREDIT
Creditisanarrangementtoreceivecash,goodsorservicesnowandpayfortheminthefuture.
Althoughconsumercreditisgenerallydefinedasborrowingmoneytomeetpersonalneeds
26
(buyingacar,payingforaneducation,payingforgroceries,etc.),itismorethanjusta
substituteforcash.Infact,manyserviceswereceiveinourdailylivesareexamplesofcredit.
Forinstance,wetypicallyconsumeutilitieslikewaterandelectricityfirst,andthenpayfor
themattheendofabillingcycle.Thistypeofcreditisprovidedfreeofcharge;therefore,
everyoneshouldtakeadvantageofit.Borrowingmoney,ontheotherhand,hasacostand
mayinvolverisk.Asaresult,youneedtobeverycarefulwhendecidingwhetherandhow
muchyoushouldborrowforaspecificpurpose.
Usingconsumercredithasseveraladvantages.First,itallowspeopletoenjoygoodsorservices
nowandpayforthemlater.Withoutusingcredit,purchasingahousewouldbeanimpossible
dreamforthemajorityofhouseholdsintheU.S.;buyingacarwouldtakeyearsofsavingsfor
mostpeople.Thetypesofloansdesignedforhome(orcar)purchasesallowaborrowertouse
his/herfutureincometopayforthepurchaseoveraperiodoftimewhileenjoyingthebenefits
providedtheasset.
Usingconsumercreditalsoreducestheneedtocarryalargeamountofcash.Today,mostof
thepurchasesofhighpriceditemsarepaidforwithcreditcards;makingtravelarrangements,
suchasflightandhotelreservationsoftenrequiresaguaranteebyacreditcard.Thisisnotonly
fortheconvenience,butalsoforthesafetyforconsumers.
Whatisthedownsideofusingcredit?Thesinglebiggestissueisthetemptationtooverspend.
Whenmakingpurchaseswithacreditcardoraloan,youareusingmoneythatyoudont
currentlyhave.Manypeoplefailtorealizethefactthatusingcreditdoesnotincreaseyour
incomeorpurchasingcapacity.Whileitallowsyoutomakeapurchaseearly,youstillneedto
payforitlater.Additionally,creditisnotfree.Creditorsofferyoutheserviceandexpectyou
topayforit(intheformofinterestand/orfinancecharges).Therefore,overspendingtiesup
yourincomeinthefutureandmayresultinseverefinancialconsequences.
TYPESOFCONSUMERCREDIT
Therearetwobasictypesofconsumercredit.Closedendcredittypicallyinvolvesborrowing
thathasaspecifiedloanamountandisforaspecificpurpose.Anagreementbetweenthe
creditor(thatis,thelender)andtheborrowerdetailsthetermsoftheloanthepurpose,the
amount,thecost(includingtheinterestrateandothercharges),thepaymentschedule,andthe
collateral,amongothers.Homemortgageloans,automobileloansandstudentloansare
examplesofclosedendcredit.
Incontrasttoclosedendcredit,openendcredit(alsoknownasrevolvingcredit)istypicallynot
usedforasinglepurpose.Youcanusethistypeofcredittomakeanypurchasesaslongasthe
totalamountyouveborroweddoesnotexceedthemaximumamountapprovedbythe
creditor,whichisyourlineofcredit.Periodically,theborrowerpaysinterestontheamount
owedandcanchoosetorepayaportionortheentireamountoftheprincipalborrowed.Credit
cardsarethemostpopulartypeofopenendcredit.TheU.S.CensusBureauestimatedthatin
2010,about180millionpeopleintheU.S.ownedcreditcardsandmorethan1.4billioncards
wereissuedbyfinancialinstitutionsandotherbusinesses.Aboutonethirdofcreditcardusers
27
payoffalltheirchargeseverymonth.Bydoingso,theydontincurfinancialcostsforusingthe
credit.Thosewhocarrybalancesontheircreditcardshavetopayinterest,andtherateson
creditcarddebtaresignificantlyhigherthanmostothertypesofconsumercredit.
Anotherexampleofopenendcreditishomeequityloans.Thistypeofborrowingusesahouse
ascollateral,butisnotusedforthepurchaseofthehouse.Thelineofcreditdependsonthe
valueofthehouseandtheamountstillowedonthehomemortgage.Oncethehomeequity
loanissetup,theborrowercanusethecreditforanypurchases.
WEBEXERCISE
GototheFederalReservewebsiteatwww.federalreserve.gov/creditcard/default.htm#anduse
theinteractivetoolstolearnabout:
Creditcardoffers,
Creditcardstatements,and
Fivetipsforgettingthemostoutofyourcreditcard.
FACTORSCREDITORSCONSIDER
Whenmakingaloan,thecreditorismakinganinvestment.Theinterestrateistherateof
returnontheinvestment.Whatfactorsdoesalenderconsiderwhendecidingwhetheraloan
applicationshouldbeapproved,andhowmuchinterestrateshouldbecharged?Themain
considerationishowriskytheinvestmentis.Riskisuncertainty,orthechancesthatthelender
mightnotreceivethereturnhethoughthewouldget,ormightnotevengettheprincipalback.
Theriskinessofaloancanbereflectedintwofactors:theprobabilityofincurringlossesandthe
severityofpotentialloss.First,thelenderassesseshowlikelyitisthattheborrowermight
defaultontheloan,whichmeanstheborrowerisunabletorepaytheprincipaland/orpay
interest.Themorelikelyitisthatdefaultwillhappen,theriskiertheloanis.Thelenderalso
considershowmuchhe/shecouldloseifadefaultoccurs.Iftheloanhasacollateral,whichis
avaluableassetpledgedtoensureloanpayments,theloanislessrisky.
Ingeneral,lendersofconsumerloansconsiderfourkeyfactors,the4Cs.Theyare:capacity,
capital,collateralandcharacter.Capacityisyourfinancialabilitymainlyyourincometo
meettheloanobligations.Alenderusuallycomparestherequiredmonthlypaymentonthe
loanwiththeborrowersmonthlyincome.Capitalistheassetsownedbytheborrower.This
factoralsoreflectstheborrowersabilitytomakerequiredpayments.Whenyouapplyfora
loan,thelenderwillaskyoutoprovidecriticalfinancialinformation,suchassalary,investment
income(interestanddividends),bankaccountbalances,andyourstockportfolio.Additionally,
youneedtoauthorizeyouremployerandfinancialinstitutionstoreleasetheinformationsothe
creditorcanverifythatwhatyouclaimintheapplicationistrue.Thelenderusesthe
informationtoassessyourcapacityandcapital.
Collateralisavaluableassetthatispledgedtotheloan.Iftheborrowerdefaults,thelender
hastherighttoselltheassetandusetheproceedstorecoverhis/herinvestment(oratleast
28
partofit).Forexample,whenyouborrowanautoloan,thecaristhecollateral.Incaseyou
areunabletomakethescheduledpayments,thelenderhasthelegalrighttotakepossessionof
thecarandsellit.
Characterreferstoonesattitudetowardfinancialobligations.Somepeopletakethese
obligationsseriouslyandwouldrathersacrificepersonalconsumptioninordertomakeloan
payments.Othersmaynotconsidermeetingtheirfinancialobligationsapriorityandbelateon
loanpaymentsonaregularbasis.Manylendersconsidercharacterthemostimportant
indicatorinpredictingwhetheraborrowercanmaketimelypaymentsonaloanandrepaythe
principal.However,attitudeisverysubjectiveanddifficulttomeasure.Creditorsthereforeuse
creditscoreasasubstitutefortheborrowerscharacter.Yourcreditscoreisanumberthat
summarizesyourhistoryofusingcredit.ThemostcommonlyusedcreditscoreiscalledaFICO
score.
WhatisaFICOscore?
TheFICOscorewasdevelopedbyFairIsaacCorporation(FICO)tomeasurecreditrisk.This
scorehasarangeof300to850,andthehigherthescore,thelowertherisk.Whencomputing
thescore,FICOusesinformationfromyourcreditreport.Thecreditreportdescribesthetypes
ofcredityouhave,thelengthoftimeyouhaveusedcredit,andwhetheryouvepaidyourbills
ontime.Theinformationiscollectedandmaintainedbycreditbureaus(orcreditreporting
agencies).Becausetherearethreecreditbureaus(Equifax,ExperianandTransUnion)that
collectinformationindependentlytopreparecreditreports,eachindividualmayhavethree
differentFICOscores.
TheFICOscoreevaluatesfivemaincategoriesofinformationincreditreports:1)payment
history;2)amountowed;3)lengthofcredithistory;4)typesofcreditinuse;and5)newcredit.
Amongthem,yourpaymenthistoryandthetotalamountyouoweonallcreditaccountsare
mostimportant,asapproximately35%and30%ofyourFICOscoreisbasedonthesetwo
factors.FICOscoresconsiderawiderangeofinformationonyourcreditreport,buttheydo
nottakeintoaccounttheinterestrateschargedonyourloansorcreditcards.Otherfactors
thatdonotaffectyourFICOscoresincludeyoursalary,occupationandtitle;yourcurrent
employerandemploymenthistory;andwhereyoulive.Nevertheless,thesefactorsmaybe
consideredbyalenderwhenhe/sheassessesyourcapacity,capitalandcollateral.
WEBEXERCISE
www.myfico.comisthewebsitedevelopedbyFairIsaacCorporationtoeducateconsumers
aboutcreditscores.Onthehomepage,clickonthelinkunderUnderstandingCredit.From
here,youcanlearnaboutwhatisinyourFICOscore,whatisnotinyourFICOscore,the
minimumrequirementsforaFICOscoreandalotmore.
Whyiscreditscoreimportant?
Thebetteryourcreditscore,thelowertheannualpercentagerate(APR)youwillbecharged.
APRisthecostofcreditexpressedinayearlyrate;itincludestheinterestrateaswellasother
lenderfeestheborrowerisrequiredtopay.Ifnoadditionalfeesarechargedonaloan,the
APRisequaltotheinterestrate.LenderschargealowerAPRifyouhaveahighFICOscore
29
becausethegoodFICOscoreindicatesthatyouvemanagedyourfinancesresponsibly.For
lenders,itsuggestsalowerpossibilitythatyouwouldbeunabletofulfillyourfinancial
responsibilityofpayinginterestandrepayingprincipal.WithoutagoodFICOscore,your
chancetogetaloan(suchasanautoloanorahomemortgage)willbeslim.Evenifyoudofind
alenderwhoiswillingtolendyouthemoney,theinterestratewillbehigher,costingyoumuch
moremoneyovertime.
SincetheFICOscoreisakeyfactorindeterminingyourabilitytoreceivecreditandalsothe
interestrateyouwillbecharged,youmaybewonderingwhatisconsideredagoodFICOscore.
Unfortunately,nosinglestandardthatisagreeduponbyalllendersexists;therefore,thereis
nosingledefinitionofexcellentorgoodcredit.Asageneralguideline,FreddieMac(youwill
learnmoreaboutthiscompanyinChapter7)suggeststhataFICOscoreabove770isexcellent;
ascorebetween700and770isgood;andascorebetween650and700isaverage.Ifyour
FICOscoreisbelowthemid600s,youmayhavedifficultyobtainingaloan.Inmid2011,the
averageFICOscoreintheU.S.wasapproximately692;theaverageinCaliforniawas687.
PAYMENTSOFCLOSEDENDCREDIT
Mostexamplesofclosedendcreditareloansthatarerepaidwithequalpaymentsovera
specifiedperiodoftime.Anautoloanmaycallforequalmonthlypaymentsover60months;a
studentloanmayberepaidwithequalmonthlypaymentsover10years;andahomemortgage
loanmayrequireequalmonthlypaymentsover360months.Withthistypeofloan,each
monthlypaymentincludesboththeinterestpaymentandtheprincipalrepayment.Every
month,theborrowerpaysinterestontheamounthe/sheowes,andaportionoftheprincipalis
repaidsotheamountinitiallyborrowedcanbecompletelypaidoffattheendoftheloanterm.
Howisthemonthlypaymentofthistypeofloandetermined?Howmuchprincipaldoesthe
borrowerneedtorepayeachmonth?
Considera$12,000,fiveyearautoloanwitha4.80%APR.Itmayseemthatthetwoquestions
abovecanbeeasilyansweredwithverysimplecalculations.First,giventhe0.40%monthly
interestrate(4.80%annualratedividedby12),theborrowerischarged$48ofinterestevery
month(principaltimesinterestrate,or$12,000x0.004).Second,theprincipalisrepaidover
60months,sotherepaymenteachmonthis$200($12,00060).Whentheresultsare
combined,theborrowerstotalmonthlypaymentbecomes$248.However,thereareproblems
intheanalysis.Astheprincipalamountisbeingrepaidovertime(thisiscalledamortization),
theamountowedbytheborrowerdecreases.Giventhesameinterestrateandadeclining
principalbalance,theinterestchargedontheloanshoulddecreaseovertime.Sohowmuch
exactlydoestheborrowerneedtopayeachmonth?Thecalculationisbasedononeofthe
formulasinChapter3:
PI = PHI
1 -
1
(1 +i)
n
i

Whenapplyingthisformulatoanamortizationloanwithmonthlypayments,PVistheamount
borrowed,iisthemonthlyinterestrate,andnisthenumberofmonths.Forthecurrent
30
example,PV=12,000,i=0.04andn=60.AfterplugginginthosenumbersandsolvingforPMT,
themonthlypaymentis$225.36.
1
Overthefiveyearperiod,theborrowerwillpayatotalof
$1,521.41ininterest,buttheamountofinterestpaymentchangesmonthbymonth,ranging
from$48inthefirstmonthtoonly90centsinthelastmonth.Thefollowingtableshowsthe
breakdownofthemonthlypaymentsduringthefirstandlastsixmonthperiods.
BreakdownofMonthlyPayment:Interestvs.Principal
Month InterestPayment PrincipalRepayment LoanBalance
$48.00 $177.36 $11,822.64

2 47.29 178.07 11,644.58
3 46.58 178.78 11,465.80
4 45.86 179.49 11,286.30
5 45.15 180.21 11,106.09
6 44.42 180.93 10,925.16
.
.
.
.
.
.
.
.
.
.
.
.
55 5.33 220.02 1,113.39
56 4.45 220.90 892.48
57 3.57 221.79 670.70
58 2.68 222.67 448.02
59 1.79 223.56 224.46
60 0.90 224.46 0.00
Howdoesgoodcredithelpyousavemoney?
YouhaveprobablyseenTVcommercialsbyautomakersthatofferspecialfinancingfor
customers.Supposeanautomakeroffers0%APR(annualpercentagerate).Howmuchdoyou
needtopayeachmonthforafiveyear,$12,000loanandhowmuchcanyousaveoverthe
termoftheloan?Becausetheinterestrateis0,theborroweronlyneedstopaybackprincipal,
butisnotchargedanyinterest.Everymonth,thepaymentis$200.Comparedwiththeloan
witha4.80%interestrate,thetotalsavingoninterestpaymentsis$1,521.41.
Onethingyoushouldknowisthatthespecialfinancingisnotavailabletoallcustomers.The
keyisyourcredit.Withoutgoodcredit,youcantqualifyforthelowAPR.Furthermore,ifyou
havepoorcredit(thedefinitionvariesbylenders),youmaynotevenbeeligibleforaloanatthe
regularinterestrate.DependingontheborrowersFICOscoreandlegallimitsofastate,
interestratesonbadcreditautoloanscouldbedoubleoreventripletheregularrate.The
PHI =
PI
1 -
1
(1 + i)
n
i
=
12,uuu
1 -
1
(1 +u.uu4)
60
u.uu4
= 22S.S6
31
followingtablecomparesthepaymentsofafiveyear,$12,000loanwithfivedifferentinterest
rates.Itrevealshowmuchhavingpoorcreditcouldpotentiallycostyou.
ComparisonofLoanPaymentswithDifferentInterestRates
InterestRate 0.0% 2.4% 4.8% 7.2% 9.6%
Monthly
Payment $200.00 $212.44 $225.36 $238.75 $252.61
TotalInterest $0.00 $746.38 $1,521.41 $2,324.90 $3,156.55
KEYTERMSTOREMEMBER
Credit
Anarrangementtoreceivecash,goodsorservicesnowbutpayforthemlater.
ConsumerCredit
Theuseofcreditforpersonalneedsbyindividualsandfamilies,incontrasttocreditusedby
businessesandgovernments.
ClosedEndCredit
Aonetimeborrowingthathasaspecifiedloanamountandisforaspecificpurpose.Closed
endcreditthatisrepaidwithequalperiodicpaymentsisalsoreferredtoasinstallmentcredit.
OpenEndCredit
Aloanwhosemaximumamountisapprovedbythecreditorbutnotdeliveredtotheborrower
atonce.Overtime,theborrowercangetmoneyfromthelender(uptothemaximum
amount),orpaybackaportionortheentireamountoftheprincipal.
LineofCredit
Themaximumamountyoucanborrowusingaspecificopenendcredit.
Default
Thesituationwhereaborrowerfailstomaketimelypaymentofinterestand/orprincipalona
loan.
4Cs
Thefourkeyfactorslendersofconsumercreditconsiderwhentheyassesstheriskinessofa
loan.Theyare:capacity,capital,collateralandcharacter.
32
FICOScore
Anumberthatsummarizesanindividualshistoryofusingcredit.ItwasdevelopedbyFairIsaac
Corporation(FICO)andhasarangeof300to850.
Thecostofcreditexpressedinayearlyrate;itincludestheinterestrateaswellasotherlenderfeesthe
borrowerisrequiredtopay.
Amortization
Thegradualrepaymentofloanprincipalovertime.

33
Chapter5FinancialDecisionMakinginCollege
Thebenefitsandcostsofattendingcollege
Keyfactorstoconsiderwhenchoosingcreditcards
Importantthingstoknowwhenrentinganapartment
KEYTERMS
IncrementalCost
IdentityTheft
LeaseAgreement
OpportunityCost
RentersInsurance
Decidingwhetherornotgoingtocollegeisrightforyouisnotaneasydecision.Manyfactors
needtobetakenintoconsideration.Furthermore,thechallengeisnotoverwhenyousendout
applicationsormakethedecisiononwhichschoolyouwillattend.Onceyoubecomeacollege
student,inadditiontomakingdecisionsdirectlyrelatedtoyoureducation(suchasselecting
yourmajorandthecoursestotakeeachsemester/quarter),youwillhavetomakemany
financialdecisionsthatyoumaynothaveencounteredbefore.Oneexampleischoosingfrom
numerouscreditcardoffersanddetermininghowmanycardsyoumayneed.Anotherexample
isrentinganapartment.Whilemostcollegestudentsliveindormitoriesduringtheirfreshman
year(sometimessophomoreyearaswell),manychoosetoliveoffcampuslateron.Such
decisionshaveimportantimplicationsonyourfinancialhealth,bothimmediatelyandinthe
longrun,andthereforedeserveyourattentionandcarefulconsideration.
PLANNINGFORCOLLEGE
Someofyoumayhavealreadymadeupyourmindregardingwhetherandwhereyoushouldgo
tocollege.Eveniftheanalysesinthissectioncannotchangeyourdecision,theyprovideyou
withadecisionmakingframeworkandhelpidentifykeyfactorsinfinancialdecisionmaking.
Likemanydecisionsinyourlife,thechoiceofgoingtocollegehassignificantimpactonyour
financialfuture.Anessentialstepinmakingthistypeofdecisionistocomparethebenefitsand
costs.
BenefitsofAttendingCollege
Canacollegedegreeguaranteethatyouwillfindawellpayingjob?Doesthelackofcollege
educationmeanyouwillneverbesuccessfulinlife?Ofcoursetheanswerstobothofthese
34
questionsareno.Attendingcollegeisalongterminvestmentandnobodycanguaranteethat
itwillpayoff.Whetheryouwillhaveasuccessfulcareeralsodependsonyourworkethic,the
professionyouchoose,andmaybealittlebitofluck.Nevertheless,ifyouhaveacollege
education,theoddsareinyourfavor.
AccordingtotheU.S.DepartmentofEducation,themedianannualsalaryforyoungadults
(ages2534)withahighschooldiplomaisabout$29,000,andthemediansalaryforthosewith
abachelorsdegreeisabout$45,000.Moreover,theincomegrowthpotentialisgreaterin
professionsthatrequirehighereducation.Eveninthesamecompany,anemployeewithbetter
educationismorelikelytogetpromotedorreceiveabiggerraise.Asaresult,theincomegap
betweenthosewithandwithoutacollegedegreeislikelytowidenasyourcareerprogresses.
MedianAnnualEarningsbyEducationAttainmentandGender
Source:NationalCenterforEducationStatistics,U.S.DepartmentofEducation
CostsofAttendingCollege
Itisevidentthatacollegeeducationcanhelpimproveyourfutureincome.Butwiththe
increasingcostofhighereducation,youmaybewonderingwhetherthisinvestmentcanreally
payoff.Letsexaminethecostofattendingcollege.Anobviouscostistuitionandfees.How
muchyouneedtopaydependsonthetypeofinstitution(forexample,fouryearuniversityvs.
communitycollege;publicvs.privateschool)andyourresidencestatus.Forfouryearpublic
colleges,instatestudentsonaveragepayabout$8,000ayear,whileoutofstatestudentspay
nearly$20,000.Theaveragetuitionandfeesatprivatecollegesisabout$27,000ayear.That
isaverysubstantialamountoverfouryears.
Additionally,youwillalsoincurroomandboard,booksandsupplies,transportationandother
personalexpenses.Whilealloftheseareactualexpensesyou(oryourparents)havetopayfor
whileyoureincollege,notallshouldbeconsideredinordertocomparethebenefitsandcosts
ofattendingcollege.Forexample,transportationisanexpenseyouwillincurregardlessof
yourdecision.Evenifyoudontgotocollegeandstartworkingfulltimerightafterhighschool
graduation,youstillneedtodrive,ortakeabus,ortakethesubwaytowork.Transportation
costscouldactuallybehigherifyoudontgotocollegethanifyoudo,especiallyifyouliveon
35
ornearcampus.Whenyoumakeafinancialdecision,youshouldfocusontheincremental(or
marginal)cost,notthetotalcost.
Notsoobviousistheopportunitycost.Whatisopportunitycost?Opportunitycostisthecost
ofanactivitymeasuredintermsofthevalueofthebestalternativethatisnotchosen.After
highschool,ifyoujointheworkforceandgetpaidthemediansalary,youwillearnabout
$29,000eachyear.Incontrast,ifyougotocollegeonafulltimebasis,youwontbeableto
workfulltimeandthereforehavetogiveuptheopportunitytoearnnearly$120,000during
thefouryearperiod.Althoughthisisnotacostyouactuallyneedtopayfor(withcash,checks
orcreditcards),itisanimportantcomponentinthetotalcostsofattendingcollege.
Therearemanywaystoreducethecostsofgoingtocollege.Grants,forexample,arefinancial
aidthatisbasedonneed;scholarshipsaretypicallybasedonacademic,artisticorathletic
credentials.Neitheroneneedstoberepaid.Studentloans,ontheotherhand,arefinancialaid
thatwillhavetobepaidbackwithinterest.Youshouldworkwithyourguidancecounselor
and/orthefinancialaidofficeatthecollegeyouareapplyingtofindwaystominimizeyourout
ofpocketcosts.
WEBEXERCISE
TheCollegeBoardisanotforprofitorganizationwhosegoalistoensurethateverystudent
hastheopportunitytopreparefor,enrollinandgraduatefromcollege.Gotoitswebsiteat
http://www.collegeboard.com/student/index.html?studenttolearnabouthowyoucan:
Planforcollege
Findacollege
Applytocollege
Payforcollege
USINGCREDITCARDS
AsdiscussedinChapter4,havinggoodcreditisveryimportantandoneofthefactors
determiningyourFICOscoreisthelengthofyourcredithistory.Formostpeople,thefirststep
ofestablishingacreditrecordistohaveacreditcardaccount.Whenincollege,youwillreceive
offersthatencourageyoutoapplyfornewcreditcards.Theyprovideallkindsofincentives:
lowAPR,cashrebates,cashadvances,andawaiveroftheannualfee,amongothers.Which
creditcardisrightforyou?Shouldyouapplyforallofthem?Howmanyshouldyouhave?
WEBEXERCISE
GotoCreditCards.com(http://www.creditcards.com)tolearnaboutvarioustypesofcredit
cards(suchaslowinterestrate,balancetransfer,reward,cashback,andstudentcreditcards)
andtheaverageAPRineachcardcategory.
36
FeaturesofCreditCards
Whenselectingacreditcard,thereareseveralfeaturesofthecardyoushouldconsider.The
firstoneistheinterestrate,orannualpercentagerate(APR).AcardwithalowAPRcanhelp
yousaveoninterestcharges.However,whenyouseeanincrediblyattractiveoffer,youneed
topayattentiontohowlongthelowinterestrateisgoodfor.Itispossiblethatthe
introductoryrateisonlyavailableforalimitedtimeandtheregularrate(usuallyinthefine
print)mightbehigherthanratesonothercards.Thesecondfactoristhecreditlimit,whichis
theamountofmoneythecreditorallowsyoutoborrow.Thislimitcanrangefromafew
hundreddollarstotensofthousandsofdollars,dependingonyourcredit.Feesandpenalties
areanotherimportantfactor.Somecreditcardissuerschargeanannualfee,whileothers
dont.Manychargefeesforcertaintransactions,suchascashadvancesandbalancetransfers.
Mostissuerschargeapenaltyifyoupayyourbilllateorspendoverthecreditlimit.Finally,you
shouldconsidertheincentivesofferedbythecard.Manycardissuershaverewardprogramsto
attractcustomers,fromcashrebatestoairlinemiles.Thesecouldbenicebenefitsiftheyare
freeandyouaregoingtomakethepurchasesanyway.
Whichofthesefeaturesismostimportantdependsonyoursituation.Ifyouexpecttocarrya
balance,thentheAPRiscritical;ontheotherhand,ifplantopaythebillinfulleverymonth,
theinterestrateisnotascrucial.Ifyouregoingtouseonecardformostpurchases,itneedsto
haveagenerouscreditlimit.Ifitdoesnt,thelikelihoodofgoingoverthelimitincreases,and
yourerunningtheriskthatyoumighthavetopayafeeandyourcreditscorewouldbe
affected.Sinceyoullusethiscardoften,agoodrewardprogrammayprovideextrabenefits.If
acardwillbeusedmainlyforanemergencysituation,thecreditlimitandincentivesbecome
lessimportant.
Severalcreditissuersoffercardsdesignedforcollegestudents.Thesecardstypicallyhave
lowercreditrequirements,chargenoannualfees,andallowyoutoearncashbackon
purchases.Thecreditlimitisrelativelylowandsomeofthemrequireanadultascosigner.
Howcanyoutakecontrolofyourcreditcardandavoidfallingintoacreditcardtrap?Hereare
somesuggestions.First,carryonlyonecreditcardforregularpurchases,andpossiblyasecond
oneforemergency.Keepinmindthatcreditcardshelpyouestablishcreditandprovide
convenience,buttheydonotincreaseyourspendingcapacity.Havingalargenumberofcards
doesntmeanyoucanaffordtobuymorestuff.Howmuchyoucanaffordtopurchasewith
creditcardsshouldbebasedonyourbudget,notthecreditlimitsofyourcards.
Anotherveryimportantthingtorememberisthatyoushouldalwayspaythebillontime.Even
ifyoucannotmakethepaymentinfull,payattheleasttheminimumamountontime.Alate
paymentcouldtriggeramuchhigherinterestrateandalsoaffectyourcreditscoreadversely.
Havingacreditcardmaybethebeginningofbuildingyourcreditandyouwanttomakesure
thatyouareofftoagoodstart.
37
WEBEXERCISE
Learninghowtousecreditcardsresponsiblyrightfromthebeginningcansaveyoufromhaving
todigyourselfoutofdebtlater.Evenifyoudonthaveacreditcardnow,understandinghow
totakecontrolofcreditcardsisveryavaluablelesson.Manyorganizationsofferadviceon
beingcreditcardsmart.Forexample,gotothewebsiteofConsumerUnion
(www.consumersunion.org/pub/core_financial_services/004893.html)andlearntipsthatcan
helpyoubuildandmaintainstrongcreditandmakeacreditcardworkforyou.
IdentityTheft
Onceyoustartusingcredit,itsveryimportantthatyouunderstandhowtomanageyourcredit
accountsandalsohowtoprotectthem,especiallyagainstidentitytheft.TheFederalBureauof
Investigation(FBI)callsidentitytheftoneofthefastestgrowingcrimesinthecountry.Itoccurs
whenapersonsidentification(includingname,socialsecuritynumberand/oranyaccount
number)isusedortransferredbysomeoneelseforunlawfulactivities.Ifithappens,youmay
havetospendextensivetimetoclosebadaccountsandopennewones;itmaycostyoualotof
moneyandtimetofixcreditrecords;youmayevenbedeniedloansorjobsduetobadcredit
causedbyidentitytheft.Theconsequencescouldbequiteserious.
ItisestimatedbytheFBIthatmorethanhalfamillionAmericansbecomevictimseachyear.
Unfortunately,fouroutoffivevictimshavenoideahowthethiefgottheirpersonal
information.Additionally,identitytheftoftengoesundetectedforalongtime.Abouthalfof
thevictimswerenotawareoftheproblemonemonthaftertheiridentitywasstolen;about
10%ofthecrimesremainunnoticedtwoormoreyearslater.Itisveryimportantthatyou
understandhowtoprotectyourselffrombeingavictimofidentitytheft.
WEBEXERCISE
GotothewebsiteoftheFederalReserveBankofBoston
(http://www.bos.frb.org/consumer/identity/video.htm)andwatchtheIdentityTheft:Protect
Yourselfvideo.YoushouldalsodownloadandreadtheIdentityTheftbrochureavailableon
thiswebpage.
RENTINGANAPARTMENT
Manyuniversitiesrequirestudentstoliveinadormitoryinthefirstyear(orthefirsttwoyears)
inschool.Afterthat,manystudentschoosetoliveoffcampusbyrentinganapartmentwith
roommates.Thiscouldbeanexcitingexperiencebecauseitmightbethefirsttimeyouliveon
yourownwithoutadultsupervision.However,thefreedomcomeswithadditional
responsibilities.Choosinganapartmentisasmuchalifestyledecisionasafinancialdecision.
Herearesomeofthefactorsyouneedtoconsiderwhenselectinganapartment.
38
LocationandBuildingFeatures
Thefirstthingtoconsideriswhereyouwanttolive.Anapartmentisatypeofrealestate,and
realestateprofessionalsoftensaythethreemostimportantthingsinrealestateare:location,
location,location.Thelocationofanapartmentmayaffectyourdecisioninmanydifferent
ways.Forexample,thedistancetoschoolandavailabilityofpublictransportationmayhavean
effectonyourcommute,intermsofbothtimeandcost;accesstoservices(likestores,
restaurantsandrecreationalactivities)and/orcloseproximitytofriendsmaybeimportantfor
you.Acrucialfactorthatyoumusttakeintoaccountisthesafetyoftheneighborhood.
Aftertheareaisdetermined,youneedtoselectanapartmentinthearea.Youneedto
considerfeaturesofthebuilding(orcommunity)aswellastheunityouwilllivein.Doesthe
buildinghaveenoughparkingforresidentsandguests?Doesithaveamenitiessuchassecured
access,aswimmingpoolandexerciseroom?Ifyourunitisnotonthegroundfloor,arethere
elevators?Doestheunithaveenoughstoragespace?Whatappliancesareincluded?These
arejustsomeexamplesofquestionsyoushouldask.Keepinmindthatyouusuallyhavetopay
ahigherrentfortheadditionalfeatures.Whendeterminingtheapartmentyoucanafford,you
shouldpaymoreattentiontowhatyouneedthantowhatyouwant.
LeaseTerms
Aleaseisacontractyouneedtosignwiththelandlord.Itdetailsyourrightsand
responsibilitiesasatenant.Additionally,itspecifiesthefinancialterms,suchasthemonthly
rentyouneedtopay,whentheagreementexpires,theoptionsyoumayhave,thesecurity
deposit,andincentives.Youneedtoreviewthetermsverycarefullysotherearenosurprises
whensomethinghappenslater.
Whencomparingthecostofdifferentalternatives,youshouldtakeintoaccountnotonlythe
monthlyrent,butalsootherfactors.Forexample,therentofanapartmentis$1,200amonth
withaninemonthlease;ifyousignaoneyearlease,thelandlordiswillingtolowerthe
monthlyrentto$1,150.Itseemstobeagooddealasyoucansave$600duringthetermofthe
lease.However,ifyouarenotgoingtostayintheapartmentduringsummer(forexample,
goinghomefortheentiresummer,studyingabroadforacoupleofmonths,ortakingan
internshipinadifferentcity),thethreeadditionalmonthsyouhavetopayrentforcouldend
upcostingyoualotofmoney.
WEBEXERCISE
Intheprocessoffindinganapartment,signingthelease,andmovingyourstuffintoyournew
apartment,therearesomanythingsyouneedtodealwith.Gotoapartments.com(at
living.apartments.com/printablechecklists)andfindchecklistsfor:
Thingsyoushouldpayattentiontowhentouringanapartmentcommunity/unit.
Questionsyoushouldaskbeforesigningalease.
Thingsyoushouldprepareforbeforethemoveinday.
39
Insurance
Mostapartmentownershaveaninsurancepolicythatprotectsthepropertyagainstaccidents
ornaturaldisasters.Ifthebuildingisdestroyedbyfireordamagedbyanearthquake,the
insurancecompanywillhelptheownerrepairorrebuildtheproperty.Theseinsurancepolicies
protectthebuilding,butnotthingsinthebuilding.Ifyourvaluablesaredamagedinan
apartmentunit,itistypicallynotthelandlordsresponsibility,regardlessofthecauseofthe
damage.
Toprotectyourpersonalbelongings,youshouldgetrentersinsurance.Withthistypeof
policy,theinsurancecompanywillreplacethingsyouloseduetofire,earthquake,theftor
otherreasons.Manypeoplethinkaccidentswonthappentome.Buttheydohappen,and
theycanhappentoyou.Bypayingasmallpriceeverymonth,youcaneliminatethepossibility
ofincurringahugelosslater.
KEYTERMSTOREMEMBER
IncrementalCost
Thecostassociatedwithoneadditionalunitofproduction,oraspecificdecision.
OpportunityCost
Thecostofanactivitythatismeasuredintermsofthevalueofthebestalternativethatisnot
chosen.
IdentityTheft
Thesituationwhereapersonsidentification(includingname,socialsecuritynumberand/or
anyaccountnumber)isusedortransferredbysomeoneelseforunlawfulactivities.
Thecostofcreditexpressedinayearlyrate;itincludestheinterestrateaswellasotherlender
feestheborrowerisrequiredtopay.
Lease
Awrittenagreementunderwhichapropertyowner(thelandlord)allowssomeoneelse(the
tenant)tousethepropertyforaspecifiedperiodoftimeinexchangeforamonetarybenefit
(therent).
RentersInsurance
Atypeofhomeinsurancethatprotectstheholderagainstaccidents,damagesandlossesthat
occurinarentedresidence.

40
Chapter6SavingandInvesting
Thepopularmeanstoinvestmoneyforlongtermgoals
Theimpactofpayingtaxesonyourrateofreturn
Thebasicsofstockandbondmarkets
Variouswaystoinvestinrealestate
Howmutualfundswork
KEYTERMS
Bonds
Bondholder
JunkBonds
Shareholder
CapitalGain
NASDAQ
CommercialRealEstate
Diversification
BeforeTaxRateofReturn
IndividualRetirementAccount(IRA)
BondIssuer
BondRating
Stocks
Dividends
DowJonesIndustrialAverage
S&P500
MutualFunds
Portfolio
AfterTaxRateofReturn
InChapter3youlearnedaboutlongtermfinancialplanningandhowthetimevalueofmoney
affectstheoutcome.Oneexamplediscussedinthatchapterwasretirement.Basedonan
annualdeposit,youcanestimatehowlongitwilltakeforyoutoreachyourretirementgoal;or
givenatargetretirementage,youcandeterminehowmuchmoneyyoumustsaveeachyearin
ordertoreachthegoal.Akeyfactorintheretirementplanningprocessistherateofreturn
youexpecttoearnonyourinvestment.Supposeyoustartworkingfulltimeattheageof22
andsave$1,000eachyearbeforeretiringattheageof65.Howmuchmoneywillyouhave
whenyouretire?Ifyoukeepthemoneyinabankaccountandearnanaveragereturnof2%a
year,youwillhaveabout$67,000in43years;ifthemoneyisinvestedinthebondmarketand
generatesanaveragereturnof5%eachyear,youwillhavealmost$143,000atretirement;if
youinvestinthestockmarket,whichproducesanaveragereturnof8%,youwillhavemore
than$329,000attheend.Thechartonthenextpagecomparestheamountyouwillhaveif
themoneyisinvestedinthreedifferenttypesofinvestments.Itclearlyshowsthatthehigher
therateofreturn,themoremoneyyouwillhaveforretirement.Whattypeinvestment
providesthehighestrateofreturn?Whatisthedownsideofinvestinginthosewithhigher
41
returns?Inthischapter,wewilldiscussthecharacteristicsofseveralpopularinvestment
vehicles.
TotalAmountAccumulatedatRetirement
POPULARINVESTMENTVEHICLES
ThankstothewelldevelopedfinancialsystemintheU.S.,therearemanydifferentwaysfor
youtosaveorinvestmoney.Someinvestmentsprovidehigher,butmorevolatile,returns,
whileothersprovidemorestable,butlower,returns.Whichoneisthebestchoiceforyou
dependsonmanyfactors,includingyourpersonalpreferencesandthestageinyourlifecycle.
Thelifecycleofinvestingcoversfourstages:accumulation,consolidation,spendingandgifting.
Whenyouareyoung,youcanfocusonaccumulatingwealthbychoosinginvestmentswithhigh
returns.Becausetheresalongtimebeforeyoureachretirement,temporaryvolatilitywillnot
affectyouasmuch.Asyougrowolder,thetimetoretirementshortens.Preservationofwhat
youhaveaccumulatedbecomesmoreimportant.Duringtheconsolidationstageyoushould
shifttoalowerriskportfolio.Onceyouretire,youenterthespendingstageasyourincome
willnotbesufficienttocoveralltheexpenses.Lateroninthelifecycle,ifyouhavemanaged
yourfinancesresponsiblyandmadesmartinvestmentdecisions,itspossiblethatyouwillhave
moresavingsthanneededforexpensesduringyourremaininglife.Consequently,youmay
wanttodonatemoneytocharitableorganizations.
BankAccounts
Thesimplestwaytogrowyourmoneyistosaveitinabankaccount.InChapter2,youlearned
aboutseveraldifferenttypesofaccounts.Savingmoneyinabankissafeandgivesyou
flexibility.MostdepositoryinstitutionsareinsuredbytheFederalDepositInsurance
Corporation(FDIC)orsimilarfederalagencies.Therefore,eveniftheinstitutionisinfinancial
difficulty,yoursavings(upto$250,000)isprotected.Theseaccountsallowyoutowithdraw
moneywhenyouneeditwithnoorverylowtransactioncost.Theonlyexceptioniscertificates
ofdeposit(CDs)althoughinthissituation,thetermisrelativelyshort,soyouarenotstuckfor
anextendedperiodoftime.Whatisthepriceyouhavetopayforsafetyandflexibility?The
relativelylowrateofreturn.Thefollowingchartshowstheannualreturnsonmoneymarket
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
23 28 33 38 43 48 53 58 63
RetirementAge
2% 5% 8%AnnualReturn
42
accountsfrom1991to2010.Duringthe20yearperiod,theaverageannualreturnwas3.30%.
Althoughthereturnfluctuated,itwasalwayspositive,rangingfrom0.1%to5.7%.
AnnualRateofReturn:MoneyMarketAccounts(19912010)
Bonds
Bondsaredebtsecurities.Thatmeanstheissuer(acompanyoragovernment)borrowsmoney
bysellingthebondstoinvestors(calledbondholders).Therearemanytypesofbonds:bonds
issuedbytheU.S.federalgovernmentarecalledTreasurybonds;thoseissuedbystateorlocal
governmentsarecalledmunicipalbonds;andthoseissuedbycorporationsarecalledcorporate
bonds.Ifyouinvestinabond,youwillreceiveaninterestpaymentfromtheissuerperiodically
andgettheprincipalbackatthebondsmaturitydate.Howmuchrateofreturnyoucanearn
dependsontheinterestrate.Priortomaturity,youcannotredeemthebondbacktotheissuer
forcash,butyoucansellitinthebondmarkettootherinvestors.Howmuchyoureceivefrom
thesalecouldbedifferentfromtheprincipalamount,dependingontheeconomicconditionsat
thetime.
Sinceabondisadebtsecurity,itispossiblethattheborrowermightdefault.Whenthat
happens,bondholderslosemoney.Similartotheconsumercreditmarketswherecreditors
assesstheriskinessofaloanbasedontheborrowerscreditscore,inthebondmarket,
investorsmeasurecreditriskusingabondratingsystem.Severalratingagencies(Moodys,
S&PandFitch)examinetheborrowersfinancialstrengthandthebondsfeaturestoassigna
ratingtothebond.Thetablebelowsummarizesthebondratingsystem:
TheBondRatingSystem
Moodys S&P Fitch
Aaa AAA AAA
Aa AA AA InvestmentGrade
A A A
Baa BBB BBB
Ba BB BB
B B B NonInvestmentGrade
C C C (JunkBonds)
D D D InDefault
Ahigherbondrating(forexample,AAA)indicatesthattheprobabilityofborrowerdefaultis
verylow.Asaresult,theinterestrateonthebondislow.Ontheotherhand,thelowera
0.00%
2.00%
4.00%
6.00%
8.00%
43
bondsrating,themoreriskisinvolvedandconsequently,ahigherinterestrateischarged.Due
toregulations,manyfinancialinstitutions(suchasbanks)areallowedtoinvestinonly
investmentgradebonds.Asaninvestment,bondsareconsideredriskierthanbankaccounts
butsaferthanstocks.Duringthelast20years,theaverageannualreturnonbondswas7.0%.
Intwoofthoseyears,investorsearnedmorethan15%,butintwootheryears,theylost
money.Thechartrevealsthereturnsoverthisperiodoftime.
AnnualRateofReturn:Bonds(19912010)
Stocks
Thestockmarketisthemostcommonlyreferredtoinvestmentopportunity.Youprobablyhear
aboutiteverydayonthenews;ifyoutakeaninvestmentcourseincollege,theprimaryfocus
willbeonstocks.Butwhatisastock?Astockrepresentsownershipinacorporation.Each
shareofstockrepresentsaportionoftheownership.Forexample,ABCCorporationhasissued
20,000sharesofstock,andyouown1,000ofthem.Youown5%(1,00020,000)ofthe
companyandareentitledto5%ofitsprofits.Companiestypicallypayaportionoftheirprofits
toshareholderseachquarter.Thepaymentiscalleddividends.
Ifyoubuysharesofstockofacompany(suchasMicrosoft,AT&T,GeneralMotorsandApple),
youreceivedividendsperiodically.Additionally,asthecompanygrows,thevalueoftheshares
youownappreciatesaswell.Youcansellthestockwhenyouneedcash.Ifthesalepriceis
higherthanthepriceyoupaidforthestock,youhaveacapitalgain(thatmeansyouvemadea
profit);otherwise,youhaveacapitalloss.
AnnualRateofReturn:Stocks(19912010)
From1991to2010,theaverageannualreturnonastockinvestment(whichincludesboth
dividendsandpriceappreciation)wasabout11.0%.Inthreeofthoseyears,thereturnwas
5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
40.00%
20.00%
0.00%
20.00%
40.00%
44
above30%.Whilethelongtermaveragereturnisquiteappealing,theresnoguaranteethat
youaregoingearnthesamereturneveryyear.Infact,infourofthe20years,investorsinthe
stockmarketsufferedlosses,ashighas37%.Anotherfactortoconsideristhetransactioncost.
Itsveryeasytosellstockswhenyouneedcash,butthetransactionisnotfree.Ifyouhaveto
buyandsellstocksfrequently,thecostscouldaddupquickly.
Peopletalkaboutthestockmarketallthetime.Whatexactlyisthestockmarket?Thatisnot
aneasyquestiontoanswer.Amarketisusuallydefinedastheplacewheregoodsorservices
aretraded,suchasasupermarketorafarmersmarket.Basedonthedefinition,astock
marketisaplacewherestocksaretraded.Wherearestockstraded?Therearemanyways
stocksaretraded,andthemarketcouldbeavirtualmarketplace.Forexample,theNewYork
StockExchange(NYSE)hasaphysicallocationwheretraderscommunicatewitheachotherin
persontomakeatrade.Incontrast,NASDAQisatelecommunicationnetworkthatconnects
buyersandsellersthroughcomputerssoalltradesareexecutedelectronically.
Becausetherearethousandsofstocksbeingtradedonaregularbasis,itisdifficulttoassess
thegeneralperformanceofthestockmarketwhenthepricesofsomestocksincreaseand
thoseofothersdecrease.Stockmarketindexeswerethereforecreatedtomeasuretheoverall
performance.ThemostrecognizedstockmarketindexintheU.S.istheDowJonesIndustrial
Average,orDowJones.Thisistheaveragepriceof30famouscompanies.Otherindexes
includetheS&P500andNASDAQComposite.
WEBEXERCISE
Gotowww.djaverages.comandselectDJIndustrialAverage/Overviewtofindoutwhat
companiesareincludedinthefamousstockindex.Howmanyofthe30stocksareyoufamiliar
with?
RealEstate
Realestateisdefinedaslandandimprovements(suchasbuildings,infrastructure,landscaping,
etc.)attachedtotheland.Itincludeshousesinthesuburbs,apartmentsandhighrise
condominiumsindowntown,officebuildings,shoppingcenters,parks,factories,andevenyour
school.Isrealestateagoodinvestment?FormostAmericans,thepurchaseoftheirhomeis
thesinglebiggestinvestmentintheirlives.Overtime,thisinvestmentmayprovideahealthy
return.However,housingpricescouldfluctuatewidelyattimes,makingthisariskyinvestment
intheshortterm.Additionally,transactioncostsonrealestatearethehighestamongpopular
investmentvehicles.
Inadditiontoyourownhouse,youcanalsoinvestincommercialrealestate,suchasoffice
buildings,retailshoppingcenters,apartmentcommunitiesandhotels.Ownersofthese
buildingsleasethespacetotenants(includingbusinessesinanofficebuilding,retailstoresina
shoppingcenter,residentsinanapartment,andguestsinahotel)andcollectrents.Ifthe
revenueisgreaterthanthecostsofoperatingtheproperty,theownercanmakeaprofit.Over
time,realestatevaluetendstoincreasesotheownercanearnacapitalgainwhensellingthe
investment.Becausecommercialrealestateisgenerallymuchmoreexpensivethansingle
45
familyhomes,itrequiresspecialexpertisetomanagecommercialbuildings.Itisnotatypical
investmentalternativeforindividualsandfamilies.
Generallyspeaking,commercialrealestateisaninvestmentwithhighriskandhighreward.
Theaverageannualreturnoverthelast20yearswas13.6%,higherthanothertypesof
investmentwehavediscussed.Thetradeoff,however,isthevolatility.Thechartbelowclearly
showsthatreturnoncommercialrealestateisveryunpredictable.
AnnualRateofReturn:CommercialRealEstate(19912010)
MutualFunds
Financialadvisorsusuallyrecommendtheirclientstohaveadiversifiedportfolio,whichmeans
investinginabroadrangeofassets.However,someinvestmentsareveryexpensive,makingit
difficultforindividualswithlimitedfinancialresourcestodiversify.Whatshouldyoudoifyou
donthavealotofmoney?Insteadofinvestinginstocks,bondsorrealestatedirectly,youcan
buymutualfunds.Withamutualfund,moneyfrommanyinvestorsispooledtogetherand
invested.Astockmutualfundbuysalargenumberofstocks;abondmutualfundinvestsin
varioustypesofbonds;ahybridfundsplitstheinvestmentinbothstocksandbonds.Thereare
alsomutualfundswithotherspecializations.Throughmutualfunds,youcaninvestinavariety
ofinvestmentsyouotherwisewontbeabletobuy.
Anotherbenefitmutualfundsprovidetosmallinvestorsisprofessionalmanagement.Well
educatedandexperiencedinvestmentexpertsarehiredbymutualfundstomanagethemoney
andmakedecisionsforyou.Toreceivetheservices,youneedtopayafeetothemutualfund
company.
TAXIMPLICATIONS
WhendiscussingbudgetinginChapter3,youlearnedthatthefederalgovernmentsprimary
sourceofrevenueistaxes.Taxesarefeeschargedbythegovernments(includingfederal,state
andlocal)onproducts,incomeoractivities.Themoneyisusedtoprovideservicestothe
public.Forexample,itmaybeusedtopaythesalariesofpublicemployeeslikepolice,
firefightersandpublicschoolteachers.Itmaybeusedtopayforexpendituressuchasbuilding
newhighwaysandmaintainingexistingstreets.Withouttaxrevenues,thegovernmentswont
befunctional.
40.00%
20.00%
0.00%
20.00%
40.00%
46
Whattypesoftaxesareyourequiredtopay?
Thetwotypesoftaxespeoplearemostfamiliarwithareincometaxandsalestax.Whenyou
earnwagesorsalaries,youneedtogiveaportionofyourincometothefederalandstate
governments.Thepercentagedependsonyourincomelevel.Usuallythehigheryourincome,
themoretaxesyoupay.Whenyoumakeapurchase(includinggroceriesatasupermarket,
foodatarestaurant,booksatabookstore,ormovieticketsatatheater),youneedtopaya
certainpercentofthepurchasepricetothestategovernment(sometimesalsothelocal
government)assalestax.Homeownersneedtopaytaxesbasedonthevalueoftheproperty
theyown.Thisiscalledpropertytax.
Therateofreturnonyourinvestmentsisaffectedbytaxationaswell.Ifyouneedtopaypart
ofyourinvestmentprofittothegovernment,thenthereturnprovidedbytheinvestment(that
is,thebeforetaxreturn)willbedifferentfromthereturnyouactuallyreceiveafterpaying
taxes(thatis,theaftertaxreturn).Asaninvestor,youaresubjecttotwotypesoftaxes.First,
theinvestmentincomeyoureceiveperiodicallysuchasdividendsfromstocksandinterest
frombankaccountsorbondsaresubjecttoincometaxes,justlikewagesandsalaries.
Additionally,whenyouselltheinvestment,ifthereisacapitalgain(meaningthesalespriceyou
receivenowisgreaterthanthepurchasepriceyoupaidinitially),thegainissubjecttocapital
gainstax.
Howdotaxesaffectyourfinancialgoals?
Becauseoftaxation,whatyouactuallyreceiveislessthanwhattheinvestmentprovides;
therefore,theaftertaxreturnisalwayslowerthanthebeforetaxreturn,unlesstheinvestor
doesnotpayanytaxes.Duetotaxation,eitheryouhavetosavemoremoneyperiodicallyorit
willtakelongertoreachthesamelongtermfinancialgoal.Otherwise,youwillendupwithless
moneyatthetimetomakeamajorpurchaseorretire.Theformulabelowshowsthe
relationshipbetweenbeforeandaftertaxreturns.
AfterTaxReturn=BeforeTaxReturn(1TaxRate)
Supposeyouaresubjecttoa20%incometaxrate(includingfederalandstate)andyour
investmentearns10%intheyear.Afterpayingincometaxes,howmuchisyouractualrateof
return?Usingtheformulaabove,itcanbecalculatedas:10%(120%)=8%.Therearetax
savingmethodsthatcanhelpmitigatetheimpact.Thegovernmentallowsyoutosavemoney
intoaretirementaccountwithoutpayingtaxesimmediately,butthetaxisduewhenyou
withdrawmoneyfromtheaccount.Forexample,anindividualretirementaccount(IRA)allows
youtocontributeupto$5,000ayearintoyourretirementfundwithouthavingtopaytaxeson
thatamount.WithoutusingtheIRA,youneedtopaytaxesonyourincomebeforeinvestingit.
Ifyouareinthe20%taxbracketandcontributethemaximumamountintotheIRA,itislike
getting$1,000infreemoneyfromthegovernmentthatyoucaninvestforyourretirement.
Youshouldtakeadvantageofitasmuchasyoucan.
47
KEYTERMSTOREMEMBER
Bonds
Bondsarecontractsthroughwhichgovernmentsandcorporations(theissuer)borrowmoney
frominvestors(thebondholders).
BondIssuer
Theentitythatborrowsmoneybyissuingabond.
Bondholder
Aninvestorwhopurchasesabond.Bondholdersarecreditorstotheissuer.
BondRating
Asystemthatevaluatesthepossibilityofdefaultbyabondissuer.Thehigherabondsrating,
thesaferitis.
JunkBonds
Bondswhoseratingsarebelowinvestmentgrade(typicallyBBandbelow).Junkbondshave
muchhigherriskthaninvestmentgradebonds.
Stocks
Ownershipofacorporationrepresentedbysharesthatareaclaimonthecorporations
earningsandassets.
Shareholder
Aninvestorwhoownssharesofacorporation.Shareholdersareownersofthecorporation.
Dividends
Periodicpaymentsofacompanysearningstoitsshareholders.
CapitalGain
Theamountbywhichthesalepriceofaninvestmentexceedsitsinitialpurchaseprice.
DowJonesIndustrialAverage
Astockindexthatisbasedonthepricesof30largecompanies.Itistheoldestandmost
quotedstockmarketindicator.
NASDAQ
AstockindexthatisbasedonthepricesofallstockstradedontheNASDAQsystem.
S&P500
Astockindexthatisbasedonthepricesof500largecorporations.
48
CommercialRealEstate
Realestatethatispurchasedforincomeproducingpurposes.Ownersofcommercialreal
estateleasespaceintheirpropertiestotenantsandcollectrent.
MutualFunds
Anentitythatpoolsmoneyfrommanyinvestorsandinvestsitinvariousinvestment
opportunities.
Diversification
Astrategydesignedtoreduceinvestmentriskbycombiningavarietyofinvestments.
Portfolio
Acollectionofinvestmentsownedbythesameindividualororganization.
BeforeTaxRateofReturn
Therateofreturngeneratedbyaninvestmentbeforeitsownerpaystaxesontheearnings.
AfterTaxRateofReturn
Therateofreturnaninvestorgetstokeepafterpayingtaxestothegovernment.
IndividualRetirementAccount(IRA)
Aspecialinvestmentaccountthatallowstheownertodeferpayingtaxesonmoneysavedfor
retirement.

49
Chapter7BuyingYourFirstHome
Thebenefitsandcostsofhomeownership
Howtochooserealestateprofessionalstohelpyouwithyourhomepurchasedecision
Howtoidentifytherighthouseforyou
Howtoselectfromnumeroustypesofhomemortgages
KEYTERMS
MedianHomePrice
RealEstateTaxes
RealEstateAgent
Mortgage
FixedRateMortgages
DiscountPoints
TaxDeduction
HazardInsurance
MortgageBroker
AdjustableRateMortgages
ClosingCosts
FormostAmericans,buyingahouseisthemostexpensive(andarguablythemostimportant)
purchaseintheirlifetime.AccordingtotheNationalAssociationofRealtors,themedianprice
ofexistingsinglefamilyhomesintheU.S.reachedthealltimehighin2006,exceeding
$220,000.ImpactedbytheGreatRecession,themedianpriceretractedtoabout$170,000in
2010.Evenatthispricelevel,itisdifficultforanaveragehouseholdtosaveenoughmoneyfor
thepurchaseofahomewithoutusinganykindofcredit.
MedianHomePricesintheU.S.(19792010)
$0
$50,000
$100,000
$150,000
$200,000
$250,000
1970 1975 1980 1985 1990 1995 2000 2005 2010
50
Housingpricesvarygreatlyacrossthecountry.InCalifornia,forexample,housingismuch
moreexpensivethaninmostofthecountry.Evenwithinthestate,themedianpriceofsingle
familyhomeschangesdramaticallyfromonemetropolitanareatoanother.Thechartbelow
compareshomepricesatthepeakin2006infourmarketswiththosein2010.Themedian
priceinSanFranciscowasabove$750,000in2006andhaddecreasedbyabout30%infour
years.Incontrast,housinginSacramentocostapproximatelyhalfofthatinSanFranciscoin
2006;aftera50%drop,itwasonlyathirdofthepriceinSanFranciscoin2010.
ComparisonofMedianHomePrices($000)
Anotherreasonthathomepurchasingdecisionsrequirecarefulconsiderationandthorough
analysisisthatsuchdecisionscannotbechangedeasilyorcancelled.Ahometransactiontakes
weeksorevenmonthstocomplete,andthetransactioncostsareusuallythousandsofdollars
ormore.Amistakecouldcostyouyourlifesavingsand/orruinyourcredit.
Whileahomepurchaseisacrucialdecisionyoueventuallymayneedtomake,itisprobablynot
somethingyouneedtoworryaboutinthenearfuture.Thus,thischapterdoesnotdiscussin
detailallaspectsofthehomebuyingprocess.Instead,ageneraloverviewisprovidedtohelp
youunderstandthebasicconceptsandkeyterminology.
HOMEOWNERSHIP
Thefirstquestionregardinghomeownershipiswhetheritisrightforyou.Anobviousfactor
thatmustbeconsideredwhenansweringthequestionisthecostofrentingvs.owningyour
residence.Ifyourentanapartmentorahouse,youpayrenttothelandlordeverymonth;if
youownahouseoracondo(andhaveborrowedmoneyforthepurchase),youmakemonthly
mortgagepayments.Typically,therentalpaymentislowerthanthemortgagepaymentona
similarresidence.However,youalsoneedtotakeintoaccountotherfactors.Aportionofthe
mortgagepaymentmaybetaxdeductible,helpingyoureducetaxliabilities;apartofthe
mortgagepaymentmayberecoupedwhenthehouseissold,soitbecomesawayto
accumulatewealth.Theseaspectswillbefurtherdiscussedlaterinthischapter.
Inadditiontocomparingrentwithmortgagepayments,youshouldalsoconsiderother
costs/constraintsofhomeownership.Theseincludedecreasedmobility,additional
responsibilitiesandinitialcosts.Rentersusuallysignashortterm(sixtotwelvemonth)lease,
soitseasytorelocatewhendesired.Ifyouwanttomovetoanewapartmentwhenthe
currentleaseexpires,theonlycostismovingyourpersonalbelongings.Ifyouownahouse,on
585
375
602
753
317
184
385
525
$0
$200
$400
$600
$800
LosAngeles Sacramento SanDiego SanFrancisco
2006 2010
51
theotherhand,thecostofswitchingtoanewhomecouldbeexpensive.Youneedtopaya
realestateagentwhohelpsyousellthehouseandfeestogetaloanforthepurchaseofanew
house.Thetotalcouldexceedthousandsofdollars.
Homeownersalsohavemorefinancialresponsibilitiesthanrenters.Periodically,homeowners
needtopayforexpensessuchasrealestatetaxes,hazardinsurance(differentfromrenters
insurance),maintenanceandrepairs.Additionally,theinitialcostforahomepurchasecouldbe
quitesubstantial.Thedownpaymentandotherclosingcostscouldadduptotensofthousands
ofdollars.Ifyourentahouse,themoneycanbesavedorinvestedandthusgenerateareturn
foryou.Thisshouldbeconsideredanopportunitycost,eventhoughitisnotanoutofpocket
expense.
WEBEXERCISE
TheDepartmentofRealEstate(DRE)oftheStateofCaliforniaprovidesusefulresourcesthat
helpconsumersprepareforissuestheymayencounterduringthehomebuyingprocess.For
furtherinformation,gototheDREwebsiteathttp://dre.ca.gov/mlb_info_hmbuyers.html.
Ifhomeownershipisrightforyou,thenyouneedtoestimatehowmuchhouseyoucanafford
beforeyoustartsearchingforahome.Theanswertothisquestiondependsonyoursavings,
yourincomeandalsothemarketconditions.Youneedtohaveenoughmoneyatthetimeof
purchasetopayforthedownpaymentandclosingcosts.Youalsoneedtohavesufficient
incometocoverthemonthlymortgagepaymentandotherhousingexpenses.Thesetwo
factorsareinterrelated.Ifyoucanaffordalargerdownpayment,youwontneedtoborrowas
muchthroughthemortgageand,asaresult,yourmonthlymortgagepaymentislower.How
muchhouseyoucanaffordalsodependsonthemarketconditions,suchasmortgageinterest
ratesandlendersunderwritingrequirements.
HOMEBUYINGPROCESS
Becausehomepurchaseisexpensiveandinvolvesacomplicatedprocess,mosthomebuyers
needhelpfrompeoplespecializedinthebusiness.Arealestateagentmayshowyouhomeson
themarketthatmeetyourneeds;representyouinnegotiationswiththeseller;andassistyou
inobtainingfinancingforthepurchase.Beforeselectinganagent,youmustdoyour
homework.Interviewseveralrealestateagentstofindouttheirlevelofexperienceinthearea
youwishtobuy.Youwanttomakesurethepersonyouhireisproperlylicensedandthereare
nodisciplinaryactionsorcomplaintsfiledagainsthim/her.Youmayalsowanttoconsiderhow
wellyouandthatpersonwillworktogetheroveranextendedperiodoftime.
Amortgageprofessionalmayalsoplayacriticalroleinyourhomebuyingexperience.Forthe
majorityofresidentialmortgages,borrowersworkwithmortgagebrokerstoobtainthe
financing,insteadofworkingdirectlywithlenders.Typically,mortgagebrokerstakealoan
application,orderverifications,processandreviewcredit,andprepareloandocumentsforthe
lender.Sincetheyarefamiliarwiththemarketconditionsandunderstandtheprosandconsof
52
varioustypesofmortgages,findingamortgagebrokerwhocanadviseyouonchoosingthe
righttypeofmortgageisveryimportant.
HOMEFINANCING
Becausethecostofahomeissohigh,mosthomebuyersborrowmoneytopayforalarge
portionofthepurchaseprice.Aloanthatisusedtofinancethepurchaseofrealestateusually
hasthepropertyascollateral.Thistypeofloaniscalledamortgage.Mortgageswithvarious
featureshavebeencreatedtomeettheneedsofconsumers.Nowletsconsidersomeofthe
populartypesofmortgages.
TypesofMortgages
Themajorityofmortgageshaveatermtomaturityof30years,whichmeanstheloanwillbe
repaidover30years.Thereareotherlengthsofmortgageterms,including15,20and40years.
Iftheinterestrateonamortgageremainsunchangedduringthetermofthemortgage,itis
calledafixedratemortgage(FRM);ontheotherhand,iftheinterestratechangesperiodically,
itiscalledanadjustableratemortgage(ARM).SomeloanscombinethefeaturesofaFRMand
anARM,withitsinterestratefixedoveranextendedperiodoftimeandthenadjusted
thereafter.A7/1mortgagemayhaveatermtomaturityof30years,buttheinterestrateis
fixedforthefirstsevenyearsandthenadjustedannuallyduringtheremaining23years.
Whiletheprincipalofmostmortgagesisrepaidovertime(throughamortization),someloans
requiretheborrowertopayinteresteachmonthwithoutrepayingaportionoftheprincipal.
Sinceeachmonthlypaymentconsistsofonlyinterestpayment,theyarecalledinterestonly
loans.
TypesofMortgagesCommonlyUsedtoFinanceHomePurchases
TypeofMortgage Characteristics
FixedRateMortgage(FRM)
AdjustableRateMortgage(ARM)
HybridMortgage
Amortgagewhoseinterestrateremainsconstantoveritsentire
termtomaturity.
Amortgagewhoseinterestratechangesperiodically.
Amortgagewhoseinterestratestaysthesameforanumberof
yearsandthenchangesperiodically.Forexample,theinterest
rateona7/1mortgagestaysconstantforsevenyearsandthen
changeseveryyear.
30YearMortgage
15YearMortgage
Amortgagethatwillberepaidover30years,with360monthly
payments.
Amortgagethatwillberepaidover15years,with180monthly
payments.
InterestOnlyMortgage Amortgagewhosemonthlypaymentsdonotincludeprincipal
repayment.Asaresult,themortgagebalancestaysconstant.
53
MonthlyMortgagePayment
Inthemortgagemarkettoday,themostpopulartypeofloanisa30year,fixedratemortgage
withamortization.Withsuchaloan,theborrowermakesaconstantpaymenteachmonthand
after360equalpayments,theloanispaidoff.Everymonth,theborrowerpaysnotonly
interestbutalsosomeprincipal,sothisisanexampleoftheamortizationloandiscussedin
Chapter4.Letsreviewhowthemonthlypaymentofsuchaloaniscalculated.Supposeyou
borrow$200,000,andtheinterestrateis6.000%.Becausetheinterestrateisanannualrate
butthepaymentsaremadeonmonthlybasis,iinthefollowingformulashouldbethemonthly
rate,or0.500%.Asaresult,themonthlypaymentis:
PHI =
PI
1 -
1
(1 + i)
n
i
=
2uu,uuu
1 -
1
(1 + u.uuS)
360
u.uuS
= 1,199.1u
Atthebeginning,mostofthepaymentrepresentsinterestandonlyasmallportionisprincipal.
Inthefirstmonth,forinstance,theborrowerpays$1,000ofinterestandrepaysonly$199.10
ofprincipal.Astheprincipalbalancedeclinesovertime,theinterestchargewillgodown.With
aconstantmonthlypayment,theborrowerwillpaybackprincipalatafasterpacelateron.The
followinggraphillustratesthebreakdownofthe$1,199.10monthlypaymentovertime.The
U.S.taxcodeallowsmortgageborrowerstodeductinterestpaymentsfromtheirincome.
Therefore,intheearlyyearsofthemortgageterm,themajorityofthemortgagepaymentis
taxdeductible.Overtime,thetaxdeductibilitydeclines.Ontheotherhand,principal
repaymentrepresentsmoneythatbelongstoyou,notthelender.Byrepayingaportionofthe
principaleachmonth,youaccumulateequityinyourhomeandwillbeabletogetthemoney
backwhenthehouseissold.
BreakdownofMonthlyMortgagePaymentoverTime
CostofMortgages
Mortgagesaremorecomplicatedthanmostothertypesofconsumercredit.Inadditionto
interest,borrowersoftenneedtopayotherfeesinordertogetaloan.Supposeyouneedto
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
1 4 7 10 13 16 19 22 25 28
Year
Interest Principal Total
54
borrow$320,000forthepurchaseofa$400,000homeandhavedecidedtousea30year,
fixedratemortgage.Whatistheinterestrateonsuchaloan?Thefollowingexhibitshowsthe
ratesofferedbyalargemortgagelender.
InterestRateson30YearFixedRateMortgages
Forthesametypeofloan,thelenderofferssixdifferentchoices,eachofwhichhasadifferent
interestrate.Holdingeverythingelsethesame,youshouldchoosetheonewiththelowest
interestrate.However,everythingelseisnotthesame.Everychoiceinthetablehasdiscount
points,whichisanupfrontfeeborrowerspaytothelenderinordertogetthespecific
interestrate.Adiscountpointisequaltoonepercentoftheloanamount.Forexample,in
ordertogetthelowestinterestrate(3.750%),youneedtopay2.90%oftheamountyouwant
toborrowasanonrefundablefee,thatis$320,000x0.034=$9,280.Ifyouprefertominimize
theupfrontexpenses,youcanchoosetheonewithonly0.40points(or$1,280),butyouwill
havetopayanannualinterestrateof4.250%.
Therearemanyotherfeesmortgagelendersmaychargewhenmakingaloan:applicationfee,
underwritingfee,originationfee,processingfee,administrationfee,brokeragefee,etc.Itsnot
easyforaborrowertofigureoutwhichoftheoptionsofferedbyalenderisthebest;itseven
moredifficulttocomparetheoffersfromdifferentlenders.Tohelpconsumersshopforthe
bestalternative,thelawsrequirelendersofconsumercredittodisclosetheannualpercentage
rate(APR).Becauseoftheclosingcosts,theAPRforamortgageloanismorecomplicatedthan
othertypesofcredit(likeautoloansorcreditcards).
55
WEBEXERCISE
Gotowww.bankrate.comandcomparemortgageratesbychangingthefollowingcriteria:
Loanamount($400,000vs.$500,000)
Termtomaturity(30yearvs.15year)
Borrowercredit(FICO>700vs.FICO<680)
Downpayment(20%downvs.10%down)
KEYTERMSTOREMEMBER
MedianHomePrice
Themidpointofanorderedarrayofactualtransactionpricesofhomes.Thisisacommonly
usedmarketindicatorofhousingvalue.
TaxDeduction
Anexpensesubtractedfromincomewhencalculatingtaxliability.Witha30%taxrate,each
dollaroftaxdeductionreducestaxableincomebyonedollarand,thus,taxliabilityby30cents.
RealEstateTaxes
Ataxassessedbystateorlocalgovernmentsonrealestateaccordingtoitsvalue.
HazardInsurance
Insurancecoverageonrealestatethatcompensatestheownerfordamagetoaproperty
causedbyfire,windorotherhazards.
RealEstateAgent
Alicensedindividualwhoprovidesrealestateservicessuchasshowinghomes,makingoffers
andcounteroffers,negotiatingprices,andassistingintheclosing.
Mortgage
Aloanthatusesrealestateascollateralfortherepaymentoftheloan.
MortgageBroker
Afirmorindividualwhosolicitsandtakesamortgageapplication,andlatersellsittoalender
foracommission.
FixedRateMortgage
Amortgagewhoseinterestrateremainsconstantovertheentirelifeoftheloan.
AdjustableRateMortgage
Amortgagewhoseinterestratechangesperiodicallybasedonapredeterminedformula.
56
DiscountPoints
Aonetimefeepaidbytheborrowertoreducetheinterestrateonamortgage.Eachpointis
onepercentoftheamountborrowed.
ClosingCosts
Expensesthatarerelatedtocompletingarealestatetransactionbutseparatefromtheactual
priceoftheproperty.
Thecostofcreditexpressedinayearlyrate;itincludestheinterestrateaswellasotherlenderfeesthe
borrowerisrequiredtopay,suchasdiscountpoints,originationfee,brokerfee,etc.
57
P
P
A
A
R
R
T
T2
2
G
GL LO OS SS SA AR RY Y

Glossary
15YearMortgageAmortgagethatwillberepaidover15years,with180monthlypayments.
30YearMortgageAmortgagethatwillberepaidover30years,with360monthlypayments.
4CsThefourkeyfactorslendersofconsumercreditconsiderwhentheyassesstheriskinessofa
loan.Theyare:capacity,capital,collateralandcharacter.
AdjustableRateMortgage(ARM)Amortgagewhoseinterestratechangesperiodicallybased
onapredeterminedformula.
AfterTaxRateofReturnTherateofreturnaninvestorgetstokeepafterpayingtaxestothe
government.
AmortizationThegradualrepaymentofloanprincipalovertime.
AnnualPercentageRate(APR)Thecostofcreditexpressedinayearlyrate;itincludesthe
interestrateaswellasotherlenderfeestheborrowerisrequiredtopay,suchasdiscount
points,originationfee,brokerfee,etc.
AnnualPercentageYield(APY)TheAPYistheinterestrateactuallyearnedorpaidinoneyear,
takingintoaccounttheeffectofcompounding.TheAPYiscalculatedbytakingoneplusthe
periodicrateandraisingittothenumberofperiodsinayear.
AutomatedTellerMachine(ATM)Amachineatabankbranchorotherlocationwhichenables
acustomertoperformbasicbankingactivities(checkingone'sbalance,withdrawingor
transferringfunds)evenwhenthebankisclosed.
BalanceTransferThetransferofalloutstandingbalancesfromonecreditcardtoanewcredit
card.Creditcardbalancetransfersaretypicallyusedbyconsumerswhowanttomovetheir
debttoacreditcardwithalowerinterestrate,fewerpenaltiesorotherbenefits,suchas
rewardpointsortravelmiles.
BankAnorganization,usuallyacorporation,charteredbyastateorfederalgovernment,which
doesmostorallofthefollowing:receivesdemanddepositsandtimedeposits,honors
instrumentsdrawnonthem,andpaysinterestonthem;discountsnotes,makesloans,and
investsinsecurities;collectschecks,drafts,andnotes;certifiesdepositor'schecks;andissues
draftsandcashier'schecks.
BankAccountAnaccountheldbyaninvestoratafinancialinstitution.Thefinancialinstitution
holdsthemoneyfortheinvestor.Unlikeabrokerageaccount,whichallowsaninvestortobuy
andsellsecurities,abankaccountisusedforsavings.Typesofbankaccountsincludesavings
accountsandcheckingaccounts.
BankingIngeneralterms,thebusinessactivityofacceptingandsafeguardingmoneyownedby
otherindividualsandentities,andthenlendingoutthismoneyinordertoearnaprofit.
BankruptcyAlegalproceedinginvolvingapersonorbusinessthatisunabletorepay
outstandingdebts.
BeforeTaxRateofReturnTherateofreturngeneratedbyaninvestmentbeforeitsownerpays
taxesontheearnings.
BoardofGovernorsThegoverningbodyoftheFederalReserveSystem,whichisresponsiblefor
U.S.monetarypolicy.Ofthesevenmembers,fiveareappointedbythePresidentoftheUnited
StatesandconfirmedbytheSenatetoservea14yearterm,whiletheChairmanandVice
ChairmanareappointedbythePresidentandconfirmedbytheSenatetoservefouryear
terms.
BondAdebtinstrumentissuedforaperiodofmorethanoneyearwiththepurposeofraising
capitalbyborrowing.TheFederalgovernment,states,cities,corporations,andmanyother
typesofinstitutionssellbonds.Generally,abondisapromisetorepaytheprincipalalongwith
interest(coupons)onaspecifieddate(maturity).
BondIssuerTheentitythatborrowsmoneybyissuingabond.
BondMarketThemarketinwhichtheissuanceandtradingofdebtsecuritiesoccurs.
BondRatingAsystemthatevaluatesthepossibilityofdefaultbyabondissuer.Thehighera
bondsrating,thesaferitis.
Bondholder:Aninvestorwhopurchasesabond.Bondholdersarecreditorstotheissuer.
Bonds:Bondsarecontractsthroughwhichgovernmentsandcorporations(theissuer)borrow
moneyfrominvestors(thebondholders).
BonusGratuitygivenasgift,orcompensationearnedasrewarduponachievingagoalor
milestone.
BrokerageFeeAfeechargedbyanagent,oragent'scompanytofacilitatetransactions
betweenbuyersandsellers.
BudgetAdetailedscheduleoffinancialactivitythatincludesagovernment,companyor
individualsincomeandexpensesexpectedduringcertainperiodinthefuture.
BudgetingProcessofexpressingquantifiedresourcerequirements(amountofcapital,amount
ofmaterial,numberofpeople)intotimephasedgoalsandmilestones.
CapitalFinancialresourcesavailableforuse.
CapitalGainTheamountbywhichthesalepriceofaninvestmentexceedsitsinitialpurchase
price.
CapitalGainTaxThetaxleviedonprofitsfromthesaleofcapitalassets.
CapitalLossThedifferencebetweenthenetcostofasecurityandthenetsalesprice,ifthe
securityissoldataloss.
CashAdvanceAloantakenoutagainstalineofcreditorcreditcard,typicallyimposinghigher
thannormalinterestcharges.
CashRebatePartialrefundforapurchasethatispaidinactualcurrency.
CashFlowIncomingsandoutgoingsofcash,representingtheoperatingactivitiesofan
organization.
CertificateOfDeposit(CD)Asavingsaccountthatpayshighinterestasasetrateforaset
periodoftime.
CheckAnegotiableinstrumentdrawnagainstdepositedfunds,topayaspecifiedamountof
moneytoaspecificpersonupondemand.Examplesincludebillsofexchangeanddrafts.
CheckingAccountAdepositaccountatafinancialinstitutionthatallowstheholdertowrite
checksagainstdepositedfunds.
ClosedEndCreditAonetimeborrowingthathasaspecifiedloanamountandisforaspecific
purpose.Closedendcreditthatisrepaidwithequalperiodicpaymentsisalsoreferredtoas
installmentcredit.
ClosingCostsExpensesthatarerelatedtocompletingarealestatetransactionbutseparate
fromtheactualpriceoftheproperty.
CommercialBankBanksthatofferabroadrangeofdepositaccounts,includingchecking,
savingsandtimedeposits,andextendsloanstoindividualsandbusinesses.
CommercialRealEstateRealestatethatispurchasedforincomeproducingpurposes.Owners
ofcommercialrealestateleasespaceintheirpropertiestotenantsandcollectrent.
CompoundingTheprocessofaccumulatingthetimevalueofmoneyforwardintime.For
example,interestearnedinoneperiodearnsadditionalinterestduringeachsubsequenttime
period.
Condominium(Condo)Aformofcollectiveownershipofrealproperty.Inacondominium,the
individualpropertyownerstypicallyowntheairspacewithintheirownwalls.Thestructures
themselves,theland,andtheamenitiesbuiltontheland,areownedincommonwiththeother
membersoftheassociation.
ConglomeratesAcorporationconsistingofseveralcompaniesindifferentbusinesses.Sucha
structureallowsfordiversificationofbusinessrisks,butthelackoffocuscanmakemanaging
thediversebusinessesmoredifficult.
ConsumerCreditTheuseofcreditforpersonalneedsbyindividualsandfamilies,incontrastto
creditusedbybusinessesandgovernments.
CorporateBondDebtobligationsissuedbycorporations.
CreditAnarrangementtoreceivecash,goodsorservicesnowbutpayforthemlater.
CreditBureauAnagencythatresearchesandcollectsindividualcreditinformationandsellsit
forafeetocreditorssotheycanmakeadecisionongrantingloans.Typicalclientsinclude
banks,mortgagelenders,creditcardcompaniesandotherfinancingcompanies.Alsocommonly
referredtoasconsumerreportingagencyorcreditreportingagency.
CreditCardAnycardthatmaybeusedrepeatedlytoborrowmoneyorbuyproductsand
servicesoncredit.Issuedbybanks,savingsandloans,retailstores,andotherbusinesses.
CreditLimitThemaximumamountacreditcardcompanywillallowsomeonetoborrowona
singlecard.
CreditRiskThepossibilitythatabondissuerwilldefault,byfailingtorepayprincipaland
interestinatimelymanner.Bondsissuedbythefederalgovernment,forthemostpart,are
immunefromdefault.Bondsissuedbycorporationsaremorelikelytobedefaultedon,since
companiesoftengobankrupt.Municipalitiesoccasionallydefaultaswell,althoughitismuch
lesscommon.
CreditScoreAstatisticallyderivednumericexpressionofaperson'screditworthinessthatis
usedbylenderstoaccessthelikelihoodthatapersonwillrepayhisorherdebts.Acreditscore
isbasedon,amongotherthings,aperson'spastcredithistory.Itisanumberbetween300and
850thehigherthenumber,themorecreditworthythepersonisdeemedtobe.
CreditUnion:Anotforprofitinstitutionthatoffersfinancialservices,similartothoseoffered
byacommercialbank,toitsmembers.
CreditorAnentity(personorinstitution)thatextendscreditbygivinganotherentitypermission
toborrowmoneyifitispaidbackatalaterdate.
CurrencyAnyformofmoneythatisinpubliccirculation.Currencyincludesbothhardmoney
(coins)andsoftmoney(papermoney).
DebitAnaccountingentrywhichresultsineitheranincreaseinassetsoradecreaseinliabilities
onacompany'sbalancesheetorinyourbankaccount.
DebitCardBankcardusedincashtransactions,butwhichisnotacreditcard.Inadebitcard
transaction,theamountofapurchaseiswithdrawnfromtheavailablebalanceinthe
cardholder'saccount.Iftheavailablefundsareinsufficient,thetransactionisnotcompleted.
DebtAnamountowedtoapersonororganizationforfundsborrowed.Debtcanbe
representedbyaloannote,bond,mortgageorotherformstatingrepaymenttermsand,if
applicable,interestrequirements.
DefaultThesituationwhereaborrowerfailstomaketimelypaymentofinterestand/or
principalonaloan.
DeficitTheamountbywhichagovernment,companyorindividualsspendingexceedsits
incomeoveraperiodoftime.
DepositThistypeofdepositisidenticaltothemoneyaninvestortransfersintoabank'ssavings
orcheckingaccounts.
DepositoryInstitutionBank,buildingsociety,creditunion,orotherfinancialinstitutionthat
solicitsandacceptssavingsofthegeneralpublicasdemanddepositsortimedeposits,andpays
afixedorvariablerateofinterest.
DerivativeAfinancialcontractwhosevalueisbasedon,or"derived"from,atraditionalsecurity
(suchasastockorbond),anasset(suchasacommodity),oramarketindex.
DirectDepositAutomatictransferofsalaries,wages,rents,benefits,orothersuchsums,
directlytotheaccountofanemployeeorbeneficiary.
DiscountPointsAonetimefeepaidbytheborrowertoreducetheinterestrateonamortgage.
Eachpointisonepercentoftheamountborrowed.
DividendsPeriodicpaymentsofacompanysearningstoitsshareholders.
DowJonesIndustrialAverageAstockindexthatisbasedonthepricesof30largecompanies.
Itistheoldestandmostquotedstockmarketindicator.
DownPaymentAtypeofpaymentmadeincashduringtheonsetofthepurchaseofahouse.
Thepaymenttypicallyrepresentsonlyapercentageofthefullpurchaseprice.
EconomicPertainingtotheeconomy.
EconomyActivitiesrelatedtotheproductionanddistributionofgoodsandservicesina
particulargeographicregion.
EffectiveRateofReturnAmeasureofthetimevalueofmoneythatfullyreflectstheeffectsof
compounding.
EquityOwnershipinterestinacorporationintheformofcommonstockorpreferredstock.
ExpenseAparticularpaymentofmoney.
ExpenditureApayment,orthepromiseofafuturepayment.
FederalDepositInsuranceCorporation(FDIC)TheU.S.corporationinsuringdepositsintheU.S.
againstbankfailure.TheFDICwascreatedin1933tomaintainpublicconfidenceandencourage
stabilityinthefinancialsystemthroughthepromotionofsoundbankingpractices.
FederalReserveSystemThecentralbankoftheUS,establishedin1913.Itisgovernedbythe
BoardofGovernorslocatedinWashington,D.C.andincludes12regionalFederalReserve
Banks.Thesystemisauthorizedtoimplementthegovernmentseconomicandfinancialpolicy
aswellastoregulatethebankingindustry.
FICOScoreAnumberthatsummarizesanindividualshistoryofusingcredit.Itwasdeveloped
byFairIsaacCorporation(FICO)andhasarangeof300to850.
FinanceAsubjectconcernedwithdeterminingvalueandmakingdecisions.Thefinance
functionallocatesresources,includingtheacquiring,investingandmanagingofresources.
FinancialAdviserAprofessionalofferingfinancialadvicetoclientsforafeeand/orcommission.
FinancialCrisisAneconomicrecessionordepressioncausedbyalackofnecessaryliquidityin
financialinstitutions.Afinancialcrisismaybecausedbynaturaldisasters,negativeeconomic
news,orsomeothereventwithasignificantfinancialimpact.Financialcrisestendtocause
decreasesinbusinessactivities,leadingtoaselfreinforcingintensificationofthecrisis.
FinancialInstitutionInstitutionwhichcollectsfundsfromthepublicandplacesthemin
financialassets,suchasdeposits,loans,andbonds,ratherthantangibleproperty.
FinancialLiteracyPossessingtheknowledgenecessarytounderstandconceptsrelatedto
finance.Theseideasmayincludebalancingacheckbook,understandinginterestrates,
employeebenefits,orhowthestockmarketworks.
FinancialSystemThefinancialsystemisthesystemthatenableslendersandborrowersto
exchangefunds.
FinancingTheactofprovidingfundsforbusinessactivities,makingpurchasesorinvesting.
Financialinstitutionsandbanksareinthebusinessoffinancingastheyprovidecapitalto
businesses,consumersandinvestorstohelpthemachievetheirgoals.
FiscalPertainingtomoney,especiallygovernmenttaxationandspendingpolicies.
FiscalPolicyDecisionsbythePresidentandCongress,usuallyrelatingtotaxationand
governmentspending,withthegoalsoffullemployment,pricestability,andeconomicgrowth.
FiscalYearAccountingperiodthatcanstartonanydayofacalendaryearbuthastwelve
consecutivemonths(52consecutiveweeks)attheendofwhichaccountbooksareclosed,
profitorlossiscomputed,andfinancialreportsarepreparedforfiling.Itmayormaynotmatch
acalendaryear.
FixedRateMortgage(FRM)Amortgagewhoseinterestrateremainsconstantovertheentire
lifeoftheloan.
FutureValue(FV)Thevalueofanassetataspecificdate.Itmeasuresthenominalfuturesum
ofmoneythatagivensumofmoneyis"worth"ataspecifiedtimeinthefutureassuminga
certaininterestrate,ormoregenerally,rateofreturn;itisthepresentvaluemultipliedbythe
accumulationfunction.Thevaluedoesnotincludecorrectionsforinflationorotherfactorsthat
affectthetruevalueofmoneyinthefuture.
HazardInsuranceInsurancecoverageonrealestatethatcompensatestheownerfordamage
toapropertycausedbyfire,windorotherhazards.
HomeEquityLoanAconsumerloansecuredbyasecondmortgage,allowinghomeownersto
borrowagainsttheirequityinthehome.
HybridFundMutualfundthatinvestsinbothstocksandbonds.Ahybridfundoffersinvestors
theopportunitytodiversifytheirportfoliowithasingleinvestmentvehicle.Theratioofstocks
andbondsmayremainfixedorvaryovertime.
HybridMortgageAmortgagewhoseinterestratestaysthesameforanumberofyearsand
thenchangesperiodically.Forexample,theinterestrateona7/1mortgagestaysconstantfor
sevenyearsandthenchangeseveryyear.
IdentityTheftThesituationwhereapersonsidentification(includingname,socialsecurity
numberand/oranyaccountnumber)isusedortransferredbysomeoneelseforunlawful
activities.
IncomeMoneyearnedthroughemploymentorinvestments.
IncomeTaxAstateorfederalgovernment'slevyonindividualsaspersonalincometaxandon
theearningsofcorporationsascorporateincometax.
IncrementalCostThecostassociatedwithoneadditionalunitofproduction,oraspecific
decision.
IndividualRetirementAccount(IRA)Aspecialinvestmentaccountthatallowstheownerto
deferpayingtaxesonmoneysavedforretirement.
IndustryAclassificationthatreferstoagroupofcompaniesthatarerelatedintermsoftheir
primarybusinessactivities.
InsuranceApromiseofcompensationforspecificpotentialfuturelossesinexchangefora
periodicpayment.Insuranceisdesignedtoprotectthefinancialwellbeingofanindividual,
companyorotherentityinthecaseofunexpectedloss.
InterestThepricepaidforborrowingmoney.Itisexpressedasapercentagerateoveraperiod
oftimeandreflectstherateofexchangeofpresentconsumptionforfutureconsumption.
InterestOnlyMortgageAmortgagewhosemonthlypaymentsdonotincludeprincipal
repayment.Asaresult,themortgagebalancestaysconstant.
IntroductoryRateAninterestratethat'susuallybelowmarketandisofferedfortheinitial
billingcycle(s)ofthecreditcard.Introductoryratescommonlyapplyonlytobalancetransfers
andcashadvances,buttheycanalsoapplytopurchases.Theintroductoryrateexpiresaftera
certainperiodoftime;howeverFederallawrequiresintroductoryratestolastatleastsix
months.
InvestmentThecreationofmoremoneythroughtheuseofcapital.
InvestmentBankingDivisionofbankingencompassingbusinessentitiesdealingwithcreation
ofcapitalforothercompanies.Inadditiontoactingasagentsorunderwritersforcompaniesin
theprocessofissuingsecurities,investmentbanksalsoadvisecompaniesonmattersrelatedto
theissueandplacementofstock.
InvestmentGradeBondsBondsthatareassignedaratinginthetopfourcategoriesby
commercialcreditratingcompanies.
InvestmentIncomeIncomecomingfrominterestpayments,dividends,capitalgainscollected
uponthesaleofasecurityorotherassets.
JunkBondsBondswhoseratingsarebelowinvestmentgrade(typicallyBBandbelow).Junk
bondshavemuchhigherriskthaninvestmentgradebonds.
LeaseAwrittenagreementunderwhichapropertyowner(thelandlord)allowssomeoneelse
(thetenant)tousethepropertyforaspecifiedperiodoftimeinexchangeforamonetary
benefit(therent).
LendToprovidemoneytemporarilyontheconditionthatitoritsequivalentwillbereturned,
oftenwithaninterestfee.
LineofCreditThemaximumamountyoucanborrowusingaspecificopenendcredit.
LoanTheactofgivingmoney,propertyorothermaterialgoodstoanotherpartyinexchange
forfuturerepaymentoftheprincipalamountalongwithinterestorotherfinancecharges.
LossAreductioninthevalueofaninvestment.
MaturityThedateonwhichadebtbecomesdueforpayment.
MedianHomePriceThemidpointofanorderedarrayofactualtransactionpricesofhomes.
Thisisacommonlyusedmarketindicatorofhousingvalue.
MonetaryPolicyTheactionsofacentralbank,currencyboardorotherregulatorycommittee
thatdeterminethesizeandrateofgrowthofthemoneysupply,whichinturnaffectsinterest
rates.Monetarypolicyismaintainedthroughactionssuchasincreasingtheinterestrate,or
changingtheamountofmoneybanksneedtokeepinthevault(bankreserves).
MonetarySystemSetofmechanismsbywhichagovernmentprovidesmoney(cash)ina
country'seconomy.Itusuallyconsistsofamint,centralbank,andcommercialbanks.
MoneyMarketAccountAsavingsaccountthatoffersthecompetitiverateofinterest(real
rate)inexchangeforlargerthannormaldeposits.
MoneySupplyTheentirequantityofbills,coins,loans,creditandotherliquidinstrumentsina
country'seconomy.
MortgageAloanthatusesrealestateascollateralfortherepaymentoftheloan.
MortgageBankAbankspecializesinfacilitatingrealestatetransactionsbybringingborrowers
andlenderstogether.
MortgageBankingThepackagingofmortgageloansforsaletoinvestors.
MortgageBrokerAfirmorindividualwhosolicitsandtakesamortgageapplication,andlater
sellsittoalenderforacommission.
MunicipalBondDebtobligationsofStateorlocalgovernmentstopayforspecialprojectssuch
ashighwaysorsewers.
MutualFundsAnentitythatpoolsmoneyfrommanyinvestorsandinvestsitinvarious
investmentopportunities.
MutualSavingsBanksAsavingsbankthatisownedby,andoperatedforthebenefitof,its
depositors.
NationalAssociationofSecuritiesDealersAutomaticQuotationSystem(NASDAQ)An
electronicquotationsystemthatprovidespricequotationstomarketparticipantsaboutthe
moreactivelytradedcommonstockissuesintheOTCmarket.About4000commonstockissues
areincludedintheNasdaqsystem.
NASDAQCompositeIndexAstockindexthatisbasedonthepricesofallstockstradedonthe
NASDAQsystem.
NeedsThingsyoumusthaveinordertosurviveormeettheminimumlivingstandards.
NewYorkStockExchange(NYSE)ThelargeststockexchangeintheU.S.,locatedonWallStreet
inNewYorkCity.TheNYSEisresponsibleforsettingpolicy,supervisingmemberactivities,
listingsecurities,overseeingthetransferofmemberseats,andevaluatingapplicants.
NominalInterestRatePublishedorstatedinterestrateondeposits,expressedincurrent
dollarsandunadjustedforcompoundingandtheeffectsofinflation.Aftersuchadjustmentsit
iscalledrealrateofinterest.Alsocallednominalrateofreturn.
OnlineBankingComputerizedservicethatallowsabank'scustomerstogetonlinewiththe
bankviatelephonelinestoviewthestatusoftheiraccount(s)andtransactionhistory.Itusually
alsoallowsthemtotransferfunds,paybills,requestcheckbooks,etc.
OpenEndCreditAloanwhosemaximumamountisapprovedbythecreditorbutnotdelivered
totheborroweratonce.Overtime,theborrowercangetmoneyfromthelender(uptothe
maximumamount),orpaybackaportionortheentireamountoftheprincipal.
OpportunityCostThecostofanactivitythatismeasuredintermsofthevalueofthebest
alternativethatisnotchosen.
OriginationFeeAnupfrontfeechargedbyalenderforprocessinganewloanapplication,used
ascompensationforputtingtheloaninplace.
PensionPostretirementbenefitsthatanemployeemightreceivefromsomeemployers.A
pensionisessentiallycompensationreceivedbytheemployeeafterhe/shehasretired.
PortfolioAgroupingoffinancialassetssuchasstocks,bondsandcash.
PresentValue(PV)Thecurrentworthofafuturesumofmoneyorstreamofcashflowsgivena
specifiedrateofreturn.Futurecashflowsarediscountedatthediscountrate,andthehigher
thediscountrate,thelowerthepresentvalueofthefuturecashflows.Determiningthe
appropriatediscountrateisthekeytoproperlyvaluingfuturecashflows,whethertheyare
earningsorobligations.
PrincipalTheamountborrowedortheamountstillowedonaloan,separatefrominterest.
ProcessingFeeAssemblingandmanagingamortgagetransaction'srecordsandinformation,
includingtheappraisal,creditreport,andemploymentandassetconfirmation.
ProfitThepositivegainfromaninvestmentorbusinessoperationaftersubtractingforall
expenses.
ProfitabilityTheabilitytoearnaprofit.
PropertyTaxAtaxleviedonrealpropertybasedonitsuseanditsassessedvalue.
RateofReturnThemoneyyouearnonaninvestment,statedasapercentage.Calculatedas
the(ValueNowminustheValueattheTimeofPurchase)dividedbytheValueattheTimeof
Purchase.
RealEstateLandplusanythingpermanentlyfixedtoit,includingbuildings,shedsandother
itemsattachedtothestructure.
RealEstateAgentAlicensedindividualwhoprovidesrealestateservicessuchasshowing
homes,makingoffersandcounteroffers,negotiatingprices,andassistingintheclosing.
RealEstateTaxAtaxassessedbystateorlocalgovernmentsonrealestateaccordingtoits
value.
RecessionAsignificantdeclineinactivityacrosstheeconomy,lastinglongerthanafew
months.Itisvisibleinindustrialproduction,employment,realincomeandwholesaleretail
trade.
RentersInsuranceAtypeofhomeinsurancethatprotectstheholderagainstaccidents,
damagesandlossesthatoccurinarentedresidence.
RetirementPlanningTheprocessofdeterminingretirementincomegoalsandtheactionsand
decisionsnecessarytoachievethosegoals.Retirementplanningincludesidentifyingsourcesof
income,estimatingexpenses,implementingasavingsprogramandmanagingassets.Future
cashflowsareestimatedtodetermineiftheretirementincomegoalwillbeachieved.
RevenueForacompany,thisisthetotalamountofmoneyreceivedbythecompanyforgoods
soldorservicesprovidedduringacertaintimeperiod.
RiskThechancethataninvestment'sactualreturnwillbedifferentthanexpected.Riskincludes
thepossibilityoflosingsomeoralloftheoriginalinvestment.
S&P500Astockindexthatisbasedonthepricesof500largecorporations.
SalesTaxApercentagetaxonthesellingpriceofgoodsandservices.
SavingAccountAdepositaccountatafinancialinstitutionthatpaysinterest,butcannotbe
withdrawnbycheckwriting.
SavingsandLoanAssociationAfinancialinstitutionthatacceptssavingsdepositsandinvests
thebulkofthefundsreceivedintomortgages.
SecuritiesPapercertificates(definitivesecurities)orelectronicrecords(bookentrysecurities)
evidencingownershipofequity(stocks)ordebtobligations(bonds).
ShareholderAninvestorwhoownssharesofacorporation.Shareholdersareownersofthe
corporation.
SingleFamilyDetachedHouseAstructureconstructedtoaccommodatelivingspaceforone
familyperverticalunit.Inotherwords,nootherlivingunitswillbeaboveorbelow.
StockMarketThemarketinwhichsharesareissuedandtradedeitherthroughexchangesor
overthecountermarkets.
StocksOwnershipofacorporationrepresentedbysharesthatareaclaimonthecorporations
earningsandassets.
SurplusTheamountofagovernment,companyorindividualsincomethatremainsafter
subtractingallexpenses.
TaxAfeechargedbyagovernmentonaproduct,income,oractivity.Iftaxislevieddirectlyon
personalorcorporateincome,thenitisadirecttax.Iftaxisleviedonthepriceofagoodor
service,thenitiscalledanindirecttax.Thepurposeoftaxationistofinancegovernment
expenditure.
TaxDeductionAnexpensesubtractedfromincomewhencalculatingtaxliability.Witha30%
taxrate,eachdollaroftaxdeductionreducestaxableincomebyonedollarand,thus,tax
liabilityby30cents.
TheGreatRecessionTherecessionthatstartedonDecember2007.Generally,theGreat
Recessionlastedlongerandwasmoreseverethanpriorrecessions.
TimeValueofMoneyTheideathatadollartodayisworthmorethanadollarinthefuture.
TownhomeAdwellingcharacterizedbytwostoryconstructionwithacommonwallorwalls
borderingneighboringdwellings.Townhomeownershipsometimesdiffersfromcondominium
ownershipinthatthetownhomeownerownsthephysicalstructureratherthanjustthe
airspacebetweenthewalls,floor,andceiling.
TransactionCostsCostsincurredwhenbuyingorsellingassets,suchascommissionsandthe
spread.
TreasuryBondsDebtobligationsoftheUSTreasurythathavematuritiesof10yearsormore.
U.S.MintTheprimaryproducerofthecoincurrencyoftheUnitedStates.Theminthasthe
consentofthegovernmenttomanufacturecoinstobeusedaslegaltender.Alongwith
production,themintisalsoresponsibleforthedistributionofthecurrency,protectionofthe
mint'sgoldandsilverassets,andoverseeingitsvariousproductionfacilities.
UnderwritingFeeUnderwritingfeesaremoniescollectedbyunderwritersforperforming
underwritingmortgageservices.
U.S.BureauOfEngravingAndPrinting(BEP)AU.S.governmentagencyresponsibleforprinting
thepapercurrency,TreasurysecuritiesandspecialtydocumentsfortheUnitedStates.The
BureauofEngravingandPrinting(BEP)ispartoftheU.S.DepartmentoftheTreasury.TheBEP
designsallpapercurrency,whichitsendstotheFederalReserveforuseinthemoneysupply.
U.S.TreasuryThedepartmentoftheU.S.governmentthatissuesTreasurysecurities.
VolatilityAmeasureofthedispersionofreturnsforagivensecurityormarketindex.
Commonly,thehigherthevolatility,theriskierthesecurity.
WantsDiscretionaryexpensesthatmaybedelayedorsubstitutedwithoutaffectingyourability
tosurvive.
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SL LI ID DE ES S

Courseoverview
Course description Course description
Learningobjectives
Requirements
Grading
Otherhousekeepingitems
[Ifyouwouldliketoknow whystudentschosetotakethiscourse,youmayaskthequestionwhyareyou
here?Studentscantalkaboutwhatattractedthemtotheclass,whattheyexpect/hopetolearn,andhowthey , y p / p , y
thinktheknowledge/skillscanhelptheminthefuture.]
1-1
ThetitleofthiscourseisFinanceLiteracy101.Whatdoesthatmean?
[Clicktoshowthemeaningoffinancialliteracy.]
Financialliteracyistheabilitytounderstandfinance.Itisaboutdevelopingtheknowledgeandskillsthatwill
allowyoutomakebetterfinancialdecisions.Butbeforewetalkaboutthe thingsthatcanhelpyoumakebetter
decisions,wefirstneedtoanswerthisquestion.
[Clicktoshowthequestions.Givestudentstheopportunitytodefinefinanceintheirownwords.Thenshow [ q pp y
thedefinitionsonthenexttwoslides.]
1-2
1-3
[After showingthedefinitionfromBritannicaEncyclopediaandMerriamWebsterDictionary,askstudents
whether these definitions help them understand the meaning of finance better ] whetherthesedefinitionshelpthemunderstand themeaningoffinancebetter.]
Sometimesthedefinitionfromaauthoritativesourcemightbetoocomplicatedorconfusing. So, istherea
simplerwaytodefinefinance?
1-4
Thisdefinitionissimpleenough.Butthedownsideofusingsuchasimpledefinitionisthatpeoplemay
underestimatethecomplexityoffinanceandhavethefalsesensethatmakingfinancialdecisionsiseasy. p y g y
Financeisnotjustaboutspendingmoney(whichmostpeopleareverygoodat),butisaboutmanagingmoney.
Mostpeopleneedhelptobecomefinanciallyliterate.Ontheotherhand,financeisnotrocketscience. Youjust
need toknow basicmath,andhavelogicalthinkinganddisciplineinordertomakesoundfinancialdecisions.
[ClicktoshowItem#2.]
Morespecifically,financedealswiththeconceptsofmoney,timeandrisk.Mostofyouprobablydontreally
understandhowtimeandriskarerelatedtomoney.Letmeuseanexampletoshowyouhowthesefactors y p y
mayaffectyourdecision.
[Clicktoshowthequestion.Askthemthisquestion:$100and$105,whichisbetter?Thesuggestedanswer
(itsnottheonlycorrectanswer)isitdepends.]
Whatdoesitdependon?
Firstofall,aretheybasedonthesamecurrency(US$,Canadian$,Australian$,etc.)?
When the economic conditions change, one US$ may be worth more or less than one Canadian$. Whentheeconomicconditionschange,oneUS$maybeworthmoreorlessthanoneCanadian$.
SupposetheyarebothinUS$,whichisbetter?Itstilldepends
Itdependsonwhetheryouarereceivingthemoneyorpayingthemoney.Manyfinancialdecisions
involvebothcashinflow(moneyyouexpecttoreceive)andcashoutflow(moneyyouneedtopay).Its
necessarytodifferentiatethetwotypesofcashflow.
Supposebotharemoneyyouwillreceive,nowwhichoneisbetter?Itstilldepends
Itdependsonwhenyouwillreceivethemoney.Thesooneryougetthemoney,thesooneryoucanspend
it,orsaveitinabankaccountandstartearninginterest.Asaresult,$100todaymaybeabetterchoice
than $105 to be received three years from now The answer depends on the interest rate you can earn on than$105tobereceivedthreeyearsfromnow.Theanswerdependsontheinterestrateyoucanearnon
thebankaccount.
Supposetheyarebothexpectedtobereceivedayearfromnow,whichisbetter?
Eventhoughtheyboth1)aremeasuredbythesamecurrency,2)arethesametypeofcashflow(money
tobereceived),and3)willoccuratthesamepointintime,theanswerisstillitdepends.
Itdependsonwhopromisestopayyouthemoney.$100promisedbysomeoneyoutrustwouldbea
betterchoicethan$105promisedbysomeoneyoubarelyknow.Thisistheconceptofrisk.
[The purpose of this question/discussion is to illustrate how the three factorsmoney time and riskare taken [Thepurposeofthisquestion/discussionistoillustratehowthethreefactors money,timeandrisk aretaken
intoaccountinfinancialdecisions.]
1-5
Nowletstalkaboutaveryimportantfinancialconcept:rateofreturn.
[ClicktoshowItems1and2.]
Letsassumethatthepreviousexample ($100or$105)involvestwoinvestmentalternatives.Bothinvestments
cost$90,butAlternativeApaysyou$100inayearwhileAlternativeBpaysyou$105inayear.Howdoyou
calculatetherateofreturnoneachone?
[Clicktoshowtheformula.] [ ]
TherateofreturnonAlternativeAis11.11%andtherateofreturnonAlternativeBis16.67%.Whenmakingan
investment,weprefertogetahigherreturn.Soifrateofreturnistheonlyfactortobeconsidered,Bis
superiortoA.
[YoucanaskstudentstoworkonquestionsintheDotheMathsection,andusetheExcelmodel01Rateof
Returntorevealtheanswers.]
1-6
Inadditiontoreturn,youshouldalsoconsidertheriskinessofaninvestment.Whatisrisk?
[Clicktorevealtheanswer.]
IfAlternativeBisofferedbysomeoneyoubarelyknow,youneedtoconsiderthepossibilitythatyoumightnot
receiveanythingattheendoftheyear,notevengettingthe$90back.Whenchoosingamonginvestment
opportunities,mostpeopletrytoavoidrisk.
1-7
[Thiscouldbeanopendiscussion.OryoucanusethefollowingexamplefromtheStudyGuide.]
Overthecourseofyourlife,youaregoingtoearnmillionsofdollars.Assumethatyoustartyourcareerat
theageof22andretireattheageof65.Youearnanannualsalaryof$45,000(whichistheaverage
forcollegegraduates)andneverreceivearaise(whichishighlyunlikely,butletsbeconservative).The
totalamountyouwillearnoverthe43yearperiodwillbe$1,935,000,nearly$2million.
[UsetheExcel model02CareerSalarytoshowstudentshowmuchmoretheycanmakeovertheirlifetime
with a small income growth You can also use the spreadsheet to how the lifetime earnings without a college withasmallincomegrowth.Youcanalsousethespreadsheettohowthelifetimeearningswithoutacollege
degree:startingage=18andstartingsalary=$29K.]
Ifyoudontknowhowtoproperlymanageyourfinances,youmayrunoutofmoneyregardlessofhowmuch
youmake.Somelotteryjackpotwinnerswentbankruptwithinjustafewyears.
[Forexample,DavidEdwardsspentover$27millioninsixyearsandwentbankrupt.]
Howisthispossible?Doyouthinkyouhavetheknowledgeandskillstomanagethemoneyyouregoingto
earn?
1-8
[Clicktoshowthelist.]
Therearesomanythingstheyaregoingtolearn.Someoftheskillsandknowledgemaybeusefulimmediately;
otherswillbenefittheminthelongrun.Whenandhowtheycanapplytheskills/knowledgedependsonthe
typeofdecision.
Remindstudentsthatthisslideisjustanoverview.Therewillbemoreindepthdiscussioninmanydifferent
areasthroughoutthecourse.
1-9
Weliveinaneconomythathasoneofthemostdeveloped,advancedfinancialsystemsintheworld.
Everyone enjoys the convenience provided by the system on a daily basis but we seldom think about Everyoneenjoystheconvenienceprovidedbythesystemonadailybasis,butweseldomthinkabout
theimportanceofit.Whatwouldourdailylivesbelikeifthefinancialsystemwetakeforgranteddid
notexist?Imagineaworldwithnobanksorotherfinancialinstitutions;nochecksorcreditcards;no
ATM.Peoplemustusecashtobuyeverything,fromgroceries,tocarsorevenhouses.Ifyoudont
haveenoughofyourownmoneytobuyahouse,theonlysourcesforborrowingarepeopleyouknow,
suchasyourparents,relativesandfriends.Ifyourmonthlyincomeisgreaterthanyourcurrent
spending,youneedtostoretheexcesscashinasafetyboxorhideitunderamattress,butyoucant
savethemoneyinabanktoearninterest.
Sowhatisthefinancialsystem?Inabroadersense,thefinancialsystemcoverseverythingthat
facilitatesthetransferofmoney(capital,funds).Componentsofthesystemincludebankswithwhich
yousavemoneyorfromwhichyouborrowmoney;creditcardcompaniesthatprovideyouthe
convenienceofnothavingtocarryalotofcash;governmentagenciesthatregulateandmonitorthe
operations of those financial institutions; and stock and bond markets where individuals and operationsofthosefinancialinstitutions;andstockandbondmarketswhereindividualsand
institutionsinvesttheirfunds,amongothers.
2-1
Itisimpossible todiscusseverythingintheU.S.financialsysteminonechapter.Wearegoingtofocusonthese
topics topics.
Someotherrelatedtopicswillbediscussedinlaterchapters.
2-2
Asdiscussedinthepreviouschapter,financeisthesubjectthatdealswithmoney.Soletsstartby
examining the money we use examiningthemoneyweuse.
[Click toshowItem#1.]
TheConstitutionoftheUnitedStatesofAmericastatesthatTheCongressshallhavethepowerto
coinmoney.
Asaresult,CongresscreatedtheU.S.Mintin1792inPhiladelphiatoproducecoinsrepresentingthe
officialU.S.currency.TheMintsfirstproductionwascoppercents,anditlateralsoissuedsilverand
goldcoinsaswell.
[Click to show Item #3 ] [ClicktoshowItem#3.]
In1861,duetoashortageofpreciousmetals,theDepartmentofTreasurybeganprintingpaper
money(notes).
Today,theBureauofEngravingandPrintingisresponsibleforproducingpapercurrencywhiletheU.S.
Mintisresponsibleforproducingcoinage.BothgovernmentagenciesarepartoftheU.S.Department
ofTreasury.
[Youcanusethehyperlinktoshowashortvideo(1:15)ofHowMoneyIsMade.]
2-3
Doyouknowhowmuchmoneyhas beenproducedandhowmanyUSDollarsareincirculation?
[Clicktoshowpictures.]
In2010,theBureauofEngravingandPrintingprintedabout6.4millionnoteswithatotalvalueofnearly$400
billion.Duringthesametime,theU.S.Mintproducedapproximately$6.4billionworthofcoins.Mostofthe
newproductions(about95%)wereusedtoreplacenotesandcoinsalreadyincirculation.Asoftheendof
2010,approximately$942billionofpapercurrencyand$40billionofcoinswereincirculation.
2-4
Weliveinaglobaleconomy,sopeopleoftenneedtouseforeigncurrencies, suchastravelingoverseasand
buying imported products (in this case the importer pays with foreign currency but charges US customers in US buyingimportedproducts(inthiscase,theimporterpayswithforeigncurrencybutchargesUScustomersinUS
dollars).
[Letsfindoutifstudentsareawareofthecurrenciesusedbyourneighboringcountriesandsomeofthemajor
economicpowersintheworld.]
Canada:CanadianDollar,CAD, orC$
Mexico:Mexican Peso
UnitedKingdom:BritishPound,
Germany:Euro,
China:Yuan, RMB,
Japan:Yen,
2-5
[Becausewepreviouslydiscussed thegovernmentagenciesthatproducemoney,this slidestartswiththe
sentence In the U S after paper notes and coins are produced they are delivered to the Federal Reserve (the sentence IntheU.S.,afterpapernotesandcoinsareproduced,theyaredeliveredtotheFederalReserve(the
Fed)beforebeingreleasedtothepublic.]
[Click toshowthetitlequestion.]
WhatistheFederalReserve?
[Clicktoshowthenexttwoitems.] [ ]
Thecentralbankisacountrysprimarymonetaryauthoritythattypicallyisresponsibleforissuingcurrency,
administeringmonetarypolicies,and regulatingandfacilitatingthebankingindustry.
TheFedisabankersbankbecausewhenbanksneedmoney,theycanborrowfrom theFederalReserve.
2-6
TheFederalReservesystemconsistsoftheBoardofGovernors(inWashingtonD.C.)andtwelve
regional Federal Reserve Banks: regionalFederalReserveBanks:
Boston
New York
Philadelphia
Cleveland
Richmond,VA
Atlanta
Chicago
St.Louis
Minneapolis
KansasCity
Dallas
SanFrancisco
TheBoardandtheReserveBankssharetheresponsibilityofimplementingthegovernmentseconomic
andfinancialpolicy.
2-7
[Refer tothedocumentTheFederalReserveSystem:PurposesandFunctions(intheAppendices)forfurther
information about the Feds duties ] informationabouttheFed sduties.]
2-8
TheFederalReserve isconsideredtobeanindependentcentralbankbecauseitsdecisionsdonothavetobe
ratified by the President or anyone else in the executive branch of the government ratifiedbythePresident,oranyoneelseintheexecutivebranchofthegovernment.
However, thesystem issubjecttooversightbytheU.S.Congress.
2-9
[Click toshowpicture.]
ThecurrentchairmanoftheBoard,Dr.BenBernanke,wasappointedbyPresidentGeorgeW.Bushand
confirmedbytheSenatein2006.HewasnominatedbyPresidentObamaandconfirmedforthesecond termin
2010.
Becauseofhisstronginfluenceontheworldslargesteconomy,Dr.Bernankeisconsideredoneofthe10most
powerfulpeopleintheworldbyForbesmagazine.
[Usethehyperlink togotoForbeswebsiteathttp://www.forbes.com/wealth/powerfulpeopleforacomplete
list.]
2-10
OneoftheFederalReservefunctionsissupervisingandregulatingbankinginstitutions.Itisimportant
to understand what banks are what they do and how they affect individuals like you Have you seen tounderstandwhatbanksare,whattheydo,andhowtheyaffectindividualslikeyou.Haveyouseen
thescenesinWesternmovieswherebanditsrobabank?Didyouwonderwhatthedifferencesare
betweenbanksinthe19
th
centuryandthoseoftoday?Traditionally,abankistheplacewherepeople
savetheirsurplusincome.Asavergivesuptherightofspendingthemoneynow;inexchange,she
getsmoremoneybacklater(principalplusinterest).Asthebankcollectssavingsfrommany
individuals,itusesthemoneytomakeloanstothosewhoneedmoremoneythantheycurrentlyearn.
Whenmakingaloan,thebankchargesaninterestrate.Thebankusesthedifferencebetweentherate
itcollectsfromborrowersandtherateitpaystosavers(thisiscalledaspread)tocoveritsexpensesof
doingbusinessandtomakeaprofit.
Today,thebusinessofcollectingdepositsandmakingloanscontinuestobeoneofthemajorfunctions
of the banking industry; however, the term bank is being used in a much broader sense. ofthebankingindustry;however,theterm bank isbeingusedinamuchbroadersense.
[Click toshowinvestmentbanks,mortgagebanksandcommercialbanks.]
2-11
Whatisacommercialbankandwhatdoesitdo?
[Clicktoshow Item#1.]
Inearly2011,thefivelargestcommercialbanksintheU.S.wereChase,BankofAmerica,Citi,WellsFargo,and
USBank.Youcanprobablyfindthebranchofficesofsome,ifnotall,ofthesebanksinyourneighborhood.
Aninterestingfeatureoftheselargebanksisthattheyhaveevolvedintolargefinancialconglomeratesthatdo
muchmorethanjustcompilingsavingsandmakingloans.Eachofthemhasoperationsincommercialbanking, j p g g g p g,
investmentbanking,mortgagebanking,aswellasmanyotherfinancialactivities.
Inadditiontocommercialbanks,othertypesoffinancialinstitutionsalsoprovidesimilarservices.
[Clicktoshowthelist ofothertypesoffinancialinstitutions.]
Becausethesefinancialinstitutions collectdeposits,theyareoftenreferredtoasdepositoryinstitutions.Ifyou
wanttosavemoneyinabank,youcanchooseanyofthefourtypesofdepositoryinstitutions.
2-12
Heres acomparisonofdepositoryinstitutionsbasedontheirkeyservicesandownershipstructure.
2-13
Eachdepository institutionoffersvarioustypesofaccounts.Herearesomeexamples:
[Click toshowCheckingAccounts.]
Thesearethemostflexibleaccounts.Youmakedepositstotheaccount,andwritecheckstopayyour
billsormakepurchases.Youhaveconvenient,frequentaccesstoyourmoney.Mostbanksallowyou
towithdrawcashormakedepositsusinganautomatedtellermachine(ATM).Manyalsoissuedebit
cardssoyoucanpurchaseproductsandservicesatbusinessesthatdonotacceptpersonalchecks.
Regularcheckingaccountsdonotpayinterest.Thosethatdopayinteresttypicallyhavemuchlower
APYthanothertypesofaccount.
[ClicktoshowSavingsAccounts.]
Thesearesimilartocheckingaccounts,buthavemorerestrictions.Savingsaccountstypicallyallow
youtomakewithdrawals,butwithouttheconvenienceofusingchecks(oronlyalimitednumberof
checks).Ifyouhavebothcheckingandsavingsaccountswiththesamebank,yourATMcardmaybe
linkedtoboth.Asavingsaccountmayhaveahigherminimumbalancerequirementthanachecking
account.Allsavingsaccountspayinterestandtherateofreturnistypicallyhigherthaninterest
earning checking accounts earningcheckingaccounts.
[ClicktoshowMoneyMarketAccounts.]
Comparedwithcheckingandsavingsaccounts,theseaccountstypicallyhavehigheraminimum
balancerequirementandotherrestrictions.Theymayallowasmallnumberofchecksandmoney
transferseachmonth.Themainbenefitofmoneymarketaccountsisthefavorablerateofreturn.The
yieldisbasedonmarketinterestrates,soitmayfluctuateovertime.
[Click toshowCertificatesofDeposit(CDs).]
Theseaccountsrequireyoutokeepyourmoneywiththebankforaspecificperiodoftime.Youdo
nothaveaccesstoyourmoneyuntiltheendoftheperiod,thatis,thematurity.CDtermsrangefrom
afewdaystoseveralyears.Sometimesthebankmayallowyoutowithdrawmoneybeforematurity,
butapenaltyisoftencharged.Inexchangefortheinflexibility,youreceiveaguaranteedyieldthatis
typicallyhigherthanothertypesofaccounts.
2-14
Whichoneisthebest?Theanswerdependsonyourfinancialsituation,suchashowmuchmoneyyou
have and when you will need the money haveandwhenyouwillneedthemoney.
Theonefactoreveryonetakesintoconsiderationwhenselectinganaccountistheinterestrate.Theidea
seemsquitesimple:thehigher,thebetter.However,simplycomparingthenominalinterestratesmayleadto
thewrongdecision.Anotherkeyfactortotakeintoaccountishowoftentheinterestiscalculated.Asinterest
d i th i i d l i t t i th t i d (th t i i t t i t t earnedinthepreviousperiodcanalsoearninterestinthecurrentperiod(thatis,interestoninterest,or
compounding),themorefrequentlyinterestiscalculated,themoremoneyyouwillhaveinyouraccount,given
thesameinterestrateandtimeperiod.
Becausemostconsumersdonotknowhowtocalculatetheeffectiverateofreturnbyfactoringinthe
compoundingfrequency,thelawsrequirebankstodiscloseannualpercentageyield(APY)soeveryonecan
meaningfullycomparethedifferentoptions.
2-15
TheAPYcan becalculatedwiththisformula.
[AskstudentstoworkonquestionsintheDotheMathsection anduse thespreadsheetmodel03Annual
PercentageYieldtorevealanswers.]
2-16
Inadditiontorateofreturn,youalsoneedtoconsidersomeother factors.
Forexample,youneedtoconsiderrestrictions andfees.Somebankaccountshaveaminimumbalance
requirement,requiringyoutohaveatleastacertainamountofmoneyinthebankatalltimes.Ifyourbalance
dropsbelowtherequirement,youarechargedafee.Otheraccountsallowyouwritealimitednumberof
checkseachmonth.Ifyouneedtowritemorechecks,feeswillbecharged.Certainaccountsdonotallowyou
towithdrawmoneyuntilaspecificdate.Ifyouneedthemoneybeforethatdate,youhavetopayafee. y p y y , y p y
Manybanksalsoofferprivilegestovarioustypesofaccounts.Forexample,somesavingsaccountsallowyouto
writealimitednumberofchecks;somebankswaivetheminimumbalancerequirementifyousetupdirect
depositforyourpaychecks(thatis,yourwagesareelectronicallydepositedintoyouraccountdirectlyfromyour
employer);someinstitutionsreimbursethefeeyouarechargedwhenusingtheATMofanotherbank.
YoumaybeenticedtodobusinesswithabankthatpayshigherAPYthanitscompetitors,butitisvery
importantthatyoualsoconsideralltheprivileges,restrictionsandpotentialfees.A$3feeyoupayattheATM
maycompletelyoffsettheadditionalinterestyouearnoverthewholeyearwithaslightlyhigherAPY.
Anotherimportantfactoristhesafetyofyourbank account.Duringeconomicrecessions,youmayhearthe
newsofbanksgoingoutofbusiness.Whatwouldhappentoyourmoneyifthebankyoudeposited
moneywithfiledforbankruptcy?Mostbanksandsavingsinstitutionsareinsuredbyagenciesthatare
affiliatedwiththefederalgovernment.IfthebankisinsuredbytheFederalDepositInsuranceCorporation
(FDIC),yourdepositsofupto$250,000areprotected.
2-17
Anessentialpartofmanagingyourfinancesisknowinghowmuchmoneyyouhave,howmuchmoney
you earn and how much money you can spend As a result knowing the balance of your bank youearn,andhowmuchmoneyyoucanspend.Asaresult,knowingthebalanceofyourbank
accountisveryimportant.Traditionally,peoplemanuallyrecordeachtransaction,forexample,
deposits,withdrawalsandcheckswritten,inordertokeeptrackofthebalance.
Manycheckbookshavepagesoftemplatesinwhichonejustfillsinthetransaction.Thatiswhythis
activityisoftenreferredtoasbalancingyourcheckbook.Today,manyfinancialinstitutionsoffer
onlinebanking,soyoucankeeptrackofallthetransactionsandyourbalancebyloggingintoyour
accountonacomputerorevenfromyoursmartphone.Butthebasicconceptsremainthesame.
[Discuss theexampleintheStudyGuideoruseadifferentexample.]
Julie had $102.50 in her checking account at the beginning. On August 10, she deposited her paycheck Juliehad$102.50inhercheckingaccountatthebeginning.OnAugust10,shedepositedherpaycheck
of$235.20.Aftertheamountiscredited(thatis,added),heraccountbalancebecame$337.70.The
nextday,Juliewroteacheckof$15(check#120)topayforpizza,soshedebited(thatis,subtracted)
theamountfromheraccount.OnAugust14,sheusedanothercheck(#121)andalsowithdrew$20
fromanATM.Afterthesetwotransactions,heraccountbalancewas$89.80.
Onethingpeopleoftenforgetisthefeestheymayhaveincurredintransactions.IfJuliewaschargeda
f h ki h f h ATM h d b d bi d f h ll feewhentakingcashoutoftheATM,thatamountneedstobedebitedfromtheaccountaswell;
otherwise,herrecordwouldnotbeconsistentwiththemonthlystatementpreparedbythebank.
Anotherpotentialreasonforinconsistentrecordsisthatpeopleforgettoincludepurchasesusinga
debitcard,especiallywhentheydontkeepthereceipts.Withoutknowingexactlyhowmuchmoney
shehasinheraccount,Juliemightwriteacheckforanamountexceedingherbalanceand
consequentlyhadtopayaheftyfeeforthebouncedcheck.
2-18
Somebankshaveonlinedemoto showcustomershowonlinebankingworks.
[Forexample,youcanusethehyperlinktogotoBankofAmericaat
http://www.bankofamerica.com/onlinebanking/?context=en andclickonViewDemotolearnwhatyou
candoonline.]
2-19
3-1
Asdiscussedinthelastchapter,animportantsteptowardasoundfinancialfutureiskeepingtrackof
your money You need to know how much money youve earned how much youve spent and how yourmoney.Youneedtoknowhowmuchmoneyyou veearned,howmuchyou vespent,andhow
muchyoucurrentlyhave.Thenextstepistodrawaroadmapforthefuture,thatis,preparinga
budget.
[Click toshowthelist.]
3-2
[ClicktoshowthedefinitionandthenItem #2.]
Forexample,iftheTVnewsreportsthatthefederalbudgethasadeficitof$1trillion,thatmeansthefederal
governmentplanstospend$1trillionmorethanitexpectstobringin(mainlyfromtaxrevenues).
InFiscalYear2012(Oct.2011toSept.2012)thefederalgovernmentexpectstotakein$2.6trillioninrevenue
andspend$3.7trillion,creatingadeficitof$1.1trillion.
[ClicktoshowItem #3.] [ ]
3-3
Whileweoftenhearaboutbudgetissuesrelatedtothegovernment,theconceptofbudgetcanbe
applied to individuals families and businesses as well appliedtoindividuals,familiesandbusinessesaswell.
[Clicktoshowthethreeitems.Afterreading them,youcangivethefollowingexamplesanddiscuss
howhavingafinancialplancanhelp.]
Ateenagermaywanttoknowwhetherhewillbeabletoaffordanewvideogamewhenitisreleased;
afamilymayneedtofigureouthowitcansaveforavacation;andacorporationmayneedtodecide
howitshouldraisefundsforamajorexpansion.Preparingadetailedplanforfuturefinancialactivities
helpsyou:1)avoidoverspending;2)assessyourabilitytoreachcertaingoals;3)identifynecessary
adjustmentsinyourfinancialhabits;and4)prepareyouforfinancialemergencies.
[Afterexplainingwhy budgetingisimportant,talkaboutdifferenttypesofbudgetingbeforeshowingthenext
slide.]
Therearedifferenttypesofbudgeting.Abudgetmayfocusonarelativelyshortperiodoftime,oranextended
periodoftime.Themostcommontypeofbudgetinginpersonalfinanceisthepreparationofamonthly
budget.
3-4
Toprepareamonthlybudget,youfirstneedtoknowhowmuchyouearn/receive(i.e.yourincome)andhow
much you spend (i e expenses) in the month The first step is to gather all the information about your income muchyouspend(i.e.expenses)inthemonth.Thefirststepistogatheralltheinformationaboutyourincome
andexpensesinrecentmonths.Forexample,yourpaystubsshowhowmuchyouearnedandhowmuchtaxes
weredeductedfromyourincome;bankaccountstatementslistallthechecksyoudeposited,checksyouwrote,
andcashwithdrawalyoumade;andcreditcardstatementsitemizeallthechargesfordifferentpurposes.
Becausesomeincomeandexpenseitemsmayvaryfromtimetotime,youneedtoestimatewhatisthetypical
amountforbudgetingpurpose.
Whataretheincomesourcesyoushouldconsider? Forateenager,theregularincomesourcesmay
includewagesfromaparttimejob,anallowancefromparents,andinterestearnedonasavings
account.Someofyoumayalsohaveothertypesofincomethatoccurlessfrequently,suchasgiftsfor
specialoccasions(birthdays,Christmas,etc.)andearningsfrombabysitting.
Forafamily,theparentssalaries/wagesmaybetheprimarysourceofincome,buttheymayalso
receiveinvestmentincome,orbonuses,amongothers.
InthesampleworksheetintheStudy Guide,severalincomesourcesarelisted.Thisbynomeans
suggeststhatthosearetheonlysources,oreveryoneshouldhaveincomefromeachofthesources.
Lineitemscanalwaysbeaddedtoordeletedfromthetemplate.
3-5
Nowletsconsiderexpenses. Herearesomeexamples.
Whenestimatingexpenses,youshouldstartwithallexpensesthatoccuronaregularbasis.First,youmayneed
topaytaxesonsomeofyourincome(wagesbutnotallowance).Ifthewagesintheincomesectionarealready
theaftertaxamount,thenyoudontneedtosubtractthetaxpaymentagain.Othertypicalexpensesmay
includeeducation,housing,foodandtransportation.Theitemsintheworksheetarebroadcategories,andyou
maywanttoaddsubcategorieswhenpreparingyourownbudget.Forexample,expensesforeducationmay
includetuitionandfees,books,schoolsuppliesandfieldtrips.Intermsoftransportation,ifyouownacar,you
mayneedtoconsidercarpayments(ifyouhaveacarloan),insuranceandgasoline;ifyoutakeabusto
school/work,thecostofbusfaresshouldbeincluded.Someofyoumayhaveotherpaymentsthatoccurona
regularbasisandareofaconstantamount,suchasacellphonebill,membershipduestoclubs,etc.
Afterregularexpenseitems,youshouldalsoconsiderdiscretionaryspending,likeshopping(clothes,shoes,
etc.),dining(pizzas,snacks,etc.)andentertainment(movies,videogames,etc.).Theseexpensesmayfluctuate
i di ll b t d t ti t th t d i t i l th periodically,butyouneedtoestimatetheamountyouspendinatypicalmonth.
Forfamilies,thelistofexpensesislongerandtheamountsaretypicallyhigher.Inadditiontotaxesand
transportation,otherregularexpensesmayincludehousing(mortgagepayment,rent,and/orhomeowner
associationdues),utilities(electricity,water,gas,trashremoval,etc.),groceries,andinsurance(health,lifeand
property).Therearealsodiscretionaryitemsafamilyneedstoconsiderinitsmonthlybudgeting.
A common mistake in preparing short term budgeting is that you forget to include expenses that occur less Acommonmistakeinpreparingshorttermbudgetingisthatyouforgettoincludeexpensesthatoccurless
frequently.Forexample,acarregistrationfeeisbilledtotheowneronceayear.Ifyoudontcalculatethe
averageamountpermonthandallocateittoeachmonth,youwillunderestimatetheoverallcostofowninga
car,andconsequently,mayhaveahugecashshortfallinthemonthwhenthefeeisdue.Forfamilies,backto
schoolandholidayshoppingareoftenoverlookedifthebudgetisnotbeingpreparedatatimewhenthose
expensesoccur.Asaresult,afamilythatnormallyhasabalancedbudgetmayhaveahardtimemeetingits
financialneedsduringcertainperiodsoftimeinayear.
3-6
Afterestimatingincomefromvarioussourcesandlistingallexpectedexpenses,youcancompareyourtotal
income with expenses Do you have enough money to cover all the expenses? incomewithexpenses.Doyouhaveenoughmoneytocoveralltheexpenses?
[Click toshowthefirsttwoitems.]
Theexpenseslistedinthebudgetsofarareallanticipateditems.Whatifsomethingunexpectedhappen?
Example:supposeyourcarbreaksdownandthecostofrepairis$800.Withcarinsurance,youdontneedto
payfortheentireamountbutarestillresponsibleforadeductibleof$500.Thiscouldeasilywipeoutthe
surplusyouveaccumulatedoverseveralmonths.
Anotherexampleofunexpectedexpenditureismedicalemergency.Studieshaveshownthatover60percent
ofbankruptciesintheU.S.werelinkedtomedicalexpenses,eventhoughmostofthosewhofiledbankruptcy
hadhealthinsurance.
Howshouldyoupreparefortheunexpected?Apossiblesolutionistosetasidemoneyforrainydays.A
teenagershouldprobablykeep10to15percentofhis/hermonthlyincomeforemergencysituations.
Incontrast,financialadvisersrecommendthatfamiliesshouldmaintainanemergencyfundofthreeto
sixmonthsoflivingexpensesforunexpectedfinancialdifficulties.
If your income is just enough to cover the expenses and the contingency, you wont be able to save money on a Ifyourincomeisjustenoughtocovertheexpensesandthecontingency,youwon tbeabletosavemoneyona
regularbasis.Toaccomplishyourlongtermfinancialgoals,youneedtosavemoneyandletthemoneywork
foryouovertime.Asaresult,settingasavingstargetisanecessarypartofthebudgetingprocess.
3-7
[Askstudentstoanswerthisquestionbeforeshowing thesuggestedanswers.]
Isitpossibleforyoutogenerateadditionalincome?
Isitpossibleforyou toreduceyourexpenses?Whichoftheexpenseitemsareessential?Whichcanbe p y y p p
postponed?Whichcanbecompletelyeliminated?
Whenyouprioritizeyourexpenses,itscriticalthatyouunderstandthedifferencebetweenwhatyouneedand
whatyouwant.Needsarethingsyoumusthaveinordertosurviveormeettheminimumliving
standards; ontheotherhand,wantsarediscretionaryexpensesthatmaybedelayedorsubstituted ; , y p y y
withoutaffectingyourabilitytosurvive.
[Usetheexamplebelow (orsomethingelse)toexplainthedifference.]
WeoftenhearpeoplesaythingslikeIneedanewpairofshoes.Ifthepersonsshoesarefalling
apartand,asaresult,he/shecantgotoschoolorwork,thenewpairofshoesarewhathe/sheneeds.
B t if th i th t th h b tt t h tfit h / h j t b ht th th h i Butifthereasonisthatthenewshoesbettermatchanoutfithe/shejustbought,thenthepurchaseis
whathe/shewants.Youaresupposedtospendmoneyonwhatyouneedfirst,andonlybuywhatyouwantif
youcanaffordit.
Afterabudgetisprepared,youneedtohavethedisciplinetofollowit.Itisimportanttoreviewthe
budgetonaregularbasisandcompareitwithyouractualincomeandexpenses.Ifwhatyouhad
plannedandwhatactuallyhappenedisverydifferent,youneedtoinvestigatewhetheritisa
temporarysituation/isolatedcase,oritislikelytobepermanent.Ifitisthelatter,eitherthebudget
needstoberevisedorthewayyouspendyourmoneyshouldbeadjusted.
3-8
Nowletsconsiderlongtermbudgeting.
[ClicktoshowItem #2.]
Forexample,ateenagerhasputtogetheraweeklybudgetbasedonhisallowanceandregular
spendingandbelieveshecansave$15eachweek.Heisreallyinterestedinanewvideogamethat
costs$75.Hisbudgetindicatesthatitwilltakefiveweeksforhimtosaveenoughmoneyforthegame.
Meanwhile,ifhewantstobuythegamewhenitisreleasedinthreeweeks,heneedstosave$10
more each week In this example the result of short term budgeting is used to project the goal over a moreeachweek.Inthisexample,the resultofshorttermbudgetingisusedtoprojectthegoalovera
longerperiodoftime.Butisthislongterm?
[Clicktoaskthequestion.]
Whileitiscalledlongtermbudgeting,thisprocesscanbeappliedtoavarietyoftimehorizons.
h d l d l l h h f h f h Incontrasttothevideogameexample,considerayoungcouplecontemplatingthepurchaseoftheirfirsthouse
infiveyears.Withamonthlybudget,theyestimatehowmuchtheycansaveeachmonthandthetotalsaving
overfiveyears.Giventhetermsofmortgagefinancing(whichwillbediscussedlaterinCh.6),theycan
determinehowmuchhousingtheycanafford.
Anothercommonapplicationoflongtermbudgetingisretirementplanning.Withamonthlybudget
andanestimateofannualsavings,onecanprojectwhenhe/shecanretire,orwhatkindsofcurrent
/ sacrificeshe/sheneedstomakeinordertoretireatacertainage.
3-9
3-10
[Click toshowallthreeitemsandthenusethefollowingexample.]
Supposeyouaresavingmoneyforthedownpaymentonanewcar. Ifyousave$55eachmonth, how
longwillittakeforyoutoaccumulate$2,000towardthepurchase?Withoutconsideringanyinterest
hecanearn,itwilltakenearlythreeyearsforyoutoreachthegoal.Butifyou savethemoneyinan
accountgeneratingan annualinterestrateof3.5%,youcanreachthegoaltwoalmosttwomonths
faster.
Heresanotherexample.Ifyousave$500eachyear,thetotalamountsavedwouldbe$10,000over20
years.However,ifthemoneyisdepositedinabankaccountthatpaysinterest,the$500savedinthe
firstyearwillearninterestduringthefollowing19years,the$500savedinthesecondyearwillearn
interestduringtheremaining18years,andsoonandsoforth.Furthermore,theinterestreceivedin
anearlieryearwillearnmoreinterestlateron.Withanannualpercentageyieldof3%,thetotal
amountofmoneyinyouraccountwillreach$13,435,about34%morethantheamountyouactually
deposited This the impact of the time value of money deposited.Thistheimpactofthe timevalueofmoney.
3-11
Theconceptoftimevalueofmoneycanbeappliedtonumerousfinancialsituations,andsomeofthemmay be
very complicated But it all starts with this simple equation verycomplicated.Butitallstartswiththissimpleequation.
Nowletsconsidersomeexamples.
3-12
Simply enter100asPV,0.04asi and3asn intotheformula.Theansweris$112.49.
[Usethespreadsheet05TVMtabFVtoanswerquestionsintheDotheMathsection.]
3-13
[UsetabPVof thesameExcelfile.]
3-14
Inthiscase,youcanfindtheFV ofeachdepositandaddthe20FVstogethertofindouthowmuchmoneyyou
willhavein20years.Butthisisaverytimeconsumingprocess.
[Clicktoshowthequestion.]
[NowusetabFV(2)intheExcelfiletoanswersolvetheproblem.]
3-15
Youcananswerthisquestionusingthesameformula.Butinthiscase,theunknownyouneedtosolveforis
PMT.
[UsetabFV(3)inthespreadsheet.]
3-16
Overthecourseofyourlife,therecouldbemanyoccasionswhenyouneedtopayforcertain
expenditures but dont have enough money to make the payment For example if you are accepted to expendituresbutdon thaveenoughmoneytomakethepayment.Forexample,ifyouareacceptedto
auniversitythatisyourtopchoiceanditoffers youapartialscholarship, youwillneedmoneytopay
fortherestofthetuitionaswellasotherlivingexpensesduringthefouryearperiod.Youmaysoon
needacar,togotoschoolortogotowork.Whatifyoucantaffordtopaytheentirepurchaseprice
withcash?Laterinyourlife,youmaywanttoown yourownhome,butthepriceofahouseisvery
expensive.Howcanyoudealwiththesesituationswhereyoujustdonthaveenoughmoneyatthe
timewhenmoneyisneeded?ThankstothefinancialsystemthatyoulearnedaboutinChapter2,you
canusecredit(thatis,borrowedmoney)forthoseexpenditures.Inthischapter,wewilldiscuss
varioustypesofconsumercreditandfactorsthatmayaffectyourabilitytogetaloan.
4-1
4-2
Creditisanarrangementtoreceivecash,goodsorservicesnowandpayfortheminthefuture.Many
serviceswereceiveinourdailylivesareexamplesofcredit.Forinstance,wetypicallyconsume
utilitieslikewaterandelectricityfirst,andthenpayforthemattheendofabillingcycle.Thistypeof
creditisprovidedfreeofcharge;therefore,everyoneshouldtakeadvantageofit.
Borrowingmoneyis alsoanexampleofusingcredit.However,itisnotfree.
Whenyouborrowmoneyfromalender,youneedtopaytheprincipalback.Additionally,youneedto
extra money called interest You will learn in our discussion later that the interest charge could be extramoney, calledinterest.Youwilllearninourdiscussionlaterthattheinterestchargecouldbe
quiteexpensive.Asaresult,youneedtobeverycarefulwhendecidingwhetherandhowmuchyou
shouldborrowforaspecificpurpose.
4-3
Therearedifferenttypesofcreditandoneofthemisconsumercredit.
Consumercreditisborrowingmoneyforpersonalpurposes.Examplesinclude:
Wewillhavemoredetaileddiscussionofthedifferenttypesofconsumercreditlater. yp
4-4
Usingconsumercredithasseveraladvantages.
[Clicktoshowtheadvantages.]
First,itallowsyoutoenjoygoodsorservicesnowandpayforthemlater.Withoutusingcredit,
purchasingahousewouldbeanimpossibledreamforthemajorityofhouseholdsintheU.S.;buyinga
carwouldtakeyearsofsavingsformostpeople.Thetypesofloansdesignedforhome(orcar)
purchasesallowyoutouseyourfutureincometopayfortheasset overaperiodoftimewhile
enjoyingthebenefitsprovidedtheasset.
Usingconsumercreditalsoreducestheneedtocarryalargeamountofcash.Today,mostofthe
purchasesofhighpriceditemsarepaidforwithcreditcards;makingtravelarrangements,suchas
flightandhotelreservationsoftenrequiresaguaranteebyacreditcard.Thisisnotonlyforthe
convenience,butalsoforthesafetyforconsumers.Usingcreditandelectronic transactionreduces
the need to having a large amount of cash and thus the risk of losing the money However it also theneedtohavingalargeamountofcashandthustheriskoflosingthemoney.However,italso
createsanewkindofsafetyconcern,i.e.identitytheft.Wewillhavefurtherdiscussionofthistopicin
nextchapter.
[Clicktoshowdisadvantages.]
Whatarethepotential downsidesofusingcredit?Thesinglebiggestissueisthetemptationto
overspend.Whenmakingpurchaseswithacreditcardoraloan,youareusingmoneythatyoudont
currentlyhave.Manypeoplefailtorealizethefactthatusingcreditdoesnotincreaseyourincomeor
purchasingcapacity.Whileitallowsyoutomakeapurchaseearly,youstillneedtopayforitlater.
Additionally,borrowingmoneyisnotfree.Creditorsofferyoutheserviceandexpectyoutopayforit
(intheformofinterestand/orfinancecharges).Therefore,overspendingtiesupyourincomeinthe
future and may result in severe financial consequences. futureandmayresultinseverefinancialconsequences.
4-5
Therearetwobasictypesofconsumercredit: closedendcreditandopenend credit.
Closedendcredittypicallyinvolvesborrowingthathasaspecifiedloanamountandisforaspecific
purpose.Anagreementbetweenthecreditor(thatis,thelender)andtheborrowerdetailstheterms
oftheloanthepurpose,theamount,thecost(includingtheinterestrateandothercharges),the
paymentschedule,andthecollateral,amongothers.
4-6
Unlike closedendcredit,openendcredit(alsoknownasrevolvingcredit)istypicallynotusedfora
single purpose singlepurpose.
Youcanusethistypeofcredittomakeanypurchasesaslongasthetotalamountyouveborrowed
doesnotexceedthemaximumamountapprovedbythecreditor,whichisyourlineofcredit.
Periodically,theborrowerpaysinterestontheamountowedandcanchoosetorepayaportionorthe
entireamountoftheprincipalborrowed.
[Click toshowexamples.]
Creditcardsarethemostpopulartypeofopenendcredit.TheU.S.CensusBureauestimatedthatin
2010,about180millionpeopleintheU.S.ownedcreditcardsandmorethan1.4billioncardshad
beenissuedbyfinancialinstitutionsandotherbusinesses.Aboutonethirdofcreditcarduserspayoff
alltheirchargeseverymonth.Bydoingso,theydontincurfinancialcostsforusingthecredit.Those
whocarrybalancesontheircreditcardshavetopayinterest,andtheratesoncreditcarddebtare
significantlyhigherthanmostothertypesofconsumercredit.
Anotherexampleofopenendcreditishomeequityloans.Thistypeofborrowingusesahouseas
collateral,butisnotusedforthepurchaseofthehouse.Thelineofcreditdependsonthevalueofthe
houseandtheamountstillowedonthehomemortgage.Oncethehomeequityloanissetup,the
borrowercanusethecreditforanypurchases.
4-7
Whenmakingaloan,thecreditorismakinganinvestment.Theinterestrateistherateofreturnon
theinvestment.Whatfactorsdoesalenderconsiderwhendecidingwhetheraloanapplicationshould
beapproved,andhowmuchinterestrateshouldbecharged?
Themainconsiderationishowriskytheinvestmentis.Riskisuncertainty,orthechancesthatthe
lendermightnotreceivethereturnhethoughthewouldget,ormightnotevengettheprincipalback.
Theriskinessofaloanisreflectedintwofactors.First,thelenderassesseshowlikelyitisthatthe
borrower might default on the loan which means the borrower is unable to repay the principal and/or borrowermightdefaultontheloan,whichmeanstheborrowerisunabletorepaytheprincipaland/or
payinterest.Themorelikelyitisthatdefaultwillhappen,theriskiertheloanis.Thelenderalso
considershowmuchhe/shecouldloseifadefaultoccurs.Iftheloanhasacollateral,whichisa
valuableassetpledgedtoensureloanpayments,theloanislessrisky.
4-8
Lenders ofconsumercreditconsiderfourkeyfactorswhendecidingwhetheraloanapplicationshouldbe
approved All of them start with the letter c so they are often referred to as the 4Cs approved.Allofthemstartwiththeletterc,sotheyareoftenreferredtoasthe4Cs.
[Clicktoshowthe4Cs.]
4-9
[ClicktoshowCapacity.]
Alenderusuallycomparestherequiredmonthlypaymentontheloanwiththeborrowersmonthlyincome.
[Clicktoshow Capital.]
Whenyouapplyforaloan,thelenderwillaskyoutoprovidecriticalfinancialinformation,suchas
salary,investmentincome(interestanddividends),bankaccountbalances,andyourstockportfolio.
Additionally you need to authorize your employer and financial institutions to release the information Additionally,youneedtoauthorizeyouremployerandfinancialinstitutionstoreleasetheinformation
sothecreditorcanverifythatwhatyouclaimintheapplicationistrue.Thelenderusesthe
informationtoassessyourcapacityandcapital.Capacity andcapitalbothmeasuretheborrowersabilityto
makepayments.Ifyoudonthavecapacityandcapital,itsmorelikelythattheyouwillbeunabletomeetthe
loanobligations(includingpayinginterestandrepayingprincipal).Asaresult,theloanisriskierandthelender
willchargeahigherinterestrate.
[Click to show Collateral ] [ClicktoshowCollateral.]
Thenextfactor iscollateral,whichisavaluableassetthatispledgedtotheloan.Iftheborrower
defaults,thelenderhastherighttoselltheassetandusetheproceedstorecoverhis/herinvestment
(oratleastpartofit).Forexample,whenyouborrowanautoloan,thecaristhecollateral.Witha
goodcollateral, eveniftheborrowerdefaults,thelendercanrecovermostoftheinvestment.Asa
result,theloanislessriskyandtheinterestrateislower.
[ClicktoshowCharacter.]
Somepeopletaketheseobligationsseriouslyandwouldrathersacrificepersonalconsumptionin
ordertomakeloanpayments.Othersmaynotconsidermeetingtheirfinancialobligationsapriority
andbelateonloanpaymentsonaregularbasis.Manylendersconsidercharacterthemostimportant
indicator in predicting whether a borrower can make timely payments on a loan and repay the indicatorinpredictingwhetheraborrowercanmaketimelypaymentsonaloanandrepaythe
principal.However,attitudeisverysubjectiveanddifficulttomeasure.
4-10
Yourcredithistorysummarizeswhathappenedinthepast,anditisnotaperfectofindicatorofwhatwill
happeninthefuture.Nevertheless,therationaleisthatyourpastbehaviorreflectsyourattitudetoward
financialobligations.
[ClicktoshowItem#3.] [ ]
4-11
Theinformationiscollectedandmaintainedbycreditbureaus(orcreditreportingagencies).Because
therearethreecreditbureaus(Equifax,ExperianandTransUnion)thatcollectinformation
independently to prepare credit reports each individual may have three different FICO scores independentlytopreparecreditreports,eachindividualmayhavethreedifferentFICOscores.
4-12
TheFICOscoreevaluatesfivemaincategoriesofinformationincreditreports:1)paymenthistory;2)
amount owed; 3) length of credit history; 4) types of credit in use; and 5) new credit Among them amountowed;3)lengthofcredithistory;4)typesofcreditinuse;and5)newcredit.Amongthem,
yourpaymenthistoryandthetotalamountyouoweonallcreditaccountsaremostimportant,as
approximately35%and30%ofyourFICOscoreisbasedonthesetwofactors.
FICOscoresconsiderawiderangeofinformationonyourcreditreport,buttheydonottakeinto
accounttheinterestrateschargedonyourloansorcreditcards.Otherfactorsthatdonotaffectyour
FICOscoresincludeyoursalary,occupationandtitle;yourcurrentemployerandemploymenthistory;
andwhereyoulive.Nevertheless,thesefactorsmaybeconsideredbyalenderwhenhe/sheassesses
yourcapacity,capitalandcollateral.
[Usethehyperlinktogotowww.myfico.com.ThisisthewebsitedevelopedbyFairIsaacCorporationto
educateconsumersaboutcreditscores.]
[ClickonEducationtoshowstudentswhatinformationtheycanobtainonthispage.Fromthispage,students
candownloadtheUnderstandingYourFICOScorebrochure(inPDF).] candownloadthe UnderstandingYourFICOScore brochure(inPDF).]
4-13
Aswetalked aboutearlier,usingconsumercredithasacost,andannualpercentagerate(APR)isusedto
measure this cost What is APR? measurethiscost.WhatisAPR?
LenderschargealowerAPRifyouhaveahighFICOscorebecausethegoodFICOscoreindicatesthat
youve managed your finances responsibly For lenders it suggests a lower possibility that you would you vemanagedyourfinancesresponsibly.Forlenders,itsuggestsalowerpossibilitythatyouwould
beunabletofulfillyourfinancialresponsibilityofpayinginterestandrepayingprincipal.Withouta
goodFICOscore,yourchancetogetaloan(suchasanautoloanorahomemortgage)willbeslim.
Evenifyoudofindalenderwhoiswillingtolendyouthemoney,theinterestratewillbehigher,
costingyoumuchmoremoneyovertime.
4-14
SincetheFICOscoreisakeyfactorindeterminingyourabilitytoreceivecreditandalsotheinterest
rate you will be charged you may be wondering what is considered a good FICO score rateyouwillbecharged,youmaybewonderingwhatisconsideredagoodFICOscore.
Unfortunately,nosinglestandardthatisagreeduponbyalllendersexists;therefore,thereisnosingle
definitionofexcellentorgoodcredit.
Asageneralguideline,itissuggestedthataFICOscoreabove770isexcellent;ascorebetween700
and770isgood;andascorebetween650and700isaverage.
IfyourFICOscoreisbelowthemid600s,youmayhavedifficultyobtainingaloan.Butkeepinmind,
eachlendermayhavehis/herowndefinitions/standards.Andtherearelenderswhospecializein
makinghighriskloans(andchargeamuchhigherinterestrate,ofcourse).
Inmid2011,theaverageFICOscoreintheU.S.wasapproximately692;theaverageinCaliforniawas
687.
4-15
Mostexamplesofclosedendcreditareloansthatarerepaidwithequalpaymentsoveraspecified
period of time An auto loan may call for equal monthly payments over 60 months; a student loan periodoftime.Anautoloanmaycallforequalmonthlypaymentsover60months;astudentloan
mayberepaidwithequalmonthlypaymentsover10years;andahomemortgageloanmayrequire
equalmonthlypaymentsover360months.Letsconsideranexample.
Withthistypeofloan,eachmonthlypaymentincludesboththeinterestpaymentandtheprincipal
repayment.Everymonth,theborrowerpaysinterestontheamounthe/sheowes,andaportionof
theprincipalisrepaidsotheamountinitiallyborrowedcanbecompletelypaidoffattheendofthe
loanterm.
[Click to show Item #3 ] [ClicktoshowItem#3.]
How muchisthemonthlypaymentonthisloan?First,giventhe0.40%monthlyinterestrate(4.80%
annualratedividedby12),theborrowerischarged$48ofinteresteverymonth(principaltimes
interestrate,or$12,000x0.004).Second,theprincipalisrepaidover60months,sotherepayment
eachmonthis$200($12,000 60).Whentheresultsarecombined,theborrowerstotalmonthly
paymentbecomes$248.However,thereareproblemsintheanalysis.Astheprincipalamountisbeing
amortized (i.e.beinggraduallyrepaidovertime),theamountowedbytheborrowerdecreases.Given
thesameinterestrateandadecliningprincipalbalance,theinterestchargedontheloanshould
decreaseovertime.Sohowexactly isthemonthlypaymentdetermined?
4-16
[Usespreadsheet06LoanPMTtoshowtheformulaandaskstudentstocomputethemonthlypayment.]
[Clicktoshowthenextthreeitems.]
Withamonthlypaymentof$225.36,thetotalamount theborrowerwillpayoverfiveyearsis
$13,521.6.$12,000ofthatistherepaymentofprincipal,andtherestisinterest.Therefore,the
borrowerwillpayatotalof$1,521.41ininterest.
The table on the next slide show the breakdown of payment each month The interest payments Thetableonthenextslideshowthebreakdownofpaymenteachmonth.Theinterestpayments
rangefrom $48inthefirstmonthtoonly90centsinthelastmonth.
4-17
4-18
YouhaveprobablyseenTVcommercialsbyautomakersthatofferspecialfinancingtocustomers.Ifan
automaker offers 0% APR (annual percentage rate) that means borrowers dont need to pay any automakeroffers0%APR(annualpercentagerate), thatmeansborrowersdon tneedtopayany
interest ontheloan.Onethingyoushouldknow thistypeofspecialfinancing isthatitisnotavailable
toallcustomers.Thekeyisyourcredit.Withoutgoodcredit,youcantqualifyforthelowAPR.
Furthermore,ifyouhavepoorcredit(thedefinitionvariesbylenders),youmaynotevenbeeligiblefor
aloanattheregularinterestrate.DependingontheborrowersFICOscoreandlegallimitsofastate,
interestratesonbadcreditautoloanscouldbedoubleoreventripletheregularrate.
Again letsassumeyouneedtoborrow$12,000withafiveyearloan.Thefollowingtable showshow
muchinterestyouneedtopayoverfiveyearsifyourechargeddifferentinterestrates.
Ifyouare qualifiedfor0%APRfinancing,allyouhavetodoispaybacktheprincipal.Thusthemonthly
paymentis$200($12,000 60).With otherinterestrates,youcancalculatethemonthlypayments
andcomparethetotalinterestchargesoverfiveyears.Clearly,havinggoodcreditmayhelpyousavea
lotofmoney.
4-19
Decidingwhetherornotgoingtocollegeisrightforyouisnotaneasydecision.Manyfactorsneedto
be taken into consideration Furthermore the challenge is not over when you send out applications or betakenintoconsideration.Furthermore,thechallengeisnotoverwhenyousendoutapplicationsor
makethedecisiononwhichschoolyouwillattend.Onceyoubecomeacollegestudent,inadditionto
makingdecisionsdirectlyrelatedtoyoureducation(suchasselectingyourmajorandthecoursesto
takeeachsemester/quarter),youwillhavetomakemanyfinancialdecisionsthatyoumaynothave
encounteredbefore.Oneexampleischoosingfromnumerouscreditcardoffersanddetermininghow
manycardsyoumayneed.Anotherexampleisrentinganapartment.Whilemostcollegestudents
liveindormitoriesduringtheirfreshmanyear(sometimessophomoreyearaswell),manychooseto
liveoffcampuslateron.Suchdecisionshaveimportantimplicationsonyourfinancialhealth,both
immediatelyandinthelongrun,andthereforedeserveyourattentionandcarefulconsideration.
5-1
5-2
Canacollegedegreeguaranteethatyouwillfindawellpayingjob?Doesthelackofcollegeeducation
mean you will never be successful in your life? Of course the answers to both questions are no meanyouwillneverbesuccessfulinyourlife?Ofcoursetheanswerstobothquestionsareno.
Attendingcollegeisalongterminvestmentandnobodycanguaranteethatitwillpayoff.Whether
youwillhaveasuccessfulcareeralsodependsonyourworkethic,theprofessionyouchoose,and
maybealittlebitofluck.Nevertheless,ifyouhaveacollegeeducation,theoddsareinyourfavor.
[Clicktoshowthechart.]
AccordingtotheU.S.DepartmentofEducation,themedianannualsalaryforyoungadults(ages25
34)withahighschooldiplomaisabout$29,000,andthemediansalaryforthosewithabachelors
degreeisabout$45,000.
5-3
Inadditiontothedifferenceinstartingsalaries,theincomegrowthpotentialisalsodifferent. Income
usually grows faster in professions that require higher education Even in the same company an usuallygrowsfaster inprofessionsthatrequirehighereducation.Eveninthesamecompany,an
employeewithbettereducationismorelikelytogetpromotedorreceiveabiggerraise.Asaresult,
theincomegapbetweenthosewithandwithoutacollegedegreeislikelytowidenasyourcareer
progresses.
[Youcanusethespreadsheet02Career Salarytoshowhowmuchthetotalincomemaybedifferent
withorwithoutacollegedegree.Whendoingso,youneedtomakeassumptionsaboutfutureincome
growthrate.]
5-4
Itisevidentthatacollegeeducationcanhelpimproveyourfutureincome.Butwiththeincreasing
cost of higher education you may be wondering whether this investment can really pay off Lets costofhighereducation,youmaybewonderingwhetherthisinvestmentcanreallypayoff.Let s
examinethecostofattendingcollege.TheCollege Boardcategorizescostsofattendingcollegeintoto
fivegroups.
Tuitionandfeesisanobvious one.Howmuchyouneedtopayonthetypeofinstitution(community
collegevs.fouryearuniversity;publicvs.private)andyourresidencestatus.Forfouryearpublic
colleges,instatestudentsonaveragepayabout$8,000ayear,whileoutofstatestudentspaynearly
$20,000.Theaveragetuitionandfeesatprivatecollegesisabout$27,000ayear.Thatisavery
substantialamountoverfouryears.
Youalsoneedtopayforroom&board,books& supplies,transportationandotherpersonalexpenses.
5-5
Whilealloftheseareactualexpensesyou(oryourparents)havetopayforwhileyoureincollege,not
all should be considered in order to compare the benefits and costs of attending college. allshouldbeconsideredinordertocomparethebenefitsandcostsofattendingcollege.
Youshouldfocusontheincrementalcosts.Incrementalcostsarethosedirectlyaffectedbyyour decision.
Thatmeansyouwillincurthecostsifandonlyifyoudecidetoattendcollege.Tuitionisdefinitelyan
incrementalcost,becauseyoudontneedtopayforitifyoudontgotocollege.
Transportationisanexpenseyouwillprobablyincurregardlessofyourdecision.Evenifyoudontgo
ll d k f ll h f h h h l d ll d d k tocollegeandstartworkingfulltimerightafterhighschoolgraduation,youstillneedtodrive,takea
bus,ortakethesubwaytowork.Transportationcostscouldactuallybehigherifyoudontgoto
collegethanifyoudo,especiallyifyouliveonornearcampus.Therefore,itisnotincremental and
shouldnotbeincludedintheanalysis.
Onemoretypeofcostthatshouldbeconsidered isopportunitycost.
[Click to show the next items ] [Clicktoshowthenextitems.]
Opportunitycostisthecostofanactivitymeasuredintermsofthevalueofthebestalternativethatis
notchosen.Thisiswhat youarenotgoingtoreceiveasaresultofyourdecision.Afterhighschool,if
youjointheworkforceandgetpaidthemediansalary,youwillearnabout$29,000eachyear.In
contrast,ifyougotocollegeonafulltimebasis,youwontbeabletoworkfulltimeandtherefore
havetogiveuptheopportunitytoearnnearly$120,000duringthefouryearperiod.Althoughthisis
notacostyouactuallyneedtopayfor,itisanimportantcomponentinthetotalcostsofattending
college. college.
Someofyoumayhavealreadymadeupyourmindregardingwhetherandwhereyoushouldgoto
college.Eventheseanalysescannotchangeyourdecision,youmustunderstand theconceptsof
incrementalandopportunitycostsbecausetheyrepresent veryimportantfinancialdecisionmaking
concepts.
[Herearewebsitesthatprovideadditionalresourcesforstudentsandfamilieslookingforfinancialaid:
www.finaid.org;www.csac.ca.gov]
5-6
[Askstudentswhethertheyhaveacreditcardandhowoftentheyuseit.]
Formostpeople,thefirststepofestablishingacreditrecordistohaveacreditcardaccount.This is
thebeginningofbuildingyourcreditandyouwanttomakesurethatyouareofftoagoodstart.
Whenincollege,youwillprobably receiveoffersthatencourageyoutoapplyfornewcreditcards.
Theyprovideallkindsofincentives:lowAPR,cashrebates,cashadvances andawaiveroftheannual
fee,amongothers.
Whichcreditcardisrightforyou?
Shouldyouapplyforallofthem?
Whatistherightnumberofcardstohave?
5-7
Thereareseveralkeyfactors youshouldconsiderwhenchoosingacreditcard.
[ l k h h f ] [Clicktoshowthefirstitem.]
Thefirstoneistheinterestrate,orannualpercentagerate(APR).AcardwithalowAPRcanhelpyousaveon
interestcharges.However,whenyouseeanincrediblyattractiveoffer,youneedtopayattentiontohowlong
thelowinterestrateisgoodfor.Itispossiblethattheintroductoryrateisonlyavailableforalimitedtime
andtheregularrate(usuallyinthefineprint)mightbehigherthanratesonothercards.
[Clicktoshowtheseconditem.]
Thesecondfactoristhecreditlimit,whichistheamountofmoneythecreditorallowsyoutoborrow.Thislimit
canrangefromafewhundreddollarstotensofthousandsofdollars,dependingonyourcredit.
[Clicktoshowthethird item.]
Feesandpenalties areanotherimportantfactor.Somecreditcardissuerschargeanannualfee,whileothers
dont.Manychargefeesforcertaintransactions,suchascashadvancesandbalancetransfers.Mostissuers
chargeapenaltyifyoupayyourbilllateorspendoverthecreditlimit.If youthinkyoumayusefeatureslike
cashadvancesorbalancetransfer,oryouthinkitslikelythatyoumayreachthecreditlimit,thenitsimportant
thatyoutakethecostintoconsideration.
[Clicktoshowthelastitem.]
Finally,youshouldconsidertheincentives offeredbythecard.Manycardissuershaverewardprogramsto
attractcustomers,fromcashrebatestoairlinemiles.Thesecouldbenicebenefitsiftheyarefreeandyouare
goingtomakethepurchasesanyway.
Whichofthesefeaturesismostimportantdependsonyoursituation.Ifyouexpecttocarryabalance,thenthe
APRiscritical;ontheotherhand,ifplantopaythebillinfulleverymonth,theinterestrateislesscrucial.If
youregoingtouseonecardformostpurchases,itneedstohaveagenerouscreditlimit.Ifitdoesnt,the
possibilityofgoingoverthelimitincreases,andyourerunningtheriskthatyoumighthavetopayafeeand
yourcreditscorewouldbeaffected.Sinceyoullusethiscardoften,agoodrewardprogrammayprovideextra y y g p g y p
benefits.Ifacardwillbeusedmainlyforanemergencysituation,thecreditlimitandincentivesbecomeless
important.
Severalcreditissuersoffercardsdesignedforcollegestudents.Thesecardstypicallyhavelowercredit
requirements,chargenoannualfees,andallowyoutoearncashbackonpurchases.Thecreditlimitis
relativelylowandsomeofthemrequireanadultascosigner.This isagoodwaytostartbuildingyourcredit.
[Usethehyperlink togotowww.federalreserve.govandusetheinteractivetoolstolearnaboutcreditcardoffersand
statement.]
5-8
Keepinmindthatcreditcardshelpyouestablishcreditandprovideconvenience,buttheydonot
increase your spending capacity Having a large number of cards and higher credit limit doesnt mean increaseyourspendingcapacity.Havingalargenumberofcardsandhighercreditlimitdoesn tmean
youcanaffordtobuymorestuff.
[Click toshowfirsttwoitems.]
Soyoushouldkeeponecreditcardforregularpurchasesandpossiblyasecondoneforemergency. Do
notoverspend.Howmuchyoucanaffordtopurchasewithcreditcardsshouldbedeterminedbased
onyourbudget,notthecreditlimitsofthecards.
[Clicktoshowthenextitem.]
Anotherveryimportantthingtorememberisthatyoushouldalwayspaythebillontime.Evenifyou
cannotmakethepaymentinfull,payattheleasttheminimumamountontime.Alatepaymentcould
trigger a much higher interest rate and also affect your credit score adversely triggeramuchhigherinterestrateandalsoaffectyourcreditscoreadversely.
5-9
Onceyoustartusingcredit,itsveryimportantthatyouunderstandhowtomanageyourcredit
accounts and also how to protect them especially against identity theft accountsandalsohowtoprotectthem,especiallyagainstidentitytheft.
[Clicktoshowitems.]
Identitytheftoccurswhenapersonsidentification(includingname,socialsecuritynumberand/oranyaccount
number)isusedortransferredbysomeoneelseforunlawfulactivities.
It i f th f t t i i i th U S F d l B f I ti ti (FBI) ti t th t th ItisoneofthefastestgrowingcrimesintheU.S.FederalBureauofInvestigation(FBI)estimatesthatmorethan
halfamillionAmericansbecomevictimseachyear.
Additionally,identitytheftoftengoesundetectedforalongtime.Abouthalfofthevictimswerenot
awareoftheproblemonemonthaftertheiridentitywasstolen;about10%ofthecrimesremain
unnoticedtwoormoreyearslater.
5-10
Ifithappens,
1) You will have to spend extensive time to close bad accounts and open new ones; 1)Youwillhavetospendextensivetimetoclosebadaccountsandopennewones;
2)You mayneedtospendalotofmoneyandtimetofixcreditrecords;and
3)Youmaybedeniedloansorjobsduetobadcreditcausedbyidentitytheft.
Theconsequencescouldbequiteserious, soitisveryimportantthatyouunderstandhowtoprotect
yourselffrombeingavictimofidentitytheft.
[Use thelinkto towww.bos.frb.org/consumer/identity/video.htmandwatchthevideo.Alsoask
studentstodownloadandreadthePDFbrochureonthesamewebpage.]
5-11
Manyuniversitiesrequirestudentstoliveinadormitoryinthefirstyear(orthefirsttwoyears)inschool.After
that you may choose to live off campus by renting an apartment with roommates This could be an exciting that,youmaychoosetoliveoffcampusbyrentinganapartmentwithroommates.Thiscouldbeanexciting
experiencebecauseitmightbethefirsttimeyouliveonyourownwithoutadultsupervision.However,the
freedomcomeswithadditionalresponsibilities.Choosinganapartmentisasmuchalifestyledecisionasa
financialdecision.Herearesomeofthefactorsyouneedtoconsiderwhenselectinganapartment.
[Click toshowtheArea.]
Thefirstthingtoconsideriswhereyouwanttolive.Anapartmentisatypeofrealestate,andrealestate
professionalsoftensaythethreemostimportantthingsinrealestateare:location,location,location. p y p g , ,
[Askstudentstodiscusswhatlocationfactorsareimportant.Afterthediscussion,clicktoshowthesuggested
factors.Thisisdefinitelynotacompletelist.]
Keepinmindthatyouusuallyhavetopayahigherrentforadditionalfeatures/amenities.Whendetermining
theapartmentyoucanafford,youshouldpaymoreattentiontowhatyouneedthantowhatyouwant.
Forexample,thedistancetoschoolandavailabilityofpublictransportationmayhaveaneffectonyour
commute,intermsofbothtimeandcost;accesstoservices(likestores,restaurantsandrecreationalactivities)
and/orcloseproximitytofriendsmaybeimportantforyou.Acrucialfactorthatyoumusttakeintoaccountis
thesafetyoftheneighborhood.
[ClicktoshowtheBuilding.]
Aftertheareaisdetermined,youneedtoselectanapartmentinthearea.Whatfeaturesofthe
building/communityareimportant?
[Askstudentstodiscusstheimportantbuildingfeatures/amenitiesandthenshowthesuggesteditems.]
Doesthebuildinghaveenoughparkingforresidentsandguests?Doesithaveamenitiessuchassecuredaccess,
aswimmingpoolandexerciseroom?Ifyourunitisnotonthegroundfloor,arethereelevators?
[ClicktoshowtheUnitanddiscussimportantfeaturesofanapartmentunit.]
5-12
Whenyourentanapartment,you willneedtosignaleaseagreement.Whatisalease?
[Clicktoshowthefirstitem.]
Youshouldreviewtheleaseverycarefullysotherearenosurpriseswhensomethinghappenslater.Inaddition
torestrictions/responsibilitiesyouresubjectto,someprovisionsintheleaseagreementmayhavefinancial
implications.
[Clicktoshowthelist.] [ ]
Whenshoppingforanapartmentandcomparingleaseterms,everybodyfocusesontherenteachlandlord
charges.Thisisdefinitelyaveryimportantfactor(ifnotthemostimportantone).Butthereareotherfactors
youneedtoconsideraswell.Forexample,oneapartmentmayofferalowerrentbutchargesyouforitemslike
havingreservedparkingandusingtheclubhouse;atanotherapartment,allthoseareincludedinthemonthly
rent,buttherentishigher.Whichoneisbetter?Itdependsontheextrachargefortheamenitiesandhow
importantthoseamenitiesaretoyou.
Anotherexampleisthe lengthoflease.Supposetherentofanapartmentis$1,200amonthwitha
ninemonthlease;ifyousignaoneyearlease,thelandlordiswillingtolowerthemonthlyrentto
$1,150.Itseemstobeagooddealasyoucansave$600duringthetermofthelease.However,ifyou
arenotgoingtostayintheapartmentduringsummer(forexample,goinghomefortheentire
summer,studyingabroadforacoupleofmonths,ortakinganinternshipinadifferentcity),thethree
additional months you have to pay rent for could end up costing you a lot more money additionalmonthsyouhavetopayrentforcouldendupcostingyoualotmoremoney.
Manypeoplechooseanapartmentbecauseofthefreebiestheycan get.Wouldyoubeenticedtosign
theleaseifthelandlordgivesyouafreeDVDplayer?AbasicmodelofDVDplayercostslessthan
$100,soitsprobablyabetterdealifyoucanget$10offyourmonthlyrentonaoneyearlease.
5-13
Mostapartmentownershaveaninsurancepolicythatprotectsthepropertyagainstaccidentsor
natural disasters If the building is destroyed by fire or damaged by an earthquake the insurance naturaldisasters.Ifthebuildingisdestroyedbyfireordamagedbyanearthquake,theinsurance
companywillhelptheownerrepairorrebuildtheproperty.Theseinsurancepoliciesprotectthe
building,butnotthingsinthebuilding.Ifyourvaluablesaredamagedinanapartmentunit,itis
typicallynotthelandlordsresponsibility,regardlessofthecauseofthedamage.
Toprotectyourpersonalbelongings,youshouldgetrentersinsurance.
[Clicktoshow thedefinition.]
Withthistypeofpolicy,theinsurancecompanywillreplacethingsyouloseduetofire,earthquake,
theftorotherreasons.
5-14
6-1
6-2
InChapter3youlearnedaboutlongtermfinancialplanningandhowthetimevalueofmoneyaffects
the outcome One example discussed in that chapter was retirement Based on an annual deposit theoutcome.Oneexamplediscussedinthatchapterwasretirement.Basedonanannualdeposit,
youcanestimatehowlongitwilltakeforyoutoreachyourretirementgoal;orgivenatarget
retirementage,youcandeterminehowmuchmoneyyoumustsaveeachyearinordertoreachthe
goal.Akeyfactorintheretirementplanningprocessistherateofreturnyouexpecttoearnonyour
investment.
Supposeyouplantosave$2,000eachyearbeforeretirement.Howmuchmoneywillyouhavewhen
youretirein40years?
[Clicktoshowthechart.]
Ifyoukeepthemoneyinabankaccountandearn3%ayear,youwillhaveabout$150,000in40years;
ifthemoneyisinvestedinaninvestmentthatgeneratesa6%returneachyear,youwillhavealmost
$310 000 at retirement; if you invest in a market that produces a return of 8% you will have more than $310,000atretirement;ifyouinvestina marketthatproducesareturnof8%,youwillhavemorethan
$675,000attheend.
Theseexamples illustratethathowmuchmoneyyouwillhaveforretirementdependsontherateof
returnyoucanearn.Whattypeinvestmentprovidesthehighestrateofreturn?Whatisthedownside
ofinvestinginthosewithhigherreturns?Letsdiscussthecharacteristicsofseveralpopular
investmentopportunities.
6-3
Thesimplestwaytogrowyourmoneyistosaveitinabankaccount.InChapter2,youlearnedabout
severaldifferenttypesofaccounts.Savingmoneyinabankissafeandgivesyouflexibility.Most
depositoryinstitutionsareinsuredbytheFederalDepositInsuranceCorporation(FDIC)orsimilar
federalagencies.Therefore,eveniftheinstitutionisinfinancialdifficulty,yoursavings(upto
$250,000)isprotected.Theseaccountsallowyoutowithdrawmoneywhenyouneeditwithnoor
verylowtransactioncost.Theonlyexceptioniscertificatesofdeposit(CDs)althoughinthissituation,
h l l h k f d d d f thetermisrelativelyshort,soyouarenotstuckforanextendedperiodoftime.
Whatisthepriceyouhavetopayforsafetyandflexibility?Therelativelylowrateofreturn.
[Showthechartonnextslide.]
6-4
Thechartshowstheannualreturnsonmoneymarketaccountsfrom1991to2010.Duringthe20
year period the average annual return was 3 30% Although the return fluctuated it was always yearperiod,theaverageannualreturnwas3.30%.Althoughthereturnfluctuated,itwasalways
positive,rangingfrom0.1%to5.7%.
6-5
Thenext typeofinvestmentisbonds.Whatisabond?
Debtmeansaloanisinvolved.
Theissuerofabond(whichistypicallyagovernmentoracompany)borrowsmoneybysellingthebondto
investors. Similartoconsumercredit,theborrower(i.e.theissuer)needstorepayprincipalandpay
interest.
Thelenders(bond investors,aka bondholders)receiveinterestpaymentfromtheissuerperiodically(twicea Thelenders(bond investors,aka bondholders)receiveinterestpaymentfromtheissuerperiodically(twicea
yearformostbonds),andgettheprincipalbackwhenthebondexpires(atthematuritydate).
6-6
6-7
[Clicktoshowitems.]
Whydoesagovernmentissuebonds?Remember inChapter3thatwhen thetaxrevenuecollectedfrom
taxpayersisnotenoughtocovertheexpenditures,thegovernmenthasadeficit.Ifthathappens,the
governmentneedstoborrowmoneyinordertopayforitsexpenditures.Issuingbondsistheprimarymethod
forgovernmentstoraisecapital.
6-8
Becauseabondisadebtsecurity,itispossiblethattheborrowermightdefault.Whenthathappens,
bondholders lose money Similar to the consumer credit markets where creditors assess the riskiness bondholderslosemoney.Similartotheconsumercreditmarketswherecreditorsassesstheriskiness
ofaloanbasedontheborrowerscreditscore,inthebondmarket,investorsmeasurecreditriskusing
abondratingsystem.Severalratingagencies(Moodys,S&PandFitch)examinetheborrowers
financialstrengthandthebondsfeaturestoassignaratingtothebond.
[Clicktoshowthetable.]
Thehigherbondrating(forexample,AAA)indicatesthattheprobabilityofborrowerdefaultisvery
low.Asaresult,theinterestrateonthebondislow.Ontheotherhand,thelowerabondsrating,the
moreriskisinvolvedandconsequently,ahigherinterestrateischarged.
Byregulations,manyfinancialinstitutions(suchasbanksandpensionfunds)areallowedtoinvestin
onlyinvestmentgradebonds.
[Clicktoshowinvestmentgraderatings.]
IfabondsratingisBBorbelow, itisnoninvestmentgrade,oroftencalledajunkbond.
[Clicktoshownoninvestmentgrade.]
Doesthetermjunkbondsuggestthatabondwithnoninvestmentgraderatingisabadinvestment?
Notnecessarily.Whatitmeansisthatthebondissuerismorelikelytodefault.Becausejunkbonds
usuallyhavehigherinterestrates,iftheissuerdoesnotdefault,junkbondinvestorscouldmakevery
goodprofits.
[ClicktoshowDrating.]
IfabondsratingisD,thatmeansitsalreadyindefault.
6-9
Asaninvestment,bondsareconsideredriskierthanbankaccountsbutsaferthanstocks.Duringthe
last 20 years the average annual return on bonds was 7 0% In two of those years bond investors last20years,theaverageannualreturnonbondswas7.0%.Intwoofthoseyears,bondinvestors
earnedmorethan15%,butintwootheryears,theylostmoney.Thechartrevealsthereturnsover
thisperiodoftime.
6-10
Thestockmarketisthemostcommonlyreferredtoinvestmentopportunity.Youprobablyhearabout
it every day on the news But what is a stock? iteverydayonthenews.But whatisastock?
[Click toshowdefinition.]
Astockrepresentsownershipinacorporation.The corporationmayhaveissuedmanyshares,and
eachshareofstockrepresentsaportionoftheownership.Forexample,ABCCorporationhasissued
20,000sharesofstock,andyouown1,000ofthem.Youown5%(1,000 20,000)ofthecompanyand
areentitledto5%ofitsprofits.
6-11
Ifyoubuysharesofstockofacompany(suchasMicrosoft,AT&T,GeneralMotorsandApple),you
receivedividendsperiodically.Forexample,ifAT&T pays$1dividendpershareandyouown300
sharesofthestock,youwillreceive$300fromthecompany.Receivingdividendsisonesourceof
returnonstockinvestment.
6-12
Anothersourceofreturnisthepricechange.
Whenthepriceofastockincreases,stockholdersmakemoney.However,theresnoguaranteethattheprice
ofastockyouownwillalwaysgoup.Themarketvalueofthestockfluctuateduetofactorssuchaseconomic
conditions,companyprofitability,etc.
[ClicktoshowItem#2.] [ ]
6-13
Itspossiblethatinvestorsmaylosemoneyduetodecliningstockprice.When thathappens,theinvestorsrate
of return becomes negative ofreturnbecomesnegative.
6-14
This chartshowsthatfrom1991to2010,theaverageannualreturnonastockinvestment(which
includes both dividends and price changes) was about 11 0% In three of those years the return was includesbothdividendsandpricechanges)wasabout11.0%.Inthreeofthoseyears,thereturnwas
above30%.Whilethelongtermaveragereturnisquiteappealing,theresnoguaranteethatyouare
goingearnthesamereturneveryyear.Infact,infourofthe20years,investorsinthestockmarket
sufferedlosses,ashighas37%(in2008).
Theresults indicatethatstockinvestmentonaverageprovidedahighestreturnthanmoneymarketandbonds.
However,italsohadthehighestrisk.
6-15
Peopletalkaboutthestockmarketallthetime.Whatexactlyisthestockmarket?Itisnotaneasy
question to answer A market is usually defined as the place where goods or services are traded such questiontoanswer.Amarketisusuallydefinedastheplacewheregoodsorservicesaretraded,such
asasupermarketorafarmersmarket.Basedonthisdefinition,astockmarketisaplacewherestocks
aretraded.
Becausetherearemanywaysstockscanbetraded,therearedifferenttypesofstockmarkets.
[ClicktoshowNYSE.]
Forexample,theNewYorkStockExchange(NYSE)hasaphysicallocationwheretraderscommunicate
witheachotherandmake transactions.Itistheoldestandlargeststockexchange intheU.S.Visitors
usedtobeabletotourtheNewYorkStockExchangeandobservethetradingactivities,buttourhas
been suspended (after 911) due to security concerns beensuspended(after911)duetosecurityconcerns.
[Usethehyperlinktoshowayoutube videoofNYSE.]
[ClicktoshowNASDAQ.]
Incontrast,NASDAQisatelecommunicationnetworkthatconnectsbuyersandsellersthrough
computerstoexecutetransactions electronically.TheNASDAQMarketSite at TimesSquareinNYCis
nottheactuallocationwheretradesareexecuted.This isatotallydifferenttypeofstockmarket.
6-16
Becausetherearethousandsofstocksbeingtradedonaregularbasis,itisdifficulttoassessthe
general performance of the stock market when the prices of some stock increase and those of others generalperformanceofthestockmarketwhenthepricesofsomestockincreaseandthoseofothers
decrease.Stockmarketindexeswerethereforecreatedtomeasuretheoverallstockmarket
performance.
Whatareexamplesofstockindexes?
[Click toshowotheritems.]
ThemostrecognizedstockmarketindexintheU.S.istheDowJonesIndustrialAverage,orDowJones.
OtherfamousindexesincludetheS&P500andNASDAQ.
Dow Jones Industrial Average is a stock index that is based on the prices of 30 large companies It is DowJonesIndustrialAverageisastockindexthatisbasedonthepricesof30largecompanies.Itis
theoldestandmostquotedstockmarketindicator.Itwasfoundedin1896.Among thecurrent
components,GeneralElectricistheoldest(addedin1907)andCiscoisthenewest(addedin2009).
NASDAQisastockindexthatisbasedonthepricesofallstockstradedontheNASDAQstock
exchange. Itcurrentlycoversmorethan3,000stocks.
S&P500isastockindexthatisbasedonthepricesof500largecorporations.Itwaspublished in
1957.
6-17
Nowletsconsiderrealestateasaninvestment.Whatisrealestate?
[Clicktoshowdefinition.]
Realestateisdefinedaslandandimprovements(suchasbuildings,infrastructure,landscaping,etc.)
attachedtotheland.Itincludeshousesinthesuburbs,apartmentsandhighrisecondominiumsin
downtown,officebuildings,shoppingcenters,parks,factories,churches,themeparks,andeven
cemeteries. Yourschoolisalsoan exampleofrealestate.
Therearemanydifferentwaystocategorizerealestate. Onecommonlyusedclassificationis
residentialvs.commercialrealestate.
[Clicktoshowdifferenttypesofrealestate.]
Examples of residential real estate include singlefamily detached homes townhomes and Examplesofresidentialrealestateincludesingle familydetachedhomes,townhomesand
condominiums.
Examplesofcommercialrealestateincludeofficebuildings,retailshoppingcenters,hotels/motels,
selfstoragefacilities,etc.
6-18
For mostAmericans,thepurchaseoftheirhomeisthesinglebiggestinvestmentintheirlives.Ifthe
valueofyourhomeincreases,youmake aprofit. However,ifthevaluegoesdown,youlosemoney.
Housingpricescouldfluctuatewidelyattimes,makingthisariskyinvestmentintheshortterm.
Additionally,transactioncostsonrealestatearethehighestamongpopularinvestmentvehicles.We
willdiscussthehomebuyingdecisioninmoredetailinthenextchapter.
Youcanalsoinvestincommercialrealestate. Ownersofthesebuildingsleasethespacetotenants
(includingbusinessesinanofficebuilding,retailstoresinashoppingcenter,residentsinanapartment,
andguestsinahotel)andcollectrents.Iftherevenueisgreaterthanthecostsofoperatingthe
property,theownercanmakeaprofit.Overtime,realestatevaluetendstoincreasesotheowner
may earn a capital gain when selling the investment Because commercial real estate is generally mayearnacapitalgainwhensellingtheinvestment.Becausecommercialrealestateisgenerally
muchmoreexpensivethansinglefamilyhomes,itrequiresspecialexpertisetomanagecommercial
buildings.Itisnotatypicalinvestmentalternativeforindividualsandfamilies.
6-19
Thischartshowstheaverage annualrateofreturnoncommercialrealestateinvestment,nothomes.
Generally speaking it is an investment with high risk and high reward The average return over the last Generallyspeaking,itisaninvestmentwithhighriskandhighreward.Theaveragereturnoverthelast
20yearswas13.6%,higherthanothertypesofinvestmentwehavediscussed.Thetradeoff,however,
isthevolatility.Thechartclearlyshowsthatreturnoncommercialrealestateisveryunpredictable.
6-20
Financialadvisorsusuallyrecommendtheirclientstohaveadiversifiedportfolio,whichmeans
investing in a broad range of assets However some investments are very expensive making it difficult investinginabroadrangeofassets.However,someinvestmentsareveryexpensive,makingitdifficult
forindividualswithlimitedfinancialresourcestodiversify.Whatshouldyoudoifyoudonthavealot
ofmoney?Insteadofinvestinginstocks,bondsorrealestatedirectly,youcanbuymutualfunds.
Withamutualfund,moneyfrommanyinvestorsispooledtogetherandinvested.Astockmutualfund
buysalargenumberofstocks;abondmutualfundinvestsinvarioustypesofbonds;ahybridfund
splitstheinvestmentinbothstocksandbonds.Therearealsomutualfundswithotherspecializations.
Whatarethebenefits ofinvestinginmutualfunds?
[Clicktoshowitems.]
Oneof thebenefitsisthelowminimuminvestmentrequirement.Evenifyoudonthavealotof
money,youcanstartinvestingtogeneratereturnforyourlongtermfinancialgoals.Throughmutual
funds,youcanalsoinvestinavarietyofinvestmentsyouotherwisewontbeabletobuy.Thiscreate
diversificationbenefits.
Anotherbenefitmutualfundsprovidetosmallinvestorsisprofessionalmanagement.Welleducated
andexperiencedinvestmentexpertsarehiredbymutualfundstomanagethemoneyandmake
decisionsforyou.Toreceivetheservices,youneedtopayafeetothemutualfundcompany.
6-21
After learningaboutseveraldifferenttypesofinvestments,youmaybewonderingwhichoneisthe
best best.
Theanswerdependsonyourpersonalpreferenceandthestageofyourlifecycle.
[Clicktoshowotheritems.]
Thelifecycleofinvestingcoversfourstages:accumulation,consolidation,spendingandgifting.When
youareyoung,youcanfocusonaccumulatingwealthbyinvestingininvestmentswithhighreturns.
Becausetheresalongtimebeforeyoureachretirement,temporaryvolatilitywillnotaffectyouas
much.During thisstage,youcanallocatemoremoneyintohighreturninvestments.
Asyougrowolder,thetimetoretirementshortens.Preservationofwhatyouhaveaccumulated
becomesmoreimportant.Duringtheconsolidationstageyoushouldshifttoalowerriskportfolio.
Onceyouretire,youenterthespendingstageasyourincomewillnotbesufficienttocoverallthe
expenses.Duringthisstage,youemphasize theimportanceofstability.
Lateroninthelifecycle,ifyouhavemanagedyourfinancesresponsiblyandmadesmartinvestment
decisions,itspossiblethatyouwillhavemoresavingsthanneededforexpensesduringyour
remaininglife.Consequently,youmaywanttodonatemoneytocharitableorganizations.
6-22
[Click toshowItems1and2.]
Thetwotypesoftaxespeoplearemostfamiliarwithareincometax andsalestax.Whenyouearn
wagesorsalaries,youneedtogiveaportionofyourincometothefederalandstategovernments.
Thepercentagedependsonyourincomelevel.Usuallythehigheryourincome,themoretaxesyou
pay.Whenyoumakeapurchase(includinggroceriesatasupermarket,foodatarestaurant,booksata
bookstore,ormovieticketsatatheater),youneedtopayacertainpercentofthepurchasepriceto
thestategovernment(sometimesalsothelocalgovernment)assalestax.
Homeownersneedtopaytaxesbasedonthevalueofthepropertytheyown.Thisiscalledproperty
tax.Ifyouowncommercialrealestate,youalsoneedtopaypropertytaxontheinvestment.
[Click to show Item #4 ] [ClicktoshowItem #4.]
Ifyoumayearnacapitalgainwhensellinganinvestment(meaningthesalespriceyoureceiveis
greaterthanthepurchasepriceyoupaidinitially). Thisgainissubjecttocapitalgainstax.
6-23
Therateofreturnonyourinvestmentsisaffectedbytaxation.
[[ClicktoshowItems #1and2.]
Ifyouneedtopaypartofyourinvestmentprofittothegovernment,thenthereturnprovidedbythe
investment(thatis,thebeforetaxreturn)willbedifferentfromthereturnyouactuallyreceiveafter
payingtaxes(thatis,theaftertaxreturn).
Becauseoftaxation,whatyouactuallyreceiveislessthanwhattheinvestmentprovides. Eitheryou
havetosavemoremoneyperiodicallyoritwilltakelongertoreachthesamelongtermfinancialgoal.
Otherwise,youwillendupwithlessmoneyatthetimetomakeamajorpurchaseorretire. Therefore,
theaftertaxreturnshouldbeusedinyourlongtermplanning.
[Clicktoshowtheformula.]
Thisformulashowstherelationshipbetweenbefore andaftertaxreturns.Supposeyouaresubject
toa20%incometaxrate(includingfederalandstate)andyourinvestmentearns10%intheyear.
Afterpayingincometaxes,youractualreturnisonly8%.
AfterTaxReturn=BeforeTaxReturn (1 TaxRate) =10% (1 20%) =10% 80% =8%
6-24
7-1
7-2
FormostAmericans,buyingahouseisthemostexpensive(andarguablythemostimportant)
purchase in their lifetime How expensive is a house? The answer to this question really depends on purchaseintheirlifetime.Howexpensive isahouse?Theanswertothis questionreallydependson
thehouse.Whichofthesehousesareyoutalkingabout?
[Clicktoshowthreepictures.]
Whenmeasuringgeneralhousingcost,peopleusuallyusethemedianhomepriceasanindicator.This
isthemidpointofanorderedarrayofactualtransactionpricesofhomes.
7-3
AccordingtotheNationalAssociationofRealtors,themedianpriceofexistingsinglefamilyhomesin
the U S reached the all time high in 2006 at $221 900 Impacted by the Great Recession the median theU.S.reachedthealltimehighin2006, at $221,900.ImpactedbytheGreatRecession,themedian
priceretractedto$173,100in2010.Asof2Q 2011,itwas$171,900.
Evenatthispricelevel,itisdifficultforanaveragehouseholdtosaveenoughmoneyforthepurchase
ofahomewithoutusinganykindofcredit.
7-4
Housingpricesvaryconsiderablyacrossthecountry.InCalifornia,forexample,housingismuchmore
expensive than in the rest of the country Even within the state the median price of homes are expensivethanintherestofthecountry.Evenwithinthestate,themedianpriceofhomesare
differentdramaticallyfromonemetropolitanareatoanother.Thischartcompareshomepricesatthe
peakin2006infourmarketswiththosein2010.ThemedianpriceinSanFranciscowasabove
$750,000in2006andhaddecreasedbyabout30%infouryears.Incontrast,housinginSacramento
costapproximatelyhalfofthatinSanFranciscoin2006;aftera50%drop,itwasonlyathirdofthe
priceinSanFranciscoin2010.
2006 2010
LosAngeles 584,800 316,700
Sacramento 374,500 183,600
SanDiego 601,800 385,200
SanFrancisco752,800 525,300
7-5
[Clicktoshowdirectcosts.]
Whenanswering thisquestion,anobviousfactoryoushouldconsideristhecostofrentingvs.owningyour
residence.Becausehousesaresoexpensive,mosthomebuyersneedtoborrowaloantopayforthepurchase
price.(Mortgageswillbediscussedlaterinthischapter.)Whenyouborrowamortgage,youmakemonthly
mortgagepayment.Thisisacostofhomeownership.Youneedtoconsiderthedifferencebetweenthe
mortgagepaymentandtherentpayment.
In addition to monthly mortgage payments, homeowners need to pay for housing expenses such as real Inadditionto monthlymortgagepayments,homeownersneedtopayforhousingexpensessuchasreal
estatetaxes,hazardinsurance(differentfromrentersinsurance),maintenanceandrepairs,etc.These
aredirect,outofpocket costs.
[Clicktoshowothercosts.]
Oneoftheindirectcostisreducedmobility.Rentersusuallysignashortterm(sixtotwelvemonth)
l it t l t h d i d If t t t t t th t lease,soitseasytorelocatewhendesired.Ifyouwanttomovetoanewapartmentasthecurrent
leaseexpires,theonlycostismovingyourpersonalbelongings.Ifyouownahouse,ontheother
hand,thecostofswitchingtoanewhomecouldbeexpensive.Youneedtopaycommissionstoareal
estateagentwhohelpsyousellthehouseandalsofeestogetaloanforthepurchaseofthenew
home.Thetotalcouldexceedthousandsofdollars.
Additionally,theinitialcostforahomepurchasecouldbequitesubstantial.Thedownpayment(i.e. y, p q p y (
theportionofthepurchasepricethatispaidforwiththehomebuyersownmoney)andotherclosingcosts
couldadduptotensofthousandsofdollars.Ifyourentahouse,themoneycanbesavedorinvested
andthusgenerateareturnforyou.Thisshouldbeconsideredanopportunitycost,eventhoughitis
notanoutofpocketexpense.
7-6
Therearesomefinancialbenefitsofowningahome.
[Clicktoshow theitems.]
AsdiscussedinChapter4,eachpaymentofamortgageconsistsofinterestpaymentandprincipal
repayment.TheU.S.taxcodeallowsmortgageborrowerstodeductinterestpaymentsfromtheir
income.Each dollarofinterestyoupayreducestheincomeyouhavetopaytaxonbyonedollar.If
yourentahouse/anapartment,therentyoupayisnottaxdeductible.Sohomeownershipmay
providetaxsavings.
Theprincipalrepaymenteverymonthrepresentsmoneythatbelongstoyou,notthelender.By
repayingaportionoftheprincipaleachmonth,youaccumulateequityinyourhomeandwillbeable
togetthemoneybackwhenthehouseissold.Whenyoupayrent,youwontbeabletogetanyofit
back.
If thevalueofhomeincreases,theentireappreciationbelongstoyou.Themoneyyouoweonthe
loandoesnotincreasewiththeincreasinghomevalue.Supposeyoubuya$200Khomeandhave
$20Ksavingsfordownpayment.Themortgageis$180K.Ifthevalueofthehouseincreasesto$220K
(a10%appreciation),yourequity(whichisthevalueofthehomeminustheloanyouowed)willjump
from$20Kto$40Kbecausewhatyouowetothelenderdoesnotchangewiththevalueofthehome.
Thisisasubstantialrateofreturn.
Youshouldkeepinmindthatthisbenefitisnotguaranteedbecausehousingvalueisunpredictable.If
thevalueofyourhomedeclinesby10%(to$180K),youloseallyourdownpayment.
7-7
Arealestateagentmayshowyouhomesonthemarketthatmeetyourneeds;representyouin
negotiationswiththeseller;andassistyouinobtainingfinancingforthepurchase.Beforeselectingan
agent,youmustdoyourhomework.Interviewseveralrealestateagentstofindouttheirlevelof
experienceintheareayouwishtobuy.Youwanttomakesurethepersonyouhireisproperly
licensedandtherearenodisciplinaryactionsorcomplaintsfiledagainsthim/her.Youmayalsowant
toconsiderwhetheryouwillenjoyworkingwiththepersonoveranextendedperiodoftime.
Amortgageprofessionalmayalsoplayacriticalroleinyourhomebuyingexperience.Forthemajority
ofresidentialmortgages,borrowersworkwithmortgagebrokerstoobtainthefinancing,insteadof
workingdirectlywithlenders.Typically,mortgagebrokerstakealoanapplication,orderverifications,
process and review credit and prepare loan documents for the lender Since they are familiar with the processandreviewcredit,andprepareloandocumentsforthelender.Sincetheyarefamiliarwiththe
marketconditionsandunderstandtheprosandconsofvarioustypesofmortgages,findingamortgage
brokerwhocanadviseyouonchoosingtherighttypeofmortgageisimportant.
[Usethehyperlink toshowstudentstheguideforfirsttimehomebuyers.Thisdocumentisavailable
intheAppendicessection.]
7-8
Aswetalkedabout earlier,mosthomebuyerscannotaffordtobuyahousewithcash.Theyhavesomeoftheir
own money but need to borrow the majority of the purchase price The portion of the purchase price that is ownmoney,butneedtoborrowthemajorityofthepurchaseprice.Theportionofthepurchasepricethatis
paidforwiththehomebuyersownmoneyiscalleddownpayment.
Ifyouwanttobuya$100Khomeandhavesaved$15K,youpay15%downandborrow85%(or$85K).
Homebuyersborrowmortgagestofinancethepurchase.
Amortgageisaloanthatusesrealestateascollateralfortherepaymentoftheloan.Iftheborrower,for
whateverreasons,failstomakescheduledmortgagepayments,thelenderhaslegalrightstosellthehouseand
usetheproceedstorecoverhis/herinvestment(i.e.theloan).
7-9
Differentcriteriaareusedtoclassify mortgages,includinginterestrate,termtomaturityand
amortization. amortization.
[Clicktoshowinterestrate.]
Iftheinterestrateonamortgageremainsunchangedduringthelife oftheloan,itiscalledafixedrate
mortgage(FRM);ontheotherhand,iftheinterestratechangesperiodically,itiscalledanadjustable
ratemortgage(ARM).SomeloanscombinethefeaturesofaFRMandanARM,withitsinterestrate
fixedoveranextendedperiodoftimeandthenadjustedthereafter.A7/1ARMmayhaveatermto
maturityof30years,buttheinterestrateisfixedforthefirstsevenyearsandthenadjustedannually
duringtheremaining23years.
[Adjustableratemortgagesaremuchmorecomplicated thanfixedratemortgages.Ifyouwantto
haveamoredetaileddiscussionofARMsandalsopaymentoptionARMs,refertotheConsumer
HandbookonARMspublishedbytheFederalReserve(availableintheAppendices).OptionARMis
thetypeofmortgagethatgotalotofhomeownersintotroubleinthishousingdownturn.]
A th l ifi ti i b d t t t t it Anotherclassificationisbasedonmortgagestermtomaturity.
[Click toshownextgroup.]
Themajorityofmortgageshaveatermtomaturityof30years,whichmeanstheloanwillberepaid
over30years.Thereareotherlengthsofmortgageterms,including15,20and40years.Thereare30
yearFRMs,30year ARMs,15yearFRMs,15yearARMs,etc.
[Click to show amortization ] [Clicktoshowamortization.]
Whiletheprincipalofmostmortgagesisrepaidovertime(throughamortization),someloansrequire
theborrowertopayinteresteachmonthwithoutrepayingaportionoftheprincipal.Sinceeach
monthlypaymentconsistsofonlyinterestpayment,theyarecalledinterestonlyloans.Ifyouonlypay
interesteachmonth,theprincipalbalanceofyour mortgagedoesnotchange.Asaresult,youcant
buildequitythroughmonthlypayments(oneofthefinancialbenefitsofhomeownershipdiscussed
earlier).
7-10
Mortgagesareatypeofclosedendcredit,sotheyaresimilartothosediscussedinChapter(autoloans).With
anamortizationloan(notaninterestonlyloan),eachmonthlypaymentincludesinterestandprincipal.
Recallthattheformulausedtocalculatethemonthlypaymentofanautoloan(PMT)includesPV,nandi.So
[Clicktoshowtheremainingitems.]
Holdingeverythingelseconstant:
1)Themoremoneyborrowed,thehigherthemonthlypayment.
2) Thehighertheinterestrate,thehigherthemonthlypayment.
3)Thelongerthetermtomaturity,thelowerthe monthlypayment.Thisisbecausethesameprincipalamount
isrepaidoveralongerperiodoftime.Asaresult,theprincipalrepaymentamounteachmonthislower.
[Usespreadsheet06LoanPMTtoshowhowthemonthlypaymentisaffectedbythesethreefactors.]
7-11
Tocalculatemonthlypayment,theinputsintotheformulaneedtobeonmonthlybasis.PV=200,000,i =0.005
(6% 12 = 0 5%) and n = 360 (number of months) (6% 12=0.5%)andn=360(numberofmonths).
AswediscussedinChapter4,thebreakdownofmonthlypaymentchangesovertime.
[Clicktoshowitems.]
7-12
Whatare theimplicationsofthischange?
Becauseonlythe interestportionofamortgagepaymentistaxdeductible,intheearlyyearsofthe
mortgageterm,themajorityofthemortgagepaymentistaxdeductible.Overtime,thetax
deductibilitydeclines.
Ontheotherhand,principalrepaymentrepresentsmoneythatbelongstoyou.Soinlateryears,you
canaccumulateequityinyourhomefaster.
7-13
Supposeyouneedtoborrow$320,000forthepurchaseofa$400,000homeandhavedecidedtouse
a 30 year fixed rate mortgage What is the interest rate on such a loan? The screenshot shows the a30year,fixedratemortgage.Whatistheinterestrateonsuchaloan?Thescreenshotshowsthe
ratesofferedbyonelargemortgagelender.
Forthesametypeofloan,thelenderoffersseveral differentchoices,eachofwhichhasadifferent
interestrate.Holdingeverythingelsethesame,youshouldchoosetheonewiththelowestinterest
rate.However,everythingelseisnotthesame.Everychoiceinthetablehasdiscountpoints,which
isanupfrontfeeborrowerspaytothelenderinordertogetthespecificinterestrate.Eachdiscount
pointisonepercentoftheloanamount.Forexample,inordertogetthelowestinterestrate
(3.750%),youneedtopay3.40%oftheamountyouwanttoborrowasanonrefundablefee,thatis
$320,000x0.034=$10,880.Ifyouprefertominimizetheupfrontexpenses,youcanchoosetheone
withonly0.15points(or$480),butyouwillhavetopayanannualinterestrateof4.375%.
[Theimageishyperlinked.Youcanclick ontheimagetogotowww.gmacmortgage.com.Inthe
Custom Rate Quote section enter the information and click on check rates ] CustomRateQuote section,entertheinformationandclickon checkrates. ]
7-14
Both interestrateanddiscountpointsrepresentcostofborrowingmoney(althoughoneispaidover
time and the other at the beginning ) There are many other fees mortgage lenders may charge when timeandtheotheratthebeginning.)Therearemanyotherfeesmortgagelendersmaychargewhen
makingaloan:applicationfee,underwritingfee,originationfee,processingfee,administrationfee,
brokeragefee,etc.Itsnoteasyforaborrowertofigureoutwhichoftheoptionsofferedbyalenderis
thebest;itsevenmoredifficulttocomparetheoffersfromdifferentlenders.Tohelpconsumersshop
forthebestalternative,thelawsrequirelendersofconsumercredittodisclosetheannualpercentage
rate(APR).
[ClicktoshowAPR.]
APRincludestheinterestrate,thediscountpoints,andalso otherlenderfees.Whencomparing
mortgagealternatives,youshouldcomparetheirAPRs,nottheinterestrates.
7-15
P
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01RateofReturn.xlsx
Howprofitableisyourinvestment?
ValueofInvestmentNow: $22
ValueofInvestmentatTimeofPurchase: $20
RateofReturn: 10.00%
Therateofreturnonyourinvestmentis10.00%.
Calculatetherateofreturnonyourinvestmentusingthefollowingequation:
DOTHEMATH
Rateofreturnisaveryimportantmeasureoftheprofitabilityofaninvestmentopportunity.It
iscalculatedastheratioofhowmuchyouearnontheinvestmenttohowmuchyoupayforthe
investment.Mathematically,therateofreturncanbecomputedbasedonaninvestments
valuenowanditsvalueattimeofpurchase:
Rotc o rcturn = _
]
Calculatetherateofreturnonthefollowinginvestmentopportunities:
Youpaid$20forastockanditisworth$22now.
Aninvestorboughtabondfor$980anditsvaluehasincreasedto$1,035.
Jasonpurchasedahousefor$300,000,andthehouseisnowworth$314,580.
Question1
Rotc o rcturn = _
]
= _
22 -2u
2u
] = 1. %
Question2
RateofReturn=5.61%
Question3
RateofReturn=4.86%
TheseproblemscanalsobesolvedwithExcelspreadsheet01RateofReturn.xlsx.

02CareerSalary.xlsx
Howmuchareyougoingtoearninyourcareer?
StartingAge: 22
RetirementAge: 65
StartingSalary: $45,000 peryear
AnnualSalaryGrowth: 0%
TotalSalaryinCareer: $1,935,000
YearbyYearBreakdown:
Age Salary Cumulative
23 45,000 45,000
24 45,000 90,000
25 45,000 135,000
26 45,000 180,000
27 45,000 225,000
28 45,000 270,000
29 45,000 315,000
30 45,000 360,000
31 45,000 405,000
32 45,000 450,000
33 45,000 495,000
34 45,000 540,000
35 45,000 585,000
36 45,000 630,000
37 45,000 675,000
38 45,000 720,000
39 45,000 765,000
40 45,000 810,000
41 45,000 855,000
42 45,000 900,000
43 45,000 945,000
44 45,000 990,000
Overthecourseofyourcareer,youwillearnthetotal
amountof$1,935,000.
03AnnualPercentageYield.xlsx
Whatisthetruereturnonyourbankaccount?
i:annualinterestrateonthebankaccount
m:compoundingfrequency,i.e.numberoftimesinterestiscalculatedinayear
i/m:periodicinterest,i.e.interestrareforeachcompoundingperiod
InteretRate: 10.00%
AnnualPercentageYieldwith:
AnnualCompounding: 10.00%
QuarterlyCompounding: 10.38%
MonthlyCompounding: 10.47%
DailyCompounding: 10.52%
Annualpercentageyield(APY)takesintoaccountboththeinterest
rateontheaccountandthenumberoftimesinterestiscalcualtedina
year.TheformulaforAPYis:
DOTHEMATH
Howisannualpercentageyield(APY)determined?Ifyouknowtheannualinterestrate(i)and
thecompoundingfrequency(m),theAPYcanbecalculatedwiththisformula:
AP = _1 +
i
m
]
m
-1
Nowcomparethefollowingthreealternatives.WhichonehasthehighestAPY?
Anaccountwitha10.50%interestrateandannualcompounding
Anaccountwitha10.25%interestrateandmonthlycompounding
Anaccountwitha10.00%interestrateanddailycompounding
Question1
AP = _1 +
i
m
]
m
-1 = _1 +
u.1uSu
1
]
1
-1 = 1. 5%
Question2
AP = _1 +
i
m
]
m
-1 = _1 +
u.1u2S
12
]
12
-1 = 1. 75%
Question3
AP = _1 +
i
m
]
m
-1 = _1 +
u.1uuu
S6S
]
365
-1 = 1. 52%
TheseproblemscanalsobesolvedwithExcelspreadsheet03AnnualPercentage
Yield.xlsx.

04MonthlyBudget.xlsx
MonthlyBudget
Income
Wages 320
Allowance 0
Interest
Others 70
Others
TotalIncome 390
Expenses
Education
Housing
Food 120
Transportation 75
Entertainment 70
Personal 0
Debt
Charity
Others 30
Others
Others
TotalExpenses 295
Contingency(9%) 9 35
Savings 50
Surplus/Deficit 10
*Contingencyisapercentageoftotalincome.
05TVM.xlsx
FV
FV:theamountofmoneyyouwillhave
PV:theamountofmoneyyoucurrentlyhave
i:theannualinterestrateonthebankaccount
n:thenumberofyearsmoneyissavedintheaccount
AmountDeposited(PV ): $100
NumberofYears(n ): 3
AnnualInterestRate(i ): 4.00%
MoneyYouWillHavein3years: $112.49
Howmuchmoneywillyouhave?
Usetheformulabelowtofindouthowmuchmoneyyouwill
haveinthefutureifyoumakeasingledeposittoday.
DOTHEMATH
Howmuchmoneywillyouhavein10yearsifyoudeposit$420inanaccountearninga3.2%
interestrate?
Howmuchwill$1becomein50yearsifitiscompoundedat10%annually?
Youjustdeposited$200ata6%interestrate.Howmuchinterestwillyouearnoverthree
years?
Question1
FI
n
= PI (1 +i)
n
= 42u (1 +u.uS2)
10
= 575. 5
Question2
FI
n
= PI (1 +i)
n
= 1 (1 +u.1u)
50
= 117. 39
Question3
FI
n
= PI (1 +i)
n
= 2uu (1 +u.u6u)
3
= 238. 2
The interest you earn during the threeyear period is the FV minus what
youdeposited,i.e.$238.20$200=$38.20.
TheseproblemscanalsobesolvedwithtabFVofExcelspreadsheet05TVM.xlsx.

05TVM.xlsx
PV
PV:theamountofmoneyyouneedtodepositnow
FV:theamountofmoneyyouwishtohaveinthefuture
YourFutureFinancialGoal(FV ): $200
MoneyYouNeedtoDeposit: $156.71
Howmuchmoneydoyouneedtodeposit?
Usetheformulabelowtofindouthowmuchmoneyyouneedtodeposit
nowinordertoreachafinancialgoalinthefuture.
DOTHEMATH
Howmuchdoyouneedtodepositintoanaccountwitha7%interestrateinorderto
accumulate$1,000infiveyears?
Givenanannualinterestrateof6%,whatisthepresentvalueof$30,000in25years?
Question1
PI =
FI
n
(1 +i)
n
=
1,uuu
(1 +u.u7)
5
= 712. 99
Question2
PI =
FI
n
(1 +i)
n
=
Su,uuu
(1 +u.u6)
25
= , 989. 9
TheseproblemscanalsobesolvedwithtabPVofExcelspreadsheet05TVM.xlsx.

05TVM.xlsx
FV(2)
FV:theamountofmoneyyouwillhave
PMT:theamountofsavingeveryyear
AnnualSaving(PMT ): $500
MoneyYouWillHavein20years: $13,435.19
Howmuchmoneywillyouhave?
Usetheformulabelowtofindouthowmuchmoneyyouwill
haveifyousaveaconstantamounteveryyear.
DOTHEMATH
Usetheequationabovetosolvethesetwoproblemsandcompareyourresultswiththe
examplesdiscussedatthebeginningofthissection.
Youplantosave$500ayear.Iftheinterestrateonyoursavingsaccountis3%,howmuch
moneywillyouhavein20years?
Howmuchdoyouneedtosaveeachyearintoanaccountwitha3%interestrateinorderto
accumulate$1millionin40years?
Question1
FI
n
= PHI
(1 +i)
n
-1
i
= Suu
(1 +u.uS)
20
-1
u.uS
= 13, 435. 19
ThisproblemcanalsobesolvedwithtabFV(2)ofExcelspreadsheet05TVM.xlsx.
Question2
PHI =
FI
n
(1 +i)
n
-1
i
=
1,uuu,uuu
(1 +u.uS)
40
-1
u.uS
= 13, 22. 38
ThisproblemcanalsobesolvedwithtabFV(3)ofExcelspreadsheet05TVM.xlsx.
05TVM.xlsx
FV(3)
PMT:theamountofmoneyyouneedtosaveeachyear
FV:theamountofmoneyyouwishtohaveinthefuture
YourFutureFinancialGoal(FV ): $1,000,000
MoneyYouNeedtoSaveEachYear: $13,262.38
Howmuchmoneydoyouneedtosaveeachyear?
Usetheformulabelowtofindouthowmuchmoneyyouneedtosaveeachyearin
ordertoreachafinancialgoalinthefuture.
06LoanPMT.xlsx
PV:theamountborrowed
PMT:themonthlypayment
i:the monthly interestrate
n:thenumberof months torepaytheloan
LoanAmount(PV ): $320,000
NumberofYears: 30 years
NumberofMonths(n ): 360 months
AnnualInterestRate: 3.75% /year
Monthly Interest Rate (i ): 0.31% /month
Mostexamplesofclosedendcredit(suchasautoloans,studentloansandmortgage
loans)arerepaidwithequalmonthlypayment.Theamountborrowedshouldbe
equaltothepresentvalueofmonthlypayments.Thefollowingformulacanbeused
tofindthemonthlyloanpayment:
PaymentofClosedEndCredit
MonthlyInterestRate(i ): 0.31% /month
MonthlyLoanPayment(PMT ):
$1,481.97
BreakdownofMonthlyPayment
InterestPayment
Principal
Repayment LoanBalance
1 1 $1,000.00 $481.97 $319,518.03
2 2 $998.49 $483.48 $319,034.55
3 3 $996.98 $484.99 $318,549.57
4 4 $995.47 $486.50 $318,063.06
5 5 $993.95 $488.02 $317,575.04
6 6 $992.42 $489.55 $317,085.49
7 7 $990.89 $491.08 $316,594.42
8 8 $989.36 $492.61 $316,101.80
9 9 $987.82 $494.15 $315,607.65
P
P
A
A
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5
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AP PP PE EN ND DI IC CE ES S

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