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04-161 Web Chapter pp2

  1. 1. © MARK SCOTT / TAXI / GETTY IMAGES Web Chapter Managing Your Personal Finances PROVIDED BY THOMSON SOUTH-WESTERN learning goals 1 How does the financial-planning process facilitate successful personal financial management? 2 How do cash flow planning and management of liquid assets contribute to your financial goals? 3 What are the advantages and disadvantages of using consumer credit? 4 What types of taxes are individuals responsible for? 5 What factors should you consider in deciding what insurance to purchase? 6 What personal goals are important when making investment decisions? 7 How do investors open a brokerage account and make securities transactions? 8 What emerging trends affect the way you manage your personal finances? 2|
  2. 2. An American Success Story As the youngest son of hard-working immigrant Although they enjoy movies and parents, in a family of nine children, Carlos Vela trips to Hawaii, Carlos sees saving as their learned from a young age the importance of mak­ most important obligation after essential ing a dollar go a long way. Raised with a strong expenses, such as mortgages, utilities, and work ethic, he began working a newspaper route food, have been paid for. Fortunately Amy in his suburban New York neighborhood at the agrees with him. The couple does not age of ten, saving his earnings in a metal cash box. squander money on clothing, and drives His father told him if he worked hard and started older cars. “I would like a Mercedes,” says saving early in life, by the time he reached his 40s Carlos, “and I can afford one now, but it is he could amass $1 million. The young Carlos not part of our plan at the moment.” In­ liked the sound of that, and decided to follow his stead, by shopping carefully and avoiding father’s advice. impulse buying, the couple is able to put Now a software designer, Carlos, 36, and his away at least $3,800 per month, ensuring wife, Amy, 34, also an immigrant and a real their financial future will be secure. estate agent, are approaching their first million. How did they do it? Their Certified Financial Looking Ahead found on Planner®, Roy Jarrett, praises the Velas for ear­ marking 25 percent of their earnings—the Carlos and Amy Vela highest rate he has seen—for savings. “We’re pleased if our clients save 10 percent of their Critical Thinking Questions: income,” he says. He credits the couple with As you read this chapter, consider the working and saving hard and spending little. The Vela’s disciplined approach to saving following questions as they relate to has increased their net worth to three- Carlos and Amy: quarters of a million dollars, produced solely 1. What personal characteristics led from savings and investments from their Carlos and Amy to save almost three- combined annual income of $155,000. Be­ cause Amy has an inside track on real estate quarters of a million dollars? in their area, the couple has been able to 2. What specific financial and investment make savvy real estate investments, retaining strategies did they follow to help them both of their former homes as rental prop­ realize their financial goals? erties. The properties have appreciated in value, while the rental income they generate 3. How would you emulate Carlos and Amy covers their overhead. to provide a secure future for yourself and your family? |3
  3. 3. P T i Principles of Personal Finance Principles of Personal Finance In today’s highly competitive world, young couples like Carlos and Amy are increasingly aware of the need for early financial planning and its importance to their future security and success. Shifts in demographics have skewed the eco­ nomic picture for many families, making proper financial planning essential. Some of these changes are: • More families (now called sandwich families) find themselves caught in the middle financially, responsible for both their children (couples are having children later in life) and their aging parents (increasing longevity), at a time in their own lives when they’re ready to retire. • Increasing numbers of blended families result from divorce and remarriage. • A significant number of single individuals are solely responsible for their own finances. • Large numbers of people have experienced job losses due to a sluggish post–September 11 economy and corporate downsizing. • The average cost for a middle-income family to raise a child to age 18 is now more than $177,700.1 • The average total cost of a college education (tuition, fees, room, board, other expenses) is almost $14,000 per year at a public university and close to $30,000 per year at a private one.2 • More employees are responsible for their own retirement funds. • People have an overwhelming amount of information to consider when choosing suitable financial products. • Changing financial obligations and world economics bring new challenges in preparing for the future. They can also bring confusion, frustration, and Exhibit 1 Can Money Buy Happiness? Money. Would life be sweeter if we all had more of it? The answer seems to be yes—and no. In a recent poll, 77 percent of adults believe America is the land of financial opportunity, yet 70 percent said the love of money is the root of all evil. And a full 76 percent of Americans believe money can’t buy happiness. Here are some other American attitudes toward money: 81 percent said money is power. 79 percent said doing what they love is more important than making money. 76 percent said money is freedom. 75 percent of married adults say they and their mate share their money. 74 percent of adults say they are living paycheck to paycheck. 70 percent said it is just as easy to love a rich person as a poor one. 60 percent of women say they manage money better while 51 percent of men say they do. 54 percent of adults say one of their biggest money pressures is meeting bills. 49 percent prefer to be happy in their personal/family life than rich. 36 percent of women and 28 percent of men report spending conflicts. 30 percent want to be able to buy a house. 29 percent said they would rather be healthy than rich. 19 percent of women and 11 percent of men have a secret stash of cash. 14 percent said they’d rather be rich. SOURCE: Gini Kopecky Wallace, “Can Money Buy Happiness?,” Family Circle (March 15, 2003), pp. 64–68. Reprinted with permission of Family Circle magazine. 4| Web Materials
  4. 4. i T P worry about meeting financial goals. Exhibit 1 reveals how Americans think about money. This chapter will provide an overview of the information and skills needed to meet the challenge of managing your own finances. We will demonstrate how the personal financial-planning process can help you manage your cash flow and meet your financial goals. We’ll describe various types of checking and savings instru- ments, and explain how to use consumer credit wisely, manage taxes, and select in- surance. Then we will outline how to set investment goals, develop an investment strategy, and make securities transactions. Finally, we will review emerging trends in personal finance. FINANCIAL PLANNING: THE FIRST STEPS In today’s world financial planning is for everyone, not just the wealthy. As Carlos 1 learning goal and Amy Vela know, you need personal financial planning whether you have too much money or too little. If you have enough money, planning can help you spend and invest it wisely. If your income seems inadequate, taking steps to control your financial situation could lead to an improved lifestyle. personal financial Personal financial planning is the process of managing one’s personal finances planning to achieve financial goals. Once you have established those goals, you can begin The process of managing gathering information, analyzing the information, and then developing, imple- one’s personal finances to menting, and monitoring a financial plan designed to meet your goals. Exhibit 2 achieve financial goals. illustrates the personal financial-planning process. Personal financial planning is a lifelong process. As your personal circum- stances change, so will your needs and goals. By creating flexible plans and revis- ing them on a regular basis, you will build a solid foundation for your financial future. Exhibit 2 Step Up to Achieve Your Financial Goals 6. Monitoring your plan. Regularly review and adjust your plan. Track the performance of the savings/investment components of the plan, and review and adjust the plan and your goals as necessary. Keeping up-to-date on the financial environment will help you monitor your plan effectively . 5. Implementing the plan. Put your plan into action. Complicated plans may require the help of financial-planning experts. 4. Developing a plan. There may be several ways to achieve your goals, so consider various alternatives before arriving at the plan that works best for you. 3. Analyzing the information. Review the data you have collected and revise your goals if necessary. 2. Gathering information. Objective and subjective information are both important components of the decision-making process. 1. Establishing financial goals. Sound financial goals are the basis of your financial plan, a road map that guides spending, saving, and investment decisions. Managing Your Personal Finances Web Chapter |5
  5. 5. P T i Principles of Personal Finance Before you set goals and develop financial plans for your future, you should as­ sess your current financial situation. Just as corporations summarize their financial position on their balance sheets, preparing a personal balance sheet will present a summary of your financial position on a given day. Assets, the things you own, are valued at current market value on your balance sheet. Liabilities are what you owe. concept check They are recorded at the amount you would have to pay if you paid off What are the benefits of personal financial the entire debt immediately. Net worth, total assets minus total liabili­ planning? ties, measures your wealth at a given point in time. Describe the six steps in the personal Completing a personal balance sheet at regular intervals, such as financial-planning process. Develop four every six months or each year, will help you track your progress toward personal financial goals for yourself, two achieving your goals. You’ll be able to see how your assets are growing short-term (1–2 years) and two long-term (5–10 years). and your debt is—hopefully—going down. Exhibit 3 is an example of How does a personal balance sheet help you the personal balance sheets for Jay Martin. As you can see in the “change” track your progress toward your financial column, he has significantly improved his net worth during calendar goals? year 2006 by saving and investing more and paying off his auto loan. Exhibit 3 Personal Balance Sheets Jay Martin Name ______________________________________ Date12/31/05 ________ 12/31/06 Date ________ Change ___________ ASSETS Liquid assets Checking accounts $ 1,230 $ 895 $ (335) ___________________________________________ Savings/money market accounts 385 1,546 1,161 ___________________________________________ Money market mutual funds ___________________________________________ Certificates of deposit (6 months) ___________________________________________ Cash on hand 76 153 77 ___________________________________________ Other ____________________ ___________________________________________ Other investment assets Certificates of deposit (>6 months) 500 1,000 500 ___________________________________________ Mutual funds 2,421 2,421 ___________________________________________ Stocks ___________________________________________ Bonds ___________________________________________ Other ____________________ ___________________________________________ Personal assets Automobile 5,346 3,421 (1,925) ___________________________________________ Furniture and appliances 3,460 8,000 4,540 ___________________________________________ Clothing 2,000 4,000 2,000 ___________________________________________ Other ____________________ ___________________________________________ Other ____________________ ___________________________________________ (1) Total assets $ 12,997 $ 21,436 $ 8,439 ___________________________________________ LIABILITIES Bills past due ___________________________________________ Credit cards $ 857 $ 472 $ (385) ___________________________________________ Auto loans 2,569 (2,569) ___________________________________________ Appliance/furniture loans ___________________________________________ Mortgage loans ___________________________________________ Education loans 9,365 8,593 (772) ___________________________________________ Other ____________________ ___________________________________________ Other ____________________ ___________________________________________ (2) Total liabilities $ 12,791 $ 9,065 $ (3,726) ___________________________________________ NET WORTH (1– 2) $ 206 $ 12,371 $ 12,165 ___________________________________________ 6| Web Materials
  6. 6. i T P CASH MANAGEMENT: WHERE’S THE MONEY? Cash management is defined as the day-to-day handling of liquid assets. Liquid 2 learning goal assets include cash, checking accounts, various savings instruments, and other as­ sets that can be converted into cash quickly at little or no cost. A cash flow plan (also called a budget) is an important tool for cash management. It helps manage personal balance sheet income and expenses, and the savings and investment contributions needed to ac- A summary of a person’s fi­ complish one’s financial goals. The following steps will help you develop and use a nancial position on a given cash flow plan: day; provides information about assets, liabilities, and • Establish your goals and calculate the savings you need to meet them. It is help- net worth. ful to prioritize your goals because you may have more goals than money. Identify each goal, estimate how much money is needed to accomplish that net worth goal, and specify the time frame for achieving the goal. An individual’s wealth at a • Estimate your income and expenses, including contributions to savings. Re­ given point in time, calculated as total assets minus total view your monthly income and estimate your monthly expenses. The liabilities. monthly budget worksheet in Exhibit 4 illustrates how to monitor your income and expenses, or you can create a spreadsheet covering several cash management months. The day-to-day handling of • Track actual income and expenses for a one-month period. Carry a pad of pa- one’s liquid assets. per with you so you don’t forget small expenditures you make, and record all income and expenses. At the end of the month, total income and ex- liquid assets penses for each category and enter them on the worksheet in Exhibit 4 in the Cash and other assets that can be converted into cash both “actual” column. quickly and at little or no cost, • Compare planned and actual income and expenses. Analyze each category that such as checking accounts. was above or below your estimate in the “planned” column and determine whether this was unusual. For example, if you needed a new suit for an unex­ Assets listed on the personal pected interview you may have exceeded your clothing allocation for the balance sheet may include month. But if you find the situation to be normal, decide whether to cut back earnings from college students’ summer jobs that are held in your spending or increase your budget for that item. Of course, if you add to checking or savings accounts. that category, you will need to reduce another by the same amount. • Modify estimates for the next month and repeat the process. Depending on your analysis, you may want to make changes to your original plan. It may take several months before you are able to live within your cash flow plan so it is important to be flexible. But within a short period you will be in control of your spending and saving. Checking Accounts Checking and savings accounts are the most common liquid as­ sets held by consumers, and a checking account is necessary to manage your income and expenses. A check is a written order, drawn on a depository institution by a depositor, ordering the depository institution to pay on demand a specific amount of money to a person or firm named on the check. Several types of checking accounts are available to meet the diverse needs of consumers. These were briefly noted in Chapter 15. © AP / WIDE WORLD PHOTOS Electronic Fund Transfers Regardless of the type of checking account you select, you will probably be of­ fered electronic fund transfer (EFT) services. EFT allows you 24-hour access to cash through an automated teller machine (ATM), and point-of-sale (POS) transfers for retail purchases with a debit card. With an ATM card and personal identification Managing Your Personal Finances Web Chapter |7
  7. 7. P T i Principles of Personal Finance Exhibit 4 Monthly Budget Worksheet Name: __________________________________________ Month of ______________________________ Planned Actual Variance Income Wages (take-home pay) __________________________________ Support from relatives __________________________________ Loans __________________________________ Withdrawals from savings __________________________________ Other ______________ __________________________________ Other ______________ __________________________________ (1) Total Available Income __________________________________ __________________________________ Expenses Fixed Expenses Housing __________________________________ Automobile payment __________________________________ Insurance __________________________________ Loan repayment __________________________________ Savings for goals __________________________________ Tuition and fees __________________________________ Other ______________ __________________________________ Subtotal, Fixed Expenses __________________________________ __________________________________ Flexible Expenses Food __________________________________ Clothing __________________________________ Personal care __________________________________ Entertainment and recreation __________________________________ Transportation __________________________________ Telephone __________________________________ Utilities (electricity, gas, water) __________________________________ Cable TV __________________________________ Medical and dental __________________________________ Books, magazines, educational supplies __________________________________ Gifts __________________________________ Other ______________ __________________________________ Other ______________ __________________________________ Subtotal, Flexible Expenses __________________________________ __________________________________ (2) Total Expenses __________________________________ __________________________________ Cash Surplus (Deficit) [(1)–(2)] __________________________________ __________________________________ cash flow plan number (PIN), you can withdraw cash, make deposits, or transfer funds between A cash management tool that accounts. You can pay for goods and services with a POS transfer using your debit includes a plan for managing card. It works very much like a credit card with one important exception: The income and expenses, includ­ money for the purchase is transferred immediately from your checking account ing contributions to savings and investment needed to ac­ to the vendor’s account. complish one’s financial goals; Using these cards requires good management skills. With both ATM and POS often called a budget. transactions, be sure to enter withdrawals in your check register. Failure to main­ tain an accurate record of your account balance may result in bounced checks. Guard your cards carefully so they are not stolen or fraudulently used. This is espe­ cially important with POS (debit) cards because they can be used without a PIN. 8| Web Materials
  8. 8. i T P If your ATM or debit card is lost or stolen, federal regulations mandate that you may be responsible for up to $50 if the loss is reported within 2 business days, up to $500 if you report it between 3 and 60 days, and for an unlimited amount if the loss is reported after 60 days. Be aware of ATM fees charged by your bank and the institutions that own the machines you use. Even small fees for withdrawing cash add up quickly if you make several withdrawals. You can usually reduce or eliminate ATM fees by using the ATMs at your own bank. Overdraft Protection Banks offer checking account holders over­ draft protection features to prevent them from bouncing checks because of insuffi­ cient funds. A returned check can be embarrassing. However, before you sign up for this service, thoroughly investigate any plan and be sure you know what you are paying. You may be able to link your checking account to a savings account at the same bank for a modest fee per overdraft. Some bounce-protection plans, however, charge the usual bounced-check fee—$25 to $35 per item—plus a per-day fee of $2 to $5 or an interest charge until the account has a positive balance. A $100 advance for 30 days would typically carry a minimum 243 percent annual percentage rate (APR)! Of course, the best way to avoid overdrafts and the extra charges they create is to track your checking account balances regularly, which is easy if you have online banking. Recently the Federal Reserve Board took action against banks that were earn­ ing millions of dollars by offering extremely expensive—as much as $2,000 a year— and deceptively advertised bounce protection plans, targeted almost exclusively to low- and moderate-income consumers. “Overdraft protection products are a delib­ erate, systematic attempt to hook consumers into overdrafts as a form of high-cost credit,” says Chi Chi Wu, staff attorney for National Consumer Law Center. “There is no question that these products are loans at outrageously high prices.”3 Balancing Your Checkbook This important task reveals possible mistakes you or the bank has made and helps you discover fraudulent debit-card withdrawals. It also helps to avoid bouncing checks, which can be expensive and embarrassing. Exhibit 5 lists the steps to follow in balancing your checkbook. Exhibit 5 Seven Easy Steps to Balancing Your Checkbook 1. If you receive canceled checks place them in numerical order. 2. Compare each check with the check entry on your bank statement and your checkbook record to make sure the amounts agree. Check off each correct item. Repeat the same process for all other withdrawals such as ATM, debit card, and cash. 3. List and total all outstanding withdrawals (withdrawals deducted in your checkbook but not yet reflected on your bank statement). 4. Repeat Steps 2 and 3 for all your deposits. 5. Subtract the total amount of any outstanding checks from your bank statement, and add any outstanding deposits to this balance to obtain your adjusted bank balance. 6. Subtract bank service charges and add interest earned to your checkbook balance to find your adjusted checkbook balance. 7. Your adjusted bank balance and adjusted checkbook balance should be the same. If not, recheck your math and the deposits and withdrawals listed in your checkbook. If you cannot find an er­ ror, you will need to consult with your bank to see if an error was made in your account. Managing Your Personal Finances Web Chapter |9
  9. 9. P T i Principles of Personal Finance Exhibit 6 Savings of Households Headed by an 18- to 34-Year-Old Holding Instrument Average Savings Instrument Percent Balance Retirement account 45% $6,600 Certificate of Deposit 6% $4,000 Savings bond(s) 13% $ 300 Stock 17% $5,700 SOURCE: “Tip Sheet Financial Guide,” Newsweek Magazine (March 24, 2003), p. 63. Savings Instruments Checking accounts are appropriate for money you may need to access on a day-to- day basis, but savings instruments are a more appropriate way to accumulate money for short-term goals (a new television or a vacation) and for unexpected expenses (emergencies and opportunities). Banks, thrift institutions, and credit unions offer a variety of savings instruments, as noted in Chapter 15. Before selecting your savings vehicle, consider your goals and how you will use it. Compare the interest rate you will receive with those paid by other institutions. Rates are always changing, but financial institutions, the Internet, and magazines such as Kiplinger’s Personal Finance and Money are excellent sources of informa­ tion. Exhibit 6 provides an overview of savings in the average young American’s household by showing the percent in the group holding the given savings instru­ ment and the average balance held. USING CONSUMER CREDIT What if you want (or need) to make a purchase before you have accumulated the 3 learning goal money? You might use a credit card or a loan to make the purchase, paying interest to the lender for the privilege of borrowing the money. We have discussed how to set goals and use various types of instruments to save for your future needs, but us­ ing credit to make purchases is the opposite of saving money to buy things. In this section, we will investigate the pros and cons of using consumer credit, look at vari­ ous types of credit, and learn how to build a positive credit rating. The Pros and Cons of Using Credit There are a number of very good reasons for using consumer credit: • Convenience. • Immediate use of a good or service. • Bargain prices on sale merchandise. • Opportunity to establish a credit rating. • Convenient record keeping. • Payment for financial emergencies. • Perks such as rebates and frequent-flyer miles. Although not as numerous, there are also important disadvantages to using con­ sumer credit: • It’s easy to overspend. • Most types of credit cost money in the form of interest charges. 10| Web Materials
  10. 10. i T P Making Ethical Choices http://gitmanxtra.swlearning.com Payday Loans are Costly Cash The ads are everywhere—“GET CASH UNTIL PAYDAY . . . in financial jeopardy with potentially damaging $100 OR MORE . . . FAST!”—on the radio, the television, consequences, you also see it as the best way to extricate the Internet, in the mail. They refer to “payday loans,” yourself from the financial mess you are in. Although it which come at a very high price, as you find out during goes completely against your character, you are so des­ your freshman year in college. perate that you agree to do it. Your parents are always after you to be responsible about money and manage the budget you have worked ETHICAL DILEMMA out together. Then your car unexpectedly breaks down Do you have a greater obligation to do the right thing for: and you need to get it repaired. To pay for the repairs you • Yourself? borrow $200 from a loan store. You plan to pay back the • Your parents? loan with money from your student loans and the al­ • Your fellow students? lowance from your parents. You are proud of yourself for • All of the above? not asking your parents for the extra money, and begin Is it ever appropriate to ignore your conscience in order to making $50 biweekly payments to roll the loan over. You save yourself? In what other way might you have resolved have paid more than $500 and still owe the original $200 your financial problems without compromising your personal loan amount when the owner of the loan store approaches integrity? you with a proposition. SOURCES: Stephen Rothman, “Officials Call Payday Financing ‘Loan Promote his loan store on campus, and for every “re­ Sharking,’” downloaded from Web site http://www.bankrate.com on ferral” you send him, $25 will be deducted from your April 16, 2003; “Payday Loans = Costly Cash,” downloaded from Web loan balance until it is paid off. You are very anxious site of the Federal Trade Commission—Consumer Alerts, at http:// that your parents not find out what you have done—you www.ftc.gov, on April 15, 2003; Michelle Samaad, “Payday Loans—An do not want to disappoint them . . . again. While you re­ Expensive Choice for Borrowers with No Options,” downloaded from alize that encouraging fellow students with temporary http://www.bankrate.com, on April 16, 2003. money problems to use this loan store could place them • Merchandise may cost more. • The legal commitment to repay debt reduces future discretionary income. The ability to overspend, especially because credit cards are so convenient to use, can be the most devastating disadvantage. The financial and psychological stress created by this debt forces some students to drop out of college altogether, or work long hours, often causing their grades to suffer. A recent poll showed that the top financial goal of 71 percent of Americans is getting out of debt.4 The secret to using credit responsibly is your cash flow plan. Don’t use credit to buy anything that does not fit into your plan. Use your credit card for convenience, using it instead of cash for purchases so that you have to write only one check for all you buy. Then be sure to pay the total bill at the end of the month. Use a credit card for credit (meaning that you will not pay it off monthly) only when really nec­ essary, revising your cash flow plan to repay the debt as quickly as possible. If you currently have outstanding debt, use a form like Exhibit 7 to inventory your debt and develop a debt repayment strategy. For Becky Sampson, whose debt inventory is presented in this exhibit, an effective strategy might be to borrow from her personal line of credit (at 12 percent) to pay off her high-interest loans— the credit-card balances (18 percent and 21 percent). But she must be careful not open-end credit to run up her credit-card balances again after paying them off. Any type of credit where the borrower applies for the credit and then, if approved, is allowed to use it over and Credit Cards over again; for example, Credit cards are the most used type of open-end credit. Open-end credit is any credit cards. type of credit where once your application for credit is approved you may use it Managing Your Personal Finances Web Chapter |11
  11. 11. P T i Principles of Personal Finance Exhibit 7 Debt Inventory Name Becky Sampson Date 10/15/2006 Current Annual Rate Monthly Latest Type of Debt Creditor of Interest Payment Balance Due Comments Auto Loans 1 University Federal 2 Credit Union 8% $315 $6,893 Car will be 3 repossessed if loan is not repaid Education Loans 1 2 Home Mortgage Loan Home Improvement Loan Other Installment Loans 1 2 Single-Payment Loans 1 2 Credit Cards 1 MasterCard 18% $22 $716 $1,000 credit line 2 Visa 21% $40 $1,608 $2,000 credit line 3 4 5 6 7 Personal Line of Credit First National Bank 12% — — $3,500 credit line Home Equity Credit Line Overdraft Protection Line Loan on Life Insurance Margin Loan from Broker Other Loans 1 2 3 TOTALS $377 $9,217 line of credit over and over again. Your line of credit is the maximum amount you can have For credit cards, the maxi­ outstanding at any one time. Some cards require the entire balance to be paid mum amount a person can upon billing, but most require a minimum monthly payment. Cards that do not have outstanding on a card require full payment upon billing are called revolving credit cards. Some credit at any one time. cards carry an annual fee while others do not. revolving credit cards When you receive your monthly bill and do not pay the entire balance, you are Credit cards that do not charged interest. Some credit cards offer a grace period, a period of time after require full payment upon making a purchase when interest is not owed if the entire balance is paid on time. billing. Those cards with no grace period will charge interest even if you pay the entire bill monthly. grace period Depending on how they are used, credit cards can be either one of the most or The period of time after a one of the least expensive ways to make purchases. Those individuals who pay off purchase is made on a credit their entire credit-card balance each month are called convenience users of credit card during which interest is cards. If they select cards with a grace period and no annual fee, they have free use not owed if the entire bal­ ance is paid on time. of money for the period of time until the bill must be paid. On the other hand, credit-card users who pay only the minimum monthly payment can incur high 12| Web Materials
  12. 12. i T P interest charges, as Exhibit 8 shows. The average credit-card late fee has more than doubled from $13 in 1995 to nearly $29 today.5 Here are some other tips to help you pay off those credit cards: • Don’t wait until the last minute. Many issuers now use a “hair-trigger” for assessing late fees. In some cases you could get hit with a $35 to $40 penalty if the payment is just a few hours late. • Talk back. If you are a customer who carries a balance and pays on time, ask for a lower interest rate and re­ moval of any fees. Tell the issuer you are tempted to switch to another issuer who is offering 0 percent inter­ est. If the bank won’t bargain, shop for a new card. • Check your statement. Credit-card fraud is widespread, so it is important to protect your credit cards and review your monthly statement carefully. Federal legislation COURTESY OF CITIGROUP, INC. limits your responsibility up to a maximum of $50 per card before you report the problem. Even though your direct loss is rather low, the thief may tie up your total line of credit for months until the issue is resolved, and may use one card to get other cards. All credit card users pay indirectly for fraudulent charges with higher inter­ est rates and fees. When something calls to you, you can buy it with your Other Card Tricks credit card. But without first Minimum monthly payments used to be around 4 percent of the outstanding bal­ consulting your budget you run the risk of overspending ance. But today many credit-card issuers set them so low they do not cover the in­ and getting into debt. Learning terest or added fees such as late-payment penalties, or fees for exceeding your to balance the benefits of con­ credit limit. So even though cardholders pay the minimum every month, their bal­ venience against the downside ance continues to grow. of temptation is important Federal bank regulators have issued a new set of guidelines designed to pre­ when using consumer credit. vent this “negative amortization.” The new rules, which apply to all banks, say that credit-card issuers must set the minimum monthly payment at an amount that will allow the cardholder to pay off the debt within a “reasonable period of time.” So although monthly minimum payments may actually increase, straining the budgets of those cardholders who regularly pay the minimum due, it will free them of debt sooner.6 Exhibit 8 Minimum Payments Don’t Pay Making minimum payments on your credit cards can cost you a bundle over a number of years. Here’s what would happen if you paid the minimum—or more—every month on a $2,705 card balance, with an 18.38 percent interest rate. Monthly Payment How Long to Pay Off Interest Paid 2% of balance 27 years, 2 months $11,047 4% of balance 8 years, 5 months $ 2,707 8% of balance 2 years, 1 month $ 594 Managing Your Personal Finances Web Chapter |13
  13. 13. P T i Principles of Personal Finance Loans Loans differ from credit cards because they are closed-end agreements. You bor­ principal row an amount of money called the principal for a specific period of time and The total amount borrowed agree to pay it back by the end of the term, by paying in installments or as a lump under a loan. sum. Interest is charged on the amount of principal borrowed, and you may also be required to secure the loan with something of value. An auto loan is a good ex­ ample of a secured installment loan: Payments on the loan are due in equal monthly installments, and if you default on the debt the lender, who initially files a lien against the auto, has the legal right to repossess the car. Loans are also used to finance a college education, fix up a home, or purchase appliances. Before you apply for a loan, shop around to get the best deal just as you would for any product you are purchasing. There are numerous sources of consumer loans. Banks and savings and loan associations offer relatively low interest rates to low-risk borrowers. Credit unions generally offer even lower interest rates, but you have to be a member of the credit union to get a loan there. Consumer finance companies spe­ cialize in borrowers who are higher risk, and captive finance companies (Ford Credit Corp. and GMAC) offer credit when you are making a specific type of purchase. On­ line lending is a relatively new way to find a loan; the “Applying Technology” box on page 15 has more information on this growing segment of online banking services. A family member may charge the lowest interest rate, but if you decide to bor­ row money from Grandma treat the transaction in a businesslike manner. Draft a loan repayment agreement specifying the amount being borrowed, the interest rate to be paid (if any), and how the debt will be repaid. Both Grandma and you should sign the agreement and keep a copy. This will help to avoid misunderstand­ ings about the terms of the loan. Three of the most important factors to consider when comparing loans are the dollar cost of credit (finance cost), the annual percentage rate of interest (APR), and the monthly payment. According to the federal Truth-in-Lending Law, prepayment penalties lenders must calculate the APR in a standardized way, so, other things being equal, Additional fees that may be a loan with a lower APR will be less expensive. owed if a loan is repaid But when the term of the loan varies, loans with the same APR will have differ­ early. ent monthly payments and finance costs. As you can see from Exhibit 9, the longer security requirements the term of the loan, the lower the monthly payment but the higher the finance Provisions that allow a cost. Selecting a shorter repayment term will save you money in the long run. lender to take back the col­ In addition to these factors, check a loan for prepayment penalties, addi­ lateral if a loan is not repaid tional fees owed if you decide to repay the loan early, and security requirements, according to the terms of which allow the lender to take back the collateral if you do not repay the loan the agreement. according to the terms of the agreement. Also beware of add-ons a lender may offer. For example, credit life insurance will repay the loan if you die while the credit life insurance loan is still outstanding. Although this sounds like a good idea, consider whether Insurance that will repay a you really need life insurance for this purpose. And if you do, find out what the loan if the borrower dies while the loan is still coverage would cost from an insurance agent rather than the lender. The lender outstanding. offers convenience, but that convenience generally comes at a cost. It is not Exhibit 9 Comparisons of a $20,000, 8-Percent Loan Number of Payments Monthly Payment Finance Cost 36 $627 $2,572 48 488 3,424 60 406 4,360 14| Web Materials
  14. 14. i T P A p p ly i n g Te ch n o lo g y Banks Branch Out on the Internet After its first month of operations, the Internet banking site processing system can handle. A West Coast bank, eager to for First National Bank of Amarillo had nearly 1,000 cus­ jump on this new business opportunity, advertised their online tomers. Amarillo is a highly competitive market for online lending services with enticing marketing slogans touting “in­ banking with six other banks offering online services. First Na­ stant decisions” and a “quick turnaround.” In the space of two tional chose to differentiate its site so users can obtain real- months it was swamped with close to 350 transactions, while time balances on their account as transactions occur, rather its internal systems were only designed to handle 75, stressing than waiting for the end-of-day totals of traditional banking. their staff and, worst of all, disgruntling their customers.8 In addition to banks wanting to take advantage of the What does all this mean for the consumer? As tempting substantial cost savings—estimates place the average teller as it may be to test the wonders of Internet lending, be or telephone transaction at $2.36 as compared with 10 cents warned that some financial institutions may be setting up for an online transaction—advances in technology and com­ unrealistic expectations for their customers. Find out how petition for business among financial institutions assure long a particular lender has been offering Internet lending— consumers of an ever more stunning array of online banking longer is better, giving the bank more time to iron out the services 24/7.7 wrinkles. But if you are at all concerned about a lender’s In­ One of the newest of these is Internet consumer lending. ternet service ability, either choose to go the traditional route According to the U.S. Census Bureau, this service tends to with your loan application and processing, or choose another appeal to households with more than $75,000 in annual bank. income. Projections by Meridien Research estimate that tra­ ditional lending transactions will stay close to their current CRITICAL THINKING QUESTIONS number of 75 million through 2005. Internet loan transac­ 1. What are some of the advantages and disadvantages of tions, on the other hand, are expected to increase from a Internet banking? current 26 million to close to 60 million by 2005. 2. What should you look for when selecting an Internet Sites such as Compubank.com and LendingTree.com are source for an important financial transaction like obtain­ unique online marketplaces where lenders compete for your ing a loan? business. You can obtain information on a wide range of loans including mortgage, car, and student loans, supported SOURCES: Greg Rohloff, “First National Enters Internet Banking Market,” Ama- by plenty of glowing satisfied customer testimonials. rillo Daily News, Web posted July 21, 2000; John Ginovsky, “Internet Consumer But if not managed properly, Internet lending can work too Lending—Do It, But Do It Right,” Bankers News (October 29, 2002). well, producing more loan originations than a traditional loan- uncommon to pay 10 times as much for credit life insurance compared to a term life policy purchased through an insurance agent! Credit History and Credit Ratings Don’t do what Daniel did—finish college with $20,000 in student loans and $9,500 in credit-card debt. Now aged 23 and a recent graduate of the University of Cali­ fornia, Riverside, he says, “I know all the temptations and traps that got me where I am now. I wish I’d had this information available to me before.” Daniel has been working with Consumer Credit Counseling Service in California for more than three years and is now their College Outreach Coordinator. As someone who has “been there and done that—over and over again,” he looks forward to sharing his experiences with other students, in the hope it will help them avoid making the same mistakes he did. Go to CollegeDebt.net (http://www.collegedebt.net) to meet Daniel and get out of debt.9 One of the reasons for using credit is to build a good credit rating. Three na­ tional credit bureaus—Equifax (800-685-1111), Experian (888-397-3742), and TransUnion (800-888-4213)—collect credit information and make it available for a fee to retailers, banks, and other organizations that are subscribers or approved recipients of this highly confidential information. Credit bureaus do not evaluate the data; they report the following types of credit information for each lender: the date the account was opened; the highest amount of credit extended; the current Managing Your Personal Finances Web Chapter |15
  15. 15. P T i Principles of Personal Finance outstanding balance; the number of times the account has been 30, 60, and 901 days overdue; and the number of inquiries there have been for this account infor­ mation. Negative account information can stay in the file for no more than 7 years, 10 years in the case of bankruptcy. Information from the three credit bureaus does not always match, so you should check all three. Lenders use information from your credit report as well as other informa­ tion from your credit application to decide whether to grant credit and under what terms. The better “score” you receive, the more likely you are to be approved for a credit card or loan, and be offered lower rates of interest. Because the infor­ mation in your credit bureau file is so important, you should periodically check your own file for accuracy. If you are applying for a loan, or have been in a dis­ pute with a creditor, request a copy of your credit report from all three major concept check credit bureaus. If you find inaccurate information in your credit file, report it to What are the pros and cons of using consumer credit? the credit bureau. The credit bureau must investigate your dispute How can an inventory of your debt help within 30 days or remove the disputed item from your file. If the inves­ you make better decisions about debt tigation does not resolve your dispute, you may add a brief statement repayment? to your file, which must be included in future reports. In addition, What is a credit bureau, and what function credit bureaus must prevent deleted information from reappearing in a does it perform in the granting of credit? credit report, and creditors are liable if they neglect to correct errors. MANAGING TAXES Although taxes represent the largest expenditure in the average American fam- ily’s budget, a whopping 91 percent say they have never cheated on their taxes.10 4 learning goal Because the tax code is very complex, some knowledge on the subject is impor­ tant. In this section we will briefly discuss the four types of taxes that are paid directly by individuals: income, Social Security and Medicare, sales, and prop­ erty taxes. Income Taxes progressive tax The federal income tax is a progressive tax, meaning the higher your taxable in- An income tax that is struc­ come the higher the percentage of your income paid in taxes. In 2004, taxpayers tured so that the higher a in the lowest tax bracket paid 10 percent on the first $7,000 of taxable income person’s taxable income, the ($14,000 for married taxpayers filing jointly), while higher income taxpayers paid higher the percentage of income paid in taxes. at rates of 15, 25, 28, 33, and 35 percent.11 Because of the progressive structure and certain tax deductions (the personal exemption and the standard deduction), peo­ ple with low incomes may pay little or no federal income taxes. Pay-as-You-Go System The federal government expects us to pay both federal income taxes and Social Security taxes (discussed later) as we earn income. This is accomplished through tax withholding by employers, or by filing quarterly tax estimates on self-employment income, investment income, and other income filing status that is not subject to withholding. When you start a new job, your employer will ask The marital status of a you to fill out a W-4 form on which you report your filing status (similar to your taxpayer specified on the marital status) and the number of withholding allowances you want to claim. The income tax return. more withholding allowances you claim, the less your employer will withhold from each paycheck. However, the goal is to have the right amount withheld, so use the withholding W-4 worksheet for guidance. allowances Allowances claimed with an employer that determine the Minimum Filing Requirements The federal government does amounts that are withheld not require all income earners to file federal income tax returns. If your income is from each of the employees’ below the minimum filing requirement in a given year, you do not have to file. If paychecks. you are entitled to a tax refund, however, you must file to receive the refund. 16| Web Materials
  16. 16. i T P Don’t let your dependents COURTESY OF HEWLETT-PACKARD. PHOTOGRAPHER STEPHANIE RAUSSER down—learn to manage your taxes with professional tax soft­ ware. Proper tax planning will help to minimize your tax bur­ den while maximizing your health. personal exemptions Taxpayers can claim personal exemptions that reduce the amount of their tax­ Deductions that reduce the able income. You can take a personal exemption for yourself, your spouse, and each amount of income on which of your dependents. If you are a taxpayer who is claimed as a dependent by someone income tax is paid. Each tax­ else, however, you cannot claim the personal exemption. In 2004 a personal exemp­ payer is entitled to a personal exemption, for himself, his tion was worth $3,100. The standard deduction is another amount that most tax­ spouse, and each of their de­ payers can automatically deduct from their gross income. In 2004 the standard pendents; a personal exemp­ deduction was $4,850 for single people and $9,700 for married couples filing jointly. tion can be used only once. If a taxpayer elects to itemize deductions, the standard deduction does not apply. standard deduction Filing a Federal Income Tax Return Individuals may use An amount that most taxpay­ one of three basic forms when filing their income tax returns: the 1040EZ, the ers can automatically deduct from their gross income in 1040A, and the 1040. The 1040EZ and the 1040A are limited to taxpayers with computing their income tax; relatively simple finances. Taxpayers can also use the TeleFile system to file their not permitted if the taxpayer returns by punching in their data on touch-tone phones, or file online at the In­ elects to itemize deductions. ternal Revenue Service Web site at http://www.irs.gov/efile/. When completing a tax return, you start by listing your gross income, which in­ earned income cludes earned income, income earned through employment (wages, tips, self- Income that is earned from employment income), and unearned income (interest, dividends, other investment employment such as wages, income). Students must include scholarship and grant proceeds in their gross in­ tips, and self-employment income. come if these exceed the direct cost of the education. After totaling your gross income from all sources, subtract any legal deductions you are eligible to take: adjustments to unearned income gross income, itemized deductions, personal exemptions, and tax credits. You may Income that is not earned claim adjustments for interest paid on student loans, job-related moving expenses, through employment such and contributions to Individual Retirement Arrangements (IRAs). In addition, a new as interest, dividends, and tax credit of $2,000 for the Clean-Fuel Vehicle Deduction is available on the purchase other investment income. of certain hybrid gas/electric motor–powered vehicles.12 The tax-filing deadline is April 15. Tax returns filed on April 15, 2005, apply to income earned in the calendar year 2004. If the 15th falls on a weekend, the filing date is the next business day. Tax Planning As long as your financial life is relatively simple, your biggest tax-planning issues will be having the correct amount of money withheld and keeping the appropriate tax records. However, once you purchase a home, Managing Your Personal Finances Web Chapter |17
  17. 17. P T i Principles of Personal Finance Exhibit 10 IRS Stress Relief Tips It’s a taxing life. Here’s how to be more organized at tax time. Get Organized – Keeping your records organized throughout the year takes little time and lots of pressure off at tax time. Use an 8” x 11” envelope for each month to keep receipts and other tax related documents where you can find them. Get Going – Don’t leave yourself too little time—you’re more likely to overlook something. Besides, the sooner you file, the sooner that refund will find its way back into your pocket. Get Help – Decide whether you’ll be doing the job yourself or using a tax preparer. The IRS sponsors Volunteer Income Tax Assistance (VITA) for taxpayers who need help but are unable to afford a preparation service. Get Online – The IRS Web site http://www.irs.gov has forms and publications for down­ loading and interactive calculators. Get Smart – Keep tax returns and supporting documentation for seven years, when support­ ing documentation can be disposed of and tax returns placed in permanent storage. Shred monthly bank, brokerage, mutual fund, or 401(k) statements when you receive year-end state­ ments, which should be kept for at least three years. SOURCES: Robert Longley, “U.S. Gov Info/Resources,” downloaded from Web site http://www.usgovinfo.about.com/library/ weekly/bltaxstress.htm, October 21, 2003; Deborah Fowles, “Making Tax Filing Easier,” downloaded from Web site http:// www.financialplan.about.com/library/weekly, October 21, 2003. begin investing, and earn a larger income, more sophisticated tax planning becomes important. You will probably need a good accountant, perhaps someone who specializes in taxation. You should also learn more about the federal income tax laws and keep up with the frequent changes made to those laws. Exhibit 10 offers some useful advice about organizing your taxes. Social Security and Medicare Taxes Like income taxes, Social Security and Medicare taxes are payroll taxes—taxes de­ ducted from each employee’s paycheck. Social Security taxes, often seen on a pay­ roll stub as FICA (Federal Insurance Contributions Act), are paid at a uniform rate on a specified amount of earned income (the wage base). Both the percentage and the wage base can change annually. Your employer matches your Social Security and Medicare paycheck with­ holding with company funds, and sends the total to the Internal Revenue Service (IRS). Self-employed people are responsible for paying both the employee’s and the employer’s share of this tax by making quarterly estimated payments. They are then allowed to deduct one-half of their Social Security tax as an adjustment to their gross income on their federal income tax returns. Sales and Property Taxes Two additional taxes are sales tax and property tax. All but five states (Alaska, Delaware, Montana, New Hampshire, and Oregon) currently have sales tax on re­ tail goods and some services. In certain states, items like food consumed in the home, prescription drugs, and services such as doctor’s fees, haircuts, and laundry bills are not taxed. Generally, sales tax rates range from 4 to 7 percent for the state’s share with an additional 1 to 2 percent added by some cities. 18| Web Materials
  18. 18. i T P The biggest single property tax for most individuals is on real estate, including a home. Property tax (real estate tax) is generally divided among concept check the city, the county, the school system (which gets the largest portion), What is a progressive tax? Explain why the and in some cases the state government. The annual property tax (often federal income tax is progressive. paid in two installments) is calculated by multiplying the appraised (or What are the personal exemption and the assessed) value of the property by the tax rate. A house appraised at standard deduction? How do these amounts differ for taxpayers who are dependents as $100,000 could be taxed at 2 percent of its assessed value, resulting in an compared with independent taxpayers? annual property tax of $2,000. Some state and local governments also im­ Briefly describe three types of taxes other pose personal property taxes on items such as automobiles, boats, and than the income tax. even the fixtures, furniture, and fittings belonging to a business. SELECTING INSURANCE While financial planning helps us meet our financial goals, we need to make 5 learning goal provision for life’s other uncertainties. We could suffer major losses from a serious illness, an auto accident, or a fire. Assessing these risks and purchasing the appro­ priate insurance to protect against them is an important part of a sound financial plan. Insurance planning involves learning about various types of insurance, such as property and liability insurance, health and disability income insurance, and life insurance, and setting priorities for your individual insurance needs. Setting Insurance Priorities Robert Hartwig, chief economist at the Insurance Information Institute, predicts the cost of insuring cars and homes could continue to rise,13 so before buying an insurance policy, it is important to identify, evaluate, and prioritize your insurance needs. Start by identifying the types of insurable risks you face. For example, if you own a car, you face the risk of being in an accident that is your fault, injuring the other driver and damaging his or her car. Your own car could also be damaged and you could be hurt. Some of the everyday insurable risks people face include: • Property damage to personal property such as automobiles, homes, and boats. • Liability losses due to negligent actions. • Medical expenses due to illness or accidents. • Loss of income due to disability or premature death. The key to managing your insurance needs in a cost-effective way is to budget (have funds set aside) to cover minor losses, and to purchase property, health, and life insurance to cover potential major losses. Property and Liability Insurance Property insurance covers financial losses from damage to or destruction of the in- sured’s property as a result of specified perils, such as fire or theft. Liability insurance covers financial losses from injuries to others and damage to or destruction of oth­ ers’ property when the insured is considered to be the cause. It also covers the in- sured’s legal-defense fees. The property and liability policies most often purchased by individuals are automobile insurance and homeowners/renters insurance. automobile liability insurance Automobile Insurance Auto insurance covers financial losses from Insurance that protects the such perils as accident, theft, fire, and liability lawsuits. The two main types of au- insured from financial losses caused by automobile- tomobile insurance are liability coverage and physical damage coverage. Automo­ related injuries to others bile liability insurance protects the insured from financial losses caused by and damage to their automobile-related injuries to others and damage to their property. Each policy property. specifies maximum payment limits. For example, a $50,000/$100,000/$25,000 Managing Your Personal Finances Web Chapter |19
  19. 19. P T i Principles of Personal Finance policy will pay up to $50,000 for each person injured in an accident but a total of no more than $100,000 per accident for personal injuries, no matter how many people are involved. In addition, it will pay a maximum of $25,000 for damage to other people’s property. All 50 states have financial responsibility laws that require drivers to show proof of liability insurance, the ability to pay the costs (up to a limit) of any acci­ dents for which they are responsible. automobile physical Automobile physical damage insurance covers damage to or loss of the poli- damage insurance cyholder’s vehicle from collision, theft, fire, or other perils. It includes collision Insurance that covers damage coverage for damage caused by crashing into another vehicle or object, and com­ to or loss of the policyholder’s prehensive (other-than-collision) coverage for losses due to perils such as fire, vehicle from collision, theft, fire, or other perils; includes floods, theft, and vandalism. collision coverage and com­ Automobile insurance rates generally depend on the driver’s age, marital prehensive (other-than- status, gender, area of residence, and driving record, as well as the characteris­ collision) coverage. tics of the automobile being insured. Young male drivers who live in cities, have more than one traffic ticket, and drive expensive, high-horsepower automobiles comprehensive are charged the highest rates. Historically this group is involved in the most (other-than-collision) accidents. coverage Automobile insurance that covers damage to or loss of Homeowners/Renters Insurance It is advisable for home­ the policyholder’s vehicle owners and renters to purchase insurance for protection against property damage due to perils such as fire, and liability losses. These policies cover losses due to fire, riots, windstorms, light­ floods, theft, and vandalism; ning, hurricanes, vandalism, frozen water pipes, and even falling airplanes. part of automobile physical Special federally subsidized insurance provides coverage for earthquakes and damage insurance. floods. Homeowners insurance covers both the dwelling and personal property (furniture, clothing, etc.) while renters insurance covers personal property but actual cash value not the dwelling. A standard policy pays out the actual cash value (similar to The market value, deter­ market value), determined by subtracting the amount of depreciation for its re­ mined by subtracting the placement cost, for personal-property losses. Policies that provide replacement amount of depreciation from its replacement cost, of cost coverage, enough money to replace lost or damaged personal property, cost personal property; the about 10 to 15 percent more. amount paid by standard Homeowners and renters should also carry liability coverage to protect homeowners and renters against financial losses arising from their liability for the injury of others. For ex­ insurance policies. ample, if one of your inebriated guests was injured in a fall after attending a party where you served liquor, you could be legally liable for the subsequent medical ex­ replacement cost penses. Comprehensive personal-liability coverage purchased as part of a home­ coverage owners policy protects against a wide range of occurrences, both on and off your Homeowners and renters in­ property. But it does not protect you when driving a motor vehicle, for slander or surance that pays enough to replace lost and damaged libel, or for professional malpractice. personal property. Health Insurance Elizabeth McKenty wanted a new treatment for her congenital heart defect. Her in­ surer said no. She appealed, and got another refusal. But McKenty, a 43-year-old librarian in Philadelphia, didn’t give up. With the help of a company that fights denials such as these she appealed again, supporting her request with medical literature showing why the new treatment would give her better odds than open- heart surgery. This time she won.14 Health insurance is a vital component of financial stability. Many families and COBRA individuals obtain health insurance coverage through group policies offered as A federal regulation that al­ part of employment fringe-benefit plans. Group policies usually include compre­ lows most employees and hensive coverage at low cost. If you leave your job, your group coverage will termi­ their families to continue nate, although a federal regulation called COBRA allows most employees and their group health insurance cov­ erage at their own expense families to continue group health coverage at their own expense for up to 18 for up to 18 months after months. You should also be aware that coverage through a parent’s policy usually leaving an employer. ends around ages 23 to 25. 20| Web Materials