Student Guide Complete (Oct 7)

High School Course
Student 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
58
PART3PowerPointSlides
Chapter1
69
Chapter2
72
Chapter3
79
Chapter4
85
Chapter5
92
Chapter6
97
Chapter7
105
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ST TU UD DY YG
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
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.
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
Usethetimevalueofmoneyequationtoanswerthefollowingquestions:
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.
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.
58
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.
59
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.
60
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.
61
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.
62
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.
63
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.
64
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.
65
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.
66
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.
67
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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PO OI IN NT TS
SL LI ID DE ES S
FinancialLiteracy101
Introduction
Financialliteracyistheabilitytounderstand
finance.
Itisaboutdevelopingtheknowledgeand
skills that will allow you to make better
FinancialLiteracy
skillsthatwillallowyoutomakebetter
financialdecisions.
Whatisfinance?
2
BritannicaEncyclopedia:
Financeistheprocessofraisingfundsor
capitalforanykindofexpenditure
Financeistheprocessofchannelingfunds
in the form of credit loans or invested
Whatisfinance?
intheformofcredit,loans,orinvested
capitaltothoseeconomicentitiesthat
mostneedthemorcanputthemtothe
mostproductiveuse.
3
69
MerriamWebsterDictionary:
1. Moneyorotherliquidresourcesofa
government,business,group,or
individual:Finances
2 The system that includes the circulation of
Whatisfinance?
2. Thesystemthatincludesthecirculationof
money,thegrantingofcredit,themaking
ofinvestments,andtheprovisionof
bankingfacilities
3. Thescienceorstudyofthemanagement
offunds
4. Theobtainingoffundsorcapital:
Financing
4
Financeisthesubjectthatdealswithmoney.
Itdealswiththeconceptsofmoney,time,
riskandhowtheyareinterrelated.
Whatisfinance?
$100and$105,whichisbetter?
5
ImportantFinancialConcepts
RateofReturn
Ameasureoftheprofitabilityofan
investmentopportunity.
Theratioofhowmuchyouearnonthe
investment to how much you pay for it investmenttohowmuchyoupayforit.
purchase of time at Value Value
now investment of Value Value
Value
Value Value
Return of Rate
:
:
) (
0
1
0
0 1

6
70
ImportantFinancialConcepts
Risk
Uncertainty
Thedegreeofuncertaintyofrateofreturn
onaninvestment.
7
Whydoyouneedtounderstand
finance?
8
Whatwillyoulearninthiscourse?
Whatisthefinancialenvironmentyoulive
in?
Howdoyouplanforyourfinancialfuture?
Whatcanyoudowhenyoudonthave y y
enoughmoney?
Whatdoyouneedtoknowaboutgoingto
college?
Whatshouldyoudowhenyouhaveexcess
money?
Canyouaffordtobuyahouse?
9
71
TheFederalReserve
TypesofFinancialInstitutions
T f B k A
Whatwillyoulearn?
TypesofBankAccounts
2
TheU.S.ConstitutionstatesthatThe
Congressshallhavethepowertocoin
money.
TheU.S.MintwasestablishedbyCongressin
1792 to produce coins.
WhoproducesmoneyintheU.S.?
1792toproducecoins.
In1861,theDepartmentofTreasurybegan
printingpapermoney(notes).
Today,theBureauofEngravingandPrinting
(BEP)isresponsibleforproducingnotesand
theU.S.Mintisresponsibleforproducing
coinage.
3
72
Howmuchmoneyisthere?
$942billion $40billion
4
Canada
Mexico
UnitedKingdom
G
Whatkindsofcurrencyareusedin
othercountries?
Germany
China
Japan
5
IntheU.S.,afterpapernotesandcoinsare
produced,theyaredeliveredtotheFederal
Reserve(theFed)beforebeingreleasedto
thepublic.
WhatistheFederalReserve?
TheFederalReserveisthecentralbankofthe
UnitedStatesandisresponsiblefor
controllingthenationsmoneysupply.
TheFederalReserveisabankersbank.
6
73
TheFederalReservewasfoundedin1913by
Congress.
TheFederalReservesystemconsistsof
The Board of Governors
TheBoardofGovernors
TwelveregionalFederalReserveBanks
7
Currently,theFedsdutiesinclude:
Conductingthenationsmonetarypolicy
Supervisingandregulatingbanking
institutions
Maintaining stability of the financial
Maintainingstabilityofthefinancial
system
Providingservicestofinancialinstitutions
andtheU.S.government
8
TheFederalReservesdecisionsdonothave
toberatifiedbythePresident,oranyone
elseintheexecutivebranchofthe
government.
The system is subject to oversight by the U.S.
ThesystemissubjecttooversightbytheU.S.
Congress.
9
74
Whoisthecurrentchairmanofthe
FederalReserve?
10
Therearedifferenttypesofbanks.
Investmentbankshelpcorporationsand
governmentsraisecapitalbydesigningand
marketingsecurities(suchasstocksand
bonds).
Whatisabank?
bonds).
Mortgagebankshelpfacilitaterealestate
transactionsbybringingborrowersand
lenderstogether.
Thefocusofourdiscussionisoncommercial
banksandotherfinancialinstitutionsthat
providesimilarservices.
11
Theprimaryfunctionofcommercialbanksis
collectingdepositsfromsavers,andthen
usingthemoneytomakeloanstoindividuals
andbusinesses.
Other types of financial institutions that
Whatdocommercialbanksdo?
Othertypesoffinancialinstitutionsthat
providesimilarservicesinclude:
Savingsandloanassociations(S&Ls)
Mutualsavingsbanks
Creditunions
12
75
ComparisonofFinancialInstitutions
TypeofInstitution KeyServicesandOwnership
Commercial Banks Provideafullrangeofservices
Ownedbyshareholders
Savings&LoansAssociations Specialize insavingsaccountsandhomemortgages
Owned by shareholders
13
Ownedbyshareholders
MutualSavingsBanks Specialize insavingsaccountsandhomemortgages
Ownedbydepositors
CreditUnions Provide variousfinancialservices
Ownedbymembershavingacommonbond
CheckingAccount
SavingsAccount
MoneyMarketAccount
CertificateofDeposit
TypesofBankAccounts
14
RateofReturn
Theideaisverysimple:thehigher,the
better.However,simplycomparingthe
interestrateisnotenough.
Howdoyouchooseabankaccount?
Thepercentagerateexpressingthetotal
amountofinterestthatwouldbereceived
ona$100depositbasedonthenominal
interestrateandthefrequencyof
compounding.
15
76
1 1
m
m
i
APY ) (
16
m
i:annualinterestrate
m:compoundingfrequency
Safety
17
Anessentialpartofmanagingyourfinances
isknowinghowmuchmoneyyouhave,how
muchmoneyyouearn,andhowmuch
moneyyoucanspend.
Howmuchmoneydoyouhave?
Youneedtounderstandhowtobalance
yourcheckbook.
18
77
Today,manyfinancialinstitutionsofferonline
banking,soyoucankeeptrackofallthe
transactionsandyourbalancebyloggingin
toyouraccountonacomputerorevenfrom
yoursmartphone.
Howmuchmoneydoyouhave?
y p
Additionally,youcantransferfunds,paybills,
orapplyforaloanonline.
Somebanksevenallowyoutocreatea
budgetandcompareitwithyouractual
spending.
19
78
FinancialPlanning&Budgeting
Themeaningofbudgetingandhowto
prepareashorttermbudget
Thepurposeoflongtermbudgeting
The difference between short term and
Whatwillyoulearn?
Thedifferencebetweenshorttermand
longtermfinancialplanning
Thebasicsofthetimevalueofmoney
2
Abudgetisaplanthatconsidersthemoney
youexpecttobringin(calledcashinflow)
andthemoneyyouneedtospend(called
cashoutflow).
If the money coming in exceeds the money
Whatisabudget?
Ifthemoneycominginexceedsthemoney
goingoutduringacertainperiodoftime,you
haveasurplus;otherwise,youhaveadeficit.
Budgetingistheprocessofpreparinga
budget.
3
79
Whyisbudgetingimportant?
Abudgethelpsyoukeeptrackofyour
money:howmuchyouveearned,howmuch
youvespent,andhowmuchyoucurrently
have.
It also helps you plan for the future: how
4
Italsohelpsyouplanforthefuture:how
muchyouaregoingtoearn,howmuchyou
canaffordtospend,andhowmuch,ifany,
youwillbeabletosave.
Ithelpsyouassessyourfinancialhealthin
thelongrun.
Income
Whatareyourincomesources?
Allowance
W
Whatshouldbeconsideredinshort
termbudgeting?
Wages
OtherSources?
5
Expenses
Whattypesofexpenseswillyouincur?
Taxes
Ed ti
Whatshouldbeconsideredinshort
termbudgeting?
Education
Food
Transportation
Housing
Others
6
80
Ifyourincomeismorethanthetotal
expenses,youhaveasurplus.
Iftheexpensesexceedyourincome,you
haveadeficit.
What else do you need to consider?
Doyouhaveenoughmoney?
Whatelsedoyouneedtoconsider?
Contingencies
Savings
7
Reviewincomesources
Reviewandprioritizeexpenses
Needsvs.Wants
Whatshouldyoudoifyouhavea
deficit?
8
Thepurposeoflongtermbudgetingisto
helpyoufigureoutif,andhow,youcan
achieveafinancialgoalinthefuture.
Itcombinestheresultsofyourshortterm
budget over an extended period of time.
Whatislongtermbudgeting?
budgetoveranextendedperiodoftime.
Howlongislongterm?
9
81
Onemajordifferenceisthatyoushould
considerthetimevalueofmoneyinlong
termplanning.
Whatisthedifferencebetweenshort
termandlongtermbudgeting?
10
Thetimevalueofmoneymeansonedollar
todayisworthmorethanonedollarinthe
future.
Todaysonedollarcanbesavedorinvested,
d h f f f
Whatisthetimevalueofmoney?
andthereforeearnarateofreturnforyou.
Asaresult,timewillhelpyoureachyour
longtermfinancialgoal.
11
Whatistimevalueofmoney?
Thetimevalueofmoneyconceptisbasedon
asimpleequation:
n
i PV FV ) ( 1
12
whereFV
n
istheamountofmoneyyouwill
haveinabankaccountinn years;PV ishow
muchyouhaveintheaccountnow;andi is
theannualinterestrate.
n
i PV FV ) ( 1
82
Supposeyouhave$100inabankaccount
thatpaysanannualinterestrateof4%.How
muchmoneywillyouhavein3years?
Howmuchmoneywillyouhave?
13
Youcanusethesameequationtosolvefor
thepresentvalue(PV).
Howmuchdoyouneedtodeposittodayin
ordertohave$200in5yearsinanaccount
that pays 5% interest rate?
Howmuchmoneydoyouneedto
save?
thatpays5%interestrate?
14
Supposeyousave$500eachyearintoan
accountwith3%interestrate.Howmuch
moneywillyouhavein20years?
Thissituationrequiresyoutoapplythetime
value of money equation to each of your
Howmuchmoneywillyouhave?
valueofmoneyequationtoeachofyour
annualdepositsandfindthefuturevalue.
Thesumofall20FVs istheamountyouwill
haveattheendofYear20.
Isthereaneasierwaytocompletethe
calculation?
15
83
Supposeyouwanttohave$1millioninthe
accountwhenyouretirein40years.How
muchdoyouneedtosaveeachyear?
Inthiscase,youneedtosolveforPMT.
Howmuchmoneydoyouneedto
save?
16
84
BorrowingandConsumerCredit
Themeaningofcredit
Theprosandconsofusingcredit
Varioustypesofconsumercredit
Th k f h ff i
Whatwillyoulearn?
Thekeyfactorsthataffectyouropportunity
toborrowmoney
Howtocalculatethemonthlypaymentofa
loan
2
Creditisanarrangementtoreceivecash,
goodsorservicesnowandpayforthemin
thefuture.
Borrowingmoneyisanexampleofusing
credit.
Whatiscredit?
credit.
Theborrowerreceivesmoneyfromalender
(theamountborrowediscalledtheprincipal)
andneedsto:
Repaytheprincipal
Payinterest
3
85
Whatisconsumercredit?
Consumercreditistheuseofcreditfor
personalneedsbyindividualsandfamilies,in
contrasttocreditusedbybusinessesand
governments.
Examples include:
4
Examplesinclude:
Borrowinganautoloanforthepurchase
ofacar
Borrowingastudentloantopayforan
education
Usingacreditcardtopayforgroceries
Advantagesofusingconsumercredit:
Immediateenjoymentofgoodsand
services
Convenience
Shouldyouuseconsumercredit?
Safety
Disadvantagesofusingconsumercredit:
Overspending
Cost
5
Closedendcreditinvolvesborrowingthat
hasaspecifiedloanamountandisfora
specificpurpose.
Examples include:
Whattypesofconsumercreditare
available?
Examplesinclude:
Homemortgageloans
Autoloans
Studentloans
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86
Openendcredit(revolvingcredit)istypically
notusedforasinglepurpose.
Ithasamaximumamountthatisapproved
by the creditor (the line of credit) but not
Whattypesofconsumercreditare
available?
bythecreditor(thelineofcredit)butnot
deliveredtotheborroweratonce.
Overtime,theborrowercangetmoneyfrom
thelender,orpaybackaportionortheentire
amountoftheprincipal.
Examplesinclude:
Creditcards
Homeequityloans
7
Whenmakingaloan,thelenderismakingan
investmentandtheinterestrateistherateof
returnontheinvestment.
Themainconsiderationishowriskythe
investment is.
Whatfactorsdolendersconsider?
investmentis.
Theriskinessofaloanisreflectedintwo
factors:
Theprobabilityofincurringlosses
Theseverityofpotentialloss
8
Ingeneral,lendersofconsumerloans
considerfourkeyfactors,the4Cs,when
decidingwhetheraloanapplicationshould
beapproved:
Capacity
Whatfactorsdolendersconsider?
Capacity
Capital
Collateral
Character
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87
Capacityisyourfinancialabilitymainlyyour
incometomeettheloanobligations.
Capitalistheassetsownedbytheborrower.
Whatarethe4Cs?
Collateralisavaluableassetthatispledged
totheloan.
Characterreferstoonesattitudetoward
financialobligations.
10
Becauseattitudeisverysubjectiveand
difficulttomeasure,creditorstypicallyuse
creditscoreasasubstitutefortheborrowers
character.
Your credit score is a number that
Howdolendersmeasurecharacter?
Yourcreditscoreisanumberthat
summarizesyourhistoryofusingcredit.
Themostcommonlyusedcreditscoreis
calledaFICOscore.
11
TheFICOscorewasdevelopedbyFairIsaac
Corporation(FICO)tomeasurecreditrisk.
Thisscorehasarangeof300to850;the
higherthescore,thelowertherisk.
WhatisaFICOscore?
Whencomputingthescore,FICOuses
informationfromyourcreditreport,which
describesthetypesofcredityouhave,the
lengthoftimeyouhaveusedcredit,and
whetheryouvepaidyourbillsontime.
12
88
WhatdoestheFICOscoreevaluate?
35%
15%
10%
10%
Paymenthistory
Amountsowed
h f di hi
13
30%
Lengthofcredithistory
NewCredit
Tyepsofcreditused
Annualpercentagerate(APR)isthecostof
creditexpressedinayearlyrate;itincludes
theinterestrateaswellasotherlenderfees
theborrowerisrequiredtopay.
The better your credit score, the lower the
Whyiscreditscoreimportant?
Thebetteryourcreditscore,thelowerthe
APRyouwillbecharged.
Havinggoodcreditcansaveyoualotof
money.
14
Nosinglestandardthatisagreeduponbyall
lendersexists;therefore,thereisnosingle
definitionofexcellentorgoodcredit.
Asageneralguideline,aFICOscoreabove
770isexcellent;ascorebetween700and770
i d d b t 650 d 700 i
Whatisgoodcredit?
isgood;andascorebetween650and700is
average.
IfyourFICOscoreisbelowthemid600s,you
mayhavedifficultyobtainingaloan.
15
89
Considera$12,000,fiveyearautoloanwith
a4.80%APR.Howmuchisthemonthly
payment?
Thistypeofloancallsforequalmonthly
payments. Each payment includes principal
Whatisyourloanpayment?
payments.Eachpaymentincludesprincipal
repaymentandinterestpayment.
Thegradualrepaymentofprincipalovertime
iscalledamortization.
16
UsingtheformulafromChapter3,youcan
calculatethemonthlypayment.Inthiscase,
themonthlypaymentis$225.36.
Thepaymentstaysthesameovertime,but
the breakdown changes month by month.
thebreakdownchangesmonthbymonth.
Astheprincipalbalancedeclines,theinterest
chargedontheloaneachmonthdecreases.
Giventheconstantmonthlypayment,the
principalportionrises.
17
Thebreakdownis:
Month
Interest
Payment
Principal
Repayment
Principal
Balance
1
$48.00 $177.36 $11,822.64
18
2
47.29 178.07 11,644.58
3
46.58 178.78 11,465.80
58
2.68 222.67 448.02
59
1.79 223.56 224.46
60
0.90 224.46 0.00

90
Interest
Howdoesgoodcredithelpyousave
money?
Letsconsiderthesame autoloanwithfive
differentinterestrates:
19
Rate 0.00% 2.40% 4.80% 7.20% 9.60%
Monthly
Payment
$200.00 $212.44 $225.36 $238.75 $252.61
Total
Interest
$0.00 $746.38 $1,521.41 $2,324.90 $3,156.55
91
FinancialDecisionMakingin
College
Thebenefitsandcostsofattendingcollege
Keyfactorstoconsiderwhenchoosingcredit
cards
Important things to know when renting an
Whatwillyoulearn?
Importantthingstoknowwhenrentingan
apartment
2
Whatarethefinancialbenefitsof
havingacollegedegree?
MedianAnnual EarningsbyEducationAttainment
3
92
Whatarethefinancialbenefitsof
havingacollegedegree?
Higherstartingsalary
Fasterincomegrowth
4
Tuitionandfees
Roomandboard
Booksandsupplies
P l
Whatarethecostsofattending
college?
Personalexpenses
Transportation
5
Shouldallthecostsbeincludedinyour
analysis?
Youshouldfocusontheincremental
costs
Whatarethecostsofattending
college?
costs.
Whatisopportunitycost?
Opportunitycostshouldbetakeninto
accountinfinancialanalysis.
6
93
Doyouhaveacreditcard?
7
Interestrate,orAPR
Creditlimit
Feesandpenalties
I ti
Howdoyouchooseacreditcard?
Incentives
8
Carryonlyonecreditcard(andpossiblya
secondoneforemergency).
Donotoverspend.
Payyourbillsontime.
Howcanyoutakecontrolofcredit
cards?
y y
9
94
Identitytheftoccurswhenapersons
identification(includingname,socialsecurity
numberand/oranyaccountnumber)isused
ortransferredbysomeoneelseforunlawful
activities.
Whatisidentitytheft?
Itisoneofthefastestgrowingcrimesinthe
U.S.FederalBureauofInvestigation(FBI)
estimatesthatmorethanhalfamillion
Americansbecomevictimseachyear.
10
Whatwillhappenifyouridentityis
stolen?
11
TheArea
Safety
Distancetoschool
Transportation
Howdoyouchooseanapartment?
TheBuilding
Quality
Parking
Amenities
TheUnit
12
95
Aleaseisacontractbetweenalandlordand
atenant.Itdetailsyourrightsand
responsibilitiesasatenant,andspecifiesthe
financialterms.
L T
Whatisaleaseagreement?
LeaseTerms:
Rent
Lengthoflease(term)
Expensesincluded/excluded
Securitydeposit
Incentives
Options
13
Rentersinsuranceisatypeofhome
insurancethatprotectstheholderagainst
accidents,damagesandlossesthatoccurina
rentedresidence.
With renters insurance, if your valuables in
Whydoyouneedrentersinsurance?
Withrenter sinsurance,ifyourvaluablesin
theapartment(suchascomputer,video
gameconsoleandfurniture)are
damaged/lostduetofire,earthquake,theft
orotherreasons,theinsurancecompanywill
replacethem.
14
96
SavingandInvesting
Thepopularmeanstoinvestmoneyforyour
longtermgoals
Thebasicsofthestockandbondmarkets
Various ways to invest in real estate
Whatwillyoulearn?
Variouswaystoinvestinrealestate
Howmutualfundswork
Theimpactofpayingtaxesonyourrateof
return
2
Howmuchmoneywillyouhavefor
yourretirement?
$400 000
$600,000
$800,000
3
$0
$200,000
$400,000
1 6 11 16 21 26 31 36
3% 6% 9%AnnualReturn
97
Howcanyouinvestyourmoney?
BankAccounts
Bonds
Stocks
RealEstate
4
MutualFunds
5.00%
6.00%
7.00%
AnnualRateofReturn(19912010)
Whatisthetypicalreturnonmoney
marketaccounts?
0.00%
1.00%
2.00%
3.00%
4.00%
5
Abondisadebtsecurity.
Theissuerofabond(whichistypicallya
governmentoracompany)borrowsmoney
bysellingthebondtoinvestors.
The investors (also known as bondholders)
Whatisabond?
Theinvestors(alsoknownasbondholders)
receiveinterestpaymentfromtheissuer
periodically,andgettheprincipalbackwhen
thebondexpires(atthematuritydate).
6
98
Priortomaturity,bondholderscannot
redeemthebondbacktotheissuerforcash,
buttheycansellitinthebondmarketto
otherinvestors.
The sale price could be different from the
Whatisabond?
Thesalepricecouldbedifferentfromthe
principalamount,dependingonthe
economicconditionsatthetime.
7
TreasurybondsareissuedbytheU.S.federal
government.
Municipalbondsareissuedbystateorlocal
governments.
Corporate bonds are issued by corporations
Whatarethetypesofbonds?
Corporatebondsareissuedbycorporations.
8
Moodys S&P Fitch
Aaa AAA AAA
Aa AA AA
Howdoyouassesstheriskinessofa
bond?
TheBondRatingSystems
Investment Grade
A A A
Baa BBB BBB
Ba BB BB
B B B
C C C
D D D
9
Investment Grade
NonInvestment Grade
(JunkBonds)
InDefault
99
15.00%
20.00%
Whatisthetypicalreturnonbond
investments?
5.00%
0.00%
5.00%
10.00%
10
Astockrepresentsownershipina
corporationandeachshareofthestock
representsaportionoftheownership.
Whatisastock?
11
Whenyoubuysharesofacompany,you
becomeoneofitsowners(alsoknownas
shareholders).
Periodicallythecompanymaypayaportion
Howdoyoumakemoneyonstock
investment?
y p y y p y p
ofitsprofitsasdividendstoitsshareholders.
12
100
Asthecompanygrows,thevalueofthe
sharesyouownmayincrease.Ifyousellthe
sharesatapricehigherthanthepriceyou
paid,youmakeaprofit(calledcapitalgain).
investment?
However,itispossiblethatthesalepriceis
lessthanthepurchaseprice.Inthatcase,
youlosemoney(capitalloss).
13
Stockinvestorsmakemoneyby
Receivingdividends
Potentiallyearningacapitalgain
investment?
14
20.00%
30.00%
40.00%
Whatisthetypicalreturnonstock
investments?
40.00%
30.00%
20.00%
10.00%
0.00%
10.00%
15
101
Therearedifferenttypesofstockmarkets.
NewYorkStockExchange(NYSE)
Locatedat11WallStreetinNewYorkCity
Whereisthestockmarket?
y
Theoldestandlargeststockexchangein
theU.S.
NASDAQ
Theworldsfirstandlargestelectronic
stockmarket
16
Astockindexisanindicatorusedtomeasure
thevaluechangesinthestockmarket(ora
sectionofthemarket).
Most Recognized Stock Indexes
Whatisastockindex?
MostRecognizedStockIndexes
NASDAQComposite
S&P500
17
Realestateislandandfixed,immovable
improvements(suchasbuildings,
landscaping,etc.)ontheland.
DifferentTypesofRealEstate
Residential real estate is mainly used as
Whatisrealestate?
Residentialrealestateismainlyusedas
residencebyitsowner.
Commercialrealestate,ontheotherhand,
ismainlyusedforincomeproducing
purposes.
18
102
BuyingaHome
InvestinginCommercialRealEstate
Howdoyouinvestinrealestate?
19
20.00%
30.00%
40.00%
Whatisthetypicalreturnonreal
estateinvestments?
40.00%
30.00%
20.00%
10.00%
0.00%
10.00%
20
Amutualfundisanentitythatpoolsmoney
frommanyinvestorsandusesthefundsto
acquireavarietyofinvestments(suchas
stocksandbonds).
How does it help small investors?
Whatisamutualfund?
Howdoesithelpsmallinvestors?
Lowminimuminvestmenthurdle
Diversification
Professionalmanagement
21
103
Itdependsonyourpersonalpreferencesand
thestageofyourlifecycle.
LifeCycleofInvesting
Accumulation
Consolidation
Whichoneisthebestinvestment?
22
Consolidation
Spending
Gifting
IncomeTax
SalesTax
PropertyTax
CapitalGainsTax
Whattypesoftaxesdoyoupay?
23
Beforetaxrateofreturniswhatyour
investmentgenerates.
Aftertaxrateofreturniswhatyouactually
getafterpayingallrelevanttaxes.
Howdotaxesaffectyourfinancial
goals?
Whichoneshouldyouuseinplanningfora
financialgoal?
AfterTaxReturn=BeforeTaxReturn (1 TaxRate)
24
104
BuyingYourFirstHome
Thebenefitsandcostsofhomeownership
Howtochooserealestateprofessionalsto
helpyouwiththehomepurchasedecision
How to find the right home for you
Whatwillyoulearn?
Howtofindtherighthomeforyou
Howtoselectfromnumeroustypesof
mortgages
2
Howmuchdoesahousecost?
3
105
$150,000
$200,000
$250,000
TheMedian HomePriceintheU.S.
4
$0
$50,000
$100,000
1970 1975 1980 1985 1990 1995 2000 2005 2010
400 000
600,000
800,000
5
0
200,000
400,000
LosAngeles Sacramento SanDiego SanFrancisco
2006 2010
Shouldyouownahome?
DirectCostsofHomeOwnership
Mortgagepayment
Otherhousingexpenses
6
OtherCosts
Lackofmobility
Opportunitycosts
106
FinancialBenefitsofHomeOwnership
Taxsavingsfrommortgagepayments
Accumulationofequity
P t ti l i ti f h l
Shouldyouownahome?
Potentialappreciationofhomevalue
7
RealEstateAgent
MortgageBanker/Broker
Whosehelpdoyouneedwhen
buyingahome?
8
Mosthomebuyersmakeadownpayment
(typically3%to20%)andborrowthe
remainingpurchasepricewithamortgage.
A mortgage is a loan that uses real estate as
Howdoyoufinancethepurchaseof
yourhome?
Amortgageisaloanthatusesrealestateas
collateralfortherepaymentoftheloan.
9
107
InterestRate
Fixedratemortgages(FRM)
Adjustableratemortgages(ARM)
Hybridmortgages
Whattypesofmortgagesare
available?
y g g
TermtoMaturity
30yearmortgages
15yearmortgages
Amortization
Interestonlymortgages
10
Mostmortgagescallforconstantmonthly
payments.Thepaymentcanbecalculated
withthepresentvalueformulainChapter3.
Forafixedratemortgage,themonthly
payment depends on:
Howmuchdoyouneedtopay?
paymentdependson:
Loanamount(PV)
Interestrate(i,monthlyrate)
Termtomaturity(n,numberofmonths)
11
Supposeyouborrow$200,000witha30
year,fixedratemortgageata6%interest
rate.Themonthlypaymentis$1,199.10.
Eachpaymentincludeinterestpaymentas
well as principal repayment
wellasprincipalrepayment.
Atthebeginning,interestrepresentsthe
majorityofthepayment.
Overtime,theportionofprincipal
repaymentincreases.
12
108
800
1,000
1,200
1,400
0
200
400
600
800
Interest Principal Total
13
Whatisthecostofborrowinga
mortgage?
14
InterestRate
DiscountPoints
OtherFees
Application
Whatisthecostofborrowinga
mortgage?
pp
Underwriting
Origination
TheAPRofamortgageincludestheinterest
rate,thediscountpoints,aswellasother
lenderfeestheborrowerisrequiredtopay.
15
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