Personal Finance

Chapter 10 & 12 Personal Finance TOPICS: 1. Stocks & Bonds 2. Who is the SEC & FDIC? 3. Mutual Funds & I.R.A.s 4. Interest Rates: Simple and Compound 5. Risk and Return: The Correlation 6. Loans, Credit Cards & Mortgages on Homes 7. Types of Insurance 8. Personal Budget Generation 9. Virtual Stock Exchange Simulation LET’S FIRST LOOK AT SOME BASICS OF INVESTING. WHO INSURES YOUR MONEY IN YOUR SAVINGS, CHECKING & CERTIFICATE OF DEPOSIT? FDIC (Federal Deposit Insurance Corporation)  An independent deposit insurance agency created by Congress in 1933 to maintain stability and public confidence in the nation's banking system.  It insures consumer deposits in a bank for up to $100,000 per account.  Deposits include checking and savings accounts and certificates of deposit (CD). WHO MONITORS THE STOCK MARKET IN THE USA? (Bonds, Stocks, & Mutual Funds) Regulating Stock Trading Stocks, bonds, and mutual funds are regulated by the: Securities and Exchange Commission (SEC) 1. The SEC regulates all trading of all securities in America. 2. They help ensure that the Stocks, Bonds, & Mutual Funds that are for sale are legitimate and from a company that shows (or could show) a profit. 3. The SEC helps protect and regulate the trading process and practices of companies. 4. They also establish ethics for stock brokers, which reduces the amount of unethical and illegal activities in the business of trading securities. (Such as insider trading.) WHAT DOES THE SEC WATCH? (Bonds, Stocks, & Mutual Funds) Securities Stocks, Bonds, and Mutual Funds are called securities: Securities: A financial instrument which represents a claim over assets or future profits of a company.  Such instruments are usually tradable on a market like the NYSE, NASDAQ, AMEX.  Certificates of Deposit (CD)  Rental Pools (time shares for vacation)  Other examples of a security include: Securities Why do corporations need stocks and bonds? The company is expanding, which is usually: 1.) CAPITAL INTENSIVE The expansion requires a lot of CAPITAL or machinery, tools, factories, training (human capital, etc.). 2.) LABOR INTENSIVE The expansion requires a lot of LABOR, which requires the company to pay more wages and salaries. Debt Securities This is known as Equity Financing: Stocks: money given by stockholders that they are willing to risk in the hopes of a return on their investment.  There is no guarantee of a return on your investment.  At least the company has been reviewed by the Securities and Exchange Commission (SEC). Two types of Stock: Common Stock: many shares of this and it does not have benefits, like paying a dividend.  Dividend is a regular payment written to the stockholder. Preferred Stock: fewer shares of this offered to the public and it generally does pay a dividend. Debt Securities This is known as Debt Financing: Bonds: bondholders become the lender.    When a bond is issued the corporation or government is borrowing money from a bondholder with the promise that it will repay the debt + interest. Generally you only make money on a bond after a long period of time (5 years, 10 years, etc.) The Federal Reserve Bank helps set the prime rate of interest on ALL debt instruments (bank loans and bonds)…  …it is the interest rate that banks should charge their best customers…  …then companies may add (or subtract) their own interest rate ON TOP of the prime rate. Government Debt Securities Types of Government Bonds:   Savings Bonds: generally sold at half face value and can be bought in dominations of $25 or $50. Interest will be paid over 30year period. T-Bills: sold at a specific discount (always changing) to the face value and can be bought in dominations of $100 up to a 52-Week period.    T-Notes: sold at a specific discount (always changing) to the face value and can be bought in dominations of $100 either for 2, 3, 5, 7, or 10 years. TIPS: (Treasury Inflation-Protected Securities) sold at a specific discount (always changing) to the face value and can be bought in dominations of $100 either for 5, 10, or 20 years. The interest rate tracks inflation. Municipal Bonds: issued by a county government to fund projects. Involve repayment at various period based on the needs of the local government. Debt Securities BONDS INVESTOR After 5 years, the company has to repay bond (+ interest) Estimated return of $635 Buys a $500, 5 year Bond at 5% interest (Compounded monthly over 60 months) (You can buy it directly from the company or you can go through a bank) COMPANY Problem: Is $635 going to be worth the same in 5 years? NO INFLATION: the steady rise of prices for goods and services. Improve factories Purchase Capital Mutual Funds (Key Word: Diversity) Mutual Funds Examples: Mutual Funds: mutual funds are not sold by the corporation directly. They are sold by banks and investment firms.  A mutual fund is a combination of hundreds of pieces of different stocks from many different corporations.  The benefit of a mutual fund is that it is a diversified investment (not all your eggs are in one basket)...  …and a mutual fund is controlled by a investment firm, which means when you buy a mutual fund you benefit from professional management. Mutual Funds INVESTOR Mutual Fund Examples MUTUAL FUND COMPANY Diversify Team of professional management Automotive Stock Medical Stock Oil Stock HOW TO SAVE FOR RETIREMENT? (IRAs, 401ks, & Mutual Funds) I.R.A. Individual Retirement Account (Setup by you) & 401K, 457 (b), or 403 (b) (Setup by your employer) BOTH ARE USUALLY FUNDED BY MUTUAL FUNDS 401Ks: In 1978, Congress amended the Internal Revenue Code, later called section 401(k), whereby employees are not taxed on income they choose to save for retirement… Saving for the Far Future IRAs & 401Ks  …however, in order to qualify an employer generally sets   up this account on behalf of a employee and contributes to the employee’s retirement and… …money cannot be withdrawn from the 401k until age 60. If money is taken out for emergencies then the employee must surrender 10% of the withdrawn amount as a penalty for early withdrawal. (457b can be withdrawn without 10% deduction) IRAs: The only difference is that these are set up by individuals and employers do not contribute to the account. So, how much can one make on these accounts? IRA & 401k EMPLOYEE REQUIREMENTS: CANNOT WITHDRAW UNTIL 60 YEARS OLD. MAX YOU CAN PUT IN PER YEAR IS $4,500 FOR AN INDIVIDUAL. BENEFITS: DEPOSIT ARE NOT TAXED UNTIL YOU RETIRE. IRA Calculator Employer (or you) places % of your paycheck in the 401K on your behalf. INVESTMENT COMPANY (BUYING MANY MUTUAL FUNDS) Medical Stock Diversify Team of professional mutual fund managers Oil Stock Automotive Stock HOW DOES ONE CALCULATE RETURNS BASED ON INTEREST RATES? Simple & Compound Methods Simple Interest versus Compound Interest 1.) Simple interest  With a simple interest rate, the interest is determined with the original loan amount.  In other words, simple interest is calculated only on the beginning principal.  Note: Simple interest is always calculated semiannually or yearly. The math would look like this: If they continued to receive 5% interest on the original $100 amount, over ten years the growth in their investment would look like this: Year 1: 5% of $100 = $5 + $100 = $105 Year 2: 5% of $100 = $5 + $105 = $110 Year 3: 5% of $100 = $5 + $110 = $115 Year 4: 5% of $100 = $5 + $115 = $120 ..... Year 10: 5% of $100 = $5 + $145 = $150 Simple Interest versus Compound Interest 2.) Compound interest  With a compound interest rate, future interest is determined with the existing amount in the account (not the original amount).  Note: Compound interest is usually calculated per month or per day. EXAMPLE: Compounding per year would be as follows: Year 1: 5% of $100 = $5 + $100 = $105 Year 2: 5% of $105 = $5.25 + $105 = $110.25 Year 3: 5% of $110.25 = $5.52 + $110.25 = $115.76 Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.54 ... Year 10: $162.89 Simple Interest versus Compound Interest Compare the TWO ways to compute interest: 1.) Simple interest Year 1: 5% of $100 = $5 + $100 = $105 Year 2: 5% of $100 = $5 + $105 = $110 Year 3: 5% of $100 = $5 + $110 = $115 Year 4: 5% of $100 = $5 + $115 = $120 . . . . Year 10: = $150 2.) Compound interest Year 1: 5% of $100 = $5 + $100 = $105 Year 2: 5% of $105 = $5.25 + $105 = $110.25 Year 3: 5% of $110.25 = $5.52 + $110.25 = $115.76 Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.54 . . . . Year 10: = $162.89 Which one would an investor prefer? Which one would a company that issues the investment prefer? Interest Earned Formulas How to compute Simple Interest Earned? (Effective Interest rate) Interest = Present Value x APR / # per year x Total # periods Gained OR PV + I = PV x i x n How to compute Compound Interest Earned? Future Value = Principal (1 + APR / # per year ) Total # periods OR “Present Value” (Effective Interest rate) FV = PV (1 + i)n Simple Interest $100 Period 0 $105 Period 1 The above example is an investment simple interest semi-annually (twice a year) at 10% interest. $110 APR =10% Period 2 Notation:  PV + PV + I = PV × i × n I = present value + interest earned  PV = present value  i = effective periodic rate (APR / # periods in 1 year)  n = total number of periods to invest PV + I = PV × i × n 27 Compound Interest $100 Period 0 $110 Period 1 The above example is an investment compounded semi-annually (twice a year) at 10% interest. $121 APR =10% Period 2 Notation:  FV = future value FV = PV (1 + i)n  PV = present value  i = effective periodic rate (APR / # periods in 1 year)  n = total number of periods to invest FV = PV (1 + i)n OR FV PV = (1 + i)n 28 Simple Interest Earned Practice PV + I = PV × i × n EX: You purchased a $1,000 Certificate of Deposit today @ 4.5% APR for 5 years. Simple interest is computed every 6-months (semi-annually). What is the future value of the bond? EFFECTIVE RATE: APR .045 / 2 periods = .0225 (effective rate) $1,000 x .0225 x 10 periods = $225 ($225 gained in interest) TOTAL INVESTMENT VALUE: $1,000 + $225 = $1,225 Compound Interest Earned Practice FV = PV (1 + i)n EX: You purchased a $1,000 Certificate of Deposit today @ 4.5% APR (annually) for 5 years. Interest is compounded every 6-months (semi-annually). What is the future value of the bond? .045 / 2 periods per year = .0225 Effective Rate of Interest EX: $1000 (1 + .0225) 10 periods = $1,249 future value ($249 gained in interest) OR EX: $1000 = $1,249 (1 + .0225) 10 Compound Interest Earned Practice FV = PV (1 + i)n EX: You have $300 in your savings today @ 2% APR (annually) for 1 year. Interest is compounded every day. What is the future value of the account? .02 / 365 periods per year = .000054 Effective Rate of Interest EX: $300 (1 + .000054) 365 periods = $305.97 future value ($5.97 gained in interest) OR EX: $300 = $305.97 (1 + .000054) 365 Compound Interest Earned Practice EX: You have $300 in your savings today @ 2% APR for 1 year. Interest is compounded every day. What is the future value of the account? EX: $300 (1 + .000054) 365 periods = $305.97 future value ($5.97 gained in interest) EX: You have $300 in your savings today @ 2% APR for 1 year. Interest is compounded every month. What is the future value of the account? 12 periods EX: $300 (1 + .0016) Notice that 2% × $300 = $6.00 = $305.81 future value ($5.81 gained in interest) Compound Interest Earned Practice EX: You purchased a $5,000 C.D. today @ 4% APR for 2 years. Interest is compounded every month. What is the future value of the bond? EFFECTIVE RATE: .04 APR ÷ 12 months = .003 (effective rate) 24 periods EX: $5000 (1 + .003) = $5,372 future value ($372 gained in interest) Compound Interest Earned Practice EX: You purchased a $20,000 bond today @ 6% APR for 10 years. Interest is compounded every month. What is the future value of the bond? EFFECTIVE RATE: APR .06 / 12 months = .005 (effective rate) 120 periods EX: $20,000 (1 + .005) = $36,387 future value ($16,387 gained in interest) OR $36,387 EX: $20,000 = (1 + .005) 120 HOW CAN INFLATION TAKE AWAY FROM RETURNS ON INVESTMENTS? Inflation: Increase in Prices over Time How can inflation effect investments? Inflation: Increase in Prices over Time Inflation and Interest Rates Inflation: the slow rise in prices for goods and services over the years MONEY IN THE BACK YARD: $1 10 Years $1 PRICES OUTSIDE THE BACK YARD: $1.00 10 Years 50% increase in price $1.50 Inflation and Interest Rates Vocab to Remember: Nominal Interest Rate: does not consider the effects of inflation. Real Interest Rate: does consider the effects of inflation. INVESTMENT EXAMPLE:  You buy a $500 bond in 2007 that you can withdraw in 5 years that will pay you 5% interest.  So let's say in five years (2012) you make about $660. The question you have to ask yourself is, what will this $660 buy you in 2012? Now you know that inflation over the next five years is going to be about 3%. So the bond is going to pay you 5% (this is known as the nominal rate of interest). What is the actual (or real rate of interest) that you receive after you adjust of inflation? How you figure this:  NOMINAL RATE (5%) MINUS inflation (3%) = REAL INTEREST RATE (2%) RISK AND RETURN: THE CORRELATION (Stocks, Bonds, Mutual Funds, Loans, Inflation, and Interest Rates) The Investment Relationship Between Risk and Return Loans: Borrowing Money When you borrow money it is required that you have some collateral. Collateral is an asset that the bank has some EQUITY in (they could sell it and get some of their money back)  It is required just in case you DEFAULT on your loan (can’t pay loan back).  The bank will repossess the collateral that you put on the loan. EXAMPLE: + BANK Collateral = LOAN If you can’t repay it… …you are going to be walking. Loans: Borrowing Money Car Loan Payment Formula PMT = i + [ i ((1 + i )n ) - 1 ] x PV Car Payment Formula Price of Car $23,000 Sales Tax 6% Down Payment $3,000.00 Total Price of Car $21,380 Interest Rate 1.00% Number of Months 60 Monthly Payment TOTAL $367.46 $26,457 The Loan Relationship Between Risk and Interest Charged No collateral loan Mortgage on a mobile home Loan for a boat Interest Charged Loan for a used car Loan for a new car Loan for a new business Mortgage on a house Loan for buying land Depends on the projected success of the business Risk to Bank Other Factors that Change Interest Rates Before we continue, remember this? “Aggregate” means “Total” “Aggregate demand” = total demand for all goods in a country “Aggregate supply” = total supply of all goods in a country We are moving into the study of MACROECONOMICS What changes Interest Rates? Demand and Supply Curve for Loans: The demand and supply curves for loans work the same way that they did for prices of goods.  Loans are a good that people buy and are subject to the Law of Supply and Law of Demand.  Instead of having price on the vertical axis, there is interest rates.  See the below example: Interest Rate 10% 9% 8% 7% 6% 5% 6% Aggregate Demand Surplus of loans available Aggregate Supply 350 400 450 500 550 600 650 Quantity of loans (in thousands) What changes Interest Rates? Question:  If consumer income increases then the demand for loans might shift to the left (decrease) because they do not need loans. What would happen to the aggregate interest rate? It could decrease (think of it as an inferior good) However, this may NOT be definite since inflation will effect the aggregate interest rate as well. Interest Rate 10% 9% 8% 7% 6% 5% 6% Aggregate Demand  Aggregate Supply 350 400 450 500 550 600 650 Quantity of loans (in thousands) CREDIT CREDITS & YOUR CREDIT SCORE (So easy to go into debt) Credit Cards  Shopping for credit cards is the same as shopping for a car  or picking the college you want to go to. It takes time in researching the best one that fits your needs. www.creditcards.com THINGS TO KNOW 1. Usually you are not charged interest if you pay off the balance within 25 days of making the purchase. 2. You must shop for the lowest interest rate, but still try to find the card that gives rewards, such as cash-back or miles for plane tickets. 3. By having a credit card and paying the balance on a regular basis, you will improve your credit history and FICO Score. (named after the Fair Issac Corp, the company that pioneered credit scoring. Scores average between 300 and 850, the higher the better) FICO Score/Credit Ratings Credit Reporting Agencies Credit Card Offer Effects of Credit Cards Great site for estimating the effects of interest charges? www.bankrate.com TYPES OF INSURANCE: HEALTH, LIFE, & LIABILITY Types of Insurance 1. Life Insurance: designed to provide loved-ones with a source of income to pay for funeral, housing, and children’s education expenses.  Becomes more expense as you get older. 2. Health Insurance: provides payments for regular and emergency healthcare procedures. Without this one can find that a single trip to the doctor can cost $600 to $2000. Emergency services can run $10,000 - $120,000.  Becomes more expense as you get older. 3. Liability Insurance: designed to provide protection incase you (or your property) injures someone. HOW TO BALANCE SPENDING AND SAVING? GENERATE A BUDGET GENERATING A BUDGET 1. Creating a budget generally requires three steps. a) Identify how you're spending money now. b) Evaluate your current spending and set goals that take into account your long-term financial objectives. c) Track your spending over time to make sure it stays within those guidelines. 2. Don't drive yourself nuts. Budgeting is a skill that comes with time. You MUST practice it on a daily/monthly basis in order for the rewards to surface. 3. Be disciplined in your practice of budgeting and you will live a richer and more rewarding life. Category Income: Taxes: (estimate 25% of your monthly income) Budgeted Amount @ Beginning of Month Actual Amount @ End of Month Difference After Tax Income: Expenses: (list the category that the expense falls into, i.e.: gas, food, entertainment, etc.) GAS ENTERTAINMENT FOOD INSURANCE CLOTHING HEALTHCARE PERSONAL CARE OTHER: please list category Totals from Worksheet A EXPENSES SUBTOTAL NET INCOME (Income - Expenses) TOTAL DIFFERENCE BETWEEN BUDGET AND ACTUAL = $ _________________ END PERSONAL FINANCE EMAIL ME ANY QUESTIONS