Answer questions, simply place in document, do not change document, no resources, no header, just place answers
Matthew Ramirez
BNF-102-098WB
Prof. Deane
18 February 2022
1. A few years ago, Simon Powell purchased a home for $220,000. Today, the home is worth $300,000. His remaining mortgage balance is $100,000. Assuming that Simon can borrow up to 80 percent of the market value, what is the maximum amount he can borrow?
5. Joshua borrowed $1,00 for one year and paid $100 in interest. The bank charged him a $10 service charge. What is the finance charge on this loan?
6. In problem 5, Joshua borrowed $1,00 on January 1, 2021, and paid it all back at once on December 31, 2021. What was the APR?
7. If Joshua paid the $1,000 in 12 equal monthly payments in problem 5, what is the APR?
10. What are the interest cost and the total amount due on a six-month loan of $1,500 at 13.2 percent simple annual interest?
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Focus on Personal Finance
An Active Approach to Help You Achieve Financial Literacy
FIFTH EDITION
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The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate
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Franco Modigliani Professor of Finance and Economics, Sloan School of Management,
Massachusetts Institute of Technology, Consulting Editor
FINANCIAL MANAGEMENT
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Focus on Personal Finance: An Active Approach
to Help You Achieve Financial Literacy
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Personal Finance
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Focus on Personal Finance
An Active Approach to Help You Achieve
Financial Literacy
FIFTH EDITION
Jack R. Kapoor
C O L L E G E O F D U P A G E
Les R. Dlabay
L A K E F O R E S T C O L L E G E
Robert J. Hughes
D A L L A S C O U N T Y C O M M U N I T Y C O L L E G E S
Melissa M. Hart
N O R T H C A R O L I N A S T A T E U N I V E R S I T Y
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FOCUS ON PERSONAL FINANCE: AN ACTIVE APPROACH TO HELP YOU ACHIEVE FINANCIAL
LITERACY, FIFTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill
Education. All rights reserved. Printed in the United States of America. Previous editions © 2013, 2010, 2008,
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not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.
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United States.
This book is printed on acid-free paper.
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All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.
Library of Congress Cataloging-in-Publication Data
Kapoor, Jack R., 1937–
Focus on personal finance : an active approach to help you achieve
financial literacy/Jack R. Kapoor, Les R. Dlabay, Robert J. Hughes, Melissa M. Hart.—Fifth edition.
pages cm
ISBN 978-0-07-786174-2 (alk. paper)
1. Finance, Personal. 2. Investments. I. Dlabay, Les R. II. Hughes, Robert
James, 1946– III. Hart, Melissa M. IV. Title.
HG179.K368 2016
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The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does
not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not
guarantee the accuracy of the information presented at these sites.
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Dedication
To my wife, Theresa, and my children, Karen, Kathryn, and
Dave; and in the memory of my parents, Ram and Sheela
Kapoor
To my wife, Linda, and my children, Carissa and Kyle; and
the memory of my parents, Les and Mary Dlabay
To my mother, Barbara Y. Hughes; and my wife, Peggy
To my husband, David Hart; and my children, Alex and
Madelyn
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Focus on . . . the Authors
Jack R. Kapoor, EdD, College of DuPage
Jack Kapoor is a professor of business and economics in the Business and Technology
Division of the College of DuPage, Glen Ellyn, Illinois, where he has taught business and
economics since 1969. He received his BA and MS from San Francisco State College and
his EdD from Northern Illinois University. He previously taught at Illinois Institute of
Technology’s Stuart School of Management, San Francisco State University’s School of
World Business, and other colleges. Professor Kapoor was awarded the Business and Tech-
nology Division’s Outstanding Professor Award for 1999–2000. He served as an assistant
national bank examiner for the U.S. Treasury Department and has been an international
trade consultant to Bolting Manufacturing Co., Ltd., Mumbai, India.
Dr. Kapoor is known internationally as a co-author of several textbooks, including
Business: A Practical Approach (Rand McNally), Business (Cengage Learning), Business
and Personal Finance (Glencoe), and Personal Finance (McGraw-Hill). He served as a
content consultant for the popular national television series The Business File: An Intro-
duction to Business and developed two full-length audio courses in Business and Personal
Finance. He has been quoted in many national newspapers and magazines, including USA
Today, U.S. News & World Report, the Chicago Sun-Times, Crain’s Small Business, the
Chicago Tribune, and other publications.
Dr. Kapoor has traveled around the world and has studied business practices in capital-
ist, socialist, and communist countries.
Les R. Dlabay, EdD, Lake Forest College
Teaching about the “Forgotten Majority” (the three billion people living on $2 or less a
day) is a priority of Les Dlabay, professor of business at Lake Forest College, Lake For-
est, Illinois. He believes our society can improve global business development through
volunteer time, knowledge sharing, and financial donations. In addition to writing several
textbooks, Dr. Dlabay teaches accounting and various international business courses. His
“hobbies” include a collection of cereal packages from over 100 countries and banknotes
from 200 countries, which are used to teach about economic, cultural, and political aspects
of international business environments.
His research involves informal and alternative financial services, microfinance, and
value chain facilitation in base-of-the-pyramid (BoP) market settings. Dlabay has pre-
sented more than 300 workshops and seminars for teachers and community organiza-
tions. He serves on the boards of Bright Hope International ( www.brighthope.org ), which
emphasizes microenterprise development through microfinance programs, and Andean
Aid ( www.andeanaid.org ), which provides tutoring assistance to school-age children in
Colombia and Venezuela. Professor Dlabay has a BS (Accounting) from the University of
Illinois, Chicago; an MBA from DePaul University; and an EdD in Business and Economic
Education from Northern Illinois University. He has twice received the “Great Teacher”
award at Lake Forest College.
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Robert J. Hughes, EdD, Dallas County
Community Colleges
Financial literacy! Only two words, but Bob Hughes, professor of business at Dallas County
Community Colleges, believes that these two words can change your life. Whether you
want to be rich or just manage the money you have, the ability to analyze financial deci-
sions and gather financial information are skills that can always be improved. Dr. Hughes
has taught personal finance, introduction to business, business math, small business man-
agement, small business finance, and accounting for over 35 years. In addition to Focus on
Personal Finance and Personal Finance, published by McGraw-Hill/Irwin, he has authored
college textbooks for Introduction to Business, Business Mathematics, and Small Business
Management. He also served as a content consultant for two popular national television
series, Dollars & Sense: Personal Finance for the 21st Century and It’s Strictly Business,
and he is the lead author for a business math project utilizing computer-assisted instruction
funded by the ALEKS Corporation. He received his BBA from Southern Nazarene Uni-
versity and his MBA and EdD from the University of North Texas. His hobbies include
writing, investing, collecting French antiques, art, and travel.
Melissa M. Hart, CPA North Carolina State University
Melissa Hart is a permanent lecturer in the Poole College of Management at North
Carolina State University. She was inducted into the Academy of Outstanding Teachers
in 2012. She teaches courses in personal finance and corporate finance. She has devel-
oped multiple ways to use technology to introduce real-life situations into the classroom
and the distance education environment. Spreading the word about financial literacy has
always been a passion of hers. It doesn’t stop at the classroom. Each year she shares her
common-sense approach of “No plan is a plan” to various student groups, clubs, high
schools, and outside organizations. She is a member of the North Carolina Association of
Certified Public Accountants (NCACPA) where she serves on the Accounting Education
Committee. She received her BBA from the University of Maryland and an MBA from
North Carolina State University. Prior to obtaining an MBA, she worked eight years in
public accounting in auditing, tax compliance, and consulting. Her hobbies include keep-
ing up with her family’s many extracurricular activities as well as working on various
crafts. She travels extensively with her family to enjoy the many cultures and beauty of the
state, the country, and the world.
Focus on . . . the Authors ix
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Question: How important are the financial decisions you make?
Answer: Because financial decisions can
change your life, they are very important. Just
for a moment think about the decisions you
make every day. For example:
• What happens if you run out of money
before your next payday?
• Should you pay cash or use a credit card?
• How much insurance do you need?
• Is this a good investment?
• How much should you save for
retirement?
For most people, the answers to questions like
these affect not only their financial security,
but also their quality of life. And while the answers to these questions are based
on your unique personal situation, this book and accompanying digital study tools
are designed to help you discover the answers to these questions, and many more.
Text (or eBook)
While the new, fifth edition of Focus on Personal Finance does not guarantee that
you will become a millionaire, it does provide the information you need to develop
a plan to achieve financial security. New to this edition is the “3 Steps to Financial
Literacy” feature. Each of the three steps is designed to give you a starting point
to help master the material in each chapter and includes websites and apps to help
you start your personal financial journey. Current content, examples, exhibits, and
box features within each chapter also illustrate how to apply important concepts to
your life. And at the end of each chapter, a chapter summary, discussion questions,
financial problems, and cases help you reinforce important concepts and review
for exams. This edition also includes a new continuing case that illustrates the
financial challenges a young couple experiences as they journey through the ups
and downs of life. Finally “Your Personal Financial Plan” sheets at the end of each
chapter help you build a plan that will enable you to achieve your personal and
financial goals both now and in the future.
Dear Personal Finance Students
and Professors
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Digital Package
As authors, we recognize the importance of providing quality digital products to
enhance learning. We’re especially proud of our digital study tools that accom-
pany this edition. For example, both the McGraw-Hill Connect™ and LearnSmart
websites contain student learning activities—all designed to help you experience
success. For more information about these digital products, visit the McGraw-Hill
website at www.mheducation.com .
Thank You
We sincerely thank you for your current and past support of Focus on Personal
Finance. We invite you to take a look at this new edition to see how Focus on Per-
sonal Finance can help you create the “right” financial plan to help you achieve
your personal and financial goals. Finally, we encourage you to email us if you
have comments or suggestions about the text or our digital study tools.
Welcome to the new Focus on Personal Finance!
Jack Kapoor
kapoorj@att.net
Les Dlabay
dlabay@lakeforest.edu
Bob Hughes
bhughes@dcccd.edu
Melissa Hart
mmhart@ncsu.edu
Dear Personal Finance Students and Professors xi
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New to This Edition
The fifth edition of Focus on Personal Finance contains new and updated boxed features,
exhibits and tables, articles, and end-of-chapter material. The following grid highlights
some of the more significant content revisions made to Focus, 5e.
Global Changes for all chapters
• New chapter opener.
• Action items for each learning objective.
• A revised Your Personal Finance Dashboard feature at the end of each chapter.
• A new Continuing Case feature at the end of each chapter.
• Revised and updated problems.
• Updated websites and apps on all “Your Personal Financial Plan” sheets.
CHAPTER 1
Personal Financial
Planning in Action
• Revised Exhibit 1–1 with expanded financial activities for various life situations.
• New coverage of the role of the financial system for personal financial decisions.
• New Exhibit 1–2 with an overview of the financial intermediaries and markets
that facilitate personal financial decisions.
• Revised Figure It Out! feature on using time value of money for achieving finan-
cial goals comparing formula, table, spreadsheet, and financial calculator methods.
CHAPTER 2
Money Management
Skills
• Revised Exhibit 2–1 with suggestions for storing and organizing financial docu-
ments in various formats.
• New content on storing financial documents “in the cloud.”
• New in-text example for calculating net worth.
• Updated content on selecting a savings technique.
• New From the Pages of Kiplinger’s Personal Finance with suggestions for budget-
ing and tracking your finances.
• New end-of-chapter case to evaluate and recommend actions for a household budget.
CHAPTER 3
Taxes in Your Financial
Plan
• New Caution! feature on IRS scams.
• Updated tax rate schedules (for 2014).
• Updated section: Calculating your Tax.
• Revised Figure It Out! feature: Short-Term and Long-Term Capital Gains.
• Revised Personal Finance in Practice: New tax form exhibits.
• Revised Exhibits 3–3 and 3–4 give updated tax forms.
• Revised Exhibit 3–5, showing tax tables and tax rate schedules.
• Updated electronic filing instructions.
• New coverage: 529 plan tax implications.
• New From the Pages of Kiplinger’s Personal Finance feature on taxes to consider
when traveling.
• Revised content on tax strategies.
• Revised Figure It Out! feature: Tax Credits vs. Tax Deductions.
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New to This Edition xiii
CHAPTER 4
Financial Services:
Savings Plans and
Payment Accounts
• Updated and expanded coverage of online and mobile banking.
• New coverage of the expanded use of and many fees associated with prepaid
debit cards.
• New Exhibit 4–2 provides an overview of mobile banking services.
• Updated coverage of “problematic” financial services such as pawnshops, payday
loan companies, and rent-to-own centers.
• New From the Pages of Kiplinger’s Personal Finance covering techniques for
enhanced saving.
• Updated coverage of various types of certificates of deposit.
• New coverage of peer-to-peer payments, which allows the transfer of money to
another person by e-mail or with a secured website.
• New Digi-Know? with coverage of chip-embedded credit and debit cards to
enhance security and reduce fraud.
CHAPTER 5
Consumer Credit
Advantages,
Disadvantages
Sources, and Costs
• New content in Advantages of Credit section highlighting the benefits that major
credit card issuers provide to their customers.
• New summary of advantages and disadvantages of credit.
• Updated Exhibit 5–2: Volume of Consumer Credit.
• Updated Did You Know? feature in the Credit Card section.
• Updated statistics for stored value cards for 2014.
• Updated Did You Know? feature in the Applying for Credit section.
• New material on credit scores: What is a credit score and what factors are used to
calculate it?
• New Did You Know? feature: What’s in Your FICO Score?
• New material on FICO and VantageScore: the consequences of not maintaining a
sound credit score can be very costly.
• New What Can You Do to Improve Your Credit Score? section and information on
how you can avoid credit-repair scams.
• New From the Pages of Kiplinger’s Personal Finance feature on how to combat
data theft.
• New material in Cosigning a Loan section: Private lenders are placing borrowers
into default and making balance due all at once when the cosigner dies or files for
bankruptcy.
• New material on the Consumer Financial Protection Bureau’s activities in 2014.
• Updated material in the Chapter 7 Bankruptcy section on filing and administrative fees.
• Updated Exhibit 5–10: U.S. Consumer Bankruptcy Filings, 1980–2014.
CHAPTER 6
Consumer Purchasing
Strategies and Wise
Buying of Motor
Vehicles
• New Did You Know? feature that provides money-saving tips and actions to avoid
overspending.
• New Caution! feature warning shoppers about buying fake and counterfeit prod-
ucts that can waste money and be dangerous.
• New From the Pages of Kiplinger’s Personal Finance comparing various sources
of previously-driven vehicles.
• New “Upside Down” example warning consumers to avoid a situation in which
the loan amount owed may exceed the current value of the vehicle.
• Revised text coverage of the consumer complaint process.
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xiv New to This Edition
CHAPTER 6
(Cont.)
• New Exhibit 6–6 with detailed information for each step of the consumer com-
plaint process.
• New Did You Know? feature with suggested websites to assist with basic legal
documents.
CHAPTER 7
Selecting and
Financing Housing
• Revised coverage of standard lease forms when renting.
• New From the Pages of Kiplinger’s Personal Finance covering current advice on
renting or buying your housing.
• Updated information on the process for financing a home purchase.
• Revised content on types of mortgages.
• Updated information on common closing costs (Exhibit 7–9).
• Expanded information on actions to take when attempting to lower your property
taxes.
CHAPTER 8
Home and Automobile
Insurance
• Added new material on Superstorm Sandy in the Potential Property Losses section.
• Updated Personal Finance in Practice feature on flood facts.
• New From the Pages of Kiplinger’s Personal Finance feature: “If my home is
damaged by a summer storm, will my insurance cover repairs?”
• New Personal Finance in Practice feature: Are You Covered?
CHAPTER 9
Health and Disability
Income insurance
• New From the Pages of Kiplinger’s Personal Finance feature on long-term care.
• Updated material in the Personal Finance in Practice box; HSAs: How They
Work in 2014.
• New and revised material in the Health Insurance and the Patient Protection and
Affordable Care Act of 2010 section.
• New section on the Affordable Care Act and the Individual Shared Responsibility
provision.
• New Personal Finance in Practice feature on the Affordable Care Act: Checklist
for You and Your Family.
• Updated and revised the section on high medical costs.
• Updated Exhibit 9–6: U.S. National Health Expenditures, 1960–2022.
• New Did You Know? feature: The average cost of a 3-day hospital stay.
• New Did You Know? feature: Victims of medical identity theft.
CHAPTER 10
Financial Planning with
Life Insurance
• Updated the How Long Will You Live? section.
• Updated Exhibit 10–1: Life Expectancy Tables, All Races, 2009.
• Revised the Types of Life Insurance Companies and Policies section.
• New Did You Know? feature: 75 million American families depend on life insur-
ance products.
• Added new material in the Term Life Insurance section.
• New Did You Know? feature: 146 million individual life insurance policies in
force in 2013.
• Expanded the discussion on group life insurance.
• New Did You Know? feature: What to do if you lose your life insurance policy.
• New Did You Know? feature: Insurance industry payouts.
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New to This Edition xv
CHAPTER 10
(Cont.)
• Expanded discussion on annuities.
• New discussion on index annuities.
• New Caution! feature emphasizes that an annuity is a long-term financial contract.
CHAPTER 11
Investing Basics and
Evaluating Bonds
• A new From the Pages of Kiplinger’s Personal Finance feature provides tips for
saving money and tactics to improve money management.
• A new Did You Know? feature provides information about the Motley Fool and
Kiplinger websites.
• Updated material and new examples are used in the section How the Time Value
of Money Affects Your Investments.
• New material about the risks of lost income and decrease in value is provided in
the section Safety and Risk section.
• A new Exhibit 11–3 helps students determine their investment risk profile.
• In the Factors That Reduce Investment Risk section, updated statistics for the
long-term performance of stocks and bonds are provided.
• A new Digi-Know? feature provides information about the Treasury Direct
website at www.treasurydirect.gov.
• A new convertible bond example for Wesco Corporation is included in the Types
of Bonds section.
• New information about the speculative nature of high-yield (junk) bonds is pro-
vided in the Types of Bonds section.
• A new example describes how Union Pacific Corporation used a sinking fund to
make sure funds were available to repay a corporate bond issue.
• An updated Did You Know? feature provides information about the yields for
10-year U.S. treasury notes and high-grade corporate bonds.
• A new interest calculation for a 4 percent IBM bond is provided in the Interest
Income section.
• A new example for calculating approximate market value is included in the Dollar
Appreciation of Bond Value section.
• An updated Exhibit 11–7 provides current information found on the Yahoo! bond
website for an AT&T bond.
• An updated Case in Point provides revised or new investment options that students
must evaluate.
CHAPTER 12
Investing in Stocks
• Updated statistics for the long-term performance of stocks and bonds is provided
in the Common and Preferred Stock section.
• A new Exhibit 12–1 provides information on the record date and ex-dividend date
for a Microsoft quarterly dividend.
• A new Did You Know? feature provides information about how fraudsters use a
practice called “pump and dump” to increase the price of a stock before selling the
stock at a profit.
• The Dollar Appreciation of Value section and a new Exhibit 12–2 illustrate how
investors made money by buying and then selling Johnson & Johnson stock at the
end of a three-year period.
• In the Possibility of Increased Value from Stock Splits section, the effect of a two-
for-one stock split by Under Armour is explained.
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xvi New to This Edition
CHAPTER 12
(Cont.)
• Exhibit 12–3 now provides revised definitions for blue-chip, micro cap, and penny
stocks.
• The information available on the Yahoo! Finance website for Facebook is discussed
in the updated The Internet section and a new Exhibit 12–4.
• A discussion of the information available from Value Line for the Disney Corpora-
tion is provided in the Stock Advisory Services section and a new Exhibit 12–5.
• A new From the Pages of Kiplinger’s Personal Finance feature presents information
about how investors can use the information in a firm’s annual report to become
better investors.
• An updated Did You Know? feature provides information on the Dow Jones
Industrial Average.
• New and updated examples are included in the Numerical Measures That influ-
ence Investment Decisions section.
• A new example includes information about projected earnings for Starbucks in the
Projected Earnings section.
• New information on beta and an example of a beta calculation for Google is pro-
vided in the Other Factors That Influence the Price of a Stock section.
• A new example describes how Papa Murphy’s used an initial public offering (IPO)
to obtain financing.
• A new Did You Know? feature describes investor options for holding securities
(physical certificates, street name, or direct registration) until they are sold.
• A new Exhibit 12–6 illustrates typical commissions charged for online, telephone,
and broker-assisted stock transactions.
• In the Sample Stock Transactions section, a new example provides information
about a limit order for eBay.
• In the Sample Stock Transactions section, a new example provides information
about a stop-loss order for General Motors.
• A new Personal Finance in Practice feature describes the techniques investors can
use to pick a winning stock.
• Exhibit 12–7 illustrates the dollar cost averaging concept for an investment in
Johnson & Johnson over a seven-year period using current stock values.
• In the Selling Short section, a new example describes how an investor could profit
using the selling short technique for a General Motors stock transaction.
• A new Case in Point asks students to evaluate the Disney Corporation using the
information in the Value Line report in Exhibit 12–5.
CHAPTER 13
Investing in Mutual
Funds
• To illustrate how important funds are for investors, updated statistics are provided
in the Why Investors Choose Mutual Funds section.
• An updated Did You Know? feature provides information about who owns mutual
funds.
• A new Exhibit 13–1 provides information about the type of securities contained in
the Invesco Dividend Income Fund.
• New statistics about the number of closed-end, exchange-traded, and open-end
funds are included in the Characteristics of Funds section.
• The fee table in Exhibit 13–2 has been updated to illustrate current fees for the
Davis Opportunity Fund.
• The investment objective for the Vanguard Mid-Cap Fund is now included in the
Classification of Mutual Funds section.
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New to This Edition xvii
CHAPTER 13
(Cont.)
• A new Did You Know? feature illustrates the type of funds investors use to obtain
their financial goals.
• The number of socially responsible funds has been updated in the Did You Know?
feature.
• A new From the Pages of Kiplinger’s Personal Finance feature describes how
employees can lower the fees associated with their retirement accounts.
• A new Exhibit 13–4 describes the information about the T. Rowe Price Value Fund
available from the Morningstar website.
• A detailed Morningstar research report for the Oakmark Global Select I Fund is
illustrated in Exhibit 13–5.
• A new Exhibit 13–6 describes a portion of the funds included in the “Kiplinger 25”
list of funds.
• In the Return on Investment section, the example for the Fidelity Stock Selector
All-Cap Fund has been updated with current price information.
• A new Did You Know? feature provides both new and updated information about
the characteristics of mutual fund owners.
• A new Case in Point asks students to evaluate the Oakmark Global Select I Fund
using the information in the Morningstar report illustrated in Exhibit 13–5.
CHAPTER 14
Starting Early:
Retirement and Estate
Planning
• New Saving Smart for Retirement section.
• Updated Exhibit 14–2: How an Average Older (651) Household Spends Its
Money.
• New Caution! box on safeguarding your Social Security card.
• Revised Did You Know? feature: Estimated average monthly Social Security
benefits in 2014.
• Revised and updated the section on Individual Retirement Accounts.
• New Did You Know? feature: Roth IRAs versus traditional IRAs.
• New From the Pages of Kiplinger’s Personal Finance feature: Roth 401(k)s.
• New Did You Know? feature: IRA assets in 2013.
• Updated stated amount will.
• Updated credit shelter trust.
• Updated estate taxes and gift taxes.
APPENDIX A
Education Financing,
Loans, and Scholarships
• New Exhibit A–1: Education compared to earnings and unemployment.
• Revised information for the 2014–15 academic year for loans and federal grants.
• New Exhibit A–3: Student loan default statistics.
APPENDIX B
Developing a Career
Search Strategy
• New highlighted example on social media résumés through LinkedIn, Twitter, and
other online networks.
• Revised coverage for a professional presentation of your résumé.
• Additional suggestions for a résumé makeover (Exhibit B–1).
• Revised Exhibit B–2 with a sample cover letter.
• Updated coverage on techniques for submitting a résumé.
• New Exhibit B–4 with suggestions for updating career planning activities.
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ancial Decisions
me money available. However, the amount, along with needs and
vary from person to person. In this book, you will have the opportu-
rent situation, learn about varied financial paths, and move forward
security.
o handle their finances so that they get full satisfaction from each
al financial goals may include buying a new car or a larger home,
eer training, contributing to charity, traveling extensively, and ensur-
ring working and retirement years. To achieve these and other goals,
y and set priorities. Financial and personal satisfaction are the result
ss that is commonly referred to as personal money management or
nning.
uation and Financial Planning
nning is the process of managing your money to achieve personal
This planning process allows you to control your financial situation.
or household has a unique situation; therefore, financial decisions
et specific needs and goals.
nancial plan can enhance the quality of your life and increase your
ng uncertainty about your future needs and resources. A financial
port that summarizes your current financial situation, analyzes your
commends f t re financial acti ities Yo can create this doc ment
LO1.1
Identify social and economic
influences on personal
financial goals and decisions.
ACTION ITEM
Do you have an emergency
fund for unexpected
expenses?
h Yes h No
personal financial
planning The process of
managing your money to
achieve personal economic
satisfaction.
financial plan A formalized
report that summarizes your
current financial situation,
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GET INSIDE THE BOOK Three Steps to Financial Literacy
Getting your finances in order is simpler than you
think, and we’re here to show you how. These new
chapter opening features break down key action
items you need to take to address the most important
personal finance issues from the chapter, as part of this
edition’s emphasis on taking action. These steps tie in
to the “Your Personal Finance Dashboard” feature at
the end of each chapter.
Learning Objective
References
Citations in the margins next to the
relevant text refer to corresponding
chapter objectives listed at the beginning
of each chapter.
Action Items
As part of this edition’s emphasis on
taking action to gain financial skills,
new Action Items are posted at the
start of each main section of a chapter.
These are designed to get you thinking
about what daily actions you can be
taking to achieve financial literacy and
independence.
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3 Steps to Financial
Literacy . . .
Building an Emergency Fund
1
Determine the desired amount of your
emergency fund based on monthly financial
needs and income volatility. Most financial
advisors recommend three to nine months.
Website: money.com
2
Monitor your daily spending to locate possible
areas of reduced spending and increased
savings.
App: BUDGT or Mint
3
Decide where to keep your emergency fund.
Your choices include a bank, credit union, and
other financial institutions.
Website: www.findabetterbank.com
kap61744_ch01_002-043.indd 2 02/12/14 10:38 pm
Focus on . . . Learning
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CHAPTER 2 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO2.1 Identify the main components of wise money management.
LO2.2 Create a personal balance sheet and cash flow statement.
LO2.3 Develop and implement a personal budget.
LO2.4 Connect money management activities with saving for personal financial goals.
kap61744_ch02_044-073.indd 45 09/10/14 2:28 pm
An interactive and engaging chapter opener gets students
organized and demonstrates the relevance of the material to
their own lives.
A Successful Money Management Plan
“Each month, I have too many days and not enough money. If the month were only 20 days
long budgeting would be easy ”
LO2.1
Identify the main components
of wise money management.
YOUR PERSONAL FINANCIAL PLAN SHEETS
5. Financial Documents and Records
6. Creating a Personal Balance Sheet
7. Creating a Personal Cash Flow Statement
8. Developing a Personal Budget
kap61744_ch02_044-073.indd 45 09/10/14 2:28 pm
Your Personal Financial
Plan Sheets
A list of the “Your Personal Financial
Plan” worksheets for each chapter is
presented at the start of each chapter for
easy reference.
Learning Objectives
Learning objectives highlight the goals
of each chapter for easy reference.
Throughout the book, in the end-of-
chapter material, and even in the supple-
ment materials, these objectives provide
a valuable foundation for assessment.
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stores, charging a meal at a restaurant, and using overdraft
-end credit. As you will soon see, you do not apply for open-
chase, as you do with closed-end credit. Rather, you can use
rchases you wish if you do not exceed your line of credit , the
dit the lender has made available to you. You may have to pay
he use of credit, or other finance charges. Usually you have
within 30 days without interest charges or to make set monthly
unt balance plus interest. Some creditors allow you a grace
bill in full before you incur any interest charges.
ng check credit . Also called a bank line of credit, this is a
ed amount that you can use by writing a special check.
ents over a set period. The finance charges are based on the
he month and on the outstanding balance.
pular. The average cardholder has more than nine credit
nd gasoline cards. Cardholders who pay off their balances in
wn as convenience users. Cardholders who do not pay off
known as borrowers.
offer a grace period, a time period during which no finance
ccount. A finance charge is the total dollar amount you pay
line of credit The dollar
amount, which may or may
not be borrowed, that a
lender makes available to a
borrower.
interest A periodic charge
for the use of credit.
revolving check credit
A prearranged loan from a
bank for a specified amount;
also called a bank line of
credit.
finance charge The total
dollar amount paid to use
credit.
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Key Terms
Key terms appear in bold type within the
text and are defined in the margins. A
list of key terms and page references is
located at the end of each chapter.
CAUTION!
g p y y p p y
have not yet repaid. The more often you make payments, the lower the interest you’ll pay.
Most credit unions use this method.
EXAMPLE: Using the Simple Interest Formula on the
Declining Balance
Using simple interest on the declining balance to compute interest charges, the interest
on a 5 percent, $1,000 loan repaid in two payments, one at the end of the first half-year
and another at the end of the second half-year, would be $37.50, as follows:
First payment:
I 5 P 3 r 3 T
5 $1,000 3 0.05 3 1/2
5 $25 interest plus $500, or $525
Second payment:
I 5 P 3 r 3 T
5 $500 3 0.05 3 1/2
5 $12.50 interest plus the remaining balance of $500, or $512.50
Total payment on the loan:
$525 1 $512.50 5 $1,037.50
Using the APR formula,
APR 5
2 3 n 3 I
_________
P(N 1 1)
5
2 3 2 3 $37.50
______________
$1,000(2 1 1)
5
$150
_______
$3,000
5 0.05, or 5 percent
ADD-ON INTEREST With the add-on interest method, interest is calculated on the
full amount of the original principal, no matter how frequently you make payments. When
ff h l i h hi h d d h l
kap61744_ch05_140-187.indd 164 11/24/14 11:42 AM
Examples
Worked-out examples featuring key concepts
and calculations appear throughout the text, a
valuable feature for students to see how personal
finance works in practice.
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Exhibit 1–5 Financial Planning in Action
Assess your
current situation
Create and implement
a budget
Pay off credit card debts
Obtain adequate
insurance
Establish a regular
savings program
Invest in safe, income-
producing financial
instruments
Use rental housing;
save for home purchase
Short-Term Financial
Strategies
Invest in financial
instrument for long-term
growth
Select tax-deferred
investments
Pay off consumer debts
and home mortgage
Long-Term Financial
Strategies
Now
Examples
1.
2.
3.
Now Within a Year
Within a Year
More Than a
Year from Now
More Than a
Year from Now
Develop financial
goals
Select appropriate
plans of action
Life situation: Single parent
Goal: Provide $20,000 college fund
in 10 years
Create and implement budget
to allow regular deposits to
savings or investment program
Continue investment program
to provide for expanded
housing needs for emergencies
Make monthly payments to
mutual funds investment
program
Purchase life insurance with
parents as beneficiaries
Make regular deposits to a
savings plan such as
certificates of deposit
Obtain life insurance for
dependent care in case of
premature death
Life situation: Middle-aged person
or couple
Goal: Provide for financial needs
of parents
Goal: Save for down payment
for home purchase
Life situation: Young couple
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g
thods can help you select the best course of action for funding
ts, educational expenses, and retirement needs of dependents.
PRACTICE QUIZ 1–1
ration of the financial system and personal financial decisions?
rson would tend to “suffer” or tend to “benefit” from inflation.
suffer benefit
suffer benefit
suffer benefit
suffer benefit
Apply Yourself!
e the recent inflation rate that reflects the change in price for
Sheet 1 Personal Financial Data
kap61744_ch01_002-043.indd 8 09/10/14 2:18 pm
PRACTICE QUIZ 1–1 PRACTICE QUIZ 1–1
1. How do personal and economic factors affect the operation of the financi
2. For each of the following situations, indicate if the person would tend to
(Circle your answer)
A person with money in a savings account. suffer benefit
A person who is borrowing money. suffer benefit
A person who is lending money. suffer benefit
A person receiving a fixed income amount. suffer benefit
Apply Yourself! Apply Yourself!
Using online research and discussion with others, calculate the recent inflatio
items frequently bought by you and your family.
S
kap61744_ch01_002-043.indd 8 09/10/14 2:18 pm
Practice Quizzes
Practice Quizzes at the end of each
major section provide questions to help
assess knowledge of the main ideas
covered in that section. These will deter-
mine whether concepts have been mas-
tered or if a need exists to do additional
study on certain topics.
Exhibits and Tables
Throughout the text, exhibits and tables
visually illustrate important personal
finance concepts and processes.
Your Personal Financial
Plan Sheet References
The integrated use of the “Your Personal
Financial Plan” sheets is highlighted
with an icon. This visual helps integrate
this study resource into the learning
process and continue to track personal
financial habits.
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. From your perspective, what are the benefits and drawbacks of each of the three alternatives for buying a
motor vehicle?
2. What factors should a person consider before buying an extended warranty?
3. What actions would you suggest when using any of the three alternatives presented in the article?
Which Route Is Best for You?
F
R
O
M
T
H
E
P
A
G
E
S
O
F
.
.
.
K
ip
li
n
ge
r’
s
P
er
so
n
al
F
in
an
ce
CPO NON-CPO PRIVATE
PARTY
Certified pre-owned
vehicles are as close
to a new-car-buying
experience as you can
get. You’ll pay an extra
$1,500 to $2,500 com-
pared with non-CPO
vehicles.
Dealers sell vehicles
they acquire at auc-
tion or through trade-
ins that aren’t scooped
up by the CPO pro-
grams. You’ll likely
pay at least 10% more
to a dealer than to a
private party.
The cheapest way to
buy a used car. Private
sellers can sell a used
car for a higher price
to you than they could
to a dealer, but they
can’t inflate the price
as much.
Condition Excellent—models
are five years old or
newer with fewer than
60,000 miles. Because
many CPOs are off-
lease, they have had
only one owner.
Mostly cosmetic
reconditioning. Don’t
expect repairs to be
made. Most dealers
offer a vehicle history
report from Auto-
Check.com or Carfax
.com.
It varies. Ask for
maintenance
records and get a
vehicle history report
on AutoCheck.com or
Carfax.com.
Inspection A 100- to 200-point
inspection. Vehicles
are repaired and
reconditioned. Worn
parts are replaced,
saving money on
future maintenance.
A dealer’s service
department inspects
the car, but get your
own mechanic to go
over the car before
you buy.
You’re on your own.
If the seller won’t
agree to let you take
it to a mechanic,
move on to the next
prospect.
Warranty Usually a year or two
extension of new-car
comprehensive and
power-train warranty,
backed by the man-
ufacturer, not the
dealer.
You get what’s left
of the new-car war-
ranty. Resist the hard
sell on an extended
warranty. Some states
have laws to protect
used-car buyers.
As with a dealer
sale, you get what’s
left of the new-car
warranty. If you get
stuck with a lemon,
you have little or no
recourse.
Financing Carmakers’ finance
companies offer lower
rates than you’d pay
on non-CPO loans.
You may save hun-
dreds of dollars in
interest.
The F&I department
will arrange financing,
but dealers may get
a commission. Get
prequalified at your
bank or credit union
and compare offers.
You’ll have to pay
cash. If you need a
loan, consider draw-
ing on a home-equity
line, or get a used-
car loan at a bank or
credit union.
Jessica L. Anderson
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Focus on . . .
Personal Finance in Real Life
Did You Know?
Each chapter contains several Did You Know?
boxes. The yellow notes contain fun facts,
information, and financial planning assistance
for wise personal financial actions.
Green Did You Know? boxes recommend
socially conscious financial activities for
students interested in giving back to others.
Blue Digi-Know? boxes share tips and topics
on using technology to help manage your
finances.
From the Pages
of . . . Kiplinger’s
Personal Finance
This one-page chapter feature presents
a recent article from the well-known
Kiplinger’s Personal Finance magazine
related to a chapter topic. Each article
covers a personal finance issue to
consider, using the questions that
accompany the article. This is an excel-
lent tool to develop critical thinking and
writing skills!
STEP 2: Develop Your Financial Goal
You should periodically analyze your financial values and goal
The purpose of this analysis is to differentiate your needs fro
your wants. Specific financial goals are vital to financial pla
ning. Others can suggest financial goals for you; however, yo
must decide which goals to pursue. Your financial goals ca
range from spending all of your current income to developing a
extensive savings and investment program for your future fina
cial security.
did you know? did you know?
According to the National Endowment for
Financial Education, 70 percent of major lottery
winners end up with financial difficulties. These winners
often squander the funds awarded them, while others
overspend and many end up declaring bankruptcy.
Having more money does not automatically mean
making better financial planning choices.
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CONSEQUENCES OF CHOICES Every decision close
off alternatives. For example, a decision to invest in stock ma
mean you cannot take a vacation. A decision to go to school ful
time may mean you cannot work full-time. Opportunity cost
what you give up by making a choice. These trade-offs cann
always be measured in dollars. However, the resources you giv
up (money or time) have a value that is lost.
EVALUATING RISK Uncertainty is also a part of ever
decision. Selecting a college major and choosing a career fie
involve risk. What if you don’t like working in this field or can
not obtain employment in it? Other decisions involve a ver
low degree of risk, such as putting money in an insured sav
ings account or purchasing items that cost only a few dollar
Your chances of losing something of great value are low in thes
situations.
In many financial decisions, identifying and evaluating ris
are difficult. Common risks to consider include:
did you know? did you know?
Nearly one billion people around the Nearly one billion people around the
world live on $1 or less a day. Various world live on $1 or less a day. Various
organizations provide these people with organizations provide these people with
basic need items and future opportuni-basic need items and future opportuni-
ties. Bright Hope International assists the ties. Bright Hope International assists the
extreme poor extreme poor by providingby providing food, clothing, food, clothing,
shelter, health care, education, orphan shelter, health care, education, orphan
support, microloans, job training, and support, microloans, job training, and
spiritual guidance. You can help to spiritual guidance. You can help to
provide assistance to the extreme poor provide assistance to the extreme poor
at www.brighthope.orgwww.brighthope.org . .
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Time Value of Money Calculations for Achieving Financial Goals
for six years, starting at the end of the first year, you will hav
$357.65 at the end of that time ($50 3 7.153). The nearb
“Figure It Out!” box presents examples of using future value
achieve financial goals.
PRESENT VALUE OF A SINGLE AMOUNT Anoth
aspect of the time value of money involves determining the cu
rent value of an amount desired in the future. Present value
the current value for a future amount based on a particular inte
est rate for a certain period of time. Present value computation
also called discounting, allow you to determine how much
deposit now to obtain a desired total in the future. For exampl
using the present value table ( Exhibit 1–3C ), if you want $1,00
five years from now and you earn 5 percent on your savings, yo
need to deposit $784 ($1,000 3 0.784).
digi – know? digi – know?
The use of mobile apps for personal finan- The use of mobile apps for personal finan-
cial activities continues to expand with cial activities continues to expand with
instant access to bank accounts, budget instant access to bank accounts, budget
amounts, investment information, and time amounts, investment information, and time
value of money calculations. Some of the value of money calculations. Some of the
most popular are mint , most popular are mint , UnsplurgeUnsplurge, Easy , Easy
Money, and Pocket Money, with costs Money, and Pocket Money, with costs
ranging from free to a few dollars. ranging from free to a few dollars.
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area provided, assess your strengths, weaknesses, oppor-
tunities, and threats related to budgeting and money man-
agement. Do online research and talk with others to get
ideas for your personal SWOT items.
SWOT ( s trengths, w eaknesses, o pportunities, t hreats) is a
planning tool used by companies and other organizations.
This technique can also be used for your money manage-
ment and budgeting activities. Listed below are examples
of possible items for each SWOT category. Now, in the
A Money Management SWOT Analysis
Personal Finance in Practice
Creating a money management SWOT analysis is only
a start. Next you need to select actions to build on your
strengths, minimize your weaknesses, take advantage of
opportunities, and avoid being a victim of threats. Through
research and innovation, weaknesses and threats can
become strengths and opportunities.
Internal (personal) Factors External (economic, social) Influences
Strengths Opportunities
• saving 5–10 percent of income
• informed on personal finance topics
• no credit card debt
• flexible job skills
Your strengths: ____________________________
____________________________
• phone apps for monitoring finances
• part-time work to supplement income
• availability of no-fee bank account
• low-interest-rate education loan
Potential opportunities: ____________________________
__ _____________________ _____
Weaknesses Threats
• high level of credit card debt
• no emergency fund
• automobile in need of repairs
• low current cash inflow
Your weaknesses: ____________________________
____________________________
• lower market value of retirement fund
• possible reduced hours at part-time job
• reduced home market value
• increased living costs (inflation)
Potential threats: ____________________________
____________________________
kap61744_ch02_044-073.indd 58 20/11/14 6:00 pm
3. If the yield on your savings account is 6.25 percent,
0.0625 3 0.72 5 0.045.
4. Your after-tax rate of return is 4.5 percent.
You may use the same procedure to determine the
real rate of return on your savings based on inflation. For
example, if you are earning 6 percent on savings and infla-
tion is 5 percent, your real rate of return (after inflation) is
5.7 percent: 0.06 3 (1 2 0.05) 5 0.057.
CALCULATION EXAMPLES:
1. What would be the after-tax return for a person who is
receiving 4 percent on savings and is in a 15 percent
tax bracket? ___________ %
2. What would be the after-tax value of $100 earned in
interest for a person who is in a 31 percent tax bracket?
$ ___________
The taxability of interest on your savings reduces your real
rate of return. In other words, you lose some portion of
your interest to taxes. This calculation consists of the fol-
lowing steps:
1. Determine your top tax bracket for federal income taxes.
2. Subtract this rate, expressed as a decimal, from 1.0.
3. Multiply the result by the yield on your savings account.
4. This number, expressed as a percentage, is your after-
tax rate of return.
For example,
1. You are in the 28 percent tax bracket.
2. 1.0 2 0.28 5 0.72.
After-Tax Savings Rate of Return After-Tax Savings Rate of Return
Figure It Out!
ANSWERS 1. 3.4 percent 5 0.04 3 (1 2 0.15); 2. $69 5 $100 3 (1 2 0.31)
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Figure It Out!
This boxed feature presents important
mathematical applications relevant to
personal finance situations and concepts.
Personal Finance in
Practice
These boxes offer information that can
assist you when faced with special sit-
uations and unique financial planning
decisions. They challenge you to apply
the concepts you have learned to your
life and record personal responses.
Many of these boxes have been updated
to include exercises and topics on ethics
in personal finance.
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Focus on . . .
Practice and Assessment
Key Formulas
A list of Key Formulas and page refer-
ences appears at the end of select chap-
ters, grouped for easy reference.
Discussion Questions
These questions test qualitative analysis
of personal finance content.
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Key Formulas
Page Topic Formula
50 Net worth Net worth 5 Total assets 2 Total liabilities
Example: 5 $125,000 2 $53,000
5 $72,000
51 Debt ratio Debt ratio 5 Liabilities/Net worth
Example: 5 $7,000/$21,000
5 0.33
51 Current ratio Current ratio 5 Liquid assets/Current liabilities
Example: 5 $8,500/$4,500
5 1.88
51 Liquidity ratio Liquidity ratio 5 Liquid assets/Monthly expenses
Example: 5 $8,500/$3,500
5 2.4
51 Debt-payments ratio Debt-payments ratio 5 Monthly credit payments/Take-home pay
Example: 5 $760/$3,800
5 0.20
51 Savings ratio Savings ratio 5 Amount saved per month/Gross monthly income
Example: 5 $460/$3,800
5 0.12
57 Cash surplus
(or deficit)
Cash surplus (or deficit) 5 Total inflows 2 Total outflows
Example: 5 $5,600 2 $4,970
$630 ( l )
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YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Are you able to set aside an amount for savings each month? Are there expenses you can
reduce, or sources of increased income that could add to the amount you save each month? An improving savings rate
is the foundation for progress toward financial independence.
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) to determine actions you might take
for improved actions for the wise use of financial
services.
Conduct a web search of online banks to obtain
information on their services. Consider how changing
interest rates might affect your decision to use vari-
ous types of financial services.
Consider various sources of financial services, such
as credit unions, which often offer low-cost alterna-
tives for financial services. For additional information
about credit unions, go to www.cuna.org and www
.creditunion.coop .
Obtain current interest rates for CDs and other sav-
ings plans at www.bankrate.com . For the latest rates
and information on U.S. savings bonds, go to www
.savingsbonds.gov .
A key indicator of your potential financial success is the
percentage of income saved each month. Various finan-
cial institutions and savings instruments can be used to
implement this element of your financial plan.
While most people in our society save nothing or very
little, financial experts recommend a savings rate of
between 5 and 10 percent. These funds might be
used for emergencies, unexpected expenses, or
short-term financial goals as well as long-term financial
security.
D
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93
P E R C E N T S A V I N G S R AT E
LO4.1 Financial products such as sav-
ings plans, checking accounts, loans, trust
services, and electronic banking are used
for managing daily financial activities.
LO4.2 Commercial banks, savings and
loan associations, mutual savings banks,
credit unions, life insurance companies,
investment companies, finance companies,
mortgage companies, pawnshops, and check-
cashing outlets may be compared on the
basis of services offered, rates and fees,
safety, convenience, and special programs
LO4.3 Commonly used savings plans
include regular savings accounts, certifi-
cates of deposit, interest-earning checking
accounts, money market accounts, money
market funds, and U.S. savings bonds. Sav-
ings plans may be evaluated on the basis of
rate of return, inflation, tax considerations,
liquidity, safety, restrictions, and fees.
LO4.4 Debit cards, online payment sys-
tems, and stored-value cards are increas-
ing in use for payment activities. Regular
checking accounts, activity accounts, and
Chapter
Summary
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Personal Finance
Dashboard
Having read the chapter, you now consider your
financial progress. The dashboard feature is
designed to help you monitor key performance
indicators in your personal financial situation.
The next step will be to review your habits and
take action for better results.
Chapter Summary
Organized by learning objective, this concise
content summary is a great study and self-
assessment tool, located conveniently at the
end of chapters.
1. Describe how advertisements, news articles, online sources, and personal observations
might be used to make wiser buying decisions. (LO6.1)
2. When using the research-based approach for purchasing described in this chapter,
which actions do you believe are overlooked by most shoppers? (LO6.2)
3. What are potential concerns associated with obtaining furniture, appliances, and other
items from a rent-to-own business? (LO6.3)
4. What is a “certified pre-owned” vehicle? What are the benefits and drawbacks of this
type of purchase? (LO6.2)
5. While fraud usually involves deceptions against consumers, what are some “frauds”
that consumers commit against businesses? (LO6.3)
Discussion
Questions
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68
Continuing
Case MANAGING A BUDGET
Assets:
Checking account: $1,250
Emergency fund savings
account: $3,100
Car: $4,000
Liabilities:
Student loan: $5,400
Credit card balance: $400
Income:
Gross monthly salary: $2,125
Net monthly salary: $1,560
Monthly Expenses:
Rent obligation: $275
Utilities obligation: $125
Food: $120
Gas/Maintenance: $100
Credit card payment: $50
Jamie Lee Jackson, age 24, now a busy full-time college student and part-time bakery
clerk, has been trying to organize all of her priorities, including her budget. She has been
wondering if she is allocating enough of her income toward savings, which includes accu-
mulating enough money toward the $9,000 down payment she needs to open her dream
cupcake café.
Jamie Lee has been making regular deposits to both her regular and her emergency savings
accounts. She would really like to sit down and get a clearer picture of how much she is
spending on various expenses, including rent, utilities, and entertainment, and how her debt
compares to her savings and assets. She realizes that she must stay on track and keep a
detailed budget if she is to realize her dream of being self-employed after college graduation.
Current Financial Situation
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24
1. The Rule of 72 provides a guideline for determining how long it takes your money to
double. This rule can also be used to determine your earning rate. If your money is
expected to double in 12 years, what is your rate of return?
2. If you desire to have $10,000 in savings eight years from now, what amount would you
need to deposit in an account that earns 5 percent?
Self-Test Solutions
1. Using the Rule of 72, if your money is expected to double in 12 years, you are earning
approximately 6 percent (72 4 12 years 5 6 percent).
2. To calculate the present value of $10,000 for eight years at 5 percent, use Exhibit 1–3C
(or Exhibit 1–C in the appendix to Chapter 1): $10,000 3 0.677 5 $6,770
Self-Test
Problems
kap61744_ch01_002-043.indd 24 20/11/14 5:43 pm
(Note: Some of these problems require the use of the time value of money tables in the
appendix directly following this chapter, a financial calculator, or spreadsheet software.)
1. Using the Rule of 72, approximate the following amounts: (LO1.1)
a. If the value of land in an area is increasing 6 percent a year, how long will it take
for property values to double?
b. If you earn 10 percent on your investments, how long will it take for your money
to double?
c. At an annual interest rate of 5 percent, how long will it take for your savings to double?
2. In 2011, selected automobiles had an average cost of $16,000. The average cost of
those same automobiles is now $20,000. What was the rate of increase for these auto-
mobiles between the two time periods? (LO1.1)
3. A family spends $46,000 a year for living expenses. If prices increase 3 percent
a year for the next three years, what amount will the family need for their living
expenses after three years? (LO1.1)
4. Ben Collins plans to buy a house for $220,000. If the real estate in his area is
expected to increase in value 2 percent each year, what will its approximate value be
seven years from now? (LO1.2)
5. What would be the yearly earnings for a person with $6,000 in savings at an annual
interest rate of 2.5 percent? (LO1.3)
6. Using time value of money tables ( Exhibit 1–3 or chapter appendix tables), calculate
the following: (LO1.3)
a. The future value of $550 six years from now at 7 percent.
b. The future value of $700 saved each year for 10 years at 8 percent.
Problems
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67
ADJUSTING THE BUDGET
Case in
Point
In a recent month, the Constantine family
had a budget deficit, which is something
they want to avoid so they do not have
future financial difficulties. Jason and
Karen Constantine and their children (ages
10 and 12) plan to discuss the situation after
dinner this evening.
While at work, Jason was talking with his
friend Ken Lopez. Ken had been a regular
saver since he was very young, starting with
a small savings account. Those funds were
then invested in various stocks and mutual
funds. While in college, Ken was able to pay
for his education while continuing to save
between $50 and $100 a month. He closely
monitored his spending. Ken realized that
the few dollars here and there for snacks and
other minor purchases quickly add up.
Today, Ken works as a customer service
manager for the online division of a retail-
ing company. He lives with his wife and
their two young children. The family’s
spending plan allows for all their needs and
also includes regularly saving and invest-
ing for the children’s education and for
retirement.
Jason asked Ken, “How come you never
seem to have financial stress in your
household?”
Ken replied, “Do you know where your
money is going each month?”
“Not really,” was Jason’s response.
“You’d be surprised by how much is spent
on little things you might do without,” Ken
responded.
“I guess so. I just don’t want to have to go
around with a notebook writing down every
amount I spend,” Jason said in a troubled
voice.
“Well, you have to take some action if you
want your financial situation to change,”
Ken countered.
That evening, the Constantine family met to
discuss their budget situation:
kap61744_ch02_044-073.indd 67 20/11/14 6:00 pm
Problems
A variety of problems allow students
to put their quantitative analysis
of personal financial decisions to
work. Each problem is tagged with a
corresponding learning objective for
easy assessment.
Continuing Case
This feature allows students to apply
course concepts in a life situation. It
encourages students to evaluate the
finances that affect a household and then
respond to the resulting shift in needs,
resources, and priorities through the
questions at the end of each case.
Self-Test Problems
Self-Test Problems are worked out using
step-by-step solutions so that students
can see how they were solved. This
user-friendly feature increases students’
comprehension of the material and gives
confidence to solve the end-of-chapter
problems.
Case in Point
Students can work through a hypothetical
personal finance dilemma in order to
apply concepts from the chapter. A series
of questions reinforces your successful
mastery and application of these chapter
topics.
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Name: Date:
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What’s Next for Your Personal Financial Plan?
• Based on this savings plan analysis, determine the best types for your current and future financial situation.
• When analyzing savings plans, what factors should you carefully investigate?
Comparing Savings Plans
Purpose: To compare the costs and benefits associated with different savings plans.
Financial Planning Activities: Analyze advertisements and contact various financial insti-
tutions to obtain the information requested below. This sheet is also available in an Excel
spreadsheet format in Connect Finance.
Suggested Websites: www.bankrate.com www.nerdwallet.com www.savingsaccounts.com
Type of savings plan (regular savings account, certificates of
deposit, interest-earning checking accounts, money market
accounts and funds, U.S. savings bonds)
Financial institution
Address/phone
Website
Annual interest rate
Annual percentage yield (APY)
Frequency of compounding
Insured by FDIC, NCUA, other
Maximum amount insured
Minimum initial deposit
Minimum time period savings that must be on deposit
Penalties for early withdrawal
Service charges/transaction fees, other costs, fees
Additional services, other information
Suggested
App:
• Savings Plan
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Nearly everyone who has made the effort to keep a daily spending diary has found it bene-
ficial. While at first the process may seem tedious, after a while recording this information
becomes easier and faster.
Directions Using the Daily Spending Diary sheets provided at the end of the book,
record every cent of your spending each day in the categories provided. Or you may create
your own format to monitor your spending. You can indicate the use of a credit card with
(CR). This experience will help you better understand your spending patterns and identify
desired changes you might want to make in your spending habits. The Daily Spending
Diary sheets are located in Appendix D at the end of the book and in Connect Finance.
Questions
1. What did your daily spending diary reveal about your spending habits? What areas of
spending might you consider changing?
2. How might your daily spending diary assist you when identifying and achieving finan-
cial goals?
“I FIRST THOUGHT THIS PROCESS WOULD BE A WASTE OF
TIME, BUT THE INFORMATION HAS HELPED ME BECOME MUCH
MORE CAREFUL OF HOW I SPEND MY MONEY.”
Spending
Diary
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Your Personal Financial Plan
The “Your Personal Financial Plan” sheets that
correlate with sections of the text are conve-
niently located at the end of each chapter. The
perforated worksheets ask students to work
through the applications and record their own
personal financial plan responses. These sheets
apply concepts learned to your unique situation
and serve as a roadmap to your personal finan-
cial future. Students can fill them out, rip them
out, submit them for homework, and keep them
filed in a safe spot for future reference. Excel
spreadsheets for each of the “Your Personal
Financial Plan” sheets are available through
Connect.
Key websites and apps are provided to help
students research and devise their personal
financial plan, and the “What’s Next for Your
Personal Financial Plan?” section at the end
of each sheet challenges students to use their
responses to plan the next level, as well as
foreshadow upcoming concepts.
Look for one or more “Your Personal Financial
Plan” icons next to most Practice Quizzes. This
graphic directs students to the Personal Financial
Plan sheet that corresponds with the preceding
section.
Daily Spending Diary
Do you buy a latte or a soda every day before
class? Do you and your friends meet for a movie
once a week? How much do you spend on gas
for your car each month? Do you like to donate
to your favorite local charity a couple of times a
year?
These everyday spending activities might go
largely unnoticed, yet they have a significant
effect on the overall health of an individual’s
finances. The Daily Spending Diary sheets offer
students a place to keep track of every cent they
spend in any category. Careful monitoring and
assessing of these daily spending habits can lead
to better control and understanding of your per-
sonal finances.
C
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h 1. What did your daily spending diary reveal about your spending habits? What areas of
spending might you consider changing?
2. How might your daily spending diary assist you when identifying and achieving finan-
cial goals?
Daily Spending Diary
Directions: Record every cent of your spending each day in the categories provided, or create your own format to monitor your spending. You can indicate the use of a credit card
with (CR). Comments should reflect what you have learned about your spending patterns and desired changes you might want to make in your spending habits. (Note: As income is
received, record in Date column.)
Month: _____________ Amount available for spending: $ _____________ Amount to be saved: $ _____________
Date
(Income)
Total
Spending
Auto,
Transportation
Housing,
Utilities
Food
(H) Home
(A) Away
Health,
Personal
Care Education
Recreation,
Leisure
Donations,
Gifts
Other
(note item,
amount) Comments
Example $83 $20
(gas) (CR)
$47 (H) $2 (pen) $4
(DVD rental)
$10
(church)
This takes time
but it helps
me control my
spending .
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Online Support for Students
and Instructors
Few textbooks provide such innovative and practical
instructional resources for both students and teachers.
The comprehensive teaching–learning package for Focus
on Personal Finance includes the following:
For Instructors
The Instructor’s site, delivered through Connect, pro-
vides the instructor with one resource for all supplemen-
tary material, including:
• Instructor’s Manual: Created and revised by the
authors, this supplement includes a “Course Planning
Guide” with instructional strategies, course projects,
and supplementary resource lists. The “Chapter Teach-
ing Materials” section of the Instructor’s Manual pro-
vides a chapter overview, the chapter objectives with
summaries, introductory activities, and detailed lec-
ture outlines with teaching suggestions. This section
also includes concluding activities, ready-to-duplicate
quizzes, supplementary lecture materials and activi-
ties, and answers to concept checks, end-of-chapter
questions, problems, and cases.
• Test Bank, revised by Michelle Grant, Bossier Parish
Community College consists of true–false, multiple-
choice, problem-solving, and essay questions. These
test items are organized by the learning objectives
for each chapter. This resource also includes answers
and an indication of difficulty level.
• Computerized Testing Software, McGraw-Hill’s EZ
Test is a flexible and easy-to-use electronic testing
program. The program allows instructors to create
tests from book-specific items. It accommodates a
wide range of question types, and instructors may
add their own questions. Multiple versions of the test
can be created, and any test can be exported for use
with course management systems such as WebCT
or BlackBoard. EZ Test Online gives you a place to
easily administer your EZ Test–created exams and
quizzes online. The program is available for Win-
dows and Macintosh environments.
• Chapter PowerPoint Presentations revised and
enhanced by Janet Payne and Vance Lesseig, Texas
State University offer more than 300 visual presenta-
tions that may be edited and manipulated to fit a particu-
lar course format. If you choose to customize the slides,
an online digital image library allows you to pick and
choose from all of the figures and tables in the book.
Assurance of Learning Ready
Assurance of learning is an important element of many
accreditation standards. Focus on Personal Finance, 5e is
designed specifically to support your assurance of learn-
ing initiatives. Each chapter in the book begins with a list
of numbered learning objectives which appear through-
out the chapter, as well as in the end-of-chapter problems
and exercises. Every test bank question is also linked to
one of these objectives, in addition to level of difficulty,
topic area, Bloom’s Taxonomy level, and AACSB skill
area. Connect, McGraw-Hill’s online homework solu-
tion, and EZ Test, McGraw-Hill’s easy-to-use test bank
software, can search the test bank by these and other cat-
egories, providing an engine for targeted Assurance of
Learning analysis and assessment.
AACSB Statement
McGraw-Hill Education is a proud corporate member
of AACSB International. Understanding the importance
and value of AACSB accreditation, Focus on Personal
Finance, 5e has sought to recognize the curricula guide-
lines detailed in the AACSB standards for business
accreditation by connecting selected questions in the test
bank to the general knowledge and skill guidelines found
in the AACSB standards.
The statements contained in Focus on Personal
Finance, 5e are provided only as a guide for the users
of this text. The AACSB leaves content coverage and
assessment within the purview of individual schools, the
mission of the school, and the faculty. While Focus on
Personal Finance, 5e and the teaching package make no
claim of any specific AACSB qualification or evaluation,
we have, within the test bank, labeled selected questions
according to the six general knowledge and skills areas.
For Students (available
through Connect and
through your class
instructor)
Digital Broadcasts
View chapter-related videos to see how personal finance
topics are applied in everyday life.
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xxviii Online Support for Students and Instructors
Narrated Student PowerPoint
Every student learns differently and the Narrated
Power Point was created with that in mind! Revised and
expanded by Lynn Kugele, University of Mississippi,
they guide students through understanding key topics
and principles by presenting real-life examples based on
chapter content.
And More!
Looking for more ways to study? Self-grading crossword
puzzles will help you learn the material. You can also
access Excel templates for the “Your Personal Financial
Plan” sheets and the Daily Spending Diary.
McGraw-Hill’s
Less Managing. More Teaching. Greater Learning.
McGraw-Hill Connect Finance is an online assignment
and assessment solution that connects students with the
tools and resources they’ll need to achieve success.
Connect helps prepare students for their future by
enabling faster learning, more efficient studying, and
higher retention of knowledge.
McGraw-Hill Connect Finance Features
Connect Finance offers a number of powerful tools and fea-
tures to make managing assignments easier, so faculty can
spend more time teaching. With Connect Finance, students
can engage with their coursework anytime and anywhere,
making the learning process more accessible and efficient.
Connect Finance offers you the features described below.
Simple assignment management With Connect
Finance, creating assignments is easier than ever, so you
can spend more time teaching and less time managing.
The assignment management function enables you to:
• Create and deliver assignments easily with select-
able end-of-chapter questions and test bank items.
• Streamline lesson planning, student progress report-
ing, and assignment grading to make classroom
management more efficient than ever.
• Go paperless with the eBook and online submission
and grading of student assignments.
Smart grading When it comes to studying, time is
precious. Connect Finance helps students learn more
efficiently by providing feedback and practice material
when they need it, where they need it. When it comes to
teaching, your time is also precious. The grading function
enables you to:
• Have assignments scored automatically, giving stu-
dents immediate feedback on their work and side-
by-side comparisons with correct answers.
• Access and review each response; manually change
grades or leave comments for students to review.
• Reinforce classroom concepts with practice tests and
instant quizzes.
Instructor Library The Connect Finance Instructor
Library is your repository for additional resources to
improve student engagement in and out of class. You can
select and use any asset that enhances your lecture.
Student Study Center The Connect Finance Student
Study Center is the place for students to access additional
resources. The Student Study Center:
• Offers students quick access to lectures, practice
materials, eBooks, and more.
• Provides instant practice material and study ques-
tions, easily accessible on the go.
LearnSmart Students want to make the best use of their
study time. The LearnSmart adaptive self-study technol-
ogy within Connect Finance provides students with a
seamless combination of practice, assessment, and reme-
diation for every concept in the textbook. LearnSmart’s
intelligent software adapts to every student response and
automatically delivers concepts that advance the stu-
dent’s understanding while reducing time devoted to the
concepts already mastered. The result for every student
is the fastest path to mastery of the chapter concepts.
LearnSmart:
• Applies an intelligent concept engine to identify the
relationships between concepts and to serve new
concepts to each student only when he or she is
ready.
• Adapts automatically to each student, so students
spend less time on the topics they understand and
practice more on those they have yet to master.
• Provides continual reinforcement and remediation,
but gives only as much guidance as students need.
• Integrates diagnostics as part of the learning experience.
• Enables you to assess which concepts students have
efficiently learned on their own, thus freeing class
time for more applications and discussion.
SmartBook SmartBook is an extension of LearnSmart—
an adaptive eBook that helps students focus their study time
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Online Support for Students and Instructors xxix
more effectively. As students read, SmartBook assesses
comprehension and dynamically highlights where they
need to study more.
Student progress tracking Connect Finance keeps
instructors informed about how each student, section, and
class is performing, allowing for more productive use of
lecture and office hours. The progress-tracking function
enables you to:
• View scored work immediately and track individual
or group performance with assignment and grade
reports.
• Access an instant view of student or class perfor-
mance relative to learning objectives.
Lecture Capture through Tegrity Campus —For an
additional charge Lecture Capture offers new ways for
students to focus on the in-class discussion, knowing
they can revisit important topics later. This can be deliv-
ered through Connect or separately. See below for more
details.
McGraw-Hill Connect Finance McGraw-Hill reinvents
the textbook learning experience for the modern student
with the new Connect Finance. The new Connect Finance
provides all of the Connect Finance features plus the
following:
• An integrated eBook, allowing for anytime, any-
where access to the textbook.
• Dynamic links between the problems or questions
you assign to your students and the location in the
eBook where that problem or question is covered.
• A powerful search function to pinpoint and connect
key concepts in a snap.
In short, the new Connect Finance offers you and your stu-
dents powerful tools and features that optimize your time
and energies, enabling you to focus on course content,
teaching, and student learning. Connect Finance also offers
a wealth of content resources for both instructors and stu-
dents. This state-of-the-art, thoroughly tested system sup-
ports you in preparing students for the world that awaits.
For more information about Connect, go to connect
.mheducation.com or contact your local McGraw-Hill
sales representative.
Tegrity Campus: Lectures 24/7
Tegrity Campus is a service that makes class time avail-
able 24/7 by automatically capturing every lecture in a
searchable format for students to review when they study
and complete assignments. With a simple one-click start-
and-stop process, you capture all computer screens and
corresponding audio. Students can replay any part of any
class with easy-to-use browser-based viewing on a PC
or Mac.
Educators know that the more students can see, hear,
and experience class resources, the better they learn. In
fact, studies prove it. With Tegrity Campus, students
quickly recall key moments by using Tegrity Campus’s
unique search feature. This search helps students effi-
ciently find what they need, when they need it, across
an entire semester of class recordings. Help turn all your
students’ study time into learning moments immediately
supported by your lecture.
To learn more about Tegrity watch a two-minute Flash
demo at http://tegritycampus.mhhe.com .
McGraw-Hill Customer Care
Contact Information
At McGraw-Hill, we understand that getting the most
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services don’t stop after you purchase our products. You
can e-mail our Product Specialists 24 hours a day to get
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fashion.
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Janice Akao, Butler Community College
Sophia Anong, University of Georgia
Anna Antus, Normandale Community College
Eddie Ary, Ouachita Baptist University
Chris A. Austin, Normandale Community College
Gail H. Austin, Rose State College
Kali Bard, Crowder College
Judy Bernard, Bluegrass Community and Technical College
Tom Bilyeu, Southwestern Illinois College
Ross Blankenship, State Fair Community College
William F. Blosel, California University of Pennsylvania
John Bockino, Suffolk County Community College
Karen Bonding, University of Virginia
Lyle Bowlin, Southeastern University
Michael Brandl, University of Texas–Austin
Jerry Braun, Daytona State College–Daytona Beach
Darleen Braunshweiger, Nassau Community College
Jennifer Brewer, Butler County Community College
Bruce Brunson, Virginia Tech
Peg Camp, University of Nebraska–Kearney
Ron Cereola, James Madison University
Stephen Chambers, Johnson County Community College
It-Keong Chew, University of Kentucky
Mary Emily Cooke, Surry Community College
Trung Dang, Lone Star College North Harris
Beth Deinert, Southeast Community College—Milford
Julie Douthit, Abilene Christian University
Bill Dowling, Savannah State University
Chip Downing, Massasoit Community College
Dorsey Dyer, Davidson County Community College
John D. Farlin, Ohio Dominican University
Garry Fleming, Roanoke College
Paula G. Freston, Merced College
Robert Friederichs, Alexandria Technical College
Mark Fronke, Cerritos College
Caroline S. Fulmer, University of Alabama
Dwight Giles, Jefferson State Community College
Michael Gordinier, Washington University
Shari Gowers, Dixie State College
Michelle Grant, Bossier Parish Community College
Michael P. Griffin, University of Massachusetts–Dartmouth
Monte Hill, Nova Community College–Annandale
Ward Hooker, Orangeburg–Calhoun Tech College
Ishappa S. Hullur, Morehead State University
Samira Hussein, Johnson County Community College
Dorothy W. Jones, Northwestern State University
Richard “Lee” Kitchen, Tallahassee Community College
Jeanette Klosterman, Hutchinson Community College
Robert Kozub, University of Wisconsin–Milwaukee
Margo Kraft, Heidelberg College
John Ledgerwood, Bethune-Cookman College
Marc LeFebvre, Creighton University
Nolan Lickey, Utah Valley State College
Joseph T. Marchese, Monroe Community College
Kenneth L. Mark, Kansas City Kansas Community College
Paul S. Marshall, Widener University
Jennifer Morton, Ivy Tech Community College of Indiana
Allan O’Bryan, Rochester Community & Tech College
Carl Parker, Fort Hays State University
David M. Payne, Ohio University
Aaron Phillips, California State University–Bakersfield
Padmaja Pillutla, Western Illinois University
Barbara Purvis, Centura College
Brenda Rice, Ozarks Technical Community College
Thank You!
We express our deepest appreciation for the efforts of the colleagues whose extensive feedback over the years has helped
to shape and create this text.
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Thank You! xxxi
Carla Rich, Pensacola Junior College
John Roberts, Florida Metropolitan University
Sammie Root, Texas State University–San Marcos
Clarence Rose, Radford University
Joan Ryan, Clackamas Community College
Martin St. John, Westmoreland County Community College
Tim Samolis, Pittsburgh Technical Institute
Steven R. Scheff, Florida Gulf Coast University
James T. Schiermeyer, Texas Tech University
Joseph Simon, Casper College
Vernon Stauble, San Bernardino Valley College
Lea Timpler, College of the Canyons
Michael Trohimczyk, Henry Ford Community College
Dick Verrone, University of North Carolina–Wilmington
Randall Wade, Rogue Community College
Shunda Ware, Atlanta Technical College
Kent Weilage, McCook Community College
Sally Wells, Columbia College
Micheline West, New Hampshire Tech
Marilyn Whitney, University of California–Davis
Bob Willis, Rogers State University
Glen Wood, Broome Community College
Russell Woodbridge, Southeastern College
Many talented professionals at McGraw-Hill Education
have contributed to the development of Focus on Personal
Finance. We are especially grateful to Chuck Synovec
Jennifer Upton, Melissa Caughlin, Keri Johnson, Debra
Kubiak, Debra Sylvester, and Kristin Bradley.
In addition, Jack Kapoor expresses special apprecia-
tion to Theresa and Dave Kapoor, Kathryn Thumme, and
Karen and Joshua Tucker for their typing, proofreading,
and research assistance. Les Dlabay would also like to
thank Bryna Mollinger for her help reviewing the man-
uscript. Finally, we thank our spouses and families for
their patience, understanding, encouragement, and love
throughout this project.
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HoHow w do you ffeeeel when you look at this cocovever? We hopee tthehe iimamage on the book
coconveys a feeling of relelaxaxatatiion n anandd overall peace e ofof mminindd—bothh achieved, in
paartt, byby ddevevele oping a solid financial plan. FrFromom cover to cover, this text’s goal
is to hehelplp yyouou ggaiainn ththe e financial liteeraracycy and personal finance skills you need to
maake sound financialal decisionsns ffor life. Use this book as a tool to help you plan
for a susuccccese sful finnana cial futurure!e
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Focus on . . . the Cover
CHAPTER 1 Personal Financial Planning in Action 2
CHAPTER 2 Money Management Skills 44
CHAPTER 3 Taxes in Your Financial Plan 74
CHAPTER 4 Financial Services: Savings Plans and Payment
Accounts 106
CHAPTER 5 Consumer Credit: Advantages, Disadvantages,
Sources, and Costs 140
CHAPTER 6 Consumer Purchasing Strategies and Wise
Buying of Motor Vehicles 188
CHAPTER 7 Selecting and Financing Housing 218
CHAPTER 8 Home and Automobile Insurance 248
CHAPTER 9 Health and Disability Income Insurance 284
CHAPTER 10 Financial Planning with Life Insurance 320
CHAPTER 11 Investing Basics and Evaluating Bonds 348
CHAPTER 12 Investing in Stocks 386
CHAPTER 13 Investing in Mutual Funds 422
CHAPTER 14 Starting Early: Retirement and Estate Planning 458
APPENDIX A Education Financing, Loans, and Scholarships 492
APPENDIX B Developing a Career Search Strategy 502
APPENDIX C Consumer Agencies and Organizations 514
APPENDIX D Daily Spending Diary 518
PHOTO CREDITS 527
INDEX 528
Brief Table of Contents
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1 Personal Financial Planning
in Action 2
Making Financial Decisions 3
Your Life Situation and Financial Planning 3
Financial Planning in Our Economy 4
Financial Planning Activities 7
Developing and Achieving Financial Goals 9
Types of Financial Goals 9
Goal-Setting Guidelines 9
Opportunity Costs and the Time Value
of Money 10
Personal Opportunity Costs 11
Financial Opportunity Costs 11
A Plan for Personal Financial Planning 15
Step 1: Determine Your Current Financial
Situation 16
Step 2: Develop Your Financial Goals 16
Step 3: Identify Alternative Courses of Action 17
Step 4: Evaluate Your Alternatives 17
Step 5: Create and Implement Your Financial
Action Plan 19
Step 6: Review and Revise Your Plan 20
Career Choice and Financial Planning 22
Appendix: Time Value of Money 32
2 Money Management Skills 44
A Successful Money Management Plan 45
Components of Money Management 45
A System for Personal Financial Records 46
Personal Financial Statements 48
Your Personal Balance Sheet: The Starting Point 48
Your Cash Flow Statement: Inflows and Outflows 51
A Plan for Effective Budgeting 54
Step 1: Set Financial Goals 54
Step 2: Estimate Income 55
Step 3: Budget an Emergency Fund and Savings 55
Step 4: Budget Fixed Expenses 55
Step 5: Budget Variable Expenses 57
Step 6: Record Spending Amounts 57
Step 7: Review Spending and Saving Patterns 58
Money Management and Achieving Financial
Goals 60
Selecting a Saving Technique 62
Calculating Savings Amounts 62
3 Taxes in Your Financial Plan 74
Taxes in Your Financial Plan 75
Planning Your Tax Strategy 75
Types of Tax 75
The Basics of Federal Income Tax 78
Step 1: Determining Adjusted Gross Income 78
Step 2: Computing Taxable Income 78
Step 3: Calculating Taxes Owed 81
Step 4: Making Tax Payments 83
Step 5: Deadlines and Penalties 84
Filing Your Federal Income Tax Return 85
Who Must File? 85
Which Tax Form Should You Use? 85
Completing the Federal Income Tax Return 85
How Do I File My State Tax Return? 88
How Do I File My Taxes Online? 88
What Tax Assistance Sources Are Available? 91
Tax Preparation Services 92
What If Your Return Is Audited? 93
Contents
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xxxiv Contents
Tax Planning Strategies 95
Consumer Purchasing 95
Investment Decisions 95
Retirement and Education Plans 97
Changing Tax Strategies 98
Flat or VAT Tax? 98
4 Financial Services: Savings
Plans and Payment
Accounts 106
Planning Your Use of Financial
Services 107
Managing Daily Money Needs 107
Sources of Quick Cash 108
Types of Financial Services 108
Online and Mobile Banking 109
Prepaid Debit Cards 110
Financial Services and Economic
Conditions 110
Sources of Financial Services 111
Comparing Financial Institutions 111
Types of Financial Institutions 112
Problematic Financial Businesses 113
Comparing Savings Plans 115
Regular Savings Accounts 115
Certificates of Deposit 115
Interest-Earning Checking Accounts 118
Money Market Accounts and Funds 118
U.S. Savings Bonds 118
Evaluating Savings Plans 120
Comparing Payment Methods 124
Electronic Payments 124
Checking Accounts 125
Evaluating Checking and Payment
Accounts 126
Other Payment Methods 127
Managing Your Checking Account 127
5 Consumer Credit: Advantages,
Disadvantages, Sources,
and Costs 140
What Is Consumer Credit? 141
The Importance of Consumer Credit in Our
Economy 141
Uses and Misuses of Credit 142
Advantages of Credit 142
Disadvantages of Credit 143
Summary: Advantages and Disadvantages
of Credit 143
Types of Credit 144
Closed-End Credit 144
Open-End Credit 145
Credit Cards 145
Sources of Consumer Credit 147
Loans 148
Applying for Credit 151
Can You Afford a Loan? 151
General Rules of Credit Capacity 151
The Five Cs of Credit 151
Your Credit Report 153
Credit Scores 155
Other Factors Considered in Determining
Creditworthiness 157
What If Your Application Is Denied? 157
What Can You Do to Improve Your Credit
Score? 158
The Cost of Credit 160
Finance Charge and Annual Percentage Rate 160
Tackling the Trade-Offs 161
Calculating the Cost of Credit 163
Protecting Your Credit 166
Billing Errors and Disputes 166
Identity Crisis: What to Do If Your Identity Is
Stolen 166
Protecting Your Credit from Theft or Loss 167
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Contents xxxv
Protecting Your Credit Information on the
Internet 167
Cosigning a Loan 169
Complaining about Consumer
Credit 169
Consumer Credit Protection Laws 169
Consumer Financial Protection Bureau 171
Managing Your Debts 171
Warning Signs of Debt Problems 171
Debt Collection Practices 172
Financial Counseling Services 173
Declaring Personal Bankruptcy 173
6 Consumer Purchasing Strategies
and Wise Buying of Motor
Vehicles 188
Consumer Buying Activities 189
Practical Purchasing Strategies 189
Warranties 191
Research-Based Buying 192
Major Consumer Purchases: Buying Motor
Vehicles 195
Phase 1: Preshopping Activities 195
Phase 2: Evaluating Alternatives 196
Phase 3: Determining Purchase Price 198
Phase 4: Postpurchase Activities 201
Resolving Consumer Complaints 203
Step 1: Initial Communication 203
Step 2: Communicate with the Company 204
Step 3: Consumer Agency Assistance 205
Step 4: Legal Action 205
Legal Options for Consumers 205
Small Claims Court 205
Class-Action Suits 206
Using a Lawyer 206
Other Legal Alternatives 206
Personal Consumer Protection 206
7 Selecting and Financing
Housing 218
Evaluating Renting and Buying Alternatives 219
Your Lifestyle and Your Choice of Housing 219
Renting versus Buying Housing 219
Rental Activities 220
Home-Buying Activities 225
Step 1: Determine Home Ownership Needs 225
Step 2: Find and Evaluate a Home 226
Step 3: Price the Property 227
The Finances of Home Buying 229
Step 4: Obtain Financing 229
Step 5: Close the Purchase Transaction 234
Home Buying: A Summary 236
A Home-Selling Strategy 236
Preparing Your Home for Selling 236
Determining the Selling Price 237
Sale by Owner 238
Listing with a Real Estate Agent 238
8 Home and Automobile
Insurance 248
Insurance and Risk Management 249
What Is Insurance? 249
Types of Risk 250
Risk Management Methods 250
Planning an Insurance Program 251
Property and Liability Insurance in Your
Financial Plan 254
Home and Property Insurance 255
Homeowner’s Insurance Coverages 255
Renter’s Insurance 258
Home Insurance Policy Forms 259
Home Insurance Cost Factors 262
How Much Coverage Do You Need? 262
Factors That Affect Home Insurance Costs 263
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xxxvi Contents
Automobile Insurance Coverages 264
Motor Vehicle Bodily Injury Coverages 264
Motor Vehicle Property Damage Coverage 266
No-Fault Insurance 267
Other Automobile Insurance Coverages 267
Automobile Insurance Costs 268
Amount of Coverage 268
Motor Vehicle Insurance Premium Factors 269
Reducing Vehicle Insurance Premiums 269
9 Health and Disability Income
Insurance 284
Health Insurance and Financial Planning 285
What Is Health Insurance? 285
Health Insurance Coverage 288
Types of Health Insurance Coverage 288
Major Provisions in a Health Insurance Policy 291
Health Insurance Trade-Offs 293
Coverage Trade-Offs 293
Which Coverage Should You Choose? 294
Private Health Care Plans and Government
Health Care Programs 295
Private Health Care Plans 295
Government Health Care Programs 298
Health Insurance and the Patient Protection and
Affordable Care Act of 2010 300
The Affordable Care Act and the Individual Shared
Responsibility Provision 303
Disability Income Insurance 305
The Need for Disability Income 305
Sources of Disability Income 306
Disability Income Insurance Trade-Offs 306
Your Disability Income Needs 307
High Medical Costs 308
Why Does Health Care Cost So Much? 310
What Is Being Done about the High Costs of
Health Care? 310
What Can You Do to Reduce Personal
Health Care Costs? 311
10 Financial Planning with Life
Insurance 320
What Is Life Insurance? 321
The Purpose of Life Insurance 321
The Principle and Psychology of Life Insurance 322
How Long Will You Live? 322
Do You Need Life Insurance? 322
Estimating Your Life Insurance Requirements 323
Types of Life Insurance Companies
and Policies 325
Types of Life Insurance Companies 325
Types of Life Insurance Policies 326
Selecting Provisions and Buying Life
Insurance 329
Key Provisions in a Life Insurance Policy 329
Buying Life Insurance 332
Financial Planning with Annuities 336
Why Buy Annuities? 337
Costs of Annuities 337
Tax Considerations 338
11 Investing Basics and Evaluating
Bonds 348
Preparing for an Investment Program 349
Establishing Investment Goals 349
Performing a Financial Checkup 350
Getting the Money Needed to Start an Investment
Program 352
How the Time Value of Money Affects Your
Investments 353
Factors Affecting the Choice of
Investments 355
Safety and Risk 355
Components of the Risk Factor 356
Investment Income 358
Investment Growth 358
Investment Liquidity 358
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Contents xxxvii
Factors That Reduce Investment Risk 359
Asset Allocation and Diversification 359
Your Role in the Investment Process 361
Conservative Investment Options: Government
Bonds 364
The Psychology of Investing in Bonds 364
Government Bonds and Debt Securities 365
Conservative Investment Options: Corporate
Bonds 367
Why Corporations Sell Corporate Bonds 367
Why Investors Purchase Corporate Bonds 369
A Typical Bond Transaction 370
The Decision to Buy or Sell Bonds 371
The Internet 371
Financial Coverage for Bond Transactions 372
Bond Ratings 372
Bond Yield Calculations 373
Other Sources of Information 374
12 Investing in Stocks 386
Common and Preferred Stock 387
Why Corporations Issue Common Stock 388
Why Investors Purchase Common Stock 388
Preferred Stock 391
Evaluating a Stock Issue 392
The Internet 392
Stock Advisory Services 394
Newspaper Coverage and Corporate News 397
Numerical Measures That Influence Investment
Decisions 398
Why Corporate Earnings Are Important 398
Dividend Yield and Total Return 400
Other Factors That Influence the Price of a Stock 401
Buying and Selling Stocks 403
Secondary Markets for Stocks 403
Brokerage Firms and Account Executives 404
Should You Use a Full-Service, Discount, or Online
Brokerage Firm? 404
Computerized Transactions 405
Sample Stock Transactions 405
Commission Charges 406
Long-Term and Short-Term Investment
Strategies 407
Long-Term Techniques 407
Short-Term Techniques 409
13 Investing in Mutual Funds 422
Why Investors Purchase Mutual Funds 423
The Psychology of Investing in Funds 424
Characteristics of Funds 425
Classifications of Mutual Funds 431
Stock Funds 431
Bond Funds 432
Other Funds 432
Choosing the Right Fund for a Retirement Account 433
How to Make a Decision to Buy or Sell Mutual
Funds 435
Managed Funds versus Index Funds 436
The Internet 437
Professional Advisory Services 438
The Mutual Fund Prospectus and Annual
Report 440
Financial Publications and Newspapers 441
The Mechanics of a Mutual Fund
Transaction 442
Return on Investment 443
Taxes and Mutual Funds 444
Purchase Options 445
Withdrawal Options 447
14 Starting Early: Retirement and
Estate Planning 458
Planning for Retirement: Start Early 459
Saving Smart for Retirement 460
Conducting a Financial Analysis 460
Estimating Retirement Living Expenses 462
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xxxviii Contents
Your Retirement Income 464
Employer Pension Plans 464
Public Pension Plans 466
Personal Retirement Plans 468
Annuities 471
Living on Your Retirement Income 471
Estate Planning 473
The Importance of Estate Planning 473
What Is Estate Planning? 473
Legal Documents 473
Legal Aspects of Estate Planning 474
Wills 474
Types of Wills 474
Formats of Wills 475
Writing Your Will 475
A Living Will 476
Trusts 477
Types of Trusts 478
Taxes and Estate Planning 478
Appendixes
A Education Financing, Loans, and
Scholarships 492
B Developing a Career Search Strategy 502
C Consumer Agencies and Organizations 514
D Daily Spending Diary 518
Photo Credits 527
Index 528
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Focus on Personal Finance
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3 Steps to Financial
Literacy . . .
Building an Emergency Fund
1 Personal Financial Planning in Action
What are the financial benefits of an
emergency fund?
You will be able to avoid or minimize a financial
crisis due to job loss, unexpected expenses,
or other unforeseen situation. At the end of the
chapter, “Your Personal Finance Dashboard”
will provide guidelines for measuring the
progress of your emergency fund along with
suggested actions to improve your personal
financial activities.
1
Determine the desired amount of your
emergency fund based on monthly financial
needs and income volatility. Most financial
advisors recommend three to nine months.
Website: money.com
2
Monitor your daily spending to locate possible
areas of reduced spending and increased
savings.
App: BUDGT or Mint
3
Decide where to keep your emergency fund.
Your choices include a bank, credit union, and
other financial institutions.
Website: www.findabetterbank.com
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Making Financial Decisions
Every person has some money available. However, the amount, along with needs and
financial choices, will vary from person to person. In this book, you will have the opportu-
nity to assess your current situation, learn about varied financial paths, and move forward
toward future financial security.
Most people want to handle their finances so that they get full satisfaction from each
available dollar. Typical financial goals may include buying a new car or a larger home,
pursuing advanced career training, contributing to charity, traveling extensively, and ensur-
ing self-sufficiency during working and retirement years. To achieve these and other goals,
people need to identify and set priorities. Financial and personal satisfaction are the result
of an organized process that is commonly referred to as personal money management or
personal financial planning.
Your Life Situation and Financial Planning
Personal financial planning is the process of managing your money to achieve personal
economic satisfaction. This planning process allows you to control your financial situation.
Every person, family, or household has a unique situation; therefore, financial decisions
must be planned to meet specific needs and goals.
A comprehensive financial plan can enhance the quality of your life and increase your
satisfaction by reducing uncertainty about your future needs and resources. A financial
plan is a formalized report that summarizes your current financial situation, analyzes your
financial needs, and recommends future financial activities. You can create this document
on your own (by using the sheets at the end of each chapter) or you can seek assistance
from a financial planner or use a money management software package.
LO1.1
Identify social and economic
influences on personal
financial goals and decisions.
ACTION ITEM
Do you have an emergency
fund for unexpected
expenses?
h Yes h No
personal financial
planning The process of
managing your money to
achieve personal economic
satisfaction.
financial plan A formalized
report that summarizes your
current financial situation,
analyzes your financial
needs, and recommends
future financial activities.
CHAPTER 1 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO1.1 Identify social and economic influences on personal financial goals and decisions.
LO1.2 Develop personal financial goals.
LO1.3 Calculate time value of money situations associated with personal financial decisions.
LO1.4 Implement a plan for making personal financial and career decisions.
YOUR PERSONAL FINANCIAL PLAN SHEETS
1. Personal Financial Data
2. Setting Personal Financial Goals
3. Achieving Financial Goals Using Time Value of Money
4. Planning Your Career
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4 Chapter 1 Personal Financial Planning in Action
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Advantages of effective personal financial planning include
• Increased effectiveness in obtaining, using, and protecting your financial resources
throughout your life.
• Increased control of your financial affairs by avoiding excessive debt, bankruptcy,
and dependence on others.
• Improved personal relationships resulting from well-planned and effectively
communicated financial decisions.
• A sense of freedom from financial worries obtained by looking to the future,
anticipating expenses, and achieving personal economic goals.
Many factors influence financial decisions. People in their 20s spend money differently
from those in their 50s. Personal factors such as age, income, household size, and personal
beliefs influence your spending and saving patterns. Your life situation or lifestyle is cre-
ated by a combination of factors.
As our society changes, different types of financial needs evolve. Today people tend to
get married at a later age, and more households have two incomes. Many households are
headed by single parents. More than 2 million women provide care for both dependent
children and parents. We are also living longer; over 80 percent of all Americans now liv-
ing are expected to live past age 65.
As Exhibit 1–1 shows, the adult life cycle —the stages in the family situation and finan-
cial needs of an adult—is an important influence on your financial activities and decisions.
Your life situation is also affected by events such as graduation, dependent children leaving
home, changes in health, engagement and marriage, divorce, birth or adoption of a child,
retirement, a career change or a move to a new area, or the death of a spouse, family mem-
ber, or other dependent.
In addition to being defined by your family situation, you are defined by your values —
the ideas and principles that you consider correct, desirable, and important. Values have a
direct influence on such decisions as spending now versus saving for the future or continu-
ing school versus getting a job.
Financial Planning in Our Economy
Daily economic transactions facilitate financial planning activities. Exhibit 1–2 shows the
monetary flows among providers and users of funds that occur in a financial system. These
financial activities affect personal finance decisions. Investing in a bond, which is a debt
security, involves borrowing by a company or government. In contrast, investing in stock,
called an equity security, represents ownership in a corporation. Other financial market
activities include buying and selling mutual funds, certificates of deposit (CDs), and com-
modity futures.
In most societies, the forces of supply and demand set prices for securities, goods, and
services. Economics is the study of how wealth is created and distributed. The economic
environment includes business, labor, and government working together to satisfy needs
and wants. As shown in Exhibit 1–2 , government agencies regulate financial activities. The
Federal Reserve System, the central bank of the United States, has significant economic
responsibility. The Fed, as it is often called, attempts to maintain an adequate money sup-
ply to encourage consumer spending, business growth, and job creation.
GLOBAL INFLUENCES The global economy can influence financial activities.
The U.S. economy is affected by both foreign investors and competition from foreign
companies. American businesses compete against foreign companies for the spending dol-
lars of American consumers. When the level of exports of U.S.-made goods is lower than
the level of imported goods, more U.S. dollars leave the country than the dollar value
of foreign currency coming into the United States. This reduces the funds available for
adult life cycle The stages
in the family situation and
financial needs of an adult.
values Ideas and principles
that a person considers
correct, desirable, and
important.
economics The study of
how wealth is created and
distributed.
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TIME TO TAKE ACTION . . . COMMON FINANCIAL GOALS AND ACTIVITIES
• Obtain appropriate career
training.
• Accumulate an appropriate
emergency fund.
• Evaluate and select appropriate
investments.
• Create an effective financial
recordkeeping system.
• Purchase appropriate types
and amounts of insurance coverage.
• Establish and implement a plan for
retirement goals.
• Develop a regular savings and invest-
ment program.
• Create and implement a flexible
budget.
• Make a will and develop an estate plan.
SPECIALIZED FINANCIAL GOALS AND ACTIVITIES FOR VARIOUS LIFE SITUATIONS
Young, Single (18–35)
Young Couple with
Children under 18
Single Parent with
Children under 18
Young, Dual-Income
Couple, No Children
• Establish financial
independence.
• Carefully manage increased
need for the use of credit.
• Obtain appropriate health,
life, and disability insurance.
• Coordinate insurance cover-
age and other benefits.
• Obtain disability insurance
to replace income during
prolonged illness.
• Obtain an appropriate
amount of life insurance for
the care of dependents.
• Contribute to savings
and investment fund for
college.
• Develop investment program
for changes in life situation
(larger house, children).
• Consider home purchase for
tax benefit.
• Use a will to name guardian
for children.
• Name a guardian for children
and make other estate plans.
• Consider tax-deferred con-
tributions to retirement fund.
Unmarried Couple,
No Children
Older Couple (50 1 ) ,
No Dependent Children
Mixed-Generation
Elderly Individuals and
Children under 18
Older (50 1 ) Single
Person, No Dependent
Children
• Plan joint and individual
bank and credit accounts.
• Review financial assets
and estate plans.
• Obtain long-term care, life,
and disability insurance
coverage.
• Make arrangement for long-
term health care coverage.
• Communicate budgeting
attitude differences.
• Consider household budget
changes several years prior
to retirement.
• Use dependent care
service.
• Review will and estate
plan.
• Discuss and share joint and
individual financial goals.
• Plan retirement housing,
living expenses, recreational
activities, and part-time
work.
• Provide for handling
finances of elderly if they
become ill.
• Plan retirement living facil-
ities, living expenses, and
activities.
• Consider a home purchase
with a property agreement.
• Consider splitting invest-
ment cost—elderly get
income while alive, principal
to survivors.
• Monitor investments
to consider current
financial needs and
market conditions.
Exhibit 1–1 Financial Planning Influences, Goals, and Activities
• 18–24
• 25–34
• 35–44
• 45–54
• 55–64
• 65 and over
• single
• married
• separated/divorced
• widowed
• no other household members
• preschool children
• elementary and secondary
schoolchildren
• college students
• dependent adults
• nondependent adults
• full-time student
• not employed
• full-time employment
or volunteer work
• part-time employment
or volunteer work
Marital StatusAge
Number and Age of
Household Members
Employment Situation
Life Situation Factors Affect Financial Planning Activities
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domestic spending and investment. Also, if foreign companies decide not to invest in the
United States, the domestic money supply is reduced. This reduced money supply can
cause higher interest rates.
INFLATION Most people are concerned with the buying power of their money.
Inflation is a rise in the general level of prices. In times of inflation, the buying power of
the dollar decreases. For example, if prices increased 5 percent during the last year, items
that previously cost $100 would now cost $105. This means more money is needed to buy
the same amount of goods and services.
Inflation is most harmful to people with fixed incomes. Due to inflation, retired people
and others whose incomes do not change are able to afford fewer goods and services. Infla-
tion can also adversely affect lenders of money. Unless an adequate interest rate is charged,
amounts repaid by borrowers in times of inflation have less buying power than the money
they borrowed.
Inflation rates vary. During the late 1950s and early 1960s, the annual inflation rate
was in the 1 to 3 percent range. During the late 1970s and early 1980s, the cost of living
increased 10 to 12 percent annually. At a 12 percent annual inflation rate, prices double
(and the value of the dollar is cut in half) in about six years. To find out how fast prices
(or your savings) will double, use the Rule of 72: Just divide 72 by the annual inflation (or
interest) rate.
inflation A rise in the
general level of prices.
Exhibit 1–2 The Financial System
Financial Regulators: Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration,
Office of the Comptroller of the Currency, Consumer Financial Protection Bureau, Securities and Exchange Commission,
state banking agencies, state insurance agencies.
Financial
Intermediaries
• banks, credit unions
• insurance companies
• investment companies
• other financial
institutions
Financial Markets
• stock markets
• bond markets
• money markets
• commodity markets
Funds
Funds
Fun
ds
Funds
FUNDS
Users
(borrowers, spenders)
of funds
• individuals
• businesses
• governments
• foreign
entities
Providers
(savers, investors)
of funds
• individuals
• businesses
• governments
• foreign
entities
EXAMPLE: Rule of 72
An annual inflation rate of 4 percent, for example, means prices will double in
18 years (72 4 4 5 18). Regarding savings, if you earn 6 percent, your money will
double in 12 years (72 4 6 5 12).
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More recently, the reported annual price increase for goods
and services as measured by the consumer price index has been
in the 2 to 4 percent range. The consumer price index (CPI),
computed and published by the Bureau of Labor Statistics, is
a measure of the average change in the prices urban consumers
pay for a fixed “basket” of goods and services.
Inflation rates can be deceptive since the index is based on
items calculated in a predetermined manner. Many people face
hidden inflation since the cost of necessities (food, gas, health
care), on which they spend the greatest proportion of their
money, may rise at a higher rate than nonessential items, which
could be dropping in price. This results in a reported inflation
rate much lower than the actual cost-of-living increase being experienced by consumers.
Deflation, a decline in prices, can also have damaging economic effects. As prices
drop, consumers expect they will go even lower. As a result, consumers cut their spending,
which causes damaging economic conditions. While widespread deflation is unlikely, cer-
tain items may be affected and their prices will drop.
INTEREST RATES In simple terms, interest rates represent the cost of money. Like
everything else, money has a price. The forces of supply and demand influence interest
rates. When consumer saving and investing increase the supply of money, interest rates
tend to decrease. However, as borrowing by consumers, businesses, and government
increases, interest rates are likely to rise.
Interest rates can have a major effect on financial planning. The earnings you receive as
a saver or an investor reflect current interest rates as well as a risk premium based on such
factors as the length of time your funds will be used by others, expected inflation, and the
extent of uncertainty about getting your money back. Risk is also a factor in the interest
rate you pay as a borrower. People with poor credit ratings pay a higher interest rate than
people with good credit ratings. Interest rates influence many financial decisions.
Financial Planning Activities
To achieve a successful financial situation, you must coordinate various components
through an organized plan and wise decision making.
OBTAINING (CHAPTER 1) You obtain financial resources from employment,
investments, or ownership of a business. Obtaining financial resources is the foundation of
financial planning, since these resources are used for all financial activities.
PLANNING (CHAPTERS 2, 3) Planned spending through budgeting is the key
to achieving goals and future financial security. Efforts to anticipate expenses along with
making certain financial decisions can reduce taxes, increase savings, and result in less
financial stress.
SAVING (CHAPTERS 2, 4) Long-term financial security starts with a regular sav-
ings plan for emergencies, unexpected bills, replacement of major items, and the purchase
of special goods and services, such as a college education, a boat, or a vacation home.
Once you have established a basic savings plan, you may use additional money for invest-
ments that offer greater financial growth.
BORROWING (CHAPTER 5) Maintaining control over your credit-buying habits
will contribute to your financial goals. The overuse and misuse of credit may cause a situ-
ation in which a person’s debts far exceed the resources available to pay those debts.
Bankruptcy is a set of federal laws allowing you to either restructure your debts or remove
bankruptcy A set of federal
laws allowing you to either
restructure your debts or
remove certain debts.
did you know? did you know?
U.S. consumer prices between 1970 and
1980 nearly doubled, while between 2000
and 2010 prices rose only about 27 percent.
Some countries, such as Bolivia and Zimbabwe,
have encountered hyperinflation in their history, with
consumer prices increasing more than
50,000 percent.
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certain debts. The people who declare bankruptcy each year may have avoided this trauma
with wise spending and borrowing decisions. Chapter 5 discusses bankruptcy in detail.
SPENDING (CHAPTERS 6, 7) Financial planning is designed not to prevent
your enjoyment of life but to help you obtain the items you want. Too often, however,
people make purchases without considering the financial consequences. Some people shop
compulsively, creating financial difficulties. You should detail your living expenses and
your other financial obligations in a spending plan. Spending less than you earn is the only
way to achieve long-term financial security.
MANAGING RISK (CHAPTERS 8, 9, 10) Adequate insurance coverage is
another component of personal financial planning. Certain types of insurance are com-
monly overlooked in financial plans. For example, the number of people who suffer dis-
abling injuries or diseases at age 50 is greater than the number who die at that age, so
people may need disability insurance more than they need life insurance. Yet surveys reveal
that most people have adequate life insurance but few have adequate disability insurance.
INVESTING (CHAPTERS 11, 12, 13) Although many types of investments are
available, people invest for two primary reasons. Those interested in current income select
investments that pay regular dividends or interest. In contrast, investors who desire long-
term growth choose stocks, mutual funds, real estate, and other investments with potential
for increased value in the future. You can achieve investment diversification by including
a variety of assets in your portfolio —these may include stocks, bond mutual funds, real
estate, and collectibles such as rare coins.
RETIREMENT AND ESTATE PLANNING (CHAPTER 14) Most people
desire financial security upon completion of full-time employment. But retirement plan-
ning also involves thinking about your housing situation, your recreational activities, and
possible part-time or volunteer work.
Transfers of money or property to others should be timed, if possible, to minimize the
tax burden and maximize the benefits for those receiving the financial resources. Knowl-
edge of property transfer methods can help you select the best course of action for funding
current and future living costs, educational expenses, and retirement needs of dependents.
PRACTICE QUIZ 1–1 PRACTICE QUIZ 1–1
1. How do personal and economic factors affect the operation of the financial system and personal financial decisions?
2. For each of the following situations, indicate if the person would tend to “suffer” or tend to “benefit” from inflation.
(Circle your answer)
A person with money in a savings account. suffer benefit
A person who is borrowing money. suffer benefit
A person who is lending money. suffer benefit
A person receiving a fixed income amount. suffer benefit
Apply Yourself! Apply Yourself!
Using online research and discussion with others, calculate the recent inflation rate that reflects the change in price for
items frequently bought by you and your family.
Sheet 1 Personal Financial Data
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CAUTION! CAUTION!
Most financial planning professionals have
a code of ethics, but not all abide by these
principles. To avoid financial difficulties and
potential fraud, make sure your financial
planner strictly applies industry policies
regarding confidentiality, integrity, objectivity
to prevent a conflict of interest, and a
commitment to continuing education.
Chapter 1 Personal Financial Planning in Action 9
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Developing and Achieving Financial Goals
Why do so many Americans—living in one of the richest countries in the world—have
money problems? The answer can be found in two main factors. The first is poor planning
and weak money management habits in areas such as spending and the use of credit. The
other factor is extensive advertising, selling efforts, and product availability that encourage
overbuying. Achieving personal financial satisfaction starts with clear financial goals.
Types of Financial Goals
What would you like to do tomorrow? Believe it or not, that question involves goal setting,
which may be viewed in three time frames:
• Short-term goals will be achieved within the next year or so, such as saving for a
vacation or paying off small debts.
• Intermediate goals have a time frame of two to five years.
• Long-term goals involve financial plans that are more than five years off, such as
retirement, money for children’s college education, or the purchase of a vacation
home.
Long-term goals should be planned in coordination with short-term and intermediate
goals. Setting and achieving short-term goals is commonly the basis for moving toward
success of long-term goals. For example, saving for a down payment to buy a house is
a short-term goal that can be a foundation for a long-term goal: owning your own home.
A goal of obtaining increased career training is different from a goal of saving money
to pay a semiannual auto insurance premium. Consumable-product goals usually occur on
a periodic basis and involve items that are used up relatively quickly, such as food, cloth-
ing, and entertainment. Durable-product goals usually involve infrequently purchased,
expensive items such as appliances, cars, and sporting equipment; these consist of tangi-
ble items. In contrast, many people overlook intangible-purchase goals. These goals may
relate to personal relationships, health, education, community service, and leisure.
Goal-Setting Guidelines
An old saying goes, “If you don’t know where you’re going, you might end up somewhere
else and not even know it.” Goal setting is central to financial decision making. Your finan-
cial goals are the basis for planning, implementing, and measuring the progress of your
spending, saving, and investing activities. Exhibit 1–1 offers typical goals and financial
activities for various life situations.
Your financial goals should take a SMART approach, in that they are:
• S — specific, so you know exactly what your goals are and can create a plan
designed to achieve those objectives.
• M — measurable by a specific amount. For example,
“Accumulate $5,000 in an investment fund within three years”
is more measurable than “Put money into an investment fund.”
• A — action-oriented, providing the basis for the personal
financial activities you will undertake. For example,
“Reduce credit card debt” will usually mean actions to pay
off amounts owed.
• R — realistic, involving goals based on your income and life
situation. For example, it is probably not realistic to expect
to buy a new car each year if you are a full-time student.
• T — time-based, indicating a time frame for achieving the
goal, such as three years. This allows you to measure your
progress toward your financial goals.
LO1.2
Develop personal financial
goals.
ACTION ITEM
Do you have specific financial
goals that you hope to
achieve in the future?
h Yes h No
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Opportunity Costs
and the Time Value of Money
In every financial decision, you sacrifice something to obtain something else that you con-
sider more desirable. For example, you might forgo current buying now to save funds for
future purchases or long-term financial security. Or you might gain the use of an expensive
item now by making credit payments from future earnings.
LO1.3
Calculate time value of
money situations associated
with personal financial
decisions.
Based on your current situation or expectations for the future, create one or more financial goals based on this four-step
process:
Developing Financial Goals
Personal Finance in Practice
STEP 1
Realistic goals for your
life situation
STEP 3
Determine time frame
STEP 4
Actions to be taken
STEP 2
State goals in
measurable terms
PRACTICE QUIZ 1–2 PRACTICE QUIZ 1–2
1. What are some examples of long-term goals?
2. What are the main characteristics of useful financial goals?
3. Match the following common goals to the life situation of the people listed.
a. Pay off student loans _____ A young couple without children
b. Start a college savings fund _____ An older person living alone
c. Increase retirement contributions _____ A person who just completed college
d. Finance long-term care _____ A single mother with a preschool daughter
Apply Yourself! Apply Yourself!
Ask friends, relatives, and others about their short-term and long-term financial goals. What are some of the common
goals for various personal situations?
Sheet 2 Setting Personal Financial Goals
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ACTION ITEM
Do you set aside an amount
of money on a regular basis
for various financial goals?
h Yes h No
Opportunity cost is what you give up by making a choice. This cost, commonly referred
to as the trade-off of a decision, cannot always be measured in dollars. Opportunity costs
should be viewed in terms of both personal and financial resources.
Personal Opportunity Costs
An important personal opportunity cost involves time that when used for one activity can-
not be used for other activities. Time used for studying, working, or shopping will not
be available for other uses. Other personal opportunity costs relate to health. Poor eating
habits, lack of sleep, or avoiding exercise can result in illness, time away from school or
work, increased health care costs, and reduced financial security. Like financial resources,
your personal resources (time, energy, health, abilities, knowledge) require planning and
wise management.
Financial Opportunity Costs
Would you rather have $100 today or $103 a year from now? How about $120 a year from
now instead of $100 today? Your choice among these alternatives will depend on several
factors including current needs, future uncertainty, and current interest rates. If you wait to
receive your money in the future, you want to be rewarded for the risk. The time value of
money involves the increases in an amount of money as a result of interest earned. Saving
or investing a dollar instead of spending it today results in a future amount greater than a
dollar. Every time you spend, save, invest, or borrow money, you should consider the time
value of that money as an opportunity cost. Spending money from your savings account
means lost interest earnings; however, what you buy with that money may have a higher
priority than those earnings.
INTEREST CALCULATIONS Three amounts are used to calculate the time value
of money for savings in the form of interest earned:
• The amount of the savings (commonly called the principal ).
• The annual interest rate.
• The length of time the money is on deposit.
These three items are multiplied to obtain the amount of interest. Simple interest is calcu-
lated as follows:
opportunity cost What a
person gives up by making a
choice.
time value of money
Increase in an amount of
money as a result of interest
earned.
For example, $500 on deposit at 6 percent for six months would earn $15 ($500 3
0.06 3 6/12 or ½ year).
The increased value of money from interest earned involves two types of time value of
money calculations, future value and present value. The amount that will be available at
a later date is called the future value. In contrast, the current value of an amount desired
in the future is the present value. Five methods are available for calculating time value of
money:
1. Formula calculation. With this conventional method, math notations are used for
computing future value and present value.
2. Time value of money tables. Traditionally, before calculators and computers, future
value and present value tables were used (see Exhibit 1–3 ) to provide for easier
computations.
Amount in
savings
Annual
interest
rate
Time
period
Interest
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A. Future Value of $1 (single amount)
PERCENT
Year 5% 6% 7% 8% 9%
5 1.276 1.338 1.403 1.469 1.539
6 1.340 1.419 1.501 1.587 1.677
7 1.407 1.504 1.606 1.714 1.828
8 1.477 1.594 1.718 1.851 1.993
9 1.551 1.689 1.838 1.999 2.172
10 1.629 1.791 1.967 2.159 2.367
B. Future Value of a Series of Annual Deposits (annuity)
PERCENT
Year 5% 6% 7% 8% 9%
5 5.526 5.637 5.751 5.867 5.985
6 6.802 6.975 7.153 7.336 7.523
7 8.142 8.394 8.654 8.923 9.200
8 9.549 9.897 10.260 10.637 11.028
9 11.027 11.491 11.978 12.488 13.021
10 12.578 13.181 13.816 14.487 15.193
C. Present Value of $1 (single amount)
PERCENT
Year 5% 6% 7% 8% 9%
5 0.784 0.747 0.713 0.681 0.650
6 0.746 0.705 0.666 0.630 0.596
7 0.711 0.665 0.623 0.583 0.547
8 0.677 0.627 0.582 0.540 0.502
9 0.645 0.592 0.544 0.500 0.460
10 0.614 0.558 0.508 0.463 0.422
D. Present Value of a Series of Annual Deposits (annuity)
PERCENT
Year 5% 6% 7% 8% 9%
5 4.329 4.212 4.100 3.993 3.890
6 5.076 4.917 4.767 4.623 4.486
7 5.786 5.582 5.389 5.206 5.033
8 6.463 6.210 5.971 5.747 5.535
9 7.108 6.802 6.515 6.247 5.995
10 7.722 7.360 7.024 6.710 6.418
NOTE: See the appendix at the end of this chapter for more complete future value and present value tables.
Exhibit 1–3
Time Value of Money
Tables (condensed)
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3. Financial calculator. A variety of calculators are programmed with financial
functions. Both future value and present value calculations are performed using
appropriate keystrokes.
4. Spreadsheet software. Excel and other spreadsheet programs have built-in formulas
for financial computations, including future value and present value.
5. Websites and apps. Many time value of money calculators are available online and
through mobile devices. These programs may be used to calculate the future value
of savings as well as loan payment amounts.
FUTURE VALUE OF A SINGLE AMOUNT Deposited money earns interest
that will increase over time. Future value is the amount to which current savings will
grow based on a certain interest rate and a certain time period. For example, $100
deposited in a 6 percent account for one year will grow to $106. This amount is com-
puted as follows:
Future value 5 $100 1 ($100 3 0.06 3 1 year) 5 $106
The same process could be continued for a second, third, and fourth year; however, the
computations would be time-consuming. The previously mentioned calculation methods
make the process easier.
An example of the future value of a single amount might involve an investment of $650
earning 8 percent for 10 years. This situation would be calculated as follows:
future value The amount
to which current savings will
increase based on a certain
interest rate and a certain
time period; also referred to
as compounding.
Formula Time Value of Money Table Financial Calculator Spreadsheet Software
FV 5 PV (1 1 i ) n
FV 5 650(1 1 0.08) 10
FV 5 $1,403.30
i —interest rate
n —number of time
periods
Using Exhibit 1–3A , multiply
the amount deposited by the
factor for the interest rate and
time period.
650 3 2.159 5 $1,403.35
(The slight difference in
this answer is the result of
rounding the decimal places.)
PV , I/Y , N , PMT , CPT FV
650 PV , 8 I/Y ,
10 N , 0 PMT ,
CPT FV $1,403.30
(Different financial calculators will
require different keystrokes.)
5 FV(rate, periods,
amount per period,
single amount)
5 FV(0.08,10,0, 2 650)
5 $1,403.30
NOTE: Expanded explanations of these time value of money calculation methods are presented in the appendix following this chapter.
Future value computations are often referred to as compounding, since interest is earned
on previously earned interest. Compounding allows the future value of a deposit to grow
faster than it would if interest were paid only on the original deposit. The sooner you make
deposits, the greater the future value will be. Depositing $1,000 in a 5 percent account at
age 40 will give you $3,387 at age 65. However, making the
$1,000 deposit at age 25 would result in an account balance of
$7,040 at age 65.
FUTURE VALUE OF A SERIES OF DEPOSITS
Many savers and investors make regular deposits. An annuity is
a series of equal deposits or payments. To determine the future
value of equal yearly savings deposits, time value of money
tables can be used (see Exhibit 1–3B ). For this table to be used,
and for an annuity to exist, the deposits must earn a constant
interest rate. For example, if you deposit $50 a year at 7 percent
did you know? did you know?
If you invest $2,000 a year (at 9 percent)
from ages 31 to 65, these funds will grow to
$470,249 by age 65. However, if you save $2,000 a
year (at 9 percent) for only 9 years (ages 22 to 30),
at age 65 this fund will be worth $579,471! Most
important: Start investing something now!
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Achieving specific financial goals may require making regular savings deposits or determining an amount to
be invested. By using time value of money calculations, you can compute the amount needed to achieve a
financial goal.
Figure It Out!
Time Value of Money Calculations for Achieving Financial Goals Time Value of Money Calculations for Achieving Financial Goals
14
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for six years, starting at the end of the first year, you will have
$357.65 at the end of that time ($50 3 7.153). The nearby
“Figure It Out!” box presents examples of using future value to
achieve financial goals.
PRESENT VALUE OF A SINGLE AMOUNT Another
aspect of the time value of money involves determining the cur-
rent value of an amount desired in the future. Present value is
the current value for a future amount based on a particular inter-
est rate for a certain period of time. Present value computations,
also called discounting, allow you to determine how much to
deposit now to obtain a desired total in the future. For example,
using the present value table ( Exhibit 1–3C ), if you want $1,000
five years from now and you earn 5 percent on your savings, you
need to deposit $784 ($1,000 3 0.784).
digi – know? digi – know?
The use of mobile apps for personal finan- The use of mobile apps for personal finan-
cial activities continues to expand with cial activities continues to expand with
instant access to bank accounts, budget instant access to bank accounts, budget
amounts, investment information, and time amounts, investment information, and time
value of money calculations. Some of the value of money calculations. Some of the
most popular are mint , most popular are mint , UnsplurgeUnsplurge, Easy , Easy
Money, and Pocket Money, with costs Money, and Pocket Money, with costs
ranging from free to a few dollars. ranging from free to a few dollars.
Situation 1: Jonie Emerson has two children who will start college in 10 years. She plans to set aside $1,500 a year for her chil-
dren’s college education during that period and estimates she will earn an annual interest rate of 5 percent on her savings. What
amount can Jonie expect to have available for her children’s college education when they start college?
Formula Time Value of Money Table Financial Calculator Spreadsheet Software
FV 5 Annuity
(1 1 i )n 2 1
___________
i
FV 5
1,500(1 1 .05)10 2 1
___________________
.05
FV 5 $18,866.85
Using Exhibit 1–3B , multiply
the amount deposited by the
factor for the interest rate
and time period.
1,500 3 12.578 5 $18,867
PV , I/Y , N , PMT , CPT FV
0 PV , 5 I/Y , 10 N , 1,500
PMT , CPT FV $18,866.84
(Different financial calculators will
require different keystrokes.)
5 FV(rate, periods, amount
per period, amount)
5 FV(0.05,10, 2 1,500)
5 $18,866.84
Conclusion: Based these calculations, if Jonie deposits $1,500 a year at an annual interest rate of 5 percent, she would have
$18,867 available for her children’s college education.
Situation 2: Don Calder wants to have $50,000 available in 10 years as a reserve fund for his parents’ retirement living expenses
and health care. If he earns an average of 8 percent on his investments, what amount must he invest today to achieve this goal?
Formula Time Value of Money Table Financial Calculator Spreadsheet Software
PV 5
FV
_______
(1 1 i)n
PV 5
50,000
__________
(1 1 .08)10
FV 5 $23,159.94
Using Exhibit 1–3C , multiply
the amount desired by the
factor for the interest rate
and time period.
50,000 3 0.463 5 $23,150
FV , N , I/Y , PMT , CPT PV
50,000 FV , 10 N , 8 I/Y , 0
PMT , CPT PV $23,159.67
(Different financial calculators will
require different keystrokes.)
5 PV(rate, periods, payment,
future value amount type)
5 PV(0.08,10,0, 2 50,000)
5 $23,159.67
Conclusion: Don needs to invest approximately $23,160 today for 10 years at 8 percent to achieve the desired financial goal.
NOTE: Expanded explanations of these time value of money calculation methods are presented in the appendix following this chapter.
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PRESENT VALUE OF A SERIES OF DEPOSITS You may also use present
value computations to determine how much you need to deposit now so that you can take
a certain amount out of the account for a desired number of years. For example, if you
want to take $400 out of an investment account each year for nine years and your money is
earning an annual rate of 8 percent, you can see from Exhibit 1–3D that you would need to
make a current deposit of $2,498.80 ($400 3 6.247).
Additional details for the formulas, tables, and other methods for calculating time value
of money are presented in the appendix at the end of this chapter.
present value The current
value for a future amount
based on a certain interest
rate and a certain time
period; also referred to as
discounting.
PRACTICE QUIZ 1–3 PRACTICE QUIZ 1–3
1. What are some examples of personal opportunity costs?
2. What does time value of money measure?
3. Use the time value of money tables in Exhibit 1–3 (or a financial calculator) to calculate the following:
a. The future value of $100 at 7 percent in 10 years.
b. The future value of $100 a year for six years earning 6 percent.
c. The present value of $500 received in eight years with an interest rate of 8 percent.
Apply Yourself! Apply Yourself!
What is the relationship between current interest rates and financial opportunity costs? Using time value of money cal-
culations, state one or more goals in terms of an annual savings amount and the future value of this savings objective.
Sheet 3 Achieving Financial Goals Using
Time Value of Money
S
T
A Plan for Personal Financial Planning
We all make hundreds of decisions each day. Most of these decisions are quite simple and
have few consequences. However, some are complex and have long-term effects on our
personal and financial situations, as shown here:
LO1.4
Implement a plan for making
personal financial and career
decisions.
ACTION ITEM
Do you consider various
types of risks when making
personal financial decisions?
h Yes h No
• to provide local and
global assistance to
those in need
• for daily living expenses
• for major expenditures
• for recreational activities
• for long-term financial
security
INCOME (sources of funds)
SPEND SAVE SHARE
While everyone makes decisions, few people consider how to make better decisions. As
Exhibit 1–4 shows, the financial planning process can be viewed as a six-step procedure
that can be adapted to any life situation.
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16 Chapter 1 Personal Financial Planning in Action
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STEP 1: Determine Your Current Financial Situation
In this first step, determine your current financial situation regarding income, savings, living
expenses, and debts. Preparing a list of current asset and debt balances and amounts spent
for various items gives you a foundation for financial planning activities. The personal finan-
cial statements discussed in Chapter 2 will provide the information needed in this phase of
financial decision making.
Exhibit 1–4 The Financial Planning Process
6
Review and
revise the
financial plan
Determine
current
financial
situation
1 2 Develop yourfinancial goals
3
Identify
alternative
courses
of action
4
Consider
• life situation
• personal values
• economic factors
Assess
• risk
• time value of money
(opportunity cost)
Evaluate alternatives
5
Create and
implement
your
financial
action
plan
The Financial
Planning Process
EXAMPLE: Step 1, Determine Your Current Situation
Carla Elliot plans to complete her college degree in the next two years. She works
two part-time jobs in an effort to pay her educational expenses. Currently, Carla
has $700 in a savings account and existing debt that includes a $640 balance on
her credit card and $2,300 in student loans. What additional information should
Carla have available when planning her personal finances?
Example from Your Life
What actions have you taken to determine your current financial situation?
STEP 2: Develop Your Financial Goals
You should periodically analyze your financial values and goals.
The purpose of this analysis is to differentiate your needs from
your wants. Specific financial goals are vital to financial plan-
ning. Others can suggest financial goals for you; however, you
must decide which goals to pursue. Your financial goals can
range from spending all of your current income to developing an
extensive savings and investment program for your future finan-
cial security.
did you know? did you know?
According to the National Endowment for
Financial Education, 70 percent of major lottery
winners end up with financial difficulties. These winners
often squander the funds awarded them, while others
overspend and many end up declaring bankruptcy.
Having more money does not automatically mean
making better financial planning choices.
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STEP 3: Identify Alternative Courses of Action
Developing alternatives is crucial when making decisions. Although many factors will influ-
ence the available alternatives, possible courses of action usually fall into these categories:
• Continue the same course of action. For example, you may determine that the
amount you have saved each month is still appropriate.
• Expand the current situation. You may choose to save a larger amount each month.
• Change the current situation. You may decide to use a money market account
instead of a regular savings account.
• Take a new course of action. You may decide to use your monthly saving budget to
pay off credit card debts.
Not all of these categories will apply to every decision; however, they do represent possible
courses of action. For example, if you want to stop working full-time to go to school, you must
generate several alternatives under the category “Take a new course of action.” Creativity in
decision making is vital to effective choices. Considering all of the possible alternatives will
help you make more effective and satisfying decisions. For instance, most people believe they
must own a car to get to work or school. However, they should consider other alternatives such
as public transportation, carpooling, renting a car, shared ownership of a car, or a company car.
Remember, when you decide not to take action, you elect to “do nothing,” which can be
a dangerous alternative.
EXAMPLE: Step 2, Develop Financial Goals
Carla Elliot’s main financial goals for the next two years are to complete her college
degree and to maintain or reduce the amounts owed. What other goals might be
appropriate for Carla?
Example from Your Life
Describe some short-term or long-term goals that might be appropriate for your life
situation.
EXAMPLE: Step 3, Identify Alternatives
To achieve her goals, Carla Elliot has several options available. She could reduce
her spending, seek a higher-paying part-time job, or use her savings to pay off
some of her debt. What additional alternatives might she consider?
Example from Your Life
List various alternatives for achieving the financial goals you identified in the previ-
ous step.
STEP 4: Evaluate Your Alternatives
You need to evaluate possible courses of action, taking into consideration your life situa-
tion, personal values, and current economic conditions. How will the ages of dependents
affect your saving goals? How do you like to spend leisure time? How will changes in
interest rates affect your financial situation?
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CONSEQUENCES OF CHOICES Every decision closes
off alternatives. For example, a decision to invest in stock may
mean you cannot take a vacation. A decision to go to school full-
time may mean you cannot work full-time. Opportunity cost is
what you give up by making a choice. These trade-offs cannot
always be measured in dollars. However, the resources you give
up (money or time) have a value that is lost.
EVALUATING RISK Uncertainty is also a part of every
decision. Selecting a college major and choosing a career field
involve risk. What if you don’t like working in this field or can-
not obtain employment in it? Other decisions involve a very
low degree of risk, such as putting money in an insured sav-
ings account or purchasing items that cost only a few dollars.
Your chances of losing something of great value are low in these
situations.
In many financial decisions, identifying and evaluating risk
are difficult. Common risks to consider include:
• Inflation risk, due to rising or falling (deflation) prices that cause changes in
buying power.
• Interest rate risk, resulting from changes in the cost of money, which can affect
your costs (when you borrow) and benefits (when you save or invest).
• Income risk may result from loss of a job or encountering illness.
• Personal risk involves tangible and intangible factors that create a less than
desirable situation, such as health or safety concerns.
• Liquidity risk occurs when savings and investments that have potential for higher
earnings are difficult to convert to cash or to sell without significant loss in value.
The best way to consider risk is to gather information based on your experience and the
experiences of others and to use financial planning information sources.
FINANCIAL PLANNING INFORMATION SOURCES Relevant informa-
tion is required at each stage of the decision-making process. In addition to this book,
common sources available to help you with your financial decisions include (1) the Internet;
(2) financial institutions, such as banks, credit unions, and investment companies; (3) media
sources, such as newspapers, magazines, television, radio, podcasts, and online videos; and
(4) financial specialists, such as financial planners, insurance agents, investment advisors,
credit counselors, lawyers, and tax preparers.
did you know? did you know?
Nearly one billion people around the Nearly one billion people around the
world live on $1 or less a day. Various world live on $1 or less a day. Various
organizations provide these people with organizations provide these people with
basic need items and future opportuni-basic need items and future opportuni-
ties. Bright Hope International assists the ties. Bright Hope International assists the
extreme poor extreme poor by providingby providing food, clothing, food, clothing,
shelter, health care, education, orphan shelter, health care, education, orphan
support, microloans, job training, and support, microloans, job training, and
spiritual guidance. You can help to spiritual guidance. You can help to
provide assistance to the extreme poor provide assistance to the extreme poor
at at www.brighthope.orgwww.brighthope.org . .
EXAMPLE: Step 4, Evaluate Alternatives
As Carla Elliot evaluates her alternative courses of action, she should consider both
her short-term and long-term situations. What risks and trade-offs should Carla
consider?
Example from Your Life
In your life, what types of risks might be encountered when planning and imple-
menting various personal financial activities?
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Do you feel stress when you think about money? Are your
financial decisions influenced by emotions rather than valid
information? Do you often have disagreements about money?
To address these and other financial concerns, two
paths exist for your daily money decisions. The easy path
involves little thinking, no planning, and minimal effort, usu-
ally resulting in wasted money and financial difficulties. In
contrast, the appropriate path takes some time and effort,
but results in lower stress and personal financial security.
Which Path Will You Choose? Only One Will Result in Financial
Security
Personal Finance in Practice
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STEP 5: Create and Implement Your Financial
Action Plan
You are now ready to develop an action plan to identify ways to achieve your goals. For
example, you can increase your savings by reducing your spending or by increasing your
income through extra time on the job. If you are concerned about year-end tax payments,
you may increase the amount withheld from each paycheck, file quarterly tax payments, or
shelter current income in a tax-deferred retirement program.
To implement your financial action plan, you may need assistance from others. For
example, you may use the services of an insurance agent to purchase property insurance or
the services of an investment broker to purchase stocks, bonds, or mutual funds. Exhibit 1–5
offers a framework for developing and implementing a financial plan, along with examples for
several life situations. Also, Appendix A provides information on financing your education.
financial goals, and future vision. This paragraph (or
list or drawing or other format) will remind you and
family members of your desired path for financial
security. The wording describes where you want to
be, and how you will get there. Develop your financial
mission statement by talking with those who can help
guide your actions. Your personal finance mission
statement may include phrases such as “My financial
mission is to change my spending habits for . . . ,”
“. . . to better understand my insurance needs . . . ,”
or “to donate (or volunteer) to local community service
organizations.”
Choosing whether to take easy or difficult actions can
result in reduced emotional stress, improved personal rela-
tionships, and expanded financial security.
You can easily start to move yourself from easy mistakes to
appropriate actions with these steps:
1. Do something. Start small, such as saving a small amount
each month. Or decide to reduce your credit card use.
2. Avoid excuses. Do not tell yourself that “I don’t have
time” or “It’s what everyone else is doing.”
3. Rate your current situation. Indicate on this scale where
you are currently in relation to the two available paths:
Spender Saver
Financial difficulties Financial security
4. Set your mission. Create a personal finance mission
statement to communicate your personal values,
It is EASY to…
…spend without planning.
…overuse credit cards.
…avoid insurance coverage.
…select investments carelessly.
…make decisions on your own.
…but APPROPRIATE to…
…save for emergencies and the future.
…maintain a low level of debt.
…have a risk management plan.
…research to avoid investment scams.
…communicate with others.
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20 Chapter 1 Personal Financial Planning in Action
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STEP 6: Review and Revise Your Plan
Financial planning is a dynamic process that does not end when you take a particular
action. You need to regularly assess your financial decisions. You should do a complete
review of your finances at least once a year. Changing personal, social, and economic fac-
tors may require more frequent assessments.
When life events affect your financial needs, this financial planning process will pro-
vide a vehicle for adapting to those changes. A regular review of this decision-making
EXAMPLE: Step 5, Create a Financial Plan
Carla has decided to reduce her course load and work longer hours in an effort
both to reduce her debt level and to increase the amount she has in savings. What
are the benefits and drawbacks of this choice?
Example from Your Life
Describe the benefits and drawbacks of a financial situation you have encountered
during the past year.
Exhibit 1–5 Financial Planning in Action
Assess your
current situation
Create and implement
a budget
Pay off credit card debts
Obtain adequate
insurance
Establish a regular
savings program
Invest in safe, income-
producing financial
instruments
Use rental housing;
save for home purchase
Short-Term Financial
Strategies
Invest in financial
instrument for long-term
growth
Select tax-deferred
investments
Pay off consumer debts
and home mortgage
Long-Term Financial
Strategies
Now
Examples
1.
2.
3.
Now Within a Year
Within a Year
More Than a
Year from Now
More Than a
Year from Now
Develop financial
goals
Select appropriate
plans of action
Life situation: Single parent
Goal: Provide $20,000 college fund
in 10 years
Create and implement budget
to allow regular deposits to
savings or investment program
Continue investment program
to provide for expanded
housing needs for emergencies
Make monthly payments to
mutual funds investment
program
Purchase life insurance with
parents as beneficiaries
Make regular deposits to a
savings plan such as
certificates of deposit
Obtain life insurance for
dependent care in case of
premature death
Life situation: Middle-aged person
or couple
Goal: Provide for financial needs
of parents
Goal: Save for down payment
for home purchase
Life situation: Young couple
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W
hether you’re
newlyweds, soon
to be wed, or
an old married
couple, money is at least as
important to a balanced, happy
marriage as love and sex. Money
is a common cause of conflict—
and even divorce—among cou-
ples. Blend your financial lives
successfully, and you are more
likely to have a happy marriage.
Because opposites attract,
combining money-management
styles that conflict is among
the greatest challenges mar-
ried couples face. Early and
frequent communication is crit-
ical, says Cathy Pareto, a finan-
cial advisor in Coral Gables, Fla.
That includes discussing your
debts, income, credit history,
investments and goals. “You’ve
got to meet in the middle,”
Pareto says. “Otherwise, I prom-
ise you there will be fights.”
Starting out. The first conversa-
tion could be an uncomfortable
one. Maybe one of you has a
low credit score or a lot of credit
card debt. Or perhaps you have
significant differences in your
approach to spending and saving.
Until you’ve had plenty of hon-
est dialogue, set the ground rules
and built the trust you need to
put your money together, Pareto
recommends keeping accounts
mostly separate. “Better to wait
to commingle than to do it too
soon and be unpleasantly sur-
prised to learn that you have an
irresponsible partner.”
You may be able to make do
with an informal split of your
finances. Alee Papazian, 27, and
Brooks Heckner, 31, of Cam-
bridge, Mass., who plan to marry
this summer, have been living
together since 2006. They have
no shared accounts or assets,
so they divvy up their mutual
expenses. To account for a gap
in their earnings, Heckner pays
$75 more in rent each month.
Papazian pays the utility bills,
and Heckner covers the cable
and Internet. Then they eyeball
most of their other expenses to
determine a fair split.
Shannon Hancock, 33, and
Scott Knight, 42, who are get-
ting married in September, are
more comfortable with the pros-
pect of combining accounts.
They chat monthly about their
individual budgets, which Han-
cock expects will help with
their transition to budgeting as
a couple. They plan to open a
joint checking account, from
which they could pay their
mortgage and other bills, and
sign up for a joint credit card.
After the honeymoon. Espe-
cially after you buy a house
and have kids, it makes
sense to merge more of your
finances—although most
financial advisors recommend
that you each keep at least
one credit card in your own
name and have access to some
money that you can spend
without having to consult your
spouse (you should check with
each other about large pur-
chases). Since Julie Billing, 37,
and her husband, Greg, 39, of
West Milton, Ohio, got married
more than 14 years ago, they
have stuck to a strategy of
merging their bank accounts.
Julie usually handles the bill
paying and budgeting. Having
such a “family CFO” is a com-
mon way for couples to handle
expenses, says Pareto.
Talk frequently about your
plans, and don’t let your
emotions become stumbling
blocks. Doug Pauley, a finan-
cial advisor in Austin, Tex.,
says sometimes it can help to
consult a financial counselor
or a financial planner you both
trust, who can add perspective
and help defuse arguments.
Lisa Gerstner
SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2011. The Kiplinger Washington Editors, Inc.
1. What are reasons for money causing conflicts among couples and with other household members?
2. Which of the actions discussed might be of value to you and others for effective personal financial planning?
3. What additional information is available at www.kiplinger.com to assist you with your financial decisions?
Yours, Mine and Our Accounts
Figuring out how to blend your finances means fewer things to fight about.
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process will help you make priority adjustments that will bring your financial goals and
activities in line with your current life situation.
EXAMPLE: Step 6, Review and Revise the Plan
Over the next 6 to 12 months, Carla Elliot should reassess her financial, personal,
and educational situation. What types of circumstances might occur that could
require that Carla take a different approach to her personal finances?
Example from Your Life
What factors in your life might affect your personal financial situation and decisions
in the future?
Career Choice and Financial Planning
Have you ever wondered why some people find great satisfaction in their work while oth-
ers only put in their time? As with other personal financial decisions, career selection and
professional growth require planning. The lifework you select is a key to your financial
well-being and personal satisfaction.
Like other decisions, career choice and professional development alternatives have risks
and opportunity costs. In recent years, many people have placed family and personal ful-
fillment above monetary reward and professional recognition. Career choices require peri-
odic evaluation of trade-offs related to personal, social, and economic factors.
In addition, changing personal and social factors will require you to continually assess
your work situation. The steps of the financial planning process can guide your career
planning, advancement, and career change. Your career goals will affect how you use this
process. If you desire more responsibility on the job, for example, you may decide to
obtain advanced training or change career fields. Appendix B provides a plan for obtaining
employment and professional advancement.
EXAMPLE: Your Career Planning Decisions
Based on your current or future career situation, describe how you might use the
financial planning process ( Exhibit 1–4 ) to plan and implement an employment
decision.
PRACTICE QUIZ 1–4 PRACTICE QUIZ 1–4
1. What actions might a person take to identify alternatives when making a financial decision?
2. Why are career planning activities considered to be personal financial decisions?
Sheet 4 Planning Your Career
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YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Have you started your emergency fund? Do you make progress each month? As with driving, a
personal finance dashboard allows you to keep track of your progress to a destination.
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) to determine actions you might take
to improve your personal financial activities.
Obtain information from various sources to reduce
spending and increase savings.
Have a specific, written financial goal to create
and build your emergency fund. Use the “Personal
Finance in Practice: Developing Financial Goals” box.
Use time value of money computations to help grow
your emergency fund. Calculators are available
at www.dinkytown.net, www.moneychimp.com/
calculator , and www.rbcroyalbank.com/tools.html .
A dashboard is a tool used by organizations to monitor
key performance indicators, such as delivery time, prod-
uct defects, or customer complaints. As an individual,
you can use a personal finance dashboard to assess
your financial situation.
An often overlooked financial action is the creation of
an emergency fund. Financial advisors commonly sug-
gest saving three to six months of living expenses for
unexpected situations. More may be needed if you are
self-employed.
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12
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MONTHS
E M E R G E N C Y S A V I N G S F U N D
3. For the following situations, identify the type of risk being described.
_____ Not getting proper rest and exercise.
_____ Not being able to obtain cash from a certificate of deposit before the maturity date.
_____ Taking out a variable rate loan when rates are expected to rise.
_____ Training for a career field with low potential demand in the future.
4. For the following main sources of personal finance information, list a specific website, organization, or person whom
you might contact in the future.
Type of information Specific source Contact information
Website
Financial institution
Media source
Financial specialist
Apply Yourself! Apply Yourself!
Talk to friends, relatives, and others about their personal financial activities. Ask about potential risks involved with mak-
ing financial decisions. What actions might be taken to investigate and reduce these risks?
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LO1.1 Financial decisions are affected
by a person’s life situation (income, age,
household size, health), personal values,
and economic factors (prices, interest rates,
and employment opportunities). The major
elements of fi nancial planning are obtain-
ing, planning, saving, borrowing, spending,
managing risk, investing, and retirement and
estate planning.
LO1.2 Financial goals should take a
S-M-A-R-T approach with goals that are:
Specific, Measurable, Action-oriented, Real-
istic, and Time-based.
LO1.3 Every decision involves a trade-off
with things given up. Personal opportunity
costs include time, effort, and health. Finan-
cial opportunity costs are based on the time
value of money. Future value and present
value calculations enable you to measure
the increased value (or lost interest) that
results from a saving, investing, borrowing,
or purchasing decision.
LO1.4 Personal financial planning involves
the following process: (1) determine your
current financial situation; (2) develop finan-
cial goals; (3) identify alternative courses of
action; (4) evaluate alternatives; (5) create
and implement a financial action plan; and
(6) review and revise the financial plan.
Chapter
Summary
adult life cycle 4
bankruptcy 7
economics 4
financial plan 3
present value 14
time value of money 11
values 4
future value 13
inflation 5
opportunity cost 11
personal financial
planning 3
Key Terms
1. In your opinion, what is the main benefit of wise financial planning? (LO1.1)
2. What factors in an economy might affect the level of interest rates? (LO1.1)
3. Talk with several people about their financial goals. How have their employment situa-
tions affected their financial decisions? (LO1.2)
4. What are possible drawbacks associated with not considering opportunity costs and
time value of money when making financial decisions? (LO1.3)
5. Describe risks that you might encounter when making financial decisions over the next
few years. (LO1.4)
Discussion
Questions
1. The Rule of 72 provides a guideline for determining how long it takes your money to
double. This rule can also be used to determine your earning rate. If your money is
expected to double in 12 years, what is your rate of return?
2. If you desire to have $10,000 in savings eight years from now, what amount would you
need to deposit in an account that earns 5 percent?
Self-Test Solutions
1. Using the Rule of 72, if your money is expected to double in 12 years, you are earning
approximately 6 percent (72 4 12 years 5 6 percent).
2. To calculate the present value of $10,000 for eight years at 5 percent, use Exhibit 1–3C
(or Exhibit 1–C in the appendix to Chapter 1): $10,000 3 0.677 5 $6,770
Self-Test
Problems
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(Note: Some of these problems require the use of the time value of money tables in the
appendix directly following this chapter, a financial calculator, or spreadsheet software.)
1. Using the Rule of 72, approximate the following amounts: (LO1.1)
a. If the value of land in an area is increasing 6 percent a year, how long will it take
for property values to double?
b. If you earn 10 percent on your investments, how long will it take for your money
to double?
c. At an annual interest rate of 5 percent, how long will it take for your savings to double?
2. In 2011, selected automobiles had an average cost of $16,000. The average cost of
those same automobiles is now $20,000. What was the rate of increase for these auto-
mobiles between the two time periods? (LO1.1)
3. A family spends $46,000 a year for living expenses. If prices increase 3 percent
a year for the next three years, what amount will the family need for their living
expenses after three years? (LO1.1)
4. Ben Collins plans to buy a house for $220,000. If the real estate in his area is
expected to increase in value 2 percent each year, what will its approximate value be
seven years from now? (LO1.2)
5. What would be the yearly earnings for a person with $6,000 in savings at an annual
interest rate of 2.5 percent? (LO1.3)
6. Using time value of money tables ( Exhibit 1–3 or chapter appendix tables), calculate
the following: (LO1.3)
a. The future value of $550 six years from now at 7 percent.
b. The future value of $700 saved each year for 10 years at 8 percent.
c. The amount a person would have to deposit today (present value) at a 5 percent
interest rate to have $1,000 five years from now.
d. The amount a person would have to deposit today to be able to take out $500 a
year for 10 years from an account earning 8 percent.
7. If you desire to have $10,000 for a down payment for a house in five years, what amount
would you need to deposit today? Assume that your money will earn 4 percent. (LO1.3)
8. Pete Morton is planning to go to graduate school in a program of study that will
take three years. Pete wants to have $8,000 available each year for various school
and living expenses. If he earns 4 percent on his money, how much must he
deposit at the start of his studies to be able to withdraw $8,000 a year for three
years? (LO1.3)
9. Carla Lopez deposits $3,000 a year into her retirement account. If these funds have
average earnings of 8 percent over the 40 years until her retirement, what will be the
value of her retirement account? (LO1.3)
10. If a person spends $10 a week on coffee (assume $500 a year), what would be the
future value of that amount over 10 years if the funds were deposited in an account
earning 3 percent? (LO1.3)
11. A financial company that advertises on television will pay you $60,000 now for
annual payments of $10,000 that you are expected to receive for a legal settlement
over the next 10 years. If you estimate the time value of money at 10 percent, would
you accept this offer? (LO1.3)
12. Tran Lee plans to set aside $2,200 a year for the next seven years, earning 3 percent.
What would be the future value of this savings amount? (LO1.3)
13. If you borrow $8,000 with a 5 percent interest rate to be repaid in five equal pay-
ments at the end of the next five years, what would be the amount of each payment?
( Note: Use the present value of an annuity table in the chapter appendix.) (LO1.3)
Problems
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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YOU BE THE FINANCIAL PLANNER
While at some point in your life you may
use the services of a financial planner, your
personal knowledge should be the founda-
tion for most financial decisions. For each
of these situations, determine actions you
might recommend.
Situation 1: Fran and Ed Blake, ages 43 and
47, have a daughter who is completing her
freshman year of college and a son three
years younger. Currently they have $34,000
in various savings and investment funds set
aside for their children’s education. With the
increasing cost of education, they are con-
cerned about whether this amount is adequate.
In recent months, Fran’s mother has required
extensive medical attention and personal care
assistance. Unable to live alone, she is now
a resident of a long-term care facility. The
cost of this service is $4,600 a month, with
annual increases of about 5 percent. While a
major portion of the cost is covered by her
Social Security and pension, Fran’s mother is
unable to cover the entire cost. In addition,
the Blakes are concerned about saving for
their own retirement. While they have consis-
tently made annual deposits to a retirement
fund, current financial demands may force
them to access some of that money.
Situation 2: “While I knew it might hap-
pen someday, I didn’t expect it right now.”
This was the reaction of Patrick Hamilton
when his company merged with another
business and moved its offices to another
state, resulting in his losing his job. Patrick
does have some flexibility in his short-term
finances since he has three months of living
expenses in a savings account. However,
“three months can go by very quickly,” as
Patrick noted.
Situation 3: Nina Resendiz, age 23, recently
received a $12,000 gift from her aunt. She
is considering various uses for these unex-
pected funds including paying off credit
card bills from her last vacation, or set-
ting aside money for a down payment on
a house. Or she might invest the money in
a tax-deferred retirement account. Another
possibility is using the money for technol-
ogy certification courses to enhance her
earning power. Nina also wants to contrib-
ute some of the funds to a homeless shelter
and a world hunger relief organization. She
is overwhelmed by the choices, and com-
ments to herself, “I want to avoid the temp-
tation of wasting the money on impulse
items. I want to make sure I use the money
on things with lasting value.”
Questions
1. In each situation, what are the main
financial planning issues that need to be
addressed?
2. What additional information would
you like to have before recommending
actions in each situation?
3. Based on the information provided,
along with Exhibit 1–1 and the financial
planning process, what actions would
you recommend in each situation?
Case in
Point
SETTING FINANCIAL GOALS
Continuing
Cas e
Jamie Lee Jackson, age 24, has recently decided to switch from attending college part-time
to full-time in order to pursue her business degree, and aims to graduate within the next
three years. She has 55 credit hours remaining in order to earn her bachelor’s degree, and
knows that it will be a challenge to complete her course of study while still working part-
time in the bakery department of a local grocery store, where she earns $390 a week. Jamie
Lee wants to keep her part-time job at the grocery store as she loves baking and creates
very decorative cakes. She dreams of opening her own cupcake café within the next five
years.
Jamie Lee currently shares a small apartment with a friend, and they split all of the associ-
ated living expenses, such as rent and utilities, although she would really like to eventually
have a place of her own. Her car is still going strong, even though it is seven years old, and
she has no plans to buy a new one any time soon. She is carrying a balance on her credit
card and is making regular monthly payments of $50 with hopes of paying it off within a
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year. Jamie has also recently taken out a student loan to cover her educational costs and
expenses. Jamie Lee just started depositing $1,800 a year in a savings account that earns
2 percent interest, in hopes of having the $9,000 down payment needed to start the cupcake
café two years after graduation.
Current Financial Situation
Checking account: $1,250
Emergency fund savings account: $3,100
Car: $4,000
Student loan: $5,400
Credit card balance: $400
Gross annual salary: $2,125
Net monthly salary: $1,560
Questions
1. Using “Your Personal Financial Plan” sheet 2, what are Jamie Lee’s short-term finan-
cial goals? How do they compare to her intermediate financial goals?
2. Browse Jamie Lee’s current financial situation. Using the SMART approach, what rec-
ommendations would you make for her to achieve her long-term goals?
3. Name two opportunity costs that would be considered in Jamie Lee’s situation?
4. Jamie Lee needs to save a total of $9,000 in order to get started in her cupcake café
venture. She is presently depositing $1,800 a year in a regular savings account earning
2 percent interest. How much will she have accumulated five years from now in this
regular savings account, assuming she will be leaving her emergency fund savings
account balance untouched and for a rainy day?
Nearly everyone who has made the effort to keep a daily spending diary has found it bene-
ficial. While at first the process may seem tedious, after a while recording this information
becomes easier and faster.
Directions Using the Daily Spending Diary sheets provided at the end of the book,
record every cent of your spending each day in the categories provided. Or you may create
your own format to monitor your spending. You can indicate the use of a credit card with
(CR). This experience will help you better understand your spending patterns and identify
desired changes you might want to make in your spending habits. The Daily Spending
Diary sheets are located in Appendix D at the end of the book and in Connect Finance.
Questions
1. What did your daily spending diary reveal about your spending habits? What areas of
spending might you consider changing?
2. How might your daily spending diary assist you when identifying and achieving finan-
cial goals?
“I FIRST THOUGHT THIS PROCESS WOULD BE A WASTE OF
TIME, BUT THE INFORMATION HAS HELPED ME BECOME MUCH
MORE CAREFUL OF HOW I SPEND MY MONEY.”
Spending
Diary
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N Personal Financial Data
Purpose: To create a directory of personal financial information.
Financial Planning Activities: Complete the information request to provide a quick
reference for vital household data. This sheet is also available in an Excel spreadsheet
format in Connect Finance.
Suggested Websites: www.money.cnn.com www.kiplinger.com www.20somethingfinance.com
Dependent Data
Name
Birth Date
Marital Status
Address
Phone
E-mail
Social Security No.
Driver’s License No.
Place of Employment
Address
Phone
Position
Length of Service
Checking Acct. No.
Financial Inst.
Address
Phone
Name Birthdate Relationship Social Security No.
What’s Next for Your Personal Financial Plan?
• Identify financial planning experts (insurance agent, banker, investment advisor, tax preparer, others) you
might contact for financial planning information or assistance.
• Discuss with other household members various financial planning priorities.
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Purpose: To identify personal financial goals and create an action plan.
Financial Planning Activities: Based on personal and household needs and values, identify
specific goals that require action. This sheet is also available in an Excel spreadsheet format
in Connect Finance.
Suggested Websites: financialplan.about.com www.planwise.com www.360financialliteracy.org
Short-Term Monetary Goals (less than two years)
Description
Amount
needed
Months
to achieve
Action
to be taken Priority
Description
Amount
needed
Months
to achieve
Action
to be taken Priority
Example: pay off
credit card debt $850 12 Use money from pay raise High
Description
Amount
needed
Months
to achieve
Action
to be taken Priority
Description Time frame Actions to be taken
Example: set up file for personal
financial records and documents Next 2–3 months
Locate all personal and financial records and
documents; set up files for various spending,
saving, borrowing categories
Intermediate Monetary Goals (two to five years)
Long-Term Monetary Goals (beyond five years)
Nonmonetary Goals
What’s Next for Your Personal Financial Plan?
• Based on various financial goals, calculate the savings deposits necessary to achieve those goals.
• Identify current economic trends that might influence various saving, spending, investing, and bor-
rowing decisions.
Suggested
App:
• Urge
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Achieving Financial Goals Using Time
Value of Money
Purpose: To calculate future and present value amounts related to financial planning
decisions.
Financial Planning Activities: Calculate future and present value amounts related to
specific financial goals using time value of money tables, a financial calculator, spreadsheet
software, or an online calculator. This sheet is also available in an Excel spreadsheet format
in Connect Finance.
Suggested Websites: www.moneychimp.com/calculator www.grunderware.com www.investopedia.com/calculator
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Future Value of a Single Amount
1. To determine future value of
a single amount
2. To determine interest lost
when cash purchases are made
times equals
(Use Exhibit 1–A in Chapter 1
appendix.)
$ ______ 3 $ ______ 5 $ ______
current
amount
future
value
amount
future
value
factor
1. To determine future values of
regular savings deposits
2. To determine future value
of regular retirement deposits
times equals
(Use Exhibit 1–B in Chapter 1
appendix.)
$ ______ 3 $ ______ 5 $ ______
regular
deposit
amount
future
value
amount
future
value of
annuity
factor
Future Value of a Series of Deposits
1. To determine an amount to be
deposited now that will grow to
desired amount
times equals
(Use Exhibit 1–C in Chapter 1
appendix.)
$ ______ 3 $ ______ 5 $ ______
present
value
amount
present
value
factor
future
amount
desired
Present Value of a Single Amount
1. To determine an amount
that can be withdrawn on
a regular basis
times equals
(Use Exhibit 1–D in Chapter 1
appendix.)
$ ______ 3 $ ______ 5 $ ______
regular
amount
to be
withdrawn
present
value of
annuity
factor
present
value
amount
Present Value of a Series of Deposits
What’s Next for Your Personal Financial Plan?
• Describe some situations in which you could use time value of money calculations for achieving various per-
sonal financial goals.
• What specific actions are you taking to achieve various financial goals?
Suggested
App:
• CF Financial
Calculator
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Planning Your Career
Purpose: To become familiar with work activities and career requirements for a field of
employment.
Financial Planning Activities: Use the Career Occupational Outlook Handbook and other
information sources (library materials, interviews, websites) to obtain information related to
one or more career areas of interest to you. This sheet is also available in an Excel spread-
sheet format in Connect Finance.
Suggested Websites: www.monster.com www.rileyguide.com careerplanning.about.com
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Career area, job titles
Nature of the work
General activities and duties
Working conditions
Physical surroundings, hours, mental
and physical demands
Training and other qualifications
Earnings
Starting and advanced
Additional information
Other questions that require
further research
Sources of additional information
Publications, trade associations,
professional organizations,
government agencies
What’s Next for Your Personal Financial Plan?
• Talk with various people who have worked in the career fields of interest to you.
• Outline a plan for long-term professional development and career advancement.
Suggested
App:
• Job Search
Organizer
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32
Chapter 1 Appendix:
Time Value of Money
• “If I deposit $10,000 today, how much will I have for a down payment on a house in
five years?”
• “Will $2,000 saved each year give me enough money when I retire?”
• “How much must I save today to have enough for my children’s college education?”
The time value of money, more commonly referred to as interest, is the cost of money
that is borrowed or lent. Interest can be compared to rent, the cost of using an apartment
or other item. The time value of money is based on the fact that a dollar received today
is worth more than a dollar that will be received one year from today, because the dollar
received today can be saved or invested and will be worth more than a dollar a year from
today. Similarly, a dollar that will be received one year from today is currently worth less
than a dollar today.
The time value of money has two major components: future value and present value.
Future value computations, which are also referred to as compounding, yield the amount to
which a current sum will increase based on a certain interest rate and period of time. Pres-
ent value, which is calculated through a process called discounting, is the current value of
a future sum based on a certain interest rate and period of time.
In future value problems, you are given an amount to save or invest and you calculate
the amount that will be available at some future date. With present value problems, you are
given the amount that will be available at some future date and you calculate the current
value of that amount. Both future value and present value computations are based on basic
interest rate calculations.
Interest Rate Basics
Simple interest is the dollar cost of borrowing or earnings from lending money. The inter-
est is based on three elements:
• The dollar amount, called the principal.
• The rate of interest.
• The amount of time.
The formula and financial calculator computations are as follows:
INTEREST RATE BASICS
Formula Financial Calculator *
Interest 5 Principal 3 Rate of interest (annual) 3 Time (years) Interest 5 Amount 3 Rate 3 Number of (or portion of)
years
The interest rate is stated as a percentage for a year. For example, you must convert 12 percent to either 0.12 or 12/100 before
doing your calculations. The time element must also be converted to a decimal or fraction. For example, three months would be
shown as 0.25, or 1/4 of a year. Interest for 2½ years would involve a time period of 2.5.
Example A: Suppose you borrow $1,000 at 5 percent and will repay it in one payment at the end of one year. Using the simple
interest calculation, the interest is $50, computed as follows:
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Chapter 1 Appendix Time Value of Money 33
Sample Problem 1
How much interest would you earn if you deposited $300 at 6 percent for 27 months?
(Answers to sample problems are later in this appendix.)
Sample Problem 2
How much interest would you pay to borrow $670 for eight months at 12 percent?
Future Value of a Single Amount
The future value of an amount consists of the original amount plus compound interest.
This calculation involves the following elements:
FV 5 Future value
PV 5 Present value
i 5 Interest rate
n 5 Number of time periods
The formula and financial calculator computations are as follows:
INTEREST RATE BASICS
Formula Financial Calculator *
$50 5 $1,000 3 0.05 3 1 (year) $50 5 1000 3 .05 3 1
Example B: If you deposited $750 in a savings account paying 8 percent, how much interest would you earn in nine months? You
would compute this amount as follows:
Interest 5 $750 3 0.08 3 3/4 (or 0.75 of a year) 5 $45 2 750 PV , 8 I/Y , 9/12 5 .75 N , 0 PMT , CPT
FV 795. 795 2 750 5 45
* NOTE: These financial calculator notations may require slightly different keystrokes when using various brands and models.
FUTURE VALUE OF A SINGLE AMOUNT
Formula Table Financial Calculator
FV 5 PV(1 1 i ) n FV 5 PV (Table factor ) PV , I/Y , N , PMT , CPT FV
Example C: The future value of $1 at 10 percent after three years is $1.33. This amount is calculated as follows:
$1.33 5 $(1.00 1 0.10) 3 Using Exhibit 1–A:
$1.33 5 $1.00 (1.33)
1 PV , 10 I/Y , 3 N , 0 PMT , CPT FV 1.33
Future value tables are available to help you determine compounded interest amounts (see Exhibit 1–A). Looking at Exhibit 1–A for
10 percent and three years, you can see that $1 would be worth $1.33 at that time. For other amounts, multiply the table factor by
the original amount. This process may be viewed as follows:
Future value $1 $1.10 $1.21 FV 5 $1.33
(rounded) Interest $0.10 Interest $0.11 Interest $0.12
After year 0 1 2 3
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34 Chapter 1 Appendix Time Value of Money
FUTURE VALUE OF A SINGLE AMOUNT
Formula Table Financial Calculator
Example D: If your savings of $400 earns 12 percent, compounded monthly, over a year and a half, use the table factor for
1 percent (the monthly rate) for 18 time periods; the future value would be:
$478.46 5 $400 (1 1 0.01) 18 $478.40 5 $400 (1.196) 2 400 PV , 12/12 5 1 I/Y , 1.5 3 12 5 18 N , 0
PMT , CPT FV 478.46
Excel formula notation for future value
of a single amount
5 FV(rate, nper, pmt, pv, type)
Example D solution 5 FV(0.01,18, 0, 2 400) 5 478.46
Sample Problem 3
What is the future value of $800 at 8 percent after six years?
Sample Problem 4
How much would you have in savings if you kept $200 on deposit for eight years at 8 percent,
compounded semiannually?
Future Value of a Series
of Equal Amounts (an Annuity)
Future value may also be calculated for a situation in which regular additions are made to
savings. The formula and financial calculator computations are as follows:
FUTURE VALUE OF A SERIES OF PAYMENTS
Formula Table Financial Calculator
FV 5 Annuity
(1 1 i )n 2 1
___________
i
Using Exhibit 1–B:
Annuity 3 Table factor
PMT , N , I/Y , PV , CPT FV
This calculation assumes that (1) each deposit is for the same amount, (2) the interest rate is the same for each time period, and
(3) the deposits are made at the end of each time period.
Example E: The future value of three $1 deposits made at the end of the next three years, earning
10 percent interest, is $3.31. This is calculated as follows:
$3.31 5 $1
(1 1 0.10)3 2 1
______________
0.10
Using Exhibit 1–B:
$3.31 5 $1 3 3.31
2 1 PMT , 3 N , 10 I/Y , 0 PV , CPT FV 3.31
This may be viewed as follows:
Future value $1 $2.10 FV 5 $3.31
(rounded) Deposit $1 Deposit $1 Deposit $1
Interest 0 Interest $0.10 Interest $0.21
After year 0 1 2 3
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Chapter 1 Appendix Time Value of Money 35
FUTURE VALUE OF A SERIES OF PAYMENTS
Formula Table Financial Calculator
Example F: If you plan to deposit $40 a year for 10 years, earning 8 percent compounded annually, the future value of this
amount is:
$579.46 5
$40(1 1 0.08)10 2 1
__________________
0.08
Using Exhibit 1–B
$579.48 5 $40(14.487)
2 40 PMT , 10 N , 10 I/Y , 0 PV , CPT FV
579.46
Excel formula notation for future value
of a series
5 FV(rate, nper, pmt)
Example F solution 5 FV(0.08,10, 2 40) 5 579.46
Sample Problem 5
What is the future value of an annual deposit of $230 earning 6 percent for 15 years?
Sample Problem 6
What amount would you have in a retirement account if you made annual deposits of $375
for 25 years earning 12 percent, compounded annually?
Present Value of a Single Amount
If you want to know how much you need to deposit now to receive a certain amount in the
future, the formula and financial calculator computations are as follows:
PRESENT VALUE OF A SINGLE AMOUNT
Formula Table Financial Calculator
PV 5
FV
_______
(1 1 i )n
Using Exhibit 1–C:
PV 5 FV(Table factor)
FV , N , I/Y , PMT , CPT PV
Example G: The present value of $1 to be received three years from now based on a 10 percent interest rate is calculated as
follows:
$0.75 5
$1
__________
(1 1 0.10)3
Using Exhibit 1–C:
$0.75 5 $1(0.751)
1 FV , 3 N , 10 I/Y , 0 PMT , CPT PV 2
.75131
This may be viewed as follows:
Present value $0.75 $0.83 $0.91 $1
(rounded) Discount (interest) Discount (interest) Discount (interest)
$0.075 $0.0825 $0.0905
After year 0 1 2 3
Present value tables are available to assist you in this process (see Exhibit 1–C). Notice that $1 at 10 percent for three years has a
present value of $0.75. For amounts other than $1, multiply the table factor by the amount involved.
Example H: If you want to have $300 seven years from now and your savings earn 10 percent, compounded semiannually
(which would be 5 percent for 14 time periods), finding how much you would have to deposit today is calculated as follows:
$151.52 5
$300
___________
(1 1 0.05)14
Using Exhibit 1–C:
$151.50 5 $300(0.505)
300 FV , 7 3 2 5 14 N , 10/2 5 5 I/Y , 0
PMT , CPT PV 2 151.52
Excel formula notation for present value
of a single amount
5 PV(rate, nper, pmt, fv, type)
Example H solution: 5 PV(0.05,14, 0, 2 300) 5 151.52
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36 Chapter 1 Appendix Time Value of Money
Sample Problem 7
What is the present value of $2,200 earning 15 percent for eight years?
Sample Problem 8
To have $6,000 for a child’s education in 10 years, what amount should a parent deposit in
a savings account that earns 12 percent, compounded quarterly?
Present Value of a Series of Equal
Amounts (an Annuity)
The final time value of money situation allows you to receive an amount at the end of each
time period for a certain number of periods. The formula and financial calculator compu-
tations are as follows:
PRESENT VALUE OF A SERIES OF PAYMENTS
Formula Table Financial Calculator
PV 5 Annuity 3
1 2
1
_______
(1 1 i )n
___________
i
Using Exhibit 1–D :
PV 5 Annuity (Table factor)
PMT , N , I/Y , FV , CPT PV
Example I: The present value of a $1 withdrawal at the end of the next three years would be $2.49, for money earning
10 percent. This would be calculated as follows:
$2.49 5 $1 [ 1 2
1
__________
(1 1 0.10)3
______________
0.10
] Using Exhibit 1–D: $2.49 5 $1(2.487) 1 PMT , 3 N , 10 I/Y , 0 FV , CPT PV 2 2.48685
This may be viewed as follows:
Present value $2.49 $1.74 $0.91 $0
(fund balance) Withdrawal 2 $1 Withdrawal 2 $1 Withdrawal 2 $1
Interest 1 $0.25 Interest 1 $0.17 Interest 1 $0.09
After year 0 1 2 3
This same amount appears in Exhibit 1–D for 10 percent and three time periods. To use the table for other situations, multiply the
table factor by the amount to be withdrawn each year.
Example J: If you wish to withdraw $100 at the end of each year for 10 years from an account that earns 14 percent, compounded
annually, what amount must you deposit now?
$521.61 5 $100 ( 1 2
1
___________
(1 1 0.14)10
_______________
0.14
) Using Exhibit 1–D: $521.60 5 $100(5.216) 100 PMT , 10 N , 14 I/Y , 0 FV , CPT PV 2 521.61
Excel formula notation for present
value of a series
5 PV(rate, nper, pmt)
Example J solution 5 PV(0.14,10, 2 100) 5 521.61
Sample Problem 9
What is the present value of a withdrawal of $200 at the end of each year for 14 years with
an interest rate of 7 percent?
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Chapter 1 Appendix Time Value of Money 37
Sample Problem 10
How much would you have to deposit now to be able to withdraw $650 at the end of each
year for 20 years from an account that earns 11 percent?
Using Present Value to Determine
Loan Payments
Present value tables (Exhibit 1–D) can also be used to determine installment payments for
a loan as follows:
PRESENT VALUE TO DETERMINE LOAN PAYMENTS
Table Financial Calculator
Amount borrowed
_____________________________________________
Present value of a series table factor (Exhibit 1–D)
5 Loan payment PV , I/Y , N , FV , CPT PMT
Example K: If you borrow $1,000 with a 6 percent interest rate to be repaid in three equal payments at the end of the next three
years, the payments will be $374.11. This is calculated as follows:
$1,000
_______
2.673
5 $374.11 1000 PV , 6 I/Y , 3 N , 0 FV , CPT PMT 2
374.10981
Excel formula notation for determining loan payment amount 5 PMT(rate, nper, pv)
Example K solution 5 PMT(.06, 3,1000) 5 $374.11
Sample Problem 11
What would be the annual payment amount for a $20,000, 10-year loan at 7 percent?
Answers to Sample Problems
(based on TVM tables)
1. $300 3 0.06 3 2.25 years (27 months) 5 $40.50.
2. $670 3 0.12 3 2/3 (of a year) 5 $53.60.
3. $800(1.587) 5 $1,269.60. (Use Exhibit 1–A, 8%, 6 periods.)
4. $200(1.873) 5 $374.60. (Use Exhibit 1–A, 4%, 16 periods.)
5. $230(23.276) 5 $5,353.48. (Use Exhibit 1–B, 6%, 15 periods.)
6. $375(133.33) 5 $49,998.75. (Use Exhibit 1–B, 12%, 25 periods.)
7. $2,200(0.327) 5 $719.40. (Use Exhibit 1–C, 15%, 8 periods.)
8. $6,000(0.307) 5 $1,842. (Use Exhibit 1–C, 3%, 40 periods.)
9. $200(8.745) 5 $1,749. (Use Exhibit 1–D, 7%, 14 periods.)
10. $650(7.963) 5 $5,175.95. (Use Exhibit 1–D, 11%, 20 periods.)
11. $20,000/7.024 5 $2,847.38. (Use Exhibit 1–D, 7%, 10 periods.)
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38 Chapter 1 Appendix Time Value of Money
Time Value of Money Application
Exercises
1. (Present value of an annuity) You wish to borrow $18,000 to buy a new
automobile. The rate is 8.6% over four years with monthly payments. Find the
monthly payment. (Answer: $444.52)
2. (Present value of an annuity) How much money must your rich uncle give
you now to finance four years of college, assuming an annual cost of $48,000
and an interest rate of 6% (applied to the principal until disbursed)? (Answer:
$166,325.07)
3. (Present value of a single amount) How much money must you set aside at age 20
to accumulate retirement funds of $100,000 at age 65, assuming a rate of interest
of 7%? (Answer: $4,761.35)
4. (Future value of a single amount) If you deposit $2,000 in a 5-year certificate of
deposit at 5.2%, how much will it be worth in five years? (Answer: $2,576.97)
5. (Future value of a single amount) If you deposit $2,000 in a 5-year certificate
of deposit at 5.2% with quarterly compounding, how much will it be worth in five
years? (Answer: $2,589.52)
6. (Future value of an annuity) You choose to invest $50/month in a 401(k) that
invests in an international stock mutual fund. Assuming an annual rate of return
of 9%, how much will this fund be worth if you are retiring in 40 years?
(Answer: $234,066.01)
7. (Future value of an annuity) Instead, you invest $600/year in a 401(k) that invests
in an international stock mutual fund. Assuming an annual rate of return of 9%,
how much will this fund be worth if you are retiring in 40 years?
(Answer: $202,729.47)
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Chapter 1 Appendix Time Value of Money 39
Time Value of Money Calculation
Methods: A Summary
The time value of money may be calculated using a variety of techniques. When achiev-
ing specific financial goals requires regular deposits to a savings or investment account,
the computation may occur in one of several ways. For example, Jonie Emerson plans to
deposit $10,000 in an account for the next 10 years. She estimates these funds will earn an
annual rate of 5 percent. What amount can Jonie expect to have available after 10 years?
Method Process, Results
Formula Calculation The most basic method
of calculating the time value of money involves
using a formula.
For this situation, the formula would be:
PV (1 1 i ) n 5 FV
The result should be
$10,000 (1 1 0.05) 10 5 $16,288.95
Time Value of Money Tables Instead of
calculating with a formula, time value of money
tables are available. The numeric factors pre-
sented ease the computational process.
Using the table in Exhibit 1–A:
$10,000 Future value of $1, 5%, 10 years
$10,000 1.629 2 $16,290
Financial Calculator A variety of financial
calculators are programmed with various finan-
cial functions. Both future value and present
value calculations may be performed using the
appropriate keystrokes.
Using a financial calculator, the keystrokes
would be:
Amount 2 10,000 PV
Time periods 10 N
Interest rate 5 I
Result FV $16,288.94
Spreadsheet Software Excel and other
software programs have built-in formulas for
various financial computations, including time
value of money.
When using a spreadsheet program, this type
of calculation would require this format:
5 FV (rate, periods, amount per period, single
amount)
The results of this example would be:
5 FV (0.05, 10, 0, 2 10,000) 5 $16,288.95
Time Value of Money Websites Many time
value of money calculators are available online.
These web-based programs perform calcula-
tions for the future value of savings as well as
determining amounts for loan payments.
Some easy-to-use calculators for computing
the time value of money and other financial
computations are located at
• www.investopedia.com/calculator/
• www.dinkytown.net
• www.moneychimp.com/calculator
• money.cnn.com/tools
Mobile Apps Financial tools on a smartphone
or other mobile device are available for time
value of money calculations.
• TVM
• Time Value of Money Calculator
• Time Value of Money Professional
NOTE: The slight differences in answers are the result of rounding.
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40 Chapter 1 Appendix Time Value of Money
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100 1.110
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210 1.232
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331 1.368
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 1.518
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611 1.685
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772 1.870
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 2.076
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 2.305
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 2.558
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594 2.839
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853 3.152
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138 3.498
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452 3.883
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797 4.310
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 4.785
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595 5.311
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054 5.895
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560 6.544
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116 7.263
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727 8.062
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835 13.585
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449 22.892
40 1.489 2.208 3.262 4.801 7.040 10.286 14.974 21.725 31.409 45.259 65.001
50 1.645 2.692 4.384 7.107 11.467 18.420 29.457 46.902 74.358 117.390 184.570
Period 12% 13% 14% 15% 16% 17% 18% 19% 20% 25% 30%
1 1.120 1.130 1.140 1.150 1.160 1.170 1.180 1.190 1.200 1.250 1.300
2 1.254 1.277 1.300 1.323 1.346 1.369 1.392 1.416 1.440 1.563 1.690
3 1.405 1.443 1.482 1.521 1.561 1.602 1.643 1.685 1.728 1.953 2.197
4 1.574 1.630 1.689 1.749 1.811 1.874 1.939 2.005 2.074 2.441 2.856
5 1.762 1.842 1.925 2.011 2.100 2.192 2.288 2.386 2.488 3.052 3.713
6 1.974 2.082 2.195 2.313 2.436 2.565 2.700 2.840 2.986 3.815 4.827
7 2.211 2.353 2.502 2.660 2.826 3.001 3.185 3.379 3.583 4.768 6.276
8 2.476 2.658 2.853 3.059 3.278 3.511 3.759 4.021 4.300 5.960 8.157
9 2.773 3.004 3.252 3.518 3.803 4.108 4.435 4.785 5.160 7.451 10.604
10 3.106 3.395 3.707 4.046 4.411 4.807 5.234 5.696 6.192 9.313 13.786
11 3.479 3.836 4.226 4.652 5.117 5.624 6.176 6.777 7.430 11.642 17.922
12 3.896 4.335 4.818 5.350 5.936 6.580 7.288 8.064 8.916 14.552 23.298
13 4.363 4.898 5.492 6.153 6.886 7.699 8.599 9.596 10.699 18.190 30.288
14 4.887 5.535 6.261 7.076 7.988 9.007 10.147 11.420 12.839 22.737 39.374
15 5.474 6.254 7.138 8.137 9.266 10.539 11.974 13.590 15.407 28.422 51.186
16 6.130 7.067 8.137 9.358 10.748 12.330 14.129 16.172 18.488 35.527 66.542
17 6.866 7.986 9.276 10.761 12.468 14.426 16.672 19.244 22.186 44.409 86.504
18 7.690 9.024 10.575 12.375 14.463 16.879 19.673 22.091 26.623 55.511 112.460
19 8.613 10.197 12.056 14.232 16.777 19.748 23.214 27.252 31.948 69.389 146.190
20 9.646 11.523 13.743 16.367 19.461 23.106 27.393 32.429 38.338 86.736 190.050
25 17.000 21.231 26.462 32.919 40.874 50.658 62.669 77.388 95.396 264.700 705.640
30 29.960 39.116 50.950 66.212 85.850 111.070 143.370 184.680 237.380 807.790 2,620.000
40 93.051 132.780 188.880 267.860 378.720 533.870 750.380 1,051.700 1,469.800 7,523.200 36,119.000
50 289.000 450.740 700.230 1,083.700 1,670.700 2,566.200 3,927.400 5,998.900 9,100.400 70,065.000 497,929.000
Exhibit 1–A Future Value (Compounded Sum) of $1 after a Given Number of Time Periods
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Chapter 1 Appendix Time Value of Money 41
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100 2.110
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310 3.342
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641 4.710
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6.228
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716 7.913
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487 9.783
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436 11.859
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579 14.164
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531 19.561
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384 22.713
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 26.212
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975 30.095
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950 39.190
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545 44.501
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599 50.396
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159 56.939
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 64.203
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 114.410
30 34.785 40.588 47.575 56.085 66.439 79.058 94.461 113.280 136.310 164.490 199.020
40 48.886 60.402 75.401 95.026 120.800 154.760 199.640 259.060 337.890 442.590 581.830
50 64.463 84.579 112.800 152.670 209.350 290.340 406.530 573.770 815.080 1,163.900 1,668.800
Period 12% 13% 14% 15% 16% 17% 18% 19% 20% 25% 30%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.120 2.130 2.140 2.150 2.160 2.170 2.180 2.190 2.200 2.250 2.300
3 3.374 3.407 3.440 3.473 3.506 3.539 3.572 3.606 3.640 3.813 3.990
4 4.779 4.850 4.921 4.993 5.066 5.141 5.215 5.291 5.368 5.766 6.187
5 6.353 6.480 6.610 6.742 6.877 7.014 7.154 7.297 7.442 8.207 9.043
6 8.115 8.323 8.536 8.754 8.977 9.207 9.442 9.683 9.930 11.259 12.756
7 10.089 10.405 10.730 11.067 11.414 11.772 12.142 12.523 12.916 15.073 17.583
8 12.300 12.757 13.233 13.727 14.240 14.773 15.327 15.902 16.499 19.842 23.858
9 14.776 15.416 16.085 16.786 17.519 18.285 19.086 19.923 20.799 25.802 32.015
10 17.549 18.420 19.337 20.304 21.321 22.393 23.521 24.701 25.959 33.253 42.619
11 20.655 21.814 23.045 24.349 25.733 27.200 28.755 30.404 32.150 42.566 56.405
12 24.133 25.650 27.271 29.002 30.850 32.824 34.931 37.180 39.581 54.208 74.327
13 28.029 29.985 32.089 34.352 36.786 39.404 42.219 45.244 48.497 68.760 97.625
14 32.393 34.883 37.581 40.505 43.672 47.103 50.818 54.841 59.196 86.949 127.910
15 37.280 40.417 43.842 47.580 51.660 56.110 60.965 66.261 72.035 109.690 167.290
16 42.753 46.672 50.980 55.717 60.925 66.649 72.939 79.850 87.442 138.110 218.470
17 48.884 53.739 59.118 65.075 71.673 78.979 87.068 96.022 105.930 173.640 285.010
18 55.750 61.725 68.394 75.836 84.141 93.406 103.740 115.270 128.120 218.050 371.520
19 63.440 70.749 78.969 88.212 98.603 110.290 123.410 138.170 154.740 273.560 483.970
20 72.052 80.947 91.025 102.440 115.380 130.030 146.630 165.420 186.690 342.950 630.170
25 133.330 155.620 181.870 212.790 249.210 292.110 342.600 402.040 471.980 1,054.800 2,348.800
30 241.330 293.200 356.790 434.750 530.310 647.440 790.950 966.700 1,181.900 3,227.200 8,730.000
40 767.090 1,013.700 1,342.000 1,779.100 2,360.800 3,134.500 4,163.210 5,529.800 7,343.900 30,089.000 120,393.000
50 2,400.000 3,459.500 4,994.500 7,217.700 10,436.000 15,090.000 21,813.000 31,515.000 45,497.000 80,256.000 165,976.000
Exhibit 1–B Future Value (Compounded Sum) of $1 Paid In at the End of Each Period for a Given
Number of Time Periods (an Annuity)
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42 Chapter 1 Appendix Time Value of Money
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712
4 0.961 0.924 0.885 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.138 0.116
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022 0.015 0.011
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009 0.005 0.003
Period 13% 14% 15% 16% 17% 18% 19% 20% 25% 30% 35% 40% 50%
1 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 0.800 0.769 0.741 0.714 0.667
2 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 0.640 0.592 0.549 0.510 0.444
3 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 0.512 0.455 0.406 0.364 0.296
4 0.613 0.592 0.572 0.552 0.534 0.515 0.499 0.482 0.410 0.350 0.301 0.260 0.198
5 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 0.320 0.269 0.223 0.186 0.132
6 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 0.262 0.207 0.165 0.133 0.088
7 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 0.210 0.159 0.122 0.095 0.059
8 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 0.168 0.123 0.091 0.068 0.039
9 0.333 0.300 0.284 0.263 0.243 0.225 0.209 0.194 0.134 0.094 0.067 0.048 0.026
10 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 0.107 0.073 0.050 0.035 0.017
11 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 0.086 0.056 0.037 0.025 0.012
12 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 0.069 0.043 0.027 0.018 0.008
13 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 0.055 0.033 0.020 0.013 0.005
14 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 0.044 0.025 0.015 0.009 0.003
15 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 0.035 0.020 0.011 0.006 0.002
16 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 0.028 0.015 0.008 0.005 0.002
17 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 0.023 0.012 0.006 0.003 0.001
18 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 0.018 0.009 0.005 0.002 0.001
19 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 0.014 0.007 0.003 0.002 0
20 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026 0.012 0.005 0.002 0.001 0
25 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010 0.004 0.001 0.001 0 0
30 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004 0.001 0 0 0 0
40 0.008 0.005 0.004 0.003 0.002 0.001 0.001 0.001 0 0 0 0 0
50 0.002 0.001 0.001 0.001 0 0 0 0 0 0 0 0 0
Exhibit 1–C Present Value of $1 to Be Received at the End of a Given Number of Time Periods
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Chapter 1 Appendix Time Value of Money 43
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.713 1.690
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.444 2.402
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.102 3.037
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.696 3.605
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.231 4.111
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.712 4.564
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 5.146 4.968
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.537 5.328
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.889 5.650
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 6.207 5.938
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.492 6.194
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.750 6.424
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.982 6.628
15 13.865 12.849 11.939 11.118 10.380 9.712 9.108 8.559 8.061 7.606 7.191 6.811
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 7.379 6.974
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 7.549 7.102
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.702 7.250
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 7.839 7.366
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.963 7.469
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077 8.422 7.843
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427 8.694 8.055
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779 8.951 8.244
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.915 9.042 8.304
Period 13% 14% 15% 16% 17% 18% 19% 20% 25% 30% 35% 40% 50%
1 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 0.800 0.769 0.741 0.714 0.667
2 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 1.440 1.361 1.289 1.224 1.111
3 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 1.952 1.816 1.696 1.589 1.407
4 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 2.362 2.166 1.997 1.849 1.605
5 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 2.689 2.436 2.220 2.035 1.737
6 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 2.951 2.643 2.385 2.168 1.824
7 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 3.161 2.802 2.508 2.263 1.883
8 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 3.329 2.925 2.598 2.331 1.922
9 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 3.463 3.019 2.665 2.379 1.948
10 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 3.571 3.092 2.715 2.414 1.965
11 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 3.656 3.147 2.752 2.438 1.977
12 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 3.725 3.190 2.779 2.456 1.985
13 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 3.780 3.223 2.799 2.469 1.990
14 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 3.824 3.249 2.814 2.478 1.993
15 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 3.859 3.268 2.825 2.484 1.995
16 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 3.887 3.283 2.834 2.489 1.997
17 6.729 6.373 6.047 5.749 5.475 5.222 4.988 4.775 3.910 3.295 2.840 2.492 1.998
18 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 3.928 3.304 2.844 2.494 1.999
19 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 3.942 3.311 2.848 2.496 1.999
20 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870 3.954 3.316 2.850 2.497 1.999
25 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948 3.985 3.329 2.856 2.499 2.000
30 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979 3.995 3.332 2.857 2.500 2.000
40 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997 3.999 3.333 2.857 2.500 2.000
50 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999 4.000 3.333 2.857 2.500 2.000
Exhibit 1–D Present Value of $1 Received at the End of Each Period for a Given Number of Time
Periods (an Annuity)
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3 Steps to Financial
Literacy . . .
Improved Cash Flow
2 Money Management Skills
Why is an improved cash flow
important for your financial situation?
A positive monthly cash flow will allow you to
set aside funds for future financial security and
avoid financial difficulties. At the end of the
chapter, “Your Personal Finance Dashboard”
will provide additional information on measur-
ing your cash flow situation.
1
Plan a system to monitor your cash inflows
(income) and outflows (spending).
App: Cashflow
2
Identify your fixed expenses. Seek actions to
take to control and reduce variable expenses.
Website: budgeting.about.com
3
Spend according to your plan to avoid a
negative cash flow and to keep away from
debt problems.
App: Spending Tracker
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A Successful Money Management Plan
“Each month, I have too many days and not enough money. If the month were only 20 days
long, budgeting would be easy.”
Daily spending and saving decisions are at the center of your financial planning activities.
You must coordinate these decisions with your needs, goals, and personal situation. Maintain-
ing financial records and planning your spending are essential skills for successful personal
financial management. The time and effort you devote to these activities will yield many
benefits. Money management refers to the day-to-day financial activities necessary to man-
age current personal economic resources while working toward long-term financial security.
Components of Money Management
As shown here, three major money management activities are interrelated:
LO2.1
Identify the main components
of wise money management.
ACTION ITEM
My money management
strategy involves:
h no spending plan.
h tracking my spending.
h using savings to pay
current bills.
CHAPTER 2 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO2.1 Identify the main components of wise money management.
LO2.2 Create a personal balance sheet and cash flow statement.
LO2.3 Develop and implement a personal budget.
LO2.4 Connect money management activities with saving for personal financial goals.
YOUR PERSONAL FINANCIAL PLAN SHEETS
5. Financial Documents and Records
6. Creating a Personal Balance Sheet
7. Creating a Personal Cash Flow Statement
8. Developing a Personal Budget
3. Creating and
implementing a plan
for spending and saving (budgeting).
2. Creating personal
financial statements
(balance sheets and cash flow statements
of income and outflows).
1. Storing and
maintaining personal financial records
and documents.
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46 Chapter 2 Money Management Skills
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First, personal financial records and documents are the foundation of systematic
resource use. These provide written evidence of business transactions, ownership of prop-
erty, and legal matters. Next, personal financial statements enable you to measure and
assess your financial position and progress. Finally, your spending plan, or budget, is the
basis for effective money management.
A System for Personal Financial
Records
Invoices, credit card statements, insurance policies, and tax
forms are the basis of financial recordkeeping and personal
economic choices. An organized system of financial records
provides a basis for (1) handling daily business activities, such
as bill paying; (2) planning and measuring financial progress;
(3) completing required tax reports; (4) making effective invest-
ment decisions; and (5) determining available resources for cur-
rent and future spending.
As Exhibit 2–1 shows, most financial records are kept in one
of three places: a home file, a safe deposit box, or a computer. A
home file should be used to keep records for current needs and
documents with limited value. Your home file may be a series
of folders, a cabinet with several drawers, or even a box. What-
ever method you use, your home system should be organized to
allow quick access to needed documents and information.
Important financial records and valuable articles should be kept in a location that pro-
vides better security than a home file. A safe deposit box is a private storage area at a finan-
cial institution with maximum security for valuables and difficult-to-replace documents.
The number of financial records and documents may seem overwhelming; however,
they can easily be organized into 10 categories (see Exhibit 2–1 ). These groups correspond
to the major topics covered in this book. You may not need to use all of these records and
documents at present. As your financial situation changes, you will add others.
How long should you keep personal finance records? Records such as birth certificates,
wills, and Social Security data should be kept permanently. Records on property and invest-
ments should be kept as long as you own these items. Federal tax laws dictate the length
of time you should keep tax-related information. Copies of tax returns and supporting data
should be saved for seven years. Normally, an audit will go back only three years; however,
under certain circumstances, the Internal Revenue Service may request information from
further back. Financial experts also recommend keeping documents related to the purchase
and sale of real estate indefinitely.
As more documents are provided electronically and people are storing financial records
“in the cloud,” consider the following actions:
• Download copies of all statements and forms to your local
storage area using a logical system of files and folders.
• Back up files on external media or use an online backup
service.
• Secure data with complex passwords and encryption.
• Scan copies of documents so that you no longer need to
keep paper versions.
• Take appropriate action to completely erase files when
discarding items that are no longer needed.
Hard copies may still be required, such as car titles, birth certif-
icates, property deeds, and life insurance policies. Original receipts
may be needed for returns or warranty service.
money management
Day-to-day financial activities
necessary to manage current
personal economic resources
while working toward long-
term financial security.
safe deposit box A private
storage area at a financial
institution with maximum
security for valuables.
did you know? did you know?
Low-income people in the United Low-income people in the United
States and around the world face a daily States and around the world face a daily
financial struggle. Diana lives in Malawi financial struggle. Diana lives in Malawi
and often has no savings, no food, and poor and often has no savings, no food, and poor
budgeting skills. However, her money man-budgeting skills. However, her money man-
agement skills improved through a program agement skills improved through a program
of Opportunity International Bank Malawi. of Opportunity International Bank Malawi.
Other organizations empowering people Other organizations empowering people
in poverty with financial literacy pro-in poverty with financial literacy pro-
grams include Women’s World Banking in grams include Women’s World Banking in
Mongolia and Junior Achievement Nigeria. Mongolia and Junior Achievement Nigeria.
CAUTION! CAUTION!
In the United States, people keep various
documents and valuables in 30 million safe
deposit boxes in banks and other financial
institutions. While these boxes are usually
very safe, each year a few people lose the
contents of their safe deposit boxes through
theft, fire, or natural disasters. Such losses
are usually, but not always, covered by the
financial institution’s insurance.
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Exhibit 2–1 Where to Keep Your Financial Records
• Current résumé
• Employee benefit information
• Social Security numbers
• Birth certificates
• Current budget
• Recent personal financial
statements (balance sheet,
income statement)
• List of financial goals
• List of safe deposit box contents
• Paycheck stubs, W-2 forms,
1099 forms
• Receipts for tax-deductible
items
• Records of taxable income
• Past income tax returns and
documentation
• Checkbook, unused checks
• Bank statements, canceled
checks
• Savings statements
• Location information and
number of safe deposit box
• Warranties
• Receipts for major purchases
• Owner’s manuals for major
appliances
• Automobile service records
• Automobile registration
• Automobile owner’s manual
• Unused credit cards
• Payment books
• Receipts, monthly statements
• List of credit account numbers
and telephone numbers of
issuers
• Lease (if renting)
• Property tax records
• Home repair, home
improvement receipts
• Original insurance policies
• List of insurance premium
amounts and due dates
• Medical information (health
and prescription history)
• Claim reports
• Records of stock, bond, and
mutual fund purchases and
sales
• List of investment certificate
numbers
• Brokerage statements
• Dividend records
• Company annual reports
• Will
• Pension plan information
• IRA statements
• Social Security information
• Trust agreements
Current Budget
Safe Deposit Box or Fireproof
Home Safe
• Birth, marriage, and
death certificates
• Citizenship papers
• Adoption, custody papers
• Military papers
• Serial n
umbers o
f
expensiv
e items
• Photog
raphs or
video of
valuable
belongin
gs
• Certificates of deposit
• List of checking and
savings account numbers
and financial institutions
• Credit c
ontacts
• List of c
redit card
numbers
and
telephon
e numbe
rs
of issuer
s
• Mortgage papers, title deed
• Automobile title
• List of insurance policy
numbers and company
names
• Annual
stock an
d
bond sta
tements
• Rare co
ins, stam
ps,
gems, an
d other
collectibl
es
• Copy o
f will
Computer, Tablet, Phone
• Scanned copies of documents
• Spreadsheet summaries of
budgets, investment records
• Digital versions of income tax
returns, wills, and estate plan
• Apps for banking activities,
financial recordkeeping, and
investment transactions
• Receipts for
small, non-
tax-deductible
purchases
• Expired
warranties
ShredderWastebasket
• Quarterly investment
account statements
(keep the annual
summary statements)
• Documents that you
no longer need with
personal information
such as your Social
Security number or
account numbers. Empty recycle bin on
regular basis. Make sure
personal data files are
completely erased.
Computer Recycle Bin
Home Files, Home Computer or Online
Personal and Employment
Records (Chapter 1)
Tax Records
(Chapter 3)
Money Management Records
(Chapter 2)
Financial Services Records
(Chapter 4)
Credit Records
(Chapter 5)
Housing Records
(Chapter 7)
Consumer Purchase & Automobile
Records (Chapter 6)
Insurance Records
(Chapters 8–10)
Estate Planning and Retirement
Records (Chapter 14)
Investment Records
(Chapters 11–13)
What Not to Keep . . .
SOURCE: @ Microsoft 2013. Screen capture reprinted with permission.
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Personal Financial Statements
Every journey starts somewhere. You need to know where you are before you can go some-
where else. Personal financial statements tell you the starting point of your financial jour-
ney. Most financial documents come from financial institutions, businesses, or the
government. However, two documents you create yourself are the personal balance sheet
and the cash flow statement, also called personal financial statements.
These reports provide information about your current financial position and present a
summary of your income and spending. The main purposes of personal financial state-
ments are to (1) report your current financial position; (2) measure your progress toward
financial goals; (3) maintain information about your financial activities; and (4) provide
data for preparing tax forms or applying for credit.
Your Personal Balance Sheet: The Starting Point
The current financial position of an individual or family is a common starting point for
financial planning. A balance sheet , also called a net worth statement or statement of
financial position, reports what you own and what you owe. You prepare a personal bal-
ance sheet to determine your current financial position using the following process:
LO2.2
Create a personal balance
sheet and cash flow
statement.
ACTION ITEM
My cash flow statement
details are :
h very simple but useful.
h very detailed.
h nonexistent.
balance sheet A financial
statement that reports what
an individual or a family owns
and owes; also called a net
worth statement or statement
of financial position.
PRACTICE QUIZ 2–1 PRACTICE QUIZ 2–1
1. What are the three major money management activities?
2. What are the benefits of an organized system of financial records and documents?
3. For each of the following records, check the column to indicate the length of time the item should be kept. “Short
time period” refers to less than five years.
Document Short time period Longer time period
Credit card statements
Mortgage documents
Receipts for furniture, clothing
Retirement account information
Will
Apply Yourself! Apply Yourself!
Talk to two or three people regarding wise and poor money management actions they have taken in their lives, and
about the system they use to keep track of various financial documents and records. Based on this information, what
actions might you take now or in the future?
Sheet 5 Financial Documents and
Records
S
R
Items of value
(what you own)
Amounts owed
(what you owe)
Net worth
(your wealth)
— =
For example, if your possessions are worth $4,500 and you owe $800 to others, your net
worth is $3,700. As shown in Exhibit 2–2 , preparation of a balance sheet involves three
main steps.
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Exhibit 2–2 Creating a Personal Balance Sheet
Liquid Assets
Checking account balance (Chap. 4)
Savings/money market accounts (Chap. 4)
Cash value of life insurance (Chap. 10)
Total liquid assets
Sandra and Mark Scott
Personal Balance Sheet as of October 31, 2016
Personal Possessions
Market value of automobile
Furniture and appliances
Home entertainment system
Home computer
Jewelry
Total household assets
Investment Assets (Chaps. 11–13)
Retirement accounts (Chap. 14)
Mutual funds (Chap. 12)
Total investment assets
Total assets
Assets
Current Liabilities
Medical bills (Chap. 9)
Charge account and credit card balances (Chap. 5)
Balance due on auto loan
Total current liabilities
Long-Term Liabilities
Mortgage (Chap. 7)
Home improvement loan (Chap. 5)
Student loan
Total long-term liabilities
Total liabilities
Net worth (assets minus liabilities)
Liabilities
$ 1,450
5,235
3,685
8,000
5,900
2,600
1,400
2,200
$ 150
3,340
1,750
91,600
1,760
1,200
$ 10,370
$ 20,100
38,670
$ 259,040
$ 5,240
94,560
$ 99,800
$ 159,240
. . . . . . . . . . . . . . . .
. . . . . . . . . . .
. . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . .
. . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . .
Real Estate
Current market value of home (Chap. 7) . . . . . . . . . . . . . . $ 189,900
26,780
11,890
Prepare a total of all items
of value (assets). Include
amounts in bank accounts,
investments, and the cost
(or estimated current
value) of your possessions.
Step 1
List and total the amounts
owed to others (liabilities).
This list will include current
debts, charge account/
credit card balances, and
amounts due on loans
and mortgages.
Step 2
Subtract total liabilities
from total assets to
determine net worth.
This amount indicates
the current financial
position of an individual
or a household.
Step 3
STEP 1: Listing Items of Value Available cash and money in bank accounts com-
bined with other items of value are the foundation of your current financial position. Assets
are cash and other tangible property with a monetary value. The balance sheet for Sandra
and Mark Scott lists their assets in four categories:
1. Liquid assets are cash and items of value that can easily be converted to cash.
Money in checking and savings accounts is liquid and is available to the Scott
family for current spending. The cash value of their life insurance may be borrowed
if needed. While assets other than liquid assets can also be converted into cash, the
process is not quite as easy.
assets Cash and other
property with a monetary
value.
liquid assets Cash and
items of value that can easily
be converted to cash.
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EXAMPLE: Net Worth
If a household has $193,000 of assets and liabilities of $88,000, the net worth
would be $105,000 ($193,000 minus $88,000).
2. Real estate includes a home, a condominium, vacation
property, or other land that a person or family owns.
3. Personal possessions are a major portion of assets for most
people. Included in this category are automobiles and other
personal belongings. Although these items have value, they
may be difficult to convert to cash. You may decide to list
your possessions on the balance sheet at their original cost.
However, these values probably need to be revised over
time, since a five-year-old television set, for example, is
worth less now than when it was new. Thus you may wish to
list your possessions at their current value (also referred to
as market value ).
4. Investment assets are funds set aside for long-term financial needs. The Scott family
will use their investments for such things as financing their children’s education,
purchasing a vacation home, and saving for retirement. Since investment assets
usually fluctuate in value, the amounts listed should reflect their value at the time
the balance sheet is prepared.
STEP 2: Determining Amounts Owed After looking at the total assets of the
Scott family, you might conclude that they have a strong financial position. However, their
debts must also be considered. Liabilities are amounts owed to others but do not include
items not yet due, such as next month’s rent. A liability is a debt you owe now, not some-
thing you may owe in the future. Liabilities fall into two categories:
1. Current liabilities are debts you must pay within a short time, usually less than a
year. These liabilities include such things as medical bills, tax payments, insurance
premiums, cash loans, and charge accounts.
2. Long-term liabilities are debts you do not have to pay in full until more than a year
from now. Common long-term liabilities include auto loans, educational loans, and
mortgages. A mortgage is an amount borrowed to buy a house or other real estate
that will be repaid over a period of 15, 20, or 30 years.
STEP 3: Computing Net Worth A person’s net worth is the difference between
total assets and total liabilities. This relationship can be stated as
Assets 2 Liabilities 5 Net worth
Net worth is the amount you would have left if all assets were sold for the listed values
and all debts were paid in full. Also, total assets equal total liabilities plus net worth. The
balance sheet of a business is commonly expressed as
Assets 5 Liabilities 1 Net worth
As Exhibit 2–2 shows, Sandra and Mark Scott have a net worth of $159,240. Since very
few people, if any, liquidate all assets, the amount of net worth has a more practical pur-
pose: It provides a measurement of your current financial position.
liabilities Amounts owed
to others.
current liabilities Debts
that must be paid within a
short time, usually less than
a year.
long-term liabilities
Debts that are not required to
be paid in full until more than
a year from now.
net worth The difference
between total assets and
total liabilities.
did you know? did you know?
According to the Bureau of the Census, U.S.
Department of Commerce, the assets most
frequently held by households are motor vehicles,
homes, savings accounts, U.S. savings bonds,
certificates of deposit, mutual funds, stocks, corporate
bonds, and retirement accounts. What are some other
assets that an individual or family might possess?
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Based on the following information, calculate the ratios requested:
Financial ratios provide guidelines for measuring the changes in your financial situation. These relationships can indicate
progress toward an improved financial position.
Ratios for Evaluating Financial Progress Ratios for Evaluating Financial Progress
Figure It Out!
A person may have a high net worth but still have financial difficulties. Having many
assets with low liquidity means not having the cash available to pay current expenses.
Insolvency is the inability to pay debts when they are due; it occurs when a person’s liabil-
ities far exceed available assets.
Individuals and families can increase their net worth by (1) increasing their savings;
(2) reducing spending; (3) increasing the value of investments and other possessions; and
(4) reducing amounts owed. Remember, your net worth is not money available to use, but
an indication of your financial position on a given date.
Your Cash Flow Statement: Inflows and Outflows
Each day, financial events can affect your net worth. When you receive a paycheck or pay
living expenses, your total assets and liabilities change. Cash flow is the actual inflow and
outflow of cash during a given time period. Income from employment will probably repre-
sent your most important cash inflow; however, other income, such as interest earned on a
insolvency The inability to
pay debts when they are due
because liabilities far exceed
the value of assets.
cash flow The actual inflow
and outflow of cash during a
given time period.
Ratio Calculation Example Interpretation
Debt ratio Liabilities divided by net
worth
$25,000/$50,000 5 0.5 Shows relationship between debt and net worth;
a low debt ratio is best.
Current ratio Liquid assets divided by
current liabilities
$4,000/$2,000 5 2 Indicates $2 in liquid assets for every $1 of cur-
rent liabilities; a high current ratio is desirable to
have cash available to pay bills.
Liquidity ratio Liquid assets divided by
monthly expenses
$10,000/$4,000 5 2.5 Indicates the number of months in which living
expenses can be paid if an emergency arises; a
high liquidity ratio is desirable.
Debt-payments
ratio
Monthly credit payments
divided by take-home pay
$540/$3,600 5 0.15 Indicates how much of a person’s earnings goes
for debt payments (excluding a home mortgage);
most financial advisors recommend a debt-
payments ratio of less than 20 percent.
Savings ratio Amount saved each month
divided by gross income
$648/$5,400 5 0.12 Financial experts recommend monthly savings
of 5–10 percent.
• Liabilities $12,000
• Liquid assets $2,200
• Monthly credit payments $150
• Monthly savings $130
• Net worth $36,000
• Current liabilities $550
• Take-home pay $900
• Gross income $1,500
(1) Debt ratio ____________________
(2) Debt-payments ratio ____________________
(3) Current ratio ____________________
(4) Savings ratio ____________________
ANSWERS: 1. $12,000/$36,000 5 0.33; 2. $150/$900 5 0.166; 3. $2,200/$550 5 4.0; 4. $130/$1,500 5 0.086, 8.66 percent.
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savings account, should also be considered. In contrast, payments for items such as rent,
food, and loans are cash outflows.
A cash flow statement , also called a personal income and expenditure statement
( Exhibit 2–3 ), is a summary of cash receipts and payments for a given period, such as a
month or a year. This report provides data on your income and spending patterns, which
will be helpful when preparing a budget.
A checking account can provide information for your cash flow statement. Deposits to
the account are your inflows; checks written, cash withdrawals, and debit card payments
are your outflows. Of course, in using this system, when you do not deposit entire amounts
received, you must also note the spending of these nondeposited amounts in your cash flow
statement.
cash flow statement A
financial statement that
summarizes cash receipts
and payments for a given
period; also called a personal
income and expenditure
statement.
Exhibit 2–3 Creating a Cash Flow Statement
Salary (gross)
Less deductions
Federal income tax
State income tax
Social Security
Total deductions
Interest earned on savings
Earnings from investments
Total income
Kim Walker
Cash Flow Statement for the Month Ended September 30, 2016
Income (cash inflows)
Fixed Expenses
Rent
Loan payment
Cable/Internet
Monthly train ticket
Life insurance
Apartment insurance
Total fixed outflows
Cash Outflows
Allocation of Surplus
Emergency fund savings
Savings for short-term/intermediate
financial goals
Savings/investing for long-term
financial security
Total surplus
$810
108
332
$4,350
$1,250
$3,100
34
62
$3,196
$1,150
216
52
196
32
23
$1,669
260
168
150
52
48
66
85
100
70
80
$2,748
+$448
168
80
200
$448
1,079
For a set time period (such
as a month), record your
income from various
sources, such as wages,
salary, interest, and
payments from the
government.
Step 1
Develop categories and
record cash payments for
the time period covered
by the cash flow
statement.
Step 2
Step 3
Subtract the total outflows
from the total inflows. A
positive number (surplus)
represents the amount
available for saving and
investing. A negative
number (deficit) represents
the amount that must be
taken out of savings or
borrowed.
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Variable Expenses
Food at home
Food away from home
Clothing
Telephone
Electricity
Personal care (dry cleaning,
laundry, cosmetics)
Medical expenses
Recreation/entertainment
Gifts
Donations
Cash surplus + (or deficit –)
Total variable outflows
Total outflows
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The process for preparing a cash flow statement involves three steps:
Total cash received
during the time period
Cash outflows during
the time period
Cash surplus or
deficit
— =
STEP 1: Record Income To create a cash flow statement, start by identifying the
funds received. Income is the inflows of cash for an individual or a household. For most
people, the main source of income is money received from a job. Other common income
sources include commissions, self-employment income, interest, dividends, gifts, grants,
scholarships, government payments, pensions, retirement income, alimony, and child
support.
In Exhibit 2–3 , notice that Kim Walker’s monthly salary (or gross income ) of $4,350 is
her main source of income. However, she does not have use of the entire amount.
Take-home pay , also called net pay, is a person’s earnings after deductions for taxes and
other items. Kim’s deductions for federal, state, and Social Security taxes are $1,250. Her
take-home pay is $3,100. This amount, plus earnings from savings and investments, is the
income she has available for use during the current month.
Take-home pay is also called disposable income, the amount a person or household has
available to spend. Discretionary income is money left over after paying for housing, food,
and other necessities. Studies report that discretionary income ranges from less than 5 per-
cent for people under age 25 to more than 40 percent for older people.
STEP 2: Record Cash Outflows Cash payments for living expenses and other
items make up the second component of a cash flow statement. Kim Walker divides her
cash outflows into two major categories: fixed expenses and variable expenses. Every indi-
vidual and household has different cash outflows, but these main categories, along with the
subcategories Kim uses, can be adapted to most situations.
1. Fixed expenses are payments that do not vary from month to month. Rent or
mortgage payments, installment loan payments, cable/Internet service, and a
monthly train ticket for commuting to work are examples of constant or fixed cash
outflows. For Kim, another type of fixed expense is the amount she sets aside
each month for payments due once or twice a year. For example, Kim pays $384
every March for life insurance. Each month, she records a fixed outflow of $32 for
deposit in a special savings account so that the money will be available when her
insurance payment is due.
2. Variable expenses are flexible payments that change from month to month.
Common examples of variable cash outflows are food, clothing, utilities (such
as electricity and telephone), recreation, medical expenses, gifts, and donations.
The use of a checkbook or some other recordkeeping system is necessary for an
accurate total of cash outflows.
STEP 3: Determine Net Cash Flow The difference between income and out-
flows can be either a positive ( surplus ) or a negative ( deficit ) cash flow. A deficit exists if
more cash goes out than comes in during a given month. This amount must be made up by
withdrawals from savings or by borrowing.
When you have a cash surplus, as Kim did ( Exhibit 2–3 ), this amount is available for
saving, investing, or paying off debts. Each month, Kim sets aside money for her emer-
gency fund in a savings account that she would use for unexpected expenses or to pay
living costs if she did not receive her salary. She deposits the rest of the surplus in savings
and investment plans that have two purposes. The first is the achievement of short-term and
income Inflows of cash to
an individual or a household.
take-home pay Earnings
after deductions for taxes
and other items; also called
disposable income.
discretionary income
Money left over after paying
for housing, food, and other
necessities.
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intermediate financial goals, such as a new car, a vacation, or reenrollment in school; the
second is long-term financial security—her retirement.
A cash flow statement provides the foundation for preparing and implementing a spend-
ing, saving, and investment plan. The cash flow statement reports the actual spending of a
household. In contrast, a budget, which has a similar format, documents projected income
and spending.
PRACTICE QUIZ 2–2 PRACTICE QUIZ 2–2
1. What are the main purposes of personal financial statements?
2. What does a personal balance sheet tell you about your financial situation?
3. For the following items, identify each as an asset (A), liability (L), cash inflow (CI), or cash outflow (CO):
Sheet 6 Creating a Personal Balance Sheet
Sheet 7 Creating a Personal Cash Flow
Statement
S
S
S
___________________ monthly rent
___________________ interest on savings account
___________________ retirement account
___________________ electric bill
___________________ automobile loan
___________________ collection of rare coins
___________________ mortgage amount
___________________ market value of automobile
4. Jan Franks has liquid assets of $6,300 and monthly expenses of $2,100. Based on the liquidity ratio, she has _____
months in which living expenses could be paid if an emergency arises.
Apply Yourself! Apply Yourself!
Use online or library research to obtain information about the assets commonly held by households in the United States.
How have the values of assets, liabilities, and net worth of U.S. consumers changed in recent years?
A Plan for Effective Budgeting
A budget , or spending plan, is necessary for successful financial planning. The common
financial problems of overusing credit, lacking a regular savings program, and failing to
ensure future financial security can be minimized through budgeting. The main purposes
of a budget are to help you live within your income, spend your money wisely, reach your
financial goals, prepare for financial emergencies, and develop wise financial management
habits. With a budget, you will be in control of your life. Without a budget, others will be
in control, such as those to whom you owe money. Use a budget to tell your money where
to go, rather than having overspending and debt control your life. Budgeting may be
viewed in seven main steps.
Step 1: Set Financial Goals
Your future plans are the foundation for a financial direction. Financial goals are plans for
your spending, saving, and investing. As discussed in Chapter 1, financial goals should
take a SMART approach with goals that are S pecific, M easurable, A ction-oriented, R eal-
istic, and T ime-based. Exhibit 2–4 gives examples of common financial goal topics based
on life situation and time.
LO2.3
Develop and implement a
personal budget.
budget A specific plan for
spending income; also called
a spending plan.
ACTION ITEM
My budgeting attitude is:
h “I don’t have enough
money to have a budget.”
h “I use an app to
monitor spending.”
h “My detailed plan
helps me avoid money
troubles.”
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Step 2: Estimate Income
As Exhibit 2–5 shows, after setting goals, you need to estimate
available money for a given time period. A common budgeting
period is a month, since many payments, such as rent or mort-
gage, utilities, and credit cards, are due each month. In deter-
mining available income, include only money that you are sure
you’ll receive. Bonuses, gifts, or unexpected income should not
be considered until the money is actually received.
Budgeting income may be difficult if your earnings vary by
season or your income is irregular, as with sales commissions.
In these situations, estimate your income on the low side to help
avoid overspending and other financial difficulties.
Step 3: Budget an Emergency Fund
and Savings
To set aside money for unexpected expenses as well as future financial security, the Robin-
sons have budgeted several amounts for savings and investments (see Exhibit 2–5 ). Finan-
cial advisors suggest that an emergency fund representing three to six months of living
expenses be established for use in periods of unexpected financial difficulty. This amount
will vary based on a person’s life situation and employment stability.
The Robinsons also set aside an amount each month for their automobile insurance
payment, which is due every six months. Both this amount and the emergency fund are put
into a savings account.
A frequent budgeting mistake is to save the amount you have left at the end of the
month. When you do that, you often have nothing left for savings. Since saving is vital for
long-term financial security, remember to always “pay yourself first.”
Step 4: Budget Fixed Expenses
Definite obligations make up this portion of a budget. As Exhibit 2–5 shows, the Robin-
sons have fixed expenses for housing, taxes, and loan payments. They make a monthly
payment of $29 for life insurance. The budgeted total for their fixed expenses is $806, or
28 percent of estimated available income.
You will notice that a budget has a similar format to the previously discussed cash flow
statement. A budget, however, involves projected or planned income and expenses. The
cash flow statement reports the actual income and expenses.
Assigning amounts to spending categories requires careful consideration. The amount
you budget for various items will depend on your current needs and plans for the future.
did you know? did you know?
According to Lynnette Khalfani
( themoneycoach.net ), LIFE is the major
budget buster:
L is “Listed” expenses (housing, utilities, food,
clothing) that are underestimated.
I involves “Impulse buying,” whether in stores
or online.
F are “Forgotten” bills, such as annual
insurance payments.
E are “Emergencies,” such as unexpected auto
or home repairs.
Personal
Situation
Short-Term Goals
(less than 2 years)
Intermediate Goals
(2–5 years)
Long-Term Goals
(over 5 years)
Single person • Complete college
• Pay off auto loan
• Take a vacation to
Europe
• Pay off education loan
• Attend graduate school
• Buy a vacation home
in the mountains
• Provide for retirement
income
Married couple
(no children)
• Take an annual
vacation
• Buy a new car
• Remodel home
• Build a stock portfolio
• Buy a retirement home
• Provide for retirement
income
Parent (young
children)
• Increase life insurance
• Increase savings
• Increase investments
• Buy a new car
• Accumulate a college
fund for children
• Move to a larger home
Exhibit 2–4
Common Financial Goals
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Exhibit 2–6 suggests budget allocations for different life situations. Although this infor-
mation can be of value when creating budget categories, maintaining a detailed record of
your spending for several months is a better source for your personal situation. However,
don’t become discouraged. Use a simple system, such as a notebook or your checkbook.
This “spending diary” will help you know where your money is going. (See Appendix D.)
Exhibit 2–5 Developing a Monthly Budget
2874
115
29
57
57
258
518
115
144
29
806
417
164
93
471
163
201
78
150
90
1,827
2,891
–15
+8
+23
–11
+9
–29
+8
–6
–4
–17
–17
18
4
5
1
28
14
6
4
16
6
6
3
5
3
63
100
Projected Inflows (income)
Salary
Budgeted Amounts
(dollars) (percent)
Actual Amounts Variance
Projected Outflows
(disbursements)
Emergency Fund and Savings:
Emergency fund savings
Savings for auto insurance
Savings for vacation
Savings for investments
Total savings
Fixed Expenses
Mortgage payment
Property taxes
Auto loan payment
Life insurance
Total fixed expenses
Variable expenses
Food
Utilities (telephone, heat,
electric, water)
Clothing
Transportation (automobile
operation, repairs, public
transportation)
Personal and health care
Entertainment
Reading, education
Gifts, donations
Personal allowances,
miscellaneous expenses
Total variable expenses
Total outflow
2874 100
115
29
57
57
258
4
1
2
2
9
518
115
144
29
806
402
172
116
460
172
172
86
144
86
1,810
2,874
Financial goals • reduce credit card debt
• increase amount in emergency fund
Monthly Budget for the Robinson Family
Record actual
amounts for inflows
and outflows.
Compare actual
amounts with
budgeted amounts to
determine variances.
Step 6
Step 7
Evaluate whether
revisions are needed
in your spending and
savings plan.
Step 3
Step 4
Step 5
Step 1
Set financial goals.
Estimate expected
income from all sources;
this amount is to be
allocated among various
outflow categories.
Step 2
Budget amount for an
emergency fund,
periodic expenses, and
financial goals.
Budget set amounts
that you are obligated
to pay.
Budget estimated
amounts to be spent
for various household
and living expenses.
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Step 5: Budget Variable Expenses
Planning for variable expenses is not as easy as budgeting for savings or fixed expenses.
Variable expenses will fluctuate by household situation, time of year, health, economic
conditions, and a variety of other factors. A major portion of the Robinsons’ planned
spending—over 60 percent of their budgeted income—is for variable living costs. They
base their estimates on past spending as well as expected changes in their cost of living.
Step 6: Record Spending Amounts
After having established a spending plan, you will need to keep track of your actual income
and expenses. This process is similar to preparing a cash flow statement. In Exhibit 2–5 ,
notice that the Robinsons estimated specific amounts for income and expenses. These are
presented under “Budgeted Amounts.” The family’s actual spending was not always the
same as planned. A budget variance is the difference between the amount budgeted and
the actual amount received or spent. The total variance for the Robinsons was a $17 deficit ,
since their actual spending exceeded their planned spending by this amount. They would
have had a surplus if their actual spending had been less than they had planned.
budget variance The
difference between the
amount budgeted and the
actual amount received or
spent.
deficit The amount by
which actual spending
exceeds planned spending.
surplus The amount by
which actual spending is less
than planned spending.
Budget Category Student
Working
Single (no
dependents)
Couple
(children
under 18)
Single Parent
(young
children)
Parents
(children over
18 in college)
Couple (over 55,
no dependent
children)
Housing (rent or mortgage
payment; utilities; furnishings
and appliances)
0–25% 30–35% 25–35% 20–30% 25–30% 25–35%
Transportation 5–10 15–20 15–20 10–18 12–18 10–18
Food (at home and away
from home)
15–20 15–25 15–25 13–20 15–20 18–25
Clothing 5–12 5–15 5–10 5–10 4–8 4–8
Personal and health care
(including child care)
3–5 3–5 4–10 8–12 4–6 6–12
Entertainment and recreation 5–10 5–10 4–8 4–8 6–10 5–8
Reading and education 10–30 2–4 3–5 3–5 6–12 2–4
Personal insurance and
pension payments
0–5 4–8 5–9 5–9 4–7 6–8
Gifts, donations, and
contributions
4–6 5–8 3–5 3–5 4–8 3–5
Savings 0–10 4–15 5–10 5–8 2–4 3–5
SOURCES: Bureau of Labor Statistics ( http://stats.bls.gov ); American Demographics; Money; The Wall Street Journal.
Exhibit 2–6 Typical After-Tax Budget Allocations for Different Life Situations
EXAMPLE: Budget Variance
If a family budgets $380 a month for food and spends $363, this would result in a
$17 budget surplus. However, if the family spent $406 on food during the month, a
$26 budget deficit would exist.
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area provided, assess your strengths, weaknesses, oppor-
tunities, and threats related to budgeting and money man-
agement. Do online research and talk with others to get
ideas for your personal SWOT items.
SWOT ( s trengths, w eaknesses, o pportunities, t hreats) is a
planning tool used by companies and other organizations.
This technique can also be used for your money manage-
ment and budgeting activities. Listed below are examples
of possible items for each SWOT category. Now, in the
A Money Management SWOT Analysis
Personal Finance in Practice
Variances for income should be viewed as the opposite of variances for expenses. Less
income than expected would be a deficit, whereas more income than expected would be
a surplus. Spending more than planned for an item may be justified by reducing spending
for another item or putting less into savings. However, revising your budget and financial
goals may be necessary.
Step 7: Review Spending and Saving Patterns
Like most decision-making activities, budgeting is a circular, ongoing process. You will
need to review and perhaps revise your spending plan on a regular basis.
REVIEW YOUR FINANCIAL PROGRESS The results of your budget may be
obvious: having extra cash in checking or falling behind in your bill payments. However,
such obvious results may not always be present. Occasionally, you will have to review
areas where spending has been more or less than expected. You can prepare an annual
summary to compare actual spending with budgeted amounts for each month. A spread-
sheet program can be useful for this purpose. This summary will help you see areas where
changes in your budget may be necessary. This review process is vital to both successful
short-term money management and long-term financial security.
Creating a money management SWOT analysis is only
a start. Next you need to select actions to build on your
strengths, minimize your weaknesses, take advantage of
opportunities, and avoid being a victim of threats. Through
research and innovation, weaknesses and threats can
become strengths and opportunities.
Internal (personal) Factors External (economic, social) Influences
Strengths Opportunities
• saving 5–10 percent of income
• informed on personal finance topics
• no credit card debt
• flexible job skills
Your strengths: ____________________________
____________________________
• phone apps for monitoring finances
• part-time work to supplement income
• availability of no-fee bank account
• low-interest-rate education loan
Potential opportunities: ____________________________
__ _____________________ _____
Weaknesses Threats
• high level of credit card debt
• no emergency fund
• automobile in need of repairs
• low current cash inflow
Your weaknesses: ____________________________
____________________________
• lower market value of retirement fund
• possible reduced hours at part-time job
• reduced home market value
• increased living costs (inflation)
Potential threats: ____________________________
____________________________
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REVISE YOUR GOALS AND BUDGET ALLOCATIONS What should
you cut first when a budget shortage occurs? This question doesn’t have easy answers,
and answers will vary for different households. The most common overspending areas
are entertainment and food, especially away-from-home meals. Purchasing less expen-
sive brand items, buying quality used products, and avoid-
ing credit card purchases are common budget adjustment
techniques. When household budgets must be cut, spending
is most frequently reduced for vacations, dining out, clean-
ing and lawn services, cable/Internet service, and charitable
donations.
At this point in the budgeting process, you may also revise
your financial goals. Are you making progress toward achieving
your objectives? Have changes in personal or economic condi-
tions affected the desirability of certain goals? Have new goals
surfaced that should be given a higher priority? Addressing
these issues while creating an effective saving method will help
ensure accomplishment of your financial goals.
SUCCESSFUL BUDGETING Having a spending plan will not eliminate financial
worries. A budget will work only if you follow it. Changes in income, living expenses,
and goals will require changes in your spending plan. Successful budgets are commonly
viewed as being:
• Well planned. A good budget takes time and effort to prepare and should involve
everyone affected by it.
• Realistic. If you have a moderate income, don’t immediately expect to save enough
money for an expensive car. A budget is designed not to prevent you from enjoying
life but to help you achieve what you want most.
• Flexible. Unexpected expenses and life situation changes will require a budget that
you can easily revise.
• Clearly communicated. Unless you and others involved are aware of the spending
plan, it will not work. The budget should be written and available to all household
members.
SELECTING A BUDGETING SYSTEM Although your bank statement will
give you a fairly complete record of expenses, it does not serve the purpose of a spending
plan. A budget requires that you outline how you will spend available income. Individuals
and households commonly use these types of budgeting systems:
• A mental budget exists only in a person’s mind. This simple system may be
appropriate if you have limited resources and minimal financial
responsibilities.
• A physical budget involves envelopes, folders, or containers to hold the
money or slips of paper. Envelopes would contain the amount of cash or a note
listing the amount to be used for “Food,” “Rent,” “Auto Payment,” and other
expenses.
• A written budget can be kept in a notebook or with multicolumn accounting
paper.
• A digital budget may involve a spreadsheet program, specialized software such as
Quicken, or an app.
The budgeting system you use will depend on your personal and financial situation. Most
important is to select a system that best helps you achieve your financial goals.
did you know? did you know?
Most households can have an additional
$500 or more a month available by not
receiving a tax refund, by cutting insurance costs, by
wiser food shopping, by using less energy, by having
a less expensive phone and cable plan, and by not
being in debt.
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Money Management and Achieving
Financial Goals
Your personal financial statements and budget allow you to achieve your financial goals with
1. Your balance sheet: reporting your current financial position—where you are now.
2. Your cash flow statement: telling you what you received and spent over the past month.
3. Your budget: planning spending and saving to achieve financial goals.
Many people prepare a balance sheet on a periodic basis, such as every three or six
months. Between those points in time, your budget and cash flow statement help you
plan and measure spending and saving activities. For example, you might prepare balance
sheets on January 1, June 30, and December 31. Your budget would serve to plan your
spending and saving between these points in time, and your cash flow statement of income
and outflows would document your actual spending and saving. This relationship may be
illustrated in this way:
LO2.4
Connect money management
activities with saving for
personal financial goals.
ACTION ITEM
My savings program is :
h not started.
h a small amount.
h achieving a financial
goal.
PRACTICE QUIZ 2–3 PRACTICE QUIZ 2–3
1. What are the main purposes of a budget?
2. How does a person’s life situation affect goal setting and amounts allocated for various budget categories?
3. For each of the following household expenses, indicate if the item is a FIXED or a VARIABLE expense.
Sheet 8 Developing a Personal Budget
_________________ food away from home
_________________ rent
_________________ health insurance premium
_________________ cable television
_________________ electricity
_________________ auto repairs
4. The Nollin family has budgeted expenses for a month of $4,560 and actual spending of $4,480. This would result in
a budget SURPLUS or DEFICIT (circle one) of $ _________________ .
Apply Yourself! Apply Yourself!
Conduct research to identify various budgeting and money management apps. Determine the features, ease of opera-
tion, and information provided by these apps. Which app would you consider using for your budgeting and money man-
agement activities?
(January 1 to June 30) (July 1 to December 31)
Actual inflows
and outflows
(cash flow statements)
Projected savings and
spending (budget)
Actual inflows
and outflows
(cash flow statements)
Projected savings and
spending (budget)
Balance
sheet
December 31
Balance
sheet
June 30
Balance
sheet
January 1
Changes in your net worth result from cash inflows and outflows. In periods when your
outflows exceed your inflows, you must draw on savings or borrow (buy on credit). When
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Y
ou’ve launched your
career, and the pay-
checks are rolling in.
If this is the first time
you’ve had to manage finances
beyond your college meal plan,
you may be surprised at how
easily the money seems to
evaporate. Even if you’ve been
working a while, you may find
that you’re living paycheck to
paycheck, without enough left
over to meet your goals. That’s
why you need a strategy for
how you’ll spend and save it—
in other words, a budget.
Yes, you need a budget. But
look at it as an opportunity to
set priorities.
Rather than view a budget as
a straitjacket on your spending,
think of it as a way to set prior-
ities. “Is having HBO now more
important than being able to
retire with the standard of liv-
ing you’d like?” asks Trent Por-
ter, a certified financial planner
and founder of Priority Finan-
cial Planning in Denver.
As a broad guideline. Alexa
von Tobel, founder and CEO
of money-management Web
site LearnVest.com , suggests
using the 50-20-30 rule. That
means that up to 50% of your
take-home pay goes toward
essential spending: rent or
mortgage payments, utility
bills, groceries, and transporta-
tion to work. Designate at least
20% for savings (including for
retirement, an emergency fund
and other goals) plus paying off
debt, such as student loans. Up
to 30% is for lifestyle choices,
such as a gym membership,
your cell-phone plan, enter-
tainment (including your cable
bill), charitable giving, shop-
ping and eating out.
Unless you work for your-
self, your employer will make
sure a portion of your pay finds
its way to the IRS.
When money is tight, you’re
going to have to make some
trade-offs. If rents are high
where you are, you may have
to live with a roommate or wait
to get a car. If giving to char-
ity or your church is crucial.
cable may have to go. “It’s not
about deprivation,” says von
Tobel. “It’s about spending
thoughtfully.”
Track your spending.
To meet your numbers, you’ll
have to keep track of what
you spend. You may want to
use a budgeting site, such as
Mint.com or LearnVest.com .
Their tools let you monitor
your bank, retirement, credit
card and investment accounts,
automatically categorize your
expenditures, and let you set
target spending limits for vari-
ous items, such as restaurants
and shopping. They also help
you organize your goals and
monitor how much you’re sav-
ing for them.
If a hard spending limit
is more effective than just a
warning at keeping you within
your budget, nothing beats
cash. Withdraw the equivalent
of your budget over the course
of the month in cash, divide
the money into categories, and
put money for each category
into envelopes (the budget site
Mvelopes.com lets you fund
virtual envelopes and track
the amount in them by linking
to your checking account and
credit cards). Once you’ve
spent all of the cash designated
for eating out, for example,
you’re done with restaurants
until next month.
As your circumstances
change, your budget should
be flexible enough to adjust.
But that doesn’t mean that you
should upgrade to a flashier car
or a downtown apartment as
soon as you get a raise. Espe-
cially if your savings are miss-
ing the mark or you’re paying
off a lot of debt, ratchet up the
amount you put toward those
areas as your income reaches a
more comfortable level.
Lisa Gerstner
How to Stretch Your Money
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GET THIS APP!
MINT
(Apple, Android, Windows) gives
you a detailed snapshot of where
your finances stand, including
charts and graphs that show
your spending and net income.
Plus, it provides alerts when bills
are due.
SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
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did you know? did you know?
In 1935, Grace Groner purchased three
shares of Abbott Laboratories stock for $180.
In 2010, at the time of her death, as a result of stock
splits and reinvested dividends, that initial investment
was worth $7.5 million. These funds are now available
to students at Lake Forest College, where Groner
attended school, to provide grants for service learning
during internships and foreign study programs.
this happens, lower assets (savings) or higher liabilities (due
to the use of credit) result in a lower net worth. When inflows
exceed outflows, putting money into savings or paying off debts
will result in a higher net worth.
Selecting a Saving Technique
Traditionally, the United States ranks low among industrial
nations in savings rate. Low savings affect personal financial
situations. Studies reveal that the majority of Americans do not
set aside an adequate amount for emergencies.
Since most people find saving difficult, financial advisors
suggest these methods to make it easier:
1. Write a check each payday to deposit in a separate savings account. Or use an automatic
payment or a smartphone app to electronically transfer an amount to savings. This
deposit can be a percentage of income, such as 5 or 10 percent, or a specific dollar
amount.
2. Payroll deduction is available at many places of employment. Under a direct deposit
system, an amount is automatically deducted from your salary and deposited in savings.
3. Saving coins or spending less on certain items can help you save. Each day, bring lunch
instead of buying it, or avoid expensive coffee and snacks. Then, put the money saved
in a container or use a phone app to transfer money to a savings or investment account.
How you save is far less important than making regular periodic savings deposits that will
help you achieve financial goals. Small amounts of savings can grow faster than most
people realize.
Calculating Savings Amounts
To achieve your financial objectives, you should convert your savings goals into specific
amounts. Your use of a savings or investment plan is vital to the growth of your money. As
Exhibit 2–7 shows, using the time value of money calculations introduced in Chapter 1 can
help you calculate progress toward achieving your financial goals.
Exhibit 2–7
Using Savings to
Achieve Financial Goals
2 years 5 years 10 years
$6,870* $8,418 $11,802
2 years 5 years 10 years
$4,160** $11,734 $28,974
2 years 5 years 10 years
$5,374$1,778† $15,080
7%
8%
12%
A single
deposit
from past
savings
Deposit
$2,000 a
year
Deposit
$200 every
three months
Set aside $6,000
for unexpected
expenses and
financial
emergencies
Save for
retirement living
expenses
Save for a down
payment to
purchase a home
† Based on quarterly compounding, explained in Chapter 4.
** Based on the future value of a series of deposits tables in Chapter 1 and Chapter 1 Appendix.
* Based on the future value of $1 tables in Chapter 1 and Chapter 1 Appendix.
With annual $2,000 deposits, this same retirement account would grow to over $500,000 in 40 years.
Financial
Goal
Saving
Method
Annual
Interest
Rate
Savings Balance after:
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YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Do you regularly maintain a record of cash inflows and outflows? Does your cash flow situation
reflect a deficit with unnecessary spending? How can you reduce spending to improve your cash flow situation?
A personal finance dashboard with key performance
indicators can help you monitor your financial situa-
tion and guide you toward financial independence. A
monthly cash flow analysis will help you achieve various
financial goals.
By comparing your cash inflows (income) and cash out-
flows (spending), you will determine if you have a sur-
plus or deficit. A surplus allows you to save more or pay
off debts. A deficit reduces your savings or increases
the amount you owe.
1
2300
2250
2200
2150
2100
250 0 150
1100
1150
1200
1250
1300
MONTHLY BUDGET
D
EF
IC
IT
SURPLU
S
2
C A S H F L O W A N A LY S I S
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) for more effective money manage-
ment and budgeting.
Develop a recordkeeping system for your financial
documents as shown in Exhibit 2–1 .
Prepare a balance sheet and a cash flow statement
on a regular basis to monitor your financial situ-
ation and progress (see the “Personal Financial
Statements” section).
Consider using an online budgeting website or app
for your money management activities. Use a web
search to locate one that fits your needs.
Develop a regular savings plan to set aside some
amount each week. Start small . . . but save some-
thing. For savings ideas go to www.americasaves
.org or www.choosetosave.org .
PRACTICE QUIZ 2–4 PRACTICE QUIZ 2–4
1. What relationship exists among personal financial statements, budgeting, and achieving financial goals?
2. What are some suggested methods to make saving easy?
3. If you wanted to obtain the following types of information, check the box for the document that you would find most useful.
Financial information needed Balance sheet Cash flow statement Budget
Amounts owed for medical expenses
Spending patterns for the past few months
Planned spending patterns for the next month
Current value of investment accounts
Amounts to deposit in savings accounts
Apply Yourself! Apply Yourself!
Talk to a young single person, a young couple, and a middle-aged person about their financial goals and saving habits.
What actions do they take to determine and achieve various financial goals?
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LO2.1 Successful money management
requires coordination of personal financial
records, personal financial statements, and
budgeting activities. An organized system
of financial records and documents should
provide ease of access as well as security
for financial documents that may be impos-
sible to replace.
LO2.2 A personal balance sheet, also
known as a net worth statement, is pre-
pared by listing all items of value (assets)
and all amounts owed to others (liabili-
ties). The difference between your total
assets and your total liabilities is your net
worth. A cash flow statement, also called
a personal income and expenditure state-
ment, is a summary of cash receipts and
payments for a given period, such as a
month or a year.
LO2.3 The budgeting process consists of
seven steps: (1) set financial goals; (2) esti-
mate income; (3) budget an emergency fund
and savings; (4) budget fixed expenses; (5)
budget variable expenses; (6) record spend-
ing amounts; and (7) review spending and
saving patterns.
LO2.4 The relationship among the per-
sonal balance sheet, cash flow statement,
and budget provides the basis for achieving
long-term financial security. Future value
and present value calculations may be used
to compute the increased value of savings
for achieving financial goals.
Chapter
Summary
assets 49
balance sheet 48
budget 54
budget variance 57
cash flow 51
cash flow statement 52
current liabilities 50
long-term liabilities 50
money management 45
net worth 50
safe deposit box 46
surplus 57
take-home pay 53
deficit 57
discretionary
income 53
income 53
insolvency 51
liabilities 50
liquid assets 49
Key Terms
Key Formulas
Page Topic Formula
50 Net worth Net worth 5 Total assets 2 Total liabilities
Example: 5 $125,000 2 $53,000
5 $72,000
51 Debt ratio Debt ratio 5 Liabilities/Net worth
Example: 5 $7,000/$21,000
5 0.33
51 Current ratio Current ratio 5 Liquid assets/Current liabilities
Example: 5 $8,500/$4,500
5 1.88
51 Liquidity ratio Liquidity ratio 5 Liquid assets/Monthly expenses
Example: 5 $8,500/$3,500
5 2.4
51 Debt-payments ratio Debt-payments ratio 5 Monthly credit payments/Take-home pay
Example: 5 $760/$3,800
5 0.20
51 Savings ratio Savings ratio 5 Amount saved per month/Gross monthly income
Example: 5 $460/$3,800
5 0.12
57 Cash surplus
(or deficit)
Cash surplus (or deficit) 5 Total inflows 2 Total outflows
Example: 5 $5,600 2 $4,970
5 $630 (surplus)
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1. Describe some common money management mistakes that can cause long-term finan-
cial concerns. (LO2.1)
2. What do you believe to be the major characteristics of an effective system to keep
track of financial documents and records? (LO2.1)
3. How might financial ratios be used when planning and implementing financial
activities? (LO2.2)
4. Discuss with several people how a budget might be changed if a household faced a
decline in income. What spending areas might be reduced first? (LO2.3)
5. What are long-term effects of low savings for both individuals and the economy of a
country? (LO2.4)
Discussion
Questions
1. The Hamilton household has $145,000 in assets and $63,000 in liabilities. What is the
family’s net worth?
2. Harold Daley budgeted $210 for food for the month of July. He spent $227 on food
during July. Does he have a budget surplus or deficit, and what amount?
Self-Test Solutions
1. Net worth is determined by assets ($145,000) minus liabilities ($63,000), resulting in a
net worth of $82,000.
2. The budget deficit of $17 is calculated by subtracting the actual spending ($227) from
the budgeted amount ($210).
Self-Test
Problems
1. Based on the following data, determine the amount of total assets, total liabilities, and
net worth. (LO2.2)
a. Total assets $ _____
b. Total liabilities $ _____
c. Net worth $ _____
2. Using the following balance sheet items and amounts, calculate the total liquid assets
and total current liabilities. (LO2.2)
a. Total liquid assets $ _____
b. Total current liabilities $ _____
3. Use the following items to determine the total assets, total liabilities, net worth, total
cash inflows, and total cash outflows. (LO2.2)
Liquid assets, $3,870
Current liabilities, $2,670
Long-term liabilities, $76,230
Investment assets, $8,340
Household assets, $87,890
Problems
Money market account, $2,600
Mortgage, $158,000
Retirement account, $87,400
Medical bills, $262
Checking account, $780
Credit card balance, $489
Rent for the month, $650
Spending for food, $345
Savings account balance, $1,890
Current value of automobile, $8,800
Credit card balance, $235
Auto insurance, $230
Video equipment, $2,350
Lunches/parking at work, $180
Personal computer, $1,200
Clothing purchase, $110
Monthly take-home salary, $2,185
Cash in checking account, $450
Balance of educational loan, $2,160
Telephone bill paid for month, $65
Loan payment, $80
Household possessions, $3,400
Payment for electricity, $90
Donations, $160
Value of stock investment, $860
Restaurant spending, $130
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a. Total assets $ _____
b. Total liabilities $ _____
c. Net worth $ _____
d. Total cash inflows $ _____
e. Total cash outflows $ _____
4. For each of the following situations, compute the missing amount. (LO2.2)
a. Assets $65,000; liabilities $18,000; net worth $ _____
b. Assets $86,500; liabilities $ _____ ; net worth $18,700
c. Assets $34,280; liabilities $12,965; net worth $ _____
d. Assets $ _____ ; liabilities $38,345; net worth $52,654
5. Based on the following financial data, calculate the ratios requested. (LO2.2)
a. Debt ratio _____
b. Current ratio _____
c. Debt-payments ratio _____
d. Savings ratio _____
6. The Fram family has liabilities of $128,000 and a net worth of $340,000. What is
their debt ratio? How would you assess this? (LO2.2)
7. Carl Lester has liquid assets of $2,680 and current liabilities of $2,436. What is his
current ratio? What comments do you have about this financial position? (LO2.2)
8. For the following situations, calculate the cash surplus or deficit: (LO2.2)
9. The Brandon household has a monthly income of $5,630 on which to base their
budget. They plan to save 10 percent and spend 32 percent on fixed expenses and 56
percent on variable expenses. (LO2.3)
a. What amount do they plan to set aside for each major budget section?
Savings $ _____
Fixed expenses $ _____
Variable expenses $ _____
b. After setting aside these amounts, what amount would remain for additional sav-
ings or for paying off debts?
10. Fran Powers created the following budget and reported the actual spending listed.
Calculate the variance for each of these categories, and indicate whether it was a
deficit or a surplus. (LO2.3)
11. Ed Weston recently lost his job. Before unemployment occurred, the Weston house-
hold (Ed; wife, Alice; two children, ages 12 and 9) had a monthly take-home income
of $3,165. Each month, the money went for the following items: $880 for rent, $180
Liabilities, $7,800
Liquid assets, $4,600
Monthly credit payments, $640
Monthly savings, $130
Net worth, $58,000
Current liabilities, $1,300
Take-home pay, $2,575
Gross income, $2,850
Cash Inflows
$3,460
4,693
4,287
Cash Outflows
$3,306
4,803
4,218
Difference (surplus or deficit)
$ _____ _____
$_____ _____
$_____ _____
Item
Food
Transportation
Housing
Clothing
Personal
Budgeted
$360
320
950
110
275
Actual
$298
334
982
134
231
Variance
_____
_____
_____
_____
_____
Deficit/Surplus
_____
_____
_____
_____
_____
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for utilities, $560 for food, $480 for automobile expenses, $300 for clothing, $280
for insurance, $250 for savings, and $235 for personal and other items. After the loss
of Ed’s job, the household’s monthly income is $1,550 from his wife’s wages and his
unemployment benefits. The Westons also have savings accounts, investments, and
retirement funds of $28,000. (LO2.3)
a. What budget items might the Westons consider reducing to cope with their finan-
cial difficulties?
b. How should the Westons use their savings and retirement funds during this finan-
cial crisis? What additional sources of funds might be available to them during this
period of unemployment?
12. Use future value and present value calculations (see tables in the appendix for Chap-
ter 1) to determine the following: (LO2.4)
a. The future value of a $600 savings deposit after eight years at an annual interest
rate of 6 percent.
b. The future value of saving $1,800 a year for five years at an annual interest rate of
5 percent.
c. The present value of a $2,000 savings account that will earn 3 percent interest for
four years.
13. Brenda plans to reduce her spending by $50 a month. What would be the future value
of this reduced spending over the next 10 years? (Assume an annual deposit to her
savings account, and an annual interest rate of 3 percent.) (LO2.4)
14. Kara George received a $5,000 gift for graduation from her uncle. If she deposits this in
an account paying 3 percent, what will be the value of this gift in 12 years? (LO2.4)
ADJUSTING THE BUDGET
Case in
Point
In a recent month, the Constantine family
had a budget deficit, which is something
they want to avoid so they do not have
future financial difficulties. Jason and
Karen Constantine and their children (ages
10 and 12) plan to discuss the situation after
dinner this evening.
While at work, Jason was talking with his
friend Ken Lopez. Ken had been a regular
saver since he was very young, starting with
a small savings account. Those funds were
then invested in various stocks and mutual
funds. While in college, Ken was able to pay
for his education while continuing to save
between $50 and $100 a month. He closely
monitored his spending. Ken realized that
the few dollars here and there for snacks and
other minor purchases quickly add up.
Today, Ken works as a customer service
manager for the online division of a retail-
ing company. He lives with his wife and
their two young children. The family’s
spending plan allows for all their needs and
also includes regularly saving and invest-
ing for the children’s education and for
retirement.
Jason asked Ken, “How come you never
seem to have financial stress in your
household?”
Ken replied, “Do you know where your
money is going each month?”
“Not really,” was Jason’s response.
“You’d be surprised by how much is spent
on little things you might do without,” Ken
responded.
“I guess so. I just don’t want to have to go
around with a notebook writing down every
amount I spend,” Jason said in a troubled
voice.
“Well, you have to take some action if you
want your financial situation to change,”
Ken countered.
That evening, the Constantine family met to
discuss their budget situation:
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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Questions
1. What situations might have created the
budget deficit for the Constantine family?
2. What amounts would you suggest for the
various categories for the family budget?
3. Describe additional actions for the Con-
stantine family related to their budget or
other money management activities.
Current Spending Suggested Budget
Rent $950 Rent $ _____
Electricity, water 120 Electricity, water _____
Telephone 55 Telephone _____
Cable, Internet 125 Cable, Internet _____
Food (at home) 385 Food (at home) _____
Food (away) 230 Food (away) _____
Auto payment 410 Auto payment _____
Gas, oil changes 140 Gas, oil changes _____
Insurance 125 Insurance _____
Clothing 200 Clothing _____
Personal, gifts 185 Personal, gifts _____
Donations 50 Donations _____
Savings 35 Savings _____
Total spending $3,010 Total budgeted $
Total monthly amount
available…………………………….. $2,800
Total monthly amount
available…………………………….. $2,800
Surplus (deficit) ($210) Surplus (deficit) $
Continuing
Case MANAGING A BUDGET
Assets:
Checking account: $1,250
Emergency fund savings
account: $3,100
Car: $4,000
Liabilities:
Student loan: $5,400
Credit card balance: $400
Income:
Gross monthly salary: $2,125
Net monthly salary: $1,560
Monthly Expenses:
Rent obligation: $275
Utilities obligation: $125
Food: $120
Gas/Maintenance: $100
Credit card payment: $50
Jamie Lee Jackson, age 24, now a busy full-time college student and part-time bakery
clerk, has been trying to organize all of her priorities, including her budget. She has been
wondering if she is allocating enough of her income toward savings, which includes accu-
mulating enough money toward the $9,000 down payment she needs to open her dream
cupcake café.
Jamie Lee has been making regular deposits to both her regular and her emergency savings
accounts. She would really like to sit down and get a clearer picture of how much she is
spending on various expenses, including rent, utilities, and entertainment, and how her debt
compares to her savings and assets. She realizes that she must stay on track and keep a
detailed budget if she is to realize her dream of being self-employed after college graduation.
Current Financial Situation
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Questions
1. According to the text, a personal balance sheet is a statement of your net worth. It is an
accounting of what you own as well as what you owe. Using the information provided,
prepare a personal balance sheet for Jamie Lee.
2. Using the “Ratios for Evaluating Financial Progress” feature earlier in the chapter ,
what is Jamie Lee’s debt ratio? When comparing Jamie Lee’s liabilities and her net
worth, is the relationship a favorable one?
3. Using the “Ratios for Evaluating Financial Progress” feature earlier in the chapter,
what is Jamie Lee’s savings ratio? Using the rule of thumb recommended by financial
experts, is she saving enough?
4. Using Exhibit 2–6 , Typical After-Tax Budget Allocations for Different Life Situations,
calculate the budget allocations for Jamie Lee using her net monthly salary (or after-
tax salary) amount. Is she within the recommended parameters for a student?
Savings:
Regular savings: $150
Emergency savings: $25
Entertainment:
Cake decorating class: $35
Movies with friends: $50
Directions Continue or start using the Daily Spending Diary sheets provided at the end
of the book, or create your own format, to record every cent of your spending in the catego-
ries provided. This experience will help you better understand your spending patterns and
help you plan for achieving financial goals. The Daily Spending Diary sheets are located in
Appendix D at the end of the book and in Connect Finance .
Questions
1. What information from your daily spending diary might encourage you to reconsider
various money management actions?
2. How can your daily spending diary assist you when planning and implementing a
budget?
“I AM AMAZED HOW LITTLE THINGS CAN ADD UP. . . . HOWEVER,
SINCE KEEPING TRACK OF ALL MY SPENDING, I REALIZE THAT
I NEED TO CUT DOWN ON SOME ITEMS SO I CAN PUT SOME
MONEY AWAY INTO SAVINGS.”
Spending
Diary
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Financial Documents and Records
Purpose: To develop a system for maintaining and storing personal documents and records.
Financial Planning Activities: Indicate the location of the following records, and create files
for the eight major categories of financial documents. This sheet is also available in an Excel
spreadsheet format in Connect Finance.
Suggested Websites: money.cnn.com www.kiplinger.com www.usa.gov
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What’s Next for Your Personal Financial Plan?
• Plan a physical or online program for storing your financial documents and records.
• Decide if various documents may no longer be needed.
Item
Home
file
Safe deposit
box
Other (specify
location—computer
file, online)
1. Money management records
• budget, financial statements
2. Personal/employment records
• current résumé, Social Security card
• educational transcripts
• birth, marriage, divorce certificates
• citizenship, military papers
• adoption, custody papers
3. Tax records
4. Financial services/consumer credit records
• unused or canceled checks
• savings, passbook statements
• credit card information, statements
• credit contracts
5. Consumer purchase, housing, and
automobile records
• warranties, receipts
• owner’s manuals
• lease or mortgage papers, title deed, property
tax info
• automobile title
• auto registration
• auto service records
6. Insurance records
• insurance policies
• home inventory
• medical information (health history)
7. Investment records
• broker statements
• dividend reports
• stock/bond records
• rare coins, stamps, and collectibles
8. Estate planning and retirement
• will
• pension, Social Security info
Suggested
App:
• Manilla
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Creating a Personal Balance Sheet
Purpose: To determine your current financial position.
Financial Planning Activities: List current values of the assets; list amounts owed for
liabilities; subtract total liabilities from total assets to determine net worth. This sheet is also
available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.kiplinger.com money.cnn.com www.lifeadvice.com
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What’s Next for Your Personal Financial Plan?
• Compare your net worth to previous balance sheets.
• Decide how often you will prepare a balance sheet.
Balance sheet as of
Assets
Liquid assets
__________________________________________________
Checking account balance ______________________
Savings/money market accounts, funds ______________________
Cash value of life insurance ______________________
Other _________________ ______________________
Total liquid assets ______________________
Household assets & possessions
Current market value of home ______________________
Market value of automobiles ______________________
Furniture ______________________
Stereo, video, camera equipment ______________________
Jewelry ______________________
Other _________________ ______________________
Other _________________ ______________________
Total household assets ______________________
Investment assets
Savings certificates ______________________
Stocks and bonds ______________________
Individual retirement accounts ______________________
Mutual funds ______________________
Other _________________ ______________________
Total investment assets ______________________
Total Assets ………………………………………
Liabilities
Current liabilities
Charge account and credit card balances ______________________
Loan balances ______________________
Other _________________ ______________________
Other _________________ ______________________
Total current liabilities ______________________
Long-term liabilities
Mortgage
Other _________________
Total long-term liabilities ______________________
Total Liabilities ………………………………………
Net Worth (assets minus liabilities) ……………………………………… ______________________
Suggested
App:
• Balance
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Creating a Personal Cash Flow Statement
Purpose: To maintain a record of cash inflows and outflows for a month (or three months).
Financial Planning Activities: Record inflows and outflows of cash for a one- (or three-)
month period. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.americasaves.org money.cnn.com
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What’s Next for Your Personal Financial Plan?
• Decide which areas of spending need to be revised.
• Evaluate your spending patterns for preparation of a budget.
For month ending ___________________________________________________________
Cash Inflows
Salary (take-home) ________________________
Other income ________________________
Other income ________________________
Total Income …………………………………………… _______________________
Cash Outflows
Fixed expenses
Mortgage or rent ________________________
Loan payments ________________________
Insurance ________________________
Other ____________ ________________________
Other ____________ ________________________
Total fixed outflows …………………………………………… _______________________
Variable expenses ________________________
Food ________________________
Clothing ________________________
Electricity ________________________
Telephone ________________________
Water ________________________
Transportation ________________________
Personal care ________________________
Medical expenses ________________________
Recreation/entertainment ________________________
Gifts ________________________
Donations ________________________
Other ____________ ________________________
Other ____________ ________________________
Total variable outflows …………………………………………… _______________________
Total Outflows …………………………………………… _______________________
Surplus/Deficit …………………………………………… _______________________
Allocation of surplus
Emergency fund savings ________________________
Financial goal savings ________________________
Other savings _________ ________________________
Suggested
App:
• Expensify
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Developing a Personal Budget
Purpose: To compare projected and actual spending for a one- (or three-) month period.
Financial Planning Activities: Estimate projected spending based on your cash flow
statement, and maintain records for actual spending for these same budget categories.
This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.betterbudgeting.com www.asec.org www.mymoney.gov
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What’s Next for Your Personal Financial Plan?
• Evaluate the appropriateness of your budget for your current life situation.
• Assess whether your budgeting activities are helping you achieve your financial goals.
Budgeted amounts
Income Dollar Percent Actual amounts Variance
Salary
Other _________________
Total income 100%
Expenses
Fixed expenses
Mortgage or rent
Property taxes
Loan payments
Insurance
Other _________________
Total fixed expenses
Emergency fund/savings
Emergency fund
Savings for ______________
Savings for ______________
Total savings
Variable expenses
Food
Utilities
Clothing
Transportation costs
Personal care
Medical and health care
Entertainment
Education
Gifts/donations
Miscellaneous
Other _________________
Other _________________
Total variable expenses
Total expenses 100%
Suggested
App:
• Home
Budget
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3 Steps to Financial
Literacy . . .
Taxes in Your Financial Plan
3 Taxes in Your Financial Plan
What’s wrong with a large tax refund?
Each year, millions of American households
receive federal tax refunds totaling over $225
billion, which represents several billion dollars
in lost earnings from investing and saving. By
not receiving a large tax refund, you can use
the money during the year for saving or other
financial needs. Monitoring your taxes through-
out the year, rather than waiting until April 15,
is a vital component of financial planning. At
the end of the chapter, “Your Personal Finance
Dashboard” will help you measure how well
you have planned for your tax situation.
1
Annually, estimate the proper tax withholding
and other tax payments (as appropriate) based
on current tax rates.
Website: www.irs.gov
2
Maintain complete and accurate tax records.
App: Expensify
3
Each year, review tax resources to ensure
that you understand tax law changes for your
financial situation.
Website: taxtopics.net
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Taxes in Your Financial Plan
Taxes are an everyday financial fact of life. You pay taxes when you get a paycheck or
make a purchase. However, most people concern themselves with taxes only immediately
before April 15. Tax planning should be an ongoing process.
Planning Your Tax Strategy
Each year, the Tax Foundation determines how long the average person works to pay taxes.
In recent years, “Tax Freedom Day” came in mid-April. This means that the time that
elapsed from January 1 until mid-April represents the portion of the year people work to
pay their taxes.
Tax planning starts with knowing current tax laws, next maintaining complete and
appropriate tax records, then making purchase and investment decisions that can reduce
your tax liability. Your primary goal should be to pay your fair share of taxes while taking
advantage of appropriate tax benefits.
Types of Tax
Most people pay taxes in four major categories: taxes on purchases, taxes on property,
taxes on wealth, and taxes on earnings.
TAXES ON PURCHASES You probably pay sales tax on many purchases. Many
states exempt food and drugs from sales tax to reduce the financial burden on low-income
households. In recent years, all but five states (Alaska, Delaware, Montana, New Hamp-
shire, and Oregon) had a general sales tax. An excise tax is imposed by the federal and
LO3.1
Identify the major tax types in
our society.
ACTION ITEM
I understand the various
types of taxes I pay.
h Yes h No
excise tax A tax
imposed on specific goods
and services, such as
gasoline, cigarettes, alcoholic
beverages, tires, and air
travel.
CHAPTER 3 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO3.1 Identify the major tax types in our society.
LO3.2 Calculate taxable income and the amount owed for federal income tax.
LO3.3 Prepare a federal income tax return.
LO3.4 Select appropriate tax strategies for various life situations.
YOUR PERSONAL FINANCIAL PLAN SHEETS
9. Federal Income Tax Estimate
10. Tax Planning Activities
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state governments on specific goods and services, such as gasoline, cigarettes, alcoholic
beverages, tires, air travel, hotels, and phone service.
TAXES ON PROPERTY Real estate property tax is a major source of revenue for
local governments. This tax is based on the value of land and buildings. Many people
have seen significant increases in property taxes in the last decade. Some areas impose a
personal property tax on the value of automobiles, boats, furniture, and farm equipment.
TAXES ON WEALTH An estate tax is imposed on the value of a person’s property
at the time of death. This federal tax is based on the fair market value of the deceased per-
son’s investments, property, and bank accounts less allowable deductions and other taxes.
Money and property passed on to heirs may be subject to a state tax. An inheritance tax
is levied on the value of property bequeathed by a deceased person. This tax is paid for the
right to acquire the inherited property.
Individuals are allowed to give money or items valued at $14,000 or less in a year to a
person without being subject to taxes. Gift amounts greater than $14,000 may have estate
tax implications later. Amounts given for tuition payments or
medical expenses are not subject to gift taxes.
TAXES ON EARNINGS The two main taxes on wages
and salaries are Social Security and income taxes. The Federal
Insurance Contributions Act (FICA) created the Social Secu-
rity tax to fund the old-age, survivors, and disability insurance
portion of the Social Security system and the hospital insurance
portion (Medicare).
Income tax is a major financial planning factor for most people. Some workers are
subject to federal, state, and local income taxes. Currently, only seven states do not have a
state income tax. Additionally, two states, New Hampshire and Tennessee, tax only divi-
dend and interest income.
Throughout the year, your employer will withhold income tax payments from your
paycheck, or you may be required to make estimated tax payments if you own your own
business. Both types of payments are only estimates; you may need to pay an additional
amount, or you may get a tax refund. The following sections will assist you in preparing
your federal income tax return and planning your future tax strategies.
estate tax A tax imposed
on the value of a person’s
property at the time of death.
inheritance tax A tax
levied on the value of
property bequeathed by a
deceased person.
digi – know? digi – know?
The Tax Foundation ( The Tax Foundation ( www.taxfoundation.orgwww.taxfoundation.org ) )
posts an annual report of state tax changes. posts an annual report of state tax changes.
PRACTICE QUIZ 3–1 PRACTICE QUIZ 3–1
1. What are the four major categories of taxes?
2. For each of the following financial planning situations, list the type of tax that is being described.
a. A tax on the value of a person’s house.
b. The additional charge for gasoline and hotels.
c. Payroll deductions for federal government retirement benefits.
d. Amount owed on property received from a deceased person.
e. Payroll deductions for a direct tax on earnings.
Apply Yourself! Apply Yourself!
Estimate the amount of all types of tax that you have paid in the last month.
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright 2014. The Kiplinger Washington Editors, Inc.
1. Why have taxes on travel-related services increased so dramatically?
2. What is a “transient occupancy tax”?
3. How can you determine the amount of taxes in advance?
F
or summer vaca-
tion, you’ve probably
included the cost of
a room in a hotel or
resort, a rental car, some nice
dinners, and a few souvenirs
in the budget. But if you fail to
include taxes, you could end
up with a bad case of traveler’s
remorse.
This year, taxes on hotels,
rental cars and restaurant meals
are expected to cost travelers
nearly $30 per day, on aver-
age, roughly the same as last
year. But that’s up from $29.17
in 2012 and about $28 in 2011,
according to the Global Busi-
ness Travel Association’s annual
survey of top U.S. destination
cities. “For a family of four that
might have budgeted $1,000 for
their trip, they could end up
$100 or $200 over budget,” says
Joseph Bates, vice-president of
research for the GBTA.
The city with the high-
est total tax burden, which
includes general sales taxes as
well as travel-related taxes, is
Chicago, where travelers pay an
average of $41.04 in taxes per
day. Second on the list is New
York City, at $38.65 per day.
Fort Lauderdale has the lowest
tax burden, at $22.61 per day.
Travel-related tax increases
enacted in 2013 include a 2%
“transient occupancy tax” tacked
on to existing tax rates for hotels
in northern Virginia (which are
popular with visitors to nearby
Washington, D.C.)
and an increase in
Minnesota’s rental-car
tax from 6.2% to 9.2%.
Taxes on travel-
related services have
been on the rise since
the 1990s, when pro-
tests against increases
in property taxes led
states, counties and
other jurisdictions to search for
alternative sources of revenue.
Taxes on hotels, rental cars and
restaurant meals were viewed
as a way to raise money with-
out increasing the tax burden
on residents. But the GBTA
argues that residents feel the
pinch, too, because locals also
eat in restaurants, stay in hotels
for special occasions and rent
cars when their own vehicles
are in the shop.
Meeting planners increas-
ingly factor in the cost of taxes
when deciding where to hold
conferences. “When you’re
talking about 1,000 people, those
numbers add up,” Bates says.
For leisure travelers, though,
figuring out the amount of
taxes in a specific destination
can be difficult, says Carol
Kokinis-Graves, senior state
tax analyst for tax publisher
CCH. State sales tax rates are
readily available (see our “State
by State Guide to Taxes,” at
kiplinger.com/links/tax map),
and most large cities provide
information about taxes and
fees on their Web sites. But
many smaller cities and juris-
dictions that impose their own
taxes may not even have a Web
presence, says Kokinis-Graves.
Still, you can avoid some
sticker shock by planning
ahead. Web sites such as Orbitz
and Expedia don’t include taxes
and fees in their initial quotes
for hotel rooms, but once you
select a specific rate and pro-
vide the dates of your planned
visit, you’ll get the total cost.
You don’t need to provide your
personal information or credit
card number to get this figure.
Web sites for some rental-car
companies and travel discount-
ers will give you the total rental
cost upfront; with others, you
must select the car you want to
reserve to get that information.
Renting a car at an off-
airport location could also save
you the airport concession
fee—typically 11% to 13% of
your total rate. Just be sure to
factor in the cost of cab fare.
Some cities tax that, too.
Sandra Block
Traveling? Better Budget for Taxes
You’ll pay plenty for hotels, rental cars and restaurant meals.
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78 Chapter 3 Taxes in Your Financial Plan
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The Basics of Federal Income Tax
Each year, millions of Americans are required to pay their share of income taxes to the
federal government. As shown in Exhibit 3–1 , this process involves several steps.
Step 1: Determining Adjusted Gross Income
This process starts with steps to determine taxable income , which is the net amount of
income, after allowable deductions, on which income tax is computed.
TYPES OF INCOME Most, but not all, income is subject to taxation. Your gross, or
total, income can consist of three main components:
1. Earned income is usually in the form of wages, salary, commission, fees, tips, or
bonuses.
2. Investment income (sometimes referred to as portfolio income ) is money received
in the form of dividends, interest, or rent from investments.
3. Passive income results from business activities in which you do not actively
participate, such as a limited partnership.
Other types of income subject to federal income tax include alimony, awards, lottery win-
nings, credit card sign-up bonuses, and prizes. For example, cash and prizes won on televi-
sion game shows are subject to both federal and state taxes.
Total income is also affected by exclusions. An exclusion is an amount not included in
gross income. For example, the foreign income exclusion allows U.S. citizens working and
living in another country to exclude a certain portion ($99,200 in 2014, adjusted each year
for inflation) of their income from federal income taxes.
Exclusions may also be referred to as tax-exempt income, or income that is not subject
to tax. For example, interest earned on most state and city bonds is exempt from federal
income tax. Tax-deferred income is income that will be taxed at a later date.
ADJUSTMENTS TO INCOME Adjusted gross income (AGI) is gross income
after certain reductions have been made. These reductions, called adjustments to income,
include contributions to an IRA or a Keogh retirement plan, penalties for early withdrawal
of savings, and alimony payments. Adjusted gross income is used as the basis for comput-
ing various income tax deductions, such as medical expenses.
Certain adjustments to income, such as tax-deferred retirement plans, are a type of tax
shelter . Tax shelters are investments that provide immediate tax benefits and a reasonable
expectation of a future financial return. In recent years, tax court rulings and changes in
the tax code have disallowed various types of tax shelters that were considered excessive.
Step 2: Computing Taxable Income
DEDUCTIONS A tax deduction is an amount subtracted from adjusted gross income
to arrive at taxable income. Every taxpayer receives at least the standard deduction , a set
amount on which no taxes are paid. As of 2014, single people receive a standard deduction
of $6,200 (married couples filing jointly receive $12,400). Blind people and individuals 65
and older receive higher standard deductions.
Many people qualify for more than the standard deduction. Itemized deductions are
expenses a taxpayer is allowed to deduct from adjusted gross income. Common itemized
deductions include:
• Medical and dental expenses —physician fees, prescription medications, hospital
expenses, medical insurance premiums, hearing aids, eyeglasses, and medical
travel that has not been reimbursed or paid by others. The amount of this
deduction is the medical and dental expenses that exceed 10 percent (as of 2014)
LO3.2
Calculate taxable income and
the amount owed for federal
income tax.
taxable income The net
amount of income, after
allowable deductions, on
which income tax is computed.
earned income Money
received for personal effort,
such as wages, salary,
commission, fees, tips, or
bonuses.
investment income
Money received in the form
of dividends, interest, or rent
from investments; also called
portfolio income.
passive income Income
resulting from business
activities in which you do not
actively participate.
exclusion An amount not
included in gross income.
tax-exempt income
Income that is not subject
to tax.
tax-deferred income
Income that will be taxed at a
later date.
adjusted gross income
(AGI) Gross income reduced
by certain adjustments,
such as contributions to an
individual retirement account
(IRA) and alimony payments.
tax shelter An investment
that provides immediate tax
benefits and a reasonable
expectation of a future
financial return.
tax deduction An amount
subtracted from adjusted
gross income to arrive at
taxable income.
ACTION ITEM
I understand how to calculate
taxable income and federal
tax owed.
h Yes h No
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Chapter 3 Taxes in Your Financial Plan 79
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of adjusted gross income. For taxpayers over 65, it will remain at 7.5 percent of
AGI through 2016.
• Taxes —state and local income tax, real estate property tax, and state or local
personal property tax.
• Interest —mortgage interest, home equity loan interest, and investment interest
expense up to an amount equal to investment income.
• Contributions —cash or property donated to qualified charitable organizations.
Contribution totals greater than 20 percent of adjusted gross income are subject to
limitations.
• Casualty and theft losses —financial losses resulting from natural disasters,
accidents, or unlawful acts.
standard deduction A set
amount on which no taxes
are paid.
itemized deductions
Expenses that can be
deducted from adjusted
gross income, such as
medical expenses, real
estate property taxes, home
mortgage interest, charitable
contributions, casualty
losses, and certain work-
related expenses.
Exhibit 3–1 Computing Taxable Income and Your Tax Liability
Gross Income
• Wages and salaries
• Profits from business
or profession
• Commissions, fees
• Employee awards
• Interest
• Gains or losses
on sale of investments
• Alimony
• Unemployment
compensation
• Royalties
• Dividends
• Property rental
• Pensions
• Tips, bonuses
• Prizes, gambling winnings
Equals: Adjusted gross income
Less: Adjustments to income
Equals: Taxable income
Less: Standard
deduction and exemptions
Less: Itemized
deductions and exemptions
Tax based on tax tables
or tax schedules
Less: Tax credits
Plus: Other taxes
Equals: Total tax due
Step 1: Determining Adjusted
Gross Income . . . . . . . . . .
Step 2:
Computing Taxable Income . . . .
Step 3: Calculating Taxes Owed . . . . . . . . . . . . . . . . . .
Step 4: Making Tax Payments
Step 5: Deadlines and Penalties . . . . . . . . . . . . . . . . . .
. . . . or . . . .
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CAUTION! CAUTION!
Watch out for IRS agent impersonators. It
has been reported that over 20,000 people
have been contacted and lost over $1 million
due to this scam. Most of these scams have
occurred over the phone. The IRS will contact
you by mail, not phone, regarding unpaid
taxes. Information on these and other tax
frauds is available at www.treasury.gov/tigta/ .
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• Moving expenses —costs incurred for a change in residence associated with a new
job that is at least 50 miles farther from your former home than your old main job
location.
• Job-related and other miscellaneous expenses —unreimbursed job travel, union
dues, required continuing education, work clothes or uniforms, investment
expenses, tax preparation fees, safe deposit box rental (for storing investment
documents), and so on. The amount of this deduction is the
expenses that exceed 2 percent (as of 2014) of adjusted gross
income.
The standard deduction or total itemized deductions, along with
the value of your exemptions (see next section), are subtracted
from adjusted gross income to obtain your taxable income. Note:
For individual returns with incomes greater than $254,200 or joint
returns greater than $305,000 in 2014, there are limitations to the
amount of itemized deductions.
You are required to maintain records to document tax deduc-
tions, such as a home filing system ( Exhibit 3–2 ). Canceled checks
and receipts serve as proof of payment for deductions such as
charitable contributions, medical expenses, and business-related
expenses. Travel expenses can be documented in a daily log with records of mileage, tolls,
parking fees, and away-from-home costs.
Generally, you should keep tax records for three years from the date you file your
return. However, you may be held responsible for providing back documentation up to six
years. Records such as past tax returns and housing documents should be kept indefinitely.
EXEMPTIONS An exemption is a deduction from adjusted gross income for yourself,
your spouse, and qualified dependents. A dependent must not earn more than a set amount
unless he or she is under age 19 or is a full-time student under age 24; you must provide
exemption A deduction
from adjusted gross income
for yourself, your spouse,
and qualified dependents.
Indicate whether each of the following items would or
would not be deductible when you compute your federal
income tax.
Certain financial benefits individuals receive are not sub-
ject to federal income tax. Indicate whether each of the
following items would or would not be included in taxable
income when you compute your federal income tax.
Is It Taxable Income? Is It Deductible?
Personal Finance in Practice
Is it taxable income . . . ? Yes No
1. Lottery winnings _____ _____
2. Child support received _____ _____
3. Worker’s compensation benefits _____ _____
4. Life insurance death benefits _____ _____
5. Municipal bond interest earnings _____ _____
6. Bartering income _____ _____
Is it deductible . . . ? Yes No
7. Life insurance premiums _____ _____
8. Gym membership _____ _____
9. Fees for traffic violations _____ _____
10. Mileage for driving to volunteer work _____ _____
11. An attorney’s fee for preparing a will _____ _____
12. Income tax preparation fee _____ _____
NOTE: These taxable income items and deductions are based on the 2014 tax year and may change due to changes in the tax code.
ANSWERS 1, 6, 10, 12—yes; 2, 3, 4, 5, 7, 8, 9, 11—no.
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more than half of the dependent’s support; and the dependent
must reside in your home or be a specified relative and must
meet certain citizenship requirements. For 2014, taxable income
was reduced by $3,950 for each exemption claimed. After
deducting the amounts for exemptions, you obtain your taxable
income, which is the amount used to determine taxes owed.
Step 3: Calculating Taxes Owed
Your taxable income is the basis for computing the amount of
tax owed.
TAX RATES Use your taxable income in conjunction with
the appropriate tax table or tax schedule. For 2014, the seven-rate system for federal
income tax was as follows:
Exhibit 3–2 A Tax Recordkeeping System
Tax Forms and Filing Information
• Current tax forms and instruction
booklets and online resources
• Reference books on current tax laws
and tax-saving techniques
• Social Security numbers of
household members
• Copies of federal tax returns
from previous years
Income Records
• W-2 forms reporting salary, wages,
and taxes withheld
• W-2P forms reporting pension income
• 1099 forms reporting interest,
dividends, and capital gains and
losses from savings and investments
• 1099 forms for self-employment
income, royalty income, and lump-sum
payments from pension or retirement
plans
Expense Records
• Receipts for medical, dependent
care, charitable donations, and
job-related expenses
• Mortgage interest (Form 1098) and
other deductible interest
• Business, investment, and
rental-property expense documents
did you know? did you know?
The most frequently overlooked tax
deductions are state sales taxes, reinvested
dividends, out-of-pocket charitable contributions,
student loan interest paid by parents, moving
expenses to take a first job, military reservists’ travel
expenses, child care credit, estate tax on income in
respect of a decedent, state tax you paid last spring,
refinancing points, and jury pay paid to employer.
Rate on
Taxable Income Single Taxpayers
Married Taxpayers
Filing Jointly Heads of Household
10% Up to $9,075 Up to $18,150 Up to $12,950
15 $9,076–$36,900 $18,151–$73,800 $12,951–$49,400
25 $36,901–$89,350 $73,801–$148,850 $49,401–$127,550
28 $89,351–$186,350 $148,851–$226,850 $127,551–$206,600
33 $186,351–$405,100 $226,851–$405,100 $206,601–$405,100
35 $405,101–$406,750 $405,101–$457,600 $405,101–$432,200
39.6 Over $406,751 Over $457,601 Over $432,201
A separate tax rate schedule also exists for married persons who file separate income tax
returns.
The 10, 15, 25, 28, 33, 35 and 39.6 percent rates are referred to as marginal tax rates .
These rates are used to calculate tax on the last (and next) dollar of taxable income. After
deductions and exemptions, a person in the 35 percent tax bracket pays 35 cents in taxes
for the next dollar of taxable income in that bracket.
In contrast, the average tax rate is based on the total tax due divided by taxable income.
Except for taxpayers in the 10 percent bracket, this rate is less than a person’s marginal tax
rate. For example, a person with taxable income of $40,000 and a total tax bill of $4,200
would have an average tax rate of 10.5 percent ($4,200 4 $40,000).
marginal tax rate The
rate used to calculate tax on
the last (and next) dollar of
taxable income.
average tax rate Total
tax due divided by taxable
income.
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As you might expect, tax credits are less readily avail-
able than tax deductions. To qualify for a $100 child care
tax credit, you may have to spend $500 in child care
expenses. In some situations, spending on deductible
items may be more beneficial than qualifying for a tax
credit. A knowledge of tax law and careful financial plan-
ning will help you use both tax credits and tax deductions
to maximum advantage.
Many people confuse tax credits with tax deductions. Is
one better than the other? A tax credit, such as eligible
child care or dependent care expenses, results in a dollar-
for-dollar reduction in the amount of taxes owed. A tax
deduction, such as an itemized deduction in the form of
medical expenses, mortgage interest, or charitable contri-
butions, reduces the taxable income on which your taxes
are based.
Here is how a $100 tax credit compares with a $100 tax
deduction:
Tax Credits versus Tax Deductions Tax Credits versus Tax Deductions
Figure It Out!
CALCULATING YOUR TAX Each of the tax rates represents a range of income
levels. These are often referred to as “brackets.” Thus, if you are married filing jointly and
have a taxable income of $95,000, you and your spouse are in the 25 percent tax bracket.
Although most computer programs will automatically calculate the tax owed, it is helpful
to understand the process to calculate the tax due. (Note: For this example, we assume that
you received no other income at different rates, such as capital gains.)
To calculate the tax on a specific amount of income, you must calculate the tax from
each of the brackets as you progress up to your taxable income. (Note: This is the tax cal-
culated prior to additional credits or other taxes, such as self-employment tax.)
CALCULATIONS
1. If a person in a 28 percent tax bracket received a $1,000 tax deduction, how much would the person’s taxes be
reduced?
2. If a person in a 33 percent tax bracket received a $200 tax credit, how much would the person’s taxes be
reduced?
TAX CREDIT
$100 TAX CREDIT $100 TAX DEDUCTION
Reduces your taxes by $100
Reduces your taxable income by $100. The amount
of your tax reduction depends on your tax bracket.
Your taxes will be reduced by $15 if you are in the
15 percent tax bracket and by $28 if you are in the
28 percent tax bracket.
TAX DEDUCTION
15% tax bracket =
1
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ALTERNATIVE MINIMUM TAX Taxpayers with high amounts of certain deduc-
tions and various types of income may be subject to an additional tax. The alternative
minimum tax (AMT) is designed to ensure that those who receive tax breaks also pay their
fair share of taxes. The AMT was originally designed to prevent those with high incomes
from using special tax breaks to pay little in taxes. However, in recent years, this tax is
affecting increasing numbers of taxpayers. Some of the tax situations that can result in a
person paying the AMT include high levels of deductions for state and local taxes, interest
on second mortgages, medical expenses, and other deductions. Income items that can trig-
ger the AMT are incentive stock options, long-term capital gains, and tax-exempt interest.
Additional information about the AMT may be obtained at www.irs.gov .
TAX CREDITS The tax owed may be reduced by a tax credit , an amount subtracted
directly from the amount of taxes owed. One example of a tax credit is the credit given for
child care and dependent care expenses. Another tax credit for low-income workers is the
earned-income credit (EIC), for working parents with taxable income under a certain
amount. Families that do not earn enough to owe federal income taxes are also eligible for
the EIC and receive a check for the amount of their credit. A tax credit differs from a
deduction in that a tax credit has a full dollar effect in lowering taxes, whereas a deduction
reduces the taxable income on which the tax liability is computed.
Recent tax credits also included:
• Foreign tax credit to avoid double taxation on income taxes paid to another country.
• Savers credit (formerly the retirement tax credit) to encourage investment
contributions to individual and employer-sponsored retirement plans by low- and
middle-income taxpayers.
• Adoption tax credit to cover expenses when adopting a child under age 18.
• Education credits to help offset college education expenses.
Step 4: Making Tax Payments
You pay federal income taxes through either payroll withholding or estimated tax payments.
WITHHOLDING The pay-as-you-go system requires an employer to deduct federal
income tax from your pay. The withheld amount is based on the number of exemptions
and the expected deductions claimed. For example, a married person with children would
have less withheld than a single person with the same salary, since the married person will
owe less tax.
tax credit An amount
subtracted directly from the
amount of taxes owed.
Tax Due for Married Filing Jointly ($95,000 taxable income)
10% Bracket
15% Bracket
25% Bracket
• Range of income ($0 –$18,150)
• $18,150 x 10% = $1,815
• Range of income ($18,150 –$73,800)
• $55,650 x 15% = $8,348
• Range of income ($73,800 –$95,000)
• $21,200 x 25% = $5,300
• Total tax due (all brackets)
• $1,815 + $8,348 + $5,300 = $15,463
Total Tax Due
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84 Chapter 3 Taxes in Your Financial Plan
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After the end of the year, you will receive a W-2 form, which
reports your annual earnings and the amounts deducted for
taxes. The difference between the amount withheld and the tax
owed is either the additional amount to pay or your refund. Stu-
dents and low-income individuals may file for exemption from
withholding if they paid no federal income tax last year and do
not expect to pay any in the current year.
Many taxpayers view an annual tax refund as a “windfall,” extra
money they count on each year. These taxpayers are forgetting the
opportunity cost of withholding excessive amounts. Others view
their extra tax withholding as “forced savings.” This is giving the
government a free loan. A payroll deduction plan for savings could
serve the same purpose while also earning interest on your funds.
ESTIMATED PAYMENTS Income from savings, investments, independent con-
tracting, royalties, and pension payments is reported on Form 1099. People who receive
such income may be required to make tax payments during the year (April 15, June 15,
September 15, and January 15 as the last payment for the previous tax year). These pay-
ments are based on an estimate of taxes due at year-end. Underpayment or failure to make
estimated payments can result in penalties and daily interest charges.
Step 5: Deadlines and Penalties
Most people are required to file a federal income tax return by April 15. If you are not able
to file on time, you can use Form 4868 to obtain an automatic six-month extension.
This extension is for the 1040 form and other documents, but it does not delay your
payment liability. You must submit the estimated amount owed along with Form 4868 by
April 15. Failure to file on time can result in a penalty for being just one day late. Underpay-
ment of quarterly estimated taxes may require paying interest on the amount you should have
paid. Underpayment due to negligence or fraud can result in penalties of 50 to 75 percent.
The good news is that if you claim a refund several months or years late, the IRS will
pay you interest. However, refunds must be claimed within three years of filing the return
or within two years of paying the tax.
did you know? did you know?
Each year more than 90,000 taxpayers do
not receive their refunds. The undeliverable
checks total over $60 million, an average of more than
$600 per check. These refund checks were returned
by the post office because it was unable to deliver
them. Taxpayers due a refund may contact the IRS at
1-800-829-1040 or go to www.irs.gov and click on
the “Where’s my refund?” link.
PRACTICE QUIZ 3–2 PRACTICE QUIZ 3–2
1. How does tax-exempt income differ from tax-deferred income?
2. When would you use the standard deduction instead of itemized deductions?
3. What is the difference between your marginal tax rate and your average tax rate?
4. For each of the following, indicate if the item is a tax deduction or a tax credit.
a. State personal income taxes paid
b. Charitable donations
c. Expenses for adopting a baby
d. Moving expenses
Apply Yourself! Apply Yourself!
Using library resources or an online search, determine the amounts that are eligible for education credits for the current year.
Sheet 9 Federal Income Tax Estimate S
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Chapter 3 Taxes in Your Financial Plan 85
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Filing Your Federal Income Tax Return
As you prepare to do your taxes, you must first determine whether you are required to file
a return. Next, you need to decide which tax form best serves you and if you are required
to submit supplementary schedules or forms.
Who Must File?
Every citizen or resident of the United States and every U.S. citizen who is a resident of
Puerto Rico is required to file a federal income tax return if his or her income is above a
certain amount. The amount is based on the person’s filing status and other factors such as
age. For example, single persons under 65 had to file a return on April 15, 2014 (for tax
year 2013) if their gross income exceeded $10,000. If your gross income is less than this
amount but taxes were withheld, you should file a return to obtain your refund. Also, if you
can be claimed as a dependent, the income limits are lower.
Your filing status is affected by marital status and dependents. The five filing status
categories are:
• Single —never-married, divorced, or legally separated individuals with no
dependents.
• Married, filing joint return —combines the spouses’ incomes.
• Married, filing separate returns —each spouse is responsible for his or her own tax;
under certain conditions, a married couple can benefit from this filing status.
• Head of household —an unmarried individual or a surviving spouse who maintains
a household (paying for more than half of the costs) for a
child or a dependent relative.
• Qualifying widow or widower —an individual whose
spouse died within the past two years and who has a
dependent; this status is limited to two years after the
death of the spouse.
In some situations, you may have a choice of filing status. In
such cases, compute your taxes under the alternatives to deter-
mine the most advantageous filing status.
Which Tax Form Should You Use?
Although about 800 federal tax forms and schedules exist, you have a choice of three
basic forms when filing your income tax (see “Personal Finance in Practice” following).
Recently about 20 percent of taxpayers used Form 1040EZ or Form 1040A; about 60 per-
cent used the regular Form 1040. Your decision in this matter will depend on your type of
income, the amount of your income, the number of your deductions, and the complexity of
your tax situation. Most tax preparation software programs will guide you in selecting the
appropriate 1040 form.
Completing the Federal Income Tax Return
The major sections of Form 1040 (see Exhibit 3–3 ) correspond to tax topics discussed in
the previous sections of this chapter:
1. Filing status and exemptions. Your tax rate is determined by your filing status and
allowances for yourself, your spouse, and each person you claim as a dependent.
2. Income. Earnings from your employment (as reported by your W-2 form) and other
income, such as savings and investment income, are reported in this section of
Form 1040.
ACTION ITEM
I know the basics of
preparing a federal income
tax return.
h Yes h No
LO3.3
Prepare a federal income tax
return.
did you know? did you know?
For determining your filing status: If you get
married on December 31, you are considered
married for the entire year. The reverse is also
true. If you get divorced by December 31, you are
considered single for the entire year.
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FORM 1040A
This form would be used by people who have less than
$100,000 in taxable income from wages, salaries, tips,
unemployment compensation, interest, or dividends and
use the standard deduction. With Form 1040A, you can
also take deductions for individual retirement account
(IRA) contributions and a tax credit for child care and
dependent care expenses. If you qualify for either Form
1040EZ or Form 1040A, you may wish to use one of them
to simplify filing your tax return. You may not want to
use either the Form 1040EZ or Form 1040A if Form 1040
allows you to pay less tax.
FORM 1040EZ
You may use Form 1040EZ if:
• You are single or married filing a joint return, under
age 65, and claim no dependents.
• Your income consisted only of wages, salaries, and
tips and not more than $1,500 of taxable interest.
• Your taxable income is less than $100,000.
• You do not itemize deductions or claim any
adjustments to income or any tax credits.
Personal Finance in Practice
FORM 1040
Form 1040 is an expanded version of Form 1040A that
includes sections for all types of income. You are required
to use this form if your income is over $100,000 or if you
can be claimed as a dependent on your parents’ return
and you had interest or dividends over a set limit.
Form 1040 allows you to itemize your deductions. You
can list various allowable expenses (medical costs, home
mortgage interest, real estate property taxes) that will
reduce taxable income and the amount you owe the gov-
ernment. You should learn about all the possible adjust-
ments to income, deductions, and tax credits for which
you may qualify.
FORM 1040X
This form is used to amend a previously filed tax return. If you discover income that was not reported, or if you find addi-
tional deductions, you should file Form 1040X to pay the additional tax or obtain a refund.
86
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3. Adjustments to income. As discussed later in the chapter, if you qualify, you may
deduct contributions (up to a certain amount) to an individual retirement account
(IRA) or other qualified retirement program.
4. Tax computation. In this section, your adjusted gross income is reduced by your
itemized deductions (see Exhibit 3–4 ) or by the standard deduction for your tax
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Chapter 3 Taxes in Your Financial Plan 87
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situation. In addition, an amount is deducted for each exemption to arrive at your
taxable income. That income is the basis for determining the amount of your tax
(see Exhibit 3–5 ).
5. Tax credits. Any tax credits for which you qualify are subtracted at this point.
6. Other taxes. Any special taxes, such as self-employment tax, are included at this
point.
7. Payments. Your total withholding and other payments are indicated in this section.
8. Refund or amount you owe. If your payments exceed the amount of income tax
you owe, you are entitled to a refund. If the opposite is true, you must make an
additional payment. Taxpayers who want their refunds sent directly to a bank
can provide the necessary account information directly on Form 1040, 1040A, or
1040EZ.
Changing economic and political environments often result in new tax
regulations, some of which may be favorable for you while others are not. An
important element of tax planning is your refund. Each year, more than 90 million
American households receive an average tax refund of over $2,500 for a total of
over $225 billion. Invested at 5 percent for a year, these refunds represent about
Exhibit 3–3 Federal Income Tax Return—Form 1040
3.
Adjusted gross
income results
from certain
deductions and
will be used as a
basis for
computing other
deductions.
1.
Your marriage
and household
situation will
affect your
taxable income
and tax rate.
2.
Your earnings
and other
sources of
income will be
reported in this
section.
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88 Chapter 3 Taxes in Your Financial Plan
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n$11.25 billion in lost earnings. By having less withheld and obtaining a smaller
refund, you can save and invest these funds for your benefit during the year.
9. Your signature. Forgetting to sign a tax return is one of the most frequent filing
errors.
How Do I File My State Tax Return?
All but seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyo-
ming) have some type of state income tax. In most states, the tax rate ranges from 1 to
10 percent. For further information about the income tax in your state, contact the state
department of revenue. States usually require income tax returns to be filed when the fed-
eral income tax return is due. For planning your tax activities, see Exhibit 3–6 .
How Do I File My Taxes Online?
Software packages such as H&R Block At Home and TurboTax allow you to complete
needed tax forms and schedules and either print for mailing or file online. Electronic filing
of federal taxes now exceeds 113 million returns annually. With e-file, taxpayers usually
5.
Tax credits are
deducted at
this point.
7.
The federal
income tax you
have had
withheld or
payments you
have made are
recorded here.
4.
In this section,
you subtract
your itemized
deductions or
the standard
deduction and
exemptions to
obtain taxable
income; your tax
is based on the
tax tables or
schedule.
6.
Any additional
taxes owed
are added at
this point.
8.
Your total tax
is compared to
your total
payments to
determine your
refund or
amount due.
9.
Don’t forget to
sign the form
and your
check!!
NOTE: These forms were used in a recent year; the current forms may not be exactly the same. Obtain current income tax forms and current tax
information from your local IRS office, select post offices and libraries, or at www.irs.gov .
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receive their refunds within three weeks. The cost for this service is usually between $15
and $40 and in some cases will be $0.
TAX PREPARATION SOFTWARE Today, most taxpayers use computers or
online products for tax recordkeeping and tax form preparation. A spreadsheet program (or
app) can be helpful in maintaining and updating income and expense data.
Using tax software can save you time when preparing your Form 1040 and accompany-
ing schedules. When selecting tax software, consider the following factors:
1. Your personal situation—are you employed or do you operate your own business?
2. Special tax situations with regard to types of income, unusual deductions, and
various tax credits.
3. Features in the software, such as “audit check,” future tax planning, and filing your
federal and state tax forms online.
4. Technical aspects, such as the hardware and operating system requirements, and
online support that is provided.
Exhibit 3–4 Schedule A for Itemized Deductions—Form 1040
Certain other
taxes may be
deducted.
Health care
expenses (not
covered by
insurance) are
listed here, but
must exceed
10% of adjusted
gross income to
be deductible.
Deductible
interest
payments are
listed here.
A variety of
other expenses
may qualify
under these
deduction
categories.
Donations and
charitable
contributions
are reported
here.
The total of
your itemized
deductions is
transferred to
Form 1040 in
the “Tax
Computation”
section.
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90 Chapter 3 Taxes in Your Financial Plan
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ELECTRONIC FILING In recent years, the IRS has made online filing easier and
less expensive. Through the Free File Alliance, online tax preparation and e-filing are avail-
able free to millions of taxpayers. This partnership between the IRS and the tax software
industry encourages more e-filing. The online filing process involves the following steps:
Step 1 Go to www.irs.gov and click “Free File” in the “Filing and Payment” section.
Step 2 The initial IRS webpage gives guidance regarding the process. Your eligi bility
for Free File is based on your income level. You can click on a Free File company to
begin your tax return. You should determine your eligibility with a particular company.
A brief description of the criteria for each is provided. A “How to use Free File” option
is also available to help you understand the process.
Step 3 Next, connect to the chosen company’s website to begin the preparation of
your tax return.
Step 4 Finally, use the company’s online software to prepare your return. Your
federal tax return is then filed electronically and your tax data are stored at the ven-
dor’s site. Taxpayers who do not qualify for the Free File Alliance program may still
be able to file online for a nominal fee or use fillable forms.
You don’t have to purchase the software; simply go to the
software company’s Internet site and pay a fee to use the tax
program.
Taxpayers who use the Free File Alliance are cautioned to
be careful consumers. A company may attempt to sell other
financial products to inexperienced taxpayers, such as expen-
sive refund anticipation loans. Also, taxpayers using the Free
File service must be aware that their state tax return might not
be included in the free program.
Exhibit 3–5 Tax Tables and Tax Rate Schedules
97,000
97,050
97,100
97,150
97,200
97,250
97,300
97,350
97,400
97,450
97,500
97,550
97,600
97,650
97,700
97,750
97,800
97,850
97,900
97,950
97,050
97,100
97,150
97,200
97,250
97,300
97,350
97,400
97,450
97,500
97,550
97,600
97,650
97,700
97,750
97,800
97,850
97,900
97,950
98,000
20,460
20,474
20,488
20,502
20,516
20,530
20,544
20,558
20,572
20,586
20,600
20,614
20,628
20,642
20,656
20,670
20,684
20,698
20,712
20,726
16,114
16,126
16,139
16,151
16,164
16,176
16,189
16,201
16,214
16,226
16,239
16,251
16,264
16,276
16,289
16,301
16,341
16,326
16,339
16,351
20,900
20,914
20,928
20,942
20,956
20,970
20,984
20,998
20,012
20,026
20,040
20,054
20,068
20,082
20,096
20,110
20,124
20,138
20,152
20,166
18,759
18,771
18,784
18,796
18,809
18,821
18,834
18,846
18,859
18,871
18,884
18,896
18,909
18,921
18,934
18,946
18,959
18,971
18,984
18,996
17,850
$0
If your taxable
income is:
Over—
But not
over—
of the
amount
over—
The tax is:
72,500
146,400
223,050
398,350
72,500
$17,850
146,400
223,050
398,350
450,000
…………. 10%
17,850
$0
72,500
146,400
223,050
398,350
97,000
Schedule Y-1— If your filing status is Married filing jointly or Qualifying widow(er)
$1,785.00 + 15%
9,982.50 + 25%
27,457.50 + 28%
49,919.50 + 33%
107,768.50 + 35%
450,000 …………. 450,000125,856 + 39.6%
NOTE: These were the federal income tax rates for 2013 that are used for illustrative purposes for the tax return included in the chapter exhibits. Current
rates may vary due to changes in the tax code and adjustments for inflation. Obtain current income tax booklets from www.irs.gov .
did you know? did you know?
Electronically filed federal income tax
returns have an accuracy rate of 99 percent,
compared to 81 percent for paper returns. Most
electronic filing programs do your calculations
and signal potential errors before you file.
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What Tax Assistance Sources Are Available?
As with other aspects of personal financial planning, many tax resources are available to
assist you.
IRS SERVICES If you prepare your own tax return or
desire tax information, the IRS can assist in seven ways:
1. Publications. The IRS offers hundreds of free booklets
and pamphlets that can be obtained at a local IRS office,
by mail request, by telephone, or downloaded. Especially
helpful is Your Federal Income Tax (IRS Publication 17).
IRS publications and tax forms are available by phone at
1-800-TAX-FORM or online at www.irs.gov .
Exhibit 3–6
Tax-Planner Calendar
• Make any last-minute changes
in withholding by your
employer to avoid penalties for
too little withholding.
• Determine if you qualify for an
IRA; if so, consider opening one.
• If you haven’t already, prepare
a preliminary tax form to
determine the most
advantageous filing status.
November
• Establish a recordkeeping
system for your tax
information.
• If you expect a refund, file
your tax return for the
previous year.
• Make your final estimated
quarterly payment for the
previous year for income
not covered by withholding.
January
• April 15 is the deadline
for filing your federal tax
return; if it falls on a
weekend, you have until
the next business day
(usually Monday).
• If necessary, file for an
automatic extension for
filing your tax forms.
April
• With the year half over,
consider or implement
plans for a personal
retirement program such
as an IRA or a Keogh plan.
July
• Determine the tax benefits of
selling certain investments by
year-end.
• Prepare a preliminary tax form
to determine the most
advantageous filing status.
• Tax returns are due October 15
for those who received the
automatic six-month extension.
October
• The third installment
for estimated tax is
due September 15 for
income not covered by
withholding.
September
• Determine if it would be
to your advantage to
make payments for next
year before December 31
of the current year.
• Decide if you can defer
income for the current year
until the following year.
December
• Tax returns are due
August 15 for those who
received the automatic
four-month extension.
• Determine if you qualify
for an IRA; if so, consider
opening one.
August
• Review your tax return
to determine whether any
changes in withholding,
exemptions, or marital
status have not been
reported to your
employer.
May
• The second installment
for estimated tax is due
June 15 for income not
covered by withholding.
June
• Check to make sure you
received W-2 and 1099
forms from all
organizations from which
you had income during the
previous year; these
should have been
received by January
31. If not, contact
the organization.
February
• Organize your records
and tax information in
preparation for filing
your tax return; if you
expect a refund, file as
soon as possible.
March
NOTE: Children born before the end of the year give you a full-year exemption, so plan accordingly!
digi – know? digi – know?
The The irs.govirs.gov website ranks in the top website ranks in the top
100 U.S. websites. In 2013, total visits 100 U.S. websites. In 2013, total visits
were over 318 billion. were over 318 billion.
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92 Chapter 3 Taxes in Your Financial Plan
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2. Recorded messages. The IRS Tele-Tax system gives you 24-hour access to about
150 recorded tax tips at 1-800-829-4477.
3. Phone hotline. Information about specific problems is available through an IRS-
staffed phone line at 1-800-829-1040.
4. Walk-in service. You can visit a local IRS office (400 are available) to obtain tax
assistance.
5. Interactive tax assistant. The IRS has developed a query-based interactive tool that
allows taxpayers to get answers for basic and advanced questions.
6. DVD. The IRS also sells a DVD with over 2,000 tax forms, publications, and FAQs.
7. IRS2Go App. This tool provides options for checking your refund status, requesting
tax records, locating free tax prep help, and other interactive tools.
TAX PUBLICATIONS Each year, several tax guides are published and offered for
sale. Publications such as J.K. Lasser’s Your Income Tax and The Ernst & Young Tax Guide
can be purchased online or at local stores. The IRS also offers Publication 17, Your Federal
Income Tax (for Individuals), which is a free resource.
THE INTERNET As with other personal finance topics, extensive information may be
found on websites such as those mentioned earlier. Be sure to access reliable websites and
print information for your records.
Tax Preparation Services
Over 40 million U.S. taxpayers pay someone to do their income taxes. The fee for this
service can range from $40 at a tax preparation service for a simple return to more than
$2,000 to a certified public accountant for a complicated return.
TYPES OF TAX SERVICES Doing your own taxes may not be desirable, espe-
cially if you have sources of income other than salary. The sources available for profes-
sional tax assistance include the following:
• Tax services range from local, one-person operations to national firms with
thousands of offices, such as H&R Block.
• Enrolled agents—government-approved tax experts—prepare returns and provide
tax advice. You may contact the National Association of Enrolled Agents at 1-800-
424-4339 for information about enrolled agents in your area.
• Many accountants offer tax assistance along with other business services. A
certified public accountant (CPA) with special training in taxes can help with tax
planning and the preparation of your annual tax return.
• Attorneys usually do not complete tax returns; however, you can use an attorney’s
services when you are involved in a tax-related transaction or when you have a
difference of opinion with the IRS.
EVALUATING TAX SERVICES When planning to use a tax preparation service,
consider these factors:
• What training and experience does the tax professional possess?
• How will the fee be determined? (Avoid preparers who earn a percentage of your
refund.)
• Does the preparer suggest you report various deductions that might be questioned?
• Will the preparer represent you if your return is audited?
• Is tax preparation the main business activity, or does it serve as a front for selling
other financial products and services?
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Additional information about tax preparers may be obtained
at the websites for the National Association of Enrolled Agents
( www.naea.org ) and the National Association of Tax Profes-
sionals ( www.natptax.com ).
TAX SERVICE WARNINGS Even if you hire a profes-
sional tax preparer, you are responsible for supplying accurate
and complete information. Hiring a tax preparer will not guar-
antee that you pay the correct amount. A study conducted by
Money magazine of 41 tax preparers reported fees ranging from
$375 to $3,600, with taxes due ranging from $31,846 to $74,450
for the same fictional family. If you owe more tax because your
return contains errors or you have made entries that are not
allowed, you are responsible for paying that additional tax, plus
any interest and penalties.
Beware of tax preparers and other businesses that offer your
refund in advance. These “refund anticipation loans” frequently
charge very high interest rates for this type of consumer credit. Studies reveal interest rates
sometimes exceeding 300 percent (on an annualized basis).
What If Your Return Is Audited?
The Internal Revenue Service reviews all returns for completeness and accuracy. If you
make an error, your tax is automatically refigured and you receive either a bill or a refund.
If you make an entry that is not allowed, you will be notified by mail. A tax audit is a
detailed examination of your tax return by the IRS. In most audits, the IRS requests more
information to support your tax return. Be sure to keep accurate records. Receipts, can-
celed checks, and other evidence can verify amounts that you claim. Avoiding common
filing mistakes helps to minimize your chances of an audit (see Exhibit 3–7 ).
tax audit A detailed
examination of your tax
return by the Internal
Revenue Service.
did you know? did you know?
Volunteer Income Tax Assistance Volunteer Income Tax Assistance
(VITA) offers free tax help to low- and (VITA) offers free tax help to low- and
moderate-income taxpayers who cannot moderate-income taxpayers who cannot
prepare their own tax returns. Certified prepare their own tax returns. Certified
volunteers provide this service at com-volunteers provide this service at com-
munity centers, libraries, schools, shopping munity centers, libraries, schools, shopping
malls, and other locations. Most locations malls, and other locations. Most locations
also offer free electronic filing. To locate also offer free electronic filing. To locate
the nearest VITA site, call 1-800-906-9887. the nearest VITA site, call 1-800-906-9887.
• Organize all tax-related information for easy access.
• Follow instructions carefully. Many people deduct total medical and dental expenses rather than the amount of these expenses
that exceeds 10 percent of adjusted gross income. The AGI threshold is 7.5 percent of your AGI if you or your spouse is age 65
or older. This will apply through December 31, 2016.
• Use the proper tax rate schedule or tax table column.
• Be sure to claim the correct number of exemptions and correct amounts of standard deductions.
• Consider the alternative minimum tax that may apply to your situation. Be sure to pay self-employment tax and tax on early IRA
withdrawals.
• Check your math several times. Also check behind the tax software to ensure accuracy.
• Sign your return (both spouses must sign a joint return), or the IRS won’t process it.
• Be sure to include the correct Social Security number(s) and to record amounts on the correct lines.
• Attach necessary documentation such as your W-2 forms and required supporting schedules.
• Make the check payable to “United States Treasury.”
• Put your Social Security number, the tax year, and a daytime telephone number on your check—and be sure to sign the check!
• Keep a photocopy of your return.
• Put the proper postage on your mailing envelope.
• Finally, check everything again—and file on time!
Exhibit 3–7 How to Avoid Common Filing Errors
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94 Chapter 3 Taxes in Your Financial Plan
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WHO GETS AUDITED? About 1 percent of all tax filers—fewer than 1.5 mil-
lion people—are audited each year. Although the IRS does not reveal its basis for audit-
ing returns, several indicators are evident. People who claim large or unusual deductions
increase their chances of an audit. Tax advisors suggest including a brief explanation or a
copy of receipts for deductions that may be questioned.
TYPES OF AUDITS The simplest and most frequent type of audit is the correspon-
dence audit. This mail inquiry requires you to clarify or document minor questions. The
office audit requires you to visit an IRS office to clarify some aspect of your tax return.
The field audit is more complex. An IRS agent visits you at your home, your business,
or the office of your accountant to have access to your records. A field audit may be done
to verify whether an individual has a home office if this is claimed.
The IRS also conducts more detailed audits for about 50,000 taxpayers. These range from
random requests to document various tax return items to line-by-line reviews by IRS employees.
YOUR AUDIT RIGHTS When you receive an audit notice, you have the right to
request time to prepare. Also, you can ask the IRS for clarification of items being ques-
tioned. When audited, follow these suggestions:
• Decide whether you will bring your tax preparer, accountant, or lawyer.
• Be on time for your appointment; bring only relevant documents.
• Present tax evidence in a logical, calm, and confident manner; maintain a positive
attitude.
• Make sure the information you present is consistent with the tax law.
• Keep your answers aimed at the auditor’s questions. Answer questions clearly and
completely. Be as brief as possible. The five best responses to questions during
an audit are “Yes,” “No,” “I don’t recall,” “I’ll have to check on that,” and “What
specific items do you want to see?”
If you disagree with the results of an audit, you may request a conference at the Regional
Appeals Office. Although most differences of opinion are settled at this stage, some tax-
payers take their cases further. A person may go to the U.S. tax court, the U.S. claims
court, or the U.S. district court. Some tax disputes have gone to the U.S. Supreme Court.
PRACTICE QUIZ 3–3 PRACTICE QUIZ 3–3
1. In what ways does your filing status affect preparation of your federal income tax return?
2. What are the main sources available to help people prepare their taxes?
3. What actions can reduce the chances of an IRS audit?
4. Which 1040 form should each of the following individuals use? (Check one for each situation.)
Tax situation 1040EZ 1040A 1040
a. A high school student with an after-school job and interest
earnings of $480 from savings accounts.
b. A college student who, because of ownership of property, is able
to itemize deductions rather than take the standard deduction.
c. A young, entry-level worker with no dependents and income only
from salary.
Apply Yourself! Apply Yourself!
Compare tax services (and providers) in your area and online.
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Tax Planning Strategies
For people to pay their fair share of taxes—no more, no less—they should practice tax
avoidance, the use of legitimate methods to reduce one’s taxes. In contrast, tax evasion is
the use of illegal actions to reduce one’s taxes. To minimize taxes owed, follow these
guidelines:
• If you expect to have the same or a lower tax rate next year, accelerate deductions
into the current year. Pay real estate property taxes or make charitable donations by
December 31.
• If you expect to have a lower or the same tax rate next year, delay the receipt of
income until next year so the funds will be taxed at a lower rate or at a later date.
• If you expect to have a higher tax rate next year, consider delaying deductions,
since they will have a greater benefit. A $1,000 deduction at 25 percent lowers your
taxes $250; at 28 percent, your taxes are lowered $280.
• If you expect to have a higher tax rate next year, accelerate the receipt of income to
have it taxed at the current lower rate.
When considering financial decisions in relation to your taxes, remember that purchasing,
investing, and retirement planning are the areas most heavily affected by tax laws.
Consumer Purchasing
The buying decisions most directly affected by taxes are the purchase of a residence, the
use of credit, and job-related expenses.
PLACE OF RESIDENCE Owning a home is one of the best tax shelters. Both real
estate property taxes and interest on the mortgage are deductible (as itemized deductions)
and thus reduce your taxable income.
CONSUMER DEBT Current tax laws allow homeowners to borrow for consumer
purchases. You can deduct interest on loans (of up to $100,000) secured by your primary
or secondary home up to the actual dollar amount you have invested in it—the difference
between the market value of the home and the amount you owe on it. These home equity
loans, which are second mortgages, allow you to use that line of credit for various pur-
chases. Some states place restrictions on home equity loans.
JOB-RELATED EXPENSES As previously mentioned, certain work expenses,
such as union dues, some travel and education costs, business tools, and job search
expenses (even if you were not successful), may be included as itemized deductions.
HEALTH CARE EXPENSES Flexible spending accounts (FSAs), also called
health savings accounts and expense reimbursement accounts, allow you to reduce your
taxable income when paying for medical expenses or child care costs. Workers are allowed
to put pretax dollars into these employer-sponsored programs. These “deposits” result in a
lower taxable income. Then, the funds in the FSA may be used to pay for various medical
expenses and dependent care costs.
Investment Decisions
A major area of tax planning involves decisions related to investing.
TAX-EXEMPT INVESTMENTS Interest income from municipal bonds, which
are issued by state and local governments, and other tax-exempt investments is not sub-
ject to federal income tax. Although municipal bonds have lower interest rates than other
investments, the tax-equivalent income may be higher. For example, if you are in the
tax avoidance The use of
legitimate methods to reduce
one’s taxes.
tax evasion The use of
illegal actions to reduce one’s
taxes.
LO3.4
Select appropriate tax
strategies for various life
situations.
ACTION ITEM
I understand tax strategies
for now and in the future.
h Yes h No
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capital gain (assets held for less than a year). However,
that same taxpayer would pay only $225 on the $1,500 (a
15 percent capital gains tax) if the investment were held for
more than a year.
You will pay a lower tax rate on the profits from stocks
and other investments if you hold the asset for more than
12 months. As of 2014, a taxpayer in the 28 percent tax
bracket would pay $420 in taxes on a $1,500 short-term
Short-Term and Long-Term Capital Gains Short-Term and Long-Term Capital Gains
Figure It Out!
35 percent tax bracket, earning $100 of tax-exempt income would be worth more to you
than earning $150 in taxable investment income. The $150 would have an after-tax value
of $97.50—$150 less $52.50 (35 percent of $150) for taxes.
TAX-DEFERRED INVESTMENTS Although tax-deferred investments, with
income taxed at a later date, are less beneficial than tax-exempt investments, they give
you the advantage of paying taxes in the future rather than now. Examples of tax-deferred
investments include:
• Tax-deferred annuities, usually issued by insurance companies. These investments
are discussed in Chapter 10.
• Section 529 savings plans are state-run, tax-deferred plans to set aside money for
a child’s education. The 529 is a savings plan to help families set aside funds for
future college costs. The 529 plans differ from state to state.
• Retirement plans such as IRA, Keogh, or 401(k) plans. The next section discusses
the tax implications of these plans.
Capital gains , profits from the sale of a capital asset such as stocks, bonds, or real estate,
are also tax-deferred; you do not have to pay the tax on these profits until the asset is sold.
In recent years, long-term capital gains (on investments held more than a year) have been
taxed at a lower rate. See the nearby “Figure It Out!” box for an example.
The sale of an investment for less than its purchase price is, of course, a capital loss.
Capital losses can be used to offset capital gains and up to $3,000 of ordinary income.
Unused capital losses may be carried forward into future years to offset capital gains or
ordinary income up to $3,000 per year.
SELF-EMPLOYMENT Owning your own business can have tax advantages.
Self-employed persons may deduct expenses such as health and certain life insurance as
business costs. However, business owners have to pay self-employment tax (Social Secu-
rity) in addition to the regular tax rate.
CHILDREN’S INVESTMENTS A child under 18, or a full-time student under 24,
with investment income of more than $2,000 is taxed at the parent’s top rate. For investment
capital gains Profits from
the sale of a capital asset
such as stocks, bonds, or
real estate.
Short-Term Capital Gain
(assets held less than a year)
Long-Term Capital Gain
(assets held a year or more)
Capital gain $1,500 $1,500
Capital gains tax rate 28% 15%
Capital gains tax $420 $225
Tax savings $195 ($420 2 $225)
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income under $2,000, the child receives a deduction of $1,000 and the next $1,000 is taxed
at his or her own rate, which is probably lower than the parent’s rate.
Retirement and Education Plans
A major tax strategy of benefit to working people is the use of tax-deferred retirement plans
such as individual retirement accounts (IRAs), Keogh plans, and 401(k) plans. Another tax
strategy involves the use of education savings plans such as Coverdell Education Savings
Accounts or 529 plans.
TRADITIONAL IRA The regular IRA deduction is available only to people who
do not participate in employer-sponsored retirement plans or who have an adjusted gross
income under a certain amount. As of 2014, the IRA contribution limit was $5,500. Older
workers, age 50 and over, were allowed to contribute up to $6,500 as a “catch up” to make
up for lost time saving for retirement.
In general, amounts withdrawn from deductible IRAs are included in gross income.
An additional 10 percent penalty is usually imposed on withdrawals made before age 59½
unless the withdrawn funds are on account of death or disability, for medical expenses, or
for qualified higher education expenses.
ROTH IRA The Roth IRA also allows a $5,500 (2014) annual contribution, which is
not tax-deductible; however, the earnings on the account are tax-free after five years. The
funds from the Roth IRA may be withdrawn before age 59½ if the account owner is dis-
abled, or for the purchase of a first home ($10,000 maximum). Like the regular IRA, the
Roth IRA is limited to people with an adjusted gross income under a certain amount.
Deductible IRAs provide tax relief up front as contributions reduce current taxes. How-
ever, taxes must be paid when the withdrawals are made from the deductible IRA. In contrast,
the Roth IRA does not have immediate benefits, but the investment grows in value on a tax-
free basis. Withdrawals from the Roth IRA are exempt from federal and state taxes.
KEOGH PLAN If you are self-employed and own your own business, you can establish
a Keogh plan. This retirement plan, also called an HR10 plan, may combine a profit-sharing
plan and a pension plan of other investments purchased by the employee. In general, with
a Keogh people may contribute 25 percent of their annual income, up to a maximum of
$52,000 (in 2014), to this tax-deferred retirement plan.
401(K) PLAN The part of the tax code called 401(k) authorizes a tax-deferred retire-
ment plan sponsored by an employer. This plan allows you to contribute a greater tax-
deferred amount ($17,500 in 2014) than you can contribute to an IRA. Older workers,
age 50 and over, may be allowed to contribute an additional $5,500 if their employer
allows. However, most companies set a limit on your contribution, such as 15 percent of
your salary. Some employers provide a matching contribution in their 401(k) plans. For
example, a company may contribute 50 cents for each $1 contributed by an employee. This
results in an immediate 50 percent return on your investment.
Tax planners advise people to contribute as much as possible to a Keogh or 401(k) plan
since (1) the increased value of the investment accumulates on a tax-free basis until the
funds are withdrawn and (2) contributions reduce your adjusted gross income for comput-
ing your current tax liability.
COVERDELL EDUCATION SAVINGS ACCOUNT This account is designed
to assist parents in saving for the education of their children. Withdrawals can be used for
a variety of educational uses for kindergarten through college-age students. Once again,
the annual contribution (limited to $2,000) is not tax-deductible and is limited to taxpayers
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with an adjusted gross income under a certain amount. However, as with the Roth IRA, the
earnings accumulate tax-free.
529 PLAN The 529 plan is an education savings plan that helps parents save for the
college education of their children. Almost every state has a 529 plan available. There is
no federal tax deduction, but the earnings grow tax-free and there are no taxes when the
money is taken out of the account for qualified education expenses. Many states allow their
residents to deduct contributions to their state plans up to a specified maximum.
Changing Tax Strategies
Each year, the tax code includes a myriad of changes. In the past few years, there have been
debates over what types of tax reform would allow the U.S. economy to recover, how to
avoid the “fiscal cliff,” and how to stimulate economic growth. Congress frequently passes
legislation that changes the tax code. These changes require that you regularly determine
how to best take advantage of the tax laws for personal financial planning.
Recent tax changes have included the following:
• Advanced (premium) tax credit was initiated. This offers someone buying insurance
through the health care exchanges an opportunity to reduce their premiums paid.
If they do not get the full credit when they pay the premium, the difference will be
available as a refundable tax credit at tax time.
• Penalties will be assessed for those who do not have health insurance. These
penalties will be levied through a program with the IRS. Taxpayers will soon have
to provide proof of health insurance with their tax return to avoid the penalty.
• Teachers will no longer be able to deduct up to $250 for unreimbursed educational
expenses.
• Employers can now allow employees with health care flexible spending accounts to
carry over up to $500 of unused funds.
• Streamlined options are available for the home office deduction for small
businesses.
In addition to these and other recent tax changes, the IRS usually modifies the tax form
and filing procedures yearly, so be sure to carefully consider changes in your personal situ-
ation and your income level. Well-informed taxpayers monitor their personal tax strategies
to best serve daily living needs and to achieve long-term financial goals.
Flat or VAT Tax?
For many years, politicians have used tax reform as a platform to run for office. Some want
to increase tax deductions to provide for certain segments, while others want to find ways
to simplify the tax code. There is no denying that the tax code has become increasingly
complex. The number of words in the tax code has reportedly grown from 1.4 million to
more than 3.8 million in the last decade!
What are some options that are being proposed? First, a flat tax proposal has been
around for many years. This would require that all taxpayers, regardless of income level
and type, pay the same percentage. While seemingly relatively easy to implement, the
reality is that this would be an increase in overall tax for quite a few people. The other
alternative, a value-added tax (VAT), would add a tax to a product for each stage in the
manufacturing process. It is believed that higher-income individuals would pay higher
taxes since they are typically the larger consumers of goods. This has been implemented
in other countries. That said, the administrative process can be a challenge for each of the
companies involved in the process to remit the tax.
What do you think will happen to the tax code in 5 years? 10 years? 20 years?
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PRACTICE QUIZ 3–4 PRACTICE QUIZ 3–4
1. How does tax avoidance differ from tax evasion?
2. What common tax-saving methods are available to most individuals and households?
3. For the following tax situations, indicate if this item refers to tax-exempt income or tax-deferred income.
a. Interest earned on municipal bonds
b. Earnings on an individual retirement account
c. Education IRA earnings used for college expenses
d. Income of U.S. citizens working in another country
Apply Yourself! Apply Yourself!
Survey friends and relatives about their tax planning strategies. Do most people get a federal tax refund or owe taxes
each year? Is their situation (refund or payment) planned?
Sheet 10 Tax Planning Activities S
YOUR PERSONAL FINANCE DASHBOARD
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items”
(in the text margin) to determine actions you might
consider related to your tax planning activities.
Consider developing a system for organizing your tax
records. See Exhibit 3–2 for an example.
Become aware of what is taxable income and what
is deductible by using the “Personal Finance in
Practice” box, “Is It Taxable Income?”.
Obtain the latest federal income tax forms and
instructions, which are available at www.irs.gov. Infor-
mation about state income taxes may be obtained at
www.taxadmin.org.
Continually update your knowledge of income tax
changes to help you make better-informed financial
decisions. Ask several people about the actions they
take to stay informed and to reduce the amount paid
in taxes.
Another indicator of your financial health is your ability
to organize and prepare key documents to maximize
your tax situation. Whether you prepare your tax return
or take it to someone to prepare, you need to have all
of the key documents to pay your “fair share.” You also
need to monitor your tax situation throughout the year.
This means understanding your tax situation and being
aware of any changes.
YOUR SITUATION: Do you owe taxes each year?
Do you receive an excessive tax refund?
TA X R E F U N D O R U N D E R P A Y M E N T ?
L
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AL
L R
EFU
ND/SMALL AMOUNT OWED LARG
E A
M
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$2500 $2500
$1500 $1500
$2000 $2000
$1000 $1000
$0$500 $500
Owing taxes each year could lead to underpayment penalties. Receiving a large tax refund could be hampering your sav-
ings ability. Paying your “fair share” in a timely manner is one of the foundations for progress toward financial independence.
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LO3.1 Tax planning can infl uence spend-
ing, saving, borrowing, and investing deci-
sions. An awareness of income taxes, sales
taxes, excise taxes, property taxes, estate
taxes, inheritance taxes, gift taxes, and
Social Security taxes is vital for successful
fi nancial planning.
LO3.2 Taxable income is determined by
subtracting adjustments to income, deduc-
tions, and allowances for exemptions from
gross income. Your total tax liability is based
on the published tax tables or tax schedules,
less any tax credits.
LO3.3 The major sections of Form 1040
provide the basic framework for filing your
federal income tax return. The main sources
of tax assistance are IRS services and pub-
lications, other publications, the Internet,
computer software, and professional tax
preparers such as commercial tax services,
enrolled agents, accountants, and attorneys.
LO3.4 You may reduce your tax burden
through careful planning and making finan-
cial decisions related to consumer purchas-
ing, and the use of debt, investments, and
retirement planning.
Chapter
Summary
adjusted gross income
(AGI) 78
average tax rate 81
capital gains 96
earned income 78
estate tax 76
excise tax 75
exclusion 78
Key Terms
tax audit 93
tax avoidance 95
tax credit 83
tax deduction 78
tax-deferred income 78
tax evasion 95
tax-exempt income 78
tax shelter 78
exemption 80
inheritance tax 76
investment income 78
itemized deductions 78
marginal tax rate 81
passive income 78
standard deduction 78
taxable income 78
1. What factors might be considered when creating a tax that is considered fair by most
people in a society? (LO3.1)
2. What are the ethical implications of not paying your fair share of taxes? (LO3.1)
3. How might tax-exempt income and tax credits be used by government to stimulate
economic growth? (LO3.2)
4. What tax information sources would you be most likely to use? Why? (LO3.2)
5. Use IRS publications and other reference materials to answer a specific tax question.
Contact an IRS office to obtain an answer for the same question. What differences, if
any, exist between the information sources? (LO3.3)
6. What tax situation would cause a person who previously used Form 1040A to be
required to file Form 1040? (LO3.3)
7. What are some advantages of electronic filing? (LO3.3)
8. What are some tax advantages and disadvantages of owning your own business? (LO3.4)
Discussion
Questions
1. A person had $3,102 withheld for federal income taxes and had a tax liability of
$3,345. Would this be a refund or an additional amount due, and for what amount?
2. Based on the following information, what is the amount of taxable income?
Self-Test
Problems
Gross salary, $46,900
Dividend income, $160
Itemized deductions, $6,150
Interest earnings, $65
One personal exemption, $3,950
Solutions
1. To determine the amount of refund or additional tax due, compare the amount of tax
liability with the amount withheld. The $3,345 tax liability minus the $3,102 would
result in an amount due of $243.
2. Taxable income is calculated by adding salary, income, and dividends, and then sub-
tracting itemized deductions and exemptions:
$46,900 1 $65 1 $160 2 $3,950 2 $6,150 5 $37,025
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What amount would Daniel report as taxable income? (LO3.2)
2. If Samantha Jones had the following itemized deductions, should she use Schedule A or
the standard deduction? The standard deduction for her tax situation is $6,200. (LO3.2)
Donations to church and other charities, $3,050
Medical and dental expenses exceeding 10 percent of adjusted gross income, $450
State income tax, $920
Job-related expenses exceeding 2 percent of adjusted gross income, $1,450
1. Daniel Simmons arrived at the following tax information:
Gross salary, $54,250
Dividend income, $140
Itemized deductions, $7,000
Interest earnings, $75
One personal exemption, $3,950
Adjustments to income, $850
Problems
3. What would be the average tax rate for a person who paid taxes of $6,435 on taxable
income of $40,780? (LO3.2)
4. Based on the following data, would Beth and Roger Simmons receive a refund or
owe additional taxes? (LO3.2)
Adjusted gross income, $42,140
Credit for child and dependent
care expenses, $400
Amount for personal exemptions,
$11,850
Itemized deductions, $12,240
Federal income tax withheld, $6,686
Tax rate on taxable income, 10 percent
5. If $4,323 was withheld during the year and taxes owed were $4,122, would the per-
son owe an additional amount or receive a refund? What is the amount? (LO3.2)
6. Noor Patel has had a busy year! She decided to take a cross-country adventure.
Along the way, she won a new car on “The Price Is Right” (valued at $14,000) and
won $500 on a scratch-off lottery ticket (the first time she ever played). She also
signed up for a credit card to start the trip and was given a sign-up bonus of $100.
How much will she have to include in her federal taxable income? (LO3.2)
7. Using the tax table on page 81, determine the amount of taxes for the following
situations: (LO3.3)
a. A head of household with taxable income of $55,000.
b. A single person with taxable income of $35,000.
c. Married taxpayers filing jointly with taxable income of $72,000.
8. If 300,000 people each receive an average refund of $2,500, based on an interest rate of 3
percent, what would be the lost annual income from savings on those refunds? (LO3.2)
9. Using the tax table in Exhibit 3–5 , determine the amount of taxes for the following
situations: (LO3.3)
a. A head of household with taxable income of $97,525.
b. A single person with taxable income of $97,001.
c. A married person filing a separate return with taxable income of $97,365.
10. Wendy Brooks prepares her own income tax return each year. A tax preparer would
charge her $75 for this service. Over a period of 10 years, how much does Wendy
gain from preparing her own tax return? Assume she can earn 3 percent on her
savings. (LO3.3)
11. Betty Sims has $30,000 of adjusted gross income and $5,000 of medical expenses.
She will be itemizing her tax deductions this year. The most recent tax year has a
medical expenses floor of 10 percent. How much of a tax deduction will Betty be
able to take? (LO3.3)
12. Each year, the Internal Revenue Service adjusts the value of an exemption based on
inflation (and rounds to the nearest $50). If the exemption in a recent year was worth
$3,950 and inflation was 1.2 percent, what would be the amount of the exemption for
the upcoming tax year? (LO3.3)
13. Would you prefer a fully taxable investment earning 10 percent or a tax-exempt
investment earning 8.25 percent? Why? (Assume a 25 percent tax rate.) (LO3.4)
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14. On December 30, you decide to make a $2,000 charitable donation. (LO3.4)
a. If you are in the 28 percent tax bracket, how much will you save in taxes for the
current year?
b. If you deposit that tax savings in a savings account for the next five years at 8 per-
cent, what will be the future value of that account?
15. Reginald Sims deposits $2,500 each year in a tax-deferred retirement account. If
he is in a 28 percent tax bracket, by what amount would his tax be reduced over a
20-year time period? (LO3.4)
16. If a person in a 33 percent tax bracket makes a deposit of $5,000 to a tax-deferred
retirement account, what amount would be saved on current taxes? (LO3.4)
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com .
Case in
Point A SINGLE FATHER’S TAX SITUATION
Ever since his wife’s death, Eric Stanford
has faced difficult personal and financial
circumstances. His job provides him with a
fairly good income but keeps him away from
his daughters, ages 8 and 10, nearly 20 days
a month. This requires him to use in-home
child care services that consume a major
portion of his income. Since the Stanfords
live in a small apartment, this arrangement
has been very inconvenient.
Due to the costs of caring for his children,
Eric has only a minimal amount withheld
from his salary for federal income taxes. Thus
more money is available during the year, but
for the last few years he has had to make a
payment in April—another financial burden.
Although Eric has created an investment fund
for his daughters’ college education and for
his retirement, he has not sought investments
that offer tax benefits. Overall, he needs to
look at several aspects of his tax planning
activities to find strategies that will best serve
his current and future financial needs.
Eric has assembled the following informa-
tion for the current tax year:
Earnings from wages, $71,604
Interest earned on savings, $50
IRA deduction, $3,000
Checking account interest, $45
Three exemptions at $3,950 each
Current standard deduction for filing status,
$9,100
Amount withheld for federal income tax,
$4,825
Tax credit for child care, $1,200
Child tax credit, $1,000
Filing status: head of household
Questions
1. What are Eric’s major financial concerns
in his current situation?
2. In what ways might Eric improve his tax
planning efforts?
3. Calculate the following:
a. What is Eric’s taxable income?
(Refer to Exhibit 3–1 )
b. What is his total tax liability? (Use tax
rate table, page 81) What is his average
tax rate?
c. Based on his withholding, will Eric
receive a refund or owe additional
tax? What is the amount?
Continuing
Case
Jamie Lee Jackson, age 26, is in her last semester of college and is waiting for a graduation
day that is just around the corner! It is the time of year again when Jamie Lee must file her
annual federal income taxes. Last year, she received an increase in salary from the bakery,
which brought her gross monthly earnings to $2,550, and she also opened up an IRA, to
which she contributed $300. Her savings accounts earn 2 percent interest per year, and she
also received an unexpected $1,000 gift from her great aunt. Jamie was also lucky enough
last year to win a raffle prize of $2,000, most of which was deposited into her regular
savings account after paying off her credit card balance.
FINANCIAL SERVICES: SAVINGS PLANS AND ACCOUNTS
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Questions
1. Jamie Lee is trying to decide between Form 1040EZ and Form 1040A to file her fed-
eral income tax return. Using the “Personal Finance in Practice” information found
on page 86, choose the most appropriate federal tax filing form for Jamie to use and
describe your reasoning for making this choice.
2. What impact on Jamie Lee’s income would the gift of $1,000 from her great aunt have
on her adjusted gross income? Would there be an impact on the adjusted gross income
with her $2,000 raffle prize winnings? Explain your answer.
3. Using Exhibit 3–1 as a guide , calculate Jamie Lee’s adjusted gross income amount
by completing the table below:
Gross income
( 2 ) Adjustments to income
5 Adjusted gross income
Current Financial Situation
Assets:
Checking account, $2,250
Savings account, $6,900 (interest earned
last year: $125)
Emergency fund savings account, $3,900
(interest earned last year: $75)
IRA balance, $350 ($300 contribution
made last year)
Car, $3,000
Liabilities:
Student loan, $10,800
Credit card balance, $0 (interest paid last
year: $55)
Income:
Gross monthly salary, $2,550
Monthly Expenses:
Rent obligation, $275
Utilities obligation, $135
Food, $130
Gas/Maintenance, $110
Credit card payment, $0
Savings:
Regular savings monthly
deposit, $175
Rainy day savings monthly
deposit, $25
Entertainment:
Cake decorating class, $40
Movies with friends, $60
4. What would Jamie Lee’s filing status be considered?
5. Jamie Lee has a marginal tax rate of 15% and an average tax rate of 11%. Explain why
there is a difference between the two rates.
Directions Continue your Daily Spending Diary to record and monitor your spending
in various categories. Your comments should reflect what you have learned about your
spending patterns and help you consider possible changes you might want to make in
your spending habits. The Daily Spending Diary sheets are located in Appendix D at the
end of the book and in Connect Finance.
Questions
1. What taxes do you usually pay that are reflected (directly or indirectly) in your daily
spending diary?
2. How might your spending habits be revised to better control or reduce the amount you
pay in taxes?
“SALES TAX ON VARIOUS PURCHASES CAN REALLY INCREASE
THE AMOUNT OF MY TOTAL SPENDING.”
Spending
Diary
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What’s Next for Your Personal Financial Plan?
• Develop a system for filing and storing various tax records related to income, deductible expenses, and cur-
rent tax forms.
• Using the IRS and other websites, identify recent changes in tax laws that may affect your financial planning
decisions.
Federal Income Tax Estimate
Purpose: To estimate your current federal income tax liability.
Financial Planning Activities: Based on last year’s tax return, estimates for the current year,
and current tax regulations and rates, estimate your current tax liability. This sheet is also
available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.irs.gov www.taxlogic.com www.walletpop.com/taxes
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Gross income (wages, salary, investment income,
and other ordinary income
$
Less Adjustments to income (see current tax regulations) 2 $
Equals Adjusted gross income 5 $
Less Standard deduction or Itemized deduction
Medical expenses
(exceeding 10% of AGI , or 7.5% for
those over 65), until 2016.
$
State/local income, property taxes $
Mortgage, home equity loan, interest $
Charitable contributions $
Casualty and theft losses $
Moving expenses, job-related
and miscellaneous expenses
(exceeding 2% of AGI)
$
Amount 2 $ Total 2 $
Less Personal exemptions 2 $
Equals Taxable income 5 $
Estimated tax (based on current tax tables or tax schedules) $
Less Tax credits 2 $
Plus Other taxes 1 $
Equals Total tax liability 5 $
Less Estimated withholding and payments 2 $
Equals Tax due (or refund) 5 $
Suggested
App:
• TaxCaster
• TaxSlayer
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What’s Next for Your Personal Financial Plan?
• Identify saving and investing decisions that would minimize future income taxes.
• Develop a plan for actions to take related to your current and future tax situation.
Tax Planning Activities
Purpose: To consider actions that can prevent tax penalties and may result in tax savings.
Financial Planning Activities: Consider which of the following actions are appropriate to
your tax situation. This sheet is also available in an Excel spreadsheet format in Connect
Finance.
Suggested Websites: www.turbotax.com taxes.about.com
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Action to be taken
(if applicable) Completed
Filing status/withholding
• Change filing status or exemptions due to changes in life
situation
• Change amount of withholding due to changes in tax
situation
• Plan to make estimated tax payments (due the 15th
of April, June, September, and January)
Tax records/documents
• Organize home files for ease of maintaining and
retrieving data
• Send current mailing address and correct Social
Security number to IRS, place of employment, and
other income sources
Annual tax activities
• Be certain all needed data and current tax forms are
available well before deadline
• Research tax code changes and uncertain tax areas
Tax-savings actions
• Consider tax-exempt and tax-deferred investments
• If you expect to have the same or a lower tax rate next
year, accelerate deductions into the current year
• If you expect to have the same or a lower tax rate next
year, delay the receipt of income until next year
• If you expect to have a higher tax rate next year,
delay deductions since they will have a greater
benefit
• If you expect to have a higher tax rate next year,
accelerate the receipt of income to have it taxed at
the current lower rate
• Start or increase use of tax-deferred retirement plans
• Other
Suggested
App:
• IRS2Go
• iDonatedIt
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3 Steps to Financial
Literacy . . . an Increased
Savings Rate
4 Financial Services: Savings Plans and Payment Accounts
An increased rate of savings will reduce
current financial difficulties and improve
long-term financial security. Higher savings
amounts will minimize your use of credit
while also setting aside for future expensive
purchases, vacations, and retirement. At the
end of the chapter, “Your Personal Finance
Dashboard” will provide additional information
on increasing your savings rate.
1
Identify areas in your budget that might be
reduced or eliminated to save money.
App: MoneyBook
2
Determine the amount that you save each
month from the reduced budget amounts.
Website: www.bankrate.com
3
Deposit your increased savings amount in an
account in a bank or credit union.
Website: www.creditunion.coop
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Planning Your Use of Financial Services
Lending practices, foreclosures, higher fees, and tougher account requirements have cre-
ated a different environment for financial services. Today, you will find more emphasis
on consolidation of accounts and online electronic banking while you encounter lower
savings rates and higher loan rates.
More than 20,000 banks, savings and loan associations, credit unions, and other finan-
cial institutions provide payment, savings, and credit services. Today, “banking” may mean
a credit union, an ATM, or a phone app to transfer funds. While some financial decisions
relate directly to goals, your daily activities require other financial services. Exhibit 4–1
is an overview of financial services and institutions for managing cash flows and moving
toward financial goals.
Managing Daily Money Needs
Buying groceries, paying the rent, and completing other routine spending activities require
a cash management plan. Cash, check, credit card, debit card, and online/mobile transfer are
the common payment choices. Mistakes made frequently when managing current cash needs
include (1) overspending as a result of impulse buying and overusing credit; (2) having
insufficient liquid assets to pay current bills; (3) using savings or borrowing to pay for cur-
rent expenses; and (4) failing to put unneeded funds in an interest-earning savings account
or investment plan.
LO4.1
Identify commonly used
financial services.
ACTION ITEM
I am least informed about:
h online banking .
h certificates of deposit .
h prepaid debit cards .
CHAPTER 4 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO4.1 Identify commonly used financial services.
LO4.2 Compare the types of financial institutions.
LO4.3 Assess various types of savings plans.
LO4.4 Evaluate different types of payment methods.
YOUR PERSONAL FINANCIAL PLAN SHEETS
11. Planning the Use of Financial Services
12. Comparing Savings Plans
13. Using Savings Plans to Achieve Financial Goals
14. Comparing Payment Methods; Bank Reconciliation
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108 Chapter 4 Financial Services: Savings Plans and Payment Accounts
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Sources of Quick Cash
No matter how carefully you manage your money, at some time you will need more cash
than you have available. To cope in that situation, you have two basic choices: liquidate
savings or borrow. A savings account, certificate of deposit, mutual fund, or other invest-
ment may be accessed when you need funds. Or a credit card cash advance or a personal
loan may be appropriate. Remember, however, that both using savings and increasing bor-
rowing reduce your net worth and your potential to achieve long-term financial security.
Types of Financial Services
Banks and other financial institutions offer services to meet a variety of needs. These ser-
vices may be viewed in these main categories:
1. Savings provides safe storage of funds for future use. Commonly referred to as time
deposits, money in savings accounts and certificates of deposit are examples of
savings plans.
2. Payment services offer an ability to transfer money to others for daily business
activities. Checking accounts and other payment methods are generally called
demand deposits.
3. Borrowing is used by most people at some time during their lives. Credit alternatives
range from short-term accounts, such as credit cards and cash loans, to long-term
borrowing, such as a home mortgage.
OTHER
FINANCIAL
SERVICE
PROVIDERS
• Pawnshop
• Check-cashing
outlet
• Payday loan
company
• Rent-to-own
center
• Car title loan
company
NON-BANK FINANCIAL SERVICE PROVIDERS
• Retailer stores (prepaid debit cards, other services)
• Online banking service provider (E*Trade Bank)
• Online payment services (PayPal)
• P2P (peer-to-peer) lending intermediaries
TYPES OF FINANCIAL SERVICES
Cash Availability
• Check cashing
• ATM/ debit cards
• Traveler’s checks
• Foreign currency exchange
Payment Services
• Checking account
• Online payments
• Cashier’s checks
• Money orders
Savings Services
• Regular savings account
• Money market account
• Certificates of deposit
• U.S. savings bonds
Credit Services
• Credit cards, cash advances
• Auto loans, education loans
• Mortgages
• Home equity loans
Investment Services
• Individual retirement accounts
(IRAs)
• Brokerage service
• Investment advice
• Mutual funds
Other Services
• Insurance; trust service
• Tax preparation
• Safe deposit boxes
• Budget counseling
• Estate planning
NON-DEPOSIT
INSTITUTIONS
• Life insurance
company
• Investment
company
• Brokerage firm
• Credit card
company
• Finance
company
• Mortgage
company
DEPOSIT INSTITUTIONS
• Commercial bank • Savings and loan association
• Credit union • Mutual savings bank
Exhibit 4–1
Financial Institutions and
Banking Services
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4. Other financial services include insurance, investments, tax assistance, and
financial planning. A trust is a legal agreement that provides for the management
and control of assets by one party for the benefit of another. This type of
arrangement is usually created through a commercial bank or a lawyer. Parents who
want to set aside certain funds for their children’s education may use a trust.
To simplify financial services, many financial businesses offer consolidated accounts.
An asset management account , also called a cash management account, provides a com-
plete financial services program for a single fee. Investment companies and others offer
this type of account, with checking, an ATM card, a credit card, online banking, and a line
of credit as well as access for buying stocks, bonds, mutual funds, and other investments.
Online and Mobile Banking
Banking online and through wireless mobile systems continues to expand (see Exhibit 4–2 ).
While most traditional financial institutions offer online banking services, web-only banks
have also become strong competitors. For example, E*Trade Bank operates online while also
providing customers with access to ATMs. These “e-banks” and “e-branches” provide nearly
every needed financial service.
Financial service activities through your smartphone or tablet have three access methods:
(1) text banking, providing account information and conducting transactions through text mes-
sages; (2) mobile web banking with online access to the financial institution’s website; and
(3) banking apps to conduct transactions using the mobile application of a bank or credit union.
Mobile and online banking provide the benefits of convenience and saving time along
with instant information access. However, concerns of privacy, security of data, ease of
overspending, costly fees, and online scams must also be considered.
More traditional electronic banking can occur through an automatic teller machine
(ATM) , also called a cash machine, which can facilitate various types of transactions. To
minimize ATM fees, compare several financial institutions. Use your own bank’s ATM to
avoid surcharges, and withdraw larger amounts to avoid fees on several small transactions.
trust A legal agreement that
provides for the management
and control of assets by
one party for the benefit of
another.
asset management
account An all-in-one
account that includes
savings, checking,
borrowing, investing, and
other financial services for a
single fee; also called a cash
management account.
automatic teller machine
(ATM) A computer terminal
used to conduct banking
transactions; also called a
cash machine.
Exhibit 4–2 Mobile Banking Services
PAYMENTS/TRANSFERS
• Access cash at ATM
• Balance inquiry
• Online payments
• Move funds among various
accounts
• Person-to-person payments
(transfer funds to another
person’s account)
• Instant payments for bills
you forgot to pay
• Tap or wave your phone to
make a purchase
• Access online images of
canceled checks
DEPOSITS
• Direct deposit of paycheck
and government payment
• Online transfer from other
account
• Take photo of check to
deposit (remote deposit)
OTHER SERVICES
• Direct deposit, transfers to
savings accounts
• Text alerts for balances,
payments, deposits
• Apply and receive approval
for loans
• Compare current interest
rates for loans
• Check rates, apply for insurance
• Buy, sell, monitor investments
• Locate ATM and bank
branches using GPS
• Access or shoot photo of
store, online coupons
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The debit card , or cash card, that activates ATM transactions is also used for purchases.
A debit card is in contrast to a credit card, since you are spending your own funds rather
than borrowing additional money. A lost or stolen debit card can be expensive. If you
notify the financial institution within two days of the lost card, your liability for unautho-
rized use is $50. However, you can be liable for up to $500 of unauthorized use if you wait
up to 60 days to notify your bank. After 60 days, your liability can be the total amount in
your account, and even more if your card is linked to other bank accounts.
However, some card issuers use the same rules for lost or stolen debit cards as for
credit cards: a $50 maximum. Of course, you are not liable for unauthorized use, such as
a con artist using your account number to make a purchase. Remember to report the fraud
within 60 days of receiving your statement to protect your right not to be charged for the
transaction.
Prepaid Debit Cards
Prepaid debit cards have become the fastest-growing payment method. For many consum-
ers, these cards are being used instead of traditional banking services. Prepaid debit cards
are issued by many financial service providers including traditional financial institutions,
retailers (such as Walmart), and non-bank companies specifically created to provide this
financial service.
“Loading” (adding funds to) prepaid debit cards may occur by cash, check, direct
deposit, online transfer, smartphone check photo, or credit card cash advance. Common
uses include in-store and online purchases as well as person-to-person payments. A sav-
ings account feature may also be connected to the card.
A major concern with prepaid debit cards has been the extensive number of fees that a
user can encounter due to few current regulations for these financial products. Beware of
fees that may include an activation fee, a monthly fee, a transaction fee, a cash-withdrawal
(ATM) fee, a balance-inquiry fee, a fee to add funds, a dormancy fee, and others.
However, the expanded use of prepaid cards has resulted in lower consumer debt since
the debit card can help control spending and buying on credit. With credit cards you “pay
later,” with debit cards you “pay now,” and with prepaid cards you “pay before.”
Some prepaid cards have celebrity endorsements, which does not mean a better deal for
consumers. Comparisons of features and fees for prepaid debit cards are available at www
.nerdwallet.com/prepaid .
Debit and credit cards will likely give way to expanded wireless transactions, including
cardless ATM access and in-store purchases. A smartphone, cash code, and PIN will be
required. App customers may authorize cash to a phone contact. Recipients are sent a code
to withdraw the approved amount. A credit card “lock and limit” app to control spending
and block unauthorized transactions will also be available.
Financial Services and Economic Conditions
Changing interest rates, rising consumer prices, and other economic factors influence
financial services. For successful financial planning, be aware of the current trends and
future prospects for interest rates (see Exhibit 4–3 ). You can learn about these trends
and prospects by reading The Wall Street Journal ( www.wsj.com ), The Financial Times
( www.ft.com ), the business section of daily newspapers, and business periodicals such as
Bloomberg Businessweek ( www.businessweek.com ), Forbes ( www.forbes.com ), and For-
tune ( www.fortune.com ).
debit card A plastic access
card used in computerized
banking transactions; also
called a cash card.
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Sources of Financial Services
Many types of businesses, including insurance companies, investment brokers, and credit
card companies, offer financial services that were once exclusive to banks. Companies
such as Ford, Walmart, and AT&T issue credit cards. Banks have also expanded their activ-
ities to provide investments, insurance, and real estate services.
Comparing Financial Institutions
The basic questions to ask when selecting a financial service provider are simple:
• Where can I get the best return on my savings?
• How can I minimize the cost of checking and payments services?
• Will I be able to borrow money if I need it?
As you use financial services, decide what you want from the organization that will
serve your needs (see Exhibit 4–4 ). With the financial marketplace constantly changing,
plan to continually consider various factors before selecting an organization.
The services offered will likely be a major factor. In addition, personal service may be
important to you. Convenience may take the form of branch office and ATM locations as
well as online services. Remember, convenience and service have a cost; compare fees and
other charges at several financial institutions.
LO4.2
Compare the types of
financial institutions.
ACTION ITEM
My primary financial service
activities involve:
h a bank or credit union .
h online payment or app .
h a prepaid debit card .
Exhibit 4–3
Changing Interest Rates
and Financial Service
Decisions
• Use long-term loans to take
advantage of current low rates.
• Select short-term savings
instruments to take advantage
of higher rates when they
mature.
When interest
rates are rising…
• Use short-term loans to take
advantage of lower rates when
you refinance the loans.
• Select long-term savings
instruments to “lock in”
earnings at current high rates.
When interest
rates are falling…
PRACTICE QUIZ 4–1 PRACTICE QUIZ 4–1
1. What are the major categories of financial services?
2. What financial services are available through electronic banking systems?
3. How do changing economic conditions affect the use of financial services?
Apply Yourself! Apply Yourself!
Talk with others about their experiences with online and mobile banking. What apps have been beneficial? What con-
cerns have been encountered?
Sheet 11 Planning the Use of Financial
Services
S
S
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Finally, also consider safety and rates. Obtain information about
earnings on savings and checking accounts and the rate you will
pay for borrowed funds. Most financial institutions have deposit
insurance to protect customers against losses; however, not all of
them are insured by federal government programs.
Types of Financial Institutions
Despite changes in the banking environment, many familiar finan-
cial institutions still serve your needs. As previously shown in
Exhibit 4–1 , some organizations (such as banks and credit unions)
offer a wide range of services, while others provide specialized
assistance, such as home loans. Distinctions among the various
types of financial institutions are disappearing. For example, today
people can buy investments through their bank and credit union as
well as from an investment company or brokerage firm.
Deposit institutions serve as intermediaries between suppliers (savers) and users (bor-
rowers) of funds. The most common of these traditional organizations are:
• Commercial banks , which offer a full range of financial services, including
checking, savings, lending, and most other services. Commercial banks, organized
as corporations with investors (stockholders) contributing the needed capital
commercial bank
A financial institution that offers
a full range of financial services
to individuals, businesses, and
government agencies.
Exhibit 4–4
Selecting a Financial
Institution
NOTE: “Your Personal Financial Plan” sheets 11, 12, and 14 at the end of the chapter can be used for this process.
Also, a fee disclosure form is available at www.pewtrusts.org/safechecking .
STEP 1. List your most important features for a financial institution related to:
• Services: checking, savings accounts; deposit insurance; loans; investments; mobile app
• Costs, fees, earnings: checking minimum balance, ATM fees; credit rates; savings rates
• Convenience: branch locations, hours; ATM locations; customer service; rewards program
• Online, mobile banking: ease of operation; services; privacy, security; other fees
STEP 2. Rank the top three or four specific features based on their importance to you.
STEP 3. Prepare a list of local, national, and online financial institutions (include the address,
phone, and website).
STEP 4. Conduct three types of research: (1) talk with people who have used various financial
institutions; (2) conduct online research on the services, policies, and fees; and (3) visit, as
appropriate, the financial institution to observe the environment and to talk with staff members.
Additional research actions may include:
• Determining the minimum balance to avoid monthly service charges.
• Obtaining a fee disclosure statement, savings rate sheet, and sample loan application.
• Assessing whether the deposit insurance and online banking services meet your needs.
STEP 5. Balance your needs with the information collected, and select where you will do
business. You may use more than one financial institution to take advantage of the best
services offered by each. This action gives you flexibility to move your money if the fees at
one place increase. Talk with a manager if you believe a fee was charged unfairly; the bank
may reverse the charge to keep you as a customer. “Switch kits” are available to make
changing banks easier. These forms and authorization letters facilitate a smooth transition of
direct deposits and automatic payments from one financial institution to another.
CAUTION! CAUTION!
“Phishing” is a scam that uses e-mail spam or
pop-up messages to deceive you into revealing
your credit card number, bank account infor-
mation, Social Security number, passwords, or
other private information. These e-mails usually
look official, like they are coming from a legiti-
mate financial institution or government agency.
This fraud also occurs by phone (live or auto-
mated calls), referred to as “vishing,” and by cell
phone text message, called “smishing.” Never
click on the link in these e-mails or disclose per-
sonal data by phone to a questionable source.
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to operate, have several types: national banks, regional banks, community banks,
and online-only banks.
• Savings and loan associations (S&Ls) , which traditionally specialized in savings
accounts and mortgages. Today, many of these organizations have expanded to offer
financial services comparable to those of a bank.
• Mutual savings banks , which are owned by depositors, also specialize in savings
accounts and mortgages. Located mainly in the northeastern United States, the
profits of a mutual savings bank go to the depositors through higher rates on savings.
• Credit unions , which are user-owned, nonprofit, cooperative organizations.
Although members traditionally had a common bond such as work location, church,
or community affiliation, credit union membership today is more flexible, with
more than 80 million people belonging to one. Annual banking studies consistently
report lower fees and lower loan rates with higher satisfaction levels for credit
unions compared to other financial institutions.
Non-deposit institutions offer various financial services. These institutions include:
• Life insurance companies, which provide financial security for dependents with
various life insurance policies, some containing savings and investment features.
Expanded activities of life insurance companies include investment and retirement
planning services.
• Investment companies, also called mutual funds, which offer a money market
fund —a combination savings–investment plan. The company uses the money from
many investors to purchase a variety of short-term financial instruments. However,
unlike accounts at most deposit institutions, investment company accounts are not
covered by federal deposit insurance.
• Brokerage firms, which employ investment advisors and financial planners, serve
as an agent between the buyer and seller for stocks, bonds, and other investment
securities. These companies obtain their earnings from commissions and fees.
Expanded financial services are available from brokerage
organizations, including checking accounts and online
banking.
• Credit card companies, which specialize in funding
short-term retail lending. However, these networks,
including VISA, MasterCard, and Discover, have also
expanded into various other banking and investing
services.
• Finance companies, which provide loans to consumers
and small businesses. These loans have short and
intermediate terms with higher rates than most other
lenders charge. Most finance companies also offer other
financial planning services.
• Mortgage companies, which are organized primarily
to provide loans for home purchases. The services of
mortgage companies are presented in Chapter 7.
These and other types of financial institutions compete for your business. More and more
of these companies are offering a combination of services (savings, checking, credit, insur-
ance, investments) from one source. These one-stop financial service operations are some-
times referred to as financial supermarkets.
Problematic Financial Businesses
Would you pay $8 to cash a $100 check? Or pay $20 to borrow $100 for two weeks?
Many people who do not have bank accounts (especially low-income consumers) make
use of financial service companies that charge very high fees and excessive interest rates.
savings and loan
association (S&L)
A financial institution that
traditionally specialized
in savings accounts and
mortgage loans.
mutual savings bank
A financial institution that
is owned by depositors
and specializes in savings
accounts and mortgage
loans.
credit union A user-owned,
nonprofit, cooperative financial
institution that is organized for
the benefit of its members.
money market fund A
savings–investment plan
offered by investment
companies, with earnings
based on investments in
various short-term financial
instruments.
did you know? did you know?
Bank customers may now access ATMs
without a debit card. Using a smartphone, both a
cash code and the PIN will be required for cash.
App customers may authorize another person from
phone contacts to obtain money. The recipient will be
sent a cash code to allow withdrawal of an approved
amount. Banks also offer a credit card “lock and limit”
app to control security and spending. This feature is
used to block overseas transactions where the card
isn’t present.
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114 Chapter 4 Financial Services: Savings Plans and Payment Accounts
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An estimated 17 million people in the United States are “unbanked,” using a variety of
“shadow” financial services rather than having a bank account. Another 20 percent of the
population are “underbanked” and make use of many of these services in addition to hav-
ing a bank account.
PAWNSHOPS Loans through pawnshops are based on the value of tangible posses-
sions such as jewelry or other valuable items. Many low- and moderate-income families
use these organizations to obtain cash loans quickly. Pawnshops charge higher fees than
other financial institutions. Thousands of consumers are increasingly in need of small
loans—usually $50 to $75, to be repaid in 30 to 45 days. Pawnshops have become the
“neighborhood bankers” and the “local shopping malls,” since they provide both lending
and retail shopping services, selling items that owners do not redeem. While states regu-
late pawnshops, the interest rates charged can range from 3 percent a month to over 100
percent annually.
CHECK-CASHING OUTLETS Most financial institutions will not cash a check
unless you have an account. The more than 6,000 check-cashing outlets (CCOs) charge
anywhere from 1 to 20 percent of the face value of a check; the average cost is 2 to 3 per-
cent. However, for a low-income family, that can be a significant portion of the total house-
hold budget. CCOs, sometimes called currency exchanges, also offer services, including
electronic tax filing, money orders, private postal boxes, utility bill payment, and the
sale of transit tokens. A person can usually obtain most of these services for less at other
locations.
PAYDAY LOAN COMPANIES Many consumer organizations caution against
using payday loans, also referred to as cash advances, check advance loans, postdated
check loans, and delayed deposit loans. Desperate borrowers pay annual interest rates of
as much as 780 percent and more to obtain needed cash from payday loan companies. The
most frequent users of payday loans are workers who have become trapped by debts or
poor financial decisions.
In a typical payday loan, a consumer writes a personal check for $115 to borrow $100
for 14 days. The payday lender agrees to hold the check until the next payday. This $15
finance charge for the 14 days translates into an annual percentage rate of 391 percent.
Some consumers “roll over” their loans, paying another $15 for the $100 loan for the next
14 days. After a few rollovers, the finance charge can exceed the amount borrowed. To pre-
vent this exploitation, some employers are offering pay advances through payroll provider
services. The loans have rates in the 9 to 18 percent range.
RENT-TO-OWN CENTERS Rental businesses offer big-screen televisions, com-
puters, seven- piece bedroom sets, and kitchen appliances. The rent-to-own (RTO) indus-
try is defined as stores that lease products to consumers who can own the item if they
complete a certain number of monthly or weekly payments. A $600 computer can result
in $1,900 of payments. Many RTO purchases can result in annual interest rates of over
300 percent.
CAR TITLE LOAN COMPANIES When in need of money, people with poor
credit ratings might obtain a cash advance using their automobile title as security for a
high-interest loan. These loans, usually due in 30 days, typically have a cost similar to
payday loans, often exceeding 200 percent. While the process is simple, the consequences
can be devastating with the repossession of your car.
All of these expensive, high-risk financial service providers should be avoided. Instead,
make an effort to properly manage your money and use the services of a reputable financial
institution, such as a credit union.
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Comparing Savings Plans
A savings plan is vital to attain financial goals. A range of savings alternatives exist
( Exhibit 4–5 ). The many types of savings plans can be grouped into the following main
categories.
Regular Savings Accounts
Regular savings accounts, previously called passbook or statement accounts, usually
involve a low or no minimum balance and allow you to withdraw money as needed.
Banks, savings and loan associations, and other financial institutions offer regular savings
accounts. At a credit union, these savings plans are called share accounts.
Certificates of Deposit
Higher earnings are available to savers when they leave money on deposit for a set time
period. A certificate of deposit (CD) is a savings plan requiring that a certain amount be left
on deposit for a stated time period (ranging from 30 days to five or more years) to earn a
specific rate of return.
These time deposits can be an attractive and safe savings alternative. However, most
financial institutions impose a penalty for early withdrawal of CD funds. For CDs of one
year or less, the penalty is usually three months of interest. CDs of more than a year will
likely have a fine of six months’ interest, while a five-year CD can result in a penalty as
high as 20 to 25 percent of the total interest to maturity on the account.
TYPES OF CDS While traditional certificates of deposit continue to be the most popu-
lar, financial institutions offer other types of CDs:
• Rising-rate or bump-up CDs may have higher rates at various intervals, such as
every six months. However, beware of ads that highlight a higher rate in the future.
This rate may be in effect only for the last few months of an 18- or 24-month CD.
LO4.3
Assess various types of
savings plans.
ACTION ITEM
When selecting a savings
plan, most important to me is:
h bank location.
h federal deposit
insurance.
h rate of return.
certificate of deposit
(CD) A savings plan
requiring that a certain
amount be left on deposit for
a stated time period to earn a
specified interest rate.
PRACTICE QUIZ 4–2 PRACTICE QUIZ 4–2
1. What factors do consumers usually consider when selecting a financial institution to meet their saving and checking
needs?
2. What are examples of deposit-type financial institutions?
3. Match the following descriptions with the appropriate financial institution:
a. commercial bank _______ Commonly used by people without a bank account.
b. credit union _______ Investment services accompany main business focus.
c. life insurance company _______ Traditionally provides widest range of financial services.
d. check-cashing outlet _______ Offers lower fees for members.
Apply Yourself! Apply Yourself!
Using the website for the Credit Union National Association ( www.cuna.org ) or other sources, obtain information about
joining a credit union and the services offered by this type of financial institution.
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116
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F
R
O
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T
H
E
P
A
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E
S
O
F
.
.
.
K
ip
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s
P
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F
in
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. What are current and long-term consequences of not saving?
2. Describe actions that you might consider to improve your savings attitude and habits.
3. Based on the information in this article, and your experiences, what suggestions would you offer for select-
ing a bank?
I
f you don’t pay your rent
or cell-phone bill, the con-
sequences are immediate.
If you fail to stash money
in savings as soon as you start
earning a paycheck, you prob-
ably won’t notice the damage
right away. But the long-term
fallout can be devastating if it
limits your choices—whether
that’s buying the house you
want, sending your kids to a
top college, or deciding when
(or even if ) you can retire.
Say you’re 25 years old and
you put $500 into a mutual
fund that earns 8% a year, and
you add $100 each month.
You’ll wind up with more than
$335,000 by the time you’re
65, excluding taxes. If you wait
until you’re 35, invest $2,500
and then add that $100 a month,
all else being equal you’ll have
only about $167,000 by age 65.
Pay yourself first. If you skim
savings off the top of each pay-
check, the cash will disappear
before you have a chance to
miss it. With a 401(k) retirement
plan at work, for example, your
employer pulls the amount you
designate from each paycheck.
For other savings, you can
schedule automatic transfers
from your checking account.
You may want to set up multiple
savings accounts if that helps
you track progress toward each
goal more easily.
Saving for retirement is
usually priority number one,
but you should also create an
emergency fund that holds
enough cash to cover at least
six months’ worth of living
expenses. Then, assuming
you have a plan to pay off any
debts, you can move on to sav-
ing for your other goals.
Choose a bank. Any savings
that you may need to access in
a pinch (and that includes your
emergency fund) should reside
in a bank, where your money
is insured. Savings accounts
and money market deposit
accounts, which often pay more
than regular savings accounts,
are generally easy to access. At
www.depositaccounts.com , look
for accounts available in your
area that pay top interest rates.
Watch out for minimum-balance
requirements and monthly
maintenance or transfer charges.
You don’t have to have a
checking account and savings
account in the same place. Banks
are increasingly offering conve-
nient features such as mobile
check deposit, which allows you
to submit a check by snapping
a picture of it with your smart
phone. Online banks, such as
Ally Bank and Evantage Bank, let
you perform many of the same
transactions as a traditional bank.
Wherever you put your
money, watch for fees. If you
regularly get cash from other
banks’ ATMs, you could pay
hundreds of dollars a year in
extra charges.
Some banks will reimburse
you for fees that other banks
charge you for using their
ATMs; the State Farm Bank Free
Checking Account, for one, will
refund all ATM charges if you
have direct deposit. Other insti-
tutions are members of large,
surcharge-free ATM networks,
such as the Allpoint network.
Most banks waive monthly
maintenance fees on checking
accounts if you have a monthly
direct deposit or maintain a
minimum balance.
L isa Gerstner
Start Saving Now
Get in the habit early, even if it’s only a small amount with each paycheck.
GET THESE APPS!
SAVEDPLUS
(Android, Apple) automatically
shifts money from your
checking account into a
savings account every time
you make a purchase. You
choose the percentage of the
purchase amount.
MASTERCARD NEARBY
(Android, Apple, Windows)
lets you search for nearby
ATMs based on your current
location, and it can filter for
features such as 24-hour
availability and fees.
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• Liquid CDs offer an opportunity to withdraw money without a penalty.
However, you will likely be required to maintain a minimum balance in the
account. This type of CD may have other restrictions such as a “waiting period”
before any funds can be withdrawn or a limit on the number of withdrawals
allowed.
• A zero-coupon CD is purchased at a deep discount (a small portion of the
face value) with no interest payments. Your initial small deposit ($5,000, for
example) grows to the maturity value of the CD ($10,000) in 10 years, which is
approximately a 6 percent annual return.
• Indexed CDs have earnings based on the stock market. In times of strong stock
performance, your earnings can be higher than those on other CDs. At other
times, however, you may earn no interest and may even lose part of your savings.
A CD based on the consumer price index can result in higher returns as inflation
increases.
Exhibit 4–5 Savings Alternatives
Benefits
• Low minimum balance
• Ease of withdrawal
• Insured
Drawback
• Low rate of return
Regular Savings Accounts
Benefits
• Favorable rate of return (based on current interest rates)
• Allows limited number of checks to be written
• Insured (money market accounts)
Drawbacks
• Higher minimum balance than regular savings accounts
• Service charge and/or lower rate if below certain balance
• Not insured (money market funds)
Money Market Account/Funds
Benefits
• Guaranteed rate of return for time of CD
• Insured (when purchased from bank or
comparable financial institution)
Drawbacks
• Possible penalty (reduced interest) for
early withdrawal
• Minimum deposit
Certificates of Deposit (CDs)
Benefits
• Rate varies with interest rates (I-bonds)
• Low minimum deposit
• Government guaranteed
• Exempt from state, local income taxes
Drawback
• Lower rate when redeemed within first
five years
U.S. Savings Bonds
less liquiditymore liquidity
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118 Chapter 4 Financial Services: Savings Plans and Payment Accounts
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• Callable CDs start with higher rates and usually have long maturities, as high as
10 to 15 years. With this savings option, if interest rates drop, the bank may “call”
(close) the account after a set period, such as one or two years. When the call option
is exercised, the saver receives the original deposit amount and any interest that has
been earned.
Beware of promotional CDs, which attempt to attract savers with gifts or special rates.
Be sure to balance the value of the item against the lost interest.
MANAGING C DS When first buying or rolling over a CD (buying a new one at
maturity), investigate potential earnings and costs. Do not allow your financial institution
to automatically roll over your money into another CD for the same term. If interest rates
have dropped, you might consider a shorter maturity. Or if you believe rates are at a peak
and you won’t need the money for some time, obtain a CD with a longer term.
Consider creating a CD portfolio with CDs maturing at different times, for example,
$2,000 in a three-month CD, $2,000 in a six-month CD, $2,000 in a one-year CD, and
$2,000 in a two-year CD. This will give you some degree of liquidity and flexibility when
you reinvest your funds.
Interest-Earning Checking Accounts
Checking accounts frequently have a savings feature. These interest-earning accounts usu-
ally pay a low interest rate. However, recently, many financial institutions have offered
high-rate checking accounts to customers who meet certain requirements. For example, a
higher interest rate might be available if you use your debit card a certain number of times
each month and agree to online statements.
Money Market Accounts and Funds
A money market account is a savings account that requires a minimum balance and has
earnings based on the changing market level of interest rates. Money market accounts may
allow a limited number of checks to be written and generally impose a fee when the
account balance goes below the required minimum, usually $1,000.
Both money market accounts and money market funds offer earnings based on current
interest rates, and both have minimum-balance restrictions and allow check writing. The
major difference is in safety. Money market accounts at banks and savings and loan asso-
ciations are covered by federal deposit insurance. This is not true of money market funds,
which are a product of investment and insurance companies. Since money market funds
invest mainly in short-term (less than a year) government and corporate securities, how-
ever, they are usually quite safe.
U.S. Savings Bonds
U.S. savings bonds are a low-risk savings program guaranteed by the federal government
that have been used to achieve various financial goals. The Treasury Department offers
several programs for buying savings bonds.
EE BONDS Series EE bonds may be purchased for any amount greater than $25.
Electronic EE bonds are purchased online at face value; for example, you pay $50 for a
$50 bond. These bonds may be obtained or purchased for any amount you desire, such as
$143.58, giving savers more flexibility.
Paper savings bonds, while no longer issued at financial institutions, are still available
through payroll savings plans or by using part or all of your federal tax refund. Paper EE
bonds are sold at half the face value, and may be purchased for set values ranging from
money market account
A savings account offered
by banks, savings and loan
associations, and credit
unions that requires a
minimum balance and has
earnings based on market
interest rates.
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$25 to $5,000, with maturity values of $50 to $10,000. Paper
savings bonds continue to be redeemed at financial institutions.
If a savings bond has been lost or stolen, it can be reissued in
either a paper or an electronic format. To locate savings bonds
issued since 1974, go to www.treasuryhunt.gov .
EE bonds increase in value as interest accrues monthly and
compounds semiannually. If you redeem the bonds before five
years, you forfeit the latest three months of interest; after five
years, you are not penalized. A bond must be held for one year
before it can be cashed. Series EE bonds continue to earn inter-
est for 30 years. The main tax advantages of series EE bonds are
(1) the interest earned is exempt from state and local taxes and
(2) federal income tax on earnings is not due until the bonds are
redeemed.
Redeemed series EE bonds may be exempt from federal
income tax if the funds are used to pay tuition and fees at a
college, university, or qualified technical school for yourself or a
dependent. The bonds must be purchased by an individual who
is at least 24 years old, and they must be issued in the names of
one or both parents. This provision is designed to assist low-
and middle-income households; people whose incomes exceed
a certain amount do not qualify for this tax exemption.
HH BONDS Series HH bonds, which are no longer sold, were current-income bonds
with interest deposited electronically to your bank account every six months. This interest
was taxed as current income on a person’s federal tax return, but it was exempt from state
and local taxes.
I BONDS The I bond has an interest rate based on two components: (1) a fixed rate for
the life of the bond and (2) an inflation rate that changes twice a year. Every six months a
new, fixed base rate is set for new bonds. The additional interest payment is recalculated
twice a year, based on the current annual inflation rate. I bonds are sold in any amount over
$25 and are purchased at face value. As with EE bonds, the minimum holding period is one
year. Interest earned on I bonds is added to the value of the bond and received when you
redeem your bond. I bonds have the same tax and education benefits as EE bonds.
A person may purchase up to $10,000 worth of electronic savings bonds of each series
(EE and I bonds) a year, for a total of $20,000. This amount applies to any person, so par-
ents may buy an additional $25,000 in each child’s name. Savings bonds are commonly
registered one of three ways: (1) single owner, (2) two owners, either as co-owners or with
one as primary owner, or (3) a beneficiary, who takes ownership of the bond when the
original owner dies.
A TreasuryDirect account at www.treasurydirect.gov provides the benefits of:
• Twenty-four-hour access to buy, manage, and redeem series EE and I electronic
savings bonds.
• Converting series EE and I paper savings bonds to electronic bonds through the
SmartExchange feature.
• Purchasing electronic savings bonds as a gift.
• Enrolling in a payroll savings plan for purchasing electronic bonds.
• Investing in other Treasury securities such as bills, notes, bonds, and TIPS
(Treasury Inflation-Protected Securities).
• Eliminating the risk that your savings bonds will be lost, stolen, or damaged.
Additional information and current value calculations may be obtained at www
.savingsbonds.gov .
did you know? did you know?
Most of the world’s population Most of the world’s population
lacks access to basic financial services. lacks access to basic financial services.
Many organizations serve these people Many organizations serve these people
with microloans, micro-savings accounts, with microloans, micro-savings accounts,
and micro-insurance programs. The and micro-insurance programs. The
Grameen Bank ( Grameen Bank ( www.grameen-info.orgwww.grameen-info.org ) )
makes loans to the poorest of the poor in makes loans to the poorest of the poor in
Bangladesh, without collateral. Opportu-Bangladesh, without collateral. Opportu-
nity International ( nity International ( www.opportunity.orgwww.opportunity.org ) )
serves more than 2.5 million people in serves more than 2.5 million people in
20 countries with loans, savings, insur-20 countries with loans, savings, insur-
ance, and business training. These efforts ance, and business training. These efforts
fight poverty and enhance community fight poverty and enhance community
development. development.
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Evaluating Savings Plans
Selection of a savings plan is usually influenced by the rate of return, inflation, tax consid-
erations, liquidity, safety, restrictions, and fees (see Exhibit 4–6 ).
RATE OF RETURN Earnings on savings can be measured by the rate of return , or
yield, the percentage of increase in the value of your savings from earned interest. For
example, a $100 savings account that earned $5 after a year would have a rate of return, or
yield, of 5 percent. This rate of return was determined by dividing the interest earned ($5)
by the amount in the savings account ($100). The yield on your savings usually will be
greater than the stated interest rate.
Compounding refers to interest that is earned on previously earned interest. Each time
interest is added to your savings, the next interest amount is computed on the new balance
in the account. The more frequent the compounding, the higher your rate of return will
be. For example, $100 in a savings account that earns 6 percent compounded annually
will increase $6 after a year. But the same $100 in a 6 percent account compounded daily
will earn $6.19 for the year. Although this difference may seem slight, large amounts held
in savings for long periods of time will result in far higher differences (see Exhibit 4–7 ).
The Truth in Savings Act requires financial institutions to disclose the following infor-
mation on savings account plans: (1) fees on deposit accounts; (2) the interest rate; (3) the
annual percentage yield (APY); and (4) other terms and conditions of the savings plan.
Truth in Savings (TIS) defines annual percentage yield (APY) as the percentage rate
expressing the total amount of interest that would be received on a $100 deposit based on
the annual rate and frequency of compounding for a 365-day period. APY reflects the
amount of interest a saver should expect to earn.
INFLATION The rate of return you earn on your savings should be compared with the
inflation rate. When inflation was over 10 percent, people with money in savings accounts
earning 5 or 6 percent were experiencing a loss in the buying power of that money. In gen-
eral, as the inflation rate increases, the interest rates offered to savers also increase.
rate of return The
percentage of increase in the
value of savings as a result of
interest earned; also called
yield.
compounding A process
that calculates interest based
on previously earned interest.
annual percentage yield
(APY) The percentage rate
expressing the total amount
of interest that would be
received on a $100 deposit
based on the annual rate and
frequency of compounding
for a 365-day period.
Exhibit 4–6
Selecting a Savings Plan
Rate of Return
Inflation
Taxes
Liquidity
Safety
Restrictions, Fees
• Percentage increase in value of savings.
• Increases with frequency of compounding.
• Higher consumer prices result in lower
buying power of interest earned on savings.
• Taxable interest reduces amount of
earnings.
• Ease with which savings can be
withdrawn.
• Availability of deposit insurance.
• Risk.
• Minimum-balance limitations.
• Fee for additional transactions.
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TAXES Like inflation, taxes reduce interest earned on savings.
For example, a 10 percent return for a saver in a 28 percent tax
bracket means a real return of 7.2 percent (the “Figure It Out!”
box shows how to compute the after-tax savings rate of return).
As discussed in Chapter 3, several tax-exempt and tax-deferred
savings plans and investments can increase your real rate of
return.
LIQUIDITY Liquidity allows you to withdraw your money
on short notice without a loss of value or fees. Some savings
plans impose penalties for early withdrawal or have other restric-
tions. With certain types of savings certificates and accounts,
early withdrawal may be penalized by a loss of interest or a lower earnings rate. Consider
the degree of liquidity you desire in relation to your savings goals. To achieve long-term
financial goals, many people trade off liquidity for a higher return.
SAFETY Most savings plans at banks, savings and loan associations, and credit unions
are insured by agencies affiliated with the federal government. Federal Deposit Insurance
Corporation (FDIC) coverage prevents a loss of money due to the failure of the insured
did you know? did you know?
To earn more interest on your savings:
(1) compare local and online banks and credit
unions; (2) combine several savings accounts into
a larger amount that might quality for a higher rate;
(3) search for special rates on checking accounts or
specialty CDs. Helpful websites include bankrate.com ,
depositaccounts.com , and checkingfinder.com .
Shorter compounding periods result in higher yields. This chart shows the growth of $10,000,
earning a rate of 4 percent, but with different compounding methods.
COMPOUNDING METHOD
End of year Daily Monthly Quarterly Annually
1 $10,408 $10,407 $10,405 $10,400
2 10,832 10,831 10,827 10,816
3 11,275 11,272 11,267 11,249
4 11,735 11,731 11,724 11,699
5 12,214 12,208 12,198 12,165
10 14,918 14,904 14,883 14,800
15 18,221 18,196 18,160 18,004
20 22,254 22,215 22,154 21,902
Annual yield 4.08% 4.07% 4.05% 4.00%
Exhibit 4–7
Compounding Frequency
Affects the Savings Yield
EXAMPLE: Annual Percentage Yield
When the number of days in the term is 365 (that is, where the stated maturity is
365 days) or where the account does not have a stated maturity, the APY formula
is simply
APY 5 100 ( Interest ________ Principal )
5 100 ( 66 ______ 1,200 )
5 100 (0.055) 5 5.5%
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3. If the yield on your savings account is 6.25 percent,
0.0625 3 0.72 5 0.045.
4. Your after-tax rate of return is 4.5 percent.
You may use the same procedure to determine the
real rate of return on your savings based on inflation. For
example, if you are earning 6 percent on savings and infla-
tion is 5 percent, your real rate of return (after inflation) is
5.7 percent: 0.06 3 (1 2 0.05) 5 0.057.
CALCULATION EXAMPLES:
1. What would be the after-tax return for a person who is
receiving 4 percent on savings and is in a 15 percent
tax bracket? ___________ %
2. What would be the after-tax value of $100 earned in
interest for a person who is in a 31 percent tax bracket?
$ ___________
The taxability of interest on your savings reduces your real
rate of return. In other words, you lose some portion of
your interest to taxes. This calculation consists of the fol-
lowing steps:
1. Determine your top tax bracket for federal income taxes.
2. Subtract this rate, expressed as a decimal, from 1.0.
3. Multiply the result by the yield on your savings account.
4. This number, expressed as a percentage, is your after-
tax rate of return.
For example,
1. You are in the 28 percent tax bracket.
2. 1.0 2 0.28 5 0.72.
After-Tax Savings Rate of Return After-Tax Savings Rate of Return
Figure It Out!
institution. Credit unions may obtain deposit insurance through the National Credit Union
Association (NCUA). Some state-chartered credit unions have opted for a private insur-
ance program. While some financial institutions have failed in recent years, savers with
deposits covered by federal insurance have not lost any money. Depositors have either
been paid, or have had the accounts taken over by a financially stable institution.
The FDIC insures amounts of up to $250,000 per depositor per insured financial insti-
tution. Coverage amounts that exceed the limit are possible by using different ownership
categories, such as individual, joint, and trust ownership accounts. For example, a joint
account, held by two people, would be covered up to $500,000, with each account owner
having $250,000 of coverage. Remember, however, that different branch offices count as
the same institution, and mergers in the financial service industry may bring accounts from
different banks together.
The FDIC and NCUA also provide deposit insurance for certain retirement accounts, up
to $250,000, including traditional IRAs, Roth IRAs, Simplified Employee Pension (SEP)
IRAs, and Savings Incentive Match Plans for Employees (SIMPLE) IRAs as well as self-
directed Keogh accounts and various plans for state government employees. Of course,
this coverage applies only to retirement accounts in financial institutions insured by the
FDIC and NCUA. While some observers had expected the standard insurance amount to
return to the previous level of $100,000 per depositor for all account categories except
IRAs and other retirement accounts, Congressional action has kept the depositor coverage
for every type of account at $250,000.
To determine if all of your deposits are insured, use the Electronic Deposit Insurance
Estimator (EDIE) at www.fdic.gov/edie/index.html . This feature includes a step-by-step
tutorial with depositor situations for different types of account and different ownership.
Information about credit union deposit coverage is available at www.ncua.gov . Since not
ANSWERS 1. 3.4 percent 5 0.04 3 (1 2 0.15); 2. $69 5 $100 3 (1 2 0.31)
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all financial institutions have federal deposit insurance, investigate this matter when you
are selecting a savings plan. Additional information on the regulation and consumer pro-
tection aspects of financial institutions is included in Appendix C.
PRACTICE QUIZ 4–3 PRACTICE QUIZ 4–3
1. What are the main types of savings plans offered by financial institutions?
2. How does a money market account differ from a money market fund?
3. How do inflation and taxes affect earnings on savings?
4. In the following financial situations, check the box that is the major influence for the person when selecting a savings plan:
Financial planning situation
Rate of
return Inflation Taxes Liquidity Safety
a. An older couple needs easy access to
funds for living expenses.
b. A person is concerned with loss of buying
power of funds on deposit.
c. A saver desires to maximize earnings from
the savings plan.
d. A middle-aged person wants assurance
that the funds are safe.
Apply Yourself! Apply Yourself!
Conduct online research to obtain past and current data on various interest rates (such as prime rate, T-bill rate, mort-
gage rate, corporate bond rate, and six-month CD rate). Information may be obtained at www.federalreserve.gov and
other websites. How do these rates affect various personal financial decisions?
Sheet 12 Comparing Savings Plans
Sheet 13 Using Savings Plans to Achieve
Financial Goals
S
S
F
EXAMPLE: Deposit Insurance
If you have a $562,000 joint account with a relative in an FDIC-insured financial
institution, $31,000 of your savings will not be covered by federal deposit insurance.
One-half of the $562,000 exceeds the $250,000 limit by $31,000.
RESTRICTIONS AND FEES Other limitations can affect your choice of a sav-
ings program. For example, there may be a delay between the time interest is earned
and the time it is added to your account. This means the interest will not be available for
your immediate use. Also, some institutions charge a transaction fee for each deposit or
withdrawal. In the past, financial institutions offered a “free gift” when a certain savings
amount was deposited. To receive this gift, you had to leave your money on deposit for
a certain time period, or you may have received less interest, since some of the earnings
covered the cost of the “free” items.
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Comparing Payment Methods
Each year, paper checks account for a smaller and smaller portion of payments in our soci-
ety. While check writing is being used less, checking accounts are still the common source
for most debit card transactions and online payments. As shown in Exhibit 4–8 , payment
alternatives may be viewed in three main categories.
Electronic Payments
Transactions not involving cash, checks, or credit cards have expanded with technology,
improved security, and increased consumer acceptance.
DEBIT CARD TRANSACTIONS Nearly every store and online retailer processes
debit card transactions, with the amount of the purchase deducted from your checking or
other bank account. Most debit cards can be used two ways: (1) with your signature, like
a credit card, and (2) with your personal identification number (PIN), like an ATM card.
When the debit card is processed like a credit card, you have more security in case of a
fraudulent transaction or a purchase dispute. But when using a debit card to check into a
hotel, buy gas, or rent a car, a merchant may freeze an amount in your bank account above
what you actually spend. This hold on your funds could result in an overdrawn account.
LO4.4
Evaluate different types of
payment methods.
ACTION ITEM
My payment account
balance is:
h updated regularly .
h based on a rough
estimate .
h only known by my
financial institution .
CAUTION! CAUTION!
Banks and other financial institutions are
increasing fees to cover lost revenue due to
lower interest rates and bad loans. These
charges include higher ATM fees, credit card
annual fees and late payment fees, overdraft
and stop-payment fees, charges for paper
statements and to talk with a teller, and even
a charge for closing your account within a
certain time period. Compare charges before
opening an account and consider changing
financial institutions to get a better deal.
Payments Checking Accounts Other Payment Methods
Debit (cash) and credit cards Regular checking account Certified check
Online, mobile payments Activity checking account Cashier’s check
Stored-value (prepaid) cards Interest-earning account Money order
Smart cards (“digital wallet”) Traveler’s checks
Peer-to-peer (P2P) payments
Exhibit 4–8
Payment Alternatives
Use a credit card to . . .
. . . delay the payment for a purchase.
. . . build a credit history with wise
buying.
. . . buy online or for major purchases.
. . . earn more generous rewards points
for spending.
Use a debit card to . . .
. . . limit your spending to available money.
. . . avoid bills that will be paid in the
future.
. . . avoid interest payment or an annual fee.
. . . obtain better protection if you
process a transaction as a credit card.
ONLINE PAYMENTS Banks and online companies serve as
third parties to facilitate online bill payments. These organizations
include www.paypal.com , www.mycheckfree.com , www.paytrust
.com , and Google Wallet (previously Google Checkout). Some
online payment services give you a choice of using a credit card
or a bank account, while others require one or the other. Linking a
transaction to your checking account, rather than to a credit card,
may not give you as much leverage when disputing a transaction.
People without a credit or debit card can use PayNearMe for
online buying and other transactions. This service allows buyers to
make a purchase and then pay cash at a local store. The consumer
receives a receipt and the seller is notified of the payment. This
cash transaction network may be used for online purchases, tele-
phone orders, loan repayments, money transfers, and other transac-
tions that might require a credit card. PayNearMe has partnerships
with several major online and storefront retailers.
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Another payment alternative with no disclosure of credit card information is eBillme,
which requires only an e-mail address to establish an account for making purchases. Then,
you make your payment to eBillme through online banking or at a local walk-in site. When
using these services, be sure to consider all fees, online security, and customer service
availability.
MOBILE TRANSFERS Apps for mobile payment systems through smartphones,
tablets, and other wireless devices are expanding. The near-field communications (NFC)
technology stores credit card and bank account information. These wireless devices replace
debit and credit cards for processing financial and purchasing transactions. A tap or wave
of your phone at the point-of-sale terminal sensor completes the purchase. While these
mobile transactions usually occur through a bank account, in the future these payments
may bypass banks with charges directly on your phone bill.
Mobile banking is increasing the availability of “person-to-person” payments with the
transfer of funds by e-mail or to a mobile phone number. The opportunity to send and
receive money through links to bank accounts and cards may also occur with online pay-
ment services.
STORED-VALUE CARDS Prepaid cards for telephone service, transit fares,
highway tolls, laundry service, and school lunches are common. While some of these
stored-value cards are disposable, others can be reloaded with an additional amount. Also
called prepaid debit cards, some stored-value cards may have activation charges, ATM
fees, and other transaction costs. Recipients of government benefits may receive Social
Security and other payments on a prepaid debit card, which is practical for people with-
out a bank account.
SMART CARDS These “digital wallets” are similar to other ATM cards with an
imbedded microchip. In addition to banking activities, the card may also store past pur-
chases, insurance information, and your medical history. Recent developments in smart
cards include an option that allows you to pay with reward points.
PEER-TO-PEER PAYMENTS Various services allow you to transfer money to
another person. While most require registering debit card, credit card, or bank account
information, some peer-to-peer (P2P) payments are conducted by e-mail and with a
secured website. Fees for the P2P service can range from less than a dollar to a percentage
of the amount transferred.
Checking Accounts
Even as electronic payments grow in popularity, a checking account is still necessary
for most people. Checking accounts fall into three major categories: regular checking
accounts, activity accounts, and interest-earning checking accounts.
REGULAR CHECKING ACCOUNTS Regular checking accounts usually have a
monthly service charge that you may avoid by keeping a minimum balance in the account.
Some financial institutions will waive the monthly fee if you keep a certain amount in sav-
ings. Avoiding the monthly service charge can be beneficial. For example, a monthly fee of
$7.50 results in $90 a year. However, you lose interest on the minimum-balance amount in
a non-interest-earning account.
ACTIVITY ACCOUNTS Activity accounts charge a fee for each check written and
sometimes a fee for each deposit in addition to a monthly service charge. However, you
do not have to maintain a minimum balance. An activity account is most appropriate for
people who write only a few checks each month and are unable to maintain the required
minimum balance .
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INTEREST-EARNING CHECKING Interest-earning checking accounts usually
require a minimum balance. If the account balance goes below this amount, you may not
earn interest and will likely incur a service charge. These are called share draft accounts
at credit unions.
Evaluating Checking and Payment Accounts
Would you rather have a checking account that pays interest and requires a $1,000 min-
imum balance or an account that doesn’t pay interest and requires a $300 minimum bal-
ance? This decision requires evaluating factors such as restrictions, fees and charges,
interest, and special services (see Exhibit 4–9 ).
RESTRICTIONS The most common limitation on a checking account is the required
amount that must be kept on deposit to earn interest or avoid a service charge. In the
past, financial institutions placed restrictions on the holding period for deposited checks.
A waiting period was usually required before you could access the funds. The Check
Clearing for the 21st Century Act (known as Check 21) shortens the processing time. This
law establishes the substitute check, which is a digital reproduction of the original paper
check, and is considered a legal equivalent of the original check.
FEES AND CHARGES Nearly all financial institutions require a minimum bal-
ance or impose service charges for checking accounts. When using an interest-bearing
checking account, compare your earnings with any service charge or fee. Also, consider
the cost of lost or reduced interest resulting from maintaining the minimum balance.
Checking account fees have increased in recent years. Items such as check printing,
Exhibit 4–9
Checking Account
Selection Factors
Mr. and Mrs.
Customer
222 This place
0931 013 35 12
0100
Date
PAY
TO THE
ORDER OF $
DOLLARS
Signature
60–781/319
MEMO
TRUST BANK
100 Any Street
Somewhere, USA
• Direct deposit
• Availability of ATMs
• Overdraft protection
• Discounts or free checking for
certain groups (students, senior
citizens)
• Free or discounted services
Special Services
• Interest rate
• Minimum deposit to earn interest
• Method of compounding
• Portion of balance for computing
interest
• Fee charged for falling below
necessary balance to earn interest
Interest
CHECKING ACCOUNT SELECTION FACTORS
• Minimum balance
• Federal deposit insurance
• Hours and location of branch offices
• Holding period for deposited checks
Restrictions
• Monthly fee
• Fees for each check or deposit
• Printing of checks
• Fee to obtain canceled check copy
• Overdraft, stop-payment order,
certified check fee
• Fees for online banking
Fees and Charges
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overdraft fees, and stop-payment orders have doubled or tripled in price at some financial
institutions.
INTEREST The interest rate, the frequency of compounding, and the interest computa-
tion method will affect the earnings on your checking account.
SPECIAL SERVICES As financial institutions attempt to reduce paper and postage
costs, canceled checks are no longer returned. Bank customers are provided with more
detailed monthly statements and will likely have online access to view and print checks
that have been paid.
Overdraft protection is an automatic loan made to checking account customers for
checks written in excess of their balance. This service is convenient but costly. Most over-
draft plans make loans based on $50 or $100 increments. An overdraft of just $1 might
trigger a $50 loan and corresponding finance charges of perhaps 18 percent. But overdraft
protection can be less costly than the fee charged for a check you write when you do not
have enough money on deposit to cover it. That fee may be $30 or more. Many financial
institutions will allow you to cover checking account overdrafts with an automatic transfer
from a savings account for a nominal fee.
Beware of checking accounts packaged with several ser-
vices (safe deposit box, traveler’s checks, low-rate loans, and
travel insurance) for a single monthly fee. This may sound like a
good value; however, financial experts observe that only a small
group of people make use of all services in the package.
Other Payment Methods
A certified check is a personal check with guaranteed payment.
The amount of the check is deducted from your balance when
the financial institution certifies the check. A cashier’s check is
a check issued by a financial institution. You may purchase one
by paying the amount of the check plus a fee. You may purchase
a money order in a similar manner from financial institutions,
post offices, and stores. Certified checks, cashier’s checks, and
money orders allow you to make a payment that the recipient
knows is valid.
Traveler’s checks allow you to make payments when you are
away from home. This payment form requires you to sign each check twice. First, you
sign the traveler’s checks when you purchase them. Then, to identify you as the authorized
person, you sign them again as you cash them. Electronic traveler’s checks, in the form of
a prepaid travel card, are also available. The card allows travelers visiting other nations to
get local currency from an ATM.
Managing Your Checking Account
Obtaining and using a checking account involve several activities.
OPENING A CHECKING ACCOUNT First, decide who the owner of the
account is. Only one person is allowed to write checks on an individual account. A joint
account has two or more owners. Both an individual account and a joint account require
a signature card. This document is a record of the official signatures of the person or per-
sons authorized to write checks on the account.
overdraft protection An
automatic loan made to
checking account customers
to cover the amount of
checks written in excess of
the available balance in the
checking account.
digi – know? digi – know?
EMV credit and debit cards contain an EMV credit and debit cards contain an
integrated chip rather than a magnetic integrated chip rather than a magnetic
strip, to provide greater security and strip, to provide greater security and
reduce fraud. This technology makes it reduce fraud. This technology makes it
very difficult to create counterfeit cards. very difficult to create counterfeit cards.
The EMV name comes from Europay, Mas-The EMV name comes from Europay, Mas-
terCard, and Visa, the companies involved terCard, and Visa, the companies involved
in developing the chip-based payment cards in developing the chip-based payment cards
that are commonly used in many countries that are commonly used in many countries
around the world. around the world.
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MAKING DEPOSITS A deposit ticket is used for adding funds to your checking
account. On this document, you list the amounts of cash and checks being deposited. Each
check you deposit requires an endorsement —your signature on the back of the check—
to authorize the transfer of the funds into your account. The three common endorsement
forms are:
• A blank endorsement is just your signature, which should be used only when you
are actually depositing or cashing a check, since a check may be cashed by anyone
once it has been signed.
• A restrictive endorsement consists of the words for deposit only, followed by your
signature, which is especially useful when you are depositing checks.
• A special endorsement allows you to transfer a check to someone else with the
words pay to the order of followed by the name of the other person and then your
signature.
WRITING CHECKS Before writing a check, record the
information in your check register and deduct the amount of the
check from your balance. Many checking account customers use
duplicate checks to maintain a record of their current balance.
The procedure for proper check writing has the following steps:
(1) record the date; (2) write the name of the person or organiza-
tion receiving the payment; (3) record the amount of the check in
numerals; (4) write the amount of the check in words; checks for
less than a dollar should be written as “only 79 cents,” for example,
and cross out the word dollars on the check; (5) sign the check;
(6) note the reason for payment.
A stop-payment order may be necessary if a check is lost or stolen. Most banks do
not honor checks with “stale” dates, usually six months old or older. The fee for a stop-
payment commonly ranges from $20 to more than $30. If several checks are missing or
you lose your checkbook, closing the account and opening a new one is likely to be less
costly than paying several stop-payment fees.
RECONCILING YOUR CHECKING ACCOUNT Each month you will
receive a bank statement summarizing deposits, checks paid, ATM withdrawals, interest
earned, and fees such as service charges and printing of checks. The balance reported on
the statement will usually differ from the balance in your checkbook. Reasons for a differ-
ence may include checks that have not yet cleared, deposits not received by the bank, and
interest earned.
To determine the correct balance, prepare a bank reconciliation, to account for differ-
ences between the bank statement and your checkbook balance. This process involves the
following steps:
1. Compare the checks written with those reported as paid on the statement. Use the
canceled checks, or compare your check register with the check numbers reported
on the bank statement. Subtract from the bank statement balance the total of the
checks written but not yet cleared.
2. Determine whether any deposits made are not on the statement; add the amount of
the outstanding deposits to the bank statement balance.
3. Subtract fees or charges on the bank statement and ATM withdrawals from your
checkbook balance.
4. Add any interest earned to your checkbook balance.
At this point, the revised balances for both the checkbook and the bank statement should
be the same. If the two do not match, check your math; make sure every check and deposit
was recorded correctly.
CAUTION! CAUTION!
Each year, consumers lose millions of dollars
by accepting phony checks, money orders,
and wire transfers for online transactions and
other business activities. Information and
videos on check scams may be obtained at
www.fakechecks.org .
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If you are a victim of identity theft, take the following
actions:
• File a police report immediately in the area where the
item was stolen. This proves you were diligent and is a
first step toward an investigation (if there ever is one).
• Call the three national credit reporting organizations
immediately to place a fraud alert on your name and
Social Security number. The numbers are: Equifax,
1-800-525-6285; Experian (formerly TRW), 1-888-
397-3742; and TransUnion, 1-800-680-7289.
• Contact the Social Security Administration fraud line
at 1-800-269-0271.
Additional information on financial privacy and identity
theft is available at www.identitytheft.org , www.idfraud
.org , and www.privacyrights.org .
People who put their Social Security and driver’s license
numbers on their checks are making identity theft fairly
easy. With one check, a con artist could know your Social
Security, driver’s license, and bank account numbers as
well as your address, phone number, and perhaps even a
sample of your signature.
An attorney had his wallet stolen. Within a week, the
thieves ordered an expensive monthly cell phone package,
applied for a Visa credit card, had a credit line approved to
buy a Gateway computer, and received a PIN number from
the Department of Motor Vehicles to change his driving
record information online.
Identity fraud can range from passing bad checks and
using stolen credit cards to theft of another person’s total
financial existence. The following quiz can help you avoid
becoming one of the more than 1,000 people who each
day have their identities stolen by con artists.
Are You Avoiding Identity Theft?
Personal Finance in Practice
Which of the following actions have you taken to avoid identity theft? Yes No
Action
needed
1. I have only my initials and last name on checks so others will not know how I sign
my checks. I do not put the full account number on my checks when paying a bill,
only the last four numbers.
2. I have my work phone and a PO box (if applicable) on my checks instead of home
information.
3. I don’t provide my Social Security number unless it is legally required.
4. I have personal documents in a locked area and shred unneeded financial
documents and CDs containing account or Social Security numbers. I clear the
hard drives of old computers.
5. I change passwords (letters, numbers, characters) and PINs often. I do not keep a
list of these in my wallet, and I guard them when using them in a public place.
6. I promptly collect my mail with account numbers and send bill payments from a
post office or a public mailbox.
7. I check my credit report regularly (all three major credit reporting agencies) to make
sure it is correct. I have my name removed from mailing lists of credit agencies and
companies offering credit promotions.
8. I have a photocopy of the contents of my wallet (both sides of each item) as a
record to cancel accounts if necessary.
9. I am suspicious of companies and individuals who request verification of personal
information.
10. I use only secured, trusted websites when making purchases or when storing
personal information online.
11. I review my bank and credit card statements each month for questionable charges.
12. I have a secured home wireless network with a password I created, a locked
router, and encrypted information.
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A failure to reconcile your bank account each month can result in not knowing:
• Your exact spending habits for wise money management.
• If the correct deposit amounts have been credited to your account.
• Any unauthorized ATM withdrawals.
• If your bank is overcharging you for fees.
• Errors that your bank may have made in your account.
PRACTICE QUIZ 4–4 PRACTICE QUIZ 4–4
1. Are checking accounts that earn interest preferable to regular checking accounts? Why or why not?
2. What factors are commonly considered when selecting a checking account?
3. For the following situations, select and describe a payment method that would be appropriate for the needs of the
person.
a. A need to send funds for a purchase from an organization that requires guaranteed payment.
b. Traveling to Asia, you desire to be able to access funds in the local currencies of various countries.
c. A desire to pay bills using your home computer instead of writing checks.
d. You write only a few checks a month and you want to minimize your costs.
4. Based on the following information, determine the true balance in your checking account.
Balance in your checkbook, $356 Balance on bank statement, $472
Service charge and other fees, $15 Interest earned on the account, $4
Total of outstanding checks, $187 Deposits in transit, $60
Apply Yourself! Apply Yourself!
Observe customers making payments in a retail store. How often are cash, checks, credit cards, debit cards, and other
payment methods used?
Sheet 14 Comparing Payment Methods;
Bank Reconciliation
S
B
EXAMPLE: Bank Reconciliation
To determine the true balance in your checking account:
Bank Statement Your Checkbook
Bank balance ……………………… $920 Checkbook balance ……………. $1,041
Subtract: Outstanding
checks …………………………….. 2 187
Subtract: Fees,
ATM withdrawals ………………. 2 271
Add: Deposit in transit …………. 1 200 Add: Interest earned,
direct deposits …………………. 1 163
Adjusted bank
statement balance …………….. 933
Adjusted checkbook
balance ……………………………. 933
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YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Are you able to set aside an amount for savings each month? Are there expenses you can
reduce, or sources of increased income that could add to the amount you save each month? An improving savings rate
is the foundation for progress toward financial independence.
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) to determine actions you might take
for improved actions for the wise use of financial
services.
Conduct a web search of online banks to obtain
information on their services. Consider how changing
interest rates might affect your decision to use vari-
ous types of financial services.
Consider various sources of financial services, such
as credit unions, which often offer low-cost alterna-
tives for financial services. For additional information
about credit unions, go to www.cuna.org and www
.creditunion.coop .
Obtain current interest rates for CDs and other sav-
ings plans at www.bankrate.com . For the latest rates
and information on U.S. savings bonds, go to www
.savingsbonds.gov .
A key indicator of your potential financial success is the
percentage of income saved each month. Various finan-
cial institutions and savings instruments can be used to
implement this element of your financial plan.
While most people in our society save nothing or very
little, financial experts recommend a savings rate of
between 5 and 10 percent. These funds might be
used for emergencies, unexpected expenses, or
short-term financial goals as well as long-term financial
security.
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P E R C E N T S A V I N G S R AT E
LO4.1 Financial products such as sav-
ings plans, checking accounts, loans, trust
services, and electronic banking are used
for managing daily financial activities.
LO4.2 Commercial banks, savings and
loan associations, mutual savings banks,
credit unions, life insurance companies,
investment companies, finance companies,
mortgage companies, pawnshops, and check-
cashing outlets may be compared on the
basis of services offered, rates and fees,
safety, convenience, and special programs
available to customers.
LO4.3 Commonly used savings plans
include regular savings accounts, certifi-
cates of deposit, interest-earning checking
accounts, money market accounts, money
market funds, and U.S. savings bonds. Sav-
ings plans may be evaluated on the basis of
rate of return, inflation, tax considerations,
liquidity, safety, restrictions, and fees.
LO4.4 Debit cards, online payment sys-
tems, and stored-value cards are increas-
ing in use for payment activities. Regular
checking accounts, activity accounts, and
interest-earning checking accounts can be
compared with regard to restrictions (such
as a minimum balance), fees and charges,
interest, and special services.
Chapter
Summary
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annual percentage yield
(APY) 120
asset management
account 109
automatic teller machine
(ATM) 109
certificate of
deposit (CD) 115
Key Terms
mutual savings bank 113
overdraft protection 127
rate of return 120
savings and loan
association (S&L) 113
trust 109
commercial bank 112
compounding 120
credit union 113
debit card 110
money market
account 118
money market fund 113
Page Topic Formula
121 Annual percentage yield (APY) APY 5 100 [ ( 1 1 Interest ________ Principal ) 365/days in term 2 1 ]
Principal 5 Amount of funds on deposit
Interest 5 Total dollar amount earned on the
principal
Days in term 5 Actual number of days in the
term of the account
122 When the number of days in the
term is 365 or where the account
does not have a stated maturity,
the APY formula is simply
APY 5 100 ( Interest ________ Principal )
Example:
100 [ ( 1 1 $56.20 ______ $1,000 )
365
____
365 2 1 ] 5 0.0562 5 5.62%
After-tax rate of return Interest rate 3 (1 2 Tax rate)
Key
Formulas
1. How has online banking changed the way consumers select and use various financial
services? (LO4.1)
2. What relationship exists between changing interest rates and the rates of return for var-
ious savings accounts, money market accounts, and certificates of deposit of various
lengths? (LO4.1)
3. What actions would you recommend to someone who was considering using the ser-
vices of a pawnshop, check-cashing outlet, or payday loan company? (LO4.2)
4. What fees and deductions may be overlooked when balancing your checking
account? (LO4.4)
5. a. What are potential benefits of an overdraft protection service for your checking
account?
b. What costs should a person consider before deciding to use the overdraft protection
service? (LO4.4)
Discussion
Questions
1. What would be the annual percentage yield (APY) for a savings account that earned
$174 on a balance of $3,250 over the past 365 days?
2. If you earned a 4.2 percent return on your savings, with a 15 percent tax rate, what is
the after-tax rate of return?
Self-Test
Problems
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Solutions
1. To calculate the APY when the number of days in the term is 365, use this formula:
APY 5 100 ( Interest ________ Principal )
5 100 ( 174 _____ 3250 )
5 100 (0.0535) 5 5.35%
2. To calculate the after-tax rate of return use
Interest rate 3 (1 2 Tax rate)
0.042 3 (1 2 0.15) 5 0.042 (0.85) 5 0.0357 5 3.57%
1. An ATM with a service fee of $2 is used by a person 100 times in a year. What would
be the future value in 10 years (use a 3 percent rate) of the annual amount paid in
ATM fees? (LO4.1)
2. If a person has ATM fees each month of $18 for six years, what would be the total
cost of those banking fees? (LO4.1)
3. A payday loan company charges 5 percent interest for a two-week period. What
would be the annual interest rate from that company? (LO4.2)
4. For each of these situations, determine the savings amount. Use the time value of
money tables in Chapter 1 (Exhibit 1–3) or in the Chapter 1 appendix. (LO4.3)
a. What would be the value of a savings account started with $700, earning 4 percent
(compounded annually) after 10 years?
b. Brenda Young desires to have $15,000 eight years from now for her daughter’s
college fund. If she will earn 6 percent (compounded annually) on her money,
what amount should she deposit now? Use the present value of a single amount
calculation.
c. What amount would you have if you deposited $1,800 a year for 30 years at 8 percent
(compounded annually)?
5. What would be the annual percentage yield for a savings account that earned $56 in
interest on $800 over the past 365 days? (LO4.3)
6. With a 28 percent marginal tax rate, would a tax-free yield of 7 percent or a taxable
yield of 9.5 percent give you a better return on your savings? Why? (LO4.3)
7. Janie has a joint account with her mother with a balance of $562,000. Based on
$250,000 of Federal Deposit Insurance Corporation coverage, what amount of
Janie’s savings would not be covered by deposit insurance? (LO4.3)
8. A certificate of deposit often charges a penalty for withdrawing funds before the
maturity date. If the penalty involves two months of interest, what would be the
amount for early withdrawal on a $20,000, 5 percent CD? (LO4.3)
9. What might be a savings goal for a person who buys a five-year CD paying 4.67 percent
instead of an 18-month savings certificate paying 3.29 percent? (LO4.4)
10. What is the annual opportunity cost of a checking account that requires a
$300 minimum balance to avoid service charges? Assume an interest rate of
3 percent. (LO4.4)
11. Compare the costs and benefits of these two checking accounts: (LO4.4)
Account 1: A regular checking account with a monthly fee of $6 when the balance
goes below $300.
Account 2: An interest-earning checking account (paying 1.2 percent), with a
monthly charge of $3 if the balance goes below $100.
Problems
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12. A bank that provides overdraft protection charges 12 percent for each $100 (or por-
tion of $100) borrowed when an overdraft occurs. (LO4.4)
a. What amount of interest would the customer pay for a $188 overdraft? (Assume
the interest is for the full amount borrowed for a whole year.)
b. How much would be saved by using the overdraft protection loan if a customer
has three overdraft charges of $30 each during the year?
13. What would be the net annual cost of the following checking accounts? (LO4.4)
a. Monthly fee, $3.75; processing fee, 25 cents per check; checks written, an average
of 14 a month.
b. Interest earnings of 4 percent with a $500 minimum balance; average monthly
balance, $600; monthly service charge of $15 for falling below the minimum bal-
ance, which occurs three times a year (no interest earned in these months).
14. Based on the following information, prepare a bank reconciliation to determine
adjusted (corrected) balance: (LO4.4)
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
Bank balance, $680
Checkbook balance, $642
Outstanding checks, $112
Direct deposits, $70
Account fees, $12
ATM withdrawals, $80
Deposit in transit, $60
Interest earned, $8
Case in
Point EVALUATING BANKING SERVICES
“Wow! My account balance is a little lower
than I expected,” commented Melanie Harper
as she reviewed her bank statement. “Wait a
minute! There’s nearly $20 in fees for ATM
withdrawals and other service charges.” “Oh
no! I also went below the minimum balance
required for my free checking account,”
Melanie groaned. “That cost me $7.50!”
Melanie is not alone in her frustration with
fees paid for financial services. While
careless money management caused many
of these charges, others could have been
reduced or eliminated by comparing costs
at various financial institutions.
Melanie has decided to investigate various
alternatives to her current banking services.
Her preliminary research provided the
following:
Mobile banking—allows faster access to
account information, to quickly transfer
funds, make payments and purchases. May
include access to expanded financial ser-
vices, such as low-cost, online investment
trading and instant loan approval.
Prepaid debit card—would prevent over-
spending, staying within the budgeted
amount loaded on the card. Cards are usu-
ally accepted in most retail locations and
online. A variety of fees might be associ-
ated with the card.
Check-cashing outlet—would result in fees
only when services are used, such as money
orders, cashing a check, obtaining a prepaid
cash card, or paying bills online.
Many people do not realize the amount
they pay each month for various bank fees.
Some basic research can result in saving
several hundred dollars a year.
Questions
1. What benefits and drawbacks might
Melanie encounter when using each
of these financial services? Mobile
banking . . . Prepaid debit card . . .
Check-cashing outlet
2. What factors should Melanie consider
when selecting among these various
banking services?
3. What actions might you take to better
understand the concerns associated with
using various banking services?
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Bank Accounts:
Checking account, $2,250 (before the theft)
Savings account, $6,900
Emergency fund savings account, $3,900
401(k) balance, $350
Questions
1. Jamie Lee is beside herself knowing that the thieves had unauthorized use of her debit/
ATM card. What is Jamie’s financial responsibility for the unauthorized use?
2. What would have been Jamie Lee’s financial liability had she waited more than two
days to report the debit/ATM card lost or stolen?
3. Using “Your Personal Financial Plan” sheet 11, what financial service would benefit
Jamie Lee now, as she had legitimate checks written to cover her monthly bills that are
now in excess of the available checking account balance due to the theft?
FINANCIAL SERVICES: SAVINGS PLANS AND PAYMENT
ACCOUNTS
Continuing
Case
Jamie Lee Jackson, age 26, is in her last semester of college and is anxiously waiting for a
graduation day that is just around the corner! She still works part-time as a bakery clerk, has
been sticking to her budget the past two years, and is on track to accumulate enough money
for the $9,000 down payment she needs to open her cupcake café within the next two years.
Jamie Lee is still single, shares a small apartment with a friend, and continues to split all
of the associated living expenses, such as rent and utilities. Unfortunately, she now has to
seriously consider finding a place of her own.
One evening, after returning to the apartment after a long shift at the bakery, Jamie learned
that her roommate had a couple of friends over earlier in the evening. As Jamie went to her
room, she noticed that her top desk drawer had been left open and her debit/ATM card, as
well as her checkbook and Social Security card, were missing. She immediately contacted
the authorities, and the police instructed her to notify her financial institution immediately.
But it was late Saturday night, and Jamie thought she had to now wait until Monday morn-
ing. Unfortunately, within no time, Jamie found that her checking account had been emptied!
Jamie Lee’s luck worsened, as she had paid many of her monthly bills late last week. Her
automobile insurance, two utility bills, and a layaway payment had all been paid for by
check. Her bank almost immediately began sending overdraft alerts through her smart-
phone for the emptied checking account.
Current Financial Situation
Directions Start (or continue) your Daily Spending Diary or use your own format to
record and monitor spending in various categories. Your comments should reflect what
you have learned about your spending patterns and help you consider possible changes
you might make. The Daily Spending Diary sheets are located in Appendix D at the end
of the book and in Connect Finance.
Questions
1. Are there any banking fees that you encounter each month? What actions might be
taken to reduce or eliminate these cash outflows?
2. What other areas of your daily spending might be reduced or revised?
“MY CASH WITHDRAWALS HAVE RESULTED IN MANY ATM FEES
THAT TAKE AWAY MONEY FROM OTHER BUDGET ITEMS.”
Spending
Diary
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What’s Next for Your Personal Financial Plan?
• Assess whether the current types and sources of your financial services are appropriate.
• Determine additional financial services you may wish to make use of in the future.
Planning the Use of Financial Services
Purpose: To indicate currently used financial services and to determine services that may be
needed in the future.
Financial Planning Activities: List (1) currently used services with financial institution infor-
mation (name, address, phone); and (2) services that are likely to be needed in the future.
This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.bankrate.com www.consumerfinance.gov banking.about.com
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Types of financial services
Current financial
services used
Additional financial
services needed
Payment services (checking, ATM, online
bill payment, money orders)
Financial Institution
Savings services (savings account, money
market account, certificate of deposit, savings
bonds)
Financial Institution
Credit services (credit cards, personal loans,
mortgage)
Financial Institution
Other financial services (investments, trust
account, tax planning)
Financial Institution
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What’s Next for Your Personal Financial Plan?
• Based on this savings plan analysis, determine the best types for your current and future financial situation.
• When analyzing savings plans, what factors should you carefully investigate?
Comparing Savings Plans
Purpose: To compare the costs and benefits associated with different savings plans.
Financial Planning Activities: Analyze advertisements and contact various financial insti-
tutions to obtain the information requested below. This sheet is also available in an Excel
spreadsheet format in Connect Finance.
Suggested Websites: www.bankrate.com www.nerdwallet.com www.savingsaccounts.com
Type of savings plan (regular savings account, certificates of
deposit, interest-earning checking accounts, money market
accounts and funds, U.S. savings bonds)
Financial institution
Address/phone
Website
Annual interest rate
Annual percentage yield (APY)
Frequency of compounding
Insured by FDIC, NCUA, other
Maximum amount insured
Minimum initial deposit
Minimum time period savings that must be on deposit
Penalties for early withdrawal
Service charges/transaction fees, other costs, fees
Additional services, other information
Suggested
App:
• Savings Plan
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What’s Next for Your Personal Financial Plan?
• Assess your current progress toward achieving various savings goals. Evaluate existing and new savings goals.
• Plan actions to expand the amount you are saving toward various savings goals.
Using Savings Plans to Achieve
Financial Goals
Purpose: Monitor savings to assist in reaching financial goals.
Financial Planning Activities: Record savings plan information along with the amount
of your balance or income on a periodic basis. This sheet is also available in an Excel
spreadsheet format in Connect Finance.
Suggested Websites: www.savingsbonds.gov www.fdic.gov www.banx.com
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Regular savings account Savings goal/Amount needed/Date needed
Acct. no.
Financial
institution
Address
Phone
Website
_________________________
_________________________
_________________________
_________________________
_________________________
_________________________
Savings goal:
Balance:
Date ___________
Date ___________
Date ___________
Date ___________
Date ___________
$ ___________
$ ___________
$ ___________
$ ___________
$ ___________
Certificate of deposit Savings goal/Amount needed/Date needed
Acct. no.
Financial
institution
Address
Phone
Website
_________________________
_________________________
_________________________
_________________________
_________________________
_________________________
Savings goal:
Balance:
Date ___________
Date ___________
Date ___________
Date ___________
Date ___________
$ ___________
$ ___________
$ ___________
$ ___________
$ ___________
Money market fund/acct. Savings goal/Amount needed/Date needed
Acct. no.
Financial
institution
Address
Phone
Website
_________________________
_________________________
_________________________
_________________________
_________________________
_________________________
Savings goal:
Balance:
Date ___________
Date ___________
Date ___________
Date ___________
Date ___________
$ ___________
$ ___________
$ ___________
$ ___________
$ ___________
U.S. savings bonds Savings goal/Amount needed/Date needed
Purchase
location
Address
Phone
Website
_________________________
_________________________
_________________________
_________________________
_________________________
_________________________
Purchase date: ___________ Maturity date: ___________
Amount: ___________
Purchase date: ___________ Maturity date: ___________
Amount: ___________
Other savings Savings goal/Amount needed/Date needed
Acct. no.
Financial
institution
Address
Phone
Website
_________________________
_________________________
_________________________
_________________________
_________________________
_________________________
Initial deposit:
Balance:
Date ___________
Date ___________
Date ___________
Date ___________
Date ___________
$ ___________
$ ___________
$ ___________
$ ___________
$ ___________
Suggested
App:
• Save Genius
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n Checking Account Reconciliation
Comparing Payment Methods; Bank
Reconciliation
Purpose: To determine the adjusted cash balance for your checking account.
Financial Planning Activities: Compare checking accounts and payment services at vari-
ous financial institutions (banks, savings and loan associations, credit unions, online banks).
Enter data from your bank statement and checkbook for the amounts requested. This sheet
is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.bankrate.com www.kiplinger.com www.depositaccounts.com
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Institution name
Address
Phone
Website
Type of account (regular checking, activity
account, bill payment service)
Minimum balance
Monthly charge below balance
“Free” checking for students?
Online banking services , mobile app banking
Branch/ATM locations
Banking hours
Other fees/costs
Printing of checks
Stop-payment order
Overdrawn account
Certified check
ATM, other charges
Other information
Statement date: Statement Balance $ __________
Step 1: Compare the checks written with those paid on
statement. Subtract the total of the checks written but
not cleared from the bank balance.
Check no. Amount 2 $ __________
Step 2: Determine whether any deposits made are not
on the statement; add the amount of the outstanding
deposits to the bank statement balance.
Deposit date Amount 1 $ __________
5 $ __________ Adjusted Balance
Checkbook Balance
Step 3: Subtract fees or charges on the bank statement
and ATM withdrawals from your checkbook balance.
Item Amount 2 $ __________
Step 4: Add interest or direct deposits earned to your
checkbook balance.
1 $ __________
Note: At this point, the two adjusted balances should
be the same. If not, carefully check your math and make
sure that deposits and checks recorded in your check-
book and on your statement are for the correct amounts.
Adjusted Balance 5 $ __________
Suggested
App:
• MoneyPass
(ATM locator)
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3 Steps to Financial
Literacy . . .
Reducing Your Debt Ratio
5
Consumer Credit:
Advantages,
Disadvantages, Sources,
and Costs
Why is a low debt-to-income ratio
important?
This ratio is an indicator of current money
troubles and potential long-term financial
disaster. Make every effort to reduce your
current debt load. At the end of the chapter,
“Your Personal Finance Dashboard” will
provide guidelines for measuring your
debt-to-income ratio.
1
Determine the current amount owed for vari-
ous debts, loans, and other credit accounts.
Website: www.budgetwise.net
2
Assess your daily spending habits to reduce
your use of credit and to pay off current loans
and credit balances.
App: Mint
3
Avoid using credit for current expenses. Make
extra payments to reduce amounts owed.
Website: www.bankrate.com
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What Is Consumer Credit?
Credit is an arrangement to receive cash, goods, or services now and pay for them in
the future. Consumer credit refers to the use of credit for personal needs (except a
home mortgage) by individuals and families, in contrast to credit used for business
purposes. Many people use credit to live beyond their means, largely because of a
change in perception about credit. Past generations viewed credit as a negative and
used it very sparingly. Society today has popularized credit with phrases such as “Life
takes Visa,” “Priceless” campaigns, and even references to a “Plunk factor” when
using a sought-after credit card. That said, when used appropriately, credit can be a
very useful tool.
Consumer credit is based on trust in people’s ability and willingness to pay bills when
due. It works because people by and large are honest and responsible. But how does con-
sumer credit affect our economy, and how is it affected by our economy?
The Importance of Consumer Credit in Our Economy
Consumer credit dates back to colonial times. Although credit was originally a privilege of
the affluent, farmers came to use it extensively. No direct finance charges were imposed;
instead, the cost of credit was added to the prices of goods. With the advent of the automo-
bile in the early 1900s, installment credit, in which the debt is repaid in equal installments
over a specified period of time, exploded on the American scene.
All economists now recognize consumer credit as a major force in the American econ-
omy. Any forecast or evaluation of the economy includes consumer spending trends and
consumer credit as a sustaining force.
credit An arrangement
to receive cash, goods, or
services now and pay for
them in the future.
consumer credit The use
of credit for personal needs
(except a home mortgage).
CHAPTER 5 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO5.1 Analyze advantages and disadvantages of using consumer credit.
LO5.2 Assess the types and sources of consumer credit.
LO5.3 Determine whether you can afford a loan and how to apply for credit.
LO5.4 Determine the cost of credit by calculating interest using various interest formulas.
LO5.5 Develop a plan to protect your credit and manage your debts.
YOUR PERSONAL FINANCIAL PLAN SHEETS
15. Consumer Credit Usage Patterns
16. Credit Card/Charge Account Comparison
17. Consumer Loan Comparison
LO5.1
Analyze advantages and
disadvantages of using
consumer credit.
ACTION ITEM
I pay any bills I have when
they are due.
h Always
h Most of the time
h Sometimes
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Uses and Misuses of Credit
Using credit to purchase goods and services may allow consumers to be more efficient or
more productive, or it may lead to more satisfying lives. Many valid reasons can be found
for using credit. A medical emergency may leave a person strapped for funds. A home-
maker returning to the workforce may need a car. An item may cost less money now than
it will cost later. Borrowing for a college education may be another valid reason. But bor-
rowing for everyday living expenses or financing a Corvette on credit when a Ford Focus
is all your budget allows is probably not reasonable.
Using credit increases the amount of money a person can spend to purchase goods and
services now. But the trade-off is that it decreases the amount of money that will be avail-
able to spend in the future. However, many people expect their incomes to increase and
therefore expect to be able to make payments on past credit purchases and still make new
purchases. This should be carefully considered.
Here are some questions you should consider before you decide how and when to make
a major purchase, for example, a car:
• Do I have the cash I need for the down payment?
• Do I want to use my savings for this purchase?
• Does the purchase fit my budget?
• Could I use the credit I need for this purchase in some better way?
• Could I postpone the purchase?
• What are the opportunity costs of postponing the purchase (alternative
transportation costs, a possible increase in the price of the car)?
• What are the dollar costs and the psychological costs of using credit (interest, other
finance charges, being in debt and responsible for making a monthly payment)?
If you decide to use credit, make sure the benefits of purchasing now (increased effi-
ciency or productivity, a more satisfying life, etc.) outweigh the costs (financial and psy-
chological) of using credit. Thus, credit, when effectively used, can help you have more
and enjoy more. When misused, credit can result in default, bankruptcy, and loss of
creditworthiness.
Advantages of Credit
Consumer credit enables people to enjoy goods and services now—a car, a home, an
education—or it can provide for emergencies, and it can pay for them all through payment
plans based on future income.
Credit cards permit the purchase of goods even when funds are low. Customers with
previously approved credit may receive other extras, such as advance notice of sales and
the right to order by phone or to buy on approval. Many retailers will accept returned mer-
chandise without a receipt because they can look up the purchase made by a credit card.
Credit cards also provide shopping convenience and the efficiency of paying for several
purchases with one monthly payment.
Credit is more than a substitute for cash. Many of the services it provides are taken for
granted. Every time you turn on the water tap, click the light switch, or telephone a friend,
you are using credit.
Using credit is safe, since charge accounts and credit cards let you shop and travel with-
out carrying a large amount of cash. It offers convenience, since you need a credit card to
make a hotel reservation, rent a car, and shop by phone or Internet. You may also use credit
cards for identification when cashing checks, and the use of credit provides you with a
record of expenses.
The use of credit cards can provide up to a 50-day “float,” the time lag between
when you make the purchase and when the lender deducts the balance from your
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checking account when payment is due. This float, offered by many credit card issuers,
includes a grace period of 20 to 25 days. During the grace period, no finance charges
are assessed on current purchases if the balance is paid in full each month within 25
days after billing.
In addition, many major credit cards provide the following benefits to their customers
at no extra cost:
• Accidental death and dismemberment insurance when you travel on a common
carrier (train, plane, bus, or ship), up to $250,000.
• Auto rental collision damage waiver (CDW) for damage due to collision or theft for
$50,000 or more.
• Roadside dispatch referral service for emergency roadside assistance, such as
towing, locksmith services, and more.
• Redemption of your points or miles for gift cards or cash, or to book travel—from
airfare, hotels, and rental cars to vacation packages.
• No foreign transaction fees for some cards, such as CapitalOne.
Finally, credit indicates stability. The fact that lenders consider you a good risk usually
means you are a responsible individual. However, if you do not repay your debts in a
timely manner, you will find that credit has many disadvantages.
Disadvantages of Credit
Perhaps the greatest disadvantage of using credit is the temptation to overspend, especially
during periods of inflation. Buying today and paying tomorrow, using cheaper dollars,
seems ideal. But continual overspending can lead to serious trouble.
Whether or not credit involves security (or collateral)—something of value to back the
loan—failure to repay a loan may result in loss of income, valuable property, and your
good reputation. It can even lead to court action and bankruptcy. Misuse of credit can cre-
ate serious long-term financial problems, cause damage to family relationships, and delay
progress toward financial goals. Therefore, you should approach credit with caution and
avoid using it more than your budget permits.
Although credit allows immediate satisfaction of needs and desires, it does not increase
total purchasing power. Credit purchases must be paid out of future income; therefore,
credit ties up the use of future income. Furthermore, if your income does not increase to
cover rising costs, your ability to repay credit commitments will diminish. Before buy-
ing goods and services on credit, consider whether they will have lasting value, whether
they will increase your personal satisfaction during present and future income periods, and
whether your current income will continue or increase.
Finally, credit costs money. It is a service for which you must pay. Paying for pur-
chases over a period of time is more costly than paying for them with cash. Purchasing
with credit rather than cash involves one obvious trade-off: The items purchased may
cost more due to monthly finance charges and the compounding effect of interest on
interest.
Summary: Advantages and Disadvantages of Credit
The use of credit provides immediate access to goods and services, flexibility in money
management, safety and convenience, a cushion in emergencies, a means of increas-
ing resources, and a good credit rating if you pay back your debts in a timely manner.
But remember, the use of credit is a two-sided coin. An intelligent decision as to its use
demands careful evaluation of your current debt, your future income, the added cost, and
the consequences of overspending.
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Types of Credit
Two basic types of consumer credit exist: closed-end and open-end credit. With closed-
end credit , you pay back one-time loans in a specified period of time and in payments of
equal amounts. With open-end credit , loans are made on a continuous basis and you are
billed periodically for at least partial payment. Exhibit 5–1 shows examples of closed-end
and open-end credit.
Closed-End Credit
Closed-end credit is used for a specific purpose and involves a specified amount.
Mortgage loans, automobile loans, and installment loans for purchasing furniture or
appliances are examples of closed-end credit. Generally, the seller holds title to the mer-
chandise until the payments have been completed and can take possession of the item if
the bill is unpaid.
The three most common types of closed-end credit are installment sales credit, install-
ment cash credit, and single lump-sum credit. Installment sales credit is a loan that allows
you to receive merchandise, usually high-priced items such as large appliances or fur-
niture. You make a down payment and usually sign a contract to repay the balance, plus
interest and service charges, in equal installments over a specified period.
Installment cash credit is a direct loan of money for personal purposes, home improve-
ments, or vacation expenses. You make no down payment and make payments in specified
amounts over a set period.
Single lump-sum credit is a loan that must be repaid in total on a specified day, usually
within 30 to 90 days. Lump-sum credit is generally, but not always, used to purchase a
single item. As Exhibit 5–2 shows, consumer installment credit reached a peak of over
$3 trillion in 2013. This number has declined slightly since then but still remains at a very
high level.
LO5.2
Assess the types and
sources of consumer credit.
closed-end credit One-
time loans that the borrower
pays back in a specified
period of time and in
payments of equal amounts.
open-end credit A line
of credit in which loans are
made on a continuous basis
and the borrower is billed
periodically for at least partial
payment.
PRACTICE QUIZ 5–1 PRACTICE QUIZ 5–1
1. What is consumer credit?
2. Why is consumer credit important to our economy?
3. List two good reasons to borrow and two unnecessary reasons to borrow.
Apply Yourself! Apply Yourself!
Using web research and discussion with family members and friends, prepare a list of advantages and disadvantages of
using credit.
Exhibit 5–1
Examples of Closed-End
and Open-End Credit
• Mortgage loans
• Automobile loans
• Installment loans (installment sales contract,
installment cash credit, single lump-sum credit)
Closed-End Credit Open-End Credit
• Cards issued by department stores, bank
cards (Visa, MasterCard)
• Travel and entertainment (T&E) (American
Express, Diners Club)
• Overdraft protection
ACTION ITEM
If I need more money for my
expenses, I borrow it.
h Never
h Sometimes
h Often
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Open-End Credit
Using a credit card issued by a department store, using a bank credit card (Visa, MasterCard)
to make purchases at different stores, charging a meal at a restaurant, and using overdraft
protection are examples of open-end credit. As you will soon see, you do not apply for open-
end credit to make a single purchase, as you do with closed-end credit. Rather, you can use
open-end credit to make any purchases you wish if you do not exceed your line of credit , the
maximum dollar amount of credit the lender has made available to you. You may have to pay
interest , a periodic charge for the use of credit, or other finance charges. Usually you have
the option to pay the bill in full within 30 days without interest charges or to make set monthly
installments based on the account balance plus interest. Some creditors allow you a grace
period of 20 to 25 days to pay a bill in full before you incur any interest charges.
Many banks extend revolving check credit . Also called a bank line of credit, this is a
prearranged loan for a specified amount that you can use by writing a special check.
Repayment is made in installments over a set period. The finance charges are based on the
amount of credit used during the month and on the outstanding balance.
Credit Cards
Credit cards are extremely popular. The average cardholder has more than nine credit
cards, including bank, retail, and gasoline cards. Cardholders who pay off their balances in
full each month are often known as convenience users. Cardholders who do not pay off
their balances every month are known as borrowers.
Most credit card companies offer a grace period, a time period during which no finance
charges will be added to your account. A finance charge is the total dollar amount you pay
line of credit The dollar
amount, which may or may
not be borrowed, that a
lender makes available to a
borrower.
interest A periodic charge
for the use of credit.
revolving check credit
A prearranged loan from a
bank for a specified amount;
also called a bank line of
credit.
finance charge The total
dollar amount paid to use
credit.
Exhibit 5–2
Volume of Consumer
Credit
All economists now recognize
consumer credit as a major
force in the American
economy.
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
’09
’10
Billions of Dollars
22 23 24 26 27 28 29 30 31 3225
2,553.5
2,648.1
2,757.0
2,924.3
3,099.2
’11
’12
’13
’04
’03
’02
’01
2000
’99
’98
’97
’96 1,242.2
1,305.0
1,400.3
1,512.8
1,686.2
1,871.9
1,984.1
2,078.3
2,219.4
’06
’07
’08
’05 2,313.9
2,418.3
2,551.9
2,595.9
SOURCE: www.federalreserve.gov/RELEASES/g19/current , accessed April 22, 2014.
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did you know?did you know?
An average household carries more than
$7,000 in credit card debt.
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to use credit. Usually, if you pay your entire balance before the due date stated on your
monthly bill, you will not have to pay a finance charge. Borrowers carry balances beyond
the grace period and pay finance charges. Many credit cards offer “teaser rates.” These
introductory rates are good for a short period of time, typically 6 to 12 months. The rates
may rise significantly after the introductory period. These should be carefully considered
before transferring a balance or making significant purchases that you may not be able to
repay during the introductory period.
Many credit card companies now offer reward programs that provide cash, rebates, or
airline tickets. These types of cards usually have higher finance charges, and the value of
the reward should be compared to the cost of the card if you do not intend to pay off the
balance monthly.
The cost of a credit card depends on the type of credit card you have and the terms set forth
by the lender. As a cardholder, you may have to pay interest or
other finance charges. Some credit card companies charge card-
holders an annual fee, usually about $40. However, many compa-
nies have eliminated annual fees in order to attract more customers.
If you are looking for a credit card, be sure to shop around for one
with no annual fee. The nearby “Personal Finance in Practice” box
offers some other helpful hints for choosing a credit card.
When you choose a credit card, shopping around can yield
big returns. Follow these suggestions to find the card that
best meets your needs and to use it wisely:
1. Department stores and gasoline companies are good
places to obtain your first credit card.
2. Bank credit cards are offered through banks and sav-
ings and loan associations. Annual fees and finance
charges vary widely, so shop around.
3. If you plan on paying off your balance every month, look
for a card that has a grace period and carries no annual
fee or a low annual fee. You might have a higher interest
rate, but you plan to pay little or no interest anyway.
4. Watch out for creditors that offer low or no annual fees
but instead charge a transaction fee every time you use
the card.
5. If you plan to carry a balance, look for a card with a low
monthly finance charge. Be sure that you understand
how the finance charge is calculated.
6. To avoid delays that may result in finance charges, fol-
low the card issuer’s instructions as to where, how, and
when to make bill payments.
7. Beware of offers of easy credit. No one can guarantee
to get you credit.
8. If your card offers a grace period, take advantage of
it by paying off your balance in full each month. With a
grace period of 25 days, you actually get a free loan
when you pay bills in full each month.
9. If you have a bad credit history and have trouble get-
ting a credit card, look for a savings institution that
will give you a secured credit card. With this type
of card, your line of credit depends on how much
money you keep in a savings account that you
open at the same time.
10. Travel and entertainment cards often charge higher
annual fees than most credit cards. Usually, you
must make payment in full within 30 days of receiv-
ing your bill, or no further purchases will be approved
on the account.
11. Be aware that debit cards are not credit cards but
simply a substitute for a check or cash. The amount
of the sale is subtracted from your checking account.
12. Think twice before you make a telephone call to a
900 number to request a credit card. You will pay
from $2 to $50 for the 900 call and may never receive
a credit card.
Before you enter the world of credit, you need to under-
stand the various options that are available to you. Which
of the preceding factors would be most important in your
choice of a credit card?
SOURCES: American Institute of Certified Public Accountants,
U.S. Office of Consumer Affairs, and Federal Trade Commission.
Choosing a Credit Card
Personal Finance in Practice
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DEBIT CARDS Don’t confuse credit cards with debit
cards. Although they may look alike, they’re very different. A
debit card electronically subtracts money from your savings or
checking account to pay for goods and services. A credit card
extends credit and delays your payment. Debit cards are most
frequently used at automatic teller machines (ATMs). More and
more, however, they are also used to purchase goods in stores
and to make other types of payments.
Raquel Garcia is serious about avoiding debt. The 18-year-
old customer representative for U-Haul recently canceled her
credit card. Now she gets her entire paycheck deposited onto a prepaid debit card,
which she uses for all her purchases. Since she can access only what’s in the account,
Garcia no longer worries about breaking her budget: “I’m spending just what I need.”
STORED VALUE (OR GIFT) CARDS Stored-value cards, gift cards, or pre-
paid cards resemble a typical debit card, using magnetic stripe technology to store infor-
mation and track funds. However, unlike traditional debit cards, stored value cards are
prepaid, providing you with immediate money. Gift card sales have exploded over the
last few years. The convenience factor for the gift giver is huge. It is estimated that sales
of gift cards reached over $118 billion at the beginning of 2014. Substantial growth has
also occurred in the area of digital gift cards. These cards are sent via e-mail to recip-
ients, who will receive an access code to activate and use their e-cards online to make
purchases.
Bankruptcy courts treat gift cards the same way they handle unsecured debt: If a retailer
goes bankrupt, holders get pennies on the dollar at most—and in many cases nothing. One
market research firm estimates that holders of gift cards recently lost more than $75 mil-
lion when the number of retailer bankruptcies increased sharply.
SMART CARDS Some lenders are starting to offer a new kind of credit card called a
smart card. A smart card is a plastic card equipped with a computer chip that can store 500
times as much data as a normal credit card. Smart cards can combine credit card balances,
a driver’s license, health care identification, medical history, and other information all in
one place. A smart card, for example, can be used to buy an airline ticket, store it digitally,
and track frequent flyer miles.
TRAVEL AND ENTERTAINMENT CARDS Travel and entertainment (T&E)
cards are really not credit cards because the balance is due in full each month. However,
most people think of T&E cards—such as Diners Club or American Express cards—as
credit cards because they don’t pay for goods or services when they purchase them.
SMARTPHONES Some phones are now equipped to make purchases. This concept,
called mobile commerce , has seen a significant increase in interest from consumers, retail-
ers, and finance companies. For example, some credit card companies, instead of provid-
ing a physical credit card, provide stickers that attach to a phone that will allow the
customer to scan the code. In addition, retailers such as Starbucks have apps that are scan-
nable barcodes to quickly pay using a mobile phone.
Sources of Consumer Credit
Many sources of consumer credit are available, including commercial banks and credit
unions. Exhibit 5–3 summarizes the major sources of consumer credit. Study and compare
the differences to determine which source might best meet your needs and requirements.
mobile commerce The
ability to purchase using a
mobile device.
did you know?did you know?
In 2013, an estimated 194 million debit card
holders will use 580 million cards for 54 trillion
transactions amounting to over $2 trillion.
SOURCE: Statistical Abstract of the United States 2014, Table 1211.
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Loans
Loans involve borrowing money with an agreement to repay it, as well as interest, within
a certain amount of time. If you were considering taking out a loan, your immediate
thought might be to go to your local bank. However, you might want to explore some
other options first.
Exhibit 5–3 Sources of Consumer Credit
Credit Source Type of Loan Lending Policies
Commercial banks Single-payment loan
Personal installment loans
Passbook loans
Check-credit loans
Credit card loans
Primary mortgages
Second mortgages
• Seek customers with established credit history
• Often require collateral or security
• Prefer to deal in large loans, such as vehicle, home
improvement, and home modernization, with the excep-
tion of credit card and check-credit plans
• Determine repayment schedules according to the purpose
of the loan
• Vary credit rates according to the type of credit, time
period, customer’s credit history, and the security offered
• May require several days to process a new credit
application
Consumer finance
companies
Personal installment loans
Primary mortgages
Second mortgages
• Often lend to consumers without established credit history
• Often make unsecured loans
• Often vary rates according to the size of the loan balance
• Offer a variety of repayment schedules
• Make a higher percentage of small loans than other
lenders
• Maximum loan size limited by law
• Process applications quickly, frequently on the same day
the application is made
Credit unions Personal installment loans
Share draft-credit plans
Credit card loans
Primary mortgages
Second mortgages
• Lend to members only
• Make unsecured loans
• May require collateral or cosigner for loans over a speci-
fied amount
• May require payroll deductions to pay off loan
• May submit large loan applications to a committee of
members for approval
• Offer a variety of repayment schedules
Life insurance companies Single-payment or
partial-payment loans
• Lend on cash value of life insurance policy
• No date or penalty on repayment
• Deduct amount owed from the value of policy benefit if
death or other maturity occurs before repayment
Federal savings banks
(savings and loan
associations)
Personal installment loans
(generally permitted by
state-chartered savings
associations)
Home improvement loans
Education loans
Savings account loans
Primary mortgages
Second mortgages
• Will lend to all creditworthy individuals
• Often require collateral
• Loan rates vary depending on size of loan, length of pay-
ment, and security involved
Consumer credit is available from several types of sources. Which sources seem to offer the widest variety of loans?
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did you know?did you know?
You can lend to micro-entrepreneurs. You can lend to micro-entrepreneurs.
Kiva.orgKiva.org is one of the first microlend- is one of the first microlend-
ing websites where you can lend money ing websites where you can lend money
to micro-entrepreneurs through a to micro-entrepreneurs through a
microfinance institution.microfinance institution.
INEXPENSIVE LOANS Parents or other family members
are often the source of the least expensive loans—loans with low
interest. They may charge only interest they would have earned
on the money if they had deposited it in a savings account. They
may even give you a loan without interest. Be aware, however,
that loans can complicate family relationships. You can borrow
(or invest) money with microlending organizations, such as
kiva.org . Borrowers with good credit can borrow at interest rates
lower than those charged by banks and credit unions.
MEDIUM-PRICED LOANS Often you can obtain medium-
priced loans—loans with moderate interest—from commercial
banks, savings and loan associations, and credit unions. Borrowing from credit unions has
several advantages. They provide personalized service, and usually they’re willing to be
patient with borrowers who can provide good reasons for late or missed payments. How-
ever, you must be a member of a credit union in order to get a loan.
EXPENSIVE LOANS The easiest loans to obtain are also the most expensive. Finance
companies and retail stores that lend to consumers will frequently charge high interest
rates, ranging from 12 to 25 percent. Banks also lend money to their credit card holders
through cash advances—loans that are billed to the customer’s credit card account. Most
cards charge higher interest for a cash advance and charge interest from the day the cash
advance is made. As a result, taking out a cash advance is much more expensive than
charging a purchase to a credit card. Read the nearby “Figure It Out!” box to learn why you
should avoid such cash advances.
HOME EQUITY LOANS A home equity loan is a loan based on your home equity—
the difference between the current market value of your home and the amount you still owe
on the mortgage.
EXAMPLE: Home Equity Loans
Depending on your income and the equity in your home, you can apply for a line of
credit for anywhere from $10,000 to $250,000 or more.
Some lenders let you borrow only up to 75 percent of the value of your home,
less the amount of your first mortgage. At some banks you may qualify to bor-
row up to 85 percent! This higher lending limit may make the difference in your
ability to get the money you need for home improvements, education, or other
expenses.
Use the following chart to calculate your home loan value, which is the approxi-
mate amount of your home equity line of credit.
Example Your Home
Approximate market value of your
home
$100,000 $
Multiply by 0.75 3 0.75 3 0.75
Approximate loan value 75,000
Subtract balance due on
mortgage(s)
50,000
Approximate credit limit available $ 25,000 $
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A cash advance is a loan billed to your credit card. You
can obtain a cash advance with your credit card at a bank
or an automated teller machine (ATM) or by using checks
linked to your credit card account.
Most cards charge a special fee when a cash advance
is taken out. The fee is based on a percentage of the
amount borrowed, usually about 2 or 3 percent.
Some credit cards charge a minimum cash advance fee,
as high as $5. You could get $20 in cash and be charged
$5, a fee equal to 25 percent of the amount you borrowed.
Most cards do not have a grace period on cash
advances. This means you pay interest every day until you
repay the cash advance, even if you do not have an out-
standing balance from the previous statement.
On some cards, the interest rate on cash advances is
higher than the rate on purchases. Be sure you check the
details on the contract sent to you by the card issuer.
Here is an example of charges that could be imposed
for a $300 cash advance that you pay off when the bill
arrives:
Cash advance fee 5 $6 (2% of $300)
Interest for one month 5 $5 (20% APR on $300)
Total cost for one month 5 $11($6 1 $5)
In comparison, a $300 purchase on a card with a grace
period could cost $0 if paid off promptly in full.
The bottom line: It is usually much more expensive
to take out a cash advance than to charge a purchase
to your credit card. Use cash advances only for real
emergencies.
Figure It Out!
Cash Advances Cash Advances
PRACTICE QUIZ 5–2 PRACTICE QUIZ 5–2
1. What are two types of consumer credit?
2. Define the following key terms:
a. Closed-end credit
b. Open-end credit
c. Line of credit
d. Interest
e. Finance charge
3. What are the major sources of:
a. Inexpensive loans
b. Medium-priced loans
c. Expensive loans
4. What is the difference between a credit and a debit card?
Apply Yourself! Apply Yourself!
Research three credit cards. List their fees and any advantages they offer. Record your findings.
Visit www.creditcards.com and www.bankrate.com for more information.
Unlike interest on most other types of credit, the interest you pay on a home equity loan
is tax-deductible. You should use these loans only for major items such as education, home
improvements, or medical bills, and you must use them with care. If you miss payments on
a home equity loan, the lender can take your home.
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Applying for Credit
Can You Afford a Loan?
The only way to determine how much credit you can assume is to first learn how to make
an accurate and sensible personal or family budget (see Chapter 2).
Before you take out a loan, ask yourself whether you can meet all of your essential
expenses and still afford the monthly loan payments. You can make this calculation in two
ways. One is to add up all your basic monthly expenses and then subtract this total from
your take-home pay. If the difference will not cover the monthly payment and still leave
funds for other expenses, you cannot afford the loan.
A second and more reliable method is to ask yourself what you plan to give up to make
the monthly loan payment. If you currently save a portion of your income that is greater
than the monthly payment, you can use these savings to pay off the loan. But if you do not,
you will have to forgo spending on entertainment, new appliances, or perhaps even neces-
sities. Are you prepared to make this trade-off? Although precisely measuring your credit
capacity is difficult, you can follow certain rules of thumb.
General Rules of Credit Capacity
DEBT PAYMENTS-TO-INCOME RATIO The debt
payments-to-income ratio is calculated by dividing your
monthly debt payments (not including house payment, which
is a long-term liability) by your net monthly income. Experts
suggest that you spend no more than 20 percent of your net
(after-tax) income on consumer credit payments. Thus, as
Exhibit 5–4 shows, a person making $1,250 per month after
taxes should spend no more than $250 on credit payments
per month.
The 20 percent is the maximum; however, 15 percent or less
is much better. The 20 percent estimate is based on the average
family, with average expenses; it does not take major emergen-
cies into account. If you are just beginning to use credit, you
should not consider yourself safe if you are spending 20 percent
of your net income on credit payments.
DEBT-TO-EQUITY RATIO The debt-to-equity ratio is
calculated by dividing your total liabilities by your net worth. In
calculating this ratio, do not include the value of your home and
the amount of its mortgage. If your debt-to-equity ratio is about
1—that is, if your consumer installment debt roughly equals
your net worth (not including your home or the mortgage)—you
have probably reached the upper limit of debt obligations.
None of the above methods is perfect for everyone; the limits given are only guidelines.
Only you, based on the money you earn, your obligations, and your financial plans for the
future, can determine the exact amount of credit you need and can afford. You must be your
own credit manager.
The Five Cs of Credit
When you’re ready to apply for a loan or a credit card, you should understand the factors
that determine whether a lender will extend credit to you.
When a lender extends credit to consumers, it takes for granted that some people will be
unable or unwilling to pay their debts. Therefore, lenders establish policies for determining
LO5.3
Determine whether you
can afford a loan and how
to apply for credit.
ACTION ITEM
If I want to see a copy of my
credit report, I can contact:
h a credit reporting
agency.
h a bank.
h the dean of my college.
did you know?did you know?
In 2013, an estimated 166 million people
used more than 1 billion credit cards to buy
goods and services worth $2.75 trillion.
0
250
500
750
1,000
1,250
1,500
1,750
2006200019971990
Cards in circulationPeople with credit cards
Millions
122
1,013
149
1,387
159
1,425
173 166
1,488
1,049
2013
SOURCE: Statistical Abstract of the United States 2014, Table 1212.
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who will receive credit. Most lenders build such policies around the “five Cs of credit”:
character, capacity, capital, collateral, and conditions.
CHARACTER: WILL YOU REPAY THE LOAN? Creditors want to know
your character —what kind of person they are lending money to. They want to know that
you’re trustworthy and stable. They may ask for personal or professional references, and
they may check to see whether you have a history of trouble with the law. Some questions
a lender might ask to determine your character are:
• Have you used credit before?
• How long have you lived at your present address?
• How long have you held your current job?
CAPACITY: CAN YOU REPAY THE LOAN? Your income and the debts you
already have will affect your capacity —your ability to pay additional debts. If you
already have a large amount of debt in proportion to your income, lenders probably won’t
extend more credit to you. Some questions a creditor may ask about your income and
expenses are:
• What is your job, and how much is your salary?
• Do you have other sources of income?
• What are your current debts?
CAPITAL: WHAT ARE YOUR ASSETS AND NET WORTH? Assets are
any items of value that you own, including cash, property, personal possessions, and invest-
ments. Your capital is the amount of your assets that exceed your liabilities, or the debts
you owe. Lenders want to be sure that you have enough capital to pay back a loan. That
way, if you lost your source of income, you could repay your loan from your savings or by
selling some of your assets. A lender might ask:
• What are your assets?
• What are your liabilities?
character The borrower’s
attitude toward his or her
credit obligations.
capacity The borrower’s
financial ability to meet credit
obligations.
capital The borrower’s
assets or net worth.
Exhibit 5–4
How to Calculate Debt
Payments-to-Income
Ratio
Spend no more than
20 percent of your net
(after-tax) income on credit
payments
Monthly gross income $1,682
Less:
All taxes 270
Social Security 112
Monthly IRA contribution 50
Monthly net income $1,250
Monthly installment credit payments:
Visa 25
MasterCard 35
Discover card 15
Education loan —
Personal bank loan —
Auto loan 175
Total monthly payments $ 250
Debt payments-to-income ratio ($250/$1,250) 20.00%
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COLLATERAL: WHAT IF YOU DON’T REPAY THE LOAN? Creditors
look at what kinds of property or savings you already have, because these can be offered as
collateral to secure the loan. If you fail to repay the loan, the creditor may take whatever
you pledged as collateral. A creditor might ask:
• What assets do you have to secure the loan (such as a vehicle, your home,
or furniture)?
• Do you have any other valuable assets (such as bonds or savings)?
CONDITIONS: WHAT IF YOUR JOB IS INSECURE? General economic
conditions , such as unemployment and recession, can affect your ability to repay a
loan. The basic question focuses on security—of both your job and the firm that
employs you.
The information gathered from your application and the credit bureau establishes your
credit rating. A credit rating is a measure of a person’s ability and willingness to make
credit payments on time. The factors that determine a person’s credit rating are income,
current debt, information about character, and how debts have been repaid in the past. If
you always make your payments on time, you will probably have an excellent credit rating.
If not, your credit rating will be poor, and a lender probably won’t extend credit to you. A
good credit rating is a valuable asset that you should protect.
Creditors use different combinations of the five Cs to reach their decisions. Some cred-
itors set unusually high standards, and others simply do not offer certain types of loans.
Creditors also use various rating systems. Some rely strictly on their own instincts and
experience. Others use a credit scoring or statistical system to predict whether an applicant
is a good credit risk. When you apply for a loan, the lender is likely to evaluate your appli-
cation by asking questions such as those included in the checklist in the nearby “Personal
Finance in Practice” box.
Your Credit Report
When you apply for a loan, the lender will review your credit history very closely. The
record of your complete credit history is called your credit report, or credit file. Your credit
records are collected and maintained by credit bureaus. Most lenders rely heavily on credit
reports when they consider loan applications. Exhibit 5–5 provides a checklist for building
and protecting your credit history.
CREDIT BUREAUS A credit bureau is an agency that collects information on how
promptly people and businesses pay their bills. The three major credit bureaus are Expe-
rian, TransUnion, and Equifax. Each of these bureaus maintains more than 200 million
credit files on individuals, based on information they receive from lenders. Several thou-
sand smaller credit bureaus also collect credit information about consumers. These firms
make money by selling the information they collect to creditors who are considering loan
applications.
Credit bureaus get their information from banks, finance companies, stores, credit card
companies, and other lenders. These sources regularly transmit information about the types
of credit they extend to customers, the amounts and terms of the loans, and the customers’
payment habits. Credit bureaus also collect some information from other sources, such as
court records.
WHAT’S IN YOUR CREDIT FILES? A typical credit bureau file contains your
name, address, Social Security number, and birth date. It may also include the following
information:
• Your employer, position, and income
• Your previous address
collateral A valuable asset
that is pledged to ensure
loan payments.
conditions The general
economic conditions that can
affect a borrower’s ability to
repay a loan.
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• Your previous employer
• Your spouse’s name, Social Security number, employer, and
income
• Whether you rent or own your home
• Checks returned for insufficient funds
In addition, your credit file contains detailed credit information.
Each time you use credit to make a purchase or take out a loan of
any kind, a credit bureau is informed of your account number and the date, amount, terms,
and type of credit. Your file is updated regularly to show how many payments you’ve
made, how many payments were late or missed, and how much
you owe. Any lawsuits or judgments against you may appear as
well. Federal law protects your rights if the information in your
credit file is incorrect.
FAIR CREDIT REPORTING Fair and accurate credit report-
ing is vital to both creditors and consumers. In 1971 the U.S. Con-
gress enacted the Fair Credit Reporting Act, which regulates the
use of credit reports. This law requires the deletion of out-of-date
information and gives consumers access to their files as well as
the right to correct any misinformation that the files may include.
The act also places limits on who can obtain your credit report.
WHO CAN OBTAIN A CREDIT REPORT? Your
credit report may be issued only to properly identified persons
for approved purposes. It may be supplied in response to a court order or by your own
written request. A credit report may also be provided for use in connection with a credit
transaction, underwriting of insurance, or some legitimate business need. Friends, neigh-
bors, and other individuals cannot be given access to credit information about you. In fact,
if they even request such information, they may be subject to a fine, imprisonment, or both.
Exhibit 5–5
Checklist for Building
and Protecting Your
Credit History
It is simple and sensible to build and protect your own credit history. Here are some steps to
get you started:
• Open a checking or savings account, or both.
• Apply for a local department store credit card.
• Take out a small loan from your bank. Make payments on time.
A Creditor Must . . . Remember That a Creditor Cannot . . .
1. Evaluate all applicants on the same basis. 1. Refuse you individual credit in your own
name if you are creditworthy.
2. Consider income from part-time
employment.
2. Require your spouse to cosign a loan.
Any creditworthy person can be your
cosigner if one is required.
3. Consider the payment history of all joint
accounts, if this accurately reflects your
credit history.
3. Ask about your family plans or assume
that your income will be interrupted to
have children.
4. Disregard information on accounts if you
can prove that it doesn’t affect your ability
or willingness to repay.
4. Consider whether you have a telephone
listing in your name.
If you want a good credit rating, you must use credit wisely. Why is it a good idea to apply
for a local department store credit card or a small loan from your bank?
SOURCE: Reprinted by permission of the Federal Reserve Bank of Minneapolis.
CAUTION! CAUTION!
Are you impatient? Researchers have discov-
ered a link between credit scores and impa-
tience. This can lead to more stress.
digi – know?digi – know?
The Fair Credit Reporting Act requires The Fair Credit Reporting Act requires
each of the nationwide consumer report-each of the nationwide consumer report-
ing companies—Experian, Equifax, and ing companies—Experian, Equifax, and
TransUnion—to provide you with a free TransUnion—to provide you with a free
copy of your credit report annually. Go to copy of your credit report annually. Go to
www.annualcreditreport.comwww.annualcreditreport.com . Beware of . Beware of
other sites that may look and sound similar. other sites that may look and sound similar.
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TIME LIMITS ON UNFAVORABLE DATA Most of the information in your
credit file may be reported for only seven years. However, if you’ve declared personal
bankruptcy, that fact may be reported for 10 years. A credit reporting agency can’t dis-
close information in your credit file that’s more than 7 or 10 years old unless you’re being
reviewed for a credit application of $75,000 or more, or unless you apply to purchase life
insurance of $150,000 or more.
INCORRECT INFORMATION IN YOUR CREDIT FILE Credit bureaus are
required to follow reasonable procedures to ensure that the information in their files is cor-
rect. Mistakes can and do occur, however. If you think that a credit bureau may be report-
ing incorrect data from your file, contact the bureau to dispute the information. The credit
bureau must check its records and change or remove the incorrect items. If you challenge
the accuracy of an item on your credit report, the bureau must remove the item unless the
lender can verify that the information is accurate.
If you are denied credit, insurance, employment, or rental housing based on the infor-
mation in a credit report, you can get a free copy of your report. Remember to request it
within 60 days of notification that your application has been denied.
WHAT ARE YOUR LEGAL RIGHTS? You have legal rights to sue a credit
bureau or creditor that has caused you harm by not following the rules established by the
Fair Credit Reporting Act.
Credit Scores
A credit score is a number that reflects the information in your credit report. The score
summarizes your credit history and helps creditors predict how likely it is that you will
repay a loan and make timely payments. Lenders use credit
scores in deciding whether to grant you credit, what terms you
are offered, or the interest rate you will pay on a loan.
Information used to calculate your credit score usually
includes the following:
• The number and type of account you have (credit cards,
auto loans, mortgages, etc.);
• Whether you pay your bills on time;
• How much of your available credit you are currently
using;
• Whether you have any collection actions against you;
• The amount of your outstanding debt; and
• The age of your accounts.
FICO AND VANTAGESCORE Typical questions in a
credit application appear in Exhibit 5–6 . The information in
your credit report is used to calculate your FICO credit score—a
number generally between 350 and 850 that rates how risky a
borrower is. The higher the score, the less risk you pose to cred-
itors. Your FICO score is available from www.myfico.com for a
fee. Free credit reports do not provide your credit score.
According to Anthony Sprauve, senior consumer credit spe-
cialist at FICO, “The consequences of not maintaining a sound
credit score can be very costly. A low score can bar you from
getting a new loan, doom you to a higher interest rate and even
cost you a new job or apartment.” Exhibit 5–7 shows a numeri-
cal depiction of your creditworthiness and how you can improve
your credit score.
did you know?did you know?
WHAT’S IN YOUR FICO WHAT’S IN YOUR FICO ® SCORE? SCORE?
The data from your credit report is generally grouped
into five categories. The percentages in the pie
diagram reflect how important each of the categories
is in determining your FICO ® score.
10%
10%
30% 35%
15%
Length of credit history
Payment history
Amounts owed
Types of credit used
New credit
SOURCE: “How Your FICO Credit Score Is Calculated,” FICO
website at http://www.myfico.com/CreditEducation/. This
information is provided by the Fair Isaac Corporation and is used
with permission. Copyright © 2001–2013 Fair Isaac Corporation.
All rights reserved. FICO is a trademark of Fair Isaac Corporation.
Further use, reproduction, or distribution is governed by the FICO
Copyright Usage Requirements, which can be found at www
.fico.com
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156 Chapter 5 Consumer Credit: Advantages, Disadvantages, Sources, and Costs
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VantageScore is a new scoring technique, the first to be developed collaboratively by
the three credit reporting companies. This model allows for a more predictive score for
consumers, even for those with limited credit histories, reducing the need for creditors
to manually review credit information. VantageScore features a common score range of
501–990 (higher scores represent lower likelihood of risk). A key benefit of VantageScore
is that as long as the three major credit bureaus have the same information regarding your
credit history, you will receive the same score from each of them. A different score alerts
you that there are discrepancies in your report.
Some consumers have very little recorded credit. They may not have credit cards or car
or home loans, but they have consistently paid their rent, phone, and utility bills. There is
an alternative way to provide a consistent payment record. The Payment Reporting Builds
Credit (PRBC) system will check on payment patterns and report to a creditor the history
of payments that are typically not included on a traditional credit report.
• Amount of loan requested.
• Proposed use of the loan.
• Your name and birth date.
• Social Security and driver’s license
numbers.
• Present and previous street addresses.
• Present and previous employers and their
addresses.
• Present salary.
• Number and ages of dependents.
• Other income and sources of other
income.
• Have you ever received credit from us?
• If so, when and at which office?
• Checking account number, institution,
and branch.
• Savings account number, institution,
and branch.
• Name of nearest relative not living with
you.
• Relative’s address and telephone
number.
• Your marital status.
• Information regarding joint applicant:
same questions as above.
Exhibit 5–6
Sample Credit
Application Questions
Exhibit 5–7 TransUnion Personal Credit Score
The higher your FICO score, the less risk you pose to creditors.
400
0% 20% 40% 60% 80% 100%
Lowest
Your credit score is:
You can purchase your
credit score for $7.95
by calling 1-866-SCORE-TU
or 1-866-726-7388.
• How can I improve my credit score?
A credit score is a snapshot of the contents of your credit report at the time it is calculated. The first step in
improving your score is to review your credit report to ensure it is accurate. Long-term, responsible credit
behavior is the most effective way to improve future scores. Pay all bills, as well as parking, traffic, and even
library fines, on time, lower balances, and use credit wisely to improve your score over time.
Highest
Lowest Highest
475 550 625 700 775 850 925
This will show a numerical depiction of your creditworthiness.
This will show how you compare to the general population.
This will show how most lenders would view your creditworthiness.
Very
Poor
Poor Fair Good
Very
Good
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You should also know what factors a lender cannot consider,
according to the law. The Equal Credit Opportunity Act (ECOA)
gives all credit applicants the same basic rights. It states that
race, nationality, age, sex, marital status, and certain other fac-
tors may not be used to discriminate against you in any part of
a credit dealing.
Other Factors Considered
in Determining Creditworthiness
AGE The Equal Credit Opportunity Act is very specific about
how a person’s age may be used as a factor in credit decisions.
A creditor may request that you state your age on an application,
but if you’re old enough to sign a legal contract (usually 18–21
years old, depending on state law), a creditor may not turn you
down or decrease your credit because of your age. Creditors
may not close your credit account because you reach a certain
age or retire.
PUBLIC ASSISTANCE You may not be denied credit
because you receive Social Security or public assistance. How-
ever, certain information related to this source of income can be
considered in determining your creditworthiness.
HOUSING LOANS The ECOA also covers applications
for mortgages or home improvement loans. In particular, it bans
discrimination against you based on the race or nationality of
the people in the neighborhood where you live or want to buy
your home, a practice called redlining.
WHAT IS THE BEST INTEREST RATE? Effective January 1, 2011, lend-
ers that provide mortgages, credit cards, auto loans, and most other financial products
must disclose important details to their customers if they utilize risk-based pricing. Risk-
based pricing seeks to differentiate consumers based on their credit information and charge
higher rates for more risky customers. Customers who do not receive the best possible (or
preferred rate) must be informed of their current credit score or the fact that risk-based
pricing was used and the fact that other customers received better rates. Customers may
also be entitled to be told what the negative factors were as well as be provided with a
scale of their ranking based upon credit score. This may allow customers an opportunity
to review their credit report and ensure accuracy prior to paying an unnecessarily higher
interest rate.
What If Your Application Is Denied?
If your credit application is denied, the ECOA gives you the right to know the reasons.
If the denial is based on a credit report from the credit bureau, you’re entitled to know
the specific information in the report that led to the denial. After you receive this infor-
mation, you can contact the credit bureau and ask for a copy of your credit report. The
bureau cannot charge a fee for this service as long as you ask to see your files within
60 days of notification that your credit application has been denied. You’re entitled to
ask the bureau to investigate any inaccurate or incomplete information and correct its
records (see Exhibit 5–8 ).
did you know?did you know?
VantageScore, which is used by lenders and
now available to consumers, is the first credit
score developed cooperatively by Experian and the
other national credit reporting companies.
The VantageScore scale approximates the
familiar academic scale, making it simple to
associate your VantageScore number with a
letter grade. You now will have clear insight into
how lenders using VantageScore will view your
creditworthiness.
Score
901–990: A 601–700: D
801–900: B 501–600: F
701–800: C
B
C
D
F
A
B
C
D
F
A
SOURCE: www.vantagescore.experian.com.
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Personal Finance in Practice
Here is what lenders look for in determining your credit-
worthiness.
CREDIT HISTORY
1. Character: Will you repay the loan? Yes No
Do you have a good attitude toward
credit obligations?
Have you used credit before?
Do you pay your bills on time?
Have you ever filed for bankruptcy?
Do you live within your means?
STABILITY
How long have you lived at your
present address? yrs.
Do you own your home?
How long have you been employed
by your present employer? yrs.
INCOME
2. Capacity: Can you repay the loan?
Your salary and occupation? $ ;
Place of occupation?
How reliable is your
income? Reliable ; Not reliable
Any other sources of income? $
EXPENSES
Number of dependents?
Do you pay any alimony or
child support? Yes ; No
Current debts? $
NET WORTH
3. Capital: What are your assets and net worth?
What are your assets? $
What are your liabilities? $
What is your net worth? $
LOAN SECURITY
4. Collateral: What if you don’t repay the loan?
What assets do you have to secure
the loan? (Car, home, furniture?)
What sources do you have besides
income? (Savings, stocks, bonds,
insurance?)
JOB SECURITY
5. Conditions: What general economic conditions can
affect your repayment of the loan?
How secure is
your job? Secure ; Not secure
How secure is the
firm you work for? Secure ; Not secure
SOURCE: Adapted from William M. Pride, Robert J. Hughes, and
Jack R. Kapoor, Business, 11th ed., 2012 (Mason, OH: South-
Western Cengage Learning, 2010), pages 555–557.
The Five Cs of Credit
What Can You Do to Improve Your Credit Score ?
A credit score is a snapshot of the contents of your credit report at the time it is calculated.
The first step in improving your score is to review your credit report to ensure it is accurate.
Long-term responsible credit behavior is the most effective way to improve future scores.
Pay bills on time, lower balances, and use credit wisely to improve your score over time.
1. Get copies of your credit report—then make sure information is correct. Go to
www.annualcreditreport.com . This is the only authorized online source for a free
credit report. Under federal law, you can get a free report from each of the three
national credit reporting companies every 12 months. You can also call 877-322-
8228 or complete the Annual Credit Report Request Form and mail it to Annual
Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348-5281.
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2. Pay your bills on time. One of the most important steps you can take to improve
your credit score is to pay your bills by the due date. You can set up automatic
payments from your bank account to help you pay on time, but be sure you have
enough money in your account to avoid overdraft fees.
3. Understand how your credit score is determined. Your credit score is usually
based on the answers to these questions.
• Do you pay your bills on time? The answer to this question is very important.
If you have paid bills late, had an account referred to a collection agency, or
have ever declared bankruptcy, this history will show up in your credit report.
• What is your outstanding debt? Many scoring models compare the amount
of debt you have and your credit limits. If the amount you owe is close to your
credit limit, it is likely to have a negative effect on your score.
• How long is your credit history? A short credit history may have a negative
effect on your score, but a short history can be offset by other factors, such as
timely payments and low balances.
• Have you applied for new credit recently? If you have applied for too many
new accounts recently, that may negatively affect your score. However, if you
request a copy of your own credit report, or if creditors are monitoring your
account or looking at credit reports to make prescreened credit offers, these
inquiries about your credit history are not counted as applications for credit.
Exhibit 5–8 What If You Are Denied Credit?
Steps you can take if you are denied credit
You receive written notification
that credit has been denied
and the reasons for denial.*
Check your
credit file at the
credit bureau.
You are not sure if the
reasons for denial are
valid or invalid.
Ask the creditor to clarify
the reasons for denial.
The federal enforcement
agency will investigate
and report back to you.
You believe the
reason(s) for denial are
valid.
*If a creditor receives no more than 150 applications during a calendar year, the disclosures may be oral.
Take steps to
improve your
creditworthiness
(i.e., increase
income, reduce
spending, pay bills
on time) and
reapply.
Apply to
another
creditor
whose
standards
may be
different.
Ask the
creditor if you
can provide
additional
information or
arrange
alternative
credit terms.
Notify the federal enforcement
agency whose name
you were given.
If the court finds discrimination,
the creditor must pay you actual
damages plus punitive damages.
Hire a private attorney to
file suit against the
creditor.
You believe the reasons for
credit denial are invalid and
the creditor has
discriminated against you.
SOURCE: Reprinted courtesy of Office of Public Information, Federal Reserve Bank of Minneapolis, Minneapolis, MN 55480.
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• How many and what types of credit accounts do you have? Many credit-
scoring models consider the number and type of credit accounts you have. A
mix of installment loans and credit cards may improve your score. However, too
many finance company accounts or credit cards might hurt your score. To learn
more about credit scoring, see the Federal Trade Commission’s website, Facts
for Consumers, at www.ftc.gov .
4. Learn the legal steps to take to improve your credit report. The Federal Trade
Commission’s Building a Better Credit Report has information on correcting errors
in your report, tips on dealing with debt and avoiding scams—and more.
5. Beware of credit-repair scams. Sometimes doing it yourself is the best way to
repair your credit. The Federal Trade Commission’s Credit Repair: How to Help
Yourself explains how you can improve your creditworthiness and lists legitimate
resources for low-cost or no-cost help.
PRACTICE QUIZ 5–3 PRACTICE QUIZ 5–3
1. What are the two general rules of measuring credit capacity? How is it calculated?
2. Define the following key terms:
a. character
b. capacity
c. capital
d. collateral
e. conditions
3. What are the factors a lender cannot consider according to the law when offering credit?
4. What is a credit bureau?
5. Write the steps you should take if you are denied credit.
Apply Yourself! Apply Yourself!
Talk to a person who has discovered an error on his or her credit report. What was their experience to get it corrected?
Sheet 15 Consumer Credit Usage
Patterns
S
P
The Cost of Credit
If you are thinking of borrowing money or opening a credit account, your first step should
be to figure out how much it will cost you and whether you can afford it. Then you should
shop for the best terms. Two key concepts that you should remember are the finance charge
and the annual percentage rate.
Finance Charge and Annual Percentage Rate
Credit costs vary. If you know the finance charge and the annual percentage rate, you can
compare credit prices from different sources. The finance charge is the total dollar amount
you pay to use credit. It includes interest costs and sometimes other costs such as service
charges, credit-related insurance premiums, or appraisal fees.
LO5.4
Determine the cost of credit
by calculating interest using
various interest formulas.
ACTION ITEM
If I know the finance charge and
the annual percentage rate,
I can compare credit prices.
h Always
h Most of the time
h Sometimes
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For example, borrowing $100 for a year might cost you $10 in interest. If there is also a
service charge of $1, the finance charge will be $11. The annual percentage rate (APR) is
the percentage cost (or relative cost) of credit on a yearly basis. The APR is your key to
comparing costs, regardless of the amount of credit or how much time you have to repay it.
Suppose you borrow $100 for one year and pay a finance charge of $10. If you can keep the
entire $100 for one year and then pay it all back at once, you are paying an APR of 10 percent.
$100
(Amount borrowed)
10 2 3 4 5 6 7 8 9 10 11
00 0 0 0 0 0 0 0 0 0
12
(Months)
$110
(Includes $10 interest)payments >>
On average, you had full use of $100 throughout the year. To calculate the average use,
add the loan balance during the first and last month, and then divide by 2:
Average balance 5
$100 1 $100
___________
2
5 $100
But if you repay the $100 and the finance charge (a total of $110) in 12 equal monthly pay-
ments, you don’t get use of $100 for the whole year. In fact, as shown next, you get use of
increasingly less of that $100 each month. In this case, the $10 charge for credit amounts
to an APR of 18.5 percent.
annual percentage rate
(APR) The percentage cost
(or relative cost) of credit
on a yearly basis. The APR
yields a true rate of interest
for comparisons with other
sources of credit.
Amount Borrowed Month Number Payment Made Loan Balance
$100 1 $ 0 $100.00
2 8.33 91.67
3 8.33 83.34
4 8.33 75.01
5 8.33 66.68
6 8.33 58.35
7 8.33 50.02
8 8.33 41.69
9 8.33 33.36
10 8.33 25.03
11 8.33 16.70
12 8.33 8.37
Note that you are paying 10 percent interest even though you had use of only $91.67
during the second month, not $100. During the last month, you owed only $8.37 (and
had use of $8.37), but the $10 interest is for the entire $100. As calculated in the previous
example, the average use of the money during the year is $100 1 $8.37 4 2, or $54.18.
The nearby “Figure It Out!” box shows how to calculate the APR.
Tackling the Trade-Offs
When you choose your financing, there are trade-offs between the features you prefer
(term, size of payments, fixed or variable interest, or payment plan) and the cost of your
loan. Here are some major trade-offs you should consider.
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Figure It Out!
There are two ways to calculate the APR: using an APR
formula and using the APR tables. The APR tables are
more precise than the formula. The formula, given below,
only approximates the APR:
r 5
2 3 n 3 I
_________
P (N 1 1)
where
r 5 Approximate APR
n 5 Number of payment periods in one year (12, if
payments are monthly; 52, if weekly)
I 5 Total dollar cost of credit
P 5 Principal, or net amount of loan
N 5 Total number of payments scheduled to pay off
the loan
Let us compare the APR when a $100 loan is paid off in
one lump sum at the end of the year and when the same
loan is paid off in 12 equal monthly payments. The stated
annual interest rate is 10 percent for both loans.
Using the formula, the APR for the lump-sum loan is
r 5
2 3 1 3 $10
____________
$100(1 1 1)
5
$20
_______
$100(2)
5
$20
_____
$200
5 0.10,
or 10 percent
Using the formula, the APR for the monthly payment
loan is
r 5
2 3 12 3 $10
_____________
$100(12 1 1)
5
$240
________
$100(13)
5
$240
_______
$1,300
5 0.1846, or 18.46 percent (rounded to
18.5 percent)
The Arithmetic of the Annual Percentage Rate (APR) The Arithmetic of the Annual Percentage Rate (APR)
TERM VERSUS INTEREST COSTS Many people choose longer-term financ-
ing because they want smaller monthly payments, but the longer the term for a loan at a
given interest rate, the greater the amount you must pay in interest charges. Consider the
following analysis of the relationship between the term and interest costs.
Suppose you’re buying a $10,000 used car. You put $2,000 down, and you need to bor-
row $8,000. Compare the following four credit arrangements:
APR
Length of
Loan
Monthly
Payment
Total Finance
Charge Total Cost
Creditor A 5% 3 years $240 $ 632 $8,632
Creditor B 5 4 years 1 84 8 43 8,843
Creditor C 6 4 years 1 88 1,018 9,018
Creditor D 6 5 years 1 55 1,280 9,280
How do these choices compare? The answer depends partly on what you need. The
lowest-cost loan is available from creditor A. If you are looking for lower monthly
payments, you could repay the loan over a longer period of time. However, you would
have to pay more in total costs. A loan from creditor B—also at a 5 percent APR, but for
four years—would add about $211 to your finance charge.
If that four-year loan were available only from creditor C, the APR of 6 percent would
add another $175 to your finance charges. The lowest payment—but the most costly—
would be the five-year loan. Other terms, such as the size of the down payment, will also
make a difference. Be sure to look at all the terms before you make your choice.
LENDER RISK VERSUS INTEREST RATE You may prefer financing that
requires low fixed payments with a large final payment or only a minimum of up-front
cash. But both of these requirements can increase your cost of borrowing because they
create more risk for your lender.
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If you want to minimize your borrowing costs, you may need to accept conditions that
reduce your lender’s risk. Here are a few possibilities:
• Variable interest rate. A variable interest rate is based on fluctuating rates in the
banking system, such as the prime rate. With this type of loan, you share the
interest rate risks with the lender. Therefore, the lender may offer you a lower initial
interest rate than it would with a fixed-rate loan.
• A secured loan. If you pledge property or other assets as collateral, you’ll probably
receive a lower interest rate on your loan.
• Up-front cash. Many lenders believe you have a higher stake in repaying a loan if
you pay cash for a large portion of what you are financing. Doing so may give you
a better chance of getting the other terms you want.
• A shorter term. As you have learned, the shorter the period of time for which you
borrow, the smaller the chance that something will prevent you from repaying
and the lower the risk to the lender. Therefore, you may be able to borrow at
a lower interest rate if you accept a shorter-term loan, but your payments will
be higher.
Calculating the Cost of Credit
The most common method of calculating interest is the simple interest formula. Other
methods, such as simple interest on the declining balance and add-on interest, are varia-
tions of this formula.
SIMPLE INTEREST Simple interest is the interest computed on principal only and
without compounding; it is the dollar cost of borrowing money. This cost is based on three
elements: the amount borrowed, which is called the principal; the rate of interest; and the
amount of time for which the principal is borrowed.
You can use the following formula to find simple interest:
Interest 5 Principal 3 Rate of interest 3 Time
or
I 5 P 3 r 3 T
simple interest Interest
computed on principal only
and without compounding.
EXAMPLE: Using the Simple Interest Formula
Suppose you have persuaded a relative to lend you $1,000 to purchase a laptop
computer. Your relative agreed to charge only 5 percent interest, and you agreed to
repay the loan at the end of one year. Using the simple interest formula, the interest
will be 5 percent of $1,000 for one year, or $50, since you have the use of $1,000
for the entire year:
I 5 $1,000 3 0.05 3 1
5 $50
Using the APR formula discussed earlier,
APR 5
2 3 n 3 I
_________
P(N 1 1)
5
2 3 1 3 $50
_____________
$1,000(1 1 1)
5
$100
_______
$2,000
5 0.05, or 5 percent
Note that the stated rate, 5 percent, is also the annual percentage rate.
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CAUTION! CAUTION!
Many banks will increase the interest rate
because of one late payment. They’ll also
slap on a penalty fee, which can run as high
as $50 a pop.
164 Chapter 5 Consumer Credit: Advantages, Disadvantages, Sources, and Costs
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SIMPLE INTEREST ON THE DECLINING BALANCE When simple inter-
est is paid back in more than one payment, the method of computing interest is known as
the declining balance method. You pay interest only on the amount of principal that you
have not yet repaid. The more often you make payments, the lower the interest you’ll pay.
Most credit unions use this method.
EXAMPLE: Using the Simple Interest Formula on the
Declining Balance
Using simple interest on the declining balance to compute interest charges, the interest
on a 5 percent, $1,000 loan repaid in two payments, one at the end of the first half-year
and another at the end of the second half-year, would be $37.50, as follows:
First payment:
I 5 P 3 r 3 T
5 $1,000 3 0.05 3 1/2
5 $25 interest plus $500, or $525
Second payment:
I 5 P 3 r 3 T
5 $500 3 0.05 3 1/2
5 $12.50 interest plus the remaining balance of $500, or $512.50
Total payment on the loan:
$525 1 $512.50 5 $1,037.50
Using the APR formula,
APR 5
2 3 n 3 I
_________
P(N 1 1)
5
2 3 2 3 $37.50
______________
$1,000(2 1 1)
5
$150
_______
$3,000
5 0.05, or 5 percent
ADD-ON INTEREST With the add-on interest method, interest is calculated on the
full amount of the original principal, no matter how frequently you make payments. When
you pay off the loan with one payment, this method produces the same annual percent-
age rate (APR) as the simple interest method. However, if you pay
in installments, your actual rate of interest will be higher than the
stated rate. Interest payments on this type of loan do not decrease
as the loan is repaid. The longer you take to repay the loan, the
more interest you’ll pay.
COST OF OPEN-END CREDIT The Truth in Lending
Act requires that open-end creditors inform consumers as to how
the finance charge and the APR will affect their costs. For example,
they must explain how they calculate the finance charge. They must also inform you when
finance charges on your credit account begin to accrue, so that you know how much time
you have to pay your bills before a finance charge is added.
COST OF CREDIT AND EXPECTED INFLATION Inflation reduces the
buying power of money. Each percentage point increase in inflation means a decrease of
about 1 percent in the quantity of goods and services you can buy with the same amount of
money. Because of this, lenders incorporate the expected rate of inflation when deciding
how much interest to charge.
Remember the earlier example in which you borrowed $1,000 from your aunt at the
bargain rate of 5 percent for one year? If the inflation rate was 4 percent that year, your
aunt’s actual rate of return on the loan would have been only 1 percent (5 percent stated
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interest minus 4 percent inflation rate). A professional lender who wanted to receive 5 per-
cent interest on your loan might have charged you 9 percent interest (5 percent interest plus
4 percent anticipated inflation rate).
AVOID THE MINIMUM MONTHLY PAYMENT TRAP On credit card bills and
with certain other forms of credit, the minimum monthly payment is the smallest amount you
can pay and remain a borrower in good standing. Lenders often encourage you to make the
minimum payment because it will then take you longer to pay off the loan. However, if you
are paying only the minimum amount on your monthly statement, you need to plan your bud-
get more carefully. The longer it takes for you to pay off a bill, the more interest you pay. The
finance charges you pay on an item could end up being more than the item is worth.
Consider the following examples. In each example, the minimum payment is based on
1/36 of the outstanding balance or $20, whichever is greater.
Original
Balance Interest Rate
Years to
Repay Interest Paid
Total Interest Paid as
Percentage of Original
Balance
$500 * 19.8% 2.5 years $ 150 30%
$500 * 12 2.5 years 78 16
$2,000 ** 19 22 years 4,800 240
$2,000 *** 19 7 years 1,120 56
*Minimum payment is 1/36 of the outstanding balance or $20, whichever is greater.
**2% minimum payment.
***4% minimum payment.
PRACTICE QUIZ 5–4 PRACTICE QUIZ 5–4
1. What are the two key concepts to remember when you borrow money?
2. What are the three major trade-offs you should consider as you take out a loan?
3. Using terms from the following list, complete the sentences below. Write the term you have chosen in the space
provided.
finance charge minimum monthly payment
annual percentage rate add-on interest method
simple interest
a. The _____ is the cost of credit on a yearly basis expressed as a percentage.
b. The total dollar amount paid to use credit is the _____ .
c. The smallest amount a borrower can pay on a credit card bill and remain a borrower in good standing is the _____ .
d. With the _____ , interest is calculated on the full amount of the original principal, no matter how often you make
payments.
e. _____ is the interest computed only on the principal, the amount that you borrow.
Apply Yourself! Apply Yourself!
Use the Internet to obtain information about the costs of closed-end and open-end credit. Visit www.bankrate.com and
www.lendingtree.com for more information.
Sheet 16 Credit Card/Charge Account
Comparison
Sheet 17 Consumer Loan Comparison
S
C
S
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Protecting Your Credit
Have you ever received a bill for merchandise you never bought or that you returned to
the store or never received? Have you ever made a payment that was not credited to your
account or been charged twice for the same item? If so, you are not alone.
Billing Errors and Disputes
The Fair Credit Billing Act (FCBA) , passed in 1975, sets procedures for promptly correcting
billing mistakes, refusing to make credit card or revolving credit payments on defective
goods, and promptly crediting your payments. This act is one of the main reasons why it is
more advantageous to buy higher dollar value items with a credit card than a debit card.
This act provides the consumer recourse against the retailer.
Follow these steps if you think that a bill is wrong or want more information about it.
First notify your creditor in writing, and include any information that might support your
case. (A telephone call is not sufficient and will not protect your rights.) Then pay the por-
tion of the bill that is not in question.
Your creditor must acknowledge your letter within 30 days. Then, within two billing
periods (but not longer than 90 days), the creditor must adjust your account or tell you
why the bill is correct. If the creditor made a mistake, you don’t have to pay any finance
charges on the disputed amount. If no mistake is found, the creditor must promptly send
you an explanation of the situation and a statement of what you owe, including any finance
charges that may have accumulated and any minimum payments you missed while you
were questioning the bill.
PROTECTING YOUR CREDIT RATING According to law, a creditor may not
threaten your credit rating or do anything to damage your credit reputation while you’re
negotiating a billing dispute. In addition, the creditor may not take any action to collect the
amount in question until your complaint has been answered.
DEFECTIVE GOODS AND SERVICES Theo used his credit card to buy a new
mountain bike. When it arrived, he discovered that some of the gears didn’t work properly.
He tried to return it, but the store would not accept a return. He asked the store to repair or
replace the bike—but still he had no luck. According to the Fair Credit Billing Act, he may
tell his credit card company to stop payment for the bike because he has made a sincere
attempt to resolve the problem with the store.
Identity Crisis: What to Do If Your Identity Is Stolen
“I don’t remember charging those items. I’ve never been in that store.” Maybe you never
charged those goods and services, but someone else did—someone who used your name
and personal information to commit fraud. When imposters use your personal information
for their own purposes, they are committing a crime.
The biggest problem? You may not know that your identity has been stolen until you
notice that something is wrong: You may get bills for a credit card account you never
opened, or you may see charges to your account for things that you didn’t purchase.
If you think that your identity has been stolen and that someone is using it to charge
purchases or obtain credit in some other way, the Federal Trade Commission recommends
that you take the following three actions immediately:
1. Contact the credit bureaus. Tell them to flag your file with a fraud alert, including
a statement that creditors should call you for permission before they open any new
accounts in your name.
2. Contact the creditors. Contact the creditors for any accounts that have been
tampered with or opened fraudulently. Follow up in writing.
Fair Credit Billing Act
(FCBA) Sets procedures
for promptly correcting
billing mistakes, refusing to
make credit card payments
on defective goods, and
promptly crediting payments.
LO5.5
Develop a plan to protect
your credit and manage your
debts.
ACTION ITEM
If I have serious credit
problems, I should:
h contact my creditors to
explain the problems.
h contact only the most
persistent creditors.
h not contact my
creditors and hope they
will forget about me.
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CAUTION! CAUTION!
If you see an error on your credit report,
contact the three major credit bureaus
immediately: Equifax (1-800-685-1111),
Experian (1-888-397-3742), and TransUnion
(1-800-916-8800).
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3. File a police report. Keep a copy of the police report in
case your creditors need proof of the crime. If you’re still
having identity problems, stay alert to new instances of
identity theft. You can also contact the Privacy Rights
Clearinghouse. Call 1-619-298-3396.
Protecting Your Credit from Theft
or Loss
Some thieves will pick through your trash in the hope of coming across your personal
information. You can prevent this from happening by tearing or shredding any papers that
contain personal information before you throw them out. Another tactic that an identity
thief may use is skimming. Skimming involves the recording of
the data on the magnetic strip of a credit or debit card. Thieves
also target ATM machines by adding a device on the machine
that will capture your PIN number. This allows them to make
fake cards and have access to your account. The best way to
avoid falling victim is to carefully look at the machine to see if
there are extra wires, strings, or cords that should not be there.
Notify the bank immediately if your card is not returned.
According to a 2014 survey by American Consumer Credit
Counseling, 64 percent of Americans do not trust retailers with
their credit and debit card information. Due to recent data breaches at Target and Neiman
Marcus, 42 percent of respondents are more likely to pay with cash or check.
If you believe that an identity thief has accessed your bank accounts, close the accounts
immediately. If your checks have been stolen or misused, stop payment on them. If your
debit card has been lost or stolen, cancel it and get another with a new personal identifica-
tion number (PIN).
Lost credit cards are a key element in credit card fraud. To protect your card, you should
take the following actions:
• Be sure that your card is returned to you after a purchase. Unreturned cards can find
their way into the wrong hands.
• Keep a record of your credit card number. You should keep this record separate
from your card.
• Notify the credit card company immediately if your card is lost or stolen. Under
the Consumer Credit Protection Act, the maximum amount that you must pay if
someone uses your card illegally is $50. However, if you manage to inform the
company before the card is used illegally, you have no obligation to pay at all.
Read the accompanying “From the Pages of . . . Kiplinger’s Personal Finance” feature
on how to combat data theft.
Protecting Your Credit Information on the Internet
The Internet is becoming almost as important to daily life as the telephone and television.
Increasing numbers of consumers use the Internet for financial activities, such as investing,
banking, and shopping.
When you make purchases online, make sure that your transactions are secure, that your
personal information is protected, and that your “fraud sensors” are sharpened. Although
you can’t control fraud or deception on the Internet, you can take steps to recognize it,
avoid it, and report it. Here’s how:
• Use a secure browser.
• Keep records of your online transactions.
digi – know? digi – know?
Opting out may also reduce identify theft. Opting out may also reduce identify theft.
You can stop preapproved credit card offers You can stop preapproved credit card offers
by logging on to by logging on to www.optoutprescreen.com www.optoutprescreen.com . .
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright 2014. The Kiplinger Washington Editors, Inc.
1. In the event of a data breach, why is it wise to request a new card?
2. What precautions should you take if you decide not to get a new card?
3. What are the pros and cons of placing a freeze on your credit report as a preventive measure?
H
ighly publicized
security breaches
at retailers Tar-
get and Neiman
Marcus have left consumers
looking for guidance on how to
guard their financial informa-
tion. We have answers to your
questions about what to do in
the event of a data breach.
Should I request a new
card? Asking your bank or
credit card issuer to send you a
new card with a new number
is the best way to nip potential
theft in the bud. And it’s an espe-
cially good idea if you suspect
that your debit card data has
been stolen, given that a debit
card provides direct access to
your bank account—and that its
legal protections are less robust
than those of a credit card.
Victims of credit card fraud are
legally responsible for up to $50.
With debit cards, your liability
could be unlimited. As soon as
you get your new card, notify
any service—say, your electric
utility or cable company—that
charge automatic bill payments
to the card so that you aren’t hit
with fees for missed payments.
If you do incur any fees, explain
the situation to the company and
ask to have them waived.
What if I decide not to get a
new card? Keep close tabs
on your bank or credit card
account. Log in daily for the
first couple of months to check
for suspicious activity, suggests
Beverly Harzog, a
credit card expert and
author of Confessions
of a Credit Junkie. After
that, try to check in
about once a week. A
weekly check-in is a
good habit to maintain
for all of your bank
and credit accounts,
regardless of whether you think
they’ve been compromised.
Could I be scammed in other
ways? If a data breach extends
to customer names, phone num-
bers, and e-mail and mailing
addresses, you could be vulner-
able to phishing scams—fake
messages designed to pry even
more personal information
from you. Fraudsters could also
piece together, say, your credit
card number, name and e-mail
address to create a convincing
e-mail that appears to be from
your financial institution, says
Jody Farmer, vice-president
of strategic marketing at
CreditCards.com . Scammers
posing as representatives from a
business or government agency
may attempt to contact you. If
you’re not sure that a message
is legitimate, don’t click on any
links that it contains or provide
any personal information that
it requests. Look up the institu-
tion’s phone number and call to
verify that it contacted you.
Should I worry about my identity
being stolen? If a retailer
offers free credit monitoring,
it wouldn’t hurt to sign up.
You can also check your credit
reports from the three major
bureaus—Equifax, Experian and
TransUnion—free once a year at
www.annualcreditreport.com .
I’m still nervous about ID theft.
What else can I do? You could
place a freeze on your credit
reports as a preventive meas-
sure, says Adam Levin, chair-
man and co-founder of Identity
Theft 911. Lenders won’t be able
to offer new credit in your name
without your permission. You’ll
have to request the freeze sep-
arately with each of the three
credit agencies. Keep in mind
that a credit freeze could cause
delays if you expect to shop for
new credit. A less drastic action
is to place a fraud alert on your
reports, which requires lenders
to take extra precautions to ver-
ify your identity before granting
new credit. An initial fraud alert
lasts 90 days, and you’ll get a
free copy of your credit report
from each of the bureaus. If you
set up an alert with one bureau,
it will notify the other two.
Lisa Gerstner
How to Combat Data Theft
We tell you how you could be affected and give you the tools to protect your
credit and financial information.
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• Review your monthly bank and credit card statements.
• Read the privacy and security policies of websites you visit.
• Keep your personal information private.
• Never give your password to anyone online.
• Don’t download files sent to you by strangers.
Cosigning a Loan
If a friend or relative ever asks you to cosign a loan, think twice. Cosigning a loan
means that you agree to be responsible for loan payments if the other party fails to
make them. When you cosign, you’re taking a chance that a professional lender will
not take. The lender would not require a cosigner if the borrower were considered a
good risk.
If you cosign a loan and the borrower does not pay the debt, you may have to pay up to
the full amount of the debt as well as any late fees or collection costs. The creditor can even
collect the debt from you without first trying to collect from the borrower. The creditor can
use the same collection methods against you that can be used against the borrower. If the
debt is not repaid, that fact will appear on your credit record.
Most private student loans today have a cosigner, typically a parent or a grandparent.
Your loan may contain provisions that allow the creditor to put you in default, even if
you’ve been making your payments on time. In 2014, according to the Consumer Financial
Protection Bureau, “We’ve received complaints that private lenders are placing borrow-
ers into default and making balance due all at once when the cosigner dies or files for
bankruptcy.”
Complaining about Consumer Credit
If you believe that a lender is not following the consumer credit protection laws, first try to
solve the problem directly with the lender. If that fails, use formal complaint procedures.
This section describes how to file a complaint with the federal agencies that administer
credit protection laws. Exhibit 5–9 provides contact information for the various federal
agencies.
Consumer Credit Protection Laws
If you have a particular problem with a bank in connection with any of the consumer credit
protection laws, you can get advice and help from the Federal Reserve System. You don’t
need to have an account at the bank to file a complaint. You may also take legal action
against a creditor. If you decide to file a lawsuit, you should be aware of the various con-
sumer credit protection laws described below.
TRUTH IN LENDING AND CONSUMER LEASING ACTS If a creditor
fails to disclose information as required under the Truth in Lending Act or the Consumer
Leasing Act, or gives inaccurate information, you can sue for any money loss you suffer.
You can also sue a creditor that does not follow rules regarding credit cards. In addition,
the Truth in Lending Act and the Consumer Leasing Act permit class action of all the peo-
ple who have suffered the same injustice.
FAIR CREDIT AND CHARGE CARD DISCLOSURE ACT This act was
initially written as an amendment to the Truth in Lending Act. This act requires that solic-
itations for credit cards in the mail, over the phone, in print, or online must provide the
necessary terms of the account. This includes finance charges as well as cash advance or
annual fees. This also includes any changes to the account.
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EQUAL CREDIT OPPORTUNITY ACT (ECOA) If you think that you can
prove that a creditor has discriminated against you for any reason prohibited by the ECOA,
you may sue for actual damages plus punitive damages—a payment used to punish the
creditor who has violated the law—up to $10,000.
FAIR CREDIT BILLING ACT A creditor that fails to follow the rules that apply
to correcting any billing errors will automatically give up the amount owed on the item in
question and any finance charges on it, up to a combined total of $50. This is true even
if the bill was correct. You may also sue for actual damages plus twice the amount of any
finance charges.
FAIR CREDIT REPORTING ACT You may sue any credit bureau or creditor
that violates the rules regarding access to your credit records, or that fails to correct errors
in your credit file. You’re entitled to actual damages plus any punitive damages the court
allows if the violation is proven to have been intentional.
CONSUMER CREDIT REPORTING REFORM ACT The Consumer Credit
Reporting Reform Act of 1977 places the burden of proof for accurate credit information
on the credit bureau rather than on you. Under this law, the creditor must prove that dis-
puted information is accurate. If a creditor or the credit bureau verifies incorrect data, you
can sue for damages.
ELECTRONIC FUND TRANSFER ACT If a financial institution does not fol-
low the provisions of the Electronic Fund Transfer Act, you may sue for actual damages
plus punitive damages of not less than $100 or more than $1,000. You are also entitled to
court costs and attorney fees in a successful lawsuit. Class-action suits are also permitted.
CREDIT CARD ACCOUNTABILITY RESPONSIBILITY AND DISCLOSURE
ACT OF 2009 (CARD ACT) This act became effective in February 2010. It
changed many of the rules by which the credit card companies could provide credit and
administer accounts. Credit card companies must now provide 45 days’ notice of rate
increases. Also, the time between receiving the statement and the payment due date has
If you think you’ve been discriminated against by: You may file a complaint with the following agency:
Consumer reporting agencies, creditors, and others not
listed below
Federal Trade Commission: Consumer Response Center – FCRA
Washington, DC 20580 1-877-382-4357
National banks, federal branches/agencies of foreign
banks (word “National” or initials “N.A.” appear in or after
bank’s name)
Office of the Comptroller of the Currency
Compliance Management, Mail Stop 6-6
Washington, DC 20219 1-800-613-6743
Federal Reserve System member banks (except
national banks and federal branches/agencies of
foreign banks)
Federal Reserve Board
Division of Consumer & Community Affairs
Washington, DC 20551 1-202-452-3693
Federal credit unions (words “Federal Credit Union” appear
in institution’s name)
National Credit Union Administration
1775 Duke Street
Alexandria, VA 22314 1- 703-519-4600
State-chartered banks that are not members of the Federal
Reserve System
Federal Deposit Insurance Corporation
Consumer Response Center, 2345 Grand Avenue, Suite 100
Kansas City, MO 64108-2638 1-877-275-3342
The law gives you certain rights as a consumer of credit. What types of complaints about a creditor might you report to these
government agencies?
Exhibit 5–9 Federal Government Agencies That Enforce the Consumer Credit Laws
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been extended to 21 days. Additionally, the credit card companies must apply payments
first to the debts that carry the higher interest rates, such as cash advances. They must also
provide a more detailed statement that includes the time and total interest amount to pay
off the balance if only the minimum payment is made. The rules by which the credit card
companies can extend credit to persons under the age of 21 have also changed. Young peo-
ple must be able to show proof of income or have a signature by a person willing to accept
responsibility for the account.
Consumer Financial Protection Bureau
If you are unable to find a resolution to a credit card situation, you may still have one more
option. The Consumer Financial Protection Bureau (CFPB) has created a one-stop com-
plaint website for credit card issues. You must visit the website, describe the circumstances
of your complaint, and indicate any monies lost due to the issue. You can continue to check
back on the website to monitor the progress of your complaint as the CFPB investigates.
The website is https://help.consumerfinance.gov/app/ask_cc_complaint .
In 2014, the CFPB ordered Bank of America to pay $727 million to about 1.4 mil-
lion consumers who were harmed by practices related to its credit card payment protec-
tion products, “Credit Protection Plus” and “Credit Protection Deluxe.” According to the
CFPB, Bank of America also illegally charged approximately 1.9 million consumers for
credit monitoring and credit reporting services. In addition, Bank of America will pay a
$20 million penalty to the CFPB.
Managing Your Debts
A sudden illness or the loss of your job may prevent you from paying your bills on time.
If you find you cannot make your payments, contact your creditors at once and try to work
out a modified payment plan with them.
Warning Signs of Debt Problems
Chris is in his late 20s. A college graduate, he has a steady job and earns an annual income
of $40,000. With the latest model sports car parked in the driveway of his new home, it
would appear that Chris has the ideal life.
However, Chris is deeply in debt. He is drowning in a sea of bills. Almost all his income
is tied up in debt payments. The bank has already begun foreclosure proceedings on his
home, and several stores have court orders to repossess practically all of his new furniture
and electronic gadgets. His current car payment is overdue, and he is behind in payments
on all his credit cards. If he doesn’t come up with a plan of action, he’ll lose everything.
Chris’s situation is all too common. Some people who seem to be wealthy are just
barely keeping their heads above water financially. Generally, the problem they share is
financial immaturity. They lack self-discipline and don’t control their impulses. They use
poor judgment or fail to accept responsibility for managing their money.
Chris and others like him aren’t necessarily bad people. They simply haven’t thought
about their long-term financial goals. Someday you could find yourself in a situation simi-
lar to Chris’s. Here are some warning signs that you may be in financial trouble:
• You make only the minimum monthly payment on credit cards.
• You’re having trouble making even the minimum monthly payment on your credit
card bills.
• The total balance on your credit cards increases every month.
• You miss loan payments or often pay late.
• You use savings to pay for necessities such as food and utilities.
• You receive second and third payment due notices from creditors.
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The Federal Reserve has enacted new rules for credit card
companies that mean new credit card protections for you.
Here are some key changes in the rules for credit card
companies as of February 22, 2010.
Your Credit Card Company Has to Tell You:
1. When they plan to increase your rate or other fees.
Your credit card company must send you a notice 45
days before they can
• increase your interest rate;
• change certain fees (such as annual fees, cash
advance fees, and late fees) that apply to your
account; or
• make other significant changes to the terms of your
card.
If your credit card company plans to make changes to
the terms of your card, it must give you the option to can-
cel the card before certain fee increases take effect.
For example, the credit card company can require you
to pay off the balance in five years, or it can double the
percentage of your balance used to calculate your mini-
mum payment (which will result in faster repayment than
under the terms of your account).
The company does not have to send you a 45-day
advance notice if
• you have a variable interest rate tied to an index;
• your introductory rate expires and reverts to the
previously disclosed “go-to” rate; or
• your rate increases because you haven’t made your
payments as agreed.
2. How long it will take to pay off your balance. Your
monthly credit card bill will include information on how
long it will take you to pay off your balance if you only
make minimum payments. It will also tell you how much
you would need to pay each month in order to pay off
your balance in three years. For example, suppose you
owe $3,000 and your interest rate is 14.4 percent—your
bill might look like this:
New balance $ 3,000.00
Minimum payment due $ 90.00
Payment due date 4/20/15
Late Payment Warning: If we do not receive your
minimum payment by the date listed above, you
may have to pay a $35 late fee and your APRs may
be increased up to the Penalty APR of 28.99%.
Minimum Payment Warning: If you make only
the minimum payment each period, you will pay
more interest and it will take you longer to pay off
your balance. For example:
If you make no
additional charges
using this card
and each month
you pay . . .
You will pay
off the balance
shown on this
statement in
about . . .
And you will
end up paying
an estimated
total of . . .
Only the mini-
mum payment
11 years $4,745
$103 3 years $3,712
(Savings 5 $1,033)
SOURCE: Board of Governors of the Federal Reserve System,
http://www.federalreserve.gov/creditcard/flash/readingyourbill
, accessed April 28, 2014.
New Credit Card Rules
Personal Finance in Practice
• You borrow money to pay off old debts.
• You exceed the credit limits on your credit cards.
• You’ve been denied credit because of a bad credit bureau report.
If you are experiencing two or more of these warning signs, it’s time for you to rethink
your priorities before it’s too late.
Debt Collection Practices
The Federal Trade Commission enforces the Fair Debt Collection Practices Act (FDCPA).
This act prohibits certain practices by debt collectors—businesses that collect debts for
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creditors. The act does not erase the legitimate debts that consumers owe, but it does con-
trol the ways in which debt collection agencies may do business.
Financial Counseling Services
If you’re having trouble paying your bills and need help, you have several options. You can
contact your creditors and try to work out an adjusted repayment plan, or you can contact
a nonprofit financial counseling program.
CONSUMER CREDIT COUNSELING SERVICES The Consumer Credit
Counseling Service (CCCS) is a nonprofit organization affiliated with the National Foun-
dation for Consumer Credit (NFCC). Local branches of the CCCS provide debt counseling
services for families and individuals with serious financial problems. The CCCS is not a
charity, a lending institution, or a government agency. CCCS counseling is usually free.
However, when the organization supervises a debt repayment plan, it sometimes charges a
small fee to help pay administrative costs.
According to the NFCC, millions of consumers contact CCCS offices each year for help
with their personal financial problems. To find an office near you, call 1-800-388-CCCS or
go to www.nfcc.org . All information is kept confidential.
Credit counselors know that most individuals who are overwhelmed with debt are
basically honest people who want to clear up their unmanageable indebtedness, the con-
dition of being deeply in debt. Too often, such problems arise from a lack of planning or a
miscalculation of earnings. The CCCS is concerned with preventing problems as much as
it is with solving them. As a result, its activities are divided into two parts:
• Aiding families with serious debt problems by helping them to manage their money
better and set up a realistic budget.
• Helping people prevent indebtedness by teaching them the importance of
budget planning, educating them about the pitfalls of unwise credit buying, and
encouraging credit institutions to withhold credit from people who cannot afford it.
See the nearby “Personal Finance in Practice” box for help in choosing a credit
counselor.
OTHER COUNSELING SERVICES In addition to the CCCS, universities,
credit unions, military bases, and state and federal housing authorities sometimes provide
nonprofit credit counseling services. These organizations usually charge little or nothing
for their assistance. You can also check with your bank or local consumer protection office
to see whether it has a listing of reputable financial counseling services, such as the Debt
Counselors of America.
Declaring Personal Bankruptcy
What if a debtor suffers from an extreme case of financial woes? Can there be any relief?
The answer is bankruptcy proceedings. Bankruptcy is a legal process in which some or all
of the assets of a debtor are distributed among the creditors because the debtor is unable to
pay his or her debts. Bankruptcy may also include a plan for the debtor to repay creditors
on an installment basis. Declaring bankruptcy is a last resort because it severely damages
your credit rating.
Anita Singh illustrates the face of bankruptcy. A 43-year-old freelance photographer
from California, she was never in serious financial trouble until she began running up big
medical costs. She reached for her credit cards to pay the bills. Because Anita didn’t have
health insurance, her debt quickly mounted and soon reached $17,000—too much to pay
off with her $25,000-a-year income. Her solution was to declare personal bankruptcy to
get relief from creditors’ demands. Medical bills are the leading cause of bankruptcy.
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6. Have other consumers been satisfied with the
service they received? Once you have identified credit
counseling organizations that suit your needs, check
them out with your state attorney general, local con-
sumer protection agency, and Better Business Bureau.
7. What are your fees? Are there setup and/or monthly
fees? Get a detailed quote in writing, and specifically
ask whether all fees are covered in the quote. If an
organization won’t help you because you can’t afford to
pay, look elsewhere for help.
8. How are your employees paid? Are the employees
or the organization paid more if I sign up for certain
services, pay a fee, or make a contribution to your
organization? Employees who are counseling you to
purchase certain services may receive a commission if
you choose to sign up for those services. Many credit
counseling organizations receive additional compensa-
tion from creditors if you enroll in a debt management
program.
9. What do you do to keep personal information about
your clients (for example, name, address, phone
number, financial information) confidential and
secure? Credit counseling organizations handle your
most sensitive financial information. The organization
should have safeguards in place to protect the privacy
of this information and prevent misuse.
Reputable credit counseling organizations employ coun-
selors who are certified and trained in consumer credit,
debt management, and budgeting. Here are a few import-
ant questions to ask when choosing a credit counselor:
1. What services do you offer? Look for an organization
that offers a range of services, including budget coun-
seling, savings and debt management classes, and
trained certified counselors.
2. Are you licensed to offer services in my state? Many
states require that credit counseling agencies register
or obtain a license before offering their services.
3. Do you offer free information? Avoid organizations
that charge for information about the nature of their
services.
4. Will I have a formal written agreement or contract
with you? Don’t commit to participate in a debt man-
agement program over the telephone. Get all verbal
promises in writing. Read all documents carefully
before you sign them. If you are told you need to act
immediately, consider finding another organization.
5. What are the qualifications of your counselors? Are
they accredited or certified by an outside organization?
Which one? If not, how are they trained? Try to use an
organization whose counselors are trained by an out-
side organization that is not affiliated with creditors.
Choosing a Credit Counselor
Personal Finance in Practice
THE U.S. BANKRUPTCY ACT OF 1978 Exhibit 5–10 illustrates the rate of
personal bankruptcy in the United States. The vast majority of bankruptcies in the United
States, like Anita Singh’s, are filed under a part of U.S. bankruptcy code known as Chapter 7.
You have two choices in declaring personal bankruptcy: Chapter 7 (a straight bankruptcy)
and Chapter 13 (a wage earner plan bankruptcy). Both choices are undesirable, and neither
should be considered an easy way to get out of debt.
Chapter 7 Bankruptcy In a Chapter 7 bankruptcy, an individual is required to draw
up a petition listing his or her assets and liabilities. A person who files for relief under the
bankruptcy code is called a debtor. The debtor submits the petition to a U.S. district court
and pays a filing fee.
Chapter 7 is a straight bankruptcy in which many, but not all, debts are forgiven. Most
of the debtor’s assets are sold to pay off creditors. Certain assets, however, receive some
protection. Among the assets usually protected are Social Security payments, unemploy-
ment compensation, and the net value of your home, vehicle, household goods and appli-
ances, tools used in your work, and books.
The courts must charge a $306 case filing fee, a $46 miscellaneous administrative fee,
and a $15 trustee fee. If the debtor is unable to pay the fees even in installments, the court
may waive the fees.
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Exhibit 5–10 U.S. Consumer Bankruptcy Filings, 1980–2013
Consumer bankruptcies have increased significantly over the past 30 years. Consumer bankruptcy filings rose from about 287,000
in 1980 to almost 2 million in 2005. Bankruptcies decreased after the Bankruptcy Abuse Prevention and Consumer Protection Act
was passed. However, poor economic conditions have caused the numbers to increase yet again despite the legislation.
2006 2007 2008 2009 2010 2011 2012
Year
Consumer Filings (in millions)
200520001995 2001
288
341
718
875
1,218
1,539
1,452
1,625
1,563
2,039
598
823
1,074
1,344
1,538
1,417
1,219
2013
1,073
19851980 1990 2002 2003 2004
0
500
1,000
2,000
1,500
2,500
SOURCE: Administrative Office of the U.S. Courts, http://www.uscourts.gov/Statistics/JudicialBusiness/2013/us-bankruptcy-
courts.aspx , accessed April 28, 2014.
In filing a petition, a debtor must provide the following information:
• A list of all creditors and the amount and nature of their claims.
• The source, amount, and frequency of the debtor’s income.
• A list of all the debtor’s property.
• A detailed list of the debtor’s monthly expenses.
The release from debt does not affect alimony, child support, certain taxes, fines, certain
debts arising from educational loans, or debts that you fail to disclose properly to the bank-
ruptcy court. Furthermore, debts arising from fraud, driving while intoxicated, or certain
other acts or crimes may also be excluded.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 On
April 20, 2005, President George W. Bush signed the Bankruptcy Abuse Prevention and
Consumer Protection Act, which is perhaps the largest overhaul of the Bankruptcy Code
since it was enacted in 1978. Signing the bill, the president declared, “Bankruptcy should
always be the last resort in our legal system. In recent years too many people have abused
the bankruptcy laws. Under the new law, Americans who have the ability to pay will be
required to pay back at least a portion of their debts. The law will help make credit more
affordable, because when bankruptcy is less common, credit can be extended to more peo-
ple at better rates. Debtors seeking to erase all debts will now have to wait eight years from
their last bankruptcy before they can file again. The law will also allow us to clamp down on
bankruptcy mills that make their money by advising abusers on how to game the system.”
Among other provisions, the law requires that:
• The director of the Executive Office for U.S. Trustees develop a financial management
training curriculum to educate individual debtors on how to better manage their
finances, and test, evaluate, and report to Congress on the curriculum’s effectiveness.
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• Debtors complete an approved instructional course in personal financial
management.
• The clerk of each bankruptcy district maintain a list of credit counseling agencies
and instructional courses on personal financial management.
Furthermore, the law may require that states should develop personal finance curricula
designed for use in elementary and secondary schools.
The bottom line: The new law made it more difficult for consumers to file a Chapter 7
bankruptcy and forces them into a Chapter 13 repayment plan.
Chapter 13 Bankruptcy In Chapter 13 bankruptcy, a debtor with a regular income
proposes a plan for using future earnings or assets to eliminate his or her debts over a
period of time. In such a bankruptcy, the debtor normally keeps all or most of his or her
property. A debtor must provide the same information that is required to file a Chapter 7
bankruptcy.
During the period when the plan is in effect, which can be as long as five years, the
debtor makes regular payments to a Chapter 13 trustee, or representative, who then dis-
tributes the money to the creditors. Under certain circumstances, the bankruptcy court may
approve a plan that permits the debtor to keep all property, even though he or she repays
less than the full amount of the debts.
EFFECTS OF BANKRUPTCY People have varying experiences in obtaining
credit after they file for bankruptcy. Some find the process more difficult, whereas others
find it easier because they have removed the burden of prior debts or because creditors
know that they cannot file another bankruptcy case for a certain period of time. Obtaining
credit may be easier for people who file a Chapter 13 bankruptcy and repay some of their
debts than for those who file a Chapter 7 bankruptcy and make no effort to repay any of
their debts.
PRACTICE QUIZ 5–5 PRACTICE QUIZ 5–5
1. What steps might you take if there is a billing error in your monthly statement?
2. What steps would you take if someone stole your identity?
3. How might you protect your credit information on the Internet?
4. What are some warning signs of debt problems?
5. Distinguish between Chapter 7 and Chapter 13 bankruptcy.
Apply Yourself! Apply Yourself!
Search online to find branches of the Consumer Credit Counseling Service across the country. Choose one in your area
and one in another part of the country. Visit the websites to find out who funds the offices.
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YOUR PERSONAL FINANCE DASHBOARD
A key indicator of your creditworthiness is your capacity
to handle a certain level of debt. Lenders will review
your current debt payments-to-income ratio. Based
upon this, they will determine how much credit they will
extend and at what interest rate. Lenders will be more
reluctant to lend to individuals who are near the top of
the acceptable range of 20 percent.
YOUR SITUATION: Are you able to pay your credit
cards off each month when the bill is due? If you carry
a balance, is it steadily increasing? Are there debts that
you can eliminate to reduce the amount of your overall
debt payments?
An improving debt payments-to-income ratio is the
foundation for progress toward financial independence.
D E B T P A Y M E N T S – T O – I N C O M E R AT I O
Reconsider your responses to the “Action Items”
(in the text margin) to determine actions you
might consider related to the wise use of credit.
Seek information from several sources when evaluat-
ing the sources of credit, including various websites
and Exhibit 5–3.
Determine how you intend to use your credit card
before choosing one. Follow the suggestions to find the
card that best meets your needs and use it wisely. See
the “Personal Finance in Practice” box on page 146.
Get copies of your credit report and make sure the
information is correct. The only authorized online
source for a free credit report is www.annualcredit-
report.com , or call 877-322-8228.
POSSIBLE ACTIONS TO TAKE
LO5.1 Consumer credit is the use of
credit by individuals and families for per-
sonal needs. Among the advantages of using
credit are the ability to purchase goods
when needed and pay for them gradually,
the ability to meet financial emergencies,
convenience in shopping, and establish-
ment of a credit rating. Disadvantages are
that credit costs money, encourages over-
spending, and ties up future income.
LO5.2 Closed-end and open-end credit
are two types of consumer credit. With
closed-end credit, the borrower pays back a
one-time loan in a stated period of time and
with a specified number of payments. With
open-end credit, the borrower is permitted
to take loans on a continuous basis and is
billed for partial payments periodically.
The major sources of consumer credit
are commercial banks, savings and loan
associations, credit unions, finance com-
panies, life insurance companies, and fam-
ily and friends. Each of these sources has
unique advantages and disadvantages.
Parents or family members are often
the source of the least expensive loans.
They may charge you only the interest they
would have earned had they not made the
loan. Such loans, however, can complicate
family relationships.
LO5.3 Two general rules for measuring
credit capacity are the debt payments-to-
income ratio and the debt-to-equity ratio. In
reviewing your creditworthiness, a creditor
seeks information from one of the three
national credit bureaus or a regional credit
bureau.
Creditors determine creditworthiness on
the basis of the five Cs: character, capacity,
capital, collateral, and conditions.
Chapter
Summary
0
5
10
30
15
20
25
G
O
O
D
CAUTION D
A
N
G
E
R
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LO5.4 Compare the finance charge and
the annual percentage rate (APR) as you
shop for credit. Under the Truth in Lend-
ing Act, creditors are required to state the
cost of borrowing so that you can compare
credit costs and shop for credit.
LO5.5 If a billing error occurs on your
account, notify the creditor in writing
within 60 days. If the dispute is not settled
in your favor, you can place your version of
it in your credit file. You may also withhold
payment on any defective goods or services
you have purchased with a credit card as
long as you have attempted to resolve the
problem with the merchant.
If you have a complaint about credit,
first try to deal directly with the creditor.
If that fails, you can turn to the appropri-
ate consumer credit law. These laws include
the Truth in Lending Act, the Consumer
Leasing Act, the Equal Credit Opportunity
Act, the Fair Credit Billing Act, the Fair
Credit Reporting Act, the Consumer Credit
Reporting Reform Act, and the Electronic
Fund Transfer Act.
If you cannot meet your obligations,
contact your creditors immediately. Also,
contact your local Consumer Credit Coun-
seling Service or other debt counseling
organizations.
A debtor’s last resort is to declare bank-
ruptcy, permitted by the U.S. Bankruptcy
Act of 1978. Consider the financial and
other costs of bankruptcy before taking this
extreme step. A debtor can declare Chapter
7 (straight) bankruptcy or Chapter 13 (wage
earner plan) bankruptcy.
annual percentage rate
(APR) 161
capacity 152
capital 152
character 152
closed-end credit 144
collateral 153
conditions 153
consumer credit 141
credit 141
Fair Credit Billing Act
(FCBA) 166
finance charge 145
interest 145
line of credit 145
mobile commerce 147
open-end credit 144
revolving check
credit 145
simple interest 163
Key Terms
Page Topic Formula
162 Calculating
annual
percentage
rate (APR)
APR 5
2 3 Number of payment periods in one year 3 Dollar cost of credit
_______________________________________________________
Loan amount (Total number of payments to pay off the loan 1 1)
5
2 3 n 3 I
_________
P(N 1 1)
163 Calculating
simple
interest
Interest (in dollars) 5 Principal borrowed 3 Interest rate
3 Length of loan in years
I 5 P 3 r 3 T
Key
Formulas
1. Vicky is trying to decide whether to finance her purchase of a used Mustang convertible.
What questions should Vicky ask herself before making her decision? (LO5.1)
2. List advantages and disadvantages of using credit. (LO5.1)
3. To finance a sofa for his new apartment, Caleb signed a contract to pay for the sofa in
six equal installments. What type of consumer credit is Caleb using? (LO5.2)
4. Alka plans to spend $5,000 on a plasma television and home theater system. She is
willing to spend some of her $9,000 in savings. However, she wants to finance the rest
and pay it off in small monthly installments out of the $400 a month she earns working
Discussion
Questions
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part-time. How might she obtain a low-interest loan and make low monthly
payments? (LO5.2)
5. Samuel applied for a loan to purchase a new car. His application was denied. What
should he do now? (LO5.3)
6. Diane wants to purchase a home in the next five years. She knows how important a
good credit score is for getting a lower interest rate. What are some ways she can con-
tinue to improve her credit score over the next few years? (LO5.3)
7. Why is it important to avoid the minimum monthly payment trap? (LO5.4)
8. Grayson just received his credit card statement. He noticed a charge for $40 to a store
he has never patronized. What steps should he take to handle this? (LO5.5)
9. What factors (including psychological) would you consider in assessing the choices in
declaring personal bankruptcy? Why should personal bankruptcy be the choice of last
resort? (LO5.5)
1. A few years ago, Simon Powell purchased a home for $110,000. Today, the home is
worth $150,000. His remaining mortgage balance is $50,000. Assuming that Simon
can borrow up to 80 percent of the market value, what is the maximum amount he can
borrow? (LO5.2)
2. Louise McIntyre’s monthly gross income is $2,000. Her employer withholds $400 in
federal, state, and local income taxes and $160 in Social Security taxes per month.
Louise contributes $80 each month for her IRA. Her monthly credit payments for Visa
and MasterCard are $35 and $30, respectively. Her monthly payment on an automobile
loan is $285. What is Louise’s debt payments-to-income ratio? Is Louise living within
her means? (LO5.3)
3. Robert Sampson owns a $140,000 townhouse and still has an unpaid mortgage of
$110,000. In addition to his mortgage, he has the following liabilities:
Visa $565
MasterCard 480
Discover card 395
Education loan 920
Personal bank loan 800
Auto loan 4,250
Total $7,410
Problems
1. Suppose that your monthly net income is $1,500. Your monthly debt payments include
your student loan payment and a gas credit card, and they total $200. What is your
debt payments-to-income ratio?
2. Suppose you borrow $1,000 at 6 percent and will repay it in one payment at the end of
one year. Use the simple interest formula to determine the amount of interest you will
pay.
Solutions
1. Use the debt payments-to-income ratio formula: Monthly debt payments/Monthly net
income.
Debt payments-to-income ratio 5
$200
______
$1,500
5 0.13, or 13%
2. Using the simple interest formula (Interest 5 Principal 3 Rate of interest 3 Time),
the interest is $60, computed as follows:
$60 5 $1,000 3 0.06 3 1 (year)
Self-Test
Problems
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Robert’s net worth (not including his home) is about $21,000. This equity is in
mutual funds, an automobile, a coin collection, furniture, and other personal prop-
erty. What is Robert’s debt-to-equity ratio? Has he reached the upper limit of debt
obligations? Explain. (LO5.3)
4. Madeline Rollins is trying to decide whether she can afford a loan she needs in order
to go to chiropractic school. Right now Madeline is living at home and works in a shoe
store, earning a gross income of $820 per month. Her employer deducts a total of $145
for taxes from her monthly pay. Madeline also pays $95 on several credit card debts
each month. The loan she needs for chiropractic school will cost an additional $120 per
month. Help Madeline make her decision by calculating her debt payments-to-income
ratio with and without the college loan. (Remember the 20 percent rule.) (LO5.3)
5. Joshua borrowed $500 for one year and paid $50 in interest. The bank charged him a
$5 service charge. What is the finance charge on this loan? (LO5.4)
6. In problem 5, Joshua borrowed $500 on January 1, 2014, and paid it all back at once
on December 31, 2014. What was the APR? (LO5.4)
7. If Joshua paid the $500 in 12 equal monthly payments, what is the APR? (LO5.4)
8. Sidney took a $200 cash advance by using checks linked to her credit card account.
The bank charges a 2 percent cash advance fee on the amount borrowed and offers no
grace period on cash advances. Sidney paid the balance in full when the bill arrived.
What was the cash advance fee? What was the interest for one month at an 18 per-
cent APR? What was the total amount she paid? What if she had made the purchase
with her credit card and paid off her bill in full promptly? (LO5.4)
9. Brooke lacks cash to pay for a $600 washing machine. She could buy it from the store
on credit by making 12 monthly payments of $52.74 each. The total cost would then
be $632.88. Instead, Brooke decides to deposit $50 a month in the bank until she has
saved enough money to pay cash for the washing machine. One year later, she has
saved $642—$600 in deposits plus interest. When she goes back to the store, she finds
that the washing machine now costs $660. Its price has gone up 10 percent—the current
rate of inflation. Was postponing her purchase a good trade-off for Brooke? (LO5.4)
10. What are the interest cost and the total amount due on a six-month loan of $1,500 at
13.2 percent simple annual interest? (LO5.4)
11. After visiting several automobile dealerships, Richard selects the car he wants. He
likes its $10,000 price, but financing through the dealer is no bargain. He has $2,000
cash for a down payment, so he needs an $8,000 loan. In shopping at several banks
for an installment loan, he learns that interest on most automobile loans is quoted at
add-on rates. That is, during the life of the loan, interest is paid on the full amount
borrowed even though a portion of the principal has been paid back. Richard borrows
$8,000 for a period of four years at an add-on interest rate of 11 percent. (LO5.4)
a. What is the total interest on Richard’s loan?
b. What is the total cost of the car?
c. What is the monthly payment?
d. What is the annual percentage rate (APR)?
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
FINANCING SUE’S HONDA ACCORD
After shopping around, Sue Wallace decided
on the car of her choice, a used Honda
Accord. The dealer quoted her a total price
of $10,000. Sue decided to use $2,000 of
her savings as a down payment and borrow
$8,000. The salesperson wrote this informa-
tion on a sales contract that Sue took with
her when she set out to find financing.
When Sue applied for a loan, she discussed
loan terms with the bank lending officer.
Case in
Point
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Jamie Lee Jackson, age 27, full-time student and part-time bakery employee, has just
moved into a bungalow-style, unfurnished home of her own. The house is only a one-bedroom,
but the rent is manageable and it has plenty of room for Jamie Lee. She decided to give
notice to her roommate that she would be leaving the apartment and the shared expenses
after the incident with the stolen checkbook and credit cards a few weeks back. Jamie had
to dip into her emergency savings account to help cover the deposit and moving expenses,
because she had not planned to move out of the apartment and be on her own this soon.
CONSUMER CREDIT: ADVANTAGES, DISADVANTAGES, SOURCE,
AND COSTS
Continuing
Case
The officer told her that the bank’s policy
was to lend only 80 percent of the total
price of a used car. Sue showed the officer
her copy of the sales contract, indicating
that she had agreed to make a $2,000, or
20 percent, down payment on the $10,000
car, so this requirement caused her no
problem. Although the bank was will-
ing to make 48-month loans at an annual
percentage rate of 9 percent on used cars,
Sue chose a 36-month repayment sched-
ule. She believed she could afford the
higher payments, and she knew she would
not have to pay as much interest if she paid
off the loan at a faster rate. The bank lend-
ing officer provided Sue with a copy of the
Truth-in-Lending Disclosure Statement
shown here.
TRUTH-IN-LENDING DISCLOSURE STATEMENT (LOANS)
Annual Percentage Rate Finance Charge Amount Financed Total of Payments 36
The cost of your credit
as a yearly rate.
9%
The dollar amount the
credit will cost you.
$1,158.32
The amount of credit
provided to you or on
your behalf.
$8,000.00
The amount you will have
paid after you have made all
payments as scheduled.
$9,158.32
You have the right to receive at this time an itemization of the Amount Financed.
h I want an itemization. h I do not want an itemization.
Your payment schedule will be:
Number of Payments Amount of Payments When Payments Are Due
36 $254.40 1st of each month
Sue decided to compare the APR she had
been offered with the APR offered by
another bank, but the 11 percent APR of the
second bank (bank B) was more expensive
than the 9 percent APR of the first bank
(bank A). Here is her comparison of the
two loans:
Bank A
9% APR
Bank B
11% APR
Amount financed $8,000 $8,000
Finance charge 1,158.32 1,428.75
Total of payments 9,158.32 9,428.75
Monthly payments 254.40 261.91
The 2 percent difference in the APRs of the
two banks meant Sue would have to pay $8
extra every month if she got her loan from
the second bank. Of course, she got the loan
from the first bank.
Questions
1. What is perhaps the most important
item shown on the disclosure statement?
Why?
2. What is included in the finance charge?
3. What amount will Sue receive from the
bank?
4. Should Sue borrow from bank A or
bank B? Why?
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Assets:
Checking account, $1,800
Savings account, $7,200
Emergency fund savings account, $2,700
IRA balance, $410
Car, $2,800
Liabilities:
Student loan balance, $10,800 (Jamie is
still a full-time student, so no payments are
required on the loan until after graduation)
Credit card balance, $4,250 (total of three
store credit cards)
Income:
Gross monthly salary from the bakery,
$2,750 (net income, $2,175)
Monthly Expenses:
Rent, $350
Utilities, $70
Food, $125
Gas/Maintenance, $130
Credit card payment, $0
Jamie is in need of a few appliances, as there is a small laundry room but no washer or
dryer, nor is there a refrigerator in the kitchen. She will also need a living room set and a
television, because Jamie only had a bedroom set to move in with. Jamie is so excited to
finally have the say in how she will furnish the bungalow, and she began shopping for her
home as soon as the lease was signed.
The home appliance store was the first stop, where Jamie chose a stacking washer and
dryer set that would fit comfortably in the laundry space provided. A stainless steel refrigera-
tor with a built-in television screen was her next choice, and the salesperson quickly began to
write up the order. She informed Jamie that if she opened up a credit card through the appli-
ance store, she would receive a discount of 10 percent off her total purchase. As she waited
for her credit to be approved, she decided to continue shopping for her other needed items.
Living room furniture was next on the list. Jamie went to a local retailer who offered
seemingly endless choices of complete sofa sets that included the coffee and end tables as
well as matching lamps. Jamie chose a contemporary-style set and again was offered the
tempting deal of opening a credit card through the store in exchange for a percentage off
her purchase and free delivery.
Jamie’s last stop was the local big box retailer, where she chose a 52” 1080p LED
HDTV. For the third time, a percentage off her first purchase at the big box retailer was all
that was needed to get Jamie to sign on the dotted line of the credit card application. She
was daydreaming of how wonderful her new home would look when a call from the appli-
ance store came through asking her to return to the store.
Jamie Lee received the unfortunate news that her credit application at the appliance
store had been denied. She left the store only to be greeted at the next two stores where she
had chosen the living room set and television with the same bad news—credit application
denied! She was informed that her credit score was too low for approval. “How could this
be?” Jamie wondered and immediately contacted the credit bureau for further explanation.
Current Financial Situation
Questions
1. What steps should Jamie Lee take to discover the reason for the denial of her credit
applications?
2. Jamie discovers that she has become the victim of identity theft, as her credit report
indicates that two credit cards have been opened in her name without her authoriza-
tion! The police had already been notified the evening of the theft incident in the apart-
ment, but what other measures should Jamie Lee take now that she has become aware
of the identity theft?
3. Fortunately for Jamie, she was able to show proof of the theft to the credit bureau and
her credit applications for her apartment furnishings were approved. The purchase
total for the appliances, living room furniture, and television amounted to $4,250. The
minimum payments among the three accounts total $325 a month. What is Jamie Lee’s
debt payments-to-income ratio?
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4. Oh, no! The television was finally delivered today, but was left on the porch by the
delivery company. When Jamie Lee was finally able to attach all the wires and cables
according to the owner’s manual, it played for half an hour and then shut off. Jamie
Lee was unable to get the television to turn back on, although she read the trouble-
shooting guide in the manual and contacted tech support from the manufacturer. Jamie
Lee lugged the television back to the store, but they would not accept a return on
electronics. What should Jamie Lee do now?
5. Jamie Lee now has to juggle the three monthly credit card bills for each of the retailers
where she purchased her home furnishings. She is interested in getting one loan to
consolidate the three store consumer credit cards so she may make a single payment
on the goods per month. Using “Your Personal Financial Plan” sheet 17, compare the
consumer loan options that Jamie Lee may consider. What are your recommendations
for her to consolidate her monthly consumer charge bills?
Directions Your ability to monitor spending and credit use is a fundamental skill for
wise money management and long-term financial security. Use the Daily Spending Diary
sheets provided at the end of the book to record all of your spending in the categories pro-
vided. Be sure to indicate the use of a credit card with (CR). The Daily Spending Diary
sheets are available in Appendix D at the end of the book and in Connect Finance.
Questions
1. Describe any aspects of your spending habits that might indicate an overuse of credit.
2. How might your Daily Spending Diary provide information for wise credit use?
“I ADMIRE PEOPLE WHO ARE ABLE TO PAY OFF THEIR CREDIT
CARDS EACH MONTH.”
Spending
Diary
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N Consumer Credit Usage Patterns
Purpose: To create a record of current consumer debt balances.
Financial Planning Activities: Record account names, numbers, and payments for current
consumer debts. This sheet is also available in an Excel spreadsheet format in Connect
Finance.
Suggested Websites: www.ftc.gov www.creditcards.com
Automobile, Education, Personal, and Installment Loans
Current Monthly
Financial institution Account number balance payment
Charge Accounts and Credit Cards
Other Loans (overdraft protection, home equity, life insurance loan)
Totals
Debt payments-to-income ratio 5
Total monthly payments
______________________
Net (after-tax) income
What’s Next for Your Personal Financial Plan?
• Survey three or four individuals to determine their uses of credit.
• Talk to several people to determine how they first established credit.
Suggested
App:
• Lemon
Wallet
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N Credit Card/Charge Account Comparison
Purpose: To compare the benefits and costs associated with different credit cards and
charge accounts.
Financial Planning Activities: Analyze ads and credit applications and contact various
financial institutions to obtain the information requested below. This sheet is also available in
an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.bankrate.com www.creditcards.com www.consumerfinance.gov
Type of credit/charge
account
Name of
company/account
Address/phone
Website
Type of purchases
that can be made
Annual fee (if any)
Annual percentage
rate (APR) (interest
calculation information)
Credit limit for new
customers
Minimum monthly
payment
Other costs:
• credit report
• late fee
• other
Restrictions (age,
minimum annual
income)
Other information for
consumers to consider
Frequent flyer or other
bonus points
What’s Next for Your Personal Financial Plan?
• Make a list of the pros and cons of using credit or debit cards.
• Contact a local credit bureau to obtain information on the services provided and the fees charged.
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N Consumer Loan Comparison
Purpose: To compare the costs associated with different sources of loans.
Financial Planning Activities: Contact or visit a bank, credit union, and consumer finance
company to obtain information on a loan for a specific purpose. This sheet is also available
in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.eloan.com www.wellsfargo.com www.ftc.gov
Type of financial
institution
Name
Address
Phone
Website
What collateral is
required?
Amount of down
payment
Length of loan (months)
Amount of monthly
payment
Total amount to
be repaid (monthly
amount 3 number
of months 1 down
payment)
Total finance charge/
cost of credit
Annual percentage rate
(APR)
Other costs
• credit life insurance
• credit report
• other
Is a cosigner required?
Other information
What’s Next for Your Personal Financial Plan?
• Ask several individuals how they would compare loans at different financial institutions.
• Survey several friends and relatives to determine if they ever cosigned a loan. If yes, what were the conse-
quences of cosigning?
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3 Steps to Financial
Literacy . . . Avoiding
Unplanned Spending
6
Consumer Purchasing
Strategies and Wise
Buying of Motor Vehicles
Avoiding impulse buying can help to reduce
overuse of credit and improve your personal
financial situation. At the end of the chapter,
“Your Personal Finance Dashboard” will
provide additional information on wise buying
and reducing and eliminating unplanned
spending.
1
Research products, shopping locations,
brands, and prices for purchases that meet
your needs.
App: PriceGrabber
2
Develop a specific shopping list to guide your
daily purchasing decisions.
App: Shopping List
3
Make a commitment to buy only items on your
list of identified needs.
Website: www.thesimpledollar.com
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Consumer Buying Activities
Daily buying decisions involve a trade-off between current spending and saving for the
future. A wide variety of economic, social, and personal factors affect daily buying habits.
These factors are the basis for spending, saving, investing, and achieving personal financial
goals. In very simple terms, the only way you can have long-term financial security is to
not spend all of your current income. In addition, overspending leads to misuse of credit
and financial difficulties.
Practical Purchasing Strategies
Comparison shopping is the process of considering alternative stores, brands, and prices.
In contrast, impulse buying involves unplanned purchasing, which can result in financial
problems. Several buying techniques are commonly suggested for wise buying.
TIMING PURCHASES Certain items go on sale the same
time each year. You can obtain bargains by buying winter cloth-
ing in mid- or late winter, or summer clothing in mid- or late
summer. Many people save by buying holiday items and other
products at reduced prices in late December and early January.
PURCHASE LOCATION Your decision to use a partic-
ular retailer is probably influenced by location, price, product
selection, and services available. Competition and technology
have changed retailing with superstores, specialty shops, and
LO6.1
Identify strategies for effective
consumer buying.
ACTION ITEM
I stay informed on wise
buying strategies.
h Agree
h Disagree
CHAPTER 6 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO6.1 Identify strategies for effective consumer buying.
LO6.2 Implement a process for making consumer purchases.
LO6.3 Describe steps to take to resolve consumer problems.
LO6.4 Evaluate legal alternatives available to consumers.
YOUR PERSONAL FINANCIAL PLAN SHEETS
18. Consumer Purchase Comparison
19. Used-Car Purchase Comparison
20. Buying vs. Leasing a Vehicle
21. Legal Services Cost Comparison
did you know? did you know?
To save money when shopping, (1) check
your budget; (2) create a list, and don’t stray
from it; (3) avoid shopping as a social activity; (4) be
careful not to let anxiety influence your purchases; and
(5) remember that bargaining can result in the thrill of
success for a deal on an item that you don’t need.
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online buying. This expanded shopping environment provides consumers with greater
choice, potentially lower prices, and the need to carefully consider buying alternatives.
BRAND COMPARISON Food and other products come in various brands. National-brand
products are highly advertised items available in many stores. Store-brand and private-label
products, sold by one chain of stores, are low-cost alternatives to famous-name products.
Since store-brand products are frequently manufactured by the same companies that
produce brand-name items, these lower-cost alternatives can result in extensive savings.
The use of one or more of the many product comparison websites can assist you when
comparing brands.
LABEL INFORMATION Certain label information is helpful; however, other infor-
mation is nothing more than advertising. Federal law requires that food labels contain
certain information. Product labeling for appliances includes information about operating
costs to assist you in selecting the most energy-efficient models. Open dating describes the
freshness or shelf life of a perishable product. Phrases such as “Use before May 2016” or
“Not to be sold after October 8” appear on most food products. However, these labels can
be confusing. Most expiration dates relate to quality, not safety. Items used after the “sell
by” date are likely to be safe for consumption. Canned and packaged food items, if not
opened, will usually be safe beyond the expiration date.
PRICE COMPARISON Unit pricing uses a standard unit of measurement to com-
pare the prices of packages of different sizes. To calculate the unit price, divide the price
of the item by the number of units of measurement, such as ounces, pounds, gallons, or
number of sheets (for items such as paper towels and facial tissues). Then compare the unit
prices for various sizes, brands, and stores.
EXAMPLE: Unit Pricing
To calculate the unit price of an item, divide the cost by the number of units. For
example, a 64-ounce product costing $8.32 would be calculated in this manner:
Unit price 5 $8.32 4 64
5 $0.13, or 13 cents an ounce
Coupons and rebates also provide better pricing for wise consumers. A family saving
about $8 a week on their groceries by using coupons will save $416 over a year and $2,080
over five years (not counting interest). Coupons are available online through websites such
as www.coolsavings.com and www.couponsurfer.com and through apps such as Coupon
Cloud and Grocery Smarts. A rebate is a partial refund of the price of a product.
When comparing prices, remember that :
• More store convenience (location, hours, sales staff) usually
means higher prices.
• Ready-to-use products have higher prices.
• Large packages are usually the best buy; however, compare
using unit pricing.
• “Sale” may not always mean saving money.
• The use of online sources and shopping apps can
save time.
Exhibit 6–1 summarizes techniques that can assist you in your
online buying decisions.
CAUTION! CAUTION!
Buying fake and counterfeit products, online
and elsewhere, may be cheap and easy, but
also very dangerous. While buying a fake purse
or watch may not cost much money, other
products can cost lives. Counterfeit prescription
medications are sold in many settings. A knock-
off airbag used as a replacement part in a vehi-
cle after an accident may not deploy properly.
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Exhibit 6–1 Wise Online Buying Activities
Consider both stores and online
Evaluate price, service, product
quality, warranties, shipping cost
and time, return policy
Determine reputation, location
Use secure buying website
Seek discounts, coupons
Select payment method based
on security, fees, other factors
1. Conduct online research.
Compare brands and features
Use label and warranty information
Use product testing reports to
assess quality, safety, nutrition
Keep receipts, other documents
Know return, complaint process
Watch e-mails for special offers
Evaluate time, effort involved
4. Plan for future purchases.
2. Compare stores.
3. Make purchase.
Warranties
Most products come with some guarantee of quality. A warranty is a written guarantee
from the manufacturer or distributor that specifies the conditions under which the product
can be returned, replaced, or repaired. An express warranty, usually in written form, is
created by the seller or manufacturer and has two forms: the full warranty and the limited
warranty A written
guarantee from the
manufacturer or distributor
of a product that specifies
the conditions under which
the product can be returned,
replaced, or repaired.
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warranty. A full warranty states that a defective product can be fixed or replaced during a
reasonable amount of time.
A limited warrant y covers only certain aspects of the product, such as parts, or requires
the buyer to incur part of the costs for shipping or repairs. An implied warranty covers a
product’s intended use or other basic understandings that are not
in writing. For example, an implied warranty of title indicates
that the seller has the right to sell the product. An implied war-
ranty of merchantability guarantees that the product is fit for
the ordinary uses for which it is intended: A toaster must toast
bread, and an MP3 player must play music or other recorded
files. Implied warranties vary from state to state.
USED-CAR WARRANTIES The Federal Trade Com-
mission (FTC) requires used cars to have a buyer’s guide
sticker telling whether the vehicle comes with a warranty and,
if so, what protection the dealer will provide. If no warranty is
offered, the car is sold “as is” and the dealer assumes no respon-
sibility for any repairs, regardless of any oral claims. FTC used-
car regulations do not apply to vehicles purchased from private
owners.
While a used car may not have an express warranty, most
states have implied warranties to protect used-car buyers. An
implied warranty of merchantability means the product is guar-
anteed to do what it is supposed to do. The used car is guaran-
teed to run—at least for a while!
NEW-CAR WARRANTIES New-car warranties provide buyers with an assurance
of quality. These warranties vary in the time, mileage, and parts they cover. The main
conditions of a new-car warranty are (1) coverage of basic parts against defects; (2) power
train coverage for the engine, transmission, and drive train; and (3) the corrosion warranty,
which usually applies only to holes due to rust, not to surface rust. Other important condi-
tions of a warranty are a statement regarding whether the warranty is transferable to other
owners of the car and details about the charges, if any, that will be made for major repairs
in the form of a deductible.
SERVICE CONTRACTS A service contract is an agreement between a business
and a consumer to cover the repair costs of a product. Frequently called extended warran-
ties, they are not warranties. For a fee, these agreements insure the buyer against losses due
to the cost of certain repairs and losses. Beware of service contracts that offer coverage for
three years but really only cover two since the item has a manufacturer’s one-year
warranty.
Automotive service contracts can cover repairs not included in the manufacturer’s war-
ranty. Service contracts range from $400 to more than $1,000; however, they do not always
include everything you might expect. These contracts usually cover failure of the engine
cooling system; however, some contracts exclude coverage of such failures if caused by
overheating.
Because of costs and exclusions, service contracts may not be a wise financial decision.
You can minimize your concern about expensive repairs by setting aside a fund of money
to pay for them. Then, if you need repairs, the money to pay for them will be available.
Research-Based Buying
Major buying decisions should be based on a specific decision-making process, which may
be viewed in four phases.
service contract An
agreement between a
business and a consumer to
cover the repair costs of a
product.
did you know? did you know?
When buying gifts or household When buying gifts or household
items, you can make a difference in the life items, you can make a difference in the life
of an artisan in a developing country by of an artisan in a developing country by
making an online purchase from Ten Thou-making an online purchase from Ten Thou-
sand Villages ( sand Villages ( www.tenthousandvillageswww.tenthousandvillages
.com.com ). This organization works to help ). This organization works to help
artisans earn a fair wage and to improve artisans earn a fair wage and to improve
their quality of life by paying for food, their quality of life by paying for food,
education, health care, and housing. education, health care, and housing.
There are also more than 100 Ten There are also more than 100 Ten
Thousand Villages stores in the United Thousand Villages stores in the United
States and Canada. States and Canada.
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PHASE 1: PRESHOPPING ACTIVITIES
Start the buying process with actions that include:
• Problem identification to set a goal and focus your purchasing activities.
• Information gathering to benefit from the buying experiences of others.
PHASE 2: EVALUATING ALTERNATIVES
With every decision, consider various options:
• Attribute assessment with a comparison of product features.
• Price analysis including consideration of the costs at various buying locations.
• Comparison shopping activities to evaluate shopping locations.
PHASE 3: SELECTION AND PURCHASE
When making your final choice, actions may include:
• Negotiation activities to obtain lower price or added quality.
• Payment alternatives including use of cash and various credit plans.
• Assessment of acquisition and installation that might be encountered.
PHASE 4: POSTPURCHASE ACTIVITIES
After making a purchase, several actions are encouraged:
• Proper maintenance and operation.
• Identification and comparison of after-sale service alternatives.
• Resolution of any purchase concerns that may occur.
PRACTICE QUIZ 6–1 PRACTICE QUIZ 6–1
1. What types of brands are commonly available to consumers?
2. In what situations can comparing prices help in purchasing decisions?
3. How does a service contract differ from a warranty?
4. Match the following descriptions with the warranties listed here. Write your answer in the space provided.
express warranty limited warranty
full warranty service contract
implied warranty
a. __________ Covers only aspects of the item purchased.
b. __________ Is commonly referred to as an extended warranty.
c. __________ Usually is in a written form.
d. __________ Covers a product’s intended use; it may not be in writing.
e. __________ Covers fixing or replacement of a product for a set time period.
Apply Yourself! Apply Yourself!
Talk to people about their brand loyalty. For what products are people most brand loyal? What factors (price, location,
information) may influence a person to change brands? Compare your findings to online research reports for brand
loyalty.
Sheet 18 Consumer Purchase Comparison S
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. From your perspective, what are the benefits and drawbacks of each of the three alternatives for buying a
motor vehicle?
2. What factors should a person consider before buying an extended warranty?
3. What actions would you suggest when using any of the three alternatives presented in the article?
Which Route Is Best for You?
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CPO NON-CPO PRIVATE
PARTY
Certified pre-owned
vehicles are as close
to a new-car-buying
experience as you can
get. You’ll pay an extra
$1,500 to $2,500 com-
pared with non-CPO
vehicles.
Dealers sell vehicles
they acquire at auc-
tion or through trade-
ins that aren’t scooped
up by the CPO pro-
grams. You’ll likely
pay at least 10% more
to a dealer than to a
private party.
The cheapest way to
buy a used car. Private
sellers can sell a used
car for a higher price
to you than they could
to a dealer, but they
can’t inflate the price
as much.
Condition Excellent—models
are five years old or
newer with fewer than
60,000 miles. Because
many CPOs are off-
lease, they have had
only one owner.
Mostly cosmetic
reconditioning. Don’t
expect repairs to be
made. Most dealers
offer a vehicle history
report from Auto-
Check.com or Carfax
.com.
It varies. Ask for
maintenance
records and get a
vehicle history report
on AutoCheck.com or
Carfax.com.
Inspection A 100- to 200-point
inspection. Vehicles
are repaired and
reconditioned. Worn
parts are replaced,
saving money on
future maintenance.
A dealer’s service
department inspects
the car, but get your
own mechanic to go
over the car before
you buy.
You’re on your own.
If the seller won’t
agree to let you take
it to a mechanic,
move on to the next
prospect.
Warranty Usually a year or two
extension of new-car
comprehensive and
power-train warranty,
backed by the man-
ufacturer, not the
dealer.
You get what’s left
of the new-car war-
ranty. Resist the hard
sell on an extended
warranty. Some states
have laws to protect
used-car buyers.
As with a dealer
sale, you get what’s
left of the new-car
warranty. If you get
stuck with a lemon,
you have little or no
recourse.
Financing Carmakers’ finance
companies offer lower
rates than you’d pay
on non-CPO loans.
You may save hun-
dreds of dollars in
interest.
The F&I department
will arrange financing,
but dealers may get
a commission. Get
prequalified at your
bank or credit union
and compare offers.
You’ll have to pay
cash. If you need a
loan, consider draw-
ing on a home-equity
line, or get a used-
car loan at a bank or
credit union.
Jessica L. Anderson
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Major Consumer Purchases: Buying
Motor Vehicles
As shown in Exhibit 6–2 , the steps for effective purchasing can be used for wise buying of
motor vehicles.
Phase 1: Preshopping Activities
First define your needs and obtain relevant product information. These activities are the
foundation for buying decisions to help you achieve your goals.
PROBLEM IDENTIFICATION Effective decision making should start with an
open mind. Some people always buy the same brand when another brand at a lower price
would also serve their needs, or when another brand at the same price may provide better
quality. A narrow view of the problem is a weakness in problem identification. You may
think the problem is “I need to have a car” when the real problem is “I need transportation.”
INFORMATION GATHERING Information is power. The better informed you are, the
better buying decisions you will make. Some people spend very little time gathering and evalu-
ating buying information. At the other extreme are people who spend much time obtaining con-
sumer information. While information is necessary for wise purchasing, too much information
can create confusion and frustration. The following information sources are frequently helpful:
1. Personal contacts allow you to learn about product performance, brand quality, and
prices from others.
2. Business organizations offer advertising, product labels, and packaging that provide
information about price, quality, and availability.
3. Media information (television, radio, newspapers, magazines, websites) can provide
valuable information with purchasing advice.
4. Independent testing organizations, such as Consumers Union, provide information
about the quality of products and services each month in Consumer Reports.
LO6.2
Implement a process for
making consumer purchases.
ACTION ITEM
I carefully plan major
purchases with research and
comparison shopping.
h Agree
h Disagree
Exhibit 6–2 A Research-Based Approach for Purchasing a Motor Vehicle
1
3
4
Preshopping Activities
• Problem identification
• Information gathering
Evaluating Alternatives
• Selecting vehicle options
• Comparing used vehicles
• Leasing a vehicle
Purchasing a
Motor Vehicle
Determining Purchase Price
• Used-car price negotiations
• Price bargaining for new cars
• Comparing financing
alternatives
Postpurchase Activities
• Automobile operation costs
• Motor vehicle maintenance
2
3
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5. Government agencies, local, state, and federal, provide publications, toll-free
telephone numbers, websites, and community programs.
6. Online reviews can provide buying guidance and shopping suggestions. However,
be cautious since many are the result of fictitious online postings.
Basic information about car buying may be obtained at www.edmunds.com , www
.caranddriver.com , www.autoweb.com , www.autotrader.com , and autos.msn.com . Consumers
Union ( www.consumerreports.org ) offers a computerized car cost data service. Car-buying
services, such as www.acscorp.com and www.autobytel.com , allow you to order your vehicle
online.
Phase 2: Evaluating Alternatives
Every purchasing situation usually has several acceptable alter-
natives. Ask yourself: Is it possible to delay the purchase or to
do without the item? Should I pay for the item with cash or buy
it on credit? Which brands should I consider? How do the price,
quality, and service compare at different stores? Is it possible to
rent the item instead of buying it? Considering such alternatives
will result in more effective purchasing decisions.
Research shows that prices can vary for all types of products.
For a camera, prices may range from under $100 to well over
$500. The price of aspirin may range from less than $1 to over
$3 for 100 five-grain tablets. While differences in quality and
attributes may exist among the cameras, the aspirin tablets are
equivalent in quantity and quality.
Many people view comparison shopping as a waste of time.
Although this may be true in certain situations, comparison
shopping can be beneficial when (1) buying expensive or com-
plex items; (2) buying items that you purchase often; (3) comparison shopping can be
done easily, such as with advertisements, catalogs, or online; (4) different sellers offer
different prices and services; and (5) product quality or prices vary greatly.
SELECTING VEHICLE OPTIONS Optional equipment
for cars may be viewed in three categories: (1) mechanical devices
to improve performance, such as power steering, power brakes, and
cruise control; (2) convenience options, including power seats, air
conditioning, audio systems, power locks, rear window defoggers,
and tinted glass; and (3) aesthetic features that add to the vehicle’s
visual appeal, such as metallic paint, special trim, and upholstery.
COMPARING USED VEHICLES The average used car
costs about $10,000 less than the average new car. Common sources
of used cars include:
• New-car dealers, which offer late-model vehicles and may give you a warranty.
Prices usually are higher than at other sources.
• Used-car dealers, which usually have older vehicles. Warranties, if offered, will be
limited. However, lower prices may be available.
• Individuals selling their own cars. This can be a bargain if the vehicle was well
maintained, but few consumer protection regulations apply to private-party sales.
Caution is suggested.
• Auctions and dealers that sell automobiles previously owned by businesses, auto
rental companies, and government agencies.
• Used-car superstores, such as CarMax, which offer a large inventory of previously
owned vehicles.
digi – know? digi – know?
Near-field communications (NFC) allow Near-field communications (NFC) allow
consumers to make purchases by wav-consumers to make purchases by wav-
ing their smartphones in front of a sen-ing their smartphones in front of a sen-
sor when paying. Technology companies, sor when paying. Technology companies,
financial service providers, and retailers financial service providers, and retailers
are combining to become a part of this are combining to become a part of this
mobile-payments network. NFC also offers mobile-payments network. NFC also offers
coupons and other deals that can result coupons and other deals that can result
in people spending more than they might in people spending more than they might
otherwise. otherwise.
CAUTION! CAUTION!
Every year, more than 450,000 people buy
used vehicles with mileage gauges rolled
back. According to the National Highway Traf-
fic Safety Administration, consumers pay over
$2,300 more than they should for vehicles
with fraudulent mileage totals.
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not going out is like money coming in). The cost difference
between a hybrid and a fuel-version vehicle would be the cur-
rent cash outflow. If the car has an expected life of eight years,
the net present value calculations might be as shown here:
The time value of money (explained in Chapter 1) may be used
to evaluate the financial benefits of a consumer purchase. For
example, when deciding to buy a hybrid car, the money saved
on gas would be considered a cash inflow (since money
Net Present Value of a Consumer Purchase: Is a Hybrid Car Worth Net Present Value of a Consumer Purchase: Is a Hybrid Car Worth
the Cost?the Cost?
Figure It Out!
Certified pre-owned (CPO) vehicles are nearly new cars that come with the original
manufacturer’s guarantee of quality. The rigorous inspection and repair process means a
higher price than other used vehicles. CPO programs were originally created to generate
demand for the many low-mileage vehicles returned at the end of a lease.
The appearance of a used car can be deceptive. A well-maintained engine may be inside
a body with rust; a clean, shiny exterior may conceal major operational problems. There-
fore, conduct a used-car inspection as outlined in Exhibit 6–3 . Have a trained and trusted
mechanic of your choice check the car to estimate the costs of potential repairs. This ser-
vice will help you avoid surprises.
LEASING A MOTOR VEHICLE Leasing is a contractual agreement with monthly
payments for the use of an automobile over a set time period, typically three, four, or five
years. At the end of the lease term, the vehicle is usually returned to the leasing company.
Leasing offers several advantages: (1) Only a small cash outflow may be required for
the security deposit, whereas buying can require a large down payment; (2) monthly lease
payments are usually lower than monthly financing payments; (3) the lease agreement pro-
vides detailed records for business purposes; and (4) you are usually able to obtain a more
expensive vehicle, more often.
Leasing also has major drawbacks: (1) You have no ownership interest in the vehicle; (2) you
must meet requirements similar to qualifying for credit; and (3) additional costs may be incurred
for extra mileage, certain repairs, turning the car in early, or even a move to another state.
This analysis for buying a hybrid car can vary based on
other factors, such as vehicle maintenance costs, miles driven
per year, and gas prices. Hybrid car cost calculators are also
available online. Remember that this decision will also be
influenced by personal attitudes and social factors. This cal-
culation format may be used to assess the financial benefits
of other consumer purchases by comparing the present value
of the cost savings over time with the price of the item.
The result: $1,032 is a positive (favorable) net present value of the savings from a hybrid car
compared to a gasoline-powered car. A negative net present value would indicate that the
financial aspects of the purchase are not desirable.
Step 1: Estimate the
annual savings on gas
(for example, 2,000 miles
at $4 a gallon), with a
vehicle getting 50 miles
per gallon rather than
25 miles per gallon.
Step 2: Calculate the
present value (PV) of a
series using either the
time value of money
tables (Chapter 1
Appendix) or a financial
calculator. Assume a 2
percent interest rate,
eight years.
Step 3: Subtract the
difference in cost of
hybrid car (compared
with a gasoline-powered
car).
Annual gas savings
$2,400
PV of annual savings
$7,032
Vehicle cost difference
$6,000
2
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When leasing, you arrange for the dealer to sell the vehicle through a financing com-
pany. As a result, be sure you know the true cost, including
1. The capitalized cost, which is the price of the vehicle. The average car buyer pays
about 92 percent of the list price for a vehicle; the average leasing arrangement has
a capitalized cost of 96 percent of the list price.
2. The money factor, which is the interest rate being paid on the capitalized cost.
3. The payment schedule, which is the amount paid monthly and the number of payments.
4. The residual value, or the expected value of the vehicle at the end of the lease.
After the final payment, you may return, keep, or sell the vehicle. If the current market
value is greater than the residual value, you may be able to sell it for a profit. However, if
the residual value is more than the market value (which is the typical case), returning the
vehicle to the leasing company is usually the best decision.
Phase 3: Determining Purchase Price
Once you’ve done your research and evaluations, other activities and decisions may be
appropriate. Products such as real estate or automobiles may be purchased using price
Exhibit 6–3
Checking Out a
Used Car
The Engine
• Check for leakage of fluids
and overheating.
• Check oil level and for signs
of leaks.
• Check radiator cap, radiator
for cracks and repairs, and for
oil in coolant.
• Check battery and cables.
• Expect a smooth, clean start.
The Road Test
• Let vehicle warm up.
• Test-drive car on a road with
which you are familiar.
• Listen for smoothness of
acceleration and transmission
(forward and reverse).
• Check brakes at different
speeds.
• Check ease of steering and
vehicle control.
Outside the Car
• Look for major dents and
signs of accidents.
• Inspect the trunk and spare
tire.
• Check tire tread wear.
• Observe smoothness of springs
and shocks when pushing
down on car.
• Check operation of doors and
windows.
• Look for leaking fluids under
vehicle.
Inside the Car
• Look for wear on pedals and
steering column.
• Check for operation of dash
lights and accessories.
• Check instrument panel for
operation of gauges.
• Start engine and check
operation of power accessories
such as radio, wipers, and
heater.
Checking Out a Used Car
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To compare the costs of purchasing and leasing a vehicle, use the following framework. This analysis involves two situ-
ations based on comparable payment amounts.
Buying versus Leasing an Automobile Buying versus Leasing an Automobile
Figure It Out!
negotiation. Negotiation may also be used in other buying situations to obtain a lower price
or additional features. Two vital factors in negotiation are (1) having all the necessary infor-
mation about the product and buying situation and (2) dealing with a person who has the
authority to give you a lower price or additional features, such as the owner or store manager.
USED-CAR PRICE NEGOTIATION Begin to determine a fair price by checking
newspaper ads for the prices of comparable vehicles. Other sources of current used-car
prices are Edmund’s Used Car Prices and the Kelley Blue Book.
A number of factors influence the basic price of a used car. The number of miles the car
has been driven, along with features and options, affect price. A low-mileage car will have
a higher price than a comparable car with high mileage. The condition of the vehicle and
the demand for the model also affect price.
PRICE BARGAINING FOR NEW CARS An important new-car price informa-
tion source is the sticker price label, printed on the vehicle with the suggested retail price.
This label presents the base price of the car with costs of added features. The dealer’s cost,
or invoice price, is an amount less than the sticker price. The difference between the sticker
price and the dealer’s cost is the range available for negotiation. This range is larger for
full-size, luxury cars; subcompacts usually do not have a wide negotiation range. Informa-
tion about dealer’s cost is available from sources such as Edmund’s New Car Prices and
Consumer Reports.
Set-price dealers use no-haggling car selling with the prices presented to be accepted
or rejected as stated. Car-buying services are businesses that help buyers obtain a specific
new car at a reasonable price. Also referred to as an auto broker, these businesses offer
Purchase Costs Example
Your
Figures
Total vehicle cost, including
sales tax ($20,000)
Down payment (or full
amount if paying cash) $ 2,000 $ _____
Monthly loan payment:
$385 3 48-month length of
financing (this item is zero if
vehicle is not financed) 18,480 _____
Opportunity cost of down
payment (or total cost of the
vehicle if it is bought for cash):
$2,000 3 4 years of financing/
ownership 3 3 percent 240 _____
Less: Estimated value of
vehicle at end of loan term/
ownership period 2 6,000 _____
Total cost to buy $14,720 _____
Leasing Costs Example
Your
Figures
Security deposit ($300)
Monthly lease payments:
$385 3 36-month length
of lease $13,860 $ _____
Opportunity cost of
security deposit: $300 security
deposit 3 3 years 3 3 percent 27 _____
End-of-lease charges *
(if applicable) 800 _____
Total cost to lease $14,687 _____
*Such as charges for extra mileage.
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desired models with options for prices ranging between $50 and $200 over the dealer’s
cost. First, the auto broker charges a small fee for price information on desired models.
Then, if you decide to buy a car, the auto broker arranges the purchase with a dealer near
your home.
To prevent confusion in determining the true price of the new
car, do not mention a trade-in vehicle until the cost of the new
car has been settled. Then ask how much the dealer is willing to
pay for your old car. If the offer price is not acceptable, sell the
old car on your own. A typical negotiating conversation might
go like this:
Customer: “I’m willing to give you $15,600 for the car. That’s
my top offer.”
Auto salesperson: “Let me check with my manager.” After
returning, “My manager says $16,200 is the best we can do.”
Customer (who should be willing to walk out at this point):
“I can go to $15,650.”
Auto salesperson: “We have the car you want, ready to go.
How about $15,700?”
If the customer agrees, the dealer receives $100 more than the customer’s “top offer.”
Other sales techniques you should avoid include:
• Lowballing, when quoted a very low price that increases when add-on costs are
included at the last moment.
• Highballing, when offered a very high amount for a trade-in vehicle, with the extra
amount made up by increasing the new-car price.
• The question “How much can you afford per month?” Be sure to also ask how
many months.
• The offer to hold the vehicle for a small deposit only. Never leave a deposit unless
you are ready to buy a vehicle or are willing to lose that amount.
• Unrealistic statements, such as “Your price is only $100 above our cost.” Usually,
hidden costs have been added in to get the dealer’s cost.
• Sales agreements with preprinted amounts. Cross out numbers you believe are not
appropriate for your purchase.
COMPARING FINANCING ALTERNATIVES You may pay cash; however,
most people buy cars on credit. Auto loans are available from banks, credit unions, consumer
finance companies, and other financial institutions. Many lenders will preapprove you for
a certain loan amount, which separates financing from negotiating the car price. Until the
new-car price is set, you should not indicate that you intend to use the dealer’s credit plan.
The lowest interest rate or the lowest payment does not necessarily mean the best credit
plan. Also consider the loan length. Otherwise, after two or three years, the value of your
car may be less than the amount you still owe; this situation is referred to as upside-down
or negative equity. If you default on your loan or sell the car at this time, you will have to
pay the difference.
did you know? did you know?
The sharing economy allows consumers
to save money or earn income through car
and bicycle rentals, home sharing, and shared nanny
services. You may also borrow drills, saws, ladders,
or lawn mowers with a community toolshed. About
5,000 sharing programs operate through websites
and apps. To avoid dangers, use a sharing service
that carefully screens participants.
EXAMPLE: Upside Down
A $26,000 vehicle is purchased with an initial loan of $18,000. After a period of
time, the vehicle may only be worth $12,000 while you still owe $15,000. To avoid
this situation, make a large down payment, have a short loan term (less than five
years), and pay off the loan faster than the decline in value of the vehicle.
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Automobile manufacturers frequently present opportunities for low-interest financing.
They may offer rebates at the same time, giving buyers a choice between a rebate and a
low-interest loan. Carefully compare low-interest financing and the rebate. Special rebates
are sometimes offered to students, teachers, credit union members, real estate agents, and
other groups.
Phase 4: Postpurchase Activities
Maintenance and ownership costs are associated with most major purchases. Correct use
can result in improved performance and fewer repairs. When you need repairs not covered
by a warranty, follow a pattern similar to that used when making the original purchase.
Investigate, evaluate, and negotiate a variety of servicing options.
In the past, when major problems occurred with a new car and the warranty didn’t
solve the difficulty, many consumers lacked a course of action. As a result, all 50 states
and the District of Columbia enacted lemon laws that require a refund for the vehicle after
the owner has made repeated attempts to obtain servicing. These laws apply when four
attempts are made to get the same problem corrected or when the vehicle has been out of
service for more than 30 days within 12 months of purchase or the first 12,000 miles. The
terms of the state laws vary.
AUTOMOBILE OPERATION COSTS Over your lifetime, you can expect to
spend more than $200,000 on automobile-related expenses. Your driving costs will vary
based on two main factors: the size of your automobile and the number of miles you drive.
These costs involve two categories:
1. Fixed Ownership Costs 2. Variable Operating Costs
Depreciation Gasoline and oil
Interest on auto loan Tires
Insurance Maintenance and repairs
License, registration, taxes, and fees Parking and tolls
The largest fixed expense associated with a new automobile is depreciation, the loss in
the vehicle’s value due to time and use. Since money is not paid out for depreciation, many
people do not consider it an expense. However, this decreased value is a cost that owners
incur. Well-maintained vehicles and certain high-quality, expensive models, such as BMW
and Lexus, depreciate at a slower rate.
Costs such as gasoline, oil, and tires increase with the number of miles driven. Planning
expenses is easier if the number of miles you drive is fairly constant. Unexpected trips and
vehicle age will increase such costs.
MOTOR VEHICLE MAINTENANCE People who sell, repair, or drive automo-
biles for a living stress the importance of regular care. While owner’s manuals and articles
suggest mileage or time intervals for certain servicing, more frequent oil changes or tune-
ups can minimize major repairs and maximize vehicle life. Exhibit 6–4 suggests mainte-
nance areas to consider.
AUTOMOBILE SERVICING SOURCES The following businesses offer auto-
mobile maintenance and repair service:
• Car dealers provide a service department with a wide range of car care services.
Service charges at a car dealer may be higher than those of other repair businesses.
• Service stations can provide convenience and reasonable prices for routine maintenance
and repairs. However, the number of full-service stations has declined in recent years.
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• Independent auto repair shops can service your vehicle at fairly competitive prices.
Since the quality of these repair shops varies, talk with previous customers.
• Mass merchandise retailers, such as Sears and Walmart, may emphasize sale of tires
and batteries as well as brakes, oil changes, and tune-ups.
• Specialty shops offer brakes, tires, automatic transmissions, and oil changes at a
reasonable price with fast service.
To avoid unnecessary expenses, be aware of the common repair frauds presented in
Exhibit 6–5 . Remember to deal with reputable auto service businesses. Be sure to get
a written, detailed estimate in advance as well as a detailed, paid receipt for the service
completed. Studies of consumer problems consistently rank auto repairs as one of the top
consumer ripoffs. Many people avoid problems and minimize costs by working on their
own vehicles.
• Get regular oil changes (every 3 months
or 3,000 miles).
• Check fluids (brake, power steering,
transmission).
• Inspect hoses and belts for wear.
• Get a tune-up (new spark plugs, fuel filter, air
filter) every 12,000–15,000 miles.
• Check and clean battery cables and
terminals.
• Check spark plug wires after 50,000 miles.
• Flush radiator and service transmission every
25,000 miles.
• Keep lights, turn signals, and horn in good
working condition.
• Check muffler and exhaust pipes.
• Check tires for wear; rotate tires every
7,500 miles.
• Check condition of brakes.
Exhibit 6–4
Extending Vehicle Life
with Proper Maintenance
The majority of automobile servicing sources are fair and honest. Sometimes, however, consum-
ers waste dollars when they fall prey to the following unethical actions:
• When checking the oil, the attendant puts the dipstick only partway down and then shows you
that you need oil.
• An attendant cuts a fan belt or punctures a hose. Watch carefully when someone checks under
your hood.
• A garage employee puts some liquid on your battery and then tries to convince you that it is
leaking and you need a new battery.
• Removing air from a tire instead of adding air to it can make an unwary driver open to buying
a new tire or paying for an unneeded patch on a tire that is in perfect condition.
• The attendant puts grease near a shock absorber or on the ground and then tells you your present
shocks are dangerous and you need new ones.
• You are charged for two gallons of antifreeze with a radiator flush when only one gallon was
put in.
Dealing with reputable businesses and a basic knowledge of your automobile are the best methods
of avoiding deceptive repair practices.
Exhibit 6–5
Common Automobile
Repair Frauds
Sheet 19 Used-Car Purchase Comparison
Sheet 20 Buying vs. Leasing a Vehicle
S
S
PRACTICE QUIZ 6–2 PRACTICE QUIZ 6–2
1. What are the major sources of consumer information?
2. What actions are appropriate when buying a used car?
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Resolving Consumer Complaints
Most customer complaints result from defective products, low quality, short product lives,
unexpected costs, deceptive pricing, and poor repairs. Federal consumer agencies estimate
annual consumer losses from fraudulent business activities at $10 billion to $40 billion for
telemarketing and mail order, $3 billion for credit card fraud and credit “repair” scams, and
$10 billion for investment swindles.
People do not anticipate problems with purchases but should be prepared for them.
To minimize consumer problems, before making a purchase (1) obtain recommendations
from friends, family members, and online reviews; (2) verify company affiliations, cer-
tifications, and licenses; and (3) understand the sale terms, return policies, and warranty
provisions. Most people do not anticipate or have problems with their purchases. However,
since problems do arise, it’s best to be prepared for them. The process for resolving differ-
ences between buyers and sellers includes the steps presented in Exhibit 6–6 .
Before starting this process, know your rights and the laws
that apply to your situation. Information on consumer rights is
available online and through phone apps, such as the one that
allows airline passengers to monitor the status of their flights.
Information on delays, cancelations, and other situations can be
submitted to keep airlines accountable.
To help ensure success when you make a complaint, keep a
file of receipts, names of people you talked to, dates of attempted
repairs, copies of letters you wrote, and costs incurred. Written
documents can help to resolve a problem in your favor. An auto-
mobile owner kept detailed records and receipts for all gasoline
purchases, oil changes, and repairs. When a warranty dispute
occurred, the owner was able to prove proper maintenance and
received a refund for the defective vehicle. Your perseverance is
vital since companies might ignore your request or delay their
response.
Step 1: Initial Communication
Most consumer complaints are resolved at the original sales location. As you talk with the
salesperson, customer service person, or store manager, avoid yelling, threatening a law-
suit, or demanding unreasonable action. A calm, rational, yet persistent approach is
recommended.
LO6.3
Describe steps to take to
resolve consumer problems.
ACTION ITEM
I am well informed on how to
take action for a consumer
complaint.
h Agree
h Disagree
Key Website for
Company Addresses
www.consumeraction.gov
3. When might leasing a motor vehicle be appropriate?
4. What maintenance activities could increase the life of your vehicle?
5. The following abbreviations appeared in an ad for selling used cars. Interpret these abbreviations.
AC ___________ Pwr Mrrs _________
ABS _________ P/S _________
Apply Yourself! Apply Yourself!
Using an online search, print ads, and store visits, compare the prices charged by different automotive service locations
for a battery, tune-up, oil change, and tires.
did you know? did you know?
The most common sources of consumer
fraud involve (1) prizes, contests, and
sweepstakes; (2) work at home, starting your own
business, phony training courses, employment
scams; (3) fraudulent diets and health claims, easy
weight loss; (4) credit repair, debt collection, mortgage
scams; (5) phony charities; (6) high-return investments
and multilevel marketing; (7) foreign money offers,
such as the Nigerian bank scam; (8) online purchases
and auctions; (9) home and auto repairs; and (10)
travel deals.
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Step 2: Communicate with the Company
Express your dissatisfaction to the corporate level if a problem is not resolved at the local
store. Use a letter or e-mail such as the one in Exhibit 6–7 . You can obtain companies’ contact
information at www.consumeraction.gov or with an online search. The websites of compa-
nies usually provide information for contacting the organization. You can obtain a company’s
consumer hotline number by calling 1-800-555-1212, the toll-free information number. Most
companies print the toll-free hotline number and website information on product packages.
Exhibit 6–6
Resolving Consumer
Complaints
STEP 1. Initial Communication
• Return to place of purchase or contact online retailer.
• Provide a detailed explanation and the action you desire.
• Be pleasant yet persistent in your efforts to obtain a resolution.
STEP 2. Communicate with the Company
• Send an e-mail with the details of the situation (Exhibit 6−7).
• Post your concerns on the company’s online social media sites.
• Comment on a blog or a consumer review website.
STEP 3. Consumer Agency Assistance
• Seek guidance from a local, state, or federal consumer agency.
• Determine if any laws have been violated in the situation.
• Consider the use of mediation or arbitration.
STEP 4. Legal Action
• Consider bringing your case to small claims court.
• Determine if a class-action suit is appropriate.
• Seek assistance from a lawyer or legal aid organization.
Exhibit 6–7 Sample Complaint E-mail
Last week I purchased (or had repaired) a (name of product with serial or
model number or service performed). I made this purchase at (location, date,
and other important details of the transaction).
Unfortunately, your product (or service) has not performed satisfactorily (or
the service was inadequate) because
Therefore, to solve the problem I would appreciate your (here state the
specific action you want). Attached are copies of my records (receipts, guarantees,
warranties, canceled checks, contracts, model and serial numbers, and any other
documents).
I am looking forward to your reply and resolution of my problem, and will
wait three weeks before seeking third-party assistance.
Appropriate Person
Company Name
Dear (Appropriate Name) :
Sincerely,
Your Name
Phone
E-mail
Describe your
purchase.
State problem.
Give history
of problem.
State reasonable
time for action.
Ask for
Include date
and location of
other details.
Name product
and serial or
model number
or service.
specific action.
Attach copies
of documents.
purchase and
NOTE: Keep copies of your letter and all related documents and information.
SOURCE: Consumer’s Resource Handbook ( www.pueblo.gsa.gov ).
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Step 3: Consumer Agency Assistance
If you do not receive satisfaction from the company, organizations are available to assist
with automobiles, appliances, health care, and other consumer concerns. Mediation
involves the use of a third party to settle grievances. In mediation, an impartial person—the
mediator —tries to resolve a conflict between a customer and a business through discus-
sion and negotiation. Mediation is a nonbinding process. It can save time and money com-
pared to other dispute settlement methods.
Arbitration is the settlement of a difference by a third party—the
arbitrator —whose decision is legally binding. After both sides
agree to arbitration, each side presents its case. Arbitrators are
selected from volunteers trained for this purpose. Most major auto-
mobile manufacturers and many industry organizations have arbi-
tration programs to resolve consumer complaints.
A vast network of government agencies is available. Problems
with local restaurants or food stores may be handled by a city or
county health department. Every state has agencies to handle prob-
lems involving deceptive advertising, fraudulent business practices,
banking, insurance companies, and utility rates. Federal agencies
are available to help with consumer concerns (see Appendix C).
Step 4: Legal Action
The next section considers various legal alternatives available to resolve consumer problems.
mediation The attempt
by an impartial third party
to resolve a difference
between two parties through
discussion and negotiation.
arbitration The settlement
of a difference by a third
party whose decision is
legally binding.
CAUTION! CAUTION!
Without realizing it, many consumers sign
contracts with provisions that stipulate arbi-
tration as the method to resolve disputes. As
a result, consumers face various risks, includ-
ing rules vastly different from a jury trial, higher
costs for the arbitrator’s time, and selection of
an arbitrator by the defendant.
PRACTICE QUIZ 6–3 PRACTICE QUIZ 6–3
1. What are common causes of consumer problems and complaints?
2. How can most consumer complaints be resolved?
3. How does arbitration differ from mediation?
Apply Yourself! Apply Yourself!
Conduct online research to determine the most frequent sources of consumer complaints.
Legal Options for Consumers
If the previous actions fail to resolve your complaint, one of the following may be appropriate.
Small Claims Court
In small claims court , a person may file a claim involving amounts below a set dollar limit.
The maximum varies from state to state, ranging from $500 to $10,000; most states have
a limit of between $1,500 and $3,000. The process usually takes place without a lawyer,
although in many states attorneys are allowed in small claims court. To effectively use
small claims court, experts suggest that you:
• Become familiar with court procedures and filing fees (usually from $5 to $50).
• Observe other cases to learn about the process.
LO6.4
Evaluate legal alternatives
available to consumers.
ACTION ITEM
I know the legal actions to
take for consumer problems.
h Agree
h Disagree
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• Present your case in a polite, calm, and concise manner.
• Submit evidence such as photographs, contracts, receipts, and other documents.
• Use witnesses who can testify on your behalf.
Class-Action Suits
Occasionally a number of people have the same complaint. A class-action suit is a legal
action taken by a few individuals on behalf of all the people who have suffered the same
alleged injustice. These people are represented by one or more lawyers. Once a situation
qualifies as a class-action suit, all of the affected parties must be notified. A person may
decide not to participate in the class-action suit and instead file an individual lawsuit.
Recent class-action suits included auto owners who were sold unneeded replacement parts
for their vehicles and a group of investors who sued a brokerage company for unauthorized
buy-and-sell transactions that resulted in high commission charges.
Using a Lawyer
In some situations, you may seek the services of an attorney.
Common sources of lawyers are referrals from friends, advertise-
ments, and the local division of the American Bar Association.
In general, straightforward legal situations such as appear-
ing in small claims court, renting an apartment, or defending
yourself on a minor traffic violation may not need legal counsel.
More complicated matters such as writing a will, settling a real
estate purchase, or suing for injury damages will likely require
the services of an attorney.
When selecting a lawyer, consider several questions: Is the lawyer experienced in your
type of case? Will you be charged on a flat fee basis, at an hourly rate, or on a contingency
basis? Is there a fee for the initial consultation? How and when will you be required to
make payment for services?
Other Legal Alternatives
Legal services can be expensive. A legal aid society is one of a network of publicly sup-
ported community law offices that provide legal assistance to people who cannot afford
their own attorney. These community agencies provide this assistance at a minimal cost or
without charge.
Prepaid legal services provide unlimited or reduced-fee legal assistance for a set fee.
Some programs provide basic services, such as telephone consultation and preparation
of a simple will, for an annual fee. Prepaid legal programs are designed to prevent minor
troubles from becoming complicated legal problems.
Personal Consumer Protection
While many laws, agencies, legal tools, and online sources are available to protect your
rights, none will be of value unless you use them. Consumer protection experts suggest
that to prevent being taken by deceptive business practices, you should
1. Do business only with reputable companies with a record of satisfying customers.
2. Avoid signing contracts and other documents you do not understand.
3. Be cautious about offerings that seem too good to be true—they probably are!
4. Compare the cost of buying on credit with the cost of paying cash; also, compare
the interest rates the seller offers with those offered by a bank or a credit union.
5. Avoid rushing to get a good deal; successful con artists depend on impulse buying.
small claims court A
court that settles legal
differences involving amounts
below a set limit and employs
a process in which the
litigants usually do not use a
lawyer.
class-action suit A
legal action taken by a few
individuals on behalf of all the
people who have suffered the
same alleged injustice.
legal aid society One
of a network of publicly
supported community law
offices that provide legal
assistance to consumers
who cannot afford their own
attorney.
did you know? did you know?
Websites such as LegalZoom, Nolo, and
Rocket Lawyer are available to assist
with basic legal documents, such as creating a
will. Beyond this minimal document preparation,
consumers are encouraged to consult a lawyer.
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contesting the claim. If the defendant does not respond, a
default judgment will most likely be entered.
Step 5. Next, a hearing date will be set. Prepare evidence
with a clear and concise presentation of ( a ) the details of
what happened and when; ( b ) evidence, such as contracts,
leases, receipts, canceled checks, credit card statements,
or photographs; and ( c ) the testimony of people who wit-
nessed aspects of the dispute or who are knowledgeable
about the type of situation. If both parties decide to set-
tle before the hearing, be sure that you receive payment
before the case is dismissed.
Step 6. At the hearing, be as clear and concise as possi-
ble, and bring supporting documentation with you. A sub-
poena may be needed requiring witnesses whom you wish
present at the hearing to appear in court.
Step 7. Once you receive a favorable judgment, you still
have to collect the funds. While the court does not collect
the money for you, the party may pay when the judgment
is rendered. If not, a letter from you or an attorney may
result in payment. Or more formal debt collection actions
might be necessary.
Every state has different procedures and regulations
related to small claims court. Conduct a web search to
obtain information for your specific location. Careful and
detailed preparation of your case is the key to a successful
small claims court case.
In every state, small claims courts are available to handle
legal disputes involving minor amounts. While specific pro-
cedures vary from state to state, these actions are usually
involved:
Step 1. Notify the defendant to request a payment for
damages with a deadline, such as within 30 days. Note in
your letter that you will initiate legal action after that point
in time.
Step 2. Determine the appropriate location for filing the
case. Also, decide if your type of case is allowed in small
claims court in your state, and if the amount is within the
state limit. (Information on state limits is available at www
.nolo.com/legal-encyclopedia/article-30031.html .)
Step 3. Obtain and complete the required filing docu-
ments. These forms can be obtained at the courthouse
or may be available online. The petition will include the
plaintiff’s name (you), the defendant (person or organiza-
tion being sued), the amount being requested, a detailed
and clear description of the claim with dates of various
actions, and copies of any pertinent documents (con-
tracts, receipts).
Step 4. File the documents and pay the required fee.
The petition will be served to the defendant notifying that
person of the suit. After being served, the defendant is
usually required to file a written response, denying or not
How to File a Suit in Small Claims Court
Personal Finance in Practice
PRACTICE QUIZ 6–4 PRACTICE QUIZ 6–4
1. In what types of situations would small claims court and class-action suits be helpful?
2. Describe situations in which you might use the services of a lawyer.
3. For the following situations, identify the legal action that would be most appropriate to take.
a. A low-income person wants to obtain the services of a lawyer to file a product-liability suit.
b. A person is attempting to obtain a $150 catering deposit that was never returned.
c. A consumer wants to settle a dispute out of court with the use of a legally binding third party.
d. A group of telephone customers were overcharged by $1.10 a month over the past 22 months.
Apply Yourself! Apply Yourself!
Interview someone who has had a consumer complaint. What was the basis of the complaint? What actions were
taken? Was the complaint resolved in a satisfactory manner?
Sheet 21 Legal Services Cost Comparison S
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YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Are you able to minimize the amount you spend on unplanned purchases? Are there areas of
spending you might reduce? A low unplanned spending ratio can result in improved financial security.
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) to determine actions you might take
to improve your daily spending habits.
Talk with experienced shoppers, such as friends, rel-
atives, and others, to learn more about their buying
habits or tips that save time and money.
Consult Appendix C for various sources of consumer
information, government agencies, and organizations
to assist you with buying decisions and to avoid
potential consumer problems.
Avoid becoming a victim of various consumer scams;
these deceptions can be very creative. Conduct a
web search to learn about small claims court pro-
cedures and other types of consumer legal actions
available in your state.
Unplanned spending, often called impulse buying, is a
common danger in preventing effective financial plan-
ning. While people may spend to feel good about them-
selves, that action often results in budget problems,
higher debt levels, and greater financial stress.
Measuring the key performance indicator of unplanned
spending as part of your personal finance dashboard
can contribute to your financial progress. Careful spend-
ing will result in lower debt, increased savings, and
achieving your financial goals.
D
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A
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ATE
FINANCIALLY SEC
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U N P L A N N E D S P E N D I N G P E R C E N T
LO6.1 Timing purchases, comparing
stores and brands, using label information,
computing unit prices, and evaluating war-
ranties are common strategies for effective
purchasing.
LO6.2 A research-based approach to
consumer buying involves (1) preshopping
activities, such as problem identification
and information gathering; (2) evaluating
alternatives; (3) determining the purchase
price; and (4) postpurchase activities, such
as proper operation and maintenance.
LO6.3 Most consumer problems can
be resolved by following these steps: (1)
Return to the place of purchase; (2) contact
the company’s main office; (3) obtain assis-
tance from a consumer agency; and (4) take
legal action.
LO6.4 Small claims court, class-action
suits, the services of a lawyer, legal aid soci-
eties, and prepaid legal services are legal
means for handling consumer problems that
cannot be resolved through communication
with the company involved or with help
from a consumer protection agency.
Chapter
Summary
arbitration 205
class-action suit 206
legal aid society 206
Key Terms
small claims court 205
warranty 191
mediation 205
service contract 192
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1. Describe how advertisements, news articles, online sources, and personal observations
might be used to make wiser buying decisions. (LO6.1)
2. When using the research-based approach for purchasing described in this chapter,
which actions do you believe are overlooked by most shoppers? (LO6.2)
3. What are potential concerns associated with obtaining furniture, appliances, and other
items from a rent-to-own business? (LO6.3)
4. What is a “certified pre-owned” vehicle? What are the benefits and drawbacks of this
type of purchase? (LO6.2)
5. While fraud usually involves deceptions against consumers, what are some “frauds”
that consumers commit against businesses? (LO6.3)
Discussion
Questions
1. An item was bought on credit with a $60 down payment and monthly payments of $70
for 36 months. What was the total cost of the item?
2. A food package with 32 ounces costs $1.76. What is the unit cost of the package?
Solutions
1. 36 3 $70 5 $2,520 plus the $60 down payment for a total of $2,580.
2. $1.76 4 32 5 5.5 cents an ounce.
Self-Test
Problems
1. An online buying club offers a membership for $300, for which you will receive a
10 percent discount on all brand-name items you purchase. How much would you have
to buy to cover the cost of the membership? (LO6.1)
2. John Walters is comparing the cost of credit to the cash price of an item. If John makes
an $80 down payment and pays $35 a month for 24 months, how much more will that
amount be than the cash price of $685? (LO6.1)
3. Calculate the unit price of each of the following items: (LO6.1)
a. Motor oil—2.5 quarts for $1.95
b. Cereal—15 ounces for $2.17
c. Canned fruit—13 ounces for 89 cents
d. Facial tissue—300 tissues for $2.25
_____ cents/quart
_____ cents/ounce
_____ cents/ounce
_____ cents/100 tissues
4. A service contract for a video projection system costs $70 a year. You expect to use
the system for five years. Instead of buying the service contract, what would be the
future value of these annual amounts after five years if you earn 3 percent on your
savings? (LO6.1)
5. A work-at-home opportunity is available in which you will receive 3 percent of the
sales for customers you refer to the company. The cost of your “franchise fee” is $600.
How much would your customers have to buy to cover the cost of this fee? (LO6.1)
6. What would be the net present value of a microwave oven that costs $159 and will
save you $68 a year in time and food away from home? Assume an average return
on your savings of 4 percent for five years. (Hint: Calculate the present value of the
annual savings, then subtract the cost of the microwave.) (LO6.1)
7. If a person saves $62 a month by using coupons and doing comparison shopping,
( a ) what is the amount for a year? ( b ) What would be the future value of this annual
amount over 10 years, assuming an interest rate of 4 percent? (LO6.1)
8. Based on financial and opportunity costs, which of the following do you believe would
be the wiser purchase? (LO6.2)
Vehicle 1: A three-year-old car with 45,000 miles, costing $16,700 and requiring
$1,385 of immediate repairs.
Problems
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Vehicle 2: A five-year-old car with 62,000 miles, costing $14,500 and requiring
$1,760 of immediate repairs.
9. Based on the following data, prepare a financial comparison of buying and leasing a
motor vehicle with a $24,000 cash price:
Down payment (to finance vehicle), $4,000
Monthly loan payment, $560
Length of loan, 48 months
Value of vehicle at end of loan, $7,200
Down payment for lease, $1,200
Monthly lease payment, $440
Length of lease, 48 months
End-of-lease charges, $600
What other factors should a person consider when choosing between buying and
leasing? (LO6.2)
10. Based on the data provided here, calculate the items requested: (LO6.2)
Annual depreciation, $2,500
Current year’s loan interest, $650
Insurance, $680
Average gasoline price, $3.50 per gallon
Parking/tolls, $420
Annual mileage, 13,200
Miles per gallon, 24
License and registration fees, $65
Oil changes/repairs, $370
a. The total annual operating cost of the motor vehicle.
b. The operating cost per mile.
11. Based on the following, calculate the costs of buying versus leasing a motor
vehicle. (LO6.2)
Purchase Costs
Down payment, $1,500
Loan payment, $450 for 48 months
Estimated value at end of loan, $4,000
Opportunity cost interest rate, 4 percent
Leasing Costs
Security deposit, $500
Lease payment, $450 for 36 months
End-of-lease charges, $600
12. A class-action suit against a utility company resulted in a settlement of $1.4 million
for 62,000 customers. If the legal fees, which must be paid from the settlement, are
$300,000, what amount will each plaintiff receive? (LO6.4)
Case in
Point ONLINE CAR BUYING
With a click of the mouse, Mackenzie
enters the auto “showroom.” In the past few
months she had realized that the repair costs
for her 11-year-old car were accelerating.
She thought it was time to start shopping
for a new car online and decided to start her
Internet search for a vehicle by looking at
small and midsized SUVs.
Her friends suggested that Mackenzie
research more than one type of vehicle. They
reminded her that comparable models were
available from various auto manufacturers.
In her online car-buying process, Mack-
enzie next did a price comparison. She
obtained more than one price quote by
using various online sources. She then pre-
pared an overview of her online car-buying
experiences.
Mackenzie’s next step was to make her
final decision. After selecting what she
planned to buy, she finalized the purchase
online and decided to take delivery at a
local dealer.
In recent years, less than 5 percent of car
buyers have actually purchased vehicles
over the Internet. That number is increas-
ing; however, car-buying experts strongly
recommend that you make a personal
examination of the vehicle before taking
delivery.
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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Questions
1. Based on Mackenzie’s experience, what
benefits and drawbacks are associated
with online car buying?
2. What additional actions might Mackenzie
consider before buying a motor vehicle?
3. What do you consider to be the
benefits and drawbacks of shopping
online for motor vehicles and other
items?
4. What actions might a car buyer take if a
lemon is purchased?
Online Car-Buying
Action Online Activities Websites Consulted
Information gathering • Review available vehicle models and
options .
• Evaluate operating costs and safety
features .
autos.msn.com
www.consumerreports.org
www.caranddriver.com
www.motortrend.com
Comparing prices • Identify specific make, model, and
features desired .
• Locate availability and specific price in
your geographic area .
www.autobytel.com
www.edmunds.com
www.kbb.com
www.nadaguides.com
Finalizing purchase • Make payment or financing
arrangements .
• Conduct in-person inspection .
• Arrange for delivery .
www.autobytel.com
www.autonation.com
www.autoweb.com
www.carsdirect.com
It sputtered and squeaked and, with a small hesitation followed by an exaggerated shudder,
it was finally over. Ol’ Reliable, the car Jamie Lee had driven since she first earned her
driver’s license at the age of 17, completed its last mile. Thirteen years and 140,000 miles
later, it was time for a new vehicle.
After skimming the Sunday newspaper and browsing the online advertisements, Jamie
Lee was ready to visit car dealers to see what vehicles would interest her. She was unsure
if she would purchase a new car or used, and how she would pay for the car. “No money
down and only $219 a month,” Jamie Lee read, “with approved credit.” It sounded like
an offer she would be interested in. Jamie Lee knew she had a good credit rating, as she
made sure she paid all of her bills on time each month and had kept a close eye on her
credit score ever since she was the victim of identity theft several years ago. The more
she thought about the brand-new car, the more excited she became. That new car fit her
personality perfectly!
As Jamie Lee inquired about the advertised vehicle with the salesperson, her excitement
quickly turned to dismay. The automobile advertised was available for $219 a month with
no money down, based on approved credit, but Jamie Lee unexpectedly found that there
were further qualifications in order to get the advertised price. The salesman explained that
the information in the fine print of the newspaper advertisement stated that the price was
based on all of the following criteria: being active in the military, a college graduate within
the last three months, a current lessee of the automobile company, and having a top-tier
credit score, which, he noted, was above 800. If Jamie Lee did not meet all of the qualifica-
tions, she would not receive the price advertised in the promotion. He could get her in that
CONSUMER PURCHASING STRATEGIES AND WISE BUYING OF
MOTOR VEHICLES
Continuing
Case
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vehicle, but it would cost her an additional $110 per month. Jamie budgeted a maximum of
$275 for her monthly car payment. She could not afford the vehicle.
Jamie Lee had to start over from scratch. She decided that she must fully research the
vehicle purchase process before browsing at another dealership. She felt she was getting
caught up in the moment and vowed to do her research before speaking with another
salesperson.
Questions
1. Jamie Lee is considering a used vehicle, but cannot decide where to begin her search.
Using “Your Personal Financial Plan” sheet 19, name the sources available to Jamie
Lee for a used-car purchase. What are the advantages and disadvantages of each?
2. Jamie Lee is attracted to the low monthly payment advertised for a vehicle lease. She
may well be able to afford a more expensive car than she originally thought. Jamie Lee
really needs to think this through. What are the advantages and disadvantages to leas-
ing a vehicle?
3. Jamie Lee sat down with a salesperson to discuss a new vehicle and its $24,000 pur-
chase price. Jamie Lee has heard that “no one really pays the vehicle sticker price.”
What guidelines may be suggested for negotiating the purchase price of a vehicle?
4. Jamie Lee has decided to purchase a certified pre-owned vehicle. What might she
expect as far as reliability and a warranty on the used car?
“USING THE DAILY SPENDING DIARY HAS HELPED ME CON-
TROL IMPULSE BUYING. WHEN I HAVE TO WRITE DOWN EVERY
AMOUNT, I’M MORE CAREFUL WITH MY SPENDING. I CAN NOW
PUT MORE IN SAVINGS.”
Spending
Diary
Directions Start (or continue) your Daily Spending Diary or use your own format to
record and monitor spending in various categories. Most people who have participated in
this activity have found it beneficial for monitoring and controlling their spending habits.
The Daily Spending Diary sheets are located in Appendix D at the end of the book and in
Connect Finance.
Questions
1. What daily spending items are amounts that might be reduced or eliminated to allow
for higher savings amounts?
2. How might a Daily Spending Diary result in wiser consumer buying and more saving
for the future?
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What’s Next for Your Personal Financial Plan?
• Which consumer information sources are most valuable for your future buying decisions?
• List guidelines to use in the future when making major purchases.
Consumer Purchase Comparison
Purpose: To research and evaluate brands and store services for purchase of a major
consumer item.
Financial Planning Activities: When considering the purchase of a major consumer item,
use ads, catalogs, an Internet search, store visits, and other sources to obtain the information
below. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.consumerreports.org www.consumerworld.org
www.clarkhoward.com
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Product
Exact description (size, model, features, etc.)
Research the item in consumer periodicals and online for information regarding your product
article/periodical ____________________________________ website ____________________________________
date/pages __________________________________________ date ________________________________________
What buying suggestions are presented in the articles?
Which brands are recommended in these articles? Why?
Contact or visit two or three stores that sell the product to obtain the following information:
Store 1 Store 2 Store 3
Company
Address
Phone/website
Brand name/cost
Product difference from item
above
Warranty (describe)
Which brand and at which
store would you buy this
product? Why?
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Used-Car Purchase Comparison
Purpose: To research and evaluate different types and sources of used vehicles.
Financial Planning Activities: When considering a used-car purchase, use advertisements,
online sources, and visits to new- and used-car dealers to obtain the information below. This
sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.carbuyingtips.com www.kbb.com www.safercar.gov
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What’s Next for Your Personal Financial Plan?
• Maintain a record of automobile operating costs.
• Prepare a plan for regular maintenance of your vehicle.
Automobile
(year, make, model)
Name
Address
Phone
Website (if applicable)
Cost
Mileage
Condition of auto
Condition of tires
Radio
Air conditioning
Other options
Warranty (describe)
Items in need of repair
Inspection items:
• Rust, major dents?
• Oil or fluid leaks?
• Condition of brakes?
• Proper operation of
heater, wipers, other
accessories?
Other information
Suggested
App:
• KBB
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Buying vs. Leasing a Vehicle
Purpose: To compare costs of buying or leasing an automobile or other vehicle. This anal-
ysis should compare two situations with comparable payment amounts, even though the
length of the agreements may differ.
Financial Planning Activities: Obtain costs related to leasing and buying a vehicle. This
sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.leasesource.com www.kiplinger.com/tools
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Purchase Costs
Total vehicle cost, including sales tax ($ ____________ )
Down payment (or full amount if paying cash) $ _____________________
Monthly loan payment: $ ____________ times ______ month loan
(this item is zero if vehicle is not financed)
$ _____________________
Opportunity cost of down payment (or total cost of the vehicle if bought
for cash):
$ ____________ times number of years of financing/ownership times ______
percent (interest rate which funds could earn) $ _____________________
Less: estimated value of vehicle at end of loan term/ownership $ _____________________
Total cost to buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
Leasing Costs
Security deposit $ _____________________
Monthly lease payments: $ ____________ times ______ months $ _____________________
Opportunity cost of security deposit: $ ____________ times years
times ______ percent $ _____________________
End-of-lease charges (if applicable) * $ _____________________
Total cost to lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
* With a closed-end lease, charges for extra mileage or excessive wear and tear; with an open-end lease, end-of-
lease payment if appraised value is less than estimated ending value.
What’s Next for Your Personal Financial Plan?
• Prepare a list of future actions to use when buying, financing, and leasing a car.
• Maintain a record of operating costs and maintenance actions for your vehicle.
Suggested
App:
• iLeaseMyCar
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What’s Next for Your Personal Financial Plan?
• Determine the best alternative for your future legal needs.
• Maintain a file of legal documents and other financial records.
Legal Services Cost Comparison
Purpose: To compare cost of services from various sources of legal assistance.
Financial Planning Activities: Contact various sources of legal services (lawyer, prepaid
legal service, legal aid society) to compare costs and available services. This sheet is also
available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.nolo.com www.abanet.org
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Type of legal service
Organization name
Address
Phone
Website
Contact person
Recommended by
Areas of specialization
Maximum initial deposit
Cost of initial consultation
Cost of simple will
Cost of real estate closing
Cost method for other
services—flat fee, hourly
rate, or contingency basis
Other information Suggested
App:
• Ask a
Lawyer
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7 Selecting and Financing Housing
What are the financial benefits of
increased home equity?
You will have the financial security of less debt
and will be able to borrow against the equity if
needed. At the end of the chapter, “Your
Personal Finance Dashboard” will provide
guidelines for measuring the progress of your
home equity amount along with suggested
actions for wise housing decisions.
1
Save for a large down payment by reducing
unnecessary spending for various monthly
budget items.
Website: www.americasaves.org
2
Make monthly payments on time to avoid late
penalties and to maintain your credit rating.
App: BillMinder
3
Pay an additional principal amount each
month, which will also result in saving thou-
sands of dollars on interest.
Website: www.bankrate.com
3 Steps to Financial
Literacy . . . Building
Home Equity
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Evaluating Renting and Buying Alternatives
As you walk around various neighborhoods, you are likely to see a variety of housing
types. When assessing housing alternatives, start by identifying factors that will influence
your choice.
Your Lifestyle and Your Choice of Housing
Although the concept of lifestyle —how you spend your time and money—may seem intan-
gible, it materializes in consumer purchases. Every buying decision is a statement about
your lifestyle. Personal preferences are the foundation of a housing decision, but financial
factors may modify the final choice.
Traditional financial guidelines suggest that “you should spend no more than 25 or 30
percent of your take-home pay on housing” or “your home should cost about 2½ times
your annual income.” Changes in various economic and social conditions have resulted in
revised guidelines. Your budgeting activities and other financial records will provide infor-
mation to determine an appropriate amount for your housing expenses.
Renting versus Buying Housing
The choice between renting and buying your residence should be analyzed based on life-
style and financial factors. Mobility is a primary motivator of renters, whereas buyers usu-
ally want permanence (see Exhibit 7–1 ). As you can see in the “Figure It Out!” box, the
choice between renting and buying may not be clear-cut. In general, renting is less costly
in the short run, but home ownership usually has long-term financial advantages.
LO7.1
Assess costs and benefits of
renting.
ACTION ITEM
Most important about a place
to live is:
h proximity to work or
school .
h cost .
h flexibility for future
moves .
CHAPTER 7 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO7.1 Assess costs and benefits of renting.
LO7.2 Implement the home-buying process.
LO7.3 Determine costs associated with purchasing a home.
LO7.4 Develop a strategy for selling a home.
YOUR PERSONAL FINANCIAL PLAN SHEETS
22. Renting vs. Buying Housing
23. Apartment Rental Comparison
24. Housing Affordability and Mortgage Qualification
25. Mortgage Company Comparison
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Rental Activities
Are you interested in a “2-bd.garden apt, a/c, crptg, mod bath, lndry, sec $850”? Not sure?
Translated, this means a two-bedroom garden apartment (at or below ground level) with
air conditioning, carpeting, a modern bath, and laundry facilities. An $850 security deposit
is required.
At some point in your life, you are likely to rent. As a tenant, you pay for the right to
live in a residence owned by someone else. Exhibit 7–2 presents the activities involved in
finding and living in a rental unit.
Advantages Disadvantages
RENTING
• Easy to move
• Fewer responsibilities for maintenance
• Minimal financial commitment
• No tax benefits
• Limitations regarding remodeling
• Restrictions regarding pets, other activities
BUYING
• Pride of ownership
• Financial benefits
• Lifestyle flexibility
• Financial commitment
• Higher living expenses than renting
• Limited mobility
Exhibit 7–1
Comparing Renting and
Buying Housing
Exhibit 7–2 Housing Rental Activities
Housing
Rental
Activities
• Select an area and rental
amount.
• Compare costs and facilities
of comparable units.
• Talk to current and past residents.
1
The Search
• Verify lease starting date, costs, and facilities.
• Talk to a lawyer about unclear aspects of the lease.
• Note in writing, signed by the owner, the
condition of the rental unit.
• Remember, if two names are on the lease,
one person can be held responsible for
the full rent.
2
Before Signing
a Lease
4
At the End of the Lease
• Keep all facilities in
good condition.
• Contact the owners
regarding needed repairs.
• Respect the rights of others regarding noise.
• Obtain renter’s insurance for personal
belongings and liability situations
(see Chapter 8).
3
Living in
Rental Property
• Clean the apartment; leave it in the same
condition as when you moved in.
• Tell landlord where to send your security deposit.
• Require that any deductions from your
security deposit be documented.
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SELECTING A RENTAL UNIT An apartment is the
most common type of rental housing. Apartments range from
modern, luxury units with extensive recreational facilities to
simple one- and two-bedroom units in quiet neighborhoods. If
you need more room, consider renting a house. If less space is
needed, rent a room in a private house. The main information
sources for rental units are newspaper ads, real estate and rental
offices, and people you know. When comparing rental units,
consider the factors in Exhibit 7–3 .
ADVANTAGES OF RENTING Renting offers mobility
when a location change is necessary or desirable. Renters have
Although the numbers in this example favor buying,
remember that in any financial decision, calculations pro-
vide only part of the answer. You should also consider your
needs and values and assess the opportunity costs asso-
ciated with renting and buying.
Comparing the costs of renting and buying involves con-
sideration of a variety of factors. The following framework
and example provide a basis for assessing these two
housing alternatives. The apartment in the example has a
monthly rent of $1,250, and the home costs $200,000. A
28 percent tax rate is assumed.
Renting versus Buying Your Place of Residence Renting versus Buying Your Place of Residence
Figure It Out!
Example Your Figures
Rental Costs
Annual rent payments $ 15,000 $ ________
Renter’s insurance 210 ________
Interest lost on security deposit (amount of security deposit times
after-tax savings account interest rate) 36 ________
Total annual cost of renting $ 15,246 ________
Buying Costs
Annual mortgage payments $ 15,168 ________
Property taxes (annual costs) 4,800 ________
Homeowner’s insurance (annual premium) 600 ________
Estimated maintenance and repairs (1%) 2,000 ________
After-tax interest lost on down payment and closing costs 750 ________
Less (financial benefits of home ownership):
Growth in equity 2 1,120 2 ________
Tax savings for mortgage interest (annual mortgage interest times tax rate) 2 3,048 2 ________
Tax savings for property taxes (annual property taxes times tax rate) 2 1,344 2 ________
Estimated annual appreciation (1.5%)* 2 3,000 2 ________
Total annual cost of buying $ 14,806 ________
*This is a nationwide average; actual appreciation of property will vary by geographic area and economic conditions.
did you know? did you know?
Lease-to-purchase and rent-with-option
allow renters to become homeowners;
however, problems can occur. Beware of offers
that may seem beneficial but can turn into financial
disasters. For example, an up-front deposit and
other purchase funds could be lost if a late rent
payment is made.
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fewer responsibilities than homeowners since they usually do not have to be concerned
with maintenance and repairs. Taking possession of a rental unit is less expensive than
buying a home.
DISADVANTAGES OF RENTING Renters do not enjoy the financial advantages
of homeowners. Tenants cannot take tax deductions for mortgage interest and property
taxes or benefit from the increased real estate value. Renters are generally limited in the
types of activities they can pursue in their place of residence. Noise from a stereo system
or parties may be monitored closely. Tenants are often subject to restrictions regarding pets
and decorating.
LEGAL DETAILS Most tenants sign a lease , a legal document that defines the condi-
tions of a rental agreement. This document presents:
• A description of the property, including the address.
• The name and address of the owner/landlord (the lessor ).
• The name of the tenant (the lessee ).
• The effective date of the lease, and the length of the lease.
• The amount of the security deposit, and amount and due date of the monthly rent.
• The date and amount due of charges for late rent payments.
• A list of the utilities, appliances, furniture, or other facilities that are included in the
rental amount.
• Restrictions regarding certain activities (pets, remodeling); tenant’s right to sublet.
• Charges for damages or for moving out of the rental unit later (or earlier) than the
lease expiration date.
• The conditions under which the landlord may enter the apartment.
Standard lease forms include conditions you may not want to accept. The fact that a
lease is printed does not mean you must accept it as is. If you have a high credit score,
lease A legal document that
defines the conditions of a
rental agreement.
Exhibit 7–3
Selecting an Apartment Selecting an Apartment
Financial aspects
Layout and facilities
Condition, size
Closets, carpeting, appliances
Type of heat, air conditioning
Plumbing, water pressure
Storage area
Room size
Doors, locks, windows
Rent, length of lease
Security deposit
Utilities, other costs
Location
Schools, church, synagogue
Shopping
Public transportation
Recreation
Building exterior
Condition of building, grounds
Parking facilities and recreation
Building interior
Exits, security
Hallway maintenance
Condition of elevators
Access to mailboxes
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CAUTION! CAUTION!
Renter’s insurance is one of the most
overlooked expenses of apartment dwell-
ers. Damage or theft of personal property
(clothing, furniture, stereo equipment, jew-
elry) is usually not covered by the landlord’s
insurance policy.
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you may be able to negotiate a lower rent or a reduced secu-
rity deposit. Also, discuss with the landlord any lease terms you
consider unacceptable.
Some leases give you the right to sublet the rental unit. Sub-
letting may be necessary if you must vacate the premises before
the lease expires. Subletting allows you to have another person
take over rent payments and live in the rental unit.
While most leases are written, oral leases are also valid. In
those situations, one party must give a 30-day written notice
to the other party before terminating the lease or imposing a
rent increase. A lease provides protection to both landlord and
tenant. The tenant is protected from rent increases unless the
lease contains a provision allowing an increase. The lease gives
the landlord the right to take legal action against a tenant for
nonpayment of rent or destruction of property.
COSTS OF RENTING A security deposit, frequently
required when you sign a lease, is usually one month’s rent. This
money is held by the landlord to cover the cost of any damages.
Some state and local laws may require that landlords pay inter-
est on a security deposit if they own buildings with a certain
number of rental units. After you vacate the rental unit, your
security deposit should be refunded within a reasonable time.
If money is deducted, you have the right to an itemized list of
repair costs.
As a renter, you will incur other expenses. For many apart-
ments, water is covered by the rent; however, other utilities may
not be included. If you rent a house, you will probably pay for heat, electricity, water, tele-
phone, and cable television. When you rent, be sure to obtain insurance coverage on your
personal property.
did you know? did you know?
Millions of people in the United Millions of people in the United
States and around the world lack ade-States and around the world lack ade-
quate housing. Habitat for Humanity quate housing. Habitat for Humanity
( ( www.habitat.orgwww.habitat.org ) has built more than ) has built more than
300,000 houses, providing shelter to over 300,000 houses, providing shelter to over
1.5 million people. The efforts of Habitat 1.5 million people. The efforts of Habitat
continue through local and global volun-continue through local and global volun-
teering as well as donations of money and teering as well as donations of money and
building supplies. building supplies.
PRACTICE QUIZ 7–1 PRACTICE QUIZ 7–1
1. What are the main benefits and drawbacks of renting a place of residence?
2. Which components of a lease are likely to be most negotiable?
3. For the following situations, would you recommend that the person rent or buy housing? (Circle your answer.)
a. A person who desires to reduce income taxes paid. rent buy
b. A person who expects to be transferred for work soon. rent buy
c. A person with few assets for housing expenses. rent buy
Apply Yourself! Apply Yourself!
Interview a tenant and a landlord to obtain their views about potential problems associated with renting. How do their
views on tenant–landlord relations differ?
Sheet 22 Renting vs. Buying Housing
Sheet 23 Apartment Rental Comparison
S
S
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. What risks are associated with buying a home?
2. How can the price-to-rent ratio be of value to you when deciding whether to rent or buy?
3. What factors are most likely to influence your decision regarding whether to rent or buy?
I
f you’re uncertain where
life might take you next—
for a job, a relationship or
just a change of scenery—
renting beats buying. It costs a
lot less in terms of time, effort
and money to break a lease
than to sell or rent out a home
that you own. Plus, the land-
lord is responsible for mainte-
nance and repairs.
Buying can be a great
investment—or a lousy one,
depending on the market
where you live when you buy
and when you sell. If you buy
and home values go down, you
may have to wait to sell to get
back the money you invested
in a down payment and mort-
gage closing costs.
It usually makes sense to
buy only if you plan to stay in
your home for five to seven
years. That’s generally long
enough to recoup the upfront
cost to get a mortgage and the
back-end costs to sell and pay
an agent’s commission. If you
fit that profile, now is a good
time to buy; most cities in
the U.S. have recovered from
the housing market bust that
began in mid 2006, and mort-
gage rates are still superlow.
Once you become a home-
owner and prices rise, you’ll
be rewarded with the power of
leverage—you may put only
20% (or less) down, but you
get 100% of the appreciation.
Regardless of whether your
home’s value goes up, you’ll
benefit from the tax
deductions for mortgage
interest and property
taxes if you itemize
deductions on your fed-
eral tax return. And you
will probably be able to
keep up to $250,000 of
profit tax-free when you
sell ($500,000 if you’re
married and file your
income taxes jointly).
If you’re on the fence
about buying or renting, take
a look at the price-to-rent ratio
where you live (the median
sale price of a home divided
by the average annual rent
for a comparable one). In
general, if the ratio is less than
15, the market rewards home
buyers; if it’s more than 20, it
rewards renters. Right now, the
ratio nationally is a balanced
14.8, according to Marcus
& Millichap, a real estate
research firm. Ratios between
15 and 20 can go either way,
depending on factors such
as taxes and the potential for
appreciation. The ratios in
such millennial meccas as
New York City, San Francisco
and Washington, D.C., typically
favor renters, but a spike in
rents and low mortgage rates
is tipping the ratios in favor of
buyers. (For a look at the larg-
est 100 cities, see “Rent vs. Buy:
Which is Cheaper for You?” at
www.trulia.com/rent_vs_buy/
and use the calculator to assess
your situation.)
INSURE YOUR STUFF
Just because you don’t own a
home doesn’t mean you shouldn’t
insure the things you own. Buy
renters insurance to reimburse
you for the cost to replace your
belongings (a replacement-
cost policy) if they’re stolen or
destroyed, as well as provide
liability coverage. The average cost
of a policy is $16 a month, says the
National Association of Insurance
Commissioners. Compare policies
at NetQuote.com or InsWeb.com.
You’ll usually get a discount if you
buy coverage through the same
company that insures your car.
Even with your down pay-
ment in hand, landing your
dream home could be a chal-
lenge, especially in markets
where the inventory of homes
for sale is low (often the same
markets where rents are inflated)
and the best homes attract mul-
tiple bids. What you can do: Get
preapproved for financing to
make your bid more attractive.
And ask the seller’s agent if you
can get the home inspected
before you make an offer so you
don’t have to include it as a con-
tingency in the contract.
Patricia Mertz Esswein
Buy or Rent?
It’s a good time to buy, but renting is better if you’re not ready to stay put
at least five years.
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Home-Buying Activities
Many people dream of having a place of residence they can call their own. Home owner-
ship is a common financial goal. Exhibit 7–4 presents the process for achieving this goal.
Step 1: Determine Home Ownership Needs
In the first phase of this process, consider the benefits and drawbacks of this major finan-
cial commitment. Also, evaluate the types of housing units and determine the amount you
can afford.
EVALUATE HOME OWNERSHIP Stability of residence and a personalized living
location are important motives of many home buyers. One financial benefit is the deduct-
ibility of mortgage interest and real estate tax payments, reducing federal income taxes.
A disadvantage of home ownership is financial uncertainty. Obtaining money for a
down payment and securing mortgage financing may be problems. Changing property val-
ues in an area can affect your financial investment. Home ownership does not provide ease
of changing living location as does renting. If changes in your situation necessitate selling
your home, doing so may be difficult.
Owning your place of residence can be expensive. The homeowner is responsible for
maintenance and costs of repainting, repairs, and home improvements. Real estate taxes
are a major expense of homeowners. Higher property values and increased tax rates mean
higher real estate taxes.
TYPES OF HOUSING AVAILABLE Home buyers generally choose from the
following options:
1. Single-family dwellings include previously owned houses, new houses, and custom-
built houses.
2. Multiunit dwellings are dwellings with more than one living unit. A duplex is a
building with separate homes. A townhouse may contain two, four, or six living units.
ACTION ITEM
The best housing purchase
for me would be :
h a house .
h a condo or townhouse .
h a mobile home .
LO7.2
Implement the home-buying
process.
Exhibit 7–4 The Home-Buying Process
1
Determine Home Ownership Needs
• Evaluate owning your place of residence.
• Assess types of housing units.
• Calculate the amount you can afford.
4
• Determine
amount of
down payment.
• Investigate the rates
and conditions of mortgages.
• Apply for mortgage and evaluate
types of mortgages.
2
Find and
Evaluate a
Property to
Purchase
• Select a location.
• Consider using a real
estate agent.
• Conduct a home
inspection.
5
Close the Purchase Transaction
• Arrange a closing date.
• Obtain funds and documents for closing.
• Request clarification of unclear aspects of
the transaction.
3
Price the Property
• Determine an appropriate
market price.
• Negotiate an agreement price.
Obtain
Financing
The Home-Buying
Process
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3. Condominiums are individually owned housing units in a building. Ownership does
not include common areas, such as hallways, outside grounds, and recreational
facilities. These areas are owned by the condominium association, which oversees
the management and operation. Condominium owners pay a monthly fee for
maintenance, repairs, improvements, and insurance of the building and common
areas. A condominium is not the building structure; it is a legal form of home
ownership.
4. Cooperative housing is a form of housing in which the units in a building are
owned by a nonprofit organization. The shareholders purchase stock to obtain the
right to live in a unit in the building. While the residents do not own the units, they
have the legal right to occupy a unit for as long as they own stock in the cooperative
association. The title for the property belongs to the co-op. This ownership
arrangement is different from condominiums, in which residents own the individual
living unit.
5. Manufactured homes are assembled in a factory and then moved to the living site.
Prefabricated homes have components built in a factory and then assembled at the
housing site. Mobile home is not a completely accurate term since very few are
moved from their original sites. Although typically smaller than 1,000 square feet,
they can offer features such as a fully equipped kitchen, fireplace, cathedral ceiling,
and whirlpool bath. The site for a mobile home may be either purchased or leased.
6. Building a home is for people who want certain specifications. Before starting such
a project, be sure you possess the necessary knowledge, money, and perseverance.
When choosing a contractor to coordinate the project, consider ( a ) the contractor’s
experience and reputation; ( b ) the contractor’s relationship with the architect,
materials suppliers, electricians, plumbers, carpenters, and other personnel; and ( c )
payment arrangements during construction. Your written contract should include a
time schedule, cost estimates, a description of the work, and a payment schedule.
DETERMINE WHAT YOU CAN AFFORD The
amount you spend on housing is affected by funds available
for a down payment, your income, and your current living
expenses. Other factors you should consider are current mort-
gage rates, the potential future value of the property, and your
ability to make monthly payments. To determine how much you
can afford to spend on a home, have a loan officer at a mortgage
company or other financial institution prequalify you. This ser-
vice is provided without charge.
You may not get all the features you want in your first home,
but financial advisors suggest getting into the housing market by
purchasing what you can afford. As you move up in the housing market, your second or
third home can include more of the features you want.
While the home you buy should be in good condition, you may wish to buy a handy-
man’s special —a home that needs work and that you are able to get at a lower price. You
will then need to put more money into the house for repairs and improvements or do some
of the work yourself.
Step 2: Find and Evaluate a Home
Next, select a location, consider using the services of a real estate agent, and conduct a
home inspection.
SELECT A LOCATION Location is considered the most important factor when
buying a home. You may prefer an urban, a suburban, or a rural setting. Or perhaps you
want to live in a small town or in a resort area. Be aware of zoning laws , restrictions on
condominium An
individually owned housing
unit in a building with several
such units.
cooperative housing A
form of housing in which a
building containing a number
of housing units is owned
by a nonprofit organization
whose members rent the
units.
zoning laws Restrictions
on how the property in an
area can be used.
did you know? did you know?
The CLUE ® (Comprehensive Loss Under-
writing Exchange) report provides a five-year
history of insurance losses at a property that a home
buyer is considering for purchase. This disclosure
report is an independent source of information. You
can find further information at www.choicetrust.com .
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how the property in an area can be used. The location of businesses and future construction
projects may influence your decision.
If you have a family, assess the school system. Educators recommend that schools be
evaluated on program variety, achievement level of students, percentage of students who
go on to college, dedication of faculty members, facilities, school funding, and involve-
ment of parents. Homeowners without children also benefit from strong schools, since the
educational advantages of a community help maintain property values.
SERVICES OF REAL ESTATE AGENTS Real estate agents have information
about housing in areas of interest to you. Their main services include (1) showing you
homes to meet your needs; (2) presenting your offer to the seller based on a market analy-
sis; (3) negotiating a settlement price; (4) assisting you in obtaining financing; and (5) rep-
resenting you at the closing. A real estate agent may also recommend lawyers, insurance
agents, home inspectors, and mortgage companies to serve your needs.
Since the home seller usually pays the commission, a buyer may not incur a direct
cost. However, this expense is reflected in the price paid for the home. In some states, the
agent could be working for the seller. In others, the agent may be working for the buyer,
the seller, or as a dual agent, working for both the buyer and the seller. When dual agency
exists, some states require that buyers sign a disclosure acknowledging that they are aware
the agent is working for both buyer and seller. This agreement, however, can limit the
information provided to each party. Many states have buyer agents who represent the buy-
er’s interests and may be paid by either the seller or the buyer.
THE HOME INSPECTION An evaluation by a trained home inspector can mini-
mize future problems. Being cautious will save you headaches and unplanned expenses.
Exhibit 7–5 presents a detailed format for inspecting a home. Some states, cities, and lend-
ers require inspection documents for pests, radon, or mold. The mortgage company will
usually conduct an appraisal, which is not a home inspection but an assessment of the
market value of the property.
Step 3: Price the Property
After selecting a home, determine an offer price and negotiate a final buying price.
DETERMINE THE HOME PRICE The amount you offer will be affected by
recent selling prices in the area, current demand for housing, the time the home has been
on the market, the owner’s need to sell, financing options, and features and condition of the
home. Each of these factors can affect your offer price. For example, you will have to offer
a higher price in times of low interest rates and high demand for homes. On the other hand,
a home that has been on the market for over a year could mean an opportunity to offer a
lower price. Your offer will be in the form of a purchase agreement, or contract, which is
your legal offer to purchase the home.
NEGOTIATE THE PURCHASE PRICE If your initial offer is accepted, you
have a valid contract. If your offer is rejected, you have several options. A counteroffer
from the owner indicates a willingness to negotiate a price. If the
counteroffer is only slightly lower than the asking price, you are
expected to move closer to that price with your next offer. If the
counteroffer is quite a bit off the asking price, you are closer to
arriving at the purchase price. If no counteroffer is forthcoming,
you may wish to make another offer to see whether the seller is
willing to do any negotiating. Negotiations may involve things
other than price, such as closing date or inclusion of existing
items, such as appliances.
did you know? did you know?
A two-story addition, a remodeled bath-
room, an updated kitchen, addition of a deck,
and a refinished basement are the upgrades most
likely to add value to a home.
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As part of the offer, the buyer must present earnest money , a portion of the purchase
price deposited as evidence of good faith. At the closing of the home purchase, the earnest
money is applied toward the down payment. This money is returned if the sale cannot be
completed due to circumstances beyond the buyer’s control.
Home purchase agreements may contain a contingency clause, stating the agreement is
binding only if a certain event occurs. For example, the contract may be valid only if the
buyer obtains financing for the home purchase within a certain time period, or it may make
the purchase of a home contingent on the sale of the buyer’s current home.
earnest money A portion
of the price of a home
that the buyer deposits as
evidence of good faith to
indicate a serious purchase
offer.
Exhibit 7–5 Conducting a Home Inspection
CONDUCTING
A HOME INSPECTION
Exterior Facilities
• Appearance of neighborhood
• Condition of streets and sidewalks
• Location of street lights, fire hydrants
• Quality of landscaping, trees, shrubs
• Condition of driveway and garage
• Outdoor lighting
• Condition of patio or porch
• Appropriate drainage system
Exterior Construction
• Material quality and condition of building
• Construction and condition of foundation
• Condition of bricks, wood, or other siding
• Condition and quality of windows
• Condition and quality of roof and gutters
• Type and condition of chimney
Interior Design
• Size and arrangement of rooms
• Amount of closet and storage space
• Door sizes for moving furniture
• Counter space and layout of kitchen
• Condition of kitchen appliances
• Ventilation for cooking
• Adequate laundry area
• Location of bedrooms relative to other areas
• Accessibility to attic and basement
• Adequate electrical outlets
Interior Construction
• Condition of electrical fixtures and wiring
• Condition of plumbing fixtures
• Adequate water pressure; water heater condition
• Type and condition of heating unit
• Quality/condition of walls, floors, and doors
• Cracks or potential ceiling problems
• Ease of operation of windows
• Type and condition of floor covering
• Condition, potential use of basement
• Condition of stairways
PRACTICE QUIZ 7–2 PRACTICE QUIZ 7–2
1. What are the advantages and disadvantages of owning a home?
2. What guidelines can be used to determine the amount to spend for a home purchase?
3. How can the quality of a school system benefit even homeowners in a community who do not have school-age children?
Apply Yourself! Apply Yourself!
Talk with a real estate agent about the process involved in selecting and buying a home. Ask about housing prices in
your area and the services the agent provides.
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CAUTION! CAUTION!
A real estate “short sale” occurs when the
new selling price is less than the amount
owed on the previous mortgage. This alterna-
tive to foreclosure can result in a “bargain” for
a home buyer. However, beware that it may
take a long time before the lender accepts
the offer, if the offer is accepted at all. Also,
the home is usually sold “as is,” which means
some items expected to be in the home may
be missing or damaged. When doing a short
sale, be sure to use a lawyer and a negotiator,
and obtain a release from any deficiencies for
previous loan amounts.
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The Finances of Home Buying
While looking for a place to buy, also consider your financing options. Most home buyers
will meet with a banker or mortgage broker early in the process to determine the amount
they can afford for their home. Financing a home purchase requires obtaining a mortgage,
having an awareness of types of mortgages, and settling the real estate transaction.
Step 4: Obtain Financing
THE DOWN PAYMENT The amount of cash available for a down payment
affects the size of the mortgage required. If you can make a large down payment, such as
20 percent or more, you will likely obtain a mortgage relatively easily. Personal savings,
sales of investments or other assets, and assistance from relatives are common down
payment sources. Parents can help their children purchase a home by giving them a cash
gift or a loan.
Private mortgage insurance (PMI) is usually required if the down payment is less than
20 percent. This protects the lender from financial loss due to default. After building up
20 percent equity in a home, a home buyer should contact the lender to cancel PMI. The
Homeowners Protection Act requires that a PMI policy be terminated automatically when
a homeowner’s equity reaches 22 percent of the property value at
the time the mortgage was executed. Homeowners can request ter-
mination earlier if they can provide proof that the equity in the
home has grown to 22 percent of the current market value.
THE MORTGAGE A mortgage is a long-term loan on a spe-
cific piece of property such as a home or other real estate. Pay-
ments on a mortgage are usually made over 10, 15, 20, 25, or
30 years. Applying for a mortgage involves three main phases:
1. You complete the mortgage application and meet with
the lender to present evidence of employment, income,
ownership of assets, and amounts of existing debts.
2. The lender obtains a credit report and verifies your
application and financial status.
3. The mortgage is either approved or denied, with the
decision based on your financial history and an evaluation
of the home you want to buy.
Today, with a credit score of 620 a person can obtain home financing. The higher
the credit score the lower the mortgage rate, given the same loan amount and down
payment.
The recent “subprime” crisis, when many mortgages were issued to borrowers with
poor credit histories, resulted in numerous loan defaults. As a result, lenders are facing new
regulations. To assure your creditworthiness for a home loan, pay down your credit cards,
make payments on time to existing loan accounts, and accumulate funds for a down pay-
ment. This process will indicate the maximum mortgage for which you qualify.
As shown in Exhibit 7–6 , the major factors that affect the affordability of your mortgage
are your income, other debts, the amount available for a down payment, the length of the
loan, and current mortgage rates. The results of this calculation are ( a ) the monthly mort-
gage payment you can afford, ( b ) the mortgage amount you can afford, and ( c ) the home
purchase price you can afford.
These sample calculations are typical of those most financial institutions use; the actual
qualifications for a mortgage may vary by lender and by the type of mortgage. The loan
commitment is the financial institution’s decision to provide the funds needed to purchase
a specific property. The approved mortgage application usually locks in an interest rate for
30 to 90 days.
LO7.3
Determine costs associated
with purchasing a home.
ACTION ITEM
The type of mortgage I would
likely use is :
h fixed-rate mortgage .
h interest-only mortgage .
h FHA or VA mortgage .
mortgage A long-term
loan on a specific piece of
property such as a home or
other real estate.
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The mortgage loan for which you can qualify is larger when interest rates are low than
when they are high. For example, a person who can afford a monthly mortgage payment of
$700 will qualify for a 30-year loan of
$130,354 at 5 percent $95,368 at 8 percent
$116,667 at 6 percent $86,956 at 9 percent
$105,263 at 7 percent $79,726 at 10 percent
As interest rates rise, fewer people are able to afford the cost of an average-priced home.
Example A Example B
Step 1: Determine your monthly gross income (annual income divided by 12). $48,000 4 12 $48,000 4 12
Step 2: With a down payment of at least 5 percent, lenders use 33 percent of monthly
gross income as a guideline for PITI (principal, interest, taxes, and insurance)
and 38 percent of monthly gross income as a guideline for PITI plus other debt
payments.
$ 4,000
3 0.38
$ 1,520
$ 4,000
3 0.33
$ 1,320
Step 3: Subtract other debt payments (e.g., payments on an auto loan) and an estimate of
the monthly costs of property taxes and homeowner’s insurance.
2 380
2 300
—
2 300
(a) Affordable monthly mortgage payment ………………………………………………………………. $ 840 $ 1,020
Step 4: Divide this amount by the monthly mortgage payment per $1,000 based on
current mortgage rates—an 8 percent, 30-year loan, for example (see Exhibit 7–7 )—and
multiply by $1,000.
4 $ 7.34
3 $ 1,000
4 $ 7.34
3 $ 1,000
(b) Affordable mortgage amount ……………………………………………………………………………. $114,441 $138,965
Step 5: Divide your affordable mortgage amount by 1 minus the fractional portion of your
down payment (e.g., 1 2 0.1 with a 10 percent down payment).
4 0.9 4 0.9
(c) Affordable home purchase price ……………………………………………………………………….. $127,157 $154,405
NOTE: The two ratios lending institutions use (step 2) and other loan requirements may vary based on a variety of factors, including the type of mortgage,
the amount of the down payment, your income level, credit score, and current interest rates. For example, with a down payment of 10 percent or more
and a credit score exceeding 720, the ratios might increase to 40/45 percent in this exhibit.
Exhibit 7–6 Housing Affordability and Mortgage Qualification Amounts
EXAMPLE: Calculate Mortgage Payment
To determine the amount of your monthly mortgage payment, multiply the factor
from Exhibit 7–7 by the number of thousands of the loan amount. For a 30-year,
7 percent, $223,000 mortgage:
Monthly payment amount 5 223 3 $6.65
5 $1,482.95
In addition to using the mortgage payment factors from Exhibit 7–7 , the monthly pay-
ment may be calculated using a formula, a financial calculator, Excel spreadsheet, website,
or app.
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Loan payment amounts may also be determined using these methods:
Various websites and apps are also available to determine monthly mortgage payments.
When comparing mortgage companies, remember that the interest rate you are quoted
is not the only factor to consider. The required down payment and the points charged will
affect the interest rate. Points are prepaid interest charged by the lender. Each discount
point is equal to 1 percent of the loan amount and should be viewed as a premium you pay
for obtaining a lower mortgage rate. In deciding whether to take a lower rate with more
points or a higher rate with fewer points, consider the following guidelines:
• If you plan to live in your home a long time (over five years), the lower mortgage
rate is probably the best action.
• If you plan to sell your home in the next few years, the higher mortgage rate with
fewer discount points may be better.
Online research may be used to compare current mortgage rates, and you can apply for a
mortgage online.
FIXED-RATE, FIXED-PAYMENT MORTGAGES As Exhibit 7–8 shows,
fixed-rate, fixed-payment mortgages are a major type of mortgage. The conventional mort-
gage usually has equal payments over 15, 20, or 30 years based on a fixed interest rate.
Mortgage payments are set to allow amortization of the loan; that is, the balance owed is
reduced with each payment. Since the amount borrowed is large, the payments made
during the early years of the mortgage are applied mainly to interest, with only small
reductions in the loan principal. As the amount owed declines, the monthly payments have
points Prepaid interest
charged by the lender.
amortization The
reduction of a loan balance
through payments made over
a period of time.
Formula Financial Calculator Excel ®
M 5 P [ i (1 1 i ) n ]/[(1 1 i ) n 2 1] (payments per year) 12 P/YR 5 PMT (rate/12,30*12,loan amount)
M 5 mortgage payment (monthly) (total loan payments) 360 N 5 denotes a formula
P 5 principal of the loan (loan amount) (interest rate) 6 I/YR rate/12 provides monthly rate
i 5 interest rate divided by 12 (loan amount) 180000 PV total number of payments, such as 12 per year
for 30 years
n 5 number of months of the loan (calculate monthly payment) PMT loan amount 2 beginning mortgage balance
Term Rate 30 Years 25 Years 20 Years 15 Years
3.0% $4.22 $4.74 $5.55 $6.91
3.5 4.49 5.01 5.80 7.15
4.0 4.77 5.28 6.06 7.40
4.5 5.07 5.56 6.33 7.65
5.0 5.37 5.85 6.60 7.91
5.5 5.68 6.14 6.88 8.17
6.0 6.00 6.44 7.16 8.43
6.5 6.32 6.67 7.45 8.71
7.0 6.65 7.06 7.75 8.98
7.5 6.99 7.39 8.06 9.27
8.0 7.34 7.72 8.36 9.56
Exhibit 7–7
Mortgage Payment
Factors (principal and
interest factors per
$1,000 of loan amount)
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an increasing impact on the loan balance. Near the end of the mortgage term, almost all of
each payment is applied to the balance.
For example, a $125,000, 30-year, 6 percent mortgage would have monthly payments
of $749.44. The payments would be divided as follows:
Loan Type Benefits Drawbacks
1. Conventional 30-year
mortgage
• Fixed monthly payments for
30 years provide certainty of
principal and interest payments.
• Higher initial rates than
adjustables.
2. Conventional 15- or
20-year mortgage
• Lower rate than 30-year fixed;
faster equity buildup and
quicker payoff of loan.
• Higher monthly payments.
3. FHA/VA fixed-rate
mortgage (30-year
and 15-year)
• Low down payment require-
ments and may be assumable
with no prepayment penalties.
• May require additional pro-
cessing time.
4. Adjustable-rate mortgage
(ARM)—payment changes
on 1-, 3-, 5-, 7-, or
10-year schedules
• Lower initial rates than fixed-
rate loans, particularly on the
1-year adjustable. Offers possi-
bility of future rate and payment
decreases. Loans with rate
“caps” may protect borrowers
against increases in rates.
• Shifts far greater interest
rate risk onto borrowers than
fixed-rate loans. May push up
monthly payments in future
years.
5. Interest-only mortgage • Lower payments; more easily
affordable.
• No decrease in amount owed;
no building equity unless
home value increases; usually
must convert to a higher fixed-
rate mortgage after 10 years.
Exhibit 7–8
Types of Mortgages
Interest Principal Remaining
Balance
For the first month $625.00 ($75,000 3 0.10 3 1/12) $124.44 $124,875.56 ($125,000 2 $124.44)
For the second month 624.72 ($74,966.82 3 0.10 3 1/12) 124.72 $124,750.84 ($124,875.56 2 $124.72)
For the 360th month 3.73 745.71 -0-
In the past, many conventional mortgages were assumable. This feature allowed a home
buyer to continue with the seller’s original agreement. Assumable mortgages were espe-
cially attractive if the mortgage rate was lower than market interest rates at the time of the
sale. Today, due to volatile interest rates, assumable mortgages are seldom offered.
GOVERNMENT-GUARANTEED FINANCING PROGRAMS These include loans
insured by the Federal Housing Authority (FHA) and loans guaranteed by the Veterans Admin-
istration (VA). These government agencies do not provide the mortgage money; rather, they
help home buyers obtain low-interest, low-down-payment loans.
To qualify for an FHA-insured loan, a person must meet certain conditions related to
the down payment and fees. Most low- and middle-income people can qualify for the FHA
loan program. The VA-guaranteed loan program assists eligible armed services veterans
with home purchases. As with the FHA program, the funds for VA loans come from a
financial institution or a mortgage company, with the risk reduced by government partici-
pation. A VA loan can be obtained without a down payment.
ADJUSTABLE-RATE, VARIABLE-PAYMENT MORTGAGES The adjustable-rate
mortgage (ARM) , also referred to as a flexible-rate mortgage or a variable-rate mortgage, has an
adjustable-rate
mortgage (ARM) A home
loan with an interest rate
that can change during
the mortgage term due to
changes in market interest
rates; also called a flexible-
rate mortgage or a variable-
rate mortgage.
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CAUTION! CAUTION!
Mortgage fraud costs lenders more than
$1 billion a year. These scams occur when
people misrepresent their income or home
value in an effort to obtain a loan. While banks
and lenders are usually the victims, individual
investors may also face losses. Communities
are affected when the deception results in
vacant buildings that are in disrepair. To avoid
participating in mortgage fraud, be sure to
verify that a mortgage company is properly
licensed and report any incorrect information
in the lending process.
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interest rate that increases or decreases during the life of the loan.
ARMs usually have a lower initial interest rate than fixed-rate mort-
gages; however, the borrower, not the lender, bears the risk of future
interest rate increases.
A rate cap restricts the amount by which the interest rate can
increase or decrease during the ARM term. This limit prevents
the borrower from having to pay an interest rate significantly
higher than the one in the original agreement. A payment cap
keeps the payments on an adjustable-rate mortgage at a given
level or limits the amount to which those payments can rise.
When mortgage payments do not rise but interest rates do, the
amount owed can increase in months in which the mortgage
payment does not cover the interest owed. This increased loan
balance, called negative amortization, means the amount of the home equity is decreasing
instead of increasing.
Consider several factors when evaluating adjustable-rate mortgages: (1) Determine the
frequency of and restrictions on allowed changes in interest rates; (2) consider the fre-
quency of and restrictions on changes in the monthly payment; (3)
investigate the possibility that the loan will be extended due to neg-
ative amortization, and find out if a limit exists on the amount of
negative amortization; and (4) find out what index is used to set the
mortgage interest rate.
INTEREST-ONLY MORTGAGE An interest-only mortgage
allows a home buyer to have lower payments for the first few years
of the loan. During that time, none of the mortgage payment goes
toward the loan amount. Once the initial period ends, the mortgage
adjusts to be interest-only at the new payment rate. Or a borrower
may obtain a different type of mortgage to start building equity.
Remember, with an interest-only mortgage, higher payments will
occur later in the loan. These are based on the amount of the orig-
inal loan since no principal has been paid. Interest-only mortgages
can be especially dangerous if the value of the property declines.
OTHER FINANCING METHODS A buy-down is an
interest rate subsidy from a home builder, a real estate developer, or the borrower that
reduces the mortgage payments during the first few years of the loan. This assistance is
intended to stimulate sales among home buyers who cannot afford conventional financ-
ing. After the buy-down period, the mortgage payments increase to the level that would
have existed without the financial assistance.
A second mortgage, more commonly called a home equity
loan, allows a homeowner to borrow on the paid-up value of
the property. Lending institutions offer a variety of home equity
loans, including a line of credit program that allows the bor-
rower to obtain additional funds. You need to be careful when
using a home equity line of credit. This revolving credit plan can
keep you continually in debt as you request new cash advances.
A home equity loan allows you to deduct the interest on con-
sumer purchases on your federal income tax return. However, it
creates the risk of losing the home if required payments on both
the first and second mortgages are not made.
Reverse mortgages (also called home equity conversion
mortgages ) provide homeowners who are 62 or older with tax-
free income in the form of a loan that is paid back (with interest)
when the home is sold or the homeowner dies.
did you know? did you know?
By taking out a 15-year instead of a 30-year
mortgage, a home buyer borrowing $200,000
can save more than $150,000 in interest over the
life of the loan. The faster equity growth and savings
on interest with the shorter mortgage will also occur
if a home buyer pays an additional amount toward
principal each month.
did you know? did you know?
Obtaining funds for a home purchase from
parents can increase the value of the home
you can afford. With shared-equity financing, parents
or other relatives who provide part of the down
payment share in the appreciation of the property.
A contract among the parties should detail ( a ) who
makes the mortgage payments and gets the tax
deduction, ( b ) how much each person will pay of the
real estate taxes, and ( c ) how and when the equity will
be shared.
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During the term of your mortgage, you may want to refinance your home, that is, obtain
a new mortgage on your current home at a lower interest rate. Before taking this action con-
sider the refinancing costs in relation to the savings gained with a lower monthly payment.
Another financing decision involves making extra payments on your mortgage. Since
this amount will be applied to the loan principal, you will save interest and pay off the
mortgage in a shorter time. Paying an additional $25 a month on a $75,000, 30-year,
10 percent mortgage will save you more than $34,000 in interest and enable you to pay
off the loan in less than 25 years. Beware of organizations that promise to help you make
additional payments on your mortgage. You can do this on your own, without the fee they
are likely to charge you.
Step 5: Close the Purchase Transaction
Before finalizing the transaction, a walk-through allows you to inspect the condition of the
home. Use a camera or video recorder to collect evidence for any last-minute items you
may need to negotiate.
The closing is a meeting of the buyer, seller, and lender of funds, or representatives of
each party, to complete the transaction. Documents are signed, last-minute details are set-
tled, and appropriate amounts are paid. A number of expenses are incurred at the closing.
The closing costs , also referred to as settlement costs, are the fees and charges paid when
a real estate transaction is completed; these commonly include the items listed in
Exhibit 7–9 .
Title insurance has two phases. First, the title company defines the boundaries of the
property being purchased and conducts a search to determine whether the property is free
of claims such as unpaid real estate taxes. Second, during the mortgage term, the title com-
pany protects the owner and the lender against financial loss resulting from future defects
in the title and from other unforeseen property claims not excluded by the policy.
Also due at closing time is the deed recording fee. The deed is the document that trans-
fers ownership of property from one party to another. With a warranty deed, the seller
closing costs Fees
and charges paid when
a real estate transaction
is completed; also called
settlement costs.
title insurance Insurance
that, during the mortgage
term, protects the owner or
the lender against financial
loss resulting from future
defects in the title and from
other unforeseen property
claims not excluded by the
policy.
deed A document that
transfers ownership of
property from one party to
another.
Exhibit 7–9
Common Closing Costs
At the transaction settlement
of a real estate purchase and
sale, the buyer and seller
will encounter a variety of
expenses that are commonly
referred to as closing costs.
COST RANGE ENCOUNTERED
By the Buyer By the Seller
Title search fee $150–$375 —
Title insurance (lender/owner policies) $700–$1,500 $2,000 1
Attorney’s fee $400–$700 $50–$700
Property survey — $100–$400
Appraisal fee (or nonrefundable application fee) $400–$600 —
Recording fees; transfer taxes $95–$130 $70–$100
Settlement fee $750–$1,000 —
Termite inspection $70–$150 —
Lender’s origination fee 1–3% of loan amount —
Reserves for home insurance and property taxes Varies —
Interest paid in advance (from the closing date
to the end of the month) and “points”
Varies —
Real estate broker’s commission — 4–7% of purchase price
NOTE: The amounts paid by the buyer are in addition to the down payment.
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Websites to consult:
__________________________________________________________________________________________________________
__________________________________________________________________________________________________________
For each of the following main aspects of home buying,
list questions, additional information, or actions you might
need to take. Locate websites that provide information for
these areas.
What Additional Home-Buying Information Do You Need?
Personal Finance in Practice
guarantees the title is good. This document certifies that the seller is the true owner of
the property, there are no claims against the title, and the seller has the right to sell the
property.
The Real Estate Settlement Procedures Act (RESPA) helps home buyers understand the
closing process and closing costs. This legislation requires that loan applicants be given
an estimate of the closing costs before the actual closing. Obtaining this information early
allows a home buyer to plan for the closing costs.
• Location. Consider the community and geographic
region. A $250,000 home in one area may be an
average-priced house, while in another part of the
country it may be fairly expensive real estate. The
demand for homes is largely affected by the economy
and the availability of jobs.
• Down payment. While making a large down payment
reduces your mortgage payments, you will also
need the funds for closing costs, moving expenses,
repairs, or furniture.
• Mortgage application. When applying for a home
loan, you will usually be required to provide copies of
paystubs, W-2, and recent tax returns, a residence
and employment history, information about bank and
investment accounts, a listing of debts, and evidence
of auto and any real estate ownership.
• Points. You may need to select between a higher rate
with no discount points and a lower rate requiring
points paid at closing. (Some states limit the amount
of closing costs.)
• Closing costs. Settlement costs can range from 2
to 6 percent of the loan amount; this amount is in
addition to your down payment.
• PITI. Your monthly payment for principal, interest,
taxes, and insurance is an important budget item.
Beware of buying “too much house” and not having
enough for other living expenses.
• Maintenance costs. As any homeowner will tell you,
owning a home can be expensive. Set aside funds for
repair and remodeling expenses.
____________________________________________________
____________________________________________________
____________________________________________________
____________________________________________________
____________________________________________________
____________________________________________________
____________________________________________________
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At the closing and when you make your monthly payments, you will probably deposit
money to be used for home expenses. For example, the lender will require that you have
property insurance. An escrow account is money, usually deposited with the lending insti-
tution, for the payment of property taxes and home insurance.
As a new home buyer, you might also consider purchasing an agreement that gives you
protection against defects in the home. Implied warranties created by state laws may cover
some problem areas; other repair costs can occur. Home builders and real estate sales com-
panies offer warranties to buyers. Coverage offered usually provides protection against
electrical, plumbing, heating, appliances, and other mechanical defects. Most home war-
ranty programs have various limitations.
Home Buying: A Summary
For most people, buying a home is the most expensive decision they will undertake. As a
reminder, the nearby “Personal Finance in Practice” box provides an overview of the major
elements to consider when making this critical financial decision.
escrow account Money,
usually deposited with the
lending financial institution,
for the payment of property
taxes and homeowner’s
insurance.
PRACTICE QUIZ 7–3 PRACTICE QUIZ 7–3
1. What are the main sources of money for a down payment?
2. What factors affect a person’s ability to qualify for a mortgage?
3. How do changing interest rates affect the amount of mortgage a person can afford?
4. Under what conditions might an adjustable-rate mortgage be appropriate?
5. For the following situations, select the type of home financing action that would be most appropriate:
a. A mortgage for a person who desires to finance a home purchase at current interest rates for the entire term of the
loan. ___________________________
b. A home buyer who wants to reduce the amount of monthly payments since interest rates have declined over the
past year. _______________________
c. A homeowner who wants to access funds that could be used to remodel the home. ________________________
d. A person who served in the military, who does not have money for a down payment. _________________________
e. A retired person who wants to obtain income from the value of her home. ________________________
Apply Yourself! Apply Yourself!
Conduct online research on various types of mortgages and current rates. Prepare a summary of your findings along
with recommended actions for selecting a mortgage.
Sheet 24 Housing Affordability and
Mortgage Qualification
Sheet 25 Mortgage Company Comparison
S
M
S
A Home-Selling Strategy
Most people who buy a home will eventually be on the other side of a real estate trans-
action. Selling your home requires preparing it for selling, setting a price, and deciding
whether to sell it yourself or use a real estate agent.
Preparing Your Home for Selling
The effective presentation of your home can result in a fast and financially favorable sale.
Real estate salespeople recommend that you make needed repairs and paint worn exterior
LO7.4
Develop a strategy for selling
a home.
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annual taxes of $5,400 ($90,000 divided by $1,000 times
$60). This rate is 6 percent of the assessed value but only
3 percent of the market value.
Although higher home values are desirable, this increase
means higher property assessments. Quickly increasing
property taxes are frustrating, but there are actions you
can take:
Property taxes vary from area to area and usually range
from 2 to 4 percent of the market value of the home. Taxes
are based on the assessed value, the amount that your
local government determines your property to be worth for
tax purposes. Assessed values normally are lower than the
market value, often about half. A home with a market value
of $180,000 may be assessed at $90,000. If the tax rate
is $60 per $1,000 of assessed value, this would result in
Lowering Your Property Taxes
Personal Finance in Practice
Beware of companies that charge fees to dispute your
property assessment. Be especially wary of letters that
look like they come from government agencies, but are
Suggested Action Your Action
Step 1: Know the appeal deadline. Call the local assessor’s office. You will usually have between 14
and 90 days to initiate your appeal. Late requests are usually not accepted. Send your appeal by
certified mail to have proof that you met the deadline; keep copies of all documents.
Step 2: Check for mistakes. The assessment office may have incorrect information. Obvious mis-
takes may include incorrect square footage, or an assessment may report a home with four bed-
rooms when there are only three.
Step 3: Determine the issues to emphasize. A property tax appeal can be based on a mistake in the
assessment or a higher assessment than comparable homes. Note items that negatively affect the
value of your home. For example, a bridge is no longer in operation near your home, making your
house much less accessible—and less valuable. Or if a garage has been taken down to increase
garden space, the home’s value likely would be lower. Compare your assessment with homes of the
same size, age, and general location. Obtain comparisons for 5 to 10 homes.
Step 4: Prepare for the hearing. Gather your evidence and prepare an organized presentation. Use
photos of comparable properties. A spreadsheet can make it easy for the hearing officials to view
your evidence. Suggest a specific corrected assessment, and give your reasons. Observe the hear-
ing of another person to become familiar with the process.
really from private companies. Avoid offers that require an
up-front fee to challenge your assessment or that request
a certified copy of your property deed.
and interior areas. Clear the garage and exterior areas, and keep the lawn cut and the leaves
raked. Keep the kitchen and bathroom clean. Remove excess furniture and dispose of
unneeded items to make the house, closets, and storage areas look larger. When showing
your home, open drapes and turn on lights. Consider environmentally friendly features
such as energy-saving light bulbs and water-saving faucets. This effort will give your prop-
erty a positive image and make it attractive to potential buyers.
Determining the Selling Price
Putting a price on your home can be difficult. You risk not selling it immediately if the price
is too high, and you may not get a fair amount if the price is too low. An appraisal , an estimate
of the current value of the property, can provide a good indication of the price you should set.
An appraisal is likely to cost between $200 and $300. This expense can help people
selling a home on their own to get a realistic view of the property’s value. An asking price
is influenced by recent selling prices of comparable homes in your area, demand in the
housing market, and current mortgage rates.
ACTION ITEM
When selling a home, I would:
h use a real estate agent .
h use an online service .
h sell by owner .
appraisal An estimate
of the current value of a
property.
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The home improvements you have made may or may not
increase the selling price. A hot tub or an exercise room may
have no value for potential buyers. Among the most desir-
able improvements are energy-efficient features, a remodeled
kitchen, an additional or remodeled bathroom, added rooms and
storage space, a converted basement, a fireplace, and an outdoor
deck or patio. Daily maintenance, timely repairs, and home
improvements will increase the future sales price.
Sale by Owner
Each year, about 10 percent of home sales are made by the
home’s owners. If you sell your home without using a real estate
agent, advertise in local newspapers and create a detailed infor-
mation sheet. Distribute the sheet at stores and in other public areas. When selling your
home on your own, obtain information about the availability of financing and financing
requirements. This will help potential buyers determine whether a sale is possible. Use the
services of a lawyer or title company to assist you with the contract, the closing, and other
legal matters.
Require potential buyers to provide names, addresses, telephone numbers, and back-
ground information. Show your home only by appointment and only when two or more
adults are at home. Selling your own home can save several thousand dollars in commis-
sion, but an investment of your time and effort is required.
Listing with a Real Estate Agent
If you sell your home with the assistance of a real estate agent, consider the person’s
knowledge of the community and the agent’s willingness to actively market your home.
A real estate agent will provide you with various services, such as suggesting a selling
price, making potential buyers and other agents aware of your home, providing advice
on features to highlight, conducting showings of your home, and handling the financial
aspects of the sale. Marketing efforts are likely to include presentation of your home on
various websites.
A real estate agent can also help screen potential buyers to determine whether they will
qualify for a mortgage. Discount real estate brokers are available to assist sellers who are
willing to take on certain duties and want to reduce selling costs.
PRACTICE QUIZ 7–4 PRACTICE QUIZ 7–4
1. What actions are recommended when planning to sell your home?
2. What factors affect the selling price of a home?
3. What should you consider when deciding whether to sell your home on your own or use the services of a real
estate agent?
Apply Yourself! Apply Yourself!
Visit a couple of homes for sale. What features do you believe would appeal to potential buyers? What efforts were
made to attract potential buyers to the open houses?
digi – know? digi – know?
Housing apps are available to make the Housing apps are available to make the
home-buying process easier. These include home-buying process easier. These include
programs to identify nearby homes available programs to identify nearby homes available
for sale, along with price information and for sale, along with price information and
other data. Other apps provide estimates of other data. Other apps provide estimates of
home values, community crime data, open-home values, community crime data, open-
house information, and mortgage calculators. house information, and mortgage calculators.
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YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Are you able to make additional mortgage payments toward the loan principal to build the
equity in your home?
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) to determine actions you might take
to make wiser housing decisions.
Use various information sources when planning a
housing decision, including discussions with people
you know and these helpful websites: homebuying
.about.com , realestate.msn.com , www.hud.gov/
buying , and www.homefair.com .
Before signing a lease, be sure you understand the
elements of this legal document. For additional infor-
mation on leases, go to apartments.about.com or
search online for lease information.
Consider what size mortgage you can afford when
starting the home-buying process at www.mort-
gage101.com or www.erate.com . Current mortgage
rate information is available at www.bankrate.com ,
www.hsh.com , and www.interest.com, as well as
from local financial institutions.
When planning to sell a home on your own, you can
find assistance at www.owners.com . Also of value is
talking with people who have sold their own homes.
For home buyers, home equity, the amount of your
ownership in the property, can be an indicator of finan-
cial progress. Equity is calculated by subtracting the
mortgage amount owed from the current market value
of the home. For example, a home worth $200,000 with
$80,000 still owed on the mortgage would have equity
of $120,000, which is 60 percent of the home’s value.
In recent years, as the market value of many homes
declined, home equity also declined for many home-
owners. Building equity through shorter mortgages and
additional principal payments can be a key financial
strategy.
D
A
N
G
E
R
O
U
S
A
DE
QU
ATE
FINANCIALLY SEC
U
R
E
MORTGAGE EQUITY PERCENTAGE
0 100
20 80
10 90
30 70
5040 60
LO7.1 Assess renting and buying alterna-
tives in terms of their financial and opportu-
nity costs. The main advantages of renting
are mobility, fewer responsibilities, and lower
initial costs. The main disadvantages of rent-
ing are few financial benefits, a restricted life-
style, and legal concerns.
LO7.2 Home buying involves five major
stages: (1) determining home ownership
needs, (2) finding and evaluating a property
to purchase, (3) pricing the property, (4)
financing the purchase, and (5) closing the
real estate transaction.
LO7.3 The costs associated with pur-
chasing a home include the down pay-
ment; mortgage origination costs; closing
costs such as a deed fee, prepaid interest,
attorney’s fees, payment for title insur-
ance, and a property survey; and an escrow
account for homeowner’s insurance and
property taxes.
LO7.4 When selling a home, you must
decide whether to make certain repairs and
improvements, determine a selling price, and
choose between selling the home yourself
and using the services of a real estate agent.
Chapter
Summary
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adjustable-rate mortgage
(ARM) 232
amortization 231
appraisal 237
closing costs 234
Key Terms
lease 222
mortgage 229
points 231
title insurance 234
zoning laws 226
condominium 226
cooperative housing 226
deed 234
earnest money 228
escrow account 236
1. What do you believe are the most important factors a person should consider when
selecting housing? (LO7.1)
2. What are some common mistakes a person might make when renting an apartment or
other housing? (LO7.1)
3. What actions would you recommend to a person who was considering buying a home
that needed several improvements? (LO7.2)
4. Describe how knowledge of current interest rates would help you better plan when
obtaining a mortgage. (LO7.3)
5. Prepare a list of actions to take when selling a home. (LO7.4)
Discussion
Questions
1. What would be the monthly payment for a $180,000, 20-year mortgage at 6 percent?
2. What is the total amount of a 30-year mortgage with monthly payments of $850?
Solutions
1. Using Exhibit 7–7 , multiply 180 times $7.16 to determine the monthly payment of
$1,288.80
2. 360 payments (30 years 3 12 months) are multiplied by $850 for a total of $306,000.
Self-Test
Problems
1. Based on the following data, would you recommend buying or renting? (LO7.1)
Rental Costs
Annual rent, $7,380
Insurance, $145
Security deposit, $650
Buying Costs
Annual mortgage payments, $9,800 ($9,575
is interest)
Property taxes, $1,780
Down payment/closing costs, $4,500
Growth in equity, $225
Insurance/maintenance, $1,050
Estimated annual appreciation, $1,700
Assume an after-tax savings interest rate of 6 percent and a tax rate of 28 percent.
2. When renting, various move-in costs will be encountered. Estimate the following
amounts: (LO7.1)
First month’s rent
Security deposit
Security deposit for utilities (if applicable)
Moving truck, other moving expenses
Household items (dishes, towels, bedding)
Furniture and appliances (as required)
Renter’s insurance
Refreshments for friends who helped you move
Other items: _________________________
$ _______________
$ _______________
$ _______________
$ _______________
$ _______________
$ _______________
$ _______________
$ _______________
$ _______________
Problems
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HOUSING DECISIONS
Case in
Point
When Mark and Valerie Bowman first saw
the house, they didn’t like it. However,
it was a dark, rainy day. They viewed the
house more favorably on their second visit,
which they had expected to be a waste of
time. Despite cracked ceilings, the need for
new paint, and a kitchen built in the 1980s,
the Bowmans saw a potential to create a
place they could call their own.
3. Many locations require that renters be paid interest on their security deposits. If you have
a security deposit of $1,800, how much would you expect a year at 2 percent? (LO7.1)
4. Condominiums usually require a monthly fee for various services. At $235 a month,
how much would a homeowner pay over a 10-year period for living in this housing
facility? (LO7.2)
5. Ben and Carla Covington plan to buy a condominium. They will obtain a $220,000, 30-year
mortgage at 5 percent. Their annual property taxes are expected to be $1,800. Property
insurance is $480 a year, and the condo association fee is $220 a month. Based on these
items, determine the total monthly housing payment for the Covingtons. (LO7.2)
6. Estimate the affordable monthly mortgage payment, the affordable mortgage
amount, and the affordable home purchase price for the following situation (see
Exhibit 7–6 ). (LO7.3)
Monthly gross income, $2,950
Other debt (monthly payment), $160
30-year loan at 6 percent
Down payment to be made—15 percent of
purchase price
Monthly estimate for property taxes and
insurance, $210
7. Based on Exhibit 7–7 , what would be the monthly mortgage payments for each of
the following situations? (LO7.3)
a. A $160,000,15-year loan at 6.5 percent.
b. A $215,000, 30-year loan at 5 percent.
c. A $190,000, 20-year loan at 6 percent.
8. Which mortgage would result in higher total payments? (LO7.3)
Mortgage A: $985 a month for 30 years.
Mortgage B: $780 a month for 5 years and $1,056 a month for 25 years.
9. If an adjustable-rate 30-year mortgage for $120,000 starts at 4.0 percent and
increases to 5.5 percent, what is the amount of increase of the monthly payment?
(Use Exhibit 7–7 .) (LO7.3)
10. Kelly and Tim Jarowski plan to refinance their mortgage to obtain a lower inter-
est rate. They will reduce their mortgage payments by $56 a month. Their closing
costs for refinancing will be $1,670. How long will it take them to cover the cost of
refinancing? (LO7.3)
11. In an attempt to have funds for a down payment in five years, James Dupont plans
to save $3,800 a year for the next five years. With an interest rate of 4 percent, what
amount will James have available for a down payment after the five years? (LO7.3)
12. Based on Exhibit 7–9 , if you were buying a home, what would be the approximate
total closing costs (excluding the down payment)? As an alternative, obtain actual
figures for the closing items by contacting various real estate organizations or by
doing online research. (LO7.3)
13. You estimate that you can save $3,450 by selling your home yourself rather than
using a real estate agent. What would be the future value of that amount if invested
for five years at 3 percent? (LO7.4)
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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Beth Young purchased her condominium
several years ago. She obtained a mortgage
rate of 6.5 percent, a very good rate then.
Recently, when interest rates dropped, Beth
was considering refinancing her mortgage
at a lower rate.
Matt and Peggy Zoran had been married for
five years and were still living in an apart-
ment. Several of their friends had purchased
homes recently. However, Matt and Peggy
were not sure they wanted to follow this
example. Although they liked their friends’
homes and had viewed online videos of
homes on the market, they also liked the
freedom from maintenance responsibility
they enjoyed as renters.
Questions
1. How could the Bowmans benefit
from buying a home that needed
improvements?
2. How might Beth Young have found out
when mortgage rates were at a level
that would make refinancing her condo-
minium more affordable?
3. Although the Zorans had good reasons
for continuing to rent, what factors
might make it desirable for an individ-
ual or a family to buy a home?
4. What actions might each of these home
buyers take to use websites or apps to
enhance their home-buying and financ-
ing activities? Based on a web search,
what advice would you offer when
using the online sources for various
phases of the home-buying process?
Continuing
Case SELECTING AND FINANCING HOUSING
Five years have passed and Jamie Lee, 34, is considering taking the plunge: Not only is she
engaged to be married, but she is also deciding on whether to purchase a new home.
Jamie Lee’s cupcake café is a success! It has been open over a year now and has earned
itself rave reviews in the local press and from its regular customers, who just cannot get
enough of her delicious cupcakes. One such customer, who stopped by on a whim in the
café’s first week of business, is Ross. After a whirlwind courtship, Ross, a self-employed
web page designer, proposed and Jamie Lee agreed to be his wife.
The bungalow that Jamie Lee has been renting for the past five years is too small for the
soon-to-be newlyweds, so Jamie Lee and Ross are trying to decide if they should move to
another rental or purchase a home of their own. They agreed to visit their local banker to
get an idea of how much home they can afford with their combined incomes.
Current Financial Situation
Assets (Jamie Lee and Ross combined) :
Checking account, $4,300
Savings account, $55,200
Emergency fund savings account,
$19,100
IRA balance, $24,000
Cars, $12,000 (Jamie Lee) and $20,000
(Ross)
Liabilities (Jamie Lee and Ross combined):
Student loan balance, $0
Credit card balance, $0
Car loans, $8,000
Income:
Jamie Lee, $45,000 gross income
($31,500 net income after taxes)
Ross, $70,000 gross income ($59,000 net
income after taxes)
Monthly Expenses (Jamie Lee and Ross
combined):
Utilities, $160
Food, $325
Gas/Maintenance, $275
Credit card payment, $0
Car loan payment, $289
Entertainment, $300
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Questions
1. Using “Your Personal Financial Plan” sheet 22, compare the advantages and the disad-
vantages of renting a home or apartment to those of purchasing a home.
2. Jamie Lee and Ross are estimating that they will be putting $40,000 from their savings
account toward a down payment on their home purchase. Using the traditional finan-
cial guideline suggestion of “two and a half times your salary plus your down pay-
ment,” calculate approximately how much Jamie Lee and Ross can spend on a house.
3. Using “Your Personal Financial Plan” sheet 24, calculate the affordable mortgage
amount that would be suggested by a lending institution based on Jamie Lee and
Ross’s income. How does this amount compare with the traditional financial guideline
found in Question 2?
Use the following amounts for Jamie Lee and Ross’s calculations:
• 10 percent down payment
• 28 percent for TIPI
• $500.00 per month for estimated combined property taxes and insurance
• 5 percent interest rate for 30 years (see Exhibit 7–7 )
4. Jamie Lee and Ross found a brand-new three-bedroom, 2½-bath home for sale in a
quiet neighborhood. The listing price is $275,000. They placed a bid of $260,000 on
the home. The seller’s counteroffer was $273,000. What should Jamie Lee and Ross do
next to demonstrate to the owner that they are serious buyers?
5. Jamie Lee and Ross received a signed contract from the seller accepting their $273,000
offer! The seller also agreed to pay two points toward Jamie Lee and Ross’s mortgage.
Calculate the benefit of having points paid toward the mortgage if Jamie Lee and Ross
are putting a $40,000 down payment on the home.
6. Calculate Jamie Lee and Ross’s mortgage payment, using the 5 percent rate for 30
years on the mortgage balance of $233,000.
Directions Your Daily Spending Diary will help you manage your housing expenses
to create a better overall spending plan. As you record daily spending, your comments
should reflect what you have learned about your spending patterns and help you consider
possible changes you might want to make. The Daily Spending Diary sheets are located
in Appendix D at the end of the book and in Connect Finance.
Questions
1. What portion of your daily spending involves expenses associated with housing?
2. What types of housing expenses might be reduced with more careful spending habits?
“AFTER I PAY MY RENT, UTILITIES, AND RENTER’S INSURANCE,
I HAVE VERY LITTLE FOR OTHER EXPENSES.”
Spending
Diary
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Rental Costs
Annual rent payments (monthly rent $ ________ 3 12) $ _______________________
Renter’s insurance $ _______________________
Interest lost on security deposit (deposit times after-tax savings account
interest rate) $ _______________________
Total annual cost of renting $
Buying Costs
Annual mortgage payments $ _______________________
Property taxes (annual costs) $ _______________________
Homeowner’s insurance (annual premium) $ _______________________
Estimated maintenance and repairs $ _______________________
After-tax interest lost because of down payment/closing costs $ _______________________
Less: financial benefits of home ownership
Growth in equity $ 2_____________________
Tax savings for mortgage interest (annual mortgage interest times tax rate) $ 2 _____________________
Tax savings for property taxes (annual property taxes times tax rate) $ 2_____________________
Estimated annual appreciation $ 2 _____________________
Total annual cost of buying $
What’s Next for Your Personal Financial Plan?
• Determine if renting or buying is most appropriate for you at the current time.
• List some circumstances or actions that might change your housing needs.
Renting vs. Buying Housing
Purpose: To compare the cost of renting or buying your place of residence.
Financial Planning Activities: Obtain estimates for comparable housing units for the data
requested below. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.homefair.com www.newbuyer.com/homes finance.move.com www.dinkytown.net
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Suggested
App:
• Realtor
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What’s Next for Your Personal Financial Plan?
• Which of these rental units would best serve your current housing needs?
• What additional information should be considered when renting an apartment?
Apartment Rental Comparison
Purpose: To evaluate and compare rental housing alternatives.
Financial Planning Activities: Obtain the information requested below to compare costs and
facilities of three apartments. This sheet is also available in an Excel spreadsheet format in
Connect Finance.
Suggested Websites: www.apartments.com www.apartmentguide.com apartments.about.com
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Name of renting person or
apartment building
Address
Phone
Monthly rent
Amount of security deposit
Length of lease
Utilities included in rent
Parking facilities
Storage area in building
Laundry facilities
Distance to schools
Distance to public
transportation
Distance to shopping
Pool, recreation area, other
facilities
Estimated utility costs:
• Electric
• Cable/Internet
• Gas
• Water
Other costs
Other information
Suggested
App:
• PadMapper
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What’s Next for Your Personal Financial Plan?
• Identify actions you might need to take to qualify for a mortgage.
• Discuss your mortgage qualifications with a mortgage broker or other lender.
Housing Affordability and Mortgage
Qualification
Purpose: To estimate the amount of affordable mortgage payment, mortgage amount, and
home purchase price.
Financial Planning Activities: Enter the amounts requested to estimate the amount of
affordable mortgage payment, mortgage amount, and home purchase price. This sheet is
also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.realestate.com homeloanlearningcenter.com mtgprofessor.com
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Step 1
Determine your monthly gross income (annual income divided by 12) . $ __________________________
Step 2
With a down payment of at least 10 percent, lenders use 28 percent of
monthly gross income as a guideline for TIPI (taxes, insurance, principal,
and interest), 36 percent of monthly gross income as a guideline for TIPI
plus other debt payments (enter 0.28 or 0.36) . 3 __________________________
Step 3
Subtract other debt payments (such as payments on an auto loan), if
applicable .
2 __________________________
Subtract estimated monthly costs of property taxes and homeowner’s
insurance .
2 __________________________
Affordable monthly mortgage payment . . . . . . . . . . . . . . . . . . . . . . . . . $ __________________________
Step 4
Divide this amount by the monthly mortgage payment per $1,000 based
on current mortgage rates (see Exhibit 7–7 ). For example, for an 8 percent,
30-year loan, the number would be $7.34. 4 __________________________
Multiply by $1,000 . 3 $1,000
Affordable mortgage amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ __________________________
Step 5
Divide your affordable mortgage amount by 1 minus the fractional portion
of your down payment (for example, 0.9 for a 10 percent down payment). 4 __________________________
Affordable home purchase price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ __________________________
Note: The two ratios used by lending institutions (Step 2) and other loan requirements are likely to vary based on
a variety of factors, including the type of mortgage, the amount of the down payment, your income level, credit
score, and current interest rates. If you have other debts, lenders will calculate both ratios and then use the one
that allows you greater flexibility in borrowing.
Suggested
App:
• Mortgage
Calculator
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What’s Next for Your Personal Financial Plan?
• What additional information should be considered when selecting a mortgage?
• Which of these mortgage companies would best serve your current and future needs?
Mortgage Company Comparison
Purpose: To compare the services and costs for different home mortgage alternatives.
Financial Planning Activities: Obtain the information requested below to compare the ser-
vices and costs for different home mortgage sources. This sheet is also available in an Excel
spreadsheet format in Connect Finance.
Suggested Websites: www.hsh.com www.eloan.com www.bankrate.com mtgprofessor.com
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Amount of mortgage:
$ _____________ Down payment: $_____________ Years: _____________
Company
Address
Phone
Website
Contact person
Application fee, credit report, prop-
erty appraisal fees
Loan origination fee
Other fees, charges (commitment,
title, tax transfer)
Fixed-rate mortgage
Monthly payment
Discount points
Adjustable-rate mortgage
• Time until first rate charge
• Frequency of rate charge
Monthly payment
Discount points
Payment cap
Interest rate cap
Rate index used
Commitment period
Other information
Suggested
App:
• Bankrate
Mortgages
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3 Steps to Financial
Literacy . . . Percent of
Personal Property Coverage
8 Home and Automobile Insurance
Each year homeowners and renters in the
United States lose billions of dollars from more
than 3 million burglaries, 500,000 fires, and
200,000 cases of damage from other perils. A
major portion of these claims is due to losses
for personal property. At the end of the chap-
ter, “Your Personal Finance Dashboard” will
provide guidelines for measuring the level of
your personal property coverage.
1
Prepare a household inventory with a description
and the value of belongings, furniture, clothing,
electronics, and other personal property.
App: III Inventory
2
Compare various insurance companies and
levels of coverage to obtain home or renter’s
insurance for your life situation.
Website: www. insure.com
3
Determine if additional personal property
coverage is needed based on the value of your
household inventory.
Website: www. insweb.com
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Insurance and Risk Management
In today’s world of the “strange but true,” you can get insurance for just about anything.
You might purchase a policy to protect yourself in the event that you’re abducted by
aliens. Some insurance companies will offer you protection if you think that you have
a risk of turning into a werewolf. If you’re a fast runner, you might be able to get a
discount on a life insurance policy. Some people buy wedding disaster insurance just in
case something goes wrong on the big day. You may never need these types of insurance,
but you’ll certainly need insurance on your home, your vehicle, and your personal prop-
erty. The more you know about insurance, the better able you will be to make decisions
about buying it.
What Is Insurance?
Insurance is protection against possible financial loss. You can’t predict the future. How-
ever, insurance allows you to be prepared for the worst. It provides protection against many
risks, such as unexpected property loss, illness, and injury. Many kinds of insurance exist,
and they all share some common characteristics. They give you peace of mind, and they
protect you from financial loss when trouble strikes.
An insurance company , or insurer , is a risk-sharing business that agrees to pay for losses
that may happen to someone it insures. A person joins the risk-sharing group by purchasing
a contract known as a policy . The purchaser of the policy is called a policyholder .
Under the policy, the insurance company agrees to take on the risk. In return the policy-
holder pays the company a premium , or fee. The protection provided by the terms of an
LO8.1
Identify types of risks and risk
management methods and
develop a risk management
plan.
ACTION ITEM
Can you list several risk
management methods?
h Yes h No
insurance Protection
against possible financial
loss.
insurance company A
risk-sharing firm that
assumes financial
responsibility for losses that
may result from an insured
risk.
CHAPTER 8 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO8.1 Identify types of risks and risk management methods and develop a risk
management plan.
LO8.2 Assess the insurance coverage and policy types available to homeowners and
renters.
LO8.3 Analyze the factors that influence the amount of coverage and cost of home
insurance.
LO8.4 Identify the important types of automobile insurance coverage.
LO8.5 Evaluate factors that affect the cost of automobile insurance.
YOUR PERSONAL FINANCIAL PLAN SHEETS
26. Current Insurance Policies and Needs
27. Home Inventory
28. Determining Needed Property Insurance
29. Apartment/Home Insurance Comparison
30. Automobile Insurance Cost Comparison
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insurance policy is known as coverage , and the people protected by the policy are known as
the insured .
Types of Risk
You face risks every day. You can’t cross the street without some danger that a motor
vehicle might hit you. You can’t own property without running the risk that it will be lost,
stolen, damaged, or destroyed.
“Risk,” “peril,” and “hazard” are important terms in insurance. In everyday use, these
terms have almost the same meanings. In the insurance business, however, each has a dis-
tinct meaning.
Risk is the chance of loss or injury. In insurance it refers to the fact that no one can
predict trouble. This means that an insurance company is taking a chance every time it issues
a policy. Insurance companies frequently refer to the insured person or property as the risk.
Peril is anything that may possibly cause a loss. It’s the reason someone takes out insur-
ance. People buy policies for protection against a wide range of perils, including fire,
windstorms, explosions, robbery, and accidents.
Hazard is anything that increases the likelihood of loss through some peril. For exam-
ple, defective house wiring is a hazard that increases the chance that a fire will start.
The most common risks are personal risks, property risks, and liability risks. Personal
risks involve loss of income or life due to illness, disability, old age, or unemployment.
Property risks include losses to property caused by perils, such as fire or theft, and haz-
ards. Liability risks involve losses caused by negligence that leads to injury or property
damage. Negligence is the failure to take ordinary or reasonable care to prevent accidents
from happening. If a homeowner doesn’t clear the ice from the front steps of her house, for
example, she creates a liability risk because visitors could fall on the ice.
Personal risks, property risks, and liability risks are types of pure, or insurable, risk.
The insurance company will have to pay only if some event that the insurance covers
actually happens. Pure risks are accidental and unintentional. Although no one can predict
whether a pure risk will occur, it’s possible to predict the costs that will accrue if one does.
A speculative risk is a risk that carries a chance of either loss or gain. Starting a small
business that may or may not succeed is an example of speculative risk. Speculative risks
are not insurable.
Risk Management Methods
Risk management is an organized plan for protecting yourself, your family, and your
property. It helps reduce financial losses caused by destructive events. Risk management
is a long-range planning process. Your risk management needs
will change at various points in your life. If you understand how
to manage risks, you can provide better protection for your-
self and your family. Most people think of risk management as
buying insurance. However, insurance is not the only way of
dealing with risk. Four general risk management techniques are
commonly used.
RISK AVOIDANCE You can avoid the risk of a traffic
accident by not driving to work. A car manufacturer can avoid
the risk of product failure by not introducing new cars. These
are both examples of risk avoidance. They are ways to avoid
risks, but they require serious trade-offs. You might have to give
up your job if you can’t get there. The car manufacturer might
lose business to competitors who take the risk of producing
exciting new cars.
insurer An insurance
company.
policy A written contract for
insurance.
policyholder A person
who owns an insurance
policy.
premium The amount
of money a policyholder is
charged for an insurance
policy.
coverage The protection
provided by the terms of an
insurance policy.
insured A person covered
by an insurance policy.
risk Chance or uncertainty
of loss; also used to mean
“the insured.”
peril The cause of a
possible loss.
hazard A factor that
increases the likelihood of
loss through some peril.
negligence Failure to take
ordinary or reasonable care in
a situation.
did you know? did you know?
The poor of the world often lack The poor of the world often lack
the ability to protect their assets. How-the ability to protect their assets. How-
ever, in recent years, microinsurance has ever, in recent years, microinsurance has
evolved to serve consumers and businesses evolved to serve consumers and businesses
not covered by traditional insurance pro-not covered by traditional insurance pro-
grams. These low-premium, low-coverage grams. These low-premium, low-coverage
policies provide low-income households policies provide low-income households
protection from losses that would have a protection from losses that would have a
major impact on their financial situation. major impact on their financial situation.
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In some cases, though, risk avoidance is practical. By taking precautions in high-crime
areas, you might avoid the risk that you will be robbed.
RISK REDUCTION You can’t avoid risks completely. However, you can decrease
the likelihood that they will cause you harm. For example, you can reduce the risk of injury
in an automobile accident by wearing a seat belt. You can reduce the risk of developing
lung cancer by not smoking. By installing fire extinguishers in your home, you reduce the
potential damage that could be caused by a fire. Your risk of illness might be lower if you
eat properly and exercise regularly.
RISK ASSUMPTION Risk assumption means taking on responsibility for the neg-
ative results of a risk. It makes sense to assume a risk if you know that the possible loss
will be small. It also makes sense when you’ve taken all the precautions you can to avoid
or reduce the risk.
When insurance coverage for a particular item is expensive, that item may not be worth
insuring. For instance, you might decide not to purchase collision insurance on an older
car. If an accident happens, the car may be wrecked, but it wasn’t worth much anyway.
Self-insurance is setting up a special fund, perhaps from savings, to cover the cost of a
loss. Self-insurance does not eliminate risks, but it does provide a way of covering losses
as an alternative to an insurance policy. Some people self-insure because they can’t obtain
insurance from an insurance company.
RISK SHIFTING The most common method of dealing with risk is to shift it. That
simply means to transfer it to an insurance company. In exchange for the fee you pay, the
insurance company agrees to pay for your losses.
Most insurance policies include deductibles. Deductibles are a combination of risk
assumption and risk shifting. A deductible is the set amount that the policyholder must pay
per loss on an insurance policy. For example, if a falling tree damages your car, you may
have to pay $200 toward the repairs. Your insurance company will pay the rest.
Exhibit 8–1 summarizes various risks and effective ways of managing them.
Planning an Insurance Program
Your personal insurance program should change along with your needs and goals. Dave
and Ellen are a young couple. How will they plan their insurance program to meet their
needs and goals?
Exhibit 8–2 outlines the steps in developing a personal insurance program.
STEP 1: SET INSURANCE GOALS Dave and Ellen’s main goal should be to
minimize personal, property, and liability risks. They also need to decide how they will
cover costs resulting from a potential loss. Income, age, family size, lifestyle, experience,
and responsibilities will be important factors in the goals they set. The insurance they buy
must reflect those goals. Dave and Ellen should try to come up with a basic risk manage-
ment plan that achieves the following:
• Reduces possible loss of income caused by premature
death, illness, accident, or unemployment.
• Reduces possible loss of property caused by perils, such
as fire or theft, or hazards.
• Reduces possible loss of income, savings, and property
because of personal negligence.
STEP 2: DEVELOP A PLAN TO REACH YOUR
GOALS Planning is a way of taking control of life instead of
just letting life happen to you. Dave and Ellen need to determine
deductible The set amount
that the policyholder must
pay per loss on an insurance
policy.
did you know? did you know?
Deductibles are a combination of risk
assumption and risk shifting. The insured
person assumes part of the risk, paying the first $100,
$250, or $500 of a claim. The majority of the risk for
a large claim is shifted to another party, the insurance
company.
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what risks they face and what risks they can afford to take. They also have to determine
what resources can help them reduce the damage that could be caused by serious risks.
Furthermore, they need to know what kind of insurance is available. The cost of dif-
ferent kinds of insurance and the way the costs vary among companies will be the key
factors in their plan. Finally, this couple needs to research the reliability record of different
insurance companies.
RISKS STRATEGIES FOR REDUCING FINANCIAL IMPACT
Personal Events Financial Impact Personal Resources Private Sector Public Sector
Disability Loss of one income
Loss of services
Increased expenses
Savings, investments
Family observing
safety precautions
Disability insurance Disability insurance
Illness Loss of one income
Catastrophic hospital
expenses
Health-enhancing
behavior
Health insurance
Health maintenance
organizations
Military health care
Medicare, Medicaid
Death Loss of one income
Loss of services
Final expenses
Estate planning
Risk reduction
Life insurance Veteran’s life
insurance
Social Security
survivor’s benefits
Retirement Decreased income
Unplanned living
expenses
Savings
Investments
Hobbies, skills
Retirement and/or
pensions
Social Security
Pension plan for
government
employees
Property loss Catastrophic storm
damage to
property
Repair or
replacement cost
of theft
Property repair and
upkeep
Security plans
Automobile
insurance
Homeowner’s
insurance
Flood insurance (joint
program with
government)
Flood insurance (joint
program with
business)
Liability Claims and
settlement costs
Lawsuits and legal
expenses
Loss of personal
assets and income
Observing safety
precautions
Maintaining property
Homeowner’s
insurance
Automobile
insurance
Malpractice insurance
Exhibit 8–1 Examples of Risks and Risk Management Strategies
Exhibit 8–2
Creating a Personal
Insurance Program
1 Set Insurance
Goals
3 Put Your Plan
into Action 2
Develop a Plan to
Reach Your Goals
4 Check Your Results
Your Insurance Plan
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How Can You Plan an Insurance Program?
Personal Finance in Practice
Dave and Ellen must ask four questions as they develop their risk management plan:
• What do they need to insure?
• How much should they insure it for?
• What kind of insurance should they buy?
• Whom should they buy insurance from?
STEP 3: PUT YOUR PLAN INTO ACTION Once they’ve developed their
plan, Dave and Ellen need to follow through by putting it into action. During this process
they might discover that they don’t have enough insurance protection. If that’s the case,
they could purchase additional coverage or change the kind of coverage they have. Another
alternative would be to adjust their budget to cover the cost of additional insurance. Finally,
Dave and Ellen might expand their savings or investment programs and use those funds in
the case of an emergency.
The best risk management plans will be flexible enough to allow Dave and Ellen to
respond to changing life situations. Their goal should be to create an insurance program
that can grow or shrink as their protection needs change.
STEP 4: CHECK YOUR RESULTS Dave and Ellen should take the time to
review their plan every two or three years, or whenever their family circumstances change.
Until recently, Dave and Ellen were satisfied with the coverage provided by their insur-
ance policies. However, when the couple bought a house six months ago, the time had
come for them to review their insurance plan. With the new house the risks became much
greater. After all, what would happen if a fire destroyed part of their home?
The needs of a couple renting an apartment differ from those of a couple who own a
house. Both couples face similar risks, but their financial responsibility differs greatly.
When you’re developing or reviewing a risk management plan, ask yourself if you’re pro-
viding the financial resources you’ll need to protect yourself, your family, and your prop-
erty. The nearby “Personal Finance in Practice” box suggests several guidelines to follow
in planning your insurance programs.
Did you: Yes No
• Seek advice from a competent and reliable insurance advisor? h h
• Determine what insurance you need to provide your family with sufficient protection if you die? h h
• Consider what portion of the family protection is met by Social Security and by group
insurance?
h h
• Decide what other needs insurance must meet (funeral expenses, savings, retirement
annuities, etc.)?
h h
• Decide what types of insurance best meet your needs? h h
• Plan an insurance program and implement it except for periodic reviews of changing needs
and changing conditions?
h h
• Avoid buying more insurance than you need or can afford? h h
• Consider dropping one policy for another that provides the same coverage for less money? h h
NOTE: Yes answers reflect wise actions for insurance planning.
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Property and Liability Insurance
in Your Financial Plan
Major natural disasters have caused catastrophic amounts of property loss in the United
States and other parts of the world. According to the Insurance Information Institute, the
first months of 2011 were violent in terms of catastrophes on a global scale. Mega catastro-
phes worldwide caused an estimated $350 billion in economic losses, shattering the previ-
ous record of $230 billion set in 2005. In 2005 Hurricanes Katrina, Rita, and Wilma caused
$50 billion in damages. In 1992 Hurricane Andrew resulted in $22.3 billion worth of insur-
ance claims , or requests for payment to cover financial losses. Superstorm Sandy, the dead-
liest and most destructive tropical cyclone of 2012, caused more than $18 billion in insured
losses and became the third costliest hurricane in the history of the U.S. insurance industry.
Most people invest large amounts of money in their homes and motor vehicles. There-
fore, protecting these items from loss is extremely important. Each year homeowners and
renters in the United States lose billions of dollars from more than 3 million burglaries,
500,000 fires, and 200,000 cases of damage from other perils. The cost of injuries and
property damage caused by vehicles is also enormous.
Think of the price you pay for home and motor vehicle insurance as an investment in
protecting your most valuable possessions. The cost of such insurance may seem high.
However, the financial losses from which it protects you are much higher.
Two main types of risk are related to your home and your car or other vehicle. One is
the risk of damage to or loss of your property. The second type involves your responsibility
for injuries to other people or damage to their property.
POTENTIAL PROPERTY LOSSES People spend a great deal of money on their
houses, vehicles, furniture, clothing, and other personal property. Property owners face
two basic types of risk. The first is physical damage caused by perils such as fire, wind,
water, and smoke. These perils can damage or destroy property. For example, a windstorm
might cause a large tree branch to smash the windshield of your car. You would have to
find another way to get around while it was being repaired. The second type of risk is loss
or damage caused by criminal behavior such as robbery, burglary, vandalism, and arson.
LIABILITY PROTECTION You also need to protect yourself from liability. Liability
is legal responsibility for the financial cost of another person’s losses or injuries. You can
be held legally responsible even if the injury or damage was not your fault. For example,
suppose that Terry falls and gets hurt while playing in her friend Lisa’s yard. Terry’s family
may be able to sue Lisa’s parents even though Lisa’s parents did nothing wrong. Similarly,
suppose that Sanjay accidentally damages a valuable painting while helping Ed move
some furniture. Ed may take legal action against Sanjay to pay the cost of the painting.
Usually, if you’re found liable, or legally responsible in a situation, it’s because negli-
gence on your part caused the mishap. Examples of such negligence include letting young
children swim in a pool without supervision or cluttering a staircase with things that could
cause someone to slip and fall.
claim A request for
payment to cover financial
losses.
liability Legal responsibility
for the financial cost of
another person’s losses or
injuries.
PRACTICE QUIZ 8–1 PRACTICE QUIZ 8–1
1. What are the three types of risk? Give an example for each.
2. What are the four methods of managing risks? Give an example for each.
3. List the four steps in planning for your insurance program.
4. Give an example of each kind of risk—personal, property, and liability.
Sheet 26 Current Insurance Policies
and Needs
S
a
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Home and Property Insurance
Your home and personal belongings are probably a major portion of your assets. Whether
you rent your dwelling or own a home, property insurance is vital. Homeowner’s insur-
ance is coverage for your place of residence and its associated financial risks, such as
damage to personal property and injuries to others (see Exhibit 8–3 ).
Homeowner’s Insurance Coverages
A homeowner’s insurance policy provides coverage for the following:
• The building in which you live and any other structures on the property.
• Additional living expenses.
• Personal property.
• Personal liability and related coverage.
• Specialized coverage.
BUILDING AND OTHER STRUCTURES The main purpose of homeown-
er’s insurance is to protect you against financial loss in case your home is damaged or
destroyed. Detached structures on your property, such as a garage or toolshed, are also
covered. Homeowner’s coverage even includes trees, shrubs, and plants.
ADDITIONAL LIVING EXPENSES If a fire or other event damages your home,
additional living expense coverage pays for you to stay somewhere else. For example, you
may need to stay in a motel or rent an apartment while your home is being repaired. These
extra living expenses will be paid by your insurance. Some policies limit additional living
expense coverage to 10 to 20 percent of the home’s coverage amount. They may also limit
payments to a maximum of six to nine months. Other policies may pay additional living
expenses for up to a year.
PERSONAL PROPERTY Homeowner’s insurance covers your household belongings,
such as furniture, appliances, and clothing, up to a portion of the insured value of the home. That
portion is usually 55, 70, or 75 percent. For example, a home insured for $160,000 might have
$112,000 (70 percent) worth of coverage for household belongings.
Personal property coverage typically limits the payout for the theft of certain items,
such as $5,000 for jewelry. It provides protection against the loss or damage of articles that
you take with you when you are away from home. For example, items you take on vacation
LO8.2
Assess the insurance
coverage and policy types
available to homeowners and
renters.
ACTION ITEM
Do you have enough home
and property insurance?
h Yes h No
homeowner’s
insurance Coverage for
a place of residence and its
associated financial risks.
Exhibit 8–3 Home Insurance Coverage
Building and
other structures r
Personal liability and
elated coverages
Personal
property
Loss of use/additional living
expenses while home is
uninhabitable
Apply Yourself! Apply Yourself!
Using web research and discussion with others, develop a risk management plan that best suits your present
need for insurance.
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or use at college are usually covered up to the policy limit. Personal property coverage
even extends to property that you rent, such as a rug cleaner, while it’s in your possession.
Most homeowner’s policies include optional coverage for personal computers, includ-
ing stored data, up to a certain limit. Your insurance agent can determine whether the
equipment is covered against data loss and damage from spilled drinks or power surges.
If something does happen to your personal property, you must prove how much it was
worth and that it belonged to you. To make the process easier, you can create a household
inventory. A household inventory is a list or other documentation of personal belongings,
with purchase dates and cost information. You can get a form for such an inventory from an
insurance agent. Exhibit 8–4 provides a list of items you might include if you decide to
compile your own inventory. For items of special value, you should have receipts, serial
numbers, brand names, and proof of value.
household inventory A
list or other documentation
of personal belongings, with
purchase dates and cost
information.
Exhibit 8–4 Household Inventory Contents
Bathroom
• Carpets, curtains
• Electrical appliances
• Linens, towels, shower curtain
Attic
• Luggage, trunks
• Holiday items
• Items in storage
• Sports equipment
• Seasonal clothing
Basement
• Washing machine
• Dryer
• Shelves
• Workbench
• Power tools
• Ironing board
Garage
• Lawn mower
• Lawn furniture
• Garden tools
• Shelving
• Workbench
• Bicycles
• Camping equipment
• Sports equipment
• Power tools
Living Room
• Air conditioner
• Books, bookcases
• Cabinets, contents
• Carpets, chairs
• Clocks, couches
• Computer, printer
• Desks, contents
• Curtains, shades
• Fireplace equipment
• Lamps, mirrors
• Pictures, piano
• Radio, television,
stereo, CDs, DVDs
• Tables, wall hangings
Hallway
• Cabinets
• Carpets
• Chairs
• Clocks
• Closet,
contents
• Curtains
• Lamps
• Mirrors
• Pictures
• Tables
Kitchen
• Cabinets, contents
• Chairs, tables
• Dishes, pans
• Silverware
• Clocks, tables
• Radio, lamps
• Electrical
appliances
• Floor coverings
• Wall hangings
• Cookbooks
• Curtains
Dining Room
• Buffet
• Cabinets
• Carpets
• Candlesticks
• Chairs
• China
• Clocks
• Dinnerware
• Linens
• Lamps
• Table
• Glassware
Personal Belongings
• Coats, hats
• Suits, slacks
• Sweaters, jackets
• Shirts, skirts
• Underwear, ties
• Shoes, socks
• Jewelry, gloves
• Furs, rainwear
• Laptop computer
Family Room
• Bar, equipment
• Books, bookcases
• Cabinets, contents
• Carpets, pictures
• Chairs, couches
• Computer
• Desks, contents
• Lamps, tables
• Musical equipment
• Television, stereo
Bedrooms
• Beds, bedding
• Books, bookcases
• Bureaus, contents
• Chests, contents
• Closets, contents
• Desks, contents
• Dressers, contents
• Electrical appliances
• Clocks
• Curtains
• Lamps
• Carpets
• Pictures
• Mirrors
• Radios, television
• Tables
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Your household inventory can include a video recording or photographs of your home
and its contents. Make sure that the closet and storage area doors are photographed open.
On the back of the photographs, indicate the date and the value of the objects. Update your
inventory, photos, and related documents on a regular basis. Keep a copy of each document
in a secure location, such as a safe deposit box.
If you own valuable items, such as expensive musical instruments, or need added pro-
tection for computers and related equipment, you can purchase a personal property floater.
A personal property floater is additional property insurance that covers the damage or loss
of a specific item of high value. The insurance company will require a detailed description
of the item and its worth. You’ll also need to have the item appraised, or evaluated by an
expert, from time to time to make sure that its value hasn’t changed.
PERSONAL LIABILITY AND RELATED COVERAGE Every day people
face the risk of financial loss due to injuries to other people or their property. The follow-
ing are examples of this risk:
• A guest falls on a patch of ice on the steps to your home and breaks his arm.
• A spark from the barbecue in your backyard starts a fire that damages a neighbor’s roof.
• Your son or daughter accidentally breaks an antique lamp while playing at a
neighbor’s house.
In each of these situations, you could be held responsible for paying for the damage. The
personal liability portion of a homeowner’s policy protects you and members of your fam-
ily if others sue you for injuries they suffer or damage to their property. This coverage
includes the cost of legal defense.
Not all individuals who come to your property are covered by your liability insur-
ance. Friends, guests, and babysitters are probably covered. However, if you have regular
employees, such as a housekeeper, a cook, or a gardener, you may need to obtain worker’s
compensation coverage for them.
Most homeowner’s policies provide basic personal liability coverage of $100,000, but
often that’s not enough. An umbrella policy , also called a personal catastrophe policy, sup-
plements your basic personal liability coverage. This added protection covers you for all
kinds of personal injury claims. For instance, an umbrella policy will cover you if someone
sues you for saying or writing something negative or untrue or for damaging his or her
reputation. Extended liability policies are sold in amounts of $1 million or more and are
useful for wealthy people. If you are a business owner, you may need other types of liabil-
ity coverage as well.
Medical payments coverage pays the cost of minor accidental injuries to visitors on
your property. It also covers minor injuries caused by you, members of your family, or
even your pets, away from home. Settlements under medical payments coverage are made
without determining who was at fault. This makes it fast and easy for the insurance com-
pany to process small claims, generally up to $5,000. If the injury is more serious, the
personal liability portion of the homeowner’s policy covers it. Medical payments coverage
does not cover injury to you or the other people who live in your home.
If you or a family member should accidentally damage another person’s property,
the supplementary coverage of homeowner’s insurance will pay for it. This protection is
usually limited to $500 or $1,000. Again, payments are made
regardless of fault. If the damage is more expensive, however,
it’s handled under the personal liability coverage.
SPECIALIZED COVERAGE FOR PSYCHOLOGICAL
AND FINANCIAL WELL-BEING Homeowner’s insur-
ance usually doesn’t cover losses from floods and earthquakes.
If you live in an area that has frequent floods or earthquakes, you
need to purchase special coverage. In some places the National
Flood Insurance Program makes flood insurance available. This
personal property
floater Additional property
insurance to cover the
damage or loss of a specific
item of high value.
umbrella policy
Supplementary personal
liability coverage; also called
a personal catastrophe
policy.
medical payments
coverage Home insurance
that pays the cost of minor
accidental injuries on one’s
property.
did you know? did you know?
For $50 to $80 a year, homeowners can
obtain $10,000 for sewage and drain backup
damage. Heavy rains that clog a sewer line can cause
damage to furniture and other items in a finished
basement.
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• You are eligible to purchase flood insurance as long
as your community participates in the National Flood
Insurance Program.
• It takes 30 days after purchase for a policy to take
effect, so it’s important to buy insurance before the
floodwaters start to rise.
• In a high-risk area, your home is more than twice as
likely to be damaged by flood than by fire.
• Anyone can be financially vulnerable to floods.
People outside of high-risk areas file over 20 percent
of NFIP claims and receive one-third of disaster
assistance for flooding.
• The average annual U.S. flood losses in the past 10
years (2003–2012) were nearly $4 billion.
• When your community participates in the Community
Rating System (CRS), you can qualify for an
insurance premium discount of up to 45 percent.
• Since 1978, the NFIP has paid over $48.1 billion for
flood insurance claims and related costs (as of July 8,
2013).
• Over 5.5 million people currently hold flood insurance
policies in more than 21,000 communities across the
United States.
For more policy and claim statistics, visit the National
Flood Insurance Program.
SOURCE: www.floodsmart.gov/floodsmart/pages/flood_facts.jsp ,
accessed May 23, 2014.
• Floods and flash floods happen in all 50 states.
• Everyone lives in a flood zone.
• Most homeowner’s insurance does not cover flood
damage.
• If you live in a Special Flood Hazard Area (SFHA) or
high-risk area and have a federally backed mortgage,
your mortgage lender requires you to have flood
insurance.
• Just an inch of water can cause costly damage to
your property.
• Flash floods often bring walls of water 10 to 20 feet
high.
• A car can easily be carried away by just two feet of
floodwater.
• Hurricanes, winter storms, and snowmelt are
common (but often overlooked) causes of flooding.
• New land development can increase flood risk,
especially if the construction changes natural runoff
paths.
• Federal disaster assistance is usually a loan that
must be paid back with interest. For a $50,000
loan at 4 percent interest, your monthly payment
would be about $240 a month ($2,880 a year) for 30
years. Compare that to a $100,000 flood insurance
premium, which is about $400 a year ($33 a month).
• If you live in a moderate-to-low risk area and are
eligible for the Preferred Risk Policy, your flood
insurance premium may be as low as $129 a year,
including coverage for your property’s contents.
Flood Facts
Personal Finance in Practice
protection is separate from a homeowner’s policy. An insurance agent or the Federal Emer-
gency Management Agency (FEMA) of the Federal Insurance Administration can give you
additional information about this coverage. Read the nearby “Personal Finance in Practice”
box to learn more about flood insurance.
You may be able to get earthquake insurance as an endorsement —addition of
coverage—to a homeowner’s policy or through a state-run insurance program. The
most serious earthquakes occur in the Pacific Coast region. However, earthquakes can
happen in other regions, too. If you plan to buy a home in an area that has a high risk
of floods or earthquakes, you may have to buy the necessary insurance in order to be
approved for a mortgage loan.
Renter’s Insurance
For people who rent, home insurance coverage includes personal property protection,
additional living expenses coverage, and personal liability and related coverage. Renter’s
insurance does not provide coverage on the building or other structures.
There are two standard renter’s insurance policies. The broad form covers your
personal property against perils specified in the policy, such as fires and thefts, and the
endorsement An addition
of coverage to a standard
insurance policy.
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CAUTION! CAUTION!
Computers and other equipment used in a
home-based business are not usually covered
by a home insurance policy. Contact your
insurance agent to obtain needed coverage.
Chapter 8 Home and Automobile Insurance 259
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comprehensive form protects your personal property against all
perils not specifically excluded in the policy. When shopping for
renter’s insurance, be aware that these policies:
• Normally pay only the actual cash value of your losses.
Replacement cost coverage is available for an extra
premium.
• Fully cover your personal property only at home. When
traveling, your luggage and other personal items are
protected up to a certain percentage of the policy’s total amount of coverage.
• Automatically provide liability coverage if someone is injured on your premises.
• May duplicate other coverage. For instance, if you are still a dependent, your
personal property may be covered by your parents’ homeowner’s policy. This
coverage is limited, however, to an amount equal to a certain percentage of the total
personal property coverage provided by the policy.
The most important part of renter’s insurance is the protection it provides for your per-
sonal property. Many renters believe that they are covered under the landlord’s insurance.
In fact, that’s the case only when the landlord is proved liable for some damage. For exam-
ple, if bad wiring causes a fire and damages a tenant’s property, the tenant may be able to
collect money from the landlord. Renter’s insurance is relatively inexpensive and provides
many of the same kinds of protection as a homeowner’s policy.
Home Insurance Policy Forms
Home insurance policies are available in several forms. The forms provide different com-
binations of coverage. Some forms are not available in all areas.
The basic form (HO-1) protects against perils such as fire, lightning, windstorms, hail,
volcanic eruptions, explosions, smoke, theft, vandalism, glass breakage, and riots.
The broad form (HO-2) covers an even wider range of perils, including falling objects
and damage from ice, snow, or sleet.
The special form (HO-3) covers all basic- and broad-form risks, plus any other risks except
those specifically excluded from the policy. Common exclusions are flood, earthquake, war,
and nuclear accidents. Personal property is covered for the risks listed in the policy.
The tenant’s form (HO-4) protects the personal property of rent-
ers against the risks listed in the policy. It does not include cover-
age on the building or other structures.
The comprehensive form (HO-5) expands the coverage of the
HO-3. The HO-5 includes endorsements for items such as replace-
ment cost coverage on contents and guaranteed replacement cost
coverage on buildings.
Condominium owner’s insurance (HO-6) protects personal
property and any additions or improvements made to the living
unit. These might include bookshelves, electrical fixtures, wallpa-
per, or carpeting. The condominium association purchases insurance on the building and
other structures.
Manufactured housing units and mobile homes usually qualify for insurance coverage
with conventional policies. However, some mobile homes may need special policies with
higher rates because the way they are built increases their risk of fire and wind damage.
The cost of mobile home insurance coverage depends on the home’s location and the way
it’s attached to the ground. Mobile home insurance is quite expensive: A $40,000 mobile
home can cost as much to insure as a $120,000 house.
In addition to the risks previously discussed, home insurance policies include coverage for:
• Credit card fraud, check forgery, and counterfeit money.
• The cost of removing damaged property.
did you know? did you know?
While more than 9 out of 10 homeowners
have property insurance, only about 4 out of
10 renters are covered.
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• Emergency removal of property to protect it from damage.
• Temporary repairs after a loss to prevent further damage.
• Fire department charges in areas with such fees.
Not everything is covered by home insurance (see Exhibit 8–5 ). Read the nearby “Kiplinger’s
Personal Finance” box for more information.
Separate coverage may be available for personal property that is not covered by a home-
owner’s insurance policy.
PRACTICE QUIZ 8–2 PRACTICE QUIZ 8–2
1. Define the following terms:
a. Homeowner’s insurance
b. Household inventory
c. Personal property floater
d. Renter’s insurance
2. Identify the choice that best completes the statement or answers the question:
a. The personal liability portion of a homeowner’s insurance policy protects the insured against financial loss when
his or her (i) house floods, (ii) jewelry is stolen, (iii) guests injure themselves, (iv) reputation is damaged.
b. Renter’s insurance includes coverage for all of the following except (i) the building, (ii) personal property, (iii) addi-
tional living expenses, (iv) personal liability.
c. The basic home insurance policy form protects against several perils, including (i) sleet, (ii) lightning, (iii) flood,
(iv) earthquake.
3. Define the following terms:
a. Umbrella policy
b. Medical payments coverage
c. Endorsement
4. List at least four personal property items that are not covered by a homeowner’s insurance policy.
Apply Yourself! Apply Yourself!
You are about to rent your first apartment. You have approximately $10,000 worth of personal belongings. Contact an
insurance agent to find out the cost of renter’s insurance.
Sheet 27 Home Inventory
CERTAIN PERSONAL PROPERTY IS NOT COVERED BY HOMEOWNER’S INSURANCE:
• Items insured separately, such as jewelry, furs, boats, or
expensive electronic equipment
• Animals, birds, or fish
• Motorized vehicles not licensed for road use, except
those used for home maintenance
• Sound devices used in motor vehicles, such as radios
and CD players
• Aircraft and parts
• Property belonging to tenants
• Property contained in a rental apartment
• Property rented by the homeowner to other people
• Business property
Exhibit 8–5 Not Everything Is Covered
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance . Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. How can you protect yourself from flood-related damage to your home?
2. Should you consider purchasing flood-related insurance if you don’t live in a coastal area?
3. Can you be held responsible if your tree damages your neighbor’s property?
W
here water-
related damage
is concerned, the
answer depends
on whether the water came
from above or below. In general,
if the damage was caused by
wind-driven rain that came in
through your roof, windows or
doors, your insurance will cover
the cost of repairs.
But if the damage is caused
by flooding, a far more common
problem during storm season,
your homeowners insurance will
not cover it. The only way to pro-
tect yourself from flood-related
damage is to buy flood insurance
from the federal National Flood
Insurance Program. Premiums
range from about $200 a year to
more than $2,000, depending on
your area’s risk of flooding.
Never assume you don’t need
flood insurance just because
you don’t live in a coastal area.
In 2011, torrential rainfall from
Hurricane Irene caused wide-
spread flooding throughout the
Northeast. Vermont was hard hit,
and many of the victims didn’t
have flood insurance. “A lot of
Vermont residents never thought
they’d be involved in major
flooding,” says Richard McGrath,
chief executive of McGrath Insur-
ance Group, in Sturbridge, Mass.
You can purchase federal
flood insurance through a local
insurance agent. Don’t wait
until storm clouds gather to
buy a policy; typically, there’s
a 30-day waiting period before
premiums take effect. For price
quotes, go to FloodSmart.gov .
Sewage backup. If heavy
rains overwhelm your
storm-water system, sew-
age could back up into your
house—an expensive and
smelly mess. Most standard
homeowners policies don’t
include sewage-backup cover-
age, but you can purchase a
rider that will pay for $10,000
to $20,000 of damages for about
$50 to $75 a year, McGrath says.
Damage from trees. Old-
growth trees lose their charm
in a hurry when lightning, wind
or heavy rain knocks them
down. If the tree hits your
house, garage or other insured
structure, the damage is usually
covered by your homeowners
insurance, says Jeanne Sal-
vatore, spokeswoman for the
Insurance Information Institute.
Damage from a neighbor’s
tree—or even from one a block
away that was uprooted in a
windstorm—is also covered.
If your insurer believes your
neighbor contributed to the
problem by failing to take care
of the tree, it may try to collect
against your neighbor’s policy,
Salvatore says. In that case, you
could get a break on all or part
of your deductible. But it works
both ways: If your tree damages
your neighbor’s property, you
could be held responsible. Your
insurer could refuse to cover
damage to your property if it
believes you were negligent.
Most policies won’t pay to
remove a tree that falls in your
yard but doesn’t hit anything—
although you may be eligible
for some coverage if the fallen
tree blocks your driveway or
prevents you from getting into
your house.
Get a tax break? You may be
able to recover some of the costs
your insurance doesn’t reim-
burse when you file your taxes.
Losses from hurricanes,
floods and other disasters that
aren’t covered by your policy
are deductible, as long as you
itemize. You won’t be able to
deduct the entire amount of
your losses, however. First,
you’ll have to reduce the
amount of your loss by $100.
Then, you can deduct only the
amount that exceeds 10% of
your adjusted gross income.
For example, if you suffered
$20,000 in unreimbursed losses
and your AGI is $100,000, you
would subtract $100, then
subtract $10,000 (10% of your
AGI) from the $19,900 balance,
bringing your deduction to
$9,900.
Sandra Block
Game Plan
“If my home is damaged by a summer storm, will my insurance
cover repairs?”
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Home Insurance Cost Factors
How Much Coverage Do You Need?
You can get the best insurance value by choosing the right coverage amount and knowing
the factors that affect insurance costs (see Exhibit 8–6 ). Your insurance should be based
on the amount of money you would need to rebuild or repair your house, not the amount
you paid for it. As construction costs rise, you should increase the amount of coverage.
In fact, today most insurance policies automatically increase coverage as construction
costs rise.
In the past, many homeowner’s policies insured the building for only 80 percent of the
replacement value. If the building were destroyed, the homeowner would have to pay for
part of the cost of replacing it, which could be expensive. Today most companies recom-
mend full coverage.
If you are borrowing money to buy a home, the lender will require that you have prop-
erty insurance. Remember, too, that the amount of insurance on your home determines the
coverage on your personal belongings. Coverage for personal belongings is usually from
55 to 75 percent of the insurance amount on your home.
Insurance companies base claim settlements on one of two methods. Under the actual
cash value (ACV) method, the payment you receive is based on the replacement cost of an
item minus depreciation. Depreciation is the loss of value of an item as it gets older. This
means you would receive less for a five-year-old bicycle than you originally paid for it.
Under the replacement value method for settling claims, you receive the full cost of
repairing or replacing an item. Depreciation is not considered. Many companies limit the
replacement cost to 400 percent of the item’s actual cash value. Replacement value cover-
age is more expensive than actual cash value coverage.
LO8.3
Analyze the factors that
influence the amount of
coverage and cost of home
insurance.
ACTION ITEM
Do you have enough
insurance coverage for your
home?
h Yes h No
actual cash value (ACV)
A claim settlement method
in which the insured receives
payment based on the
current replacement cost of
a damaged or lost item, less
depreciation.
replacement value A
claim settlement method in
which the insured receives
the full cost of repairing or
replacing a damaged or lost
item.
Exhibit 8–6
Determining the Amount
of Home Insurance You
Need
Replacement value
of the home
Value of the
contents
Liability
coverage
desired
Protection for
specific items such
as jewelry, furs,
cameras, silverware,
or antiques
EXAMPLE: Replacement Cost and Time Value of Money
To save on future home insurance costs, you need a new roof and a burglar alarm
system that will cost $10,000 five years from now. You can earn 3 percent on your
savings. How much should you deposit now to obtain $10,000 five years from
today?
PV 5 $10,000 3 0.863 5 $8,630 (from Exhibit 1–C)
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Factors That Affect Home Insurance Costs
The cost of your home insurance will depend on several factors, such as the location of the
building and the type of building and construction materials. The amount of coverage and
type of policy you choose will also affect the cost of home insurance. Furthermore, differ-
ent insurance companies offer different rates.
LOCATION OF HOME The location of your home affects your insurance rates.
Insurance companies offer lower rates to people whose homes are close to a water supply
or fire hydrant or located in an area that has a good fire department. On the other hand,
rates are higher in areas where crime is common. People living in regions that experience
severe weather, such as tornadoes and hurricanes, may also pay more for insurance.
TYPE OF STRUCTURE The type of home and its construction influence the price
of insurance coverage. A brick house, for example, will usually cost less to insure than a
similar structure made of wood. However, earthquake coverage is more expensive for a
brick house than for a wood dwelling because a wooden house is more likely to survive an
earthquake. Also, an older house may be more difficult to restore to its original condition.
That means that it will cost more to insure.
COVERAGE AMOUNT AND POLICY TYPE The policy and the amount of
coverage you select affect the premium you pay. Obviously, insuring a $300,000 home
costs more than insuring a $100,000 home.
The deductible amount in your policy also affects the cost of your insurance. If you
increase the amount of your deductible, your premium will be lower because the company
will pay out less in claims. The most common deductible amount is $250. Raising the
deductible from $250 to $500 or $1,000 can reduce the premium you pay by 15 percent
or more.
EXAMPLE: Increase a Deductible to Reduce the Premium
Suppose your home insurance policy premium is $800 with a $250 deductible. If
you increase the amount of your deductible to $500, you reduce the premium by
10 percent, or $80.
HOME INSURANCE DISCOUNTS Most companies offer discounts if you take
action to reduce risks to your home. Your premium may be lower if you have smoke detec-
tors or a fire extinguisher. If your home has dead-bolt locks and alarm systems, which
make a break-in harder for thieves, insurance costs may be lower. Some companies offer
discounts to people who don’t file any claims for a certain number of years.
COMPANY DIFFERENCES You can save more than
30 percent on homeowner’s insurance by comparing rates from
several companies. Some insurance agents work for only one
company. Others are independent agents who represent several
different companies. Talk to both types of agent. You’ll get the
information you need to compare rates.
Don’t select a company on the basis of price alone; also con-
sider service and coverage. Not all companies settle claims in
the same way. Suppose that all homes on Evergreen Terrace
are dented on one side by large hail. They all have the same
kind of siding. Unfortunately, the homeowners discover that this
did you know? did you know?
In some areas, a home can be automatically
rejected for insurance coverage if it has had
two or three claims of any sort in the past three
years. Homes that have had water damage, storm
damage, and burglaries are most vulnerable to
rejection.
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Sheet 28 Determining Needed Property
Insurance
Sheet 29 Apartment/Home Insurance
Comparison
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type of siding is no longer available so all the siding on all of the houses will need to be
replaced. Some insurance companies will pay to replace all the siding. Others will pay
only to replace the damaged parts.
State insurance commissions and consumer organizations can give you information
about different insurance companies. Consumer Reports rates insurance companies on a
regular basis.
Read the nearby “Personal Finance in Practice” box to learn how you can lower the cost
of homeowner’s and renter’s insurance.
Automobile Insurance Coverages
Motor vehicle crashes cost over $150 billion in lost wages and medical bills every year.
Traffic accidents can destroy people’s lives physically, financially, and emotionally. Buy-
ing insurance can’t eliminate the pain and suffering that vehicle accidents cause. It can,
however, reduce the financial impact.
Every state in the United States has a financial responsibility law , a law that requires
drivers to prove that they can pay for damage or injury caused by an automobile accident.
All states have laws requiring people to carry motor vehicle insurance. These laws impose
heavy fines, suspension of a driver’s license, community service, and even imprisonment if
you don’t carry car insurance. Indeed, opportunity costs of driving without insurance can
be very high. Very few people have the money they would need to meet financial responsi-
bility requirements on their own.
The coverage provided by motor vehicle insurance falls into two categories. One is
protection for bodily injury. The other is protection for property damage (see Exhibit 8–7 ).
Motor Vehicle Bodily Injury Coverages
Most of the money that motor vehicle insurance companies pay out in claims goes for legal
expenses, medical expenses, and other costs that arise when someone is injured. The main
types of bodily injury coverage are bodily injury liability, medical payments, and unin-
sured motorist protection.
LO8.4
Identify the important types
of automobile insurance
coverage.
ACTION ITEM
Do you have an adequate
amount of automobile
insurance?
h Yes h No
financial responsibility
law State legislation that
requires drivers to prove their
ability to cover the cost of
damage or injury caused by
an automobile accident.
PRACTICE QUIZ 8–3 PRACTICE QUIZ 8–3
1. In the space provided, write “T” if you believe the statement is true, “F” if the statement is false.
a. Today most insurance policies automatically increase coverage as construction costs rise. _______
b. In the past, many homeowner’s policies insured the building for only 50 percent of the replacement value. _______
c. Most mortgage lenders do not require that you buy home insurance. _______
d. Coverage for personal belongings is usually from 55 to 75 percent of the insurance amount on your home. _______
2. What are the two methods insurance companies use in settling claims?
3. List the five factors that affect home insurance costs.
Apply Yourself! Apply Yourself!
Research the web to learn about the natural disasters that occur most frequently in your part of the country. How would
you protect your home from such natural disasters?
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gives you the money to rebuild your home and replace
its contents. An actual cash value policy is cheaper but
pays only what your property is worth at the time of the
loss—your cost minus depreciation.
5. Ask about special coverage you might need. You
may have to pay extra for computers, cameras, jewelry,
art, antiques, musical instruments, stamp collections,
and other items.
6. Remember that flood and earthquake damage are
not covered by a standard homeowner’s policy.
The cost of a separate earthquake policy will depend
on the likelihood of earthquakes in your area. Home-
owners who live in areas prone to flooding should take
advantage of the National Flood Insurance Program.
Call 1-888-CALLFLOOD or visit www.fema.gov/
national-flood-insurance-program .
7. If you are a renter do NOT assume your landlord
carries insurance on your personal belongings. Pur-
chase a special policy for renters.
How can you lower your cost of homeowner’s and renter’s
insurance? Shop around and compare the cost. Here are
a few tips that can save you hundreds of dollars annually.
1. Consider a higher deductible. Increasing your
deductible by just a few hundred dollars can make a
big difference in your premium.
2. Ask your insurance agent about discounts. You may
be able to secure a lower premium if your home has
safety features such as dead-bolt locks, smoke detec-
tors, an alarm system, storm shutters, or fire retardant
roofing material. Persons over 55 years of age or long-
term customers may also be offered discounts.
3. Insure your house, NOT the land under it. After a
disaster, the land is still there. If you don’t subtract the
value of the land when deciding how much homeown-
er’s insurance to buy, you will pay more than you should.
4. Make certain you purchase enough coverage to
replace what is insured. “Replacement” coverage
How to Lower the Cost of Insurance
Personal Finance in Practice
BODILY INJURY LIABILITY Bodily injury liability is insurance that covers physi-
cal injuries caused by a vehicle accident for which you were responsible. If pedestrians,
people in other vehicles, or passengers in your vehicle are injured or killed, bodily injury
liability coverage pays for expenses related to the crash.
Liability coverage is usually expressed by three numbers, such as 100/300/50. These
amounts represent thousands of dollars of coverage. The first two numbers refer to bodily
injury coverage. In this example, $100,000 is the maximum amount that the insurance
company will pay for the injuries of any one person in any one accident. The second num-
ber, $300,000, is the maximum amount the company will pay all injured parties (two or
more) in any one accident. The third number, $50,000, indicates the limit for payment for
damage to the property of others (see Exhibit 8–8 ).
MEDICAL PAYMENTS COVERAGE Medical payments coverage is insurance
that applies to the medical expenses of anyone who is injured in your vehicle, including
you. This type of coverage also provides additional medical benefits for you and members
bodily injury liability
Coverage for the risk of
financial loss due to legal
expenses, medical costs, lost
wages, and other expenses
associated with injuries
caused by an automobile
accident for which the
insured was responsible.
medical payments
coverage Automobile
insurance that covers
medical expenses for people
injured in one’s car.
Exhibit 8–7 Two Major Categories of Automobile Insurance
Bodily Injury Coverages
Bodily injury
liability
Medical
payments
Uninsured
motorist
protection
Property Damage Coverages
Property
damage
liability
Collision
Comprehensive
physical
damage
Buying bodily injury and property damage coverage can reduce the financial impact of an accident. What type of expenses would be paid for by bodily
injury liability coverage?
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of your family; it pays medical expenses if you or your family members are injured while
riding in another person’s vehicle or if any of you are hit by a vehicle.
UNINSURED MOTORIST PROTECTION Unfortunately, you cannot assume
that everyone who is behind the wheel is carrying insurance. How can you guard yourself
and your passengers against the risk of getting into an accident with someone who has no
insurance? The answer is uninsured motorist protection.
Uninsured motorist protection is insurance that covers you and your family members if
you are involved in an accident with an uninsured or hit-and-run driver. In most states it
does not cover damage to the vehicle itself. Penalties for driving uninsured vary by state,
but they generally include stiff fines and suspension of driving privileges.
Underinsured motorist coverage protects you when another driver has some insurance,
but not enough to pay for the injuries he or she has caused.
Motor Vehicle Property Damage Coverage
One afternoon, during a summer storm, Carrie was driving home from her job as a hostess
at a pancake house. The rain was coming down in buckets, and she couldn’t see very well.
As a result, she didn’t realize that the car in front of her had stopped to make a left turn,
and she hit the car. The crash totaled Carrie’s new car. Fortunately, she had purchased
property damage coverage. Property damage coverage protects you from financial loss if
you damage someone else’s property or if your vehicle is damaged. It includes property
damage liability, collision, and comprehensive physical damage. (See the nearby “Personal
Finance in Practice: Are You Covered?” feature.)
PROPERTY DAMAGE LIABILITY Property damage liability is motor vehicle
insurance that applies when you damage the property of others. In addition, it protects you
when you’re driving another person’s vehicle with the owner’s permission. Although the
damaged property is usually another car, the coverage also extends to buildings and to
equipment such as street signs and telephone poles.
COLLISION Collision insurance covers damage to your vehicle when it is involved in
an accident. It allows you to collect money no matter who was at fault. However, the
amount you can collect is limited to the actual cash value of your vehicle at the time of the
accident. If your vehicle has many extra features, make sure that you have a record of its
condition and value.
COMPREHENSIVE PHYSICAL DAMAGE Comprehensive physical damage
coverage protects you if your vehicle is damaged in a nonaccident situation. It covers your
uninsured motorist
protection Automobile
insurance coverage for the
cost of injuries to a person
and members of his or her
family caused by a driver with
inadequate insurance or by a
hit-and-run driver.
property damage liability
Automobile insurance
coverage that protects a
person against financial loss
when that person damages
the property of others.
collision Automobile
insurance that pays for
damage to the insured’s
car when it is involved in an
accident.
Exhibit 8–8
Automobile Liability
Insurance Coverage
100/300/50
Bodily Injury
Liability
Property Damage
Liability
Indicates $50,000 limit
for payment for damage
of property of others
Indicates $100,000 limit
that will be paid to one
person in an accident
Indicates $300,000 limit
that will be paid to all
persons in an accident
The three numbers used to describe liability coverage refer to the limits on different types of payments. Why do you
think the middle number is the highest?
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6. A person takes legal action against you for
injuries you caused in an automobile accident.
________________________________________________
7. Water from a local lake rises and damages your
furniture and carpeting. ___________________________
8. Your automobile needs repairs because you hit a tree.
________________________________________________
9. You damaged a valuable tree when your
automobile hit it, and you want to pay for the
damage. _________________________________________
10. While riding with you in your automobile, your nephew
is injured in an accident and incurs various medical
expenses. _______________________________________
Often people believe their insurance will cover various finan-
cial losses. For each of the following situations, name the type
of home or automobile insurance that would protect you.
1. While you are on vacation, clothing and other personal
belongings are stolen. ______________________________
2. Your home is damaged by fire, and you have to live in a
hotel for several weeks. _____________________________
3. You and members of your family suffer injuries in an
automobile accident caused by a hit-and-run driver.
__________________________________________________
4. A delivery person is injured on your property and takes
legal action against you. _____________________________
5. Your automobile is accidentally damaged by some
people playing baseball. ____________________________
ARE YOU COVERED?
Personal Finance in Practice
vehicle against risks such as fire, theft, falling objects, vandalism, hail, floods, tornadoes,
earthquakes, and avalanches.
No-Fault Insurance
To reduce the time and cost of settling vehicle injury cases, various states are trying a num-
ber of alternatives. Under the no-fault system , drivers who are involved in accidents collect
money from their own insurance companies. It doesn’t matter who caused the accident.
Each company pays the insured up to the limits of his or her coverage. Because no-fault
systems vary by state, you should investigate the coverage of no-fault insurance in your
state.
Other Automobile Insurance Coverages
Several other kinds of motor vehicle insurance are available to you. Wage loss insurance
pays for any salary or income you might have lost because of being injured in a vehicle
accident. Wage loss insurance is usually required in states with a no-fault insurance sys-
tem. In other states it’s available by choice.
Towing and emergency road service coverage pays for mechanical assistance in the
event that your vehicle breaks down. This can be helpful on long trips or during bad
weather. If necessary, you can get your vehicle towed to a service station. However, once
your vehicle arrives at the repair shop, you are responsible for paying the bill. If you belong
to an automobile club, your membership may include towing coverage. If that’s the case,
paying for emergency road service coverage could be a waste of money. Rental reimburse-
ment coverage pays for a rental car if your vehicle is stolen or being repaired.
no-fault system An
automobile insurance
program in which drivers
involved in accidents
collect medical expenses,
lost wages, and related
injury costs from their own
insurance companies.
ANSWERS (1) Personal property coverage of home insurance; (2) additional living expenses of home insurance; (3) uninsured
motorist protection; (4) personal liability coverage of home insurance; (5) comprehensive physical damage; (6) bodily injury liability;
(7) flood insurance—requires coverage separate from home insurance; (8) collision; (9) property damage liability of automobile
insurance; (10) medical payments.
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268 Chapter 8 Home and Automobile Insurance
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Automobile Insurance Costs
Motor vehicle insurance is not cheap. The average household spends more than $1,200
for motor vehicle insurance yearly. The premiums are related to the amount of claims
insurance companies pay out each year. Your automobile insurance cost is directly related
to coverage amounts and factors such as the vehicle, your place of residence, and your
driving record.
Amount of Coverage
The amount you will pay for insurance depends on the amount of coverage you require.
You need enough coverage to protect yourself legally and financially.
LEGAL CONCERNS As discussed earlier, most people who are involved in motor
vehicle accidents cannot afford to pay an expensive court settlement with their own money.
For this reason, most drivers buy liability insurance.
In the past, bodily injury liability coverage of 10/20 was usu-
ally enough. However, some people have been awarded millions
of dollars in recent cases, so coverage of 100/300 is usually
recommended.
PROPERTY VALUES Just as medical expenses and legal
settlements have increased, so has the cost of vehicles. There-
fore, you should consider a policy with a limit of $50,000 or
even $100,000 for property damage liability.
ACTION ITEM
Do you know what factors
determine your motor vehicle
insurance premium?
h Yes h No
LO8.5
Evaluate factors that affect
the cost of automobile
insurance.
PRACTICE QUIZ 8–4 PRACTICE QUIZ 8–4
1. List the three main types of bodily injury coverage.
2. In the space provided, write “T” if the statement is true, “F” if it is false.
a. Financial responsibility law requires drivers to prove that they can pay for damage or injury caused by an automo-
bile accident. _______
b. Insurance that covers physical injuries caused by a vehicle accident for which you were responsible is called
uninsured motorist protection. ________
c. Automobile liability coverage is usually expressed by three numbers, 100/300/50. ________
d. The first two numbers in 100/300/50 refer to the limit for payment for damage to the property of others. ________
e. Uninsured motorist protection is insurance that covers you and your family members if you are involved in an
accident with an uninsured motorist or hit-and-run driver. ________
f. Collision insurance covers damage to your vehicle when it is involved in an accident. ________
3. What is no-fault insurance? What is its purpose?
4. List at least three other kinds of automobile insurance that are available to you.
Apply Yourself! Apply Yourself!
Research the make and model of vehicles that are most frequently stolen, consequently resulting in higher insurance rates.
did you know? did you know?
Foods and drinks that were reported as the
most common distractions in auto accidents:
coffee, hot soup, tacos, chili-covered foods,
hamburgers, chicken, jelly- or cream-filled doughnuts,
and soft drinks.
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Chapter 8 Home and Automobile Insurance 269
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Motor Vehicle Insurance Premium Factors
Vehicle type, rating territory, and driver classification are three other factors that influence
insurance costs.
VEHICLE TYPE The year, make, and model of a vehicle will affect insurance costs.
Vehicles that have expensive replacement parts and complicated repairs will cost more
to insure. Also, premiums will probably be higher for vehicle makes and models that are
frequently stolen.
RATING TERRITORY In most states your rating terri-
tory is the place of residence used to determine your vehicle
insurance premium. Different locations have different costs. For
example, rural areas usually have fewer accidents and less fre-
quent occurrences of theft. Your insurance would probably cost
less there than if you lived in a large city.
DRIVER CLASSIFICATION Driver classification is
based on age, sex, marital status, driving record, and driving
habits. In general, young drivers (under 25) and elderly driv-
ers (over 70) have more frequent and more serious accidents.
As a result these groups pay higher premiums. Your driving
record will also influence your insurance premiums. If you have
accidents or receive tickets for traffic violations, your rates will
increase.
The cost and number of claims that you file with your insur-
ance company will also affect your premium. If you file expen-
sive claims, your rates will increase. If you have too many
claims, your insurance company may cancel your policy. You will then have more diffi-
culty getting coverage from another company. To deal with this problem, every state has
an assigned risk pool. An assigned risk pool includes all the people who can’t get motor
vehicle insurance. Some of these people are assigned to each insurance company operat-
ing in the state. These policyholders pay several times the normal rates, but they do get
coverage. Once they establish a good driving record, they can reapply for insurance at
regular rates.
Insurance companies may also consider your credit score when deciding whether to
sell, renew, or cancel a policy and what premium to charge. However, an insurer cannot
refuse to issue you a home or auto insurance policy solely based on your credit report.
Read the nearby “Personal Finance in Practice” box to understand how insurance compa-
nies use credit information.
Reducing Vehicle Insurance
Premiums
Two ways in which you can reduce your vehicle insurance costs
are by comparing companies and taking advantage of discounts.
COMPARING COMPANIES Rates and services vary
among motor vehicle insurance companies. Even among com-
panies in the same area, premiums can vary by as much as
100 percent. You should compare the service and rates of local
insurance agents. Most states publish this type of information.
assigned risk pool
Consists of people who are
unable to obtain automobile
insurance due to poor driving
or accident records and must
obtain coverage at high rates
through a state program
that requires insurance
companies to accept some
of them.
digi – know? digi – know?
Global positioning systems (GPS) and other Global positioning systems (GPS) and other
technology are being used to encourage technology are being used to encourage
safer driving and reduce auto insurance safer driving and reduce auto insurance
costs. In Britain, one insurance company costs. In Britain, one insurance company
adjusts premiums each month based on a adjusts premiums each month based on a
driver’s braking and acceleration habits. driver’s braking and acceleration habits.
The Car Chip ( The Car Chip ( www.carchipconnect.comwww.carchipconnect.com ) )
allows parents to monitor the speed and allows parents to monitor the speed and
braking actions of young drivers. braking actions of young drivers.
did you know? did you know?
An automobile insurance company once paid
$3,600 for damages to a car in an accident
caused by a mouse. The critter apparently got into
the car while it was parked and then crawled up the
driver’s pant leg while the car was on an interstate
highway. The driver lost control of the vehicle and
crashed into a roadside barrier. Another claim resulted
when a barbecued steak fell off a 17th-floor balcony
and dented a car.
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CAUTION! CAUTION!
Your insurance company may charge an
extra fee if you are involved in an accident or
cited for a serious traffic violation. Worse, the
insurer may not renew your insurance policy.
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rating tier, or level, or by placing you into a specific
company within their group of companies. Some
insurance companies use credit information along
with other more traditional rating factors such as
motor vehicle records and claims history. Where
permitted by state law, some insurance companies
may use credit reports only to determine your rate.
The FCRA requires an insurance company to tell you
if it has taken “adverse action” against you because of
your credit report information. If the company tells you that
you have been adversely affected, it must also tell you the
name of the national credit bureau that supplied the infor-
mation so you can get a free copy of your credit report.
The best way to know for sure if your credit score is affect-
ing your acceptance with an insurer for the best policy at
the best rate is to ask.
The Fair Credit Reporting Act (FCRA, discussed in
Chapter 5) allows insurance companies to examine your
credit report without your permission. These companies
believe that consumers who are financially responsible
have fewer and less costly losses and therefore should pay
less for their insurance. Insurance companies use credit
scores in two ways:
• Underwriting —deciding whether to issue you a new
policy or to renew your existing policy. Some state
laws prohibit insurance companies from refusing
to issue you a new policy or from renewing your
existing policy based solely on information obtained
from your credit report. In addition, some state laws
prohibit insurance companies from using your credit
information as the sole factor in accepting you and
placing you into a specific company within their
group of companies.
• Rating —deciding what price to charge you for your
insurance, either by placing you into a specific
Is It Ethical for Insurance Companies to Use Credit Information?
Personal Finance in Practice
Furthermore, you can check a company’s reputation with sources
such as Consumer Reports or your state insurance department.
PREMIUM DISCOUNTS The penalties of poor driving
behavior can be severe. For example, car insurance premiums
increased 18 percent if you had only one moving violation in 2010;
for two moving violations the average premium increased 34 percent
compared to drivers with no violations. Annual premiums jumped
to 53 percent higher if you had three violations.
The best way for you to keep your rates down is to maintain a good driving record by
avoiding accidents and traffic tickets. In addition, most insurance companies offer various
discounts. If you are under 25, you can qualify for reduced rates by taking a driver training
program or maintaining good grades in college.
Furthermore, installing security devices will decrease the chance of theft and lower
your insurance costs. Being a nonsmoker can qualify you for lower motor vehicle insur-
ance premiums as well. Discounts are also offered for insuring two or more vehicles with
the same company.
Increasing the amounts of deductibles will also lead to a lower premium. If you have an
old car that’s not worth much, you may decide not to pay for collision and comprehensive
coverage. However, before you make this move, you should compare the value of your car
for getting to college or work with the cost of these coverages.
Choose your car carefully. Some makes and models are more costly to insure than oth-
ers. Contact your insurance agent before purchasing your car. And finally, maintain a good
credit history. Many insurers are now examining your credit reports.
The nearby “Figure It Out!” box presents motor vehicle insurance cost comparison.
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PRACTICE QUIZ 8–5 PRACTICE QUIZ 8–5
1. In the space provided, write “A” if you agree with the statement, “D” if you disagree.
a. Motor vehicle insurance is not cheap. ________
b. The average household spends less than $500 for motor vehicle insurance yearly. ________
Sheet 30 Automobile Insurance Cost
Comparison
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RESEARCH
Identify a make, model, and year of a vehicle you might like to own. Research two insurance companies and get prices
using this example. You can get their rates by telephone. Many also have websites. Using your workbook or on a sepa-
rate sheet of paper, record your findings. How do they compare? Which company would you choose and why?
Before Mario bought the car he wanted, he needed to be sure he could afford the insurance for it. In this example he
chose low liability, uninsured motorist coverage, and high deductibles to keep his insurance payments as low as possi-
ble. Clearly insurer B offered a lower price for the same coverage.
Motor Vehicle Insurance—How Much Will It Cost? Motor Vehicle Insurance—How Much Will It Cost?
Figure It Out!
Investigating Insurance Companies
Insurer A Insurer B
Bodily Injury Coverage:
• Bodily injury liability $50,000 each person; $100,000 each accident
• Uninsured motorist protection
• Medical payments coverage $2,000 each person
$472
208
48
$358
84
46
Property Damage Coverage:
• Property damage liability $50,000 each accident
• Collision with $500 deductible
• Comprehensive physical damage with $500 deductible
182
562
263
178
372
202
Car rental 40 32
Discounts: good driver, air bags, garage parking (165)
Annual total $1,610 $1,272
EXAMPLE: Time Value of Money—Insuring Two Vehicles
with the Same Insurer
Suppose you insure your cars with two separate companies, paying $600 and $800
a year. If you insure both cars with the same company, you may save 10 percent on
the annual premiums, or $140 a year. What is the future value of the annual savings
over 10 years based on an annual interest rate of 3 percent?
The total premium $600 plus $800 5 $1,400
Ten percent of 1,400 5 $1,400 3 0.10 5 $140
Future value of $140 over 10 years at 3 percent:
$140 3 11.464 5 $1,604.96 (from Exhibit 1-B)
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c. Most people who are involved in an automobile accident can afford to pay an expensive court settlement with
their own money. ________
d. Liability coverage of 100/300 is usually recommended. ________
e. You should consider a policy with a limit of $50,000 or even $100,000 for property damage liability. ________
f. The year, make, and model of a vehicle do not affect insurance costs. ________
g. Your automobile insurance would probably cost more in rural areas than if you lived in a large city. ________
2. List the five factors that determine driver classification.
3. What are the two ways by which you can reduce your vehicle insurance costs?
Apply Yourself! Apply Yourself!
Using web research, find the laws in your state regarding uninsured motorist protection.
YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Have you established a specific and measurable portion of coverage for your household
belongings? Do you have adequate additional living expense coverage if a fire or other event damages your home?
Some policies limit additional living expense coverage to 10 to 20 percent of a home’s total coverage amount. Have you
considered a personal property floater for additional property insurance that covers the damage or loss of a specific item
of high value?
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) to determine actions you might take
to improve your home and automobile insurance
coverages.
Seek advice from a competent and reliable insurance
advisor. Then decide what types of insurance best
meet your needs.
Determine how you can lower the cost of home-
owner’s and renter’s insurance. See the “Personal
Finance in Practice” box on the topic in this chapter.
If you live in a flood-prone area, visit the Federal
Emergency Management Agency’s (FEMA) website
at www.FloodSmart.gov . For more information about
federal flood insurance, contact the National Flood
Insurance Program at 1-800-638-6620.
A personal finance dashboard can help you determine
if you have proper coverage for household belongings.
Homeowner’s insurance protects you against financial
loss in case your home is damaged or destroyed.
Your household belongings, such as furniture, appli-
ances, and clothing, are covered by the personal prop-
erty portion of a homeowner’s insurance policy up to a
portion of the insured value of the home. That portion
may range from 55 to 75 percent.
D
A
N
G
E
R
O
U
S
A
DE
QU
ATE
FINANCIALLY SEC
U
R
E
PERCENT OF PERSONAL PROPERTY COVERAGE
0 100
20 80
10 90
30 70
5040 60
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LO8.1 The main types of risk are per-
sonal risk, property risk, and liability risk.
Risk management methods include avoid-
ance, reduction, assumption, and shifting.
Planning an insurance program is a way
to manage risks.
Property and liability insurance protect
your homes and motor vehicles against
financial loss.
LO8.2 A homeowner’s policy provides
coverage for buildings and other structures,
additional living expenses, personal prop-
erty, personal liability and related cover-
ages, and specialized coverages.
Renter’s insurance provides many of the
same kinds of protection as homeowner’s
policies.
LO8.3 The factors that affect home
insurance coverage and costs include the
location, the type of structure, the coverage
amount and policy type, discounts, and the
choice of insurance company.
LO8.4 Motor vehicle bodily injury cov-
erages include bodily injury liability, med-
ical payments coverage, and uninsured
motorist protection.
Motor vehicle property damage cover-
ages include property damage liability, col-
lision, and comprehensive physical damage.
LO8.5 Motor vehicle insurance costs
depend on the amount of coverage you need
as well as vehicle type, rating territory, and
driver classification.
Chapter
Summary
Key Terms
actual cash value
(ACV) 262
assigned risk pool 269
bodily injury
liability 265
claim 254
collision 266
coverage 250
deductible 251
endorsement 258
financial responsibility
law 264
hazard 250
peril 250
personal property
floater 257
policy 249
policyholder 249
premium 249
property damage
liability 266
replacement value 262
risk 250
umbrella policy 257
uninsured motorist
protection 266
homeowner’s
insurance 255
household
inventory 256
insurance 249
insurance company 249
insured 250
insurer 249
liability 254
medical payments
coverage 257, 265
negligence 250
no-fault system 267
1. Survey friends and relatives to determine the types of insurance coverages they have.
Also, obtain information about the process used to select these coverages. (LO8.1)
2. Outline a personal insurance plan with the following phases: (a) Identify personal,
financial, and property risks; (b) set goals you might achieve when obtaining needed
insurance coverages; and (c) describe actions you might take to achieve these insur-
ance goals. (LO8.1)
3. Talk to a financial planner or an insurance agent about the financial difficulties faced
by people who lack adequate home and auto insurance. What common coverages do
many people overlook? (LO8.2)
4. Contact two or three insurance agents to obtain information about home or renter’s
insurance. Use “Your Personal Financial Plan” sheet 29 to compare the coverages and
costs. (LO8.2)
5. Examine a homeowner’s or renter’s insurance policy. What coverages does the policy
include? Does the policy contain unclear conditions or wording? (LO8.3)
6. Contact two or three insurance agents to obtain information about automobile insur-
ance. Use “Your Personal Financial Plan” sheet 30 to compare costs and coverages for
various insurance companies. (LO8.5)
Discussion
Questions
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1. Eric Fowler and his wife Susan just purchased their first home, which cost $130,000.
They purchased a homeowner’s policy to insure the home for $120,000 and personal
property for $75,000. They declined any coverage for additional living expenses. The
deductible for the policy is $500.
Soon after Eric and Susan moved into their new home, a strong windstorm caused
damage to their roof. They reported the roof damage to be $17,000. While the roof
was under repair, the couple had to live in a nearby hotel for three days. The hotel
bill amounted to $320. Assuming the insurance company settles claims using the
replacement value method, what amount will the insurance company pay for the
damages to the roof?
2. Eric’s Ford Mustang and Susan’s Toyota Prius are insured with the same insurance
agent. They have 50/100/15 vehicle insurance coverage. The very week of the wind-
storm, Susan had an accident. She lost control of her car, hit a parked car, and damaged
a storefront. The damage to the parked car was $4,300 and the damage to the store was
$15,400. What amount will the insurance company pay for Susan’s car accident?
Solutions
1. Home damages:
Home value: $130,000
Insured amount: $120,000
Damage amount reported: $17,000
Additional living expenses incurred: $320
Total expenses incurred from windstorm: $17,320
Deductible on the policy: $500
Insurance company covered amount ($17,000 2 $500 deductible): $16,500
Eric and Susan’s costs ($500 1 $320 hotel bill): $820
2. Car accident:
Store damage amount: $15,400
Parked car damage amount: $4,300
Total damages: $19,700
Insurance company covered amount (50/100/15): $15,000
Eric and Susan’s costs ($19,700 2 $15,000): $4,700
Self-Test
Problems
1. Most home insurance policies cover jewelry for $1,000 and silverware for $2,500
unless items are covered with additional insurance. If $4,500 worth of jewelry and
$6,000 worth of silverware were stolen from a family, what amount of the claim would
not be covered by insurance? (LO8.2)
2. What amount would a person with actual cash value (ACV) coverage receive for two-
year-old furniture destroyed by a fire? The furniture would cost $2,000 to replace
today and had an estimated life of five years. (LO8.2)
3. What would it cost an insurance company to replace a family’s personal property
that originally cost $25,000? The replacement costs for the items have increased 15
percent. (LO8.2)
4. If Carissa Dalton has a $130,000 home insured for $100,000, based on the 80 percent
coinsurance provision, how much would the insurance company pay on a $5,000
claim? (LO8.2)
5. For each of the following situations, what amount would the insurance company
pay? (LO8.2)
a. Wind damage of $835; the insured has a $500 deductible.
b. Theft of a stereo system worth $1,150; the insured has a $250 deductible.
c. Vandalism that does $425 of damage to a home; the insured has a $500 deductible.
Problems
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6. Becky Fenton has 25/50/10 automobile insurance coverage. If two other people are
awarded $35,000 each for injuries in an auto accident in which Becky was judged at
fault, how much of this judgment would the insurance cover? (LO8.4)
7. Kurt Simmons has 50/100/15 auto insurance coverage. One evening he lost control of
his vehicle, hitting a parked car and damaging a storefront along the street. Damage
to the parked car was $5,400, and damage to the store was $12,650. What amount
will the insurance company pay for the damages? What amount will Kurt have to
pay? (LO8.4)
8. Karen and Mike currently insure their cars with separate companies, paying $700
and $900 a year. If they insured both cars with the same company, they would save
10 percent on the annual premiums. What would be the future value of the annual
savings over 10 years based on an annual interest rate of 4 percent? (LO8.4)
9. When Carolina’s house burned down, she lost household items worth a total of
$50,000. Her house was insured for $160,000 and her homeowner’s policy provided
coverage for personal belongings up to 55 percent of the insured value of the house.
Calculate how much insurance coverage Carolina’s policy provides for her personal
possessions and whether she will receive payment for all of the items destroyed in
the fire. (LO8.2)
10. Dave and Ellen are newly married and living in their first house. The yearly pre-
mium on their homeowner’s insurance policy is $450 for the coverage they need.
Their insurance company offers a 5 percent discount if they install dead-bolt
locks on all exterior doors. The couple can also receive a 2 percent discount if
they install smoke detectors on each floor. They have contacted a locksmith, who
will provide and install dead-bolt locks on the two exterior doors for $60 each.
At the local hardware store, smoke detectors cost $8 each, and the new house
has two floors. Dave and Ellen can install them themselves. What discount will
Dave and Ellen receive if they install the dead-bolt locks? If they install smoke
detectors? (LO8.2)
11. In the preceding example, assuming their insurance rates remain the same, how many
years will it take Dave and Ellen to earn back in discounts the cost of the dead-bolts?
The cost of the smoke detectors? Would you recommend Dave and Ellen invest in the
safety items? Why or why not? (LO8.2)
12. Shaan and Anita currently insure their cars with separate companies, paying $650
and $575 a year. If they insure both cars with the same company, they will save
10 percent on their annual premiums. What would be the future value of the annual
savings over 10 years based on an annual interest rate of 6 percent? (LO8.5)
WE RENT, SO WHY DO WE NEED INSURANCE?
Case in
Point
“Have you been down in the basement?”
Nathan asked his wife Erin as he entered
their apartment.
“No, what’s up?” responded Erin.
“It’s flooded because of all that rain we got
last weekend!” he exclaimed.
“Oh no! We have the extra furniture my
mom gave us stored down there. Is every-
thing ruined?” Erin asked.
“The couch and coffee table are in a foot of
water; the love seat was the only thing that
looked OK. Boy, I didn’t realize the base-
ment of this building wasn’t waterproof.
I’m going to call our landlady to complain.”
As Erin thought about the situation, she
remembered that when they moved in last
fall, Kathy, their landlady, had informed
them that her insurance policy covered the
building but not the property belonging to
each tenant. Because of this, they had pur-
chased renter’s insurance. “Nathan, I think
our renter’s insurance will cover the dam-
age. Let me give our agent a call.”
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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When Erin and Nathan purchased their
insurance, they had to decide whether they
wanted to be insured for cash value or for
replacement costs. Replacement was more
expensive, but it meant they would collect
enough to go out and buy new household
items at today’s prices. If they had opted
for cash value, the couch for which Erin’s
mother had paid $1,000 five years ago
would be worth less than $500 today.
Erin made the call and found out their
insurance did cover the furniture in the
basement, and at replacement value after
they paid the deductible. The $300 they had
invested in renter’s insurance last year was
well worth it!
Not every renter has as much foresight as
Erin and Nathan. Fewer than 4 in 10 rent-
ers have renter’s insurance. Some aren’t
even aware they need it. They may assume
they are covered by the landlord’s insur-
ance, but they aren’t. This mistake can be
costly.
Think about how much you have invested
in your possessions and how much it would
cost to replace them. Start with your ste-
reo equipment or the flat screen television
and DVD player that you bought last year.
Experts suggest that people who rent start
thinking about these things as soon as they
move into their first apartment. Your policy
should cover your personal belongings and
provide funds for living expenses if you are
dispossessed by a fire or other disaster.
Questions
1. Why is it important for people who rent
to have insurance?
2. Does the building owner’s property
insurance ever cover the tenant’s per-
sonal property?
3. What is the difference between cash
value and replacement value?
4. When shopping for renter’s insurance,
what coverage features should you look
for?
Assets (Jamie Lee and Ross combined):
Checking account, $4,300
Savings account, $22,200
Emergency fund savings
account, $20,500
IRA balance, $26,000
Cars, $10,000 (Jamie Lee) and
$18,000 (Ross)
Liabilities (Jamie Lee and Ross
combined):
Student loan balance, $0
Credit card balance, $2,000
Car loans, $6,000
Income:
Jamie Lee, $50,000 gross income
($37,500 net income after taxes)
Ross, $75,000 gross income ($64,000 net
income after taxes)
Monthly Expenses (Jamie Lee and Ross
combined):
Mortgage, $1,252
Property taxes and insurance, $500
Utilities, $195
Food, $400
Gas/Maintenance, $275
Credit card payment, $250
Car loan payment, $289
Entertainment, $300
Continuing
Case
Jamie Lee and Ross have had several milestones in the past year. They are newlyweds,
recently purchased their first home, and now have twins on the way!
Jamie Lee and Ross have to seriously consider their insurance needs. Since they have fam-
ily, a home, and, now, babies on the way, they need to develop a risk management plan to
help them should an unexpected event arise.
Current Financial Situation
HOME AND AUTOMOBILE INSURANCE
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Questions
1. Based on their current life status, what are some of the goals Jamie Lee and Ross
should set to achieve when developing their insurance plan?
2. What four questions should Jamie Lee and Ross ask themselves as they develop the
risk management plan?
3. Once Jamie Lee and Ross put their insurance plan into action, what should they do to
maintain their plan?
4. Jamie and Ross decided to conduct a checkup on their homeowner’s insurance policy.
They noticed that they had omitted covering Jamie Lee’s diamond wedding band set
from their policy. What if it got lost or stolen? It was a major purchase and, besides
the emotional value, the cost to replace the diamond jewelry would be very high. What
type of policy should Jamie Lee and Ross consider to cover the diamond wedding
rings?
5. Mr. Ferrell, Jamie Lee and Ross’s insurance agent, suggested a flood insurance policy
in addition to their regular homeowner’s policy. Jamie Lee and Ross looked quizzi-
cally at the agent, as they do not live within two miles of a body of water. What is the
basis for Mr. Ferrell’s claim for the necessity of the flood policy?
6. Using “Your Personal Financial Plan” sheet 27, create a home inventory for Jamie
Lee and Ross. Consider items of value that may be located in each of the rooms of the
house and determine a dollar amount for each item. What is the total cost of the items?
7. Considering the value of Jamie Lee and Ross’s automobiles, what type of automobile
insurance coverage would you suggest for them?
8. What financial strategy would you suggest to Jamie Lee and Ross to enable them to
save money on their insurance premiums?
Directions As you continue (or start) using your Daily Spending Diary sheets, you
should be able to make better choices for your spending priorities. The financial data you
develop will help you better understand your spending patterns and help you plan for
achieving financial goals. The Daily Spending Diary sheets are located in Appendix D at
the end of the book and in Connect Finance.
Questions
1. What information from your Daily Spending Diary might encourage you to use your
money differently?
2. How can your spending habits be altered to ensure that you will be able to afford
appropriate home and auto insurance coverage?
“MY SPENDING TAKES MOST OF MY MONEY. SO AFTER PAYING
FOR CAR INSURANCE, MY BUDGET IS REALLY TIGHT.”
Spending
Diary
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What’s Next for Your Personal Financial Plan?
• Talk with friends and relatives to determine the types of insurance coverage they have.
• Conduct a web search for various types of insurance on which you need additional information.
Current Insurance Policies and Needs
Purpose: To establish a record of current and needed insurance coverage.
Financial Planning Activities: List current insurance policies and areas where new or additional
coverage is needed. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.insure.com www.insweb.com www.accuquote.com
26
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Current Coverage Needed Coverage
Property ____________________________________________________
Company ____________________________________________________
Policy no. ____________________________________________________
Coverage amounts ____________________________________________________
Deductible ____________________________________________________
Annual premium ____________________________________________________
Agent ____________________________________________________
Address ____________________________________________________
Phone ____________________________________________________
Website ____________________________________________________
Automobile Insurance
Company ____________________________________________________
Policy no. ____________________________________________________
Coverage amounts ____________________________________________________
Deductible ____________________________________________________
Annual premium ____________________________________________________
Agent ____________________________________________________
Address ____________________________________________________
Phone ____________________________________________________
Website ____________________________________________________
Disability Income Insurance
Company ____________________________________________________
Policy no. ____________________________________________________
Coverage ____________________________________________________
Contact ____________________________________________________
Phone ____________________________________________________
Website ____________________________________________________
Health Insurance
Company ____________________________________________________
Policy no. ____________________________________________________
Policy provisions ____________________________________________________
Contact ____________________________________________________
Phone ____________________________________________________
Website ____________________________________________________
Life Insurance
Company ____________________________________________________
Policy no. ____________________________________________________
Type of policy ____________________________________________________
Amount of coverage ____________________________________________________
Cash value ____________________________________________________
Agent ____________________________________________________
Phone ____________________________________________________
Website ____________________________________________________
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NHome Inventory
Purpose: To create a record of personal belongings for use when settling home insurance claims.
Financial Planning Activities: For each area of the home, list your possessions including a descrip-
tion (model, serial number), cost, and date of acquisition. Also consider photographs and videos of
your possessions. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.insweb.com www.money.com www.ambest.com
Item, Description Cost Date Acquired
Attic
Bathroom
Bedrooms
Family room
Living room
Hallways
Kitchen
Dining room
Basement
Garage
Other items
What’s Next for Your Personal Financial Plan?
• Determine common items that may be overlooked when preparing a home inventory.
• Talk to a local insurance agent to point out the areas of protection that many people tend to overlook.
Suggested
App:
• III Inventory
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Real Property (this section not applicable to renters)
Current replacement value of home $
Personal Property
Estimated value of appliances, furniture, clothing, and other household $
items (conduct an inventory)
Type of coverage for personal property (check one)
Actual cash value
Replacement value
Additional coverage for items with limits on standard personal property coverage such as jewelry; firearms; silver-
ware; and photographic, electronic, and computer equipment
Item Amount
Personal Liability
Amount of additional personal liability coverage desired for possible personal $
injury claims
Specialized Coverages
If appropriate, investigate flood or earthquake coverage excluded from $
home insurance policies
Note: Use sheet 29 to compare companies, coverages, and costs for apartment or home insurance.
What’s Next for Your Personal Financial Plan?
• Outline the steps involved in planning an insurance program.
• Outline special types of property and liability insurance such as personal computer insurance, trip cancellation
insurance, and liability insurance.
Determining Needed Property Insurance
Purpose: To determine property insurance needed for a home or apartment.
Financial Planning Activities: Estimate the value and your needs for the categories below.
This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.iii.org www.quicken.com www.naic.org
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NApartment/Home Insurance Comparison
Purpose: To research and compare companies, coverages, and costs for apartment or home
insurance.
Financial Planning Activities: Contact three insurance agents to obtain the information requested
below. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.freeinsurancequotes.com www.insure.com www.insureuonline.org
Type of building apartment home condominium
Location
Type of construction Age of building
Company name
Agent’s name, address,
and phone
Coverage: Premium Premium Premium
Dwelling
$
Other structure
$
(does not apply to
apartment/condo
coverage)
Personal property
$
Additional living
expenses
$
Personal liability
Bodily injury
$
Property damage
$
Medical payments
Per person
$
Per accident
$
Deductible amount
Other coverage
$
Service charges or fees
Total Premium
What’s Next for Your Personal Financial Plan?
• List the reasons most commonly given by renters for not having renter’s insurance.
• Determine cost differences for home insurance among various local agents and online providers.
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Suggested
App:
• iCompare
Car
Insurance
Automobile Insurance Cost Comparison
Purpose: To research and compare companies, coverages, and costs for auto insurance.
Financial Planning Activities: Contact three insurance agents to obtain the information
requested below. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.autoinsuranceindepth.com www.progressive.com www.standardandpoors.com
What’s Next for Your Personal Financial Plan?
• Research actions that you might take to reduce automobile insurance costs.
• Talk to friends, relatives, and insurance agents to determine methods of reducing the cost of auto insurance.
Automobile (year, make, model, engine size)
Driver’s age Sex Total miles driven in a year
Full- or part-time driver?
Driver’s education completed?
Accidents or violations within the past three years?
Company name
Agent’s name, address,
and phone
E-mail, website
Policy length
(6 months, 1 year)
Coverage: Premium Premium Premium
Bodily injury liability
Per person
$
Per accident
$
Property damage
liability per accident
$
Collision deductible
$
Comprehensive
deductible
$
Medical payments
per person
$
Uninsured motorist
liability
Per person
$
Per accident
$
Other coverage
Service charges
Total Premium
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3 Steps to Financial
Literacy . . . Income Percent
Covered by Disability
9 Health and Disability Income Insurance
A commonly overlooked element of financial
planning is disability income insurance. Many
financial experts point out that people between
the ages of 40 and 65 have a greater chance
of missing at least three months of work due to
an accident or illness than they do of dying. At
the end of the chapter, “Your Personal Finance
Dashboard” will provide guidelines for deter-
mining the appropriate coverage for disability
income insurance for your life situation.
1
Calculate the amount of income that you
would need if you are unable to work due to a
non-work-related accident or illness.
App: Mint
2
Determine if you have disability income
insurance coverage through your employer.
Website: www.ssa.gov
3
Decide if you need additional disability income
insurance to protect you against loss of
income.
Website: www.defendyourincome.org
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Health Insurance and Financial Planning
What Is Health Insurance?
Health insurance is a form of protection that eases the financial burden people may experi-
ence as a result of illness or injury. You pay a premium, or fee, to the insurer. In return the
company pays most of your medical costs. Although plans vary in what they cover, they
may reimburse you for hospital stays, doctors’ visits, medications, and sometimes vision
and dental care.
Health insurance includes both medical expense insurance, as discussed above, and dis-
ability income insurance. Medical expense insurance typically pays only the actual med-
ical costs. Disability income insurance provides payments to make up for some of the
income of a person who cannot work as a result of injury or illness. In this chapter the term
“health insurance” refers to medical expense insurance.
Health insurance plans can be purchased in several different ways: group health insur-
ance, individual health insurance, and COBRA.
GROUP HEALTH INSURANCE Most people who have health insurance are cov-
ered under group plans. Typically, these plans are employer sponsored. This means that the
employer offers the plans and usually pays some or all of the premiums. However, not all
employers provide health insurance to their employees. The Affordable Care Act of 2010
requires large employers to provide health insurance coverage for all employees. Other
organizations, such as labor unions and professional associations, also offer group plans.
Group insurance plans cover you and your immediate family. The Health Insurance Por-
tability and Accountability Act of 1996 (HIPAA) set new federal standards to ensure that
workers would not lose their health insurance if they changed jobs. As a result, a parent
with a sick child, for example, can move from one group health plan to another without a
LO9.1
Recognize the importance of
health insurance in financial
planning.
ACTION ITEM
I am aware of several
different ways of purchasing
health insurance.
h Yes h No
CHAPTER 9 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO9.1 Recognize the importance of health insurance in financial planning.
LO9.2 Analyze the costs and benefits of various types of health insurance coverage as
well as major provisions in health insurance policies.
LO9.3 Assess the trade-offs of different health insurance plans.
LO9.4 Evaluate the differences among health care plans offered by private companies
and by the government.
LO9.5 Explain the importance of disability income insurance in financial planning and
identify its sources.
LO9.6 Explain why the costs of health insurance and health care have been increasing.
YOUR PERSONAL FINANCIAL PLAN SHEETS
31. Assessing Current and Needed Health Care Insurance
32. Disability Income Insurance Needs
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• Assess your benefit coverage as your family
status changes. Marriage, divorce, childbirth or
adoption, or the death of a spouse are life events
that may require changes in your health benefits.
You, your spouse, and dependent children may
be eligible for a special enrollment period under
provisions of the Health Insurance Portability and
Accountability Act (HIPAA). Even without life-
changing events, the information provided by your
employer should tell you how you can change
benefits or switch plans, if more than one plan is
offered.
• Know that changing jobs and other life events
can affect your health benefits. Under COBRA,
you, your covered spouse, and your dependent
children may be eligible to purchase extended health
coverage under your employer’s plan if you lose
your job, change employers, get divorced, or upon
occurrence of certain other events.
• Look for wellness programs. More and more
employers are establishing wellness programs that
encourage employees to work out, stop smoking,
and generally adopt healthier lifestyles.
• Plan for retirement. Before you retire, find out
what health benefits, if any, extend to you and
your spouse during your retirement years. Consult
with your employer’s human resources office,
your union, and the plan administrator, and check
your SPD.
• Know how to file an appeal if your health
benefits claim is denied. Understand how your
plan handles grievances and where to make
appeals of the plan’s decisions. Keep records and
copies of correspondence. Check your health
benefits package and your SPD to determine who
is responsible for handling problems with benefit
claims.
SOURCE: U.S. Department of Labor ( www.dol.gov/ebsa/publications ),
accessed May 28, 2014.
The Department of Labor’s Employee Benefits Secu-
rity Administration (EBSA) administers several important
health benefit laws covering employer-based health plans.
These laws govern your basic rights to information about
how your health plan works, how to qualify for benefits,
and how to make claims for benefits. In addition, there are
specific laws protecting your right to health benefits when
you lose coverage or change jobs.
• Realize that your options are important. There are
many different types of health benefit plans. Find out
which one your employer offers, and then check out
the plan, or plans, offered. Your employer’s human
resource office, the health plan administrator, or your
union can provide information to help you match your
needs and preferences with the available plans. If
your employer offers a high-deductible health plan,
look into setting up a Health Savings Account to save
money for future medical expenses on a tax-free
basis. The more information you have, the better your
health care decisions will be.
• Review the benefits available. Do the plans cover
preventive care, well-baby care, vision or dental
care? Are there deductibles? Answers to these
questions can help determine the out-of-pocket
expenses you may face. Matching your needs and
those of your family members will result in the best
possible benefits. Cheapest may not always be best.
Your goal is high-quality health benefits.
• Read your plan’s Summary Plan Description (SPD).
Provided by your health plan administrator, the SPD
outlines your benefits and your legal rights under the
Employee Retirement Income Security Act (ERISA),
the federal law that protects your health benefits. It
should contain information about the coverage of
dependents, what services will require a copay, and
the circumstances under which your employer can
change or terminate a health benefits plan. Save
the SPD and all other health plan brochures and
documents, along with memos or correspondence
from your employer relating to health benefits.
Starting a New Job? Make Your Health Benefits Work for You
Personal Finance in Practice
lapse in coverage. Moreover, the parent will not have to pay more for coverage than other
employees do.
Are you starting a new job? Read the nearby “Personal Finance in Practice” box to
make your group health benefits work for you.
The cost of group insurance is relatively low because many people are insured under the
same policy —a contract with a risk-sharing group, or insurance company. However, group
insurance plans vary in the amount of protection that they provide. For example, some
plans limit the amount that they will pay for hospital stays and surgical procedures. If your
plan does not cover all of your health insurance needs, you have several choices.
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If you are married, you may be able to take advantage of a coordination of benefits
(COB) provision, which is included in most group insurance plans. This provision allows
you to combine the benefits from more than one insurance plan. The benefits received
from all the plans are limited to 100 percent of all allowable medical expenses. For exam-
ple, a couple could use benefits from one spouse’s group plan and from the other spouse’s
plan up to 100 percent.
If this type of provision is not available to you, or if you are single, you can buy individ-
ual health insurance for added protection.
INDIVIDUAL HEALTH INSURANCE Some people do
not have access to an employer-sponsored group insurance plan
because they are self-employed. Others are simply dissatisfied
with the coverage that their group plan provides. In these cases
individual health insurance may be the answer. You can buy
individual health insurance directly from the company of your
choice. Plans usually cover you as an individual or cover
you and your family. Individual plans can be adapted to
meet your own needs. You should comparison shop, however,
because rates vary.
THE CONSOLIDATED OMNIBUS BUDGET RECONCILIATION ACT
OF 1986 (COBRA). If you are covered under your employer’s health plan and you
lose your job, have your hours reduced, or get laid off, and your employer’s health plan
continues to exist, you and your dependents may qualify to purchase temporary extended
health coverage under COBRA at group rates under the employer’s plan. Divorce, legal
separation, loss of dependent child status, the covered employee’s death, or entitlement
to Medicare may also give your covered spouse and dependent children the right to elect
continued coverage under COBRA. Your plan must be notified of these events. Generally,
COBRA covers group health plans maintained by employers with 20 or more employ-
ees. The group health plan is required to provide you with a written notice indicating
your eligibility for COBRA coverage. If you are eligible, you will have 60 days from the
date the notice is sent or from the date your coverage ends—whichever is later—to elect
COBRA. If the employer is too small to be subject to COBRA, state law may require the
plan’s insurer to provide some continuation coverage. Caution: Not everyone qualifies for
COBRA. You have to work for a private company or state or local government to benefit.
did you know? did you know?
Two-thirds of all health insurers use
prescription data not only to deny coverage
to individuals and families, but also to charge some
customers higher premiums or exclude certain
medical conditions from policies.
PRACTICE QUIZ 9–1 PRACTICE QUIZ 9–1
1. What is health insurance?
2. What are the three ways of purchasing health insurance?
3. For the following statements, circle “T” for true or “F” for false.
a. Health insurance is available only as a benefit from an employer. T F
b. You can continue your health insurance even if you leave a job. T F
Apply Yourself! Apply Yourself!
Ask someone in a human resources office of an organization to obtain information on the health insurance provided as
an employee benefit.
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Health Insurance Coverage
Several types of health insurance coverage are available, either through a group plan or
through individual purchase. Some benefits are included in nearly every health insurance
plan; other benefits are seldom offered.
Types of Health Insurance Coverage
BASIC HEALTH INSURANCE COVERAGE Basic health insurance coverage
includes hospital expense coverage, surgical expense coverage, and physician expense
coverage.
Hospital Expense Hospital expense coverage pays for some or all of the daily costs
of room and board during a hospital stay. Routine nursing care, minor medical supplies,
and the use of other hospital facilities are covered as well. For example, covered expenses
would include anesthesia, laboratory fees, dressings, X-rays, local ambulance service, and
the use of an operating room.
Be aware, though, that most policies set a maximum amount they will pay for each day
you are in the hospital. They may also limit the number of days they will cover. Recall
from Chapter 8 that many policies require a deductible. A deductible is a set amount that
the policyholder must pay toward medical expenses before the insurance company pays
benefits.
Surgical Expense Surgical expense insurance pays all or part of the surgeon’s fees
for an operation, whether it is done in a hospital or in the doctor’s office. Policies often
have a list of the services that they cover, which specifies the maximum payment for each
type of operation. For example, a policy might allow $500 for an appendectomy. If the
entire surgeon’s bill is not covered, the policyholder has to pay the difference. People often
buy surgical expense coverage in combination with hospital expense coverage.
Physician Expense Physician expense insurance meets some or all the costs of phy-
sician care that do not involve surgery. This form of health insurance covers treatment in a
hospital, a doctor’s office, or even a patient’s home. Plans may cover routine doctor visits,
X-rays, and lab tests. Like surgical expense, physician expense specifies maximum ben-
efits for each service. Physician expense coverage is usually combined with surgical and
hospital coverage in a package called basic health insurance.
Major Medical Expense Insurance Coverage Most people find that basic health
insurance meets their usual needs. The cost of a serious illness or accident, however, can
quickly go beyond the amounts that basic health insurance will pay. Chen had emergency
surgery, which meant an operation, a two-week hospital stay, a number of lab tests, and
several follow-up visits. He was shocked to discover that his basic health insurance paid
less than half of the total bill, leaving him with debts of more than $10,000.
Chen would have been better protected if he had had major medical expense insurance.
This coverage pays the large costs involved in long hospital stays and multiple surgeries.
In other words, it takes up where basic health insurance coverage leaves off. Almost
every type of care and treatment prescribed by a physician, in and out of a hospital, is
covered. Maximum benefits can range from $5,000 to more than $1 million per illness
per year.
Of course, this type of coverage isn’t cheap. To control premiums, most major medical
plans require a deductible. Some plans also include a coinsurance provision. Coinsurance
is the percentage of the medical expenses the policyholder must pay in addition to the
deductible amount. Many policies require policyholders to pay 20 or 25 percent of expenses
after they have paid the deductible.
LO9.2
Analyze the costs and
benefits of various types of
health insurance coverage
as well as major provisions in
health insurance policies.
ACTION ITEM
I am aware of several types
of health insurance coverage
available to me.
h Yes h No
basic health insurance
coverage Hospital expense
insurance, surgical expense
insurance, and physician
expense insurance.
hospital expense
insurance Pays part or
all of hospital bills for room,
board, and other charges.
deductible An amount
the insured must pay before
benefits become payable by
the insurance company.
surgical expense
insurance Pays part or all
of the surgeon’s fees for an
operation.
physician expense
insurance Provides
benefits for doctors’ fees for
nonsurgical care, X-rays, and
lab tests.
coinsurance A provision
under which both the insured
and the insurer share the
covered losses.
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Some major medical policies contain a stop-loss provision. Stop-loss is a p rovision that
requires the policyholder to pay all costs up to a certain amount, after which the insurance
company pays 100 percent of the remaining expenses, as long as they are covered in the
policy. Typically, the policyholder will pay between $3,000 and $5,000 in out-of-pocket
expenses before the coverage begins.
Major medical expense insurance may be offered as a single policy with basic health
insurance coverage, or it can be bought separately. Comprehensive major medical insur-
ance is a type of complete insurance that helps pay hospital, surgical, medical, and other
bills. It has a low deductible, usually $500 to $1,000. Many major medical policies set
limits on the benefits they will pay for certain expenses, such as surgery and hospital room
and board.
HOSPITAL INDEMNITY POLICIES A hospital indemnity
policy pays benefits when you’re hospitalized. Unlike most
of the other plans mentioned, however, these policies don’t
directly cover medical costs. Instead you are paid in cash,
which you can spend on medical or nonmedical expenses as
you choose. Hospital indemnity policies are used as a supple-
ment to—and not a replacement for—basic health or major
medical policies. The average person who buys such a policy,
however, usually pays much more in premiums than he or she
receives in payments.
DENTAL EXPENSE INSURANCE Dental expense insurance provides reim-
bursement for the expenses of dental services and supplies. It encourages preventive den-
tal care. The coverage normally provides for oral examinations (including X-rays and
cleanings), fillings, extractions, oral surgery, dentures, and braces. As with other insurance
plans, dental insurance may have a deductible and a coinsurance provision, stating that the
policyholder pays from 20 to 50 percent after the deductible.
VISION CARE INSURANCE An increasing number of insurance companies are
including vision care insurance as part of group plans. Vision care insurance may cover
eye examinations, glasses, contact lenses, eye surgery, and the treatment of eye diseases.
PSYCHOLOGY OF DREAD DISEASE POLICIES Dread disease, trip acci-
dent, death insurance, and cancer policies are usually sold through the mail, in newspapers
and magazines, or by door-to-door salespeople. These kinds of policies play upon unrealis-
tic fears, and they are illegal in many states. They cover only specific conditions, which are
already fully covered if you are insured under a major medical plan.
LONG-TERM CARE INSURANCE Long-term care insurance (LTC) provides
coverage for the expense of daily help that you may need if you become seriously ill or
disabled and are unable to care for yourself. It is useful whether you require a lengthy stay
in a nursing home or just need help at home with daily activities such as dressing, bathing,
stop-loss A provision
under which an insured pays
a certain amount, after which
the insurance company pays
100 percent of the remaining
covered expenses.
long-term care insurance
(LTC) Provides day-in, day-
out care for long-term illness
or disability.
did you know? did you know?
The Coalition Against Insurance Fraud
provides “scam alerts” on phony health
coverage, including a list of 10 warning signs.
Visit www.insurancefraud.org .
EXAMPLE: Deductibles and Coinsurance
Ariana’s policy includes an $800 deductible and a coinsurance provision requiring
her to pay 20 percent of all bills. If her bill total is $3,800, for instance, the company
will first exclude $800 from coverage, which is Ariana’s deductible. It will then pay
80 percent of the remaining $3,000, or $2,400. Therefore, Ariana’s total costs are
$1,400 ($800 for the deductible and $600 for the coinsurance).
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. Why is it important to work with your parent’s doctor to provide the information the insurer needs for
long-term-care benefits?
2. Why might you want to have a caregiver come in for a shorter period for more days rather than a longer
period for fewer days?
3. Why is it important to keep track of the paperwork submitted to an insurance company?
4. What steps can you take if your claim is denied?
A
long-term-care
insurance policy
can help cover the
costs of care in a
nursing home, an assisted-
living facility or at home.
Follow these steps, and you’re
more likely to get through the
claims process smoothly.
1. Find out what triggers
benefits. Most policies pay only
if the patient needs help with at
least two out of six activities of
daily living (such as bathing or
dressing) or there is evidence
of cognitive impairment. But
the requirements for making a
claim vary. Work with your par-
ent’s doctor to provide the infor-
mation the insurer needs.
2. Find out about home-care
requirements. If you plan to
provide care at home for your
parent, call the insurer to find
out about requirements for
payouts—especially before you
hire a caregiver to come into the
home. Some insurers require
home caregivers to be licensed
or from an agency, for exam-
ple. A few pay benefits even
to relatives who provide care.
Many insurers have care coordi-
nators who can help you search
for caregivers or facilities.
3. Understand the waiting
period. Most policies have
waiting periods of at least 60 days.
However, some companies
have a zero-day waiting period
for home care but a longer
waiting period for assisted liv-
ing or nursing homes. Others
count every calendar day from
the time your parent met the
requirement for needing help
with activities of daily living
or the cognitive-impairment
requirement, even if he or she
didn’t receive care every day.
Still others count only the days
on which your parent received
care—which can extend the
waiting period. To speed things
up, you may want to have a
caregiver come in for a shorter
period for more days rather than
a longer period for fewer days.
4. Keep track of the paperwork.
That includes forms you
submit and communications
with the facility and the
long-term-care insurer. Some-
times payouts are delayed
because of paperwork issues.
Keep records of all phone
calls and dates that you or
the doctor or the facility sent
information, and follow up
to make sure the paperwork
has been received. Also ask
your insurer or agent if there
is anything you can do to
streamline the paperwork;
some insurers will arrange
direct billing between the
nursing home and insurer.
5. Appeal a denied claim. If
you have a dispute, work
through the insurer’s appeals
process, and contact your state
insurance department for help
(see www.naic.org for links).
Kimberly Lankford
Get a Long-Term-Care Insurer to Pay Up
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and household chores. Annual premiums range from less than $1,000 to over $16,000,
depending on your age and extent of the coverage. The older you are when you enroll, the
higher your annual premium. Typically, individual insurance plans are sold to the 50- to
80-year age group, pay benefits for a maximum of two to six years, and carry a dollar limit
on the total benefits they will pay.
According to experts, long-term care protection makes sense for people with a net worth of
$100,000 to $2 million. If your net worth is less than $100,000, you will exhaust your assets
and qualify for Medicaid; if your assets are more than $2 million, you can fund your own
long-term care. If you purchase a policy, consider at least a three-year term with a daily bene-
fit that would cover the nursing-facility cost in your area. Recently, the national daily average
of a nursing facility was $229 per day, or more than $83,585 per year. The nearby “Personal
Finance in Practice” box can help you compare the features of long-term care policies.
Explore services available in your community to help meet long-term care needs. Care
given by family members can be supplemented by visiting nurses, home health aides,
friendly visitor programs, home-delivered meals, chore services, adult day care centers,
and respite services for caregivers who need a break from daily responsibilities.
These services are becoming more widely available. Some or all of them may be found
in your community. Your local area Agency on Aging or Office on Aging can help you
locate the services you need. Call the Eldercare Locator at 1-800-677-1116 to locate your
local office.
Major Provisions in a Health Insurance Policy
All health insurance policies have certain provisions in common. You have to be sure that
you understand what your policy covers. What are the benefits? What are the limits? The
following are details of provisions that are usually found in health insurance policies:
• Eligibility: The people covered by the policy must meet specified eligibility
requirements, such as family relationship and, for children, a certain age.
• Assigned benefits: You are reimbursed for payments when you turn in your bills and
claim forms. When you assign benefits, you let your insurer make direct payments
to your doctor or hospital.
• Internal limits: A policy with internal limits sets specific levels of repayment for
certain services. Even if your hospital room costs $600 a day, you won’t be able to
get more than $250 if an internal limit specifies that maximum.
• Copayment: A copayment is a flat fee that you pay every time you receive a
covered service. The fee is usually between $20 and $30, and the insurer pays the
balance of the cost of the service. This is different from coinsurance, which is the
percentage of your medical costs for which you are responsible after paying your
deductible.
• Service benefits: Policies with this provision list coverage in terms of services, not
dollar amounts: You’re entitled to X-rays, for instance, not $40 worth of X-rays per
visit. Service benefits provisions are always preferable to dollar amount coverage
because the insurer will pay all the costs.
• Benefit limits: This provision defines a maximum benefit, either in terms of a dollar
amount or in terms of number of days spent in the hospital.
• Exclusions and limitations: This provision specifies services that the policy does
not cover. It may include preexisting conditions (a condition you were diagnosed
with before your insurance plan took effect), cosmetic surgery, or more.
• Guaranteed renewable: This provision means that the insurer can’t cancel the
policy unless you fail to pay the premiums. It also forbids insurers to raise
premiums unless they raise all premiums for all members of your group.
• Cancellation and termination: This provision explains the circumstances under
which the insurer can cancel your coverage. It also explains how you can convert
your group contract into an individual contract.
copayment A provision
under which the insured pays
a flat dollar amount each time
a covered medical service is
received after the deductible
has been met.
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What do you need to know when you are comparing LTC policies? You should consider asking the following questions:
Shopping for a Long-Term Care Policy
Personal Finance in Practice
Policy 1 Policy 2
1. Are these services covered?
Skilled Nursing Care _______ ______
Home Health Care _______ ______
Custodial/Personal Care _______ ______
Homemaker Services _______ ______
2. What is the daily allowance for these
services?
Skilled Nursing Care _______ ______
Home Health Care _______ ______
Custodial/Personal Care _______ ______
Homemaker Services _______ ______
3. Does this policy pay for care in any
licensed facility? _______ ______
If not, what won’t it pay for? _______ ______
4. Does the policy pay for care
received in:
Adult day care centers? _______ ______
Assisted living facilities? _______ ______
One’s home? _______ ______
5. How long will the policy pay
benefits for:
Home Health Care? _______ ______
Skilled Nursing Care? _______ ______
Custodial/Personal Care? _______ ______
Homemaker Services? _______ ______
Adult Day Care Centers? _______ ______
Assisted Living Facilities? _______ ______
6. What is the policy’s maximum lifetime
benefit?
For Home Care _______ ______
For Assisted Living Facility Care _______ ______
For Nursing Home Care _______ ______
Policy 1 Policy 2
7. What is the waiting period before bene-
fits begin for:
Home Health Care? _______ ______
Assisted Living Facility Care? _______ ______
Nursing Home Care? _______ ______
Is the waiting period calendar days, or
covered service days? _______ ______
8. How long will it be before pre-existing
conditions are covered? _______ ______
9. What does the policy use to decide if
you’re eligible for benefits?
Inability to complete activities of daily
living (ADLs) _______ ______
Doctor certification of medical
necessity _______ ______
Prior hospital stay _______ ______
Cognitive impairment _______ ______
Other _______ ______
10. Is the policy renewable? _______ ______
11. Does the policy offer inflation protection? _______ ______
12. Are benefits adjusted for inflation? _______ ______
13. Are you allowed to buy more coverage? _______ ______
14. Is there a waiver-of-premium provision?
If so:
How long must you be in a nursing
home before it begins? _______ ______
Does the waiver apply to home care? _______ ______
15. What is the annual cost of the policy? _______ ______
With inflation adjustment _______ ______
Without inflation adjustment _______ ______
16. Is there a free trial period? _______ ______
SOURCE: Adapted from the National Association of Insurance Commission-
ers publication “A Shopper’s Guide to Long-Term Care Insurance.”
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Health Insurance Trade-Offs
Different health insurance policies may offer very different benefits. As you decide which
insurance plan to buy, consider the following trade-offs.
Coverage Trade-Offs
REIMBURSEMENT VERSUS INDEMNITY A reimbursement policy pays
you back for actual expenses. An indemnity policy provides you with specific amounts,
regardless of how much the actual expenses may be.
LO9.3
Assess the trade-offs of
different health insurance
plans.
ACTION ITEM
In choosing health insurance
coverage, I should get a
basic plan and a major
medical supplement policy.
h Yes h No
PRACTICE QUIZ 9–2 PRACTICE QUIZ 9–2
1. What three types of coverage are included in the basic health insurance?
2. What benefits are provided by:
a. Hospital expense coverage?
b. Surgical expense coverage?
c. Physician expense coverage?
3. Match the following terms with an appropriate statement.
coinsurance a. Requires the policyholder to pay all costs up to a certain amount. __________________
stop-loss b. The percentage of the medical expenses you must pay. ___________________________
hospital indemnity policy c. A policy used as a supplement to basic health or major medical policies. ____________
exclusions and limitations d. Defines who is covered by the policy. ___________________________________________
copayment e. Specifies services that the policy does not cover. _________________________________
eligibility f. A flat fee that you pay every time you receive a covered service. ____________________
Apply Yourself! Apply Yourself!
Raj is thinking about buying major medical insurance to supplement his basic health insurance from work. Describe a
situation in which Raj would need major medical.
EXAMPLE: Reimbursement versus Indemnity
Katie and Seth are both charged $200 for an office visit to the same specialist.
Katie’s reimbursement policy has a deductible of $300. Once she has met the
deductible, the policy will cover the full cost of such a visit. Seth’s indemnity policy
will pay him $125, which is what his plan provides for a visit to any specialist.
INTERNAL LIMITS VERSUS AGGREGATE LIMITS A policy with inter-
nal limits will cover only a fixed amount for an expense, such as the daily cost of room and
board during a hospital stay. A policy with aggregate limits will limit only the total amount
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of coverage (the maximum dollar amount paid for all benefits in
a year), such as $1 million in major expense benefits, or it may
have no limits.
DEDUCTIBLES AND COINSURANCE The cost of
a health insurance policy can be greatly affected by the size of
the deductible (the set amount that the policyholder must pay
toward medical expenses before the insurance company pays
benefits). It can also be affected by the terms of the coinsurance
provision (which states what percentage of the medical expenses
the policyholder must pay in addition to the deductible amount).
OUT-OF-POCKET LIMITS Some policies limit the amount of money you must
pay for the deductible and coinsurance. After you have reached that limit, the insurance
company covers 100 percent of any additional costs. Out-of-pocket limits help you lower
your financial risk, but they also increase your premiums.
BENEFITS BASED ON REASONABLE AND CUSTOMARY CHARGES
Some policies consider the average fee for a service in a particular geographical area. They
then use the amount to set a limit on payments to policyholders. If the standard cost of a
certain procedure is $1,500 in your part of the country, then your policy won’t pay more
than that amount.
Which Coverage Should You Choose?
Now that you are familiar with the available types of health insurance and some of their
major provisions, how do you choose one? The type of coverage you choose will be
affected by the amount you can afford to spend on the premiums and the level of benefits
that you feel you want and need. It may also be affected by the kind of coverage your
employer offers, if you are covered through your employer.
You can buy basic health coverage, major medical coverage, or both basic and major
medical coverage. Any of these three choices will take care of at least some of your
medical expenses. Ideally, you should get a basic plan and a major medical supplement.
Another option is to purchase a comprehensive major medical policy that combines the
value of both plans in a single policy. Exhibit 9–1 describes the most basic features you
should look for.
did you know? did you know?
International health care insurance provides
health coverage no matter where you are
in the world. The policy term is flexible so you can
purchase only for the time you will be out of the
country. Check online or contact your current health
care provider for coverage information.
A health insurance plan should:
• Offer basic coverage for hospital and doctor bills .
• Provide at least 120 days’ hospital room and board in full .
• Provide at least a $1 million lifetime maximum for each family member .
• Pay at least 80 percent for out-of-hospital expenses after a yearly deductible of $500 per person
or $1,000 per family .
• Impose no unreasonable exclusions .
• Limit your out-of-pocket expenses to no more than $3,000 to $5,000 a year, excluding dental,
vision care, and prescription costs .
Although health insurance plans vary greatly, all plans should have the same basic features.
Would you add anything to this list of must-haves?
Exhibit 9–1
Health Insurance
Must-Haves
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Private Health Care Plans and Government
Health Care Programs
Private Health Care Plans
Most health insurance in the United States is provided by private organizations rather than
by the government. Private health care plans may be offered by a number of sources: pri-
vate insurance companies; hospital and medical service plans; health maintenance orga-
nizations; preferred provider organizations; home health care agencies; and employer
self-funded health plans.
PRIVATE INSURANCE COMPANIES Several hundred private insurance com-
panies are in the health insurance business. They provide mostly group health plans to
employers, which in turn offer them to their employees as a benefit. Premiums may be
fully or partially paid by the employer, with the employee paying any remainder. These
policies typically pay you for medical costs you incur, or they send the payment directly to
the doctor, hospital, or lab that provides the services.
HOSPITAL AND MEDICAL SERVICE PLANS Blue Cross and Blue Shield
are statewide organizations similar to private health insurance companies. Each state has
its own Blue Cross and Blue Shield. The “Blues” provide health insurance to millions of
Americans. Blue Cross provides hospital care benefits. Blue Shield provides benefits for
surgical and medical services performed by physicians.
LO9.4
Evaluate the differences
among health care plans
offered by private companies
and by the government.
ACTION ITEM
I am aware of health care
plans offered by private
companies and by the
government.
h Yes h No
Blue Cross An independent
membership corporation that
provides protection against
the cost of hospital care.
PRACTICE QUIZ 9–3 PRACTICE QUIZ 9–3
1. As you decide which health insurance plan to buy, what trade-offs would you consider?
2. Match the following terms with an appropriate statement.
reimbursement a. A policy that will cover only a fixed amount of an expense. ___________________________
indemnity b. A policy that pays you back for actual expenses. ___________________________________
internal limits c. A policy that provides you with specific amounts, regardless of how much the actual
expenses may be. ______________________________________________________________
deductible d. After you have reached a certain limit, the insurance company covers 100 percent of any
additional cost. _________________________________________________________________
out-of-pocket limit e. The set amount that you must pay toward medical expenses before the insurance com-
pany pays benefits. _____________________________________________________________
3. What basic features should be included in your health insurance plan?
Apply Yourself! Apply Yourself!
Prepare a list of trade-offs that are important to you in a health insurance policy.
Sheet 31 Assessing Current and Needed
Health Care Insurance
S
H
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296 Chapter 9 Health and Disability Income Insurance
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HEALTH MAINTENANCE ORGANIZATIONS Ris-
ing health care costs have led to an increase in managed care
plans. According to a recent industry survey, 23 percent of
employed Americans are enrolled in some form of managed
care. Managed care refers to prepaid health plans that provide
comprehensive health care to their members. Managed care is
designed to control the cost of health care services by con-
trolling how they are used. Managed care is offered by health
maintenance organizations (HMOs), preferred provider organi-
zations (PPOs), and point-of-service plans (POSs).
Health maintenance organizations are an alternative to basic
health insurance and major medical expense insurance. A health
maintenance organization (HMO) is a health insurance plan
that directly employs or contracts with selected physicians and
other medical professionals to provide health care services in
exchange for a fixed, prepaid monthly premium.
HMOs are based on the idea that preventive services will
minimize future medical problems. Therefore, these plans typ-
ically cover routine immunizations and checkups, screening
programs, and diagnostic tests. They also provide customers with coverage for surgery,
hospitalization, and emergency care. If you have an HMO, you will usually pay a small
copayment for each covered service. Supplemental services may include vision care and
prescription services, which are typically available for an additional fee.
When you first enroll in an HMO, you must choose a plan physician from a list of doc-
tors provided by the HMO. The physician provides or arranges for all of your health care
services. You must receive care through your plan physician; if you don’t, you are respon-
sible for the cost of the service. The only exception to this rule is in the case of a medical
emergency. If you experience a sudden illness or injury that would threaten your life or
health if not treated immediately, you may go to the emergency room of the nearest hospi-
tal. All other care must be provided by hospitals and doctors under contract with the HMO.
HMOs are not for everyone. Many HMO customers complain that their HMO denies
them necessary care. Others feel restricted by the limited choice of doctors.
Exhibit 9–2 provides some tips on using and choosing an HMO: Because HMOs require
you to use only certain doctors, you should make sure that these doctors are near your
home or office. You should also be able to change doctors easily if you don’t like your first
choice. Similarly, second opinions should always be available at the HMO’s expense, and
you should be able to appeal any case in which the HMO denies care. Finally, look at the
costs and benefits: Will you incur out-of-pocket expenses or copayments? What services
will the plan provide?
PREFERRED PROVIDER ORGANIZATIONS A variation on the HMO is a
preferred provider organization (PPO) , a group of doctors and hospitals that agree to pro-
vide specified medical services to members at prearranged fees. PPOs offer these dis-
counted services to employers either directly or indirectly through an insurance company.
The premiums for PPOs are slightly higher than the premiums for HMOs.
PPO plan members often pay no deductibles and may make minimal copayments.
Whereas HMOs require members to receive care from HMO providers only, PPOs allow
members greater flexibility. Members can either visit a preferred provider (a physician
whom you select from a list, as in an HMO) or go to their own physicians. Patients who
decide to use their own doctors do not lose coverage as they would with an HMO. Instead
they must pay deductibles and larger copayments.
Increasingly, the difference between PPOs and HMOs is becoming less clear. A point-
of-service (POS) plan combines features of both HMOs and PPOs. POSs use a network of
participating physicians and medical professionals who have contracted to provide ser-
vices for certain fees. As with your HMO, you choose a plan physician who manages your
Blue Shield An
independent membership
corporation that provides
protection against the cost of
surgical and medical care.
managed care Prepaid
health plans that provide
comprehensive health care to
members.
health maintenance
organization (HMO) A
health insurance plan that
provides a wide range of
health care services for
a fixed, prepaid monthly
premium.
preferred provider
organization (PPO) A
group of doctors and
hospitals that agree to
provide health care at rates
approved by the insurer.
point-of-service (POS)
plan A network of selected
contracted, participating
providers; also called an
HMO-PPO hybrid or open-
ended HMO.
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How to Use an HMO
When you first enroll in an HMO, you must choose a plan
physician (family practitioner, internist, pediatrician, or obste-
trician-gynecologist) who provides or arranges for all of your
health care services. It is extremely important that you receive
your care through the plan physician. If you don’t, you are
responsible for the cost of the service rendered.
The only exceptions to the requirement that care be received
through the plan physician are medical emergencies. A medical
emergency is a sudden onset of illness or a sudden injury that
would jeopardize your life or health if not treated immediately.
In such instances, you may use the facilities of the nearest
hospital emergency room. All other care must be provided by
hospitals and doctors under contract with the HMO.
How to Choose an HMO
If you decide to enroll in an HMO, you should consider these
additional factors:
1. Accessibility. Since you must use plan providers, it is
extremely important that they be easily accessible from your
home or office.
2. Convenient office hours. Your plan physician should have
convenient office hours.
3. Alternative physicians. Should you become dissatisfied with
your first choice of a physician, the HMO should allow you
the option to change physicians.
4. Second opinions. You should be able to obtain second
opinions.
5. Type of coverage. You should compare the health care
services offered by various HMOs, paying particular atten-
tion to whether you will incur out-of-pocket expenses or
copayments.
6. Appeal procedures. The HMO should have a convenient and
prompt system for resolving problems and disputes.
7. Price. You should compare the prices various HMOs charge
to ensure that you are getting the most services for your
health care dollar.
What to Do When an HMO Denies
Treatment or Coverage
• Get it in writing. To better defend your case, ask for a letter
detailing the clinical reasons your claim was denied and
the name and medical expertise of the HMO staff member
responsible.
• Know your rights. The plan document or your HMO’s
member services department will tell you how experimental
treatments are defined and covered and how the appeals
process works.
• Keep records. Make copies of any correspondence, including
payments and any reimbursements. Also, keep a written log
of all conversations relevant to your claim.
• Find advocates. Enlist the help of your doctor, employer, and
state insurance department to lobby your case before the
HMO.
SOURCE: Reprinted from the May 18, 1997, issue of BusinessWeek by special permission © 1999 McGraw-Hill Companies, Inc.
Exhibit 9–2 Tips on Using and Choosing an HMO
care and controls referrals to specialists. As long as you receive care from a plan provider,
you pay little or nothing, just as you would with an HMO. However, you’re allowed to seek
care outside the network at a higher charge, as with a PPO.
HOME HEALTH CARE AGENCIES Rising hospital costs, new medical technol-
ogy, and the increasing number of elderly people have helped make home care one of the
fastest-growing areas of the health care industry. Home health care consists of home health
agencies; home care aide organizations; and hospices, facilities that care for the terminally
ill. These providers offer medical care in a home setting in agreement with a medical order,
often at a fraction of the cost hospitals would charge for a similar service.
EMPLOYER SELF-FUNDED HEALTH PLANS Some companies choose to
self-insure. The company runs its own insurance plan, collecting premiums from employ-
ees and paying medical benefits as needed. However, these companies must cover any
costs that exceed the income from premiums. Unfortunately, not all corporations have the
financial assets necessary to cover these situations, which can mean a financial disaster for
the company and its employees.
NEW HEALTH CARE ACCOUNTS Health savings accounts (HSAs), which
Congress authorized in 2003, are the newest addition to the alphabet soup of health insur-
ance available to American workers. Now you and your employer must sort through HSAs,
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5. Your company can match part or all of your HSA contri-
butions if it wishes, just as it does with 401(k)s.
6. You can invest your HSA in stocks, bonds, or mutual
funds. Unused money remains in your account at the
end of the year and grows tax-free.
7. You can also take your HSA with you if you change jobs
or retire.
8. To help you shop for health care now that you’re
spending your own money, employers say they will give
you detailed information about prices and quality of
doctors and hospitals in your area.
SOURCE: U.S. Department of the Treasury ( www.irs.gov/pub/irs-
drop/rp-13-25 ), accessed May 24, 2014.
1. Your company offers a health insurance policy with an
annual deductible of at least $1,250.
2. You can put pretax dollars into an HSA each year, up to
the amount of the deductible—but no more than $6,550
for family coverage or $3,300 for individual coverage,
plus a $1,000 catch-up contribution for those who are
over 55.
3. You withdraw the money from your HSA tax-free, but
it can be used only for your family’s medical expenses.
After the deductible and copays are met, insurance still
typically covers 80 percent of health costs.
4. HSA plans are required to have maximum out-of-
pocket spending limits, $6,350 for individuals, $12,700
for families. That’s when your company’s insurance
kicks in again at 100 percent coverage.
HSAs: How They Work in 2014
Personal Finance in Practice
health reimbursement accounts (HRAs), and flexible spending accounts (FSAs). Each has
its own rules about how money is spent, how it can be spent, and how it is taxed.
How do FSAs, HRAs, and HSAs differ? FSAs allow you to contribute pretax dollars
to an account managed by your employer. You use the money for health care spending but
forfeit anything left over at the end of the year.
HRAs are tied to high-deductible policies. They are funded solely by your employer
and give you a pot of money to spend on health care. You can carry over unspent money
from year to year, but you lose the balance if you switch jobs. Premiums tend to be lower
than for traditional insurance but higher than for HSAs. You can invest the funds in stocks,
bonds, and mutual funds. The money grows tax-free but can be spent only on health care.
HSAs allow you to contribute money to a tax-free account that can be used for out-of-
pocket health care expenses if you buy high-deductible health insurance policies to cover
catastrophic expenses. Exhibit 9–3 summarizes the important features of HSAs, FSAs, and
HRAs. Also, read the “Personal Finance in Practice” box to learn how HSAs work in 2014.
In addition to the private sources of health insurance and health care discussed in this
section, government health care programs cover over 50 million people. The next section
discusses these programs.
Government Health Care Programs
The health insurance coverage discussed thus far is normally purchased through private
companies. Some consumers, however, are eligible for health insurance coverage under
programs offered by federal and state governments.
MEDICARE Perhaps the best-known government health program is Medicare. Medi-
care is a federally funded health insurance program available mainly to people over 65 and
to people with disabilities. Medicare has four parts: hospital insurance (Part A), medical
insurance (Part B), Medicare Advantage Plan (Part C), and Prescription Drug Coverage
(Part D). Medicare hospital insurance is funded by part of the Social Security payroll tax.
Part A helps pay for inpatient hospital care, inpatient care in a skilled nursing facility,
home health care, and hospice care. Program participants pay a single annual deductible.
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Part B helps pay for doctors’ services and a variety of other medical services and sup-
plies not covered or not fully covered by Part A. Part B has a deductible and a 20 percent
coinsurance provision. Medicare medical insurance is a supplemental program paid for by
individuals who feel that they need it. A regular monthly premium is charged. The federal
government matches this amount. For a brief summary of Medicare Parts A, B, C, and D,
see the nearby “Personal Finance in Practice” box.
Medicare is constantly in financial trouble. Health care costs continue to grow, and the
proportion of senior citizens in society is rising. This situation puts Medicare in danger of
running out of funds. According to recent projections, the program will be bankrupt by the
year 2035 if no changes are made.
The Balanced Budget Act of 1997 created the new Medicare Choice program. This
program allows many Medicare members to choose a managed care plan in addition to
their Medicare coverage. For some additional costs, members can receive greater benefits.
Exhibit 9–4 compares features of different Medicare options.
What Is Not Covered by Medicare? Although Medicare is very helpful for meeting
medical costs, it does not cover everything. In addition to the deductibles and coinsurance
payments, Medicare will not cover some medical expenses at all. These are certain types
of skilled or long-term nursing care, out-of-hospital prescription drugs, routine checkups,
dental care, and most immunizations. Medicare also severely limits the types of services
it will cover and the amount it will pay for those services. If your doctor does not accept
Medicare’s approved amount as payment in full, you’re responsible for the difference.
Medigap Those eligible for Medicare who would like more coverage may buy Medigap
(MedSup) insurance . Medigap insurance supplements Medicare by filling the gap between
Medicare payments and medical costs not covered by Medicare. It is offered by private com-
panies. For more information about Medicare supplement insurance, visit www.medicare
.gov/publications , or call 1-800-Medicare and request the booklet “Choosing a Medigap
Policy: A Guide to Health Insurance for People with Medicare.” You may also visit
http://www.medicare.gov/supplement-other-insurance/medigap/whats-medigap.html or call
your state insurance department.
Medigap (MedSup)
insurance Supplements
Medicare by filling the gap
between Medicare payments
and medical costs not
covered by Medicare.
Health Savings Accounts
(HSAs)
Flexible-Spending
Accounts (Arrangements)
(FSAs)
Health Reimbursement
Accounts (HRAs)
• Employer sponsored
• Set aside tax-free dollars
you can use to pay for med-
ical expenses that are not
covered by insurance
• Tied to a high-deductible
policy
• Unspent money can be car-
ried over and accumulate
year to year
• Can invest the funds in
stocks, bonds, and mutual
funds
• The money grows tax-free
but can be spent only on
health care
• You own the funds; you take
any unspent funds with you
if you leave the employer
• Employer sponsored
• Set aside tax-free dollars
you can use to pay for med-
ical expenses that are not
covered by insurance
• Not tied to a high-deductible
policy
• Money left over can’t be car-
ried over; if you don’t use it,
you lose it to your employer
• Employer sponsored
• Funded solely by your
employer to spend on your
health care
• Reimbursement of claims is
tax-deductible for employers
• Tied to high-deductible
policies
• The maximum annual contri-
bution is determined by your
employer’s plan document
• Can carry over unspent
money from year to year, but
you lose the balance if you
change jobs
• Premiums tend to be lower
than for traditional insurance
but higher than for HSAs
Exhibit 9–3
Comparison of HSAs,
FSAs, and HRAs
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Most people get their Medicare health care coverage in
one of two ways. Your costs vary depending on your plan,
coverage, and the services you use.
MEDICARE ADVANTAGE PLANS LIKE
HMOS AND PPOS
Called “Part C,” this option combines your Part A
(Hospital) and Part B (Medical)
Private insurance companies approved by Medicare pro-
vide this coverage. Generally, you must see doctors in the
plan. Your costs may be lower than in the Original Medi-
care Plan, and you may get extra benefits.
1
Part D (Prescription Drug Coverage)
Most Part C plans cover prescription drugs. If they don’t,
you may be able to choose this coverage. Plans cover dif-
ferent drugs. Medically necessary drugs must be covered.
For information about Medicare, visit www.medicare.gov
or call 1-800-MEDICARE (1-800-633-4227).
SOURCE: Medicare & You (Washington, DC: The Centers for
Medicare and Medicaid Services, 2014).
Medicare is health insurance for people age 65 or older,
under age 65 with certain disabilities, and any age with
end-stage renal disease (permanent kidney failure requir-
ing dialysis or a kidney transplant).
ORIGINAL MEDICARE PLAN
Part A
(Hospital)
Part B
(Medical)
Medicare provides this coverage. Part B is optional. You
have your choice of doctors. Your costs may be higher
than in Medicare Advantage Plans.
1
Part D
(Prescription Drug Coverage)
You can choose this coverage. Private companies
approved by Medicare run these plans. Plans cover differ-
ent drugs. Medically necessary drugs must be covered.
1
Medigap (Medicare Supplement Insurance) Policy
You can choose to buy this private coverage (or an
employer or union may offer similar coverage) to fill in gaps
in Part A and Part B coverage. Costs vary by policy and
company.
or
A Brief Look at Medicare
Personal Finance in Practice
MEDICAID The other well-known government health program is Medicaid, a medi-
cal assistance program offered to certain low-income individuals and families. Medicaid
is administered by states, but it is financed by a combination of state and federal funds.
Unlike Medicare, Medicaid coverage is so comprehensive that people with Medicaid do
not need supplemental insurance. Typical Medicaid benefits include physicians’ services,
inpatient and outpatient hospital services, lab services, skilled nursing and home health
services, prescription drugs, eyeglasses, and preventive care for people under the age of 21.
Health Insurance and the Patient Protection
and Affordable Care Act of 2010
Americans had been debating for years that the nation needs health care reform to ensure
that we get high-quality, affordable health care. The Patient Protection and Affordable Care
Act of 2010 sets aside $635 billion over the next 10 years to help finance this reform. Here
are the key provisions of the act that will take effect now and in the years to come. The act:
• Offers tax credits for small businesses to make employee coverage more affordable.
• Prohibits denying coverage to children with preexisting medical conditions.
• Provides access to affordable insurance for those who are uninsured because of a
preexisting condition through a temporary subsidized high-risk pool.
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• Bans insurance companies from dropping people from coverage when they get sick.
• Eliminates copayments for preventive services and exempts preventive services
from deductibles under the Medicare program.
• Requires new health plans to allow young people up to their 26th birthday to
remain on their parents’ insurance policy.
• Prohibits health insurance companies from placing lifetime caps on coverage.
• Restricts the use of annual limits to ensure access to needed care in all plans.
• Requires new private plans to cover preventive services with no copayment and
with preventive services being exempt from deductibles.
• Ensures that consumers in new plans have access to an effective internal and
external appeals process to appeal decisions by their health insurance plans.
Current
Options
New Options
(Medicare and
Choice) Plan Description
Original Medicare ✔ ✔ • You choose your health care providers.
• Medicare pays your providers for covered services.
• Most beneficiaries choose Medicare supplemental
insurance to cover deductible and copayments.
Medicare health
maintenance
organization (HMO)
✔ ✔ • You must live in the plan’s service area.
• You agree to use the plan network of doctors, hospitals,
and other health providers, except in an emergency.
• Medicare pays the HMO to provide all medical services.
Preferred provider
organization (PPO)
✔ • Works like an HMO, except you have the choice to see
a health provider out of the network.
• If you do see an out-of-network provider, you will pay
a higher cost.
Provider-sponsored
organization (PSO)
✔ • Works like a Medicare HMO, except the networks
are managed by health care providers (doctors and
hospitals) rather than an insurance company.
Private fee for service ✔ • Medicare pays a lump sum to a private insurance
health plan.
• Providers can bill more than what the plan pays; you are
responsible for paying the balance.
• The plan may offer more benefits than Original Medicare.
Medical savings
account (MSA)
✔ • Medicare MSAs are a special type of savings account
that can be used to pay medical bills.
• Centers for Medicare and Medicaid Services (CMS) will
make an annual lump-sum deposit into enrollee’s account
(only Medicare can deposit funds into this account).
• MSAs work with a special private insurance company
and carry a very high deductible.
• Funds withdrawn for nonmedical purposes are taxable
and subject to a penalty.
SOURCE: Medicare & You (Washington, DC: The Centers for Medicare and Medicaid Services, 2014).
Exhibit 9–4 A Comparison of Various Medicare Plans
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• Provides aid to states in establishing offices of health insurance consumer
assistance to help individuals with the filing of complaints and appeals.
• Increases funds for community health centers to allow for nearly a doubling of the
number of patients seen by the centers over the next five years.
• Provides new investments to increase the number of primary care practitioners,
including doctors, nurses, nurse practitioners, and physician assistants.
• Requires health insurance companies to submit justification for all requested
premium increases.
• Requires that most Americans purchase health insurance by 2014.
• Creates state-based health insurance marketplaces (also called insurance
exchanges ) through which individuals can purchase coverage, with subsidies
available to lower-income individuals.
• Expands the Medicaid program for the nation’s poorest individuals.
• Requires employers with more than 20 employees to provide health insurance to
their employees or pay penalties. 1
The law is expansive and will be implemented over several years, but all major provi-
sions took effect in January 2014. On June 28, 2012, the Supreme Court, in a 5 to 4 vote,
upheld the majority of the landmark Affordable Care Act. Under the law, if you don’t have
health insurance, you will have to pay 1 percent of your income to the IRS starting in 2014.
However, there are some exceptions for religious beliefs and financial hardship.
According to the Health and Human Services secretary,
Three years ago, the Affordable Care Act ushered in a new day for health care. Since then,
more than 6.3 million seniors and people with disabilities with Medicare have saved more
1 HealthCare.gov website at www.healthcare.gov , accessed March 20, 2013.
costs, and you’ll need income information to find out
how much.
5. Set your budget. There will be different types of health
plans to meet a variety of needs and budgets, and
breaking them down by cost can help narrow your
choices.
6. Ask your employers whether they plan to offer
health insurance, especially if you work for a small
business.
7. Explore current options. You will be able to get help
with insurance now, through existing programs or
changes that are in effect already from the new health
care law. Use HealthCare.gov resources to get infor-
mation about health insurance for adults up to age 26,
children in families with limited incomes, and Medicare
for people who are over 65 or are disabled.
SOURCE: HealthCare.gov website at http://www.healthcare.gov/
marketplace/get-ready/consumer-checklist/index.html , accessed
May 28, 2014.
Whether you are uninsured or just want to explore new
options, the Health Insurance Marketplace will give you
and your family more choice and selection in health plans.
SEVEN STEPS YOU CAN TAKE TO GET
READY NOW
1. Learn about different types of health insurance.
Through the marketplace , you’ll be able to choose a
health plan that gives you the right balance of costs
and coverage.
2. Make a list of questions before it’s time to choose
your health plan. For example, “Can I stay with my
current doctor?” or “Will this plan cover my health
costs when I’m traveling?”
3. Make sure you understand how insurance works,
including deductibles, out-of-pocket maximums,
copayments, etc. Consider these details while you’re
shopping around. Visit the HealthCare.gov website to
learn more about how insurance works.
4. Start gathering basic information about your house-
hold income. Most people will qualify to get a break on
The Affordable Care Act: Checklist for You and Your Family
Personal Finance in Practice
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than $6.1 billion on prescription drugs. Nearly 71 million Americans got expanded access
to preventive services at no charge through their private insurance plans, and 47 million
women now have guaranteed access to additional preventive services without cost sharing.
More than 3.1 million young adults who were uninsured were able to gain coverage by being
able to stay on their parents’ insurance policies until they turned 26. And parents no longer
have to worry about insurers denying coverage to their children because of a pre-existing
condition.
Americans are getting more value for their health care dollars due to the health care
law. Affordable Care Act initiatives are promoting coordinated care; paying for quality, not
quantity; and dramatically reducing fraud and waste, contributing to the slowest growth in
national health spending in 50 years. 2
The act’s opponents, however, claim that
Three years later, the act has failed to live up to its name, leaving a trail of broken promises
in its wake. Instead of lowering costs as promised and making the system simpler for
patients, the law has added a litany of new rules, regulations and fines. The pledge that ‘If
you like your current health care plan, you’ll be able to keep it’ is already broken. In fact,
the Congressional Budget Office estimated that 7 million people will lose their coverage, no
matter how much they like it. Even though the law promised that families could save $2,500
in health care premiums, the average family premium has, in fact, increased by more than
$3,000 since 2008. Moreover, the House Ways and Means Committee reported that the law
includes about $1.1 trillion in new taxes that will hit Americans at all income levels. And a
recent Government Accountability Office report shows that the law will add $6.2 trillion to the
primary deficit. Nothing is free; it’s being paid with higher taxes and insurance premiums. 3
An ethical dilemma: Is a government-run health care system that provides universal
health care to all the most ethical? The current health care issues and the health care reform
will have long-term effects on federal and state governments, insurance companies, health
care providers, pharmaceutical companies, and, most important, patients. Most Americans
believe that an ethical health care system should provide high, if not the highest, quality of
health care and freedom of choice; and it must be affordable and available to all citizens.
Will “Obamacare” have long-term positive or negative effects on the general population?
Only time will tell!
The Affordable Care Act is intended to make our health insurance system work better
for families. It also contains some of the strongest anti–health care fraud provisions in
American history.
The Affordable Care Act and the Individual
Shared Responsibility Provision
Under the Affordable Care Act, the federal government, state governments, insurers,
employers, and individuals share the responsibility for health insurance coverage begin-
ning in 2014. Many people already have qualifying health insurance coverage (called mini-
mum essential coverage) and do not need to do anything more than maintain that coverage.
The individual shared responsibility provision requires you and each member of your
family to
• Have minimum essential coverage, or
• Have an exemption from the responsibility to have minimum essential coverage, or
• Make a shared responsibility payment when you file your 2014 federal income tax
return in 2015.
2 Kathleen Sebelius, “Affordable Care Act at 3: Looking Forward and Expanding Access,” Health
Care Blog, HealthCare.gov, accessed March 22, 2013.
3 Rob Engstrom, “Three Years Ago Today,” U.S. Chamber of Commerce (Washington, DC), http://
www.uschamber.com/healthcare , accessed March 23, 2013.
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MINIMUM ESSENTIAL COVERAGE If you and your family need to acquire
minimum essential coverage, you may have several of the following options:
• Health insurance coverage provided by your employer.
• Health insurance purchased through the Health Insurance Marketplace in the area
where you live, where you may qualify for financial assistance.
• Coverage provided under a government-sponsored program for which you are
eligible (including Medicare, Medicaid, and health care programs for veterans).
• Health insurance purchased directly from an insurance company.
• Other health insurance coverage that is recognized by the Department of Health and
Human Services as minimum essential coverage.
You can learn more at HealthCare.gov about which health insurance options are avail-
able to you, how to purchase health insurance coverage, and how to get financial assistance
with the cost of insurance. If you purchase health insurance through the marketplace and
you meet certain requirements, you may be eligible for a premium tax credit to help pay
your premiums.
EXEMPTIONS You may be exempt from the requirement to maintain minimum
essential coverage and thus will not have to make a shared responsibility payment when
you file your 2014 federal income tax return in 2015, if you meet certain criteria. You may
be exempt if you
• Have no affordable coverage options because the minimum amount you must pay
for the annual premiums is more than 8 percent of your household income, or
• Have a gap in coverage for less than three consecutive months, or
• Qualify for an exemption for one of several other reasons, including having a
hardship that prevents you from obtaining coverage, or belonging to a group
explicitly exempt from the requirement.
MAKING A PAYMENT If you or any of your dependents don’t have minimum
essential coverage and you don’t have an exemption, you will need to make an individual
shared responsibility payment on your tax return. Remember, choosing to make the indi-
vidual shared responsibility payment instead of purchasing minimum essential coverage
means you will also have to pay the entire cost of all your medical care.
For 2014, the annual payment amount was
• The greater of 1 percent of your household income that is above the tax return filing
threshold for your filing status, or
• Your family’s flat dollar amount, which is $95 per adult and $47.50 per child,
limited to a family maximum of $285.
For more information about the individual shared responsibility provision and detailed
examples of the payment calculation, visit irs.gov .
GOVERNMENT CONSUMER HEALTH INFORMATION WEBSITES
The Department of Health and Human Services operates more than 60 websites with a
wealth of reliable information related to health and medicine. For example:
• Healthfinder: Healthfinder includes links to more than 1,000 websites operated by
government and nonprofit organizations. It lists topics according to subject ( www.
hhs.gov ).
• MedlinePlus: MedlinePlus is the world’s largest collection of published medical
information. It was originally designed for health professionals and researchers,
but it’s also valuable for students and others who are interested in health care and
medical issues ( www.nlm.nih.gov/medlineplus ).
• NIH Health Information Page: The National Institutes of Health (NIH) operates
a website called the NIH Health Information Page, which can direct you to
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the consumer health information in NIH publications and on the Internet
( www.nih.gov ).
• FDA: The Food and Drug Administration (FDA) also runs a website. This
consumer protection agency’s site provides information about the safety of various
foods, drugs, cosmetics, and medical devices ( www.fda.gov ).
PRACTICE QUIZ 9–4 PRACTICE QUIZ 9–4
1. What are the six sources of private health plans?
2. Match the following terms with the appropriate statement.
Blue Cross a. A medical assistance program offered to certain low-income individuals and
families. ______________________________________________________________________
Blue Shield b. A health insurance plan that combines features of both HMOs and PPOs. ____________
HMOs c. A statewide organization that provides hospital care benefits. _______________________
PPOs d. A federally funded health insurance program available mainly to people over 65 and to
people with disabilities. _________________________________________________________
point-of-service (POS) e. Health insurance plans that directly employ or contract with selected physicians to
provide health services in exchange for a fixed, prepaid monthly premium. ____________
Medicare f. A statewide organization that provides benefits for surgical and medical services
performed by physicians. ________________________________________________________
Medicaid g. Groups of doctors and hospitals that agree to provide specified medical services to
members at prearranged fees. ___________________________________________________
3. What health care services are not covered by Medicare?
Apply Yourself! Apply Yourself!
Talk to several people covered by Medicare and Medicaid to obtain information on the coverage provided and the
difficulties sometimes faced.
Disability Income Insurance
The Need for Disability Income
Before disability insurance existed, people who were ill lost more money from missed pay-
checks than from medical bills. Disability income insurance was set up to protect against
such loss of income. This kind of coverage is very common today, and several hundred
insurance companies offer it.
Disability income insurance provides regular cash income when you’re unable to work
because of a pregnancy, a non-work-related accident, or an illness. It protects your earning
power, your most valuable resource.
The exact definition of a disability varies from insurer to insurer. Some insurers will
pay you when you are unable to work at your regular job. Others will pay only if you are
so ill or badly hurt that you can’t work at any job. A violinist with a hand injury, for
instance, might have trouble doing his or her regular work but might be able to perform
a range of other jobs. A good disability income insurance plan p ays you if you can’t
LO9.5
Explain the importance of
disability income insurance in
financial planning and identify
its sources .
ACTION ITEM
Since I am a healthy adult,
I don’t need to worry about
disability income insurance.
h Yes h No
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work at your regular job. A good plan will also pay partial benefits if you are able to
work only part-time.
Many people make the mistake of ignoring disability insurance, not realizing that it’s
very important insurance to have. Disability can cause even greater financial problems
than death. Disabled persons lose their earning power but still have to meet their living
expenses. In addition, they often face huge costs for their medical treatment and special
care that their disabilities require.
Sources of Disability Income
Before you buy disability income insurance from a private insurance company, remember that
you may already have some form of insurance of this kind. This coverage may be available
through worker’s compensation if you’re injured on the job. Disability benefits may also be
available through your employer or through Social Security in case of a long-term disability.
WORKER’S COMPENSATION If your disability is a
result of an accident or illness that occurred on the job, you may
be eligible to receive worker’s compensation benefits in your
state. Benefits will depend on your salary and your work history.
EMPLOYER PLANS Many employers provide disability
income insurance through group insurance plans. In most cases
your employer will pay part or all of the cost of such insurance.
Some policies may provide continued wages for several months
only, whereas others will give you long-term protection.
SOCIAL SECURITY Social Security may be best known
as a source of retirement income, but it also provides disability
benefits. If you’re a worker who pays into the Social Security system, you’re eligible for
Social Security funds if you become disabled. How much you get depends on your salary
and the number of years you’ve been paying into Social Security. Your dependents also
qualify for certain benefits. However, Social Security has very strict rules. Workers are con-
sidered disabled if they have a physical or mental condition that prevents them from work-
ing and that is expected to last for at least 12 months or to result in death. Benefits start at
the sixth full month the person is disabled. They stay in effect as long as the disability lasts.
PRIVATE INCOME INSURANCE PROGRAMS Privately owned insurance
companies offer many policies to protect people from loss of income resulting from ill-
ness or disability. Disability income insurance gives weekly or monthly cash payments to
people who cannot work because of illness or accident. The amount paid is usually 40 to
60 percent of a person’s normal income. Some plans, however, pay as much as 75 percent.
Disability Income Insurance Trade-Offs
As with the purchase of health insurance, you must make certain trade-offs when you
decide among different private disability insurance policies. Keep the following in mind as
you look for a plan that is right for you.
WAITING OR ELIMINATION PERIOD Benefits won’t begin the day you
become disabled. You’ll have to wait anywhere between one and six months before you
can begin collecting. The span of time is called an elimination period. Usually a policy
with a longer elimination period charges lower premiums.
disability income
insurance Provides
payments to replace income
when an insured person is
unable to work.
did you know? did you know?
Nearly one in five Americans will become
disabled for one year or more before the age
of 65, according to the Life Foundation, a nonprofit
organization dedicated to helping consumers make
smart financial decisions. The number of workers who
become disabled has risen by 35 percent since 2000,
according to the Social Security Administration.
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DURATION OF BENEFITS Every policy names a specified period during which
benefits will be paid. Some policies are valid for only a few years. Others are automatically
canceled when you turn 65. Still others continue to make payments for life. You should
look for a policy that pays benefits for life. If your policy stops payments when you turn
65, then permanent disability could be a major financial as well as physical loss.
AMOUNT OF BENEFITS You should aim for a benefit amount that, when added
to other sources of income, will equal 70 to 80 percent of your take-home pay. Of course,
the greater the benefit, the greater the cost, or premium.
ACCIDENT AND SICKNESS COVERAGE Some disability policies pay only
for accidents. Coverage for sickness is important, though. Accidents are not the only cause
of disability.
GUARANTEED RENEWABILITY If your health becomes poor, your disability
insurer may try to cancel your coverage. Look for a plan that guarantees coverage as long
as you continue to pay your premiums. The cost may be higher, but it’s worth the extra
security and peace of mind. You may even be able to find a plan that will stop charging the
premiums if you become disabled, which is an added benefit.
Your Disability Income Needs
Once you have found out what your benefits from the numerous public and private
sources would be, you should determine whether those benefits would meet your dis-
ability income needs. Ideally, you’ll want to replace all the income you otherwise would
have earned. This should enable you to pay your day-to-day expenses while you’re
recovering. You won’t have work-related expenses and your taxes will be lower during
the time you are disabled. In some cases you may not have to pay certain taxes at all.
Use Exhibit 9–5 to determine how much income you will have available if you become
disabled.
Monthly
Amount
After
Waiting:
For a
Period of:
Sick leave or short-term disability _______ _______ _______
Group long-term disability _______ _______ _______
Social Security _______ _______ _______
Other government programs _______ _______ _______
Individual disability insurance _______ _______ _______
Credit disability insurance _______ _______ _______
Other income: _______ _______ _______
Savings _______ _______ _______
Spouse’s income _______ _______ _______
Total monthly income while disabled: $ _______
Exhibit 9–5
Calculating Disability
Income
How much income will you
have available if you become
disabled?
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High Medical Costs
Affordable health care has become one of the most important social issues of our time.
News broadcasts abound with special reports on “America’s health care crisis” or politi-
cians demanding “universal health insurance.”
What do an aging and overweight population, the cost of prescription drugs, the grow-
ing number of uninsured, and advancements in medical technology have in common?
These and other factors all add up to rising health costs. The United States has the highest
per capita medical expenditures of any country in the world. We spend twice as much
on health care as the average for the 24 industrialized countries in Europe and North
America.
Health care costs were estimated at $3.09 trillion in 2014 (see Exhibit 9–6 ). Since 1993,
health care spending as a percentage of gross domestic product (GDP) has remained rel-
atively constant at 13.6 percent, except in 1997, when it fell to 13.4 percent, and in 2011,
when it increased to 17.7 percent. The latest projections from the Centers for Medicare and
Medicaid Services show that improving economic conditions, the provisions of the Afford-
able Care Act, and the aging population will continue to increase health care spending in
2015 and beyond. Over the 2012–2022 period, national health spending is projected to
grow at an average annual rate of 5.8 percent. By 2022, health spending financed by fed-
eral, state, and local governments is projected to account for 49 percent of national health
spending and to reach a total of $2.4 trillion.
RAPID INCREASE IN MEDICAL EXPENDITURES Since federally spon-
sored health care began in 1965, U.S. health care expenditures rose from $41.6 billion, or
about 6 percent of GDP, to $3.09 trillion in 2014, about 18 percent of GDP.
HIGH ADMINISTRATIVE COSTS In the United States, administrative costs
consume nearly 26 percent of health care dollars, compared to 1 percent under Canada’s
socialized system. These costs include activities such as enrolling beneficiaries in a health
plan, paying health insurance premiums, checking eligibility, obtaining authorizations
LO9.6
Explain why the costs of
health insurance and health
care have been increasing.
ACTION ITEM
To avoid high medical costs,
I eat a balanced diet and
keep my weight under
control.
h Yes h No
PRACTICE QUIZ 9–5 PRACTICE QUIZ 9–5
1. What is the purpose of disability income insurance?
2. What are the four sources of disability income?
3. Match the following terms with an appropriate statement.
waiting or elimination period a. A specified period during which benefits are paid. _____________________
duration of benefits b. A plan that guarantees coverage as long as you continue to pay your
premiums. _______________________________________________________
guaranteed renewability c. A period of one to six months that must elapse before benefits can be
collected. ________________________________________________________
Apply Yourself! Apply Yourself!
Contact an insurance agent to obtain cost information for an individual disability income insurance policy.
Sheet 32 Disability Income Insurance
Needs
S
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Exhibit 9–6 U.S. National Health Expenditures, 1960–2022
2000
1,311
2005
2,021
2017∗
3,660
2018∗
3,889
2019∗
4,142
2020∗2021∗2022∗
4,416
4,702
5,009
2016∗
3,458
2015∗
3,273
2014∗
3,093
2013
2,915
2012
2,807
2011
2,701
2010
2,600
2,000
1,900
1,800
1,700
1,600
1,500
1,400
1,300
1,200
1,100
1,000
900
800
700
600
500
400
300
200
100
0
2,100
2,200
2,300
2,400
3,300
3,200
3,100
3,000
2,900
2,800
2,700
2,600
2,500
3,400
3,500
3,600
3,700
3,800
3,900
4,000
4,100
4,200
4,300
4,400
4,500
4,600
4,700
4,800
4,900
5,000
$5,100
Billions of dollars
1960
27.1
1970
74.4
1980
250.1
1990
666.2
1995
988.5
* Projected.
SOURCES: U.S. Department of Health and Human Services. The Centers for Medicare and Medicaid Services. www.cms.gov , accessed May 24, 2014.
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for specialist referrals, and filing reimbursement claims. More
than 1,100 different insurance forms are now in use in the
United States.
Is it ethical for insurance companies to spend 26 percent on
administrative costs? No, according to the Centers for Medicare
and Medicaid Services. Under the Affordable Care Act, starting
in 2011, companies are required to spend 80 to 85 percent of
premiums on medical care and improving the quality of health
care. If they don’t, insurance companies must provide a rebate
to their customers starting in 2012.
Why Does Health Care Cost
So Much?
The high and rising costs of health care are attributable to many
factors, including:
digi – know? digi – know?
Health information technology (health Health information technology (health
IT) allows health care providers to better IT) allows health care providers to better
manage patient care through secure manage patient care through secure
use and sharing of health information. use and sharing of health information.
It includes the use of electronic health It includes the use of electronic health
records (EHRs) instead of paper medical records (EHRs) instead of paper medical
records to maintain your health informa-records to maintain your health informa-
tion. Health IT promises to expand access tion. Health IT promises to expand access
to affordable care and to make our health to affordable care and to make our health
care system more efficient and reduce care system more efficient and reduce
paperwork for patients and doctors. For paperwork for patients and doctors. For
more information, visit the U.S. Depart-more information, visit the U.S. Depart-
ment of Health and Human Services web-ment of Health and Human Services web-
site at site at HealthIT.govHealthIT.gov . .
• The use of sophisticated, expensive technologies.
• Duplication of tests and sometimes duplication of
technologies that yield similar results.
• Increases in the variety and frequency of treatments,
including allegedly unnecessary tests.
• The increasing number and longevity of elderly people.
• Regulations that result in cost shifting rather than cost reduction.
• The increasing number of accidents and crimes that require emergency medical
services.
• Limited competition and restrictive work rules in the health care delivery system.
• Labor intensiveness and rapid average earnings growth for health care professionals
and executives.
• Using more expensive medical care than necessary, such as going to an emergency
room with a bad cold.
• Built-in inflation in the health care delivery system.
• Aging baby boomers’ use of more health care services, whether they’re going to the
doctor more often or snapping up pricier drugs, from Celebrex to Viagra.
• Other major factors that cost billions of dollars each year, including fraud,
administrative waste, malpractice insurance, excessive surgical procedures, a wide
range of prices for similar services, and double health coverage.
According to the Government Accountability Office, fraud and abuse account for
nearly 10 percent of all dollars spent on health care. In 2010, that was a loss of more than
$97 billion to Medicare and Medicaid.
Because third parties—private health insurers and government—pay such a large part
of the nation’s health care bill, hospitals, doctors, and patients often lack the incentive to
make the most economical use of health care services.
What Is Being Done about the High Costs
of Health Care?
In the private sector, concerned groups such as employers, labor unions, health insurers,
health care professionals, and consumers have undertaken a wide range of innovative
activities to contain the costs of health care. These activities include:
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• Programs to carefully review health care fees and charges and the use of health care
services.
• The establishment of incentives to encourage preventive care and provide more
services out of hospitals, where this is medically acceptable.
• Involvement in community health planning to help achieve a better balance between
health needs and health care resources.
• The encouragement of prepaid group practices and other alternatives to fee-for-
service arrangements.
• Community health education programs that motivate people to take better care of
themselves.
• Physicians encouraging patients to pay cash for routine medical care and
lab tests.
President Obama maintains that improving health information technology could
lower costs; setting up electronic medical records would be a smart investment and
could reduce medical errors. According to Karen Davis, president of Commonwealth
Fund, a health policy research organization, “Improvements in health information tech-
nology could save $88 billion over 10 years, though no gains will be realized in the first
few years.”
What Can You Do to Reduce Personal
Health Care Costs?
The best way to avoid the high cost of illness is to stay well. The prescription is the same
as it has always been:
1. Eat a balanced diet and keep your weight under control.
2. Avoid smoking and don’t drink to excess.
3. Get sufficient rest, relaxation, and exercise.
4. Drive carefully and watch out for accident and fire
hazards in the home.
5. Protect yourself from medical ID theft.
did you know? did you know?
According to the Medical Identity Fraud Alliance,
an estimated 1.85 million people in the United
States were victims of medical identity theft in 2012.
PRACTICE QUIZ 9–6 PRACTICE QUIZ 9–6
1. What are the reasons for rising health care expenditures?
2. What are various groups doing to curb the high costs of health care?
3. What can individuals do to reduce health care costs?
Apply Yourself! Apply Yourself!
Create a list of personal actions that you can take to reduce the costs of health care.
Sheet 32 Disability Income Insurance
Needs
S
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LO9.1 Health insurance is protection
that provides payments of benefi ts for a
covered sickness or injury. Health insur-
ance should be a part of your overall insur-
ance program to safeguard your family’s
economic security. Health insurance plans
can be purchased through group health
insurance, individual health insurance, and
COBRA.
LO9.2 Four basic types of health insurance
are available under group and individual pol-
icies: hospital expense insurance, surgical
expense insurance, physician expense insur-
ance, and major medical expense insurance.
Major provisions of a health insurance policy
include eligibility requirements, assigned bene-
fits, internal limits, copayment, service bene-
fits, benefit limits, exclusions and limitations,
guaranteed renewability, and cancellation and
termination.
LO9.3 Health insurance policy trade-
offs include reimbursement versus indem-
nity, internal limits versus aggregate limits,
deductibles and coinsurance, out-of-pocket
limits, and benefits based on reasonable and
customary charges.
LO9.4 Health insurance and health care
are available from private insurance compa-
nies, hospital and medical service plans such
as Blue Cross/Blue Shield, health mainte-
nance organizations (HMOs), preferred pro-
vider organizations (PPOs), point-of-service
plans (POSs), home health care agencies,
and employer self-funded health plans.
The federal and state governments offer
health coverage in accordance with laws
Chapter
Summary
YOUR PERSONAL FINANCE DASHBOARD
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) to determine actions you might take
to improve your health and disability income insurance
requirements.
Review your disability income policy and explanation
of benefits.
Check if your employer provides disability income
insurance through group insurance plans. In most
cases, your employer will pay part or all of the cost of
such insurance.
Contact the Social Security Administration. If you pay
into the Social Security system, you are eligible for
Social Security funds if you become disabled.
After you find out what your benefits would be from
numerous public and private sources, you should
determine whether those benefits would meet your
disability income needs.
For more information on disability income insurance,
visit www.iii.org and www.ahip.org .
A personal finance dashboard with key performance indi-
cators can help you monitor your financial situation and
guide you toward financial independence. Disability can
be more disastrous financially than death. If you are dis-
abled, you lose your earning power, but you still have liv-
ing expenses and often huge expenses for medical care.
YOUR SITUATION: Do you know how disability is
defined? When do your benefits begin? How long do
your benefits last? What is the amount of your benefits?
Can benefits be reduced by Social Security disability
and worker’s compensation payments? Are the ben-
efits adjusted for inflation? You should aim for benefit
amounts that, when added to your other income, equal
70 or 80 percent of your gross pay.
D
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QU
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FINANCIALLY SEC
U
R
E
INCOME PERCENT COVERED BY DISABILITY
0 100
20 80
10 90
30 70
5040 60
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that define the premiums and benefits. Two
well-known government health programs
are Medicare and Medicaid.
LO9.5 Disability income insurance pro-
vides regular cash income lost by employees
as the result of an accident, illness, or preg-
nancy. Sources of disability income insur-
ance include the employer, Social Security,
worker’s compensation, and private insurance
companies.
LO9.6 Health care costs, except during
1994–1996, have gone up faster than the
rate of inflation. Among the reasons for
high and rising health care costs are the use
of expensive technologies, duplication of
tests and sometimes technologies, increases
in the variety and frequency of treatments,
unnecessary tests, the increasing number
and longevity of elderly people, regula-
tions that shift rather than reduce costs, the
increasing number of accidents and crimes
requiring emergency services, limited com-
petition and restrictive work rules in the
health care delivery system, rapid earnings
growth among health care professionals,
and built-in inflation in the health care
delivery system.
Key Terms
basic health insurance
coverage 288
Blue Cross 295
Blue Shield 295
coinsurance 288
copayment 291
deductible 288
disability income
insurance 305
physician expense
insurance 288
point-of-service (POS)
plan 296
preferred provider
organization (PPO) 296
stop-loss 289
surgical expense
insurance 288
health maintenance
organization
(HMO) 296
hospital expense
insurance 288
long-term care insurance
(LTC) 289
managed care 296
Medigap (MedSup)
insurance 299
1. What is the relationship between health insurance coverage and other aspects of finan-
cial planning? (LO 9.1)
2. Should employers be required to provide employees some type of health insur-
ance coverage, even if it is a group plan, with each employee paying his or her full
premium? (LO 9.1)
3. Larry and Liz are a young couple both working full-time and earning about $70,000
a year. They recently purchased a house and took out a large mortgage. Since both of
them work, they own two cars and are still making payments on them. Liz has major
medical health insurance through her employer, but Larry’s coverage is inadequate.
They have no children, but they hope to start a family in about three years. Liz’s
employer provides disability income insurance, but Larry’s employer does not. Ana-
lyze the need for health and disability insurance for Liz and Larry. (LO9.2)
4. Pam is 31 and recently divorced, with children ages 3 and 6. She earns $40,000 a year
as a secretary. Her employer provides her with basic health insurance coverage. She
receives child support from the children’s father, but he misses payments often and is
always behind in payments. Her ex-husband, however, is responsible for the children’s
medical bills. Analyze the need for health and disability insurance for Pam. (LO9.2)
5. List the benefits included in your employee benefit package, such as health insurance,
disability income insurance, and life insurance. Discuss the importance of such a bene-
fit package to the consumer. (LO9.3)
6. Obtain sample health insurance policies from insurance agents or brokers, and analyze
the policies for definitions, coverage, exclusions, limitations on coverage, and amounts
of coverage. In what ways are the policies similar? In what ways do they differ?
(LO9.3)
Discussion
Questions
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1. The Tucker family has health insurance coverage that pays 80 percent of out-of-hospital
expenses after a $500 deductible per person. If one family member has doctor and pre-
scription medication expenses of $1,100, what amount would the insurance company
pay? (LO9.2)
2. A health insurance policy pays 65 percent of physical therapy costs after a $200 deductible.
In contrast, an HMO charges $15 per visit for physical therapy. How much would a person
save with the HMO if he or she had 10 physical therapy sessions costing $50 each? (LO9.2)
3. Becky’s comprehensive major medical health insurance plan at work has a deductible
of $750. The policy pays 85 percent of any amount above the deductible. While on a
hiking trip, Becky contracted a rare bacterial disease. Her medical costs for treatment,
including medicines, tests, and a six-day hospital stay, totaled $8,893. A friend told her
that she would have paid less if she had a policy with a stop-loss feature that capped
her out-of-pocket expenses at $3,000. Was her friend correct? Show your computations.
Then determine which policy would have cost Becky less and by how much. (LO9.2)
4. Georgia, a widow, has take-home pay of $600 a week. Her disability insurance cover-
age replaces 70 percent of her earnings after a four-week waiting period. What amount
would she receive in disability benefits if an illness kept Georgia from work for 16
weeks? (LO9.5)
Problems
1. The MacDonald family of five has health insurance coverage that pays 75 percent of
out-of-hospital expenses after a $600 deductible per person. Mrs. MacDonald incurred
doctor and prescription medication expenses of $1,380. What amount would the insur-
ance company pay?
2. Under Rose’s PPO, emergency room care at a network hospital is 80 percent cov-
ered after the member has met a $300 annual deductible. Assume that Rose went to a
hospital within her PPO network and that she had not met her annual deductible yet.
Her total emergency room bill was $850. What amount did Rose have to pay? What
amount did the PPO cover?
3. Gene, an assembly line worker at an automobile manufacturing plant, has take-home
pay of $900 a week. He is injured in an accident that kept him off work for 18 weeks.
His disability insurance coverage replaces 65 percent of his earnings after a six-week
waiting period. What amount would he receive in disability benefits?
Solutions
1. Total expenses 5 $ 1,380
Deductible 5 2 600
$ 780
Insurance company will pay 75 percent of $780 or $780 3 0.75 5 $585.
2. Total bill 5 $ 850
Deductible 5 2 300
$ 550
Rose pays $550 3 0.20 5 $110 1 $300 5 $410.
PPO covers $440 ($850 2 $410) .
3. Insurance will replace 65 percent of $900, or $900 3 0.65 5 $585 per week. Insur-
ance will pay for 18 minus 6 weeks, or 12 weeks, or $585 3 12 5 $7,020.
Self-Test
Problems
7. What do you consider to be an “ethical” health care system? Explain your answer. (LO9.4)
8. Visit the Social Security Administration’s web page to determine your approximate
monthly Social Security disability benefits should you become disabled in the current
year. Or call your Social Security office to request the latest edition of Social Security:
Understanding the Benefits. (LO9.5)
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5. Stephanie was injured in a car accident and was rushed to the emergency room. She
received stitches for a facial wound and treatment for a broken finger. Under Stepha-
nie’s PPO plan, emergency room care at a network hospital is 80 percent covered after
the member has met a $300 annual deductible. Assume that Stephanie went to a hos-
pital within her PPO network. Her total emergency room bill was $850. What amount
did Stephanie have to pay? What amount did the PPO cover? (LO9.2)
Questions 6, 7, and 8 are based on the following scenario:
Ronald Roth started his new job as controller with Aerosystems today. Carole,
the employee benefits clerk, gave Ronald a packet that contains information on the
company’s health insurance options. Aerosystems offers its employees the choice
between a private insurance company plan (Blue Cross/Blue Shield), an HMO, and
a PPO. Ronald needs to review the packet and make a decision on which health care
program fits his needs. The following is an overview of that information.
a. Blue Cross/Blue Shield plan: The monthly premium cost to Ronald will be
$42.32. For all doctor office visits, prescriptions, and major medical charges, Ron-
ald will be responsible for 20 percent and the insurance company will cover 80
percent of covered charges. The annual deductible is $500.
b. The HMO is provided to employees free of charge. The copayment for doctors’
office visits and major medical charges is $10. Prescription copayments are $5.
The HMO pays 100 percent after Ronald’s copayment. No annual deductible.
c. The POS requires that the employee pay $24.44 per month to supplement the cost
of the program with the company’s payment. If Ron uses health care providers
within the plan, he pays the copayments as described above for the HMO. He can
also choose to use a health care provider out of the network and pay 20 percent
of all charges after he pays a $500 deductible. The POS will pay for 80 percent of
those covered visits. No annual deductible.
Ronald decided to review his medical bills from the previous year to see what
costs he had incurred and to help him evaluate his choices. He visited his general
physician four times during the year at a cost of $125 for each visit. He also spent
$65 and $89 on prescriptions during the year. Using these costs as an example,
what would Ron pay for each of the plans described above? (For the purposes of the
POS computation, assume that Ron visited a physician outside of the network plan.
Assume he had his prescriptions filled at a network-approved pharmacy.)
6. What annual medical costs will Ronald pay using the sample medical expenses pro-
vided if he enrolls in the Blue Cross/Blue Shield plan? (LO9.2)
7. What total costs will Ronald pay if he enrolls in the HMO plan? (LO9.2)
8. If Ronald selects the POS plan, what will his annual medical costs be? (LO9.2)
9. In 2005, Joelle spent $5,000 on her health care. If this amount increased by 6 percent
per year, what would be the amount Joelle spent in 2015 for the same health care? (Hint:
Use the time value of money table in Chapter 1 Appendix, Exhibit 1–A.) (LO9.6)
10. As of 2012, per capita spending on health care in the United States was about $9,000.
If this amount increased by 7 percent a year, what would be the amount of per cap-
ita spending for health care in 8 years? (Hint: Use the time value of money table in
Chapter 1 Appendix, Exhibit 1–A.) (LO9.6)
BUYING ADEQUATE HEALTH INSURANCE COVERAGE
Case in
Point
Kathy Jones was a junior at Glenbard High
School. She had two younger brothers.
Her father, the assistant manager of a local
supermarket, had take-home pay of $3,000
a month. He had a group health insurance
policy and a $30,000 life insurance policy.
He said that he could not afford to buy addi-
tional insurance. All of his monthly salary
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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was used to meet current expenses, includ-
ing car and house payments, food, clothing,
transportation, children’s allowances, recre-
ation and entertainment, and vacation trips.
One evening, Kathy was talking with her
father about insurance, which she was
studying in an economics course. She asked
what kind of insurance program her father
had for their family. The question started
Mr. Jones thinking about how well he was
planning for his wife and children. Since
the family had always been in good health,
Mr. Jones felt that additional health and life
insurance was not essential. Maybe after he
received a raise in his salary and after his
daughter was out of high school, he could
afford to buy more insurance.
Questions
1. Do you think Kathy’s father was plan-
ning wisely for the welfare of his fam-
ily? Can you suggest ways in which this
family could have cut monthly expenses
and thus set aside some money for more
insurance?
2. Although Mr. Jones’s salary was not big
enough to buy insurance for all possible
risks, what protection do you think he
should have had at this time?
3. Suppose Mr. Jones had been seriously
injured and unable to work for at least
one year. What would his family have
done? How might this situation have
affected his children?
Continuing
Case
Jamie Lee and Ross, happy newlyweds with a new home and twins on the way, are anx-
iously awaiting their new bundles of joy. Ross was understandably nervous as he wondered
if everything would go smoothly with Jamie’s pregnancy. Fortunately, they coordinated
benefits from the medical insurance group plan offered by Ross’s employment at the
graphics agency and Jamie Lee’s own plan, although Ross’s plan would be their primary.
His employer offers a health care savings plan, but Ross had not previously realized the
benefit of participating.
Jamie Lee has had maternity care that she has been comfortable with so far, but Ross
needed to review their health insurance policies with the potential of extensive medical
expenses just on the horizon. He wondered if his salary would be enough to pay for the
expenses that were not covered for out-of-network doctors.
Current Medical Insurance Plan Provisions
Jamie Lee and Ross have a PPO, or preferred provider organization, plan.
In-Network Medical Care:
Jamie Lee and Ross currently have a $15 copayment on regular preventive care doctor vis-
its and a $30 copayment on specialists that are preferred providers or participating mem-
bers from the PPO plan’s list.
Out-of-Network Medical Care:
Jamie Lee and Ross have the choice of seeking medical care from the professional of their
choice outside the PPO member list, but will incur a deductible of $500 per person/$1,000
per family, per year.
After the deductible is met, there is a coinsurance of 80 percent/20 percent. The insurance
company will cover 80 percent of the allowable medical fees and the policyholders will be
responsible for the other 20 percent of the allowable medical fees.
Medical fees that are not allowed under the medical plan provisions would be 100 percent
of the policyholders’ responsibility.
Out-of-Pocket Limits:
Their health insurance plan provides an out-of-pocket limit of $7,500 per year.
HEALTH AND DISABILITY INCOME INSURANCE
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Questions
1. Using the information on the ACA and health planning from the “Personal Finance in
Practice” box in this chapter, what are some of the strategies that Ross can use to better
prepare financially for the arrival of the twins?
2. How could Jamie Lee and Ross prepare for the birth of the twins with their existing
PPO plan?
3. Jamie Lee and Ross learned that the hospital that they plan to use for the delivery is
not a participating hospital. What will their financial responsibility be for the nonpar-
ticipating hospital expenses?
4. The doctor’s office has estimated the hospital expense for Jamie Lee and the babies’
delivery, without complications, to be approximately $18,000. Based on their health
insurance policy, how much would Jamie Lee and Ross owe for this out-of-network
hospital stay?
5. Surprise! The babies arrived five weeks early and Jamie Lee and Ross are the proud
parents of triplets : two boys and a girl! Since they were preterm, they will need to
spend a few extra days in the hospital for observation. How will Ross and Jamie Lee
make provisions for adding the babies to their health insurance policy now that they
have arrived?
Directions Continue your Daily Spending Diary to record and monitor spending in
various categories. Your comments should reflect what you have learned about your
spending patterns and help you consider possible changes you might want to make in
your spending habits. The Daily Spending Diary sheets are located in Appendix D at the
end of the book and in Connect Finance.
Questions
1. What spending actions might directly or indirectly affect your health and physical
well-being?
2. What amounts (if any) are currently required from your spending for the cost of health
and disability insurance?
“SOME OF MY EATING HABITS NOT ONLY WASTE MONEY BUT
ARE ALSO NOT BEST FOR MY HEALTH.”
Spending
Diary
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What’s Next for Your Personal Financial Plan?
• Talk to others about the impact of their health insurance on other financial decisions.
• Contact an insurance agent to obtain cost information for an individual health insurance plan.
Assessing Current and Needed Health
Care Insurance
Purpose: To assess current and needed medical and health care insurance
Financial Planning Activities: Assess current and needed medical and health care insurance.
Investigate your existing medical and health insurance, and determine the need for additional
coverages. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.insure.com www.lifehappens.org www.insurekidsnow.gov
31
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Insurance company
Address
Type of coverage h individual health policy h group health policy
h HMO h PPO h other
Premium amount (monthly/quarterly/semiannually/annually)
Main coverages
Amount of coverage for
• Hospital costs
• Surgery costs
• Physicians’ fees
• Lab tests
• Outpatient expenses
• Maternity
• Major medical
Other items covered/amounts
Policy restrictions (deductible, coinsurance, maximum limits)
Items not covered by this insurance
Of items not covered, would supplemental coverage be appropriate for your personal situation?
What actions related to your current (or proposed additional) coverage are necessary? Suggested
App:
• Healthcare
Bluebook
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Monthly Expenses
Disability Income Insurance Needs
Purpose: To determine financial needs and insurance coverage related to employment
disability situations.
Financial Planning Activities: Use the categories below to determine your potential income
needs and disability insurance coverage. This sheet is also available in an Excel spreadhseet
format in Connect Finance.
Suggested Websites: www.ssa.gov www.insweb.com www.dol.gov
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Current When Disabled
Mortgage (or rent) $ __________________________ $ __________________________
Utilities $ __________________________ $ __________________________
Food $ __________________________ $ __________________________
Clothing $ __________________________ $ __________________________
Insurance payments $ __________________________ $ __________________________
Debt payments $ __________________________ $ __________________________
Auto/transportation $ __________________________ $ __________________________
Medical/dental care $ __________________________ $ __________________________
Education $ __________________________ $ __________________________
Personal allowances $ __________________________ $ __________________________
Recreation/entertainment $ __________________________ $ __________________________
Contributions, donations $ __________________________ $ __________________________
Total monthly expenses $ __________________________
Total monthly expenses when disabled $ __________________________
Substitute Income Monthly Benefit *
Group disability insurance $ __________________________
Social Security $ __________________________
State disability insurance $ __________________________
Worker’s compensation $ __________________________
Credit disability insurance (in some auto loan or home mortgages) $ __________________________
Other income (investments, etc.) $ __________________________
Total projected income when disabled $ __________________________
If projected income when disabled is less than expenses, additional disability income insurance should be
considered.
*Most disability insurance programs have a waiting period before benefits start, and they may have a limit as to
how long benefits are received.
What’s Next for Your Personal Financial Plan?
• Survey several people to determine if they have disability insurance.
• Talk to an insurance agent to compare the costs of disability income insurance available from several insur-
ance companies.
Suggested
App:
• myCigna
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3 Steps to Financial
Literacy . . . Determining
Your Life Insurance
Coverage
10
Financial Planning with
Life Insurance
Why is life insurance important?
Providing for the financial needs of family
members and other dependents is the primary
purpose of life insurance. At the end of the
chapter, “Your Personal Finance Dashboard”
will provide additional information on planning
for an appropriate amount of life insurance.
1
Calculate the current and future financial
needs of your dependents and household
members.
App: Insurance Needs Calculator
2
Determine the amount of life insurance based
on the financial needs from Step 1.
Website: www.bankrate.com
3
Compare types of life insurance policies and
costs among various companies and sources
of life insurance.
App: Life Insurance Quotes
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What Is Life Insurance?
Even though putting a price on your life is impossible, you probably own some life
insurance—through a group plan where you work, as a veteran, or through a policy you
bought. Life insurance is one of the most important and expensive purchases you may ever
make; therefore, it is important that you budget for this need. Deciding whether you need
it and choosing the right policy from dozens of options take time, research, and careful
thought. This chapter will help you make decisions about life insurance. It describes what
life insurance is and how it works, the major types of life insurance coverage, and how you
can use life insurance to protect your family.
When you buy life insurance, you’re making a contract with the company issuing the pol-
icy. You agree to pay a certain amount of money—the premium—periodically. In return the
company agrees to pay a death benefit, or a stated sum of money upon your death, to your
beneficiary. A beneficiary is a person named to receive the benefits from an insurance policy.
The Purpose of Life Insurance
Most people buy life insurance to protect the people who depend on them from financial
losses caused by their death. Those people could include a spouse, children, an aging par-
ent, or a business partner or corporation. Life insurance benefits may be used to:
• Pay off a home mortgage or other debts at the time of death.
• Provide lump-sum payments through an endowment for children when they reach a
specified age.
• Provide an education or income for children.
• Make charitable donations after death.
• Provide a retirement income.
• Accumulate savings.
LO10.1
Define life insurance and
determine your life insurance
needs.
ACTION ITEM
I need life insurance because
someone depends on me for
financial support.
h Yes h No
beneficiary A person
designated to receive
something, such as life
insurance proceeds, from the
insured.
CHAPTER 10 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO10.1 Define life insurance and determine your life insurance needs.
LO10.2 Distinguish between the types of life insurance companies and analyze vari-
ous life insurance policies these companies issue.
LO10.3 Select important provisions in life insurance contracts and create a plan to
buy life insurance.
LO10.4 Recognize how annuities provide financial security.
YOUR PERSONAL FINANCIAL PLAN SHEETS
33. Determining Life Insurance Needs
34. Life Insurance Policy Comparison
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• Establish a regular income for survivors.
• Set up an estate plan.
• Pay estate and gift taxes.
The Principle and Psychology of Life Insurance
No one can say with any certainty how long a particular person will live. Still, insur-
ance companies are able to make some educated guesses. Over the years they’ve compiled
tables that show about how long people live. Using these tables, the company will make
a rough guess about a person’s life span and charge him or her accordingly. The sooner a
person is likely to die, the higher the premiums he or she will pay.
How Long Will You Live?
If history is a guide, you’ll live longer than your ancestors did. In 1900 an American male
could be expected to live 46.3 years. By 2014, in contrast, life expectancy had risen to 76.1
years for men and 80.9 for women. Exhibit 10–1 shows about how many years a person
can be expected to live today. For instance, a 30-year-old woman can be expected to live
another 51.9 years. That doesn’t mean that she has a high probability of dying at age 81.9.
This just means that 51.9 is the average number of additional years a 30-year-old woman
may expect to live.
Do You Need Life Insurance?
Before you buy life insurance, you’ll have to decide whether you need it at all. Generally,
if your death would cause financial hardship for somebody, then life insurance is a wise
purchase. Households with children usually have the greatest need for life insurance. Sin-
gle people who live alone or with their parents, however, usually have little or no need for
life insurance unless they have a great deal of debt or want to provide for their parents, a
friend, relative, or charity.
EXPECTATION OF LIFE IN YEARS
Age Male Female
0 76.0 80.9
1 75.5 80.4
5 71.6 76.4
10 66.6 71.5
15 61.7 66.5
20 56.9 61.6
25 52.2 58.8
30 47.6 51.9
35 42.9 47.1
40 38.3 42.3
45 33.7 37.7
EXPECTATION OF LIFE IN YEARS
Age Male Female
50 29.4 33.1
55 25.3 28.7
60 21.3 24.4
65 17.6 20.3
70 14.2 16.5
75 11.0 12.9
80 8.2 9.7
85 5.9 7.0
90 4.1 4.9
95 2.9 3.4
100 2.1 2.4
Exhibit 10–1 Life Expectancy Tables, All Races, 2009
This table helps insurance companies determine insurance premiums. Use the table to find the average
number of additional years a 20-year-old male and female are expected to live.
SOURCE: CDC/NCHS, National Vital Statistics Report, Volume 62, Number 7, United States Life Tables, 2009, January 6, 2014, p. 3, accessed at www.cdc
.gov/nchs/fastats/life-expectancy.htm, accessed October 16, 2014.
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Estimating Your Life Insurance Requirements
In estimating your life insurance requirements, consider the insurance coverage that your
employer offers you as a fringe benefit. Many employers provide employees with life
insurance coverage equal to their yearly salary. For example, if you earn $55,000 per year,
you may receive $55,000 of insurance coverage. Some employers offer insurance of two
or more times the salary with increased contributions from employees. The premiums are
usually lower than premiums for individual life insurance policies, and you don’t have to
pass a physical exam.
There are four general methods for determining the amount of insurance you may need:
the easy method, the DINK method, the “nonworking” spouse method, and the “family
need” method.
THE EASY METHOD Simple as this method is, it is remarkably useful. It is based
on the insurance agent’s rule of thumb that a “typical family” will need approximately
70 percent of your salary for seven years before they adjust to the financial consequences
of your death. In other words, for a simple estimate of your life insurance needs, just mul-
tiply your current gross income by 7 (7 years) and 0.70 (70 percent).
EXAMPLE: The Easy Method
$40,000 current income 3 7 5 $280,000 3 0.70 5 $196,000
Example from Your Life
$ ______ current income 3 7 5 $ _______ 3 0.70 5 $ _______
This method assumes your family is “typical.” You may need more insurance if you have
four or more children, if you have above-average family debt, if any member of your fam-
ily suffers from poor health, or if your spouse has poor employment potential. On the other
hand, you may need less insurance if your family is smaller.
THE DINK (DUAL INCOME, NO KIDS) METHOD If you have no depen-
dents and your spouse earns as much or more than you do, you have very simple insurance
needs. Basically, all you need to do is ensure that your spouse will not be unduly burdened
by debts should you die. Here is an example of the DINK method:
EXAMPLE: The DINK Method
Example Your Figures
Funeral expenses $ 5,000 $ ___________
One-half of mortgage 60,000 ___________
One-half of auto loan 7,000 ___________
One-half of credit card balance 1,500 ___________
One-half of personal debt 1,500 ___________
Other debts 1,000 ___________
Total insurance needs $76,000 $___________
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The net result (line 7) is an estimate of the shortfall your family would face upon your death. Remember, these are just
rules of thumb. For a complete analysis of your needs, consult a professional.
SOURCES: About Life Insurance, Metropolitan Life Insurance Company, February 1997, p. 3; The TIAA Guide to Life Insurance Planning for People in Educa-
tion (New York: Teachers Insurance and Annuity Association, January 1997), p. 3.
A Worksheet to Calculate Your Life Insurance Needs A Worksheet to Calculate Your Life Insurance Needs
Figure It Out!
This method assumes your spouse will continue to work after your death. If your spouse
suffers poor health or is employed in an occupation with an uncertain future, you should
consider adding an insurance cushion to see him or her through hard times.
THE “NONWORKING” SPOUSE METHOD Insurance experts have esti-
mated that extra costs of up to $10,000 a year may be required to replace the services of
a homemaker in a family with small children. These extra costs may include the cost of a
housekeeper, child care, more meals out, additional carfare, laundry services, and so on.
They do not include the lost potential earnings of the surviving spouse, who often must
take time away from the job to care for the family.
To estimate how much life insurance a homemaker should carry, simply multiply the
number of years before the youngest child reaches age 18 by $10,000:
1. Five times your personal yearly income ________ (1)
2. Total approximate expenses above and beyond your daily living costs for you and your dependents
(e.g., tuition, care for a disabled child or parent) amount to ________ (2)
3. Your emergency fund (3 to 6 months of living expenses) amounts to ________ (3)
4. Estimated amount for your funeral expenses (U.S. average is $5,000 to $10,000) 1 ________ (4)
5. Total estimate of your family’s financial needs (add lines 1 through 4) 5 ________ (5)
6. Your total liquid assets (e.g., savings accounts, CDs, money market funds, existing life insurance
both individual and group, pension plan death benefits, and Social Security benefits) 2 ________ (6)
7. Subtract line 6 from line 5 and enter the difference here 5 ________ (7)
EXAMPLE: The “Nonworking” Spouse Method
Youngest child’s age 5 8 years
10 years 3 $10,000 5 $100,000
Example from Your Life
______ years 3 $10,000 5 $ _______
If there are teenage children, the $10,000 figure can be reduced. If there are more than
two children under age 13, or if anyone in the family suffers poor health or has special
needs, the $10,000 figure should be adjusted upward.
THE “FAMILY NEED” METHOD The first three methods assume you and your
family are “typical” and ignore important factors such as Social Security and your liquid
assets. The nearby “Figure It Out!” box provides a detailed worksheet for making a thor-
ough estimate of your life insurance needs.
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Although this method is quite thorough, if you believe it does not address all of your
special needs, you should obtain further advice from an insurance expert or a financial
planner.
As you determine your life insurance needs, don’t forget to consider the life insurance
you may already have. You may have ample coverage through your employer and through
any mortgage and credit life insurance you purchased.
Before you consider types of life insurance policies, you must decide what you want
your life insurance to do for you and your dependents. First, how much money do you want
to leave to your dependents should you die today? Will you require more or less insurance
protection to meet their needs as time goes on? Second, when would you like to be able
to retire? What amount of income do you believe you and your spouse would need then?
Third, how much will you be able to pay for your insurance program? Are the demands on
your family budget for other living expenses likely to be greater or lower as time goes on?
When you have considered these questions and developed some approximate answers,
you are ready to select the types and amounts of life insurance policies that will help you
accomplish your objectives.
PRACTICE QUIZ 10–1 PRACTICE QUIZ 10–1
1. What is life insurance? What is its purpose?
2. For each of the following statements, indicate your response by writing “T” or “F.”
a. Life insurance is one of the least important and least expensive purchases. _____
b. A beneficiary is a person named to receive the benefits from an insurance policy. _____
c. Life insurance benefits may be used to pay off a home mortgage or other debts at the time of death. _____
d. The sooner a person is likely to die, the higher the premiums he or she will pay. _____
e. All people need to purchase a life insurance policy. _____
3. What are the four methods of determining life insurance needs?
Apply Yourself! Apply Yourself!
Interview relatives and friends to determine why they purchased life insurance. Summarize your findings.
Sheet 33 Determining Life Insurance
Needs
S
N
Types of Life Insurance
Companies and Policies
Types of Life Insurance Companies
You can purchase the new or extra life insurance you need from two types of life insur-
ance companies: stock life insurance companies, owned by shareholders, and mutual life
insurance companies, owned by policyholders. Of the 868 life insurance companies in the
United States, about 75 percent are stock companies, and about 25 percent are mutual.
Stock companies generally sell nonparticipating (or nonpar ) policies, while mutual
companies specialize in the sale of participating (or par ) policies. A participating policy
has a somewhat higher premium than a nonparticipating policy, but a part of the premium
is refunded to the policyholder annually. This refund is called the policy dividend. In
2012, mutual companies had $5.1 trillion of life insurance in force and stock life insurers
had $13.7 trillion.
LO10.2
Distinguish between the types
of life insurance companies and
analyze various life insurance
policies these companies issue.
ACTION ITEM
I am aware of different types
of life insurance companies
and policies they offer.
h Yes h No
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A long debate about w hether stock companies or mutual companies offer less expensive
life insurance has been inconclusive. You should check with both stock and mutual compa-
nies to determine which type offers the best policy for your particular needs at the lowest
price.
If you wish to pay exactly the same premium each year, you should choose a nonpar-
ticipating policy with its guaranteed premiums. However, you may prefer life insurance
whose annual price reflects the company’s experience with its investments, the health of its
policyholders, and its general operating costs, that is, a participating policy.
Nevertheless, as with other forms of insurance, price should not be your only consider-
ation in choosing a life insurance policy. You should consider the financial stability of and
service provided by the insurance company.
Types of Life Insurance Policies
Both mutual insurance companies and stock insurance compa-
nies sell two basic types of life insurance: temporary and per-
manent insurance. Temporary insurance can be term, renewable
term, convertible term, or decreasing term insurance. Permanent
insurance is known by different names, including whole life,
straight life, ordinary life, and cash-value life insurance. As you
will learn in the next section, permanent insurance can be lim-
ited payment, variable, adjustable, or universal life insurance. Other types of insurance
policies—group life and credit life insurance—are generally temporary forms of insur-
ance. Exhibit 10–2 lists major types and subtypes of life insurance.
TERM LIFE INSURANCE Term insurance, sometimes called temporary life insur-
ance, provides protection against loss of life for only a specified term, or period of time. A
term insurance policy pays a benefit only if you die during the period it covers, which may
be 1, 5, 10, or 20 years, or up to age 70. If you stop paying the premiums, your coverage
stops. Term insurance is often the best value for customers. You need insurance coverage
most while you are raising children. As your children become independent and your assets
increase, you can reduce your coverage. Of the new individual life policies purchased in
2012, 36 percent (or 3.6 million) were term insurance policies. Term insurance comes in
many different forms. Here are some examples.
Renewable Term The coverage of term insurance ends at the conclusion of the term,
but you can continue it for another term—five years, for example—if you have a renewable
option. However, the premium will increase because you will be older. It also usually has
an age limit; you cannot renew after you reach a certain age.
Multiyear Level Term The most popular, a multiyear level term, or straight term, policy
guarantees that you will pay the same premium for the duration of your policy.
nonparticipating policy
Life insurance that does not
provide policy dividends; also
called a nonpar policy.
participating policy Life
insurance that provides
policy dividends; also called
a par policy.
term insurance Life
insurance protection for a
specified period of time;
sometimes called temporary
life insurance.
Term (temporary)
Whole, Straight,
or Ordinary Life Other Types
• Renewable term • Limited payment • Group life
• Multiyear level term • Variable life • Credit life
• Convertible term • Adjustable life • Endowment life
• Decreasing term • Universal life
• Return of premium
Exhibit 10–2
Major Types and
Subtypes of Life
Insurance
did you know? did you know?
Seventy-five million—or two out of three—
American families depend on life insurers’
products for protection, long-term savings, and a
guarantee of lifetime income during retirement.
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Conversion Term This type of policy allows you to change from term to permanent
coverage. This will have a higher premium.
Decreasing Term Term insurance is also available in a form that pays less to the ben-
eficiary as time passes. The insurance period you select might depend on your age or on
how long you decide that the coverage will be needed. For example, if you have a mort-
gage on a house, you might buy a 25-year decreasing term policy as a way to make sure
that the debt could be paid if you died. The coverage would decrease as the balance on the
loan decreased.
Return-of-Premium Term Recently, insurance companies began to sell return-of-
premium term life policies. These policies return all the premiums if you survive to the
end of the policy term. Premiums are higher than the regular term policy but you do get all
your money back.
WHOLE LIFE INSURANCE The other major type of life insurance is known as
whole life insurance (also called a straight life policy, a cash-value policy, or an ordinary
life policy ). Whole life insurance is a permanent policy for which you pay a specified pre-
mium each year for the rest of your life. In return the insurance company pays your bene-
ficiary a stated sum when you die. The amount of your premium depends mostly on the age
at which you purchase the insurance.
Whole life insurance may also serve as an investment. Part of each premium you pay is
set aside in a savings account. When and if you cancel the policy, you are entitled to the
accumulated savings, which is known as the cash value. Whole life policies are popular
because they provide both a death benefit and a savings component. You can borrow from
your cash value if necessary, although you must pay interest on the loan. Cash-value poli-
cies may make sense for people who intend to keep the policies for the long term or for
people who want a more structured way to save. However, the Consumer Federation of
America Insurance Group suggests that you explore other savings and investment strate-
gies before investing your money in a permanent policy.
Remember, the primary purpose of buying life insurance is
not for investment; it is to protect loved ones who depend on
you for financial support upon your death. Furthermore, buying
life insurance later in life can be expensive and you may not
qualify because of poor health or chronic diseases.
The premium of a term insurance policy will increase each
time you renew your insurance. In contrast, whole life policies
have a higher annual premium at first, but the rate remains the
same for the rest of your life. Several types of whole life pol-
icies have been developed to meet the needs of different customers. These include the
limited payment policy, the variable life policy, the adjustable life policy, and universal life
insurance.
Limited Payment Policy Limited payment policies charge premiums for only a cer-
tain length of time, usually 20 or 30 years or until the insured reaches a certain age. At
the end of this time, the policy is “paid up,” and the policyholder remains insured for life.
When the policyholder dies, the beneficiary receives the full death benefit. The annual
premiums are higher for limited payment policies because the premiums have to be paid
within a shorter period of time.
Variable Life Policy With a variable life policy, your premium payments are fixed. As
with a cash-value policy, part of your premium is placed in a separate account; this money
is invested in a stock, bond, or money market fund. The death benefit is guaranteed, but the
cash value of the benefit can vary considerably according to the ups and downs of the stock
market. Your death benefit can also increase, depending on the earnings of that separate fund.
whole life insurance An
insurance plan in which the
policyholder pays a specified
premium each year for as
long as he or she lives; also
called a straight life policy, a
cash-value life policy, or an
ordinary life policy.
cash value The amount
received after giving up a life
insurance policy.
did you know? did you know?
One hundred and forty-six million individual
life insurance policies were in force at the
beginning of 2013. Of the new individual policies
issued in 2012, 64 percent were whole life policies.
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Adjustable Life Policy An adjustable life policy allows you to change your coverage
as your needs change. For example, if you want to increase or decrease your death benefit,
you can change either the premium payments or the period of coverage.
Universal Life Universal life insurance is essentially a term policy with a cash value.
Part of your premium goes into an investment account that grows and earns interest. You
are able to borrow or withdraw your cash value. Unlike a traditional whole life policy, a
universal life policy allows you to change your premium without changing your coverage.
Exhibit 10–3 compares the important features of term life, whole life, and universal life
insurance.
OTHER TYPES OF LIFE INSURANCE POLICIES Other types of life
insurance policies include group life insurance, credit life insurance, and endowment life
insurance.
Group Life Insurance Group life insurance is basically a variation of term insurance.
It covers a large number of people under a single policy. The people included in the group
do not need medical examinations to get the coverage. Group insurance is usually offered
through employers, who pay part or all of the costs for their employees, or through profes-
sional organizations, which allow members to sign up for the coverage. Group plans are
easy to enroll in, but they can be much more expensive than similar term policies. In 2012,
group insurance represented 39 percent of all life insurance policies in force and provided
$8 trillion of protection.
universal life insurance
A whole life policy that
combines term insurance
and investment elements.
Term Life Whole Life Universal Life
Premium Lower initially, increasing with
each renewal.
Higher initially than term;
normally doesn’t increase.
Flexible premiums.
Protects for A specified period. Entire life if you keep the
policy.
A flexible time period.
Policy benefits Death benefits only. Death benefits and
eventually a cash and
loan value.
Flexible death benefits and
eventually a cash and loan
value.
Advantages Low outlay.
Initially, you can purchase a
larger amount of coverage for a
lower premium.
Helps you with financial
discipline.
Generally fixed premium
amount.
Cash value accumulation.
You can take loan against
policy.
More flexibility.
Takes advantages of current
interest rates.
Offers the possibility of
improved mortality rates
(increased life expectancy
because of advancements in
medicine, which may lower
policy costs).
Disadvantages Premium increases with age.
No cash value.
Costly if you surrender early.
Usually no cash value for
at least three to five years.
May not meet short-term
needs.
Same as whole life.
Greater risks due to program
flexibility.
Low interest rates can affect
cash value and premiums.
Options May be renewable or
convertible to a whole life
policy.
May pay dividends.
May provide a reduced
paid-up policy.
Partial cash surrenders
permitted.
May pay dividends.
Minimum death benefit.
Partial cash surrenders
permitted.
Exhibit 10–3 Comparing the Major Types of Life Insurance
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Credit Life Insurance Credit life insurance is used to pay off certain debts, such as
auto loans or mortgages, in the event that you die before they are paid in full. These types
of policies are not the best buy for the protection that they offer. Decreasing term insurance
is a better option.
Endowment Life Insurance Endowment is life insurance that provides coverage for
a specific period of time and pays an agreed-upon sum of money to the policyholder if he
or she is still living at the end of the endowment period. If the policyholder dies before that
time, the beneficiary receives the money.
PRACTICE QUIZ 10–2 PRACTICE QUIZ 10–2
1. What are the two types of life insurance companies?
2. For each of the following statements, indicate your response by writing “T” or “F.”
a. Stock life insurance companies generally sell participating (or par) policies. _____
b. Mutual life insurance companies specialize in the sale of nonparticipating (nonpar) policies. _____
c. If you wish to pay exactly the same premium each year, you should choose a nonpar policy. _____
d. Permanent insurance is known as whole life, straight life, ordinary life, and cash-value life insurance. _____
e. Term life insurance is the most expensive type of policy. _____
3. What are the five forms of term insurance?
4. What are the four forms of whole life insurance?
5. Define the following types of life insurance policies:
a. Group life insurance.
b. Credit life insurance.
c. Endowment life insurance.
Apply Yourself! Apply Yourself!
Choose one stock and one mutual life insurance company. Obtain and compare premiums for $50,000 term, whole life,
and universal life insurance.
Selecting Provisions and Buying
Life Insurance
Key Provisions in a Life Insurance Policy
Study the provisions in your policy carefully. The following are some of the most common
features.
NAMING YOUR BENEFICIARY You decide who receives the benefits of your
life insurance policy: your spouse, your child, or your business partner, for example. You
can also name contingent beneficiaries, those who will receive the money if your primary
beneficiary dies before or at the same time as you do. Update your list of beneficiaries as
your needs change.
INCONTESTABILITY CLAUSE The incontestability clause says that the insurer
can’t cancel the policy if it’s been in force for a specified period, usually two years. After
LO10.3
Select important provisions
in life insurance contracts
and create a plan to buy life
insurance.
ACTION ITEM
I have started budgeting for
my life insurance premiums
while I am still young and
healthy.
h Yes h No
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that time the policy is considered valid during the lifetime of
the insured. This is true even if the policy was gained through
fraud. The incontestability clause protects the beneficiaries from
financial loss in the event that the insurance company refuses to
meet the terms of the policy.
THE GRACE PERIOD When you buy a life insurance
policy, the insurance company agrees to pay a certain sum of
money under specified circumstances and you agree to pay a
certain premium regularly. The grace period allows 28 to 31
days to elapse, during which time you may pay the premium
without penalty. After that time, the policy lapses if you have
not paid the premium.
POLICY REINSTATEMENT A lapsed policy can be put
back in force, or reinstated, if it has not been turned in for cash.
To reinstate the policy, you must again qualify as an acceptable
risk, and you must pay overdue premiums with interest. There is
a time limit on reinstatement, usually one or two years.
NONFORFEITURE CLAUSE One important feature of the whole life policy is
the nonforfeiture clause. This provision prevents the forfeiture of accrued benefits if you
choose to drop the policy. For example, if you decide not to continue paying premiums,
you can exercise specified options with your cash value.
MISSTATEMENT OF AGE PROVISION The misstatement of age provision
says that if the company finds out that your age was incorrectly stated, it will pay the
benefits your premiums would have bought if your age had been correctly stated. The
provision sets forth a simple procedure to resolve what could otherwise be a complicated
legal matter.
POLICY LOAN PROVISION A loan from the insurance company is available on
a whole life policy after the policy has been in force for one, two, or three years, as stated
in the policy. This feature, known as the policy loan provision, permits you to borrow any
amount up to the cash value of the policy. However, a policy loan reduces the death benefit
by the amount of the loan plus interest if the loan is not repaid.
SUICIDE CLAUSE In the first two years of coverage, beneficiaries of someone who
dies by suicide receive only the amount of the premiums paid. After two years beneficia-
ries receive the full value of death benefits.
RIDERS TO LIFE INSURANCE POLICIES An insurance company can change
the conditions of a policy by adding a rider to it. A rider is a document attached to a policy
that changes its terms by adding or excluding specified conditions or altering its benefits.
Waiver of Premium Disability Benefit One common rider is a waiver of premium
disability benefit. This clause allows you to stop paying premiums if you’re totally and
permanently disabled before you reach a certain age, usually 60. The company continues
to pay the premiums at its own expense.
Accidental Death Benefit Another common rider to life insurance is an accidental
death benefit, sometimes called double indemnity. Double indemnity pays twice the value
of the policy if you are killed in an accident. Again, the accident must occur before a cer-
tain age, generally 60 to 65. Experts counsel against adding this rider to your coverage.
The benefit is very expensive, and your chances of dying in an accident are slim.
nonforfeiture clause A
provision that allows the
insured not to forfeit all
accrued benefits.
rider A document attached
to a policy that modifies its
coverage.
double indemnity A
benefit under which the
company pays twice the
face value of the policy if the
insured’s death results from
an accident.
did you know? did you know?
LEED (Leadership in Energy and LEED (Leadership in Energy and
Environmental Design) is an international Environmental Design) is an international
certification used to measure how well a certification used to measure how well a
building or community performs. LEED building or community performs. LEED
is used to assess energy savings, water is used to assess energy savings, water
efficiency, CO efficiency, CO 2 emissions reduction, and emissions reduction, and
improved indoor air quality. The program improved indoor air quality. The program
provides a guide for developing environmen-provides a guide for developing environmen-
tally friendly building design, construction, tally friendly building design, construction,
operations, and maintenance. operations, and maintenance.
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Guaranteed Insurability Option A third important rider is known as a guaranteed
insurability option. This rider allows you to buy a specified additional amount of life insur-
ance at certain intervals without undergoing medical exams. This is a good option for
people who anticipate needing more life insurance in the future.
Cost-of-Living Protection This special rider is designed to help prevent inflation
from eroding the purchasing power of the protection your policy provides. A loss, reduc-
tion, or erosion of purchasing power refers to the impact inflation has on a fixed amount
of money. As inflation increases the cost of goods and services, that fixed amount will not
buy as much in the future as it does today. Exhibit 10–4 shows the effects of inflation on a
$100,000 life insurance policy. However, your insurance needs are likely to be smaller in
later years.
Accelerated Benefits Accelerated benefits, also known as living benefits, are life
insurance policy proceeds paid to the policyholder who is terminally ill before he or she
dies. The benefits may be provided for directly in the policies, but more often they are
added by riders or attachments to new or existing policies. A representative list of insurers
that offer accelerated benefits is available from the National Insurance Consumer Help-
line (NICH) at 1-800-942-4242. Although more than 150 companies offer some form of
accelerated benefits, not all plans are approved in all states. NICH cannot tell you whether
a particular plan is approved in any given state. For more information, check with your
insurance agent or your state department of insurance.
Second-to-Die Option A second-to-die life insurance policy,
also called survivorship life, insures two lives, usually husband and
wife. The death benefit is paid when the second spouse dies. Usu-
ally a second-to-die policy is intended to pay estate taxes when
both spouses die. However, some attorneys claim that with the right
legal advice, you can minimize or avoid estate taxes completely.
Now that you know the various types of life insurance policies
and the major provisions of and riders to such policies, you are
ready to make your buying decisions.
Exhibit 10–4
Effects of Inflation on a
$100,000 Life Insurance
Policy
Assumed Annual Inflation Rate: 3%
Purchasing Power After:
100
80
60
40
20
0
5 years
5 years
$86,261
10 years 15 years 20 years
10 years
$74,409
15 years
$64,186
20 years
$55,368
SOURCE: The TIAA Guide to Life Insurance Planning for People in Education (New York: Teachers Insurance and
Annuity Association, January 1997), p. 8.
CAUTION! CAUTION!
Each rating agency uses its own criteria to
determine financial ratings. Even though all
use an “A,” “B,” or “C” grading system, what
is “A” for one might be “AA 1 ” or “Aa1” for
another.
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332 Chapter 10 Financial Planning with Life Insurance
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Buying Life Insurance
You should consider a number of factors before buying life
insurance. As discussed earlier in this chapter, these factors
include your present and future sources of income, other savings
and income protection, group life insurance, group annuities
(or other pension benefits), Social Security, and, of course, the
financial strength of the company.
FROM WHOM TO BUY? Look for insurance coverage
from financially strong companies with professionally quali-
fied representatives. It is not unusual for a relationship with an
insurance company to extend over a period of 20, 30, or even
50 years. For that reason alone you should choose carefully
when deciding on an insurance company or an insurance agent.
Fortunately, you have a choice of sources.
Sources Protection is available from a wide range of private
and public sources, including insurance companies and their
representatives; private groups such as employers, labor unions,
and professional or fraternal organizations; government pro-
grams such as Medicare and Social Security; and financial insti-
tutions and manufacturers offering credit insurance.
Rating Insurance Companies Some of the strongest,
most reputable insurance companies in the nation provide excel-
lent insurance coverage at reasonable costs. In fact, the financial
strength of an insurance company may be a major factor in holding down premium costs
for consumers.
Locate an insurance company by checking the reputations of local agencies. Ask mem-
bers of your family, friends, or colleagues about the insurers they prefer. Exhibit 10–5
describes the rating systems used by A. M. Best and the other big four rating agencies.
Choosing Your Insurance Agent An insurance agent handles the technical side of
insurance. However, that’s only the beginning. The really important part of the agent’s job
is to apply his or her knowledge of insurance to help you select the proper kind of protec-
tion within your financial boundaries.
Is it ethical for an attorney who is also a licensed insurance agent to sell life insurance to
clients? Yes, according to experts, if terms are fair and reasonable to you and you consent
in writing to the terms of the transactions and to the conflict of interest.
Choosing a good agent is among the most important steps in building your insurance
program. How do you find an agent? One of the best ways to begin is by asking your par-
ents, friends, neighbors, and others for their recommendations. The “Personal Finance in
Practice” box offers guidelines for choosing an insurance agent.
COMPARING POLICY COSTS Each life insurance company designs the pol-
icies it sells to make them attractive and useful to many policyholders. One policy may
have features another policy doesn’t; one company may be more selective than another
company; one company may get a better return on its investments than another company.
These and other factors affect the prices of life insurance policies.
In brief, five factors affect the price a company charges for a life insurance policy:
the company’s cost of doing business, the return on its investments, the mortality rate it
expects among its policyholders, the features the policy contains, and competition among
companies with comparable policies.
did you know? did you know?
If you have misplaced a life insurance policy,
your state’s insurance commission may be
able to help you locate it. Or you can search for it at
www.policylocator.org .
digi – know? digi – know?
If you shop for insurance on the Inter- If you shop for insurance on the Inter-
net, make sure that the website is secure. net, make sure that the website is secure.
Look for the lock icon in the address bar, Look for the lock icon in the address bar,
or a URL that begins with “https:” and or a URL that begins with “https:” and
never provide personal data if you don’t never provide personal data if you don’t
trust the site. For more information on trust the site. For more information on
life insurance, visit life insurance, visit www.accuquote.comwww.accuquote.com ; ;
www.acli.comwww.acli.com ; ; www.iii.orgwww.iii.org ; ; www.naic.orgwww.naic.org ; ;
www.insure.comwww.insure.com ; and your state insurance ; and your state insurance
department. department.
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Checklist for Choosing an Insurance Agent
Personal Finance in Practice
Yes No
1. Is your agent available when needed? Clients sometimes have problems that need
immediate answers.
h h
2. Does your agent advise you to have a financial plan? Each part of the plan should be
necessary to your overall financial protection.
h h
3. Does your agent pressure you? You should be free to make your own decisions about
insurance coverage.
h h
4. Does your agent keep up with changes in the insurance field? Agents often attend
special classes or study on their own so that they can serve their clients better.
h h
5. Is your agent happy to answer questions? Does he or she want you to know exactly
what you are paying for an insurance policy?
h h
A. M. Best
Standard
& Poor’s,
Duff & Phelps Moody’s Weiss Research
Superior A 1 1 AAA Aaa A 1
A 1
Excellent A AA 1 Aa1 A
A 2 AA Aa2 A 2
AA 2 Aa3 B 1
Good B 1 1 A 1 A1 B
B 1 A A2 B 2
A 2 A3 C 1
Adequate B BBB 1 Baa1 C
B 2 BBB Baa2 C 2
BBB 2 Baa3 D 1
Below average C 1 1 BB 1 Ba1 D
C 1 BB Ba2 D 2
BB 2 Ba3 E 1
Weak C B 1 B1 E
C 2 B B2 E 2
D B 2 B3
Nonviable E CCC Caa F
F CC Ca
C, D C
Exhibit 10–5
Rating Systems of Major
Rating Agencies
You Should Deal with
Companies Rated Superior
or Excellent
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review your coverage periodically to ensure that it keeps
up with your changing needs.
Remember that your need for life insurance coverage
will change over time. Your income may go up or down,
or your family size might change. Therefore, it is wise to
Ten Golden Rules of Buying Life Insurance
Personal Finance in Practice
Consider the time value of money in comparing policy costs. Ask your agent to give you
interest-adjusted indexes. An interest-adjusted index is a method of evaluating the cost of
life insurance by taking into account the time value of money. Highly complex mathemat-
ical calculations and formulas combine premium payments, dividends, cash-value buildup,
and present value analysis into an index number that makes possible a fairly accurate cost
comparison among insurance companies. The lower the index number, the lower the cost
of the policy. The nearby “Figure It Out!” box shows how to use an interest-adjusted index
to compare the costs of insurance.
OBTAINING AND EXAMINING A POLICY A life insurance policy is issued
after you submit an application for insurance and the insurance company accepts the appli-
cation. The company determines your insurability by means of the information in your
application, the results of a medical examination, and the inspection report. When you
receive a life insurance policy, read every word of the contract and, if necessary, ask your
agent for a point-by-point explanation of the language. Many insurance companies have
rewritten their contracts to make them more understandable. These are legal documents,
and you should be familiar with what they promise, even though they use technical terms.
After you buy new life insurance, you have a 10-day “free-look” period during which
you can change your mind. If you do so, the company will return your premium without
penalty.
CHOOSING SETTLEMENT OPTIONS Selecting the appropriate settlement
option is an important part of designing a life insurance program. The most common
interest-adjusted
index A method of
evaluating the cost of life
insurance by taking into
account the time value of
money.
SOURCE: American Council of Life Insurance, 1001 Pennsylvania Avenue NW, Washington, DC 20004-2599.
Follow these rules when buying life insurance Done
1. Understand and know what your life insurance needs are before you make any purchase,
and make sure the company you choose can meet those needs.
h
2. Buy your life insurance from a company that is licensed in your state. h
3. Select an agent who is competent, knowledgeable, and trustworthy. h
4. Shop around and compare costs. h
5. Buy only the amount of life insurance you need and can afford. h
6. Ask about lower premium rates for nonsmokers. h
7. Read your policy and make sure you understand it. h
8. Inform your beneficiaries about the kinds and amount of life insurance you own. h
9. Keep your policy in a safe place at home, and keep your insurance company’s name and
your policy number in a safe deposit box.
h
10. Check your coverage periodically, or whenever your situation changes, to ensure that it
meets your current needs.
h
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not giving you $2,100. What if you had invested the annual
premiums in a conservative stock mutual fund? At an 8
percent annual yield, your account would have accumu-
lated to $9,610 in 20 years. (See Exhibit 1–B.) Therefore,
instead of having received $2,100 from the insurance com-
pany, you have paid the company $5,010 for 20 years of
insurance protection:
Premiums you paid
over 20 years $4,200
Time value of money 5,410 ($9,610 2 $4,200)
Total cost 9,610
Cash value 4,600
Net cost of insurance 5,010 ($9,610 2 $4,600)
Be sure to request interest-adjusted indexes from
your agent; if he or she doesn’t give them to you, look for
another agent. As you have seen in the example, you can
compare the costs among insurance companies by com-
bining premium payments, dividends, cash-value buildup,
and present value analysis into an index number.
In determining the cost of insurance, don’t overlook the
time value of money. You must include as part of that cost
the interest (opportunity cost) you would earn on money if
you did not use it to pay insurance premiums. For many
years, insurers did not assign a time value to money in
making their sales presentations. Only recently has the
insurance industry widely adopted interest-adjusted cost
estimates.
If you fail to consider the time value of money, you may
get the false impression that the insurance company is giv-
ing you something for nothing. Here is an example. Sup-
pose you are 35 and have a $10,000 face amount, 20-year,
limited-payment, participating policy. Your annual pre-
mium is $210, or $4,200 over the 20-year period. Your div-
idends over the 20-year payment period total $1,700, so
your total net premium is $2,500 ($4,200 2 $1,700). Yet the
cash value of your policy at the end of 20 years is $4,600. If
you disregard the interest your premiums could otherwise
have earned, you might get the impression that the insur-
ance company is giving you $2,100 more than you paid
($4,600 2 $2,500). But if you consider the time value of
money (or its opportunity cost), the insurance company is
Determining the Cost of Insurance: The Time Value of Money Determining the Cost of Insurance: The Time Value of Money
Figure It Out!
settlement options are lump-sum payment, limited installment pay-
ment, life income option, and proceeds left with the company.
Lump-Sum Payment The insurance company pays the face
amount of the policy in one installment to the beneficiary or to the
estate of the insured. This form of settlement is the most widely
used option.
Limited Installment Payment This option provides for payment of the life insurance
proceeds in equal periodic installments for a specified number of years after your death.
Life Income Option Under the life income option, pay-
ments are made to the beneficiary for as long as she or he lives.
The amount of each payment is based primarily on the sex and
attained age of the beneficiary at the time of the insured’s death.
Proceeds Left with the Company The life insurance pro-
ceeds are left with the insurance company at a specified rate of
interest. The company acts as trustee and pays the interest to the
beneficiary. The guaranteed minimum interest rate paid on the
proceeds varies among companies.
SWITCHING POLICIES Think twice if your agent suggests that you replace the
whole life or universal life insurance you already own. Before you give up this protection,
make sure you are still insurable (check medical and any other qualification requirements).
Ask your agent or company for an opinion about the new proposal to get both sides of the
argument. The nearby “Personal Finance in Practice” box presents 10 important guidelines
for purchasing life insurance.
CAUTION! CAUTION!
Never buy coverage you don’t understand.
It is the agent’s responsibility to explain your
coverage in terms you can understand.
did you know? did you know?
The life insurance industry pays out $1.5
billion every day through payments from
life insurance, annuities, long-term care insurance,
disability income insurance, and deposit funds used
for retirement.
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Financial Planning with Annuities
As you have seen so far, life insurance provides a set sum of money at your death. How-
ever, if you want to enjoy benefits while you are still alive, you might consider annuities.
An annuity protects you against the risk of outliving your assets.
An annuity is a financial contract written by an insurance company that provides you
with regular income. Generally, you receive the income monthly, often with payments
arranged to continue for as long as you live. Annuities may be fixed, providing a specific
income for life, or variable, with payouts above a guaranteed minimum level dependent on
investment return. The payments may begin at once ( immediate annuity ) or at some future
date ( deferred annuity ).
IMMEDIATE ANNUITIES People approaching retirement age can purchase imme-
diate annuities. These annuities provide income payments at once. They are usually pur-
chased with a lump-sum payment. When you are 65, you may no longer need all of your
life insurance coverage—especially if you have grown children. You may decide to con-
vert the cash value of your insurance policy into a lump-sum payment for an immediate
annuity.
DEFERRED ANNUITIES With deferred annuities, income payments start at some
future date. Meanwhile, interest accumulates on the money you deposit. Younger people
often buy such annuities to save money toward retirement. A deferred annuity purchased
LO10.4
Recognize how annuities
provide financial security.
ACTION ITEM
An annuity protects me
against the risk of outliving
my assets.
h Yes h No
annuity A contract that
provides a regular income for
as long as the person lives.
PRACTICE QUIZ 10–3 PRACTICE QUIZ 10–3
1. What are the key provisions in a life insurance policy?
2. What is a rider?
3. What are the various riders in a life insurance policy?
4. What factors do you consider in choosing an insurance agent?
5. What are the four most common settlement options?
6. Match the following terms with the appropriate definition:
endowment a. A person named to receive the benefits from an insurance policy. _____________________
beneficiary b. Provides coverage for a specific period of time and pays an agreed-upon sum of money
to the policyholder if he or she is still living at the end of the period.
_______________________________________________________________________________
whole life insurance c. A permanent policy for which the policyholder pays a specified premium for the rest of
his or her life. ___________________________________________________________________
double indemnity d. A rider to a life insurance policy that pays twice the value of the policy if the policyholder
is killed in an accident. __________________________________________________________
Apply Yourself! Apply Yourself!
Examine your life insurance policies and the policies of other members of your family. Note the contractual provisions of
each policy. What does the company promise to do in return for premiums?
Sheet 34 Life Insurance Policy
Comparison
S
C
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with a lump-sum payment is known as a single-premium deferred annuity. A premium is
the payment you make. These annuities are popular because of the greater potential for
tax-free growth. If you are buying a deferred annuity on an installment basis, you may
want one that allows flexible premiums, or payments. That means that your contributions
can vary from year to year.
As with the life insurance principle, discussed earlier, the predictable mortality experi-
ence of a large group of individuals is fundamental to the annuity principle. By determin-
ing the average number of years a large number of persons in a given age group will live,
the insurance company can calculate the annual amounts to pay to each person in the group
over his or her entire life.
Because the annual payouts per premium amount are determined by average mortality
experience, annuity contracts are more attractive for people whose present health, living
habits, and family mortality experience suggest that they are likely to live longer than
average. As a general rule, annuities are not advisable for people in poor health, although
exceptions to this rule exist.
INDEX ANNUITIES A type of fixed annuity, an index annuity, has earnings that
accumulate at a rate based on a formula linked to one or more equity-based indexes, such
as the S&P 500. Index annuities may offer death benefit protection.
Why Buy Annuities?
A primary reason for buying an annuity is to give you retirement
income for the rest of your life. You should fully fund your IRAs,
Keoghs, and 401(k)s before considering annuities. We discuss
retirement income in Chapter 14.
Although people have been buying annuities for many years,
the appeal of variable annuities increased during the mid-1990s
due to a rising stock market. A fixed annuity states that the annui-
tant (the person who is to receive the annuity) will receive a fixed
amount of income over a certain period or for life. With a variable
annuity, the monthly payments vary because they are based on the
income received from stocks or other investments.
Today, variable annuities are part of the retirement and investment plans of many Amer-
icans. Before buying any variable annuity, however, request a prospectus from the insur-
ance company or from your insurance agent and read it carefully. The prospectus contains
important information about the annuity contract, including fees and charges, investment
options, death benefits, and annuity payout options. Compare the benefits and costs of the
annuity to other variable annuities and to other types of investments, such as mutual funds,
discussed in Chapter 13.
Some of the growth in the use of annuities can be attributed to the passage of the
Employee Retirement Income Security Act (ERISA) of 1974. Annuities are often pur-
chased for individual retirement accounts (IRAs), which ERISA made possible. They may
also be used in Keogh-type plans for self-employed people. As you will see in Chapter 14,
contributions to both IRA and Keogh plans are tax-deductible up to specified limits.
Costs of Annuities
You will pay several charges when you purchase a variable annuity. Be sure you under-
stand all the costs before you invest. These costs will reduce the value of your account and
the return on your investment. The most common costs are:
• Surrender charges. The insurance company will assess a “surrender” charge if you
withdraw money within a certain period, usually within 6 to 8 years. Generally, the
surrender charge declines gradually over a period of 7 to 10 years.
CAUTION! CAUTION!
An annuity is a long-term financial contract.
You should enter into an annuity arrangement
only after a thorough review of your personal
finances and retirement goals.
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• Mortality and expense risk charge. This charge is equal to a certain percentage
of your account value, usually 1.25 percent per year. The charge compensates the
insurance company for insurance risks it assumes under the annuity contract. Profit
from the mortality and expense risk charge is sometimes used to pay the insurer’s
costs of selling the variable annuity, such as a commission paid to your financial
professional for selling the variable annuity to you.
EXAMPLE: Surrender Charge
You purchase a variable annuity contract with a $10,000 purchase payment.
The contract has a schedule of surrender charges, beginning with a 7 percent
charge in the first year, and declining by 1 percent each year. In addition, you
are allowed to withdraw 10 percent of your contract value each year free of
surrender charges. In the first year, you decide to withdraw $5,000, or one-half
of your contract value of $10,000 (assuming that your contract value has not
increased or decreased because of investment performance). In this case, you
could withdraw $1,000 (10 percent of contract value) free of surrender charges,
but you would pay a surrender charge of 7 percent, or $280, on the other $4,000
withdrawn.
EXAMPLE: Mortality and Expense Risk Charge
Your variable annuity has a mortality and expense risk charge at an annual
rate of 1.25 percent of account value. Your average account value during the
year is $20,000, so you will pay $250 in mortality and expense risk charges
that year.
• Administrative fees. Your insurance company may deduct fees to cover
recordkeeping and other administrative expenses. The fee may be charged as a flat
account maintenance fee (perhaps $25 or $30 per year) or as a percentage of your
account value (usually 0.15 percent per year).
EXAMPLE: Administrative Fees
Your variable annuity charges administrative fees at an annual rate of 0.15 percent
of account value. Your average account value during the year is $50,000. You will
pay $75 in administrative fees.
• Fund expenses. You will also indirectly pay the fees and expenses imposed by the
mutual funds that are the underlying investment options for your variable annuity.
Read the “Kiplinger’s Personal Finance” box to learn more about the costs and benefits
of variable annuities.
Tax Considerations
When you buy an annuity, the interest on the principal, as well as the interest compounded
on that interest, builds up free of current income tax. The Tax Reform Act of 1986 preserves
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2012. The Kiplinger Washington Editors, Inc.
1. Why was the author of “A Tolerable Annuity” reluctant to write a positive article about a variable annuity?
2. What led the author to reconsider his opinion about variable annuities?
3. How does the Vanguard variable annuity differ from other variable annuities?
4. Does the author recommend a variable annuity for most clients? Explain your answer.
I
never thought that I would
write a positive article
about a variable annuity.
As an investment advisor,
I get sales pitches almost daily
touting the huge commissions
I could make by selling variable
annuities. The trouble is, what’s
potentially a good deal for me is
usually a lousy deal for my cli-
ents, who could be stuck paying
annual fees of 3% or more.
But Vanguard is now offering
a guaranteed-income provision
for its variable annuity, and
that is causing me to recon-
sider. For a total annual cost
of 1.45% to 1.55%—about half
the industry average—you get
a balanced portfolio of stocks
and bonds. Plus, you get a guar-
antee that you’ll receive a fixed
sum annually—no matter how
much the markets may decline.
How it works. A variable
annuity is a hybrid: part invest-
ment, part insurance. Say you
invest $100,000 in the Vanguard
variable annuity. If you’re
between 59½ and 64 years old,
you can withdraw 4.5%, or
$4,500, in the first year (4%, or
$4,000, for a couple). If you’re
older, your initial withdrawal
percentage is slightly higher.
Assume that the stock and
bond markets rally and that
your account grows 10%, to
$110,000, the next year. Instead
of withdrawing $4,500, you can
withdraw $4,950 from your
account in the second year—a
10% increase. Now assume that
the markets fall the following
year, and your account shrinks
from $110,000 to $90,000.
Thanks to the income guaran-
tee, you will still receive $4,950
that year. In other words, your
minimum annual withdrawal
benefit can never shrink below
its previous high-water mark.
Investment accounts are val-
ued once a year for the purpose
of computing your high- water
mark. The value of your account
rises and falls with the markets
but also declines with your
annual withdrawals.
The Vanguard variable
annuity has three investment
options. The best, in my view, is
an actively managed balanced
fund that is virtually identical
to Vanguard Wellington (symbol
VWELX), which keeps 60% to
70% in stocks and the remain-
der in bonds. Or you can choose
an option that invests 60% in
Vanguard stock index funds and
40% in the firm’s bond index
funds, or a more conservative
plan that keeps 40% in stock
index funds and 60% in bond
index funds. The Wellington
option costs 0.60% annually;
the others cost 0.50% a year.
Unlike many variable annu-
ities, the terms of Vanguard’s
annuity are flexible. Say your
investment account grows
over the next decade and you
decide that you don’t need the
guaranteed-withdrawal benefit.
You can ask Vanguard to remove
the benefit. You’ll still have a
variable annuity, but your annual
expenses will drop by 0.95 per-
centage point. Why not hold on
to the guarantee? Because, over
time, the
additional
charges of
nearly 1% a
year will be
a significant
drain on your
returns.
I wouldn’t
recommend
a variable
annuity for most clients, nor
would Vanguard. It’s unlikely
that the stock market will pro-
duce anything like the wretched
returns it did in the past decade.
That means most people will
do better in retirement with
a well-diversified investment
portfolio. You should be able
to withdraw 4% a year from
your portfolio initially and give
yourself an annual cost-of-living
adjustment, too—at least in years
when the markets perform well.
Is the Vanguard annuity right
for you? If stocks make you
nervous, check out Vanguard’s
low-cost variable annuity with a
guaranteed payout. And it might
be a good alternative if you have
a higher-cost annuity you’d like to
swap for a lower-cost one. To com-
pare Vanguard’s variable- annuity
prices against others, try the free
calculator at https://personal
.vanguard.com/us/whatweoffer/
annuities/costcalculator .
Bottom line: If you need
guaranteed income and you are
risk-averse, it’s nice to know
you can finally buy a product
that meets your needs and
doesn’t charge an arm and a leg.
Steve Goldberg
A Tolerable Annuity
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340 Chapter 10 Financial Planning with Life Insurance
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the tax advantage of annuities (and insurance) but curtails deductions for IRAs. With an
annuity, there is no maximum annual contribution. Also, if you die during the accumula-
tion period, your beneficiary is guaranteed no less than the amount invested.
Exhibit 10–6 shows the difference between an investment in an annuity and an invest-
ment in a certificate of deposit (CD). Remember, federal income tax on an annuity is
deferred, whereas the tax on interest earned on a CD must be paid currently.
As with any other financial product, the advantages of annuities are tempered by draw-
backs. In the case of variable annuities, these drawbacks include reduced flexibility and
fees that lower investment return.
Exhibit 10–6
Tax-Deferred Fixed
Annuity versus Taxable
CD (a 30-year projection
of performance; single
deposit of $30,000)
100,000
0
50,000
20151050
$200,000
30
CD: 3.5% Annuity: 6% Tax bracket: 33%
150,000
25
Annuity $172,305CD $60,134
PRACTICE QUIZ 10–4 PRACTICE QUIZ 10–4
1. What is an annuity?
2. What is the difference between an immediate and a deferred annuity?
3. As a general rule, are annuities advisable for people in poor health? Why or why not?
4. What are fixed and variable annuities?
Apply Yourself! Apply Yourself!
Interview friends, relatives, and others who have bought annuities. Which type of annuity did they purchase, and why?
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YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Do you know if you need life insurance? Have you taken time to consider why you need life
insurance and to find a sales agent who is knowledgeable and trustworthy? Have you evaluated the advantages and
disadvantages of term life, whole life, and other life insurance options available to you?
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items”
(in the text margin) in the chapter to determine
actions you might take to improve your life insurance
requirements.
Check if your employer provides life insurance
through group insurance plans. In most cases,
your employer will pay part or all of the cost of such
insurance.
Choose a reputable life insurance company; then
obtain and compare premiums for $100,000 term,
whole life, and universal life insurance.
Examine your life insurance policy and note its con-
tractual provisions. What does the company promise
to do in return for premiums?
For more information on life insurance, visit www
.accuquote.com , www.acli.com , www.iii.org , www
.InsureUonline.org , and www.insure.com .
A personal finance dashboard with key performance
indicators can help you monitor your financial situation
and guide you toward financial independence. Your
need for life insurance will change with changes in your
life. For example, if you are single or live with your par-
ents, you may not need life insurance, unless you have
a debt or want to provide for your parents, a friend, a
relative, or charity. However, as children are born, your
need for life insurance will increase. As children grow
older and leave the nest, you will probably need less
insurance.
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FINANCIALLY SEC
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NUMBER OF TIMES INCOME
OF LIFE INSURANCE COVERAGE
0 10
2 8
1 9
3 7
54 6
LO10.1 Life insurance protects the peo-
ple who depend on you from financial losses
caused by your death. You can use the easy
method, the DINK method, the “nonworking”
spouse method, or the “family need” method
to determine your life insurance needs.
LO10.2 Two types of insurance compa-
nies—stock and mutual—sell nonparticipat-
ing and participating policies. Both sell two
basic types of insurance: term life and whole
life. Many variations and combinations of
these types are available.
LO10.3 Most life insurance policies have
standard features. An insurance company
can change the conditions of a policy by
adding a rider to it.
Before buying life insurance, consider all
your present and future sources of income;
then compare the costs and choose appro-
priate settlement options.
LO10.4 An annuity pays while you live,
whereas life insurance pays when you die.
With a fixed annuity, you receive a fixed
amount of income over a certain period or
for life. With a variable annuity, the monthly
payments vary because they are based on
the income received from stocks or other
investments.
Chapter
Summary
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annuity 336
beneficiary 321
cash value 327
double indemnity 330
interest-adjusted index 334
Key Terms
term insurance 326
universal life
insurance 328
whole life insurance 327
nonforfeiture clause 330
nonparticipating
policy 325
participating policy 325
rider 330
1. Choose a current issue of Money, Kiplinger’s Personal Finance, Consumer Reports,
or Worth and summarize an article that provides information on human life expec-
tancy and how life insurance may provide financial security. (LO10.1)
2. Analyze the four methods of determining life insurance requirements. Which method
is best, and why? (LO10.1)
3. Visit a few websites of companies such as Metropolitan Life, New York Life, Trans-
america Life, Lincoln Benefit Life, or others of your choice. Then summarize the
various types of insurance coverage available from these companies. (LO10.2)
4. Contact your state insurance department to get information about whether your state
requires interest-adjusted cost disclosure. Summarize your findings. (LO10.3)
5. Review the settlement options on your family’s life insurance policies, and discuss
with your family which option would be the best choice for them at
this time. (LO10.3)
6. Is it legal or ethical for an insurance agent to suggest a variable life insurance policy to
an 80-year-old man? Explain your answer. (LO10.4)
Discussion
Questions
1. Suppose that yours is a typical family. Your annual income is $60,000. Use the easy
method to determine your need for life insurance.
2. Using the “nonworking” spouse method, what should be the life insurance needs for a
family whose youngest child is two years old?
3. Suppose your annual premium for a $20,000, twenty-year limited-payment policy is
$420 over the twenty-year period. The cash value of your policy at the end of 20 years
is $9,200. Assume that you could have invested the annual premium in a mutual fund
yielding 7 percent annually. What is the net cost of your insurance for the 20-year
period?
Solutions
1. Current gross income 5 $60,000
Multiply gross income by 7 years 5 $420,000
Take 70 percent of $420,000 5 $420,000 3 0.70
Approximate insurance needed 5 $294,000
2. Youngest child’s age 5 2 years
16 years before the child is 18 years old
Insurance needed 16 3 $10,000 5 $160,000
3. Premiums paid over 20 years 5 $420 3 20 5 $8,400
Time value of 20-year annual payments of $420 at 7 percent yield.
(See Exhibit 1–B; use a factor of 40.995) 5 40.995 3 $420 5 $17,218
Cash value 5 $9,200
Net cost of insurance 5 $17,218 2 9,200 5 $8,018
Self-Test
Problems
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1. You are the wage earner in a “typical family,” with $40,000 gross annual income.
Use the easy method to determine how much insurance you should carry. (LO10.1)
2. You and your spouse are in good health and have reasonably secure careers. Each of you
makes about $40,000 annually. You own a home with an $80,000 mortgage, and you
owe $15,000 on car loans, $5,000 in personal debts, and $4,000 on credit card loans.
You have no other debts. You have no plans to increase the size of your family in the
near future. Estimate your total insurance needs using the DINK method. (LO10.1)
3. Shaan and Anita are married and have two children, ages 4 and 7. Anita is a “non-
working” spouse who devotes all of her time to household activities. Estimate how
much life insurance Shaan and Anita should carry. (LO10.1)
4. Obtain premium rates for $50,000 whole life, universal life, and term life policies from
local insurance agents. Compare the costs and provisions of these policies. (LO10.2)
5. Use the “Figure It Out!” worksheet in this chapter to calculate your own life
insurance needs. (LO10.1)
6. Use Exhibit 10–1 to find the average number of additional years a 25-year-old male
and female are expected to live, based on the statistics gathered by the U.S. govern-
ment as of 2009. (LO10.1)
7. Mark and Parveen are the parents of three young children. Mark is a store manager
in a local supermarket. His gross salary is $75,000 per year. Parveen is a full-time
stay-at-home mom. Use the easy method to estimate the family’s life insurance
needs. (LO10.1)
8. You are a dual-income, no-kids family. You and your spouse have the following debts
(total): mortgage, $200,000; auto loan, $10,000; credit card balance, $4,000; other
debts, $10,000. Further, you estimate that your funeral will cost $8,000. Your spouse
expects to continue to work after your death. Using the DINK method, what should
be your need for life insurance? (LO10.1)
9. Using the “nonworking” spouse method, what should be the life insurance needs for
a family whose youngest child is 10 years old? (LO10.1)
10. Using the “nonworking” spouse method, what should be the life insurance needs for
a family whose youngest child is five years old? (LO10.1)
11. Your variable annuity charges administrative fees at an annual rate of 0.15 percent of
account value. Your average account value during the year is $200,000. What is the
administrative fee for the year? (LO10.4)
12. Sophia purchased a variable annuity contract with $25,000 purchase payment. Surren-
der charges begin with 7 percent in the first year and decline by 1 percent each year.
In addition, Sophia can withdraw 10 percent of her contract value each year with-
out paying surrender charges. In the first year, Sophia needed to withdraw $6,000.
Assume that the contract value had not increased or decreased because of investment
performance. What was the surrender charge Sophia had to pay? (LO10.4)
13. Shelly’s variable annuity has a mortality and expense risk charge at an annual rate of
1.25 percent of account value. Her account value during the year is $50,000. What
was Shelly’s mortality and expense risk charge for the year? (LO10.4)
Problems
LIFE INSURANCE FOR THE YOUNG MARRIED
Case in
Point
Jeff and Ann are both 28 years old. They
have been married for three years, and they
have a son who is almost two. They expect
their second child in a few months.
Jeff is a teller in a local bank. He has just
received a $30-a-week raise. His income is
$480 a week, which, after taxes, leaves him
with $1,648 a month. His company pro-
vides $20,000 of life insurance, a medical/
hospital/surgical plan, and a major medical
plan. All of these group plans protect him
as long as he stays with the bank.
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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When Jeff received his raise, he decided
that part of it should be used to add to his
family’s protection. Jeff and Ann talked to
their insurance agent, who reviewed the
insurance Jeff obtained through his job.
Under Social Security, they also had some
basic protection against the loss of Jeff’s
income if he became totally disabled or if
he died before the children were 18.
But most of this protection was only basic,
a kind of floor for Jeff and Ann to build
on. For example, monthly Social Security
payments to Ann would be approximately
$1,250 if Jeff died leaving two chil-
dren under age 18. Yet the family’s total
expenses would soon be higher after the
birth of the second baby. Although the
family’s expenses would be lowered if Jeff
died, they would be at least $250 a month
more than Social Security would provide.
Questions
1. What type of policy would you suggest
for Jeff and Ann? Why?
2. In your opinion do Jeff and Ann need
additional insurance? Why or why not?
Continuing
Case
Assets (Jamie Lee and Ross combined) :
Checking account, $2,500
Savings account, $16,000
Emergency fund savings account, $19,100
IRA balance, $25,000
Cars, $11,500 (Jamie Lee) and
$19,000 (Ross)
Liabilities (Jamie Lee and Ross
combined) :
Student loan balance, $0
Credit card balance, $3,500
Car loans, $7,000
Income:
Jamie Lee, $45,000 gross income
($31,500 net income after taxes)
Ross, $73,000 gross income ($60,800 net
income after taxes)
Monthly Expenses
Mortgage, $1,225
Property taxes, $400
Homeowner’s insurance, $200
Utilities, $160
Food, $500
Gas/Maintenance, $275
Credit card payment, $275
Car loan payment, $289
Entertainment, $125
FINANCIAL PLANNING WITH LIFE INSURANCE
Surprise! Jamie Lee and Ross were stunned to find that their family of two has grown to a
family of five. They were expecting twins until they found out the day they were born that
they were actually the parents of triplets!
Ross immediately had worries of being able to provide for the growing family: diapers,
formula, college expenses times three. What if something happened to him or Jamie Lee?
How would the surviving parent be able to provide for such a large family?
Current Financial Situation
Questions
1. Within days of the triplets’ arrival, Jamie Lee and Ross began researching and compar-
ing various agencies for the purchase of a life insurance policy. What characteristics
should Ross look for when choosing a life insurance agency? What sources could he
reference for help when choosing a life insurance agency?
2. Jamie Lee and Ross need to ensure that the surviving spouse and the children will not
have financial hardship in the event of a loss. Using the easy method and considering
Ross’s salary in the calculation, how much life insurance will they need?
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3. With so many policy variations to choose from, Ross and Jamie Lee are unsure which
company is offering the most competitive rates. How will they be able to compare the
rates between the various companies?
4. Jamie Lee and Ross have a limited budget for the life insurance necessity now that
they have the additional present-day expenses of the triplets to consider. What type of
life insurance would you recommend for the family at this life stage, and what are its
associated advantages and disadvantages?
Directions As you continue to record and monitor spending in various categories, be
sure to consider how various decisions will affect your long-term financial security. Vari-
ous comments you record might remind you to consider possible changes you might want
to make in your spending habits. The Daily Spending Diary sheets are located in Appendix
D at the end of the book and in Connect Finance.
Questions
1. Are there any spending amounts or items that you might consider reducing or
eliminating?
2. What actions might you consider now or in the future regarding spending on life
insurance?
“I’M NOT SURE SPENDING FOR LIFE INSURANCE IS NECESSARY
FOR MY LIFE SITUATION.”
Spending
Diary
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Household expenses to be covered
Final expenses (funeral, estate taxes, etc.) 1 $ _____________________
Payment of consumer debt amounts 2 $ _____________________
Emergency fund 3 $ _____________________
College fund 4 $ _____________________
Expected living expenses:
Average living expense $ _____________________
Spouse’s income after taxes $ 2 _____________________
Annual Social Security benefits $ 2 _____________________
Net annual living expenses $ _____________________
Years until spouse is 90 $ _____________________
Investment rate factor (see below) $ _____________________
Total living expenses 5 $ _____________________
Total monetary needs (1 1 2 1 3 1 4 1 5) $ _____________________
Less: Total current investments $ _____________________
Life insurance needs $ _____________________
Investment rate factors
Years until spouse is 90 25 30 35 40 45 50 55 60
Conservative investment 20 22 25 27 30 31 33 35
Aggressive investment 16 17 19 20 21 21 22 23
Note: Use “Your Personal Financial Plan” sheet 34 to compare life insurance policies.
What’s Next for Your Personal Financial Plan?
• Survey several people to determine their reasons for buying life insurance.
• Talk to an insurance agent to compare the rates charged by different companies and for different age
categories.
Determining Life Insurance Needs
Purpose: To estimate life insurance coverage needed to cover expected expenses and
future family living costs.
Financial Planning Activities: Estimate the amounts for the categories listed below. This
sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.insure.com www.kiplinger.com/tools/
33
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Life Insurance Policy Comparison
Purpose: To research and compare companies, coverages, and costs for different insurance
policies.
Financial Planning Activities: Analyze ads and contact life insurance agents to obtain the
information requested below. This sheet is also available in an Excel spreadsheet format in
Connect Finance.
Suggested Websites: www.insure.com www.accuquote.com
34
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Age:
Company
Agent’s name, address,
and phone
Type of insurance
(term, straight/whole,
limited payment,
endowment, universal)
Type of policy
(individual, group)
Amount of coverage
Frequency of payment
(monthly, quarterly,
semiannually, annually)
Premium amount
Other costs:
• Service charges
• Physical exam
Rate of return (annual
percentage increase in
cash value; not
applicable for term
policies)
Benefits of insurance
as stated in ad or by
agent
Potential problems or
disadvantages of this
coverage
What’s Next for Your Personal Financial Plan?
• Talk to a life insurance agent to obtain information on the methods he or she suggests for determining the
amount of life insurance a person should have.
• Research the differences in premium costs between a mutual and a stock company.
Suggested
App:
• LIFE
Foundation
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3 Steps to Financial
Literacy . . . Starting an
Investment Program
11
Investing Basics and
Evaluating Bonds
Why invest?
While many people dream of being the world’s
next millionaire, dreaming doesn’t make it hap-
pen. You must learn how to evaluate different
investments to become a smart investor. At
the end of the chapter, “Your Personal Finance
Dashboard” will help you measure your prog-
ress and suggest actions to improve your
investing skills.
1
Establish investment goals and perform a
financial checkup.
Website: www.genywealth.com/
financial-goals-example
2
Save the money needed to open a brokerage
account.
Website: www.brokerstance.com
3
Evaluate all investments before investing
your money.
Website: finance.yahoo.com
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Preparing for an Investment Program
Many people ask the question: Why begin an investment program now? This chapter will
help you understand the importance of beginning an investment program as soon as you
can because the sooner you start an investment program, the more time your investments
have to work for you.
Like other decisions, the decision to start an investment plan is one you must make
for yourself. In fact, the specific goals you want to accomplish must be the driving force
behind your investment plan.
Establishing Investment Goals
Some financial planners suggest that investment goals be stated in terms of money: By
December 31, 2022, I will have total assets of $120,000. Other financial planners believe
investors are more motivated to work toward goals that are stated in terms of the partic-
ular things they desire: By January 1, 2024, I will have accumulated enough money to
purchase a second home in the mountains. Regardless of how they are stated, investment
goals must be specific and measurable. The following questions will help you establish
valid investment goals:
1. How much money do you need to satisfy your investment goals?
2. How much risk are you willing to assume in an investment program?
3. What possible economic or personal conditions could alter your investment goals?
4. Considering your economic circumstances and how long your investments can
work for you, are your investment goals reasonable?
5. Are you willing to make the sacrifices necessary to ensure that you meet your
investment goals?
LO11.1
Explain why you should
establish an investment
program.
CHAPTER 11 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO11.1 Explain why you should establish an investment program.
LO11.2 Describe how safety, risk, income, growth, and liquidity affect your investment
program.
LO11.3 Identify the factors that can reduce investment risk.
LO11.4 Understand why investors purchase government bonds.
LO11.5 Recognize why investors purchase corporate bonds.
LO11.6 Evaluate bonds when making an investment.
YOUR PERSONAL FINANCIAL PLAN SHEETS
35. Establishing Investment Goals
36. Assessing Risk for Investments
37. Evaluating Corporate Bonds
ACTION ITEM
My investment goals are
written down.
h Yes h No
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Your investment goals are always oriented toward the future. For example, you may
establish a short-term goal of accumulating $3,000 in a savings account over the next 12
months. You may then use the $3,000 to purchase stocks or mutual funds to help you
obtain your intermediate or long-term investment goals.
Performing a Financial Checkup
In this section, we examine several factors you should consider before making your first
investment.
ETHICAL CONCERNS: PAYING YOUR BILLS ON TIME While there
are many reasons why people can’t pay their bills on time, the problem often starts with
people wanting more than they can afford. From both a legal and ethical standpoint, you
have an obligation to pay for credit purchases. Moreover, business firms that extend credit
expect you will pay for a product or service purchased when you use credit.
If you don’t pay for products or services purchased on credit, there are serious repercus-
sions. For example:
• Merchandise can be repossessed.
• A business can sue to recover the cost of the product or service.
• Your credit score can be lowered to reflect late or missed payments.
• The cost of additional credit, if available, may be higher because of lower credit
scores or late or missed payments.
Some consumers believe the only way out of their financial problems is to declare per-
sonal bankruptcy, but think about the long-term consequences. First, filing bankruptcy is
not cheap and most lawyers expect to be paid (usually in cash) before they file the nec-
essary legal documents and represent you in court. Second, remember that bankruptcy
will affect your ability to obtain future credit for a home, automobile, or other consumer
purchases.
WORK TO BALANCE YOUR BUDGET Many individuals regularly spend
more than they make. They purchase items on credit and then must make monthly
installment payments and pay finance charges ranging between 12 and 18 percent or
higher. With this situation, investing in certificates of deposit, bonds, stocks, mutual
funds, or other investments that might earn 1 to 10 percent makes no sense until credit
card and installment purchases, along with the accompanying finance charges, are
reduced or eliminated. A good rule of thumb is to limit consumer credit payments to
20 percent of your net (after-tax) income. Eventually, the amount of cash remaining
after the bills are paid will increase and can be used to start a savings program or
finance investments. For help balancing your budget, visit one of the following web-
sites: Quicken at www.quicken.com ; MoneyStrands at www.money.strands.com ; or
Mint at www.mint.com .
MANAGE YOUR CREDIT CARD DEBT While all cardholders have reasons
for using their credit cards, it is very easy to get in trouble by using your credit cards.
Watch for the following five warning signs:
1. Experts suggest that you pay your credit card balance in full each month. One of
the first warning signs is the inability to pay your entire balance each month.
2. Don’t use your credit cards to pay for many small purchases during the month.
Often this leads to a “real surprise” when you open your credit card statement and
realize how much you spent during the month.
3. Don’t use the cash advance provision that accompanies most credit cards. The
reason is simple: The annual percentage rate is usually higher for cash advances.
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2013. The Kiplinger Washington Editors, Inc.
1. In today’s world where consumers are bombarded with advertisements to buy “everything,” what specific
steps can you take to spend less, save more, and live better?
2. What are the advantages of having part of your paycheck automatically deposited in a savings or invest-
ment account?
3. Why is it important to be motivated to save and invest for specific things that you want either now or in the
future?
C
lare K. Levison is a CPA
and author of “Frugal
Isn’t Cheap.” She is a
financial-literacy spokes-
woman for the American Institute
of Certified Public Accountants.
Here are excerpts from Kiplinger’s
recent interview with Levison:
Isn’t frugality a synonym for
deprivation?
Some financial gurus make fru-
gality all about abstinence, but
I think it’s about being smart—
prioritizing and taking respon-
sibility for your choices. It’s not
so much “I won’t” or “I can’t,”
but “I’d rather.” Ask yourself:
What is most important to me?
Where will I put my discretion-
ary dollars? What will I truly
enjoy? What will enhance my
life? The goal—to quote my
book’s subhead—is to “Spend
less, save more, and live better.”
I encourage people to find
one thing each day that they
can do to save money. Get
out of the habit of spending
when you’re bored. Stay out of
the malls, discount stores and
online shopping sites. Call up
a friend and have a chat, take
your dog for a walk, go to the
library to see what new books
are available. Take care of the
stuff you already have. Clean
out your bedroom closet. It
doesn’t sound like fun, but
no one who does any of those
things says, “Gosh, I wish I
hadn’t done that.”
Should I cut up my plastic?
No. We’re moving away from
a cash-based society. Online
banking and other tools make
it easy to check your accounts
so that you’re aware of what
you’re spending. You probably
check Facebook and text mes-
sages every day. Just add this
to your list. When you reach
your spending limit, stop!
What do you think of tactics
such as extreme couponing?
It’s a version of hoarding, and
it doesn’t provide as good a
return as it should. You spend
all your time clipping coupons,
and you accumulate 500 jars of
mayo that you can’t consume
in a reasonable time. “But it’s
free!” you say. No matter. If you
don’t need it, it’s no bargain.
And you clutter up your life.
How can I save more?
Put your saving on autopilot.
Have as much as 20% of your
paycheck direct-deposited to
savings. Save 80% of any raises
or bonuses. And make it exciting.
Saving is liberating, because
you’re not beholden to a bank,
credit card company or your par-
ents. You’ll have money when
you need it, which equates to
independence and freedom—
and that’s exciting. Think of fun
things that motivate you. Saving
for retirement may sound diffi-
cult and boring, but how about
saving for a condo on the beach
when you’re x years old?
Pat Mertz Esswein
Why Frugality Is Liberating
I t lets you focus on what you really want.
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4. Think about the number of cards you really need. Most experts recommend that an
individual have one or two cards and use those cards for emergencies.
5. Get help if you think you are in trouble. You may want to review the discussion on
organizations that help people manage their finances presented in Chapter 5.
START AN EMERGENCY FUND An emergency fund is an amount of money
you can obtain quickly in case of immediate need. This money should be deposited in a
savings account or in a money market mutual fund that provides immediate access to cash
if needed.
Most financial planners agree that an amount equal to at least three months’ living
expenses is reasonable.
emergency fund An
amount of money you can
obtain quickly in case of
immediate need.
did you know? did you know?
Both the Motley Fool and the Kiplinger
websites provide excellent information to
help you begin an investment program and plan for
retirement. For more information, go to www.fool.
com or www.kiplinger.com and look for topics like
investing, saving, or retirement.
SOURCE: The Motley Fool website ( www.fool.com ) and the
Kiplinger website ( www.kiplinger.com ), accessed March 17, 2014.
EXAMPLE: Calculating an Amount for Emergencies
If your monthly expenses total $1,800, you should save at least $5,400 before you
can begin investing.
Minimum emergency fund 5 Monthly expenses 3 3 months
5 $1,800 3 3 months
5 $5,400
Example from Your Life
$ ___________________ 3 3 months 5 $ _______________
monthly expenses
HAVE ACCESS TO OTHER SOURCES OF CASH FOR EMERGENCY
NEEDS To meet unexpected emergencies, you may also want to establish a line of
credit at a commercial bank, savings and loan association, or credit union. A line of credit
is a short-term loan that is approved before you actually need the money.
The cash advance provision offered by major credit card companies can also be used in
an emergency. However, both lines of credit and credit cards have a ceiling, or maximum
dollar amount, that limits the amount of available credit. If you have already exhausted both
of these sources of credit on everyday expenses, they will not be available in an emergency.
Getting the Money Needed to Start an
Investment Program
How badly do you want to achieve your investment goals? Are
you willing to sacrifice some purchases to provide financing for
your investments? The answers to both questions are extremely
important. Take Rita Johnson, a 32-year-old nurse in a large
St. Louis hospital. As part of a divorce settlement in 2007, she
received a cash payment of almost $55,000. At first, she was
tempted to spend this money on a new BMW and new furniture.
But after some careful planning, she decided to save $25,000
in a certificate of deposit and invest the remainder in a conser-
vative mutual fund. On May 31, 2014, these investments were
valued at $79,000.
What is important to you? What do you value? Each of these
questions affects your investment goals. At one extreme are peo-
ple who save or invest as much of each paycheck as they can. At
line of credit A short-
term loan that is approved
before the money is actually
needed.
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the other extreme are people who spend everything they earn and run out of money before
their next paycheck. Most people find either extreme unacceptable and take a more middle-
of-the-road approach. These people often spend money on the items that make their lives
more enjoyable and still save enough to fund an investment program. Suggestions to help
you obtain the money you need to fund an investment program are listed in Exhibit 11–1 .
For many people, the easiest way to begin an investment
program is to participate in an employer-sponsored retirement
account—often referred to as a 401(k) or a 403(b) account. Many
employers will match part or all of your contributions to retire-
ment accounts. For example, an employer may contribute $0.50 for
every $1.00 the employee contributes up to a certain percentage of
their annual salary. More information on different types of retire-
ment accounts is provided in Chapter 14.
How the Time Value of Money Affects Your
Investments
Many people never start an investment program because they have only small sums of
money. But even small sums grow over a long period of time. Mary and Peter Miller, for
example, began their investment program by investing $1,000 each year when they were
in their 20s. Now 20 years later, their investment portfolio is worth over $40,000. How did
they do it? They took advantage of the time value of money. Simply put: If you save money
over a long period of time, make quality investments, and let the time value of money work,
you can achieve the same type of result. The information in the nearby “Figure It Out!”
box illustrates this important personal finance concept. For instance, assume you invest
$2,500 each year for 30 years. Also, assume that the investment earns 6 percent each year.
To determine how much your investment is worth at the end of 30 years, use the table in the
“Figure It Out!” box and follow these steps:
1. Locate the table factor for 6 percent and 30 years.
2. The table factor is 79.058.
3. Multiply the $2,500 yearly investment by the 79.058 table factor.
$2,500 3 79.058 5 $197,645 total dollar return
Suggestion Comments
1. Pay yourself first. Many financial experts recommend that you
(1) pay your monthly bills, (2) save or invest a
reasonable amount of money, and (3) use the
money left over for personal expenses and
entertainment.
2. Take advantage of employer-sponsored
retirement programs.
Some employers will match part or all of
the contributions you make to a company-
sponsored retirement program.
3. Participate in an elective savings
program.
You can elect to have money withheld from
your paycheck each payday and automatically
deposited in a savings or investment account.
4. Make a special savings effort one or
two months each year.
By cutting back to the basics, you can obtain
money for investment purposes.
5. Take advantage of gifts, inheritances,
and windfalls.
Use money from unexpected sources to fund
an investment program.
Exhibit 11–1
Five Suggestions to Help
You Accumulate the
Money Needed to Fund
Your Investments
CAUTION! CAUTION!
Today, many employers are reducing or elim-
inating matching provisions in their employee
retirement plans.
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$2,000 invested each year at 4 percent for 40 years equals $190,052.
$2,000 invested each year at 11 percent for 40 years equals $1,163,660.
QUESTION
How do you calculate these amounts?
ANSWER: The calculations were based on the time value of money concept discussed in Chapter 1. The fact is that this
type of calculation is so important to your investment program that it makes sense to review the concept. While you
can calculate the answers by using a formula, many people find that it is easier to use a table factor from a future value
table like the one illustrated below. To work the first problem, follow these steps:
1. Locate the table factor for 4 percent and 40 years.
2. The table factor is 95.026.
3. Multiply the $2,000 yearly deposit by the 95.026 table factor.
$2,000 3 95.026 5 $190,052
NOW IT’S YOUR TURN.
Using the table below, calculate the future value of a $1,500 annual investment that earns 7 percent a year for 25 years.
Using the Time Value of Money to Calculate Investment Returns Using the Time Value of Money to Calculate Investment Returns
Figure It Out!
In this example, your investments total $75,000 ($2,500 3 30 years 5 $75,000). To
determine your investment earnings during the 30-year period, subtract the total of all
investments from the total dollar return at the end of 30 years ($197,645 2 $75,000 5
$122,645).
In this example, notice that the value of your investments increases each year because
of two factors. First, it is assumed you will invest another $2,500 each year. Second, all
investment earnings are allowed to accumulate and are added to your yearly deposits.
Tryout problem answer: $94,873.50
FUTURE VALUE (COMPOUNDED SUM) OF $1 PAID IN AT THE END OF EACH PERIOD
OF A GIVEN NUMBER OF TIME PERIODS (AN ANNUITY)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6.228
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 64.203
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 114.410
30 34.785 40.588 47.575 56.085 66.439 79.058 94.461 113.280 136.310 164.490 199.020
40 48.886 60.402 75.401 95.026 120.800 154.760 199.640 259.060 337.890 442.590 581.830
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Also, notice that if investments earn a higher rate of return each year, total dollar returns
increase dramatically. For example, a $2,000 annual investment that earns 11 percent
a year is worth $1,163,660 at the end of 40 years, compared to $190,052 for a $2,000
investment that earns 4 percent each year for the same 40-year period. The rate of return
and the length of time your money is invested do make a difference. The search for higher
returns is one reason many investors choose stocks, mutual funds, and other investments
that offer higher potential returns compared to certificates of deposit or government or
corporate bonds.
PRACTICE QUIZ 11–1 PRACTICE QUIZ 11–1
1. What factors should you consider when performing a financial checkup?
2. How can you obtain the money needed to begin investing?
3. In your own words, describe the time value of money concept and how it could affect your investment program.
Apply Yourself! Apply Yourself!
Visit the Mint website ( www.mint.com ) and describe the services available to individuals who need help managing their
finances.
Sheet 35 Establishing Investment Goals S
Factors Affecting the Choice of
Investments
Although each investor may have specific, individual goals for investing, all investors must
consider a number of factors before choosing an investment alternative.
Safety and Risk
The safety and risk factors are two sides of the same coin. Safety in an investment means
minimal risk or loss. On the other hand, risk in an investment means a measure of uncer-
tainty about the outcome. Investments range from very safe to very risky. At one end of
the investment spectrum are very safe investments. Investments in this category include
government bonds, savings accounts, certificates of deposit, and certain corporate bonds,
stocks, and mutual funds. Real estate may also be a very safe investment. Investors pick
investments that have less risk because they know there is very little chance that invest-
ments of this kind will become worthless.
At the other end of the investment spectrum are speculative investments. A speculative
investment is a high-risk investment made in the hope of earning a relatively large profit in
a short time. Such investments offer the possibility of a larger dollar return, but if they are
unsuccessful, you may lose most or all of your initial investment. Speculative stocks, cer-
tain bonds, some mutual funds, some real estate, commodities, options, precious metals,
precious stones, and collectibles are risk-oriented investments.
From an investor’s standpoint, one basic rule sums up the relationship between the fac-
tors of safety and risk: The potential return on any investment should be directly related to
LO11.2
Describe how safety, risk,
income, growth, and liquidity
affect your investment
program.
ACTION ITEM
I understand how the factors
of safety and risk affect an
investment decision.
h Yes h No
speculative investment
A high-risk investment made
in the hope of earning a
relatively large profit in a
short time.
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the risk the investor assumes. The fact is there is some risk associated with all investments.
In fact, you may experience two types of risks with many investments.
• First, investors often choose some investments because they provide a predictable
source of income. For example, you may choose to purchase a stock because a
corporation pays dividends. If the corporation experiences financial difficulties,
it may reduce or omit dividend payments to stockholders. In other words, there is
a risk that you will not receive income payments. With the exception of savings
accounts and certificates of deposit, income payments are not guaranteed with most
investments.
• A second type of risk associated with many investments is that an investment will
decrease in value. For example, the value of Apple stock decreased approximately
10 percent in January 2014 when executives suggested that sales and profit growth
may slow in the future. 1
Exhibit 11–2 lists a number of factors related to safety and risk that can affect an inves-
tor’s choice of investments.
Often beginning investors are afraid of the risk associated with many investments. But
remember that without the risk, obtaining the larger returns that really make an investment
program grow is impossible. To help you determine how much risk you are willing to
assume, take the test for risk tolerance presented in Exhibit 11–3 .
Components of the Risk Factor
When choosing an investment, you must carefully evaluate changes in the risk factor. In
fact, the overall risk factor can be broken down into four components.
INFLATION RISK As defined in Chapter 1, inflation is a rise in the general level
of prices. During periods of high inflation, there is a risk that the financial return on an
investment will not keep pace with the inflation rate. To see how inflation reduces your
buying power, let’s assume you have deposited $10,000 in a certificate of deposit at
1 percent interest. At the end of one year, your money will have earned $100 in interest
($10,000 3 1% 5 $100). Assuming an inflation rate of 3 percent, it will cost you an addi-
tional $300 ($10,000 3 3% 5 $300), or a total of $10,300, to purchase the same amount of
goods you could have purchased for $10,000 a year earlier. Thus, even though you earned
$100, you lost $200 in purchasing power. And after paying taxes on the $100 interest, your
loss of purchasing power is even greater.
INTEREST RATE RISK The interest rate risk associated with preferred stocks or
government or corporate bonds is the result of changes in the interest rates in the economy.
The value of these investments decreases when overall interest rates increase. In contrast,
1 The Yahoo Finance website ( http://fi nance.yahoo.com ), accessed March 18, 2014.
Investments with Less Risk Investments with Higher Risks
People with no financial training
or investment background
Investors with financial training
and investment background
Older investors Younger investors
Lower-income investors Higher-income investors
Families with children Single individuals or married couples with no
children
Employees worried about job loss Employees with secure employment positions
Exhibit 11–2
Factors That Can Affect
Your Tolerance for Risk
and Your Investment
Choices
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the value of these same investments increases when overall interest rates decrease. Assume
you purchase a Microsoft corporate bond that pays 4.2 percent interest and hold it for three
years before deciding to sell your bond. The value of your bond will decrease if interest
rates for comparable bonds increase during the three-year period. On the other hand, the
value of your Microsoft bond will increase if interest rates for comparable bonds decrease
during the three-year period.
BUSINESS FAILURE RISK The risk of business failure is associated with invest-
ments in stock and corporate bonds or mutual funds that invest in stocks or bonds. With
each of these investments, you face the possibility that bad management, unsuccessful
products, competition, or a host of other factors will cause the business to be less profitable
than originally anticipated or experience a loss. The business may even fail and be forced
to file for bankruptcy, in which case your investment may become totally worthless.
MARKET RISK Economic growth is not as systematic and predictable as most
investors might believe. Generally, a period of rapid expansion is followed by a period of
recession. For instance, the business cycle—the recurring time period between economic
expansion and recession—has lasted a little less than six years since World War II. 2
The prices of stocks, bonds, mutual funds, and other investments may also fluctuate
because of the behavior of investors in the marketplace and may have nothing to do with
2 The Investopedia website ( www.investopedia.com ), accessed March 17, 2014.
Read the statements below and choose the answer that most closely matches how you feel about investing.
1–Not At All Like Me 5-Not Quite Sure 10–Fits Me Perfectly
I would prefer to invest in the stock market than in more
conservative investments like savings accounts, certificates
of deposit, or bonds.
1 2 3 4 5 6 7 8 9 10
I like a lot of risk in my investments because I’m more
likely to make money that way.
1 2 3 4 5 6 7 8 9 10
I look for short-term investments that I can buy and sell
within a year.
1 2 3 4 5 6 7 8 9 10
Instead of a buy-and-hold strategy, I prefer to use the
speculative techniques of buying stock on margin and
selling short.
1 2 3 4 5 6 7 8 9 10
Sometimes, I use the money in my investment account
for immediate cash needs or buy something I really want.
1 2 3 4 5 6 7 8 9 10
Exhibit 11–3 A Quick Test to Measure Investment Risk
WHAT TYPE OF INVESTOR ARE YOU?
Total up your score from above, and write your score here: _____. Based on your score, what type of investor are you?
High-Risk Investor (38 to 50 points):
You could be described as a speculative,
aggressive investor. You enjoy the pursuit
of high returns, and you realize that there
will be ups and downs as you chase
larger profits.
Moderate-Risk Investor (24 to 37
points): You are neither particularly con-
servative nor aggressive in your invest-
ment choices. You try to balance your
desire to maximize your returns with your
long-term desire for a comfortable and
stable financial future and planning for
retirement.
Low-Risk Investor (5 to 23 points): You
could be described as a conservative
investor. You aren’t going to take risks to
chase high returns, but you aren’t going
to suffer big losses either.
SOURCE: Adapted from the quiz “Determine your risk profile” on the Wells Fargo website (www.wellsfargo.com).
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the fundamental changes in the financial health of the corporations
that issue these investments. Such fluctuations may be caused by
political or social conditions. The price of petroleum stocks, for
instance, may increase or decrease as a result of political activity
in the Middle East.
Investment Income
Investors sometimes purchase certain investments because they want
a predictable source of income. The most conservative investments—
passbook savings accounts, certificates of deposit, and securities
issued by the United States government—are also the most predict-
able sources of income. With these investments, you know exactly
how much income will be paid on a specific date.
If investment income is a primary objective, you can also choose
municipal bonds, corporate bonds, preferred stocks, utility stocks,
or selected common stock issues. Other investments that may pro-
vide income potential are mutual funds and real estate rental property.
Investment Growth
To investors, growth means their investments will increase in value. Often the greatest
opportunity for growth is an investment in common stock. Companies with earnings poten-
tial, sales revenues that are increasing, and managers who can solve the problems asso-
ciated with rapid expansion are often considered to be growth companies. These same
companies generally pay little or no dividends.
The money the companies keep can provide at least part of the financing they need for
future growth and expansion and control the cost of borrowing money. As a result, they
grow at an even faster pace. Growth financed by profits reinvested in the company nor-
mally increases the dollar value of a share of stock for the investor.
Other investments that may offer growth potential include mutual funds and real estate.
For example, many mutual funds are referred to as growth funds or aggressive growth
funds because of the growth potential of the individual securities included in the fund.
Investment Liquidity
Liquidity is the ability to buy or sell an investment quickly without substantially affecting the
investment’s value. Investments range from near-cash investments to frozen investments
from which it is virtually impossible to get your money. Interest-bearing checking and
savings accounts are very liquid because they can be quickly converted to cash. Certificates
of deposit impose penalties for withdrawing money before the maturity date. With other
investments, you may be able to sell quickly, but market conditions, economic conditions, or
many other factors may prevent you from regaining the amount you originally invested.
liquidity The ability to buy
or sell an investment quickly
without substantially affecting
the investment’s value.
PRACTICE QUIZ 11–2 PRACTICE QUIZ 11–2
1. Why are safety and risk two sides of the same coin?
2. In your own words, describe each of the four components of the risk factor.
3. How do income, growth, and liquidity affect the choice of an investment?
Sheet 36 Assessing Risk for Investments S
CAUTION! CAUTION!
To avoid investment scams, the experts
suggest you watch out for sales pitches that
begin with any of the following:
• Your profit is guaranteed.
• There’s no risk.
• Just make the check out to me.
Above all, take your time and check out any
investment offer before you invest.
SOURCE: “Five Tips to Help You Avoid
Investment Fraud,” AARP ( www.aarp.org ),
accessed March 26, 2014.
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Factors That Reduce Investment Risk
Consider the following: Since 1926—almost 90 years—stocks have returned an average
of almost 10 percent a year. During the same period, U.S. government securities earned
just over 5 percent. 3 These facts suggest that everyone should invest in stocks because they
offer the largest returns. In reality, stocks may have a place in your investment portfolio,
but establishing an investment program is more than just picking a bunch of stocks or
mutual funds that invest in stocks. Before making the decision to purchase stocks, consider
the factors of portfolio management and asset allocation.
Asset Allocation and Diversification
Earlier in this chapter, we examined how safety, risk, income, growth, and liquidity affect
your investment choices. Now let’s compare the factors that affect the choice of invest-
ments with some typical investment alternatives. Exhibit 11–4 ranks each alternative in
terms of safety, risk, income, growth, and liquidity. More detailed information on each
investment alternative is provided later in this chapter and in Chapters 12 and 13.
ASSET ALLOCATION Asset allocation is the process of spreading your assets
among several different types of investments to lessen risk. The term asset allocation is a
fancy way of saying you need to diversify and avoid the pitfall of putting all your eggs in
one basket. Asset allocation is often expressed in percentages. For example, what
percentage of my assets do I want to put in stocks and mutual funds? What percentage do
I want to put in bonds or certificates of deposit? The diversification provided by investing
in different investments provides a measure of safety and reduces risk, because a loss in
one type of investment is usually offset by gains from other types of investments. Typical
investments include:
• Stocks issued by large corporations (large cap).
• Stocks issued by medium-size corporations (midcap).
• Stocks issued by small, rapidly growing companies (small cap).
• Foreign stocks.
• Bonds.
• Cash.
ACTION ITEM
I use asset allocation to
minimize risk when investing.
h Agree h Disagree
LO11.3
Identify the factors that can
reduce investment risk.
3 “Money 101 Lesson 4: Basics of Investing,” CNN/Money ( http://money.cnn.com/magazines/moneymag/
money101/lesson4/index.htm ), accessed March 19, 2014.
asset allocation The
process of spreading your
assets among several
different types of investments
to lessen risk.
Apply Yourself! Apply Yourself!
In this section, information was provided about how income and growth can affect an individual’s choice of investments.
Assume you are the investor in each of the following situations. Then choose either income or growth investments and
justify your choice.
Life Situation Income or Growth Justification
An unemployed single parent who
has just received a $300,000 divorce
settlement
A 25-year-old single investor with a full-
time job that pays $36,000 a year
A retired couple with $650,000 in retire-
ment savings
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Note: Mutual funds can also be included as an investment, but the typical mutual fund
will invest in the securities just listed or a combination of these securities.
The percentage of your investments that should be invested in each asset class is deter-
mined by:
• Your age;
• Your investment objectives;
• How much you can save and invest each year;
• The dollar value of your current investments;
• The economic outlook for the economy; a nd
• Other factors.
Today, many personal finance websites provide asset allocation calculators to help you
determine the right types of investments for your investment program. For example, the
asset allocation calculator provided by Bankrate considers your age, tolerance for risk,
how much you can save or invest each year, and some of the other factors mentioned above
to determine the appropriate types of investments for your situation. To use this Bankrate
calculator, go to www.bankrate.com and enter “asset allocation calculator” in the search
window. Then supply the information required to build a customized investment program.
You can also find other asset allocation calculators by using a search engine like Google
or Yahoo!
To help you decide how much risk is appropriate for your investment program, many
financial planners suggest that you think of your investment program as a pyramid con-
sisting of four levels ranging from low risk to high risk, as illustrated in Exhibit 11–5 .
Regardless of which type of investment you choose for your investment program and the
percentage you invest in each type, it may be necessary to adjust your asset allocation from
time to time. Often, the main reasons for making changes are the amount of time that your
investments have to work for you and your age.
THE TIME FACTOR The amount of time that your investments have to work for you
is another important factor when managing your investment portfolio. Recall the invest-
ment returns presented earlier in this section. Since 1926, stocks have returned an average
of almost 10 percent a year and returned more than other investment alternatives. And yet,
during the same period, there were years when stocks decreased in value. 4 The point is that
if you invested at the wrong time and then couldn’t wait for the investment to recover, you
lost money.
The amount of time you have before you need your investment money is crucial. If
you can leave your long-term investments alone and let them work for 5 to 10 years or
more, then you can invest in stocks and mutual funds. On the other hand, if you need your
4 “Money 101 Lesson 4: Basics of Investing,” CNN/Money ( http://money.cnn.com/magazines/moneymag/
money101/lesson4/index.htm ), accessed March 19, 2014.
FACTORS TO BE EVALUATED
Type of Investment Safety Risk Income Growth Liquidity
Corporate stock Average Average Average High Average
Corporate bonds Average Average High Low Average
Government bonds High Low Low Low High
Mutual funds Average Average Average Average Average
Real estate Average Average Average Average Low
Exhibit 11–4
Factors Used to Evaluate
Traditional Investment
Alternatives
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investment money in two years or less, you should probably invest in short-term govern-
ment bonds, highly rated corporate bonds, or certificates of deposit. By taking a more
conservative approach for short-term investments, you reduce the possibility of having to
sell your investments at a loss because of depressed market value or a staggering economy.
YOUR AGE A final factor to consider when choosing an investment is your age.
Younger investors tend to invest a large percentage of their nest egg in growth-oriented
investments. If their investments take a nosedive, they have time to recover. On the other
hand, older investors tend to be more conservative and invest in government bonds,
high-quality corporate bonds, and very safe corporate stocks or mutual funds. As a result, a
smaller percentage of their nest egg is placed in growth-oriented investments.
Financial experts like Suze Orman, author of The Road to Wealth, suggest that you
subtract your age from 110, and the difference is the percentage of your assets that should
be invested in growth investments. For example, if you are 30 years old, subtract 30
from 110, which gives you 80. Therefore, 80 percent of your assets should be invested
in growth-oriented investments while the remaining 20 percent should be kept in safer,
conservative investments. 5
Your Role in the Investment Process
Successful investors continually evaluate their investments. They never sit back and let
their investments manage themselves. Some factors to consider when choosing different
investments are described next.
EVALUATE POTENTIAL INVESTMENTS Let’s assume you have $25,000 to
invest. Also assume your investment will earn a 10 percent return the first year. At the end
of one year, you will have earned $2,500 and your investment will be worth $27,500. Not
a bad return on your original investment! Now ask yourself: How long would it take to
earn $2,500 if I had to work for this amount of money at a job? For some people, it might
take a month; for others, it might take longer. The point is that if you want this type of
return, you should be willing to work for it, but the work takes a different form than a job.
When choosing an investment, the work you invest is the time needed to research different
investments so that you can make an informed decision. More information on evaluating
different investment alternatives is presented at the end of this chapter and in Chapter 12
(stocks) and Chapter 13 (mutual funds).
5 Suze Orman, The Road to Wealth (New York: Riverbend Books, 2001), p. 371.
Exhibit 11–5
Typical Investments for
Financial Security, Safety
and Income, Growth,
and Speculation
High risk
Level 4
Speculation
Speculative stocks, options,
commodities, and other high-risk
investments
Growth stocks, growth-oriented
mutual funds, and rental property
U.S. securities, selected corporate and
municipal bonds, income stocks, and
conservative mutual funds
Cash, CDs, money-market
mutual funds, and
U.S. government bonds
Level 3
Growth
Level 2
Safety and Income
Level 1
Financial Security
Investment Pyramid
Low risk
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MONITOR THE VALUE OF YOUR INVESTMENTS AND YOUR
FINANCIAL HEALTH Monitoring the value of your investments will help if you
have a personal financial crisis or the nation experiences an economic crisis. With either
type of crisis, often many people are caught off guard and must scramble to find the money
to pay their monthly bills. In some cases, individuals are forced to sell some or all of
their investments at depressed prices just to buy food for the family and pay for everyday
necessities.
To survive a crisis, many experts recommend that you take action to make sure your
financial affairs are in order. Here are six steps you can take:
1. Establish a larger than usual emergency fund. Under normal circumstances, an
emergency fund of three months’ living expenses is considered adequate, but you
may want to increase your fund in anticipation of a crisis.
2. Know what you owe. Make a list of all your debts and the amount of the required
monthly payments; then identify the debts that must be paid. Typically these
include the mortgage or rent, medicine, utilities, food, and transportation costs.
3. Reduce spending. Cut back to the basics and reduce the amount of money spent
on entertainment, dining at restaurants, and vacations. The money saved from
reduced spending can be used to increase your emergency fund or pay for everyday
necessities.
4. Notify credit card companies and lenders if you are unable to make payments.
Although not all lenders are willing to help, many will work with you and
lower your interest rate, reduce your monthly payment, or extend the time for
repayment.
5. Monitor the value of your investment and retirement accounts. Tracking the value
of your stock, mutual fund, and retirement accounts, for example, will help you
decide which investments to sell if you need cash for emergencies.
well-planned investment program can provide, you must
overcome the fear of investing. According to the experts,
the five steps below can reduce fear and at the same time
help you become a “smart” investor.
Just the thought of losing hard-earned cash on a “bad”
investment often keeps would-be investors from making
that first investment. Still, if you want to become financially
secure and enjoy the peace of mind that establishing a
Psychology 101: Conquering the Fear of Investing
Personal Finance in Practice
Take This Step Why This Step Is Important
1. Don’t start investing before you create an
emergency fund.
By creating an emergency fund, you reduce the possibility of having to sell your
investments at a loss because of depressed market value.
2. Do your homework before investing any
money.
Learn to be a good investor. Begin by looking at investment websites like Yahoo!
Finance ( http://finance.yahoo.com ) and the Motley Fool ( www.fool.com ).
3. Begin investing with small amounts of
money.
Begin by investing small amounts of money that you can afford to lose. Once suc-
cessful, you can add to existing investments or purchase additional investments.
4. After the purchase, monitor the value of
all investments.
Monitor the value of your investments to determine if you should hold, sell, or
increase your stake in a specific investment.
5. Continue to learn about investing. Once you begin investing, it is important to continue to learn. Begin by determining
the type of investments that interest you. Then develop a plan to organize informa-
tion about specific investment alternatives.
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6. Consider converting investments to cash to preserve
value. According to personal finance experts, most
investors accumulate more money when they use a buy-
and-hold approach over a long period of time. Still,
there may be times when you could sell some of your
investments and use the cash for emergencies or to
weather an economic crisis.
Above all, don’t panic. While financial problems are stress-
ful, staying calm and considering all the options may help
reduce the stress.
If you choose to invest in stocks, bonds, mutual funds, com-
modities, or options, you can determine the value of your hold-
ings by looking at the price quotations reported on the Internet
and in newspapers. Your real estate holdings may be compared
with similar properties currently for sale in the surrounding area.
Finally, you can determine the value of your precious metals,
gemstones, and collectibles by checking with reputable dealers
and investment firms. To monitor the value of their investments,
many investors use a simple chart. To construct a chart, place the
original purchase price of your investment in the middle on the
side of the chart. Then use price increments of a logical amount
to show increases and decreases in dollar value. Place individual dates along the bottom
of the chart. For stocks, bonds, mutual funds, and similar investments, you may want to
graph every two weeks and chart current values on, say, a Friday. For longer-term invest-
ments like real estate, you can chart current values every six months. Computer software
or investment portfolio management tools are available on many investment websites to help
you track the value of your investments. A word of caution: If an investment is beginning to
have a large increase or decrease in value, you may want to check dollar values more fre-
quently—in some cases, daily.
KEEP ACCURATE RECORDS Accurate recordkeeping can help you spot oppor-
tunities to maximize profits or reduce dollar losses when you sell your investments. Accu-
rate recordkeeping can also help you decide whether you want to invest additional funds
in a particular investment. At the very least, you should keep purchase records for each of
your investments that include the actual dollar cost of the investment, plus any commis-
sions or fees you paid. It is also useful to keep a list of the sources of information (Internet
addresses, business periodicals, research publications, etc.), along with copies of the mate-
rial you used to evaluate each investment. Then, when it is time to reevaluate an existing
investment, you will know where to begin your search for current information. Finally,
accurate recordkeeping is also necessary for tax purposes.
OTHER FACTORS THAT IMPROVE INVESTMENT DECISIONS To
achieve their financial goals, many people seek professional help. In many cases, they
turn to stockbrokers, lawyers, accountants, bankers, or insurance agents. However, these
professionals are specialists in one specific field and may not be qualified to provide the
type of advice required to develop a thorough financial plan. Another source of investment
help is a financial planner who has had training in securities, insurance, taxes, real estate,
and estate planning.
Whether you are making your own decisions or have professional help, you must con-
sider the tax consequences of selling your investments. Taxes were covered in Chapter 3,
and it is not our intention to cover them again. And yet, you are responsible for deter-
mining how taxes affect your investment decisions. To find more information about how
investments are taxed, visit the Internal Revenue Service website at www.irs.gov .
did you know? did you know?
If you really want to be socially If you really want to be socially
responsible, then prove it by choosing responsible, then prove it by choosing
green investments. To begin, green investments. To begin,
• Learn what socially responsible investing is. • Learn what socially responsible investing is.
• Research socially responsible companies • Research socially responsible companies
and mutual funds. and mutual funds.
• Pick your investments and then monitor • Pick your investments and then monitor
both their financial performance and both their financial performance and
their social responsibility record. their social responsibility record.
For more information, visit the US SIF For more information, visit the US SIF
(The Forum for Sustainable and Responsible (The Forum for Sustainable and Responsible
Investment) website at Investment) website at www.ussif.orgwww.ussif.org . .
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Conservative Investment Options:
Government Bonds
Provide feedback on the following statements to see if government or corporate bond
investments may be right for you:
LO11.4
Understand why investors
purchase government bonds.
ACTION ITEM
I know why some people
choose to invest in
government or corporate
bonds.
h Agree h Disagree
Statement Yes No
1. Stocks seem to be overpriced and will probably go down in the next 12
to 24 months.
_____ _____
2. I need to convert my investments to cash in a short period of time. _____ _____
3. I’m afraid I will lose the money invested in speculative investments. _____ _____
PRACTICE QUIZ 11–3 PRACTICE QUIZ 11–3
1. Assume you must choose an investment that will help you obtain your investment goals. Rank the following invest-
ments from 1 (low) to 5 (high) and then justify your choice for your investment portfolio. (See Exhibit 11–4 and
Exhibit 11–5 for help evaluating each investment.)
Investment
Rank
(1 5 low; 5 5 high) Justification
Corporate stocks
Corporate bonds
Government bonds
Mutual funds
Real estate
2. Why should investors be concerned with asset allocation and the time their investments have to work for them?
3. Why should you monitor the value of your investments?
Apply Yourself! Apply Yourself!
Use the Suze Orman method to determine the percentage of your investments that should be invested in growth
investments.
If you answered yes to any of these questions, you may want to consider the more con-
servative investments described in this section and the next section.
The Psychology of Investing in Bonds
Bonds are a conservative investment option that may offer more income or growth poten-
tial than savings accounts or certificates of deposit. They are also a safer investment when
compared to stocks, mutual funds, or other investments. Bonds are often considered a “safe
harbor” in troubled economic times. For example, many stock and mutual fund investors
lost money during the period from 2008 to 2011 because of the nation’s economic crisis.
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As an alternative to leaving your money in stocks and mutual funds, assuming that you
thought the financial markets were headed for a period of decline, you could have moved
money into government or corporate bonds. That’s exactly what Joe Goode did before the
2008 economic crisis. Although his friends thought he was crazy for taking such a con-
servative approach, he actually avoided a downturn in the stock market. Now many of his
friends wish they had made the same decision. According to Joe, he earned interest on his
government and corporate bonds while preserving his investment funds for a return to the
stock market when the economy began to improve.
Investors also purchase bonds as a way to use asset allocation to diversify their invest-
ment portfolio. If diversification is your goal, you may also purchase bond funds. Bond
funds are an indirect way of owning bonds issued by the U.S. Treasury; state and local
governments; and corporations. Many financial experts recommend bond funds for small
investors because they offer diversification and professional management. The advantages
and disadvantages of bond funds are discussed in more detail in Chapter 13—Investing in
Mutual Funds.
Government Bonds and Debt Securities
The U.S. government and state and local governments issue bonds to obtain financing.
A government bond is a written pledge of a government or a municipality to repay a spec-
ified sum of money, along with interest. In this section, we discuss bonds issued by each
level of government and look at why investors purchase these bonds.
U.S. TREASURY BILLS, NOTES, AND BONDS Traditionally, investors
chose U.S. government securities because they were backed by the full faith and credit of
the U.S. government and carried a decreased risk of default. Today, as a result of concerns
about the national debt and downgrades or threats of downgrades by U.S. rating agencies,
many investors are beginning to worry about what were once considered risk-free invest-
ments. Even with these concerns, investors from around the world still regard U.S. govern-
ment securities as a very conservative and safe investment.
In this section, we discuss four principal types of securities issued by the U.S. Treasury:
Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation-Protected Securities
(TIPS). These securities can be purchased through Treasury Direct at www.treasurydirect.gov .
Treasury Direct conducts auctions to sell Treasury securities, and buyers interested in pur-
chasing these securities at such auctions may bid competitively or noncompetitively. If they
bid competitively, they must specify the rate or interest yield they are willing to accept. If they
bid noncompetitively, they are willing to accept the interest rate determined at auction. Trea-
sury securities may also be purchased through banks or brokers, which charge a commission.
For each type of U.S. government security, the minimum purchase
is $100 with additional increments of $100 above the minimum.
U.S. government securities can be held until maturity or sold
or redeemed before maturity. Interest paid on U.S. government
securities (and growth in principal for TIPS) is taxable for fed-
eral income tax purposes but is exempt from state and local
taxation. More information about U.S. government securities is
provided in Exhibit 11–6 .
STATE AND LOCAL GOVERNMENT SECURI-
TIES A municipal bond is a debt security issued by a state or
local government. Such securities are used to finance the ongo-
ing activities of state and local governments and major projects
such as airports, schools, toll roads, and toll bridges. They may
be purchased directly from the government entity that issued
them or through account executives.
government bond
The written pledge of a
government or a municipality
to repay a specified sum of
money, along with interest.
municipal bond A debt
security issued by a state or
local government.
digi – know? digi – know?
Just about everything you want to know Just about everything you want to know
about U.S. Treasury bills, notes, bonds, and about U.S. Treasury bills, notes, bonds, and
Treasury Inflation- Protected Securities Treasury Inflation- Protected Securities
can be found at Treasury Direct. can be found at Treasury Direct.
• In addition to the basics, you can access • In addition to the basics, you can access
research information, financial calcula-research information, financial calcula-
tors, and other tools to fine-tune your tors, and other tools to fine-tune your
investment program. investment program.
• Take a look at • Take a look at www.treasurydirect.govwww.treasurydirect.gov . .
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State and local securities are classified as either general obligation bonds or revenue
bonds. A general obligation bond is backed by the full faith, credit, and unlimited taxing
power of the government that issued it. A revenue bond is repaid from the income gener-
ated by the project it is designed to finance. Although both general obligation and revenue
bonds are relatively safe, defaults have occurred in recent years.
If the risk of default worries you, you can purchase insured municipal bonds. A number
of states offer to guarantee payments on selected securities, and there are private insur-
ers. Even if a municipal bond issue is insured, however, financial experts worry about the
insurer’s ability to pay off in the event of default on a large bond issue. Most advise inves-
tors to determine the underlying quality of a bond whether or not it is insured.
One of the most important features of municipal bonds is that the interest on them may
be exempt from federal taxes. Whether or not the interest on municipal bonds is tax exempt
often depends on how the funds obtained from their sale are used. You are responsible, as
an investor, to determine whether or not interest on municipal bonds is taxable. Municipal
bonds exempt from federal taxation are generally exempt from state and local taxes only in
the state where they are issued. Although the interest on municipal bonds may be exempt
from taxation, a capital gain that results when you sell a municipal bond before maturity
and at a profit may be taxable just like capital gains on other investments sold at a profit.
Because of their tax-exempt status, the interest rates on municipal bonds are lower than
those on taxable bonds. By using the following formula, you can calculate the taxable
equivalent yield for a municipal security:
Taxable equivalent yield 5
Tax-exempt yield
________________
1.0 2 Your tax rate
general obligation bond
A bond backed by the full
faith, credit, and unlimited
taxing power of the
government that issued it.
revenue bond A bond that
is repaid from the income
generated by the project it is
designed to finance.
Type of Security Maturity Interest Notes
Treasury bills (T-bills) 4, 13, 26, or 52 weeks Discounted securities
because the actual
purchase price is less
than the maturity value.
At maturity, the gov-
ernment repays the
face value of T-bills.
The difference
between the purchase
price and the face
value is interest.
Treasury notes 2, 3, 5, 7, and 10 years Interest is paid every
six months until
maturity.
Interest rate is slightly
higher than T-bills
because of the longer
maturity.
Treasury bonds 30 years Interest is paid every
six months until
maturity.
Interest rate is slightly
higher than T-bills and
T-notes because of
the longer maturity.
Treasury Inflation-
Protected Securities
(TIPS)
5, 10, or 30 years
At maturity, you are
paid the adjusted princi-
pal or original principal,
whichever is greater.
Interest is paid every
six months until matu-
rity at a fixed rate
applied to the
adjusted principal.
The principal of TIPS
securities increases
with inflation and
decreases with
deflation.
Exhibit 11–6
Information about
Treasury Bills, Treasury
Notes, Treasury Bonds,
and Treasury Inflation-
Protected Securities
(TIPS)
EXAMPLE: Determining Taxable Equivalent Yield
The taxable equivalent yield on a 5 percent, tax-exempt municipal bond for a
person in the 28 percent tax bracket is 6.94 percent, as follows:
Taxable equivalent yield 5
0.05
__________
1.0 2 0.28
5 0.0694, or 6.94 percent
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Once you have calculated the taxable equivalent yield, you can compare the return on
tax-exempt securities with the return on taxable investments.
PRACTICE QUIZ 11–4 PRACTICE QUIZ 11–4
1. What is the difference between a Treasury bill, a Treasury note, a Treasury bond, and TIPS?
2. Explain the difference between a general obligation bond and a revenue bond.
3. What are the risks involved when investing in state and local securities?
Apply Yourself! Apply Yourself!
Using the formula presented in this section, calculate the taxable equivalent yields for the following tax-exempt bonds.
Tax-Exempt
Yield
Equivalent Yield for a
Taxpayer in the 25% Tax
Bracket
Equivalent Yield for a
Taxpayer in the 28% Tax
Bracket
Equivalent Yield for a
Taxpayer in the 33% Tax
Bracket
3%
4%
5.5%
Conservative Investment Options:
Corporate Bonds
A corporate bond is a corporation’s written pledge to repay a specified amount of money
with interest. The face value is the dollar amount the bondholder will receive at the bond’s
maturity. The usual face value of a corporate bond is $1,000. Between the time of purchase
and the maturity date, the corporation pays interest to the bondholder.
The maturity date of a corporate bond is the date on which the corporation is to repay
the borrowed money. Maturity dates for bonds generally range from 1 to 30 years after the
date of issue.
The actual legal conditions for a corporate bond are described in a bond indenture.
A bond indenture is a legal document that details all of the conditions relating to a bond
issue. Since corporate bond indentures are very difficult for the average person to read and
understand, a corporation issuing bonds appoints a trustee. The trustee is a financially
independent firm that acts as the bondholders’ representative. Usually the trustee is a com-
mercial bank or some other financial institution. If the corporation fails to live up to all
the provisions in the indenture agreement, the trustee may bring legal action to protect the
bondholders’ interests.
Why Corporations Sell Corporate Bonds
Bonds can be used to finance a corporation’s ongoing business activities or when it is dif-
ficult to sell stock. The sale of bonds can also improve a corporation’s financial leverage—
the use of borrowed funds to increase the corporation’s return on investment. Finally, the
LO11.5
Recognize why investors
purchase corporate bonds.
corporate bond A
corporation’s written pledge
to repay a specified amount
of money with interest.
face value The dollar
amount the bondholder will
receive at the bond’s maturity.
maturity date For a
corporate bond, the date on
which the corporation is to
repay the borrowed money.
ACTION ITEM
I appreciate the advantages
of investing in corporate
bonds.
h Agree h Disagree
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interest paid to bond owners is a tax-deductible expense and thus can be used to reduce the
taxes the corporation must pay to the federal and state governments.
Corporate bonds are a form of debt financing. Bond owners must be repaid at a future
date, and interest payments on bonds are required. In the event of bankruptcy, bondholders
have a claim to the assets of the corporation prior to that of stockholders.
TYPES OF BONDS Most corporate bonds are debentures. A debenture is a bond
that is backed only by the reputation of the issuing corporation. If the corporation fails to
make either interest payments or repayment at maturity, debenture bondholders become
general creditors, much like the firm’s suppliers.
To make a bond issue more appealing to conservative investors, a corporation may issue
a mortgage bond. A mortgage bond (sometimes referred to as a secured bond ) is a cor-
porate bond secured by various assets of the issuing firm. Because of this added secu-
rity, interest rates on mortgage bonds are usually lower than interest rates on unsecured
debentures.
A special type of bond a corporation may issue is a convertible bond. A convertible
bond can be exchanged, at the owner’s option, for a specified number of shares of the
corporation’s common stock. This conversion feature allows investors to enjoy the lower
risk of a corporate bond but also take advantage of the speculative nature of common
stock. For example, assume you purchase a $1,000 convertible bond that is issued by
Wesco—a leading wholesaler and distributor of electrical products. Each bond can be
converted to 34.6433 shares of the company’s common stock. This means you could
convert the bond to common stock whenever the price of the company’s common stock
is $28.87 ($1,000 4 34.6433 5 $28.87) or higher. Generally, the interest rate on a con-
vertible bond is 1 to 2 percent lower than that on traditional bonds because of the con-
version factor.
Investors in search of higher interest can purchase a high-yield bond. A high-yield bond
is a corporate bond that pays higher interest but also has a higher risk of default. Before
investing in high-yield bonds, keep in mind these investments are often referred to as “junk
bonds” in the financial world. High-yield ( junk) bonds are sold by companies with a poor
earnings history, companies with a questionable credit record, and newer companies with
the unproven ability to increase sales and earn profits. They are also frequently used in
connection with leveraged buyouts—a situation where investors acquire a company and
sell high-yield bonds to pay for the company. So why do investors purchase high-yield
bonds? The answer is simple: Corporations issuing high-yield bonds must offer investors
interest rates that are three to four percentage ponts higher than safer bond issues. Caution:
You should not invest in high-yield bonds unless you fully understand all of the risks asso-
ciated with this type of investment.
PROVISIONS FOR REPAYMENT Today most corporate bonds are callable.
A call feature allows the corporation to call in, or buy, outstanding bonds from current
bondholders before the maturity date. In most cases, corporations issuing callable bonds
agree not to call them for the first 5 to 10 years after the bonds have been issued. The
money needed to call a bond may come from the firm’s profits, the sale of additional stock,
or the sale of a new bond issue that has a lower interest rate.
A corporation may use one of two methods to ensure that it has sufficient funds avail-
able to redeem a bond issue at maturity. First, the corporation may establish a sinking fund.
A sinking fund is a fund to which annual or semiannual deposits are made for the purpose
of redeeming a bond issue. To repay a $275 million bond issue, Union Pacific Corporation
agreed to make annual sinking fund payments in order to retire 95 percent of the bonds in
the issue prior to the bond maturity date.
Second, a corporation may issue serial bonds. Serial bonds are bonds of a single issue that
mature on different dates. For example, Seaside Productions used a 20-year, $100 million
bond indenture A legal
document that details all of
the conditions relating to a
bond issue.
trustee A financially
independent firm that
acts as the bondholders’
representative.
debenture A bond that
is backed only by the
reputation of the issuing
corporation.
mortgage bond A
corporate bond secured
by various assets of the
issuing firm.
convertible bond A bond
that can be exchanged, at
the owner’s option, for a
specified number of shares
of the corporation’s common
stock.
high-yield bond A
corporate bond that pays
higher interest but also has a
higher risk of default.
call feature A feature that
allows the corporation to call
in, or buy, outstanding bonds
from current bondholders
before the maturity date.
sinking fund A fund to
which annual or semiannual
deposits are made for the
purpose of redeeming a
bond issue.
serial bonds Bonds of a
single issue that mature on
different dates.
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bond issue to finance its expansion. None of the bonds mature
during the first 10 years. Thereafter, 10 percent of the bonds
mature each year until all the bonds are retired at the end of the
20-year period.
Detailed information about provisions for repayment, along
with other vital information (including maturity date, interest
rate, bond rating, call provisions, trustee, and details about secu-
rity), is available from Moody’s Investors Service, Standard &
Poor’s Corporation, Fitch Ratings Service, and Mergent, Inc.
Why Investors Purchase Corporate
Bonds
Basically, investors purchase corporate bonds for three reasons:
(1) interest income, (2) possible increase in value, and (3) repay-
ment at maturity.
INTEREST INCOME Bondholders normally receive inter-
est payments every six months until the bond’s maturity. The
formula to calculate the amount of interest is face value times the
interest rate, as illustrated below.
did you know? did you know?
Bond yields for investors who invest in
10-year Treasury notes and high-grade
corporate bonds:
SOURCE: The Federal Reserve website at www.federalreserve
.gov , accessed March 21, 2014.
2005 2010
P
e
rc
e
n
t
Current
0
2
4
6
8
4.29
5.23
3.22
4.94
2.71
4.45
10 10-Year Treasury Note
High-Grade Corporate Bonds
EXAMPLE: Interest Calculation (IBM)
Assume you purchase a $1,000 bond issued by IBM that pays 4 percent inter-
est each year. Using the following formula, you can calculate the annual interest
amount.
Amount of annual interest 5 Face value 3 Interest rate
5 $1,000 3 4 percent
5 $1,000 3 0.04
5 $40
Note: Yearly interest of $40 will be paid in two installments of $20 at the end of
each six-month period.
The method used to pay bondholders their interest depends on whether they own regis-
tered bonds or registered coupon bonds. A registered bond is registered in the owner’s
name by the issuing company. Most registered bonds are now tracked electronically, using
computers to record the owners’ information. Interest checks for registered bonds are
mailed directly to the bondholder of record. A variation of a registered bond is the regis-
tered coupon bond. A registered coupon bond is registered for principal only, not for inter-
est. While only the registered owner can collect the principal at maturity, interest payments
can be paid to anyone who presents one of the detachable coupons to the issuing corpora-
tion or the paying agent.
DOLLAR APPRECIATION OF BOND VALUE Most beginning investors
think that a $1,000 bond is always worth $1,000. In reality, the price of a corporate bond
may fluctuate until the maturity date. Changes in overall interest rates in the economy are
registered bond A bond
that is registered in the
owner’s name by the issuing
company.
registered coupon bond
A bond that is registered for
principal only, not for interest.
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the primary cause of most bond price fluctuations. Changing bond prices that result from
changes in overall interest rates in the economy are an example of interest rate risk, dis-
cussed earlier in this chapter. When IBM issued the bond mentioned earlier, the 4 percent
interest rate was competitive with the interest rates offered by other corporations issuing
bonds at that time. If overall interest rates fall, the price of your IBM bond will increase
due to its higher 4 percent interest rate. Because your IBM bond has increased in value,
you may want to sell your bond at the current higher price. Or, if you prefer, you can hold
your bond until maturity and receive the bond’s face value. Note: While the interest rate for
corporate bonds is fixed, the price and the yield for your IBM bond are not. In this case,
yield is the rate of return earned by an investor who holds a bond for a stated period of
time—usually a 12-month period. Changes in the yield for a bond are caused by an increase
or a decrease in the current price of a bond. The actual steps required to calculate yield are
described in the next section.
On the other hand, if overall interest rates for comparable bonds rise, the price of your
IBM bond will decrease due to its fixed 4 percent stated interest rate. Keep in mind, you
can always sell your bond, but if the price has decreased below the price you paid, you will
incur a loss. In this situation, many investors choose to hold the bond until maturity and
collect the face value.
It is possible to approximate a bond’s current market value using the following formula:
Approximate market value 5
Dollar amount of annual interest
___________________________
Comparable interest rate
yield The rate of return
earned by an investor who
holds a bond for a stated
period of time.
EXAMPLE: Calculating Approximate Market Value
Assume you purchase an IBM bond that pays 4 percent or annual interest of $40
and has a face value of $1,000. Also assume new corporate bond issues of compa-
rable quality are currently paying 5 percent. The approximate market value is $800,
as follows:
Approximate market value 5
Dollar amount of annual interest
_____________________________
Comparable interest rate
5
$40
____
5%
5 $800
The price of a bond may also be affected by the financial condition of the company or
government unit issuing the bond, the factors of supply and demand, an upturn or down-
turn in the economy, and the proximity of the bond’s maturity date.
BOND REPAYMENT AT MATURITY Corporate bonds are repaid at maturity.
After you purchase a bond, you have two options: You may keep the bond until maturity
and then redeem it, or you may sell the bond to another investor. In either case, the value
of your bond is closely tied to the corporation’s ability to repay its bond indebtedness.
For example, the value of bonds issued by J.C. Penney dropped in value when the retail-
er’s sales revenue dropped, the corporation experienced large dollar losses, and investors
feared the company would be forced to file for bankruptcy protection.
A Typical Bond Transaction
Most bonds are sold through full-service brokerage firms, discount brokerage firms, or the
Internet. If you use a full-service brokerage firm, your account executive should provide
both information and advice about bond investments. As with other investments, the chief
advantage of using a discount brokerage firm or trading online is lower commissions, but
you must do your own research.
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Generally, if you purchase a $1,000 corporate bond through an account executive or
brokerage firm, you should expect to pay a minimum commission of between $5 and $25.
If you purchase more bonds, the commission usually drops to $1 to $10 per bond. You
should also expect to pay commissions when you sell bonds.
PRACTICE QUIZ 11–5 PRACTICE QUIZ 11–5
1. Calculate the annual interest and the semiannual interest payment for corporate bond issues with a face value of
$1,000.
Annual Interest Rate Annual Interest
Semiannual Interest
Payment
6%
6.5%
7%
2. In your own words, describe why corporations issue corporate bonds.
3. List the three reasons investors purchase corporate bonds.
Apply Yourself! Apply Yourself!
Historically, the dollar return for bonds is less than the return for stocks. Still, investors often choose corporate and gov-
ernment bonds for their investment portfolio. In the chart below, describe the advantages and disadvantages of bond
investments.
Type of Bond Advantages Disadvantages
Corporate
Government
The Decision to Buy or Sell Bonds
One basic principle we have stressed throughout this chapter is the need to evaluate any
potential investment. As you will see in this section, a number of sources of information
can be used to evaluate bond investments.
The Internet
By accessing a corporation’s web page and locating the topics “financial information,”
“annual report,” or “investor relations,” you can find many of the answers to the questions
asked in “Your Personal Financial Plan” sheet 37, Evaluating Corporate Bonds.
When investing in bonds, you can use the Internet in three other ways. First, you can
obtain price information on specific bond issues to track your investments. Second, you
can trade bonds online and pay lower commissions than you would pay a full-service or
discount brokerage firm. Third, you can get research about a corporation and its bond
issues (including recommendations to buy or sell) by accessing specific bond websites.
LO11.6
Evaluate bonds when making
an investment.
ACTION ITEM
I know how to evaluate bond
investments.
h Yes h No
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The following are popular websites for corporate and government bond investors: www
.bondsonline.com , www.fmsbonds.com , www.treasurydirect.gov , www.emuni.com , and
bonds.yahoo.com . Be warned: Bond websites are not as numerous as websites that provide
information on stocks, mutual funds, or other investment alternatives. And many of the
better bond websites charge a fee for their research and recommendations.
You may want to visit the Moody’s website ( www.moodys.com ), the Standard & Poor’s
website ( www.standardandpoors.com ), Fitch Ratings ( www.fitchratings.com ), and Mer-
gent, Inc. ( www.mergent.com ) to obtain detailed information about both corporate and
government bonds.
Financial Coverage for Bond Transactions
In bond quotations, prices are given as a percentage of the face value, which is usually
$1,000. Thus, to find the actual current price for a bond, you must multiply the face value
($1,000) by the bond quotation.
EXAMPLE: Determining Bond Prices
To calculate the current price for a bond, you multiply the bond price quotation by
the face value—usually $1,000. If the bond price quotation is 84, the current price
is $840, as shown below.
Current price 5 Bond price quotation 3 Face value
5 84% 3 $1,000
5 0.84 3 $1,000
5 $840
While some information about bonds may be available in The Wall Street Journal
or larger metropolitan newspapers, today most bond investors use the Internet to obtain
detailed information on bond issues. Detailed information obtained from the Yahoo!
Finance website ( bonds.yahoo.com ) for a $1,000 AT&T corporate bond, which pays 6.40
percent interest and matures in 2038, is provided in Exhibit 11–7 .
Bond Ratings
To determine the quality and risk associated with bond issues, investors rely on the bond
ratings provided by Moody’s Investors Service, Inc., Standard & Poor’s Corporation, Fitch
Ratings, and Mergent. All four companies rank thousands of corporate and municipal bonds.
As Exhibit 11–8 illustrates, bond ratings range from AAA (the highest) to D (the
lowest) for Standard & Poor’s and Aaa (the highest) to C (the lowest) for Moody’s. Fitch
ratings and the ratings provided by Mergent are similar to the bond ratings provided by
Standard & Poor’s and Moody’s. For both Moody’s and Standard & Poor’s, the first four
individual categories represent investment-grade securities. Investment-grade securities
are suitable for conservative investors who want a safe investment that provides a predict-
able source of income. Bonds in the next two individual categories are considered specula-
tive in nature. Finally, the C and D categories are used to rank bonds where there are poor
prospects of repayment or even continued payment of interest. Bonds in these categories
may be in default.
Generally, the ratings for U.S. government securities issued by the Treasury Depart-
ment and state and local government securities are similar to those of corporate bonds.
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Bond Yield Calculations
The current yield is determined by dividing the annual interest amount by the bond’s cur-
rent price. The following formula may help you complete this calculation:
Current yield 5
Annual interest amount
___________________
Current price
current yield Determined
by dividing the yearly dollar
amount of interest by the
bond’s current price.
AT&T INC.
Overview
1. Price: 117.70
2. Coupon (%): 6.400
3. Maturity Date: 15-May-2038
4. Yield to Maturity (%): 5.114
5. Current Yield (%): 5.437
6. Fitch Ratings: A
7. Coupon Payment Frequency: Semi-Annual
8. First Coupon Date: 15-Nov-2008
9. Type: Corporate
10. Callable: No
1. Price quoted as a percentage of the face value: $1,000 3 117.70% 5 $1177.00
2. Coupon (%) is the rate of interest: 6.400 percent
3. Maturity Date is the date when bondholders will receive repayment of the face value:
May 15, 2038
4. Yield to Maturity (%) takes into account the relationship among a bond’s maturity value, the
time to maturity, the current price, and the amount of interest: 5.114 percent
5. Current Yield (%) is determined by dividing the dollar amount of annual interest by the current
price of the bond: $64 4 $1,177 5 5.437 percent
6. Fitch Ratings is issued by Fitch Bond Ratings and is used to assess the risk associated with
this bond: A
7. Coupon Payment Frequency tells bondholders how often they will receive interest payments:
Semi-Annual
8. First Coupon Date: November 15, 2008
9. Type: Corporate
10. Callable tells the bondholder if the bond is callable or not: No
SOURCE: Yahoo! Finance bond website ( bonds.yahoo.com ), accessed March 22, 2014.
Exhibit 11–7
Bond Information
Available by Accessing
the Yahoo! Bond Website
EXAMPLE: Calculating Current Yield
Assume you own a D.R. Horton corporate bond that pays 6.5 percent interest on an
annual basis. This means that each year you will receive $65 ($1,000 3 6.5% 5 $65).
Also assume the current price of the D.R. Horton bond is $1,060. Because the current
price is more than the bond’s face value, the current yield decreases to 6.13 percent,
as follows:
Current yield 5
$65
_______
$1,060
5 0.0613, or 6.13 percent
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Whereas the interest rate for corporate bonds is fixed, the current yield is not. The rea-
son for changes in the current yield is simple: During the time you own a bond, the price of
a bond may go up or down. In the previous example, the current price of the D.R. Horton
bond (that has a stated interest rate of 6.5 percent) was more than the bond’s face value. As
a result, the current yield decreased to 6.13 percent. Keep in mind that a bond’s price can
also decrease below its face value. When this happens, the current yield will increase and
be higher than the stated interest rate.
This calculation allows you to compare the yield on a bond investment with the yields
of other investment alternatives, which include savings accounts, certificates of deposit,
common stock, preferred stock, and mutual funds. Naturally, the higher the current yield,
the better! A current yield of 7 percent is better than a current yield of 6.13 percent.
Other Sources of Information
Investors can use two additional sources of information to evaluate potential bond invest-
ments. First, business and personal finance magazines can provide information about the
economy and interest rates and investment information about a corporation or government
entity that issues bonds.
Second, a number of federal agencies provide information that may be useful to bond
investors in either printed form or on the Internet. Reports and research published by the
Federal Reserve System, the U.S. Treasury, the Bureau of Economic Analysis, and the
Quality Moody’s
Standard &
Poor’s Description
High-grade Aaa AAA Bonds that are judged to be of the best quality.
Aa AA Bonds that are judged to be of high quality by all standards. Together with the
first group, they comprise what are generally known as high-grade bonds.
Medium-grade A A Bonds that possess many favorable investment attributes and are to be con-
sidered upper-medium-grade obligations.
Baa BBB Bonds that are considered medium-grade obligations; i.e., they may possess
certain speculative risks.
Speculative Ba BB Bonds that are judged to have more speculative elements than higher-rated
bond issues; their future may be determined by economic or adverse busi-
ness conditions.
B B Bonds that generally lack characteristics of the desirable investment and are
subject to high risk of nonpayment of interest and principal.
Poor prospects or Default Caa CCC Bonds that are of poor standing and very high risk.
Ca Bonds that represent obligations that are highly speculative and are likely in,
or very near, default.
C Bonds that are in default with little prospect for recovery of principal and interest.
CC Bonds that are very close to default and Standard & Poor’s expects default
to be a virtual certainty.
C Standard & Poor’s rating given to bonds that are highly vulnerable to nonpay-
ment and have lower prospects of eventual recovery of principal or interest.
D Bond issues in default.
SOURCE: “Long-Term Corporate Obligation Ratings,” Moody’s website ( www.moodys.com ), accessed March 24, 2014, and Standard & Poor’s Corpora-
tion, Global Credit Portal website ( www.globalcreditportal.com ), accessed March 24, 2014.
Exhibit 11–8 Description of Bond Ratings Provided by Moody’s Investors Service and Standard &
Poor’s Corporation
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Department of Commerce may be used to assess the nation’s economy. You can also obtain
information that corporations have reported to the Securities and Exchange Commission
by accessing the SEC website at www.sec.gov . Finally, state and local governments will
provide information about specific municipal bond issues.
PRACTICE QUIZ 11–6 PRACTICE QUIZ 11–6
1. What type of information about bonds is available on the Internet?
2. Calculate the current price for the following bonds:
Face Value Bond Quotation Current Price
$1,000 103
$1,000 77.5
3. Explain what the following bond ratings mean for investors:
a. Aaa
b. BBB
c. CC
Apply Yourself! Apply Yourself!
Visit one of the bond websites listed in this section and describe how this type of information could help you evaluate a
bond investment.
Sheet 37 Evaluating Corporate Bonds S
YOUR PERSONAL FINANCE DASHBOARD
POSSIBLE ACTIONS TO TAKE
Reconsider the three steps to start an investment
program at the beginning of the chapter to determine
actions you might take to improve your personal
financial activities.
Reevaluate your financial goals to make sure they
reflect what is important to you.
Establish an emergency fund that can be used to
meet unexpected emergencies.
Use the suggestions in Exhibit 11–1 to obtain the
money needed to fund your investment program.
Once you have established your investment goals
and completed your financial checkup, it’s time to
start investing—assuming you have enough money
to finance your investments. Unfortunately, the money
doesn’t automatically appear.
YOUR SITUATION: Have you established specific
and measurable investment goals? Have you performed
a financial checkup to see if you are ready to begin
investing? Do you have any money to invest? All three
questions are important and should be answered before
you begin to invest.
N
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S
S
OME PROGRESS READ
Y
TO
IN
V
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S
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MY FINANCIAL CHECKUP IS COMPLETE AND
I’M READY TO INVEST
BEGINNING AN INVESTMENT PROGRAM
0% 100%
20% 80%
10% 90%
30% 70%
50%40% 60%
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asset allocation 359
bond indenture 367
call feature 368
convertible bond 368
corporate bond 367
current yield 373
debenture 368
emergency fund 352
face value 367
registered bond 369
registered coupon
bond 369
revenue bond 366
serial bonds 368
sinking fund 368
speculative
investment 355
trustee 367
yield 370
general obligation
bond 366
government bond 365
high-yield bond 368
line of credit 352
liquidity 358
maturity date 367
mortgage bond 368
municipal bond 365
LO11.1 In addition to developing invest-
ment goals, you must make sure your per-
sonal financial affairs are in order. The next
step is the accumulation of an emergency
fund equal to at least three months’ living
expenses. Then, it’s time to save the money
needed to establish an investment program.
The time value of money concept can help
you achieve your goals—especially if you
start sooner rather than later.
LO11.2 All investors must consider the
factors of safety, risk, income, growth, and
liquidity. Especially important is the rela-
tionship between safety and risk. Basically,
this relationship can be summarized as fol-
lows: The potential return for any invest-
ment should be directly related to the risk
the investor assumes. In addition to safety
and risk, investors choose investments that
provide income, growth, or liquidity.
LO11.3 Asset allocation is the process
of spreading your assets among several dif-
ferent types of investments to lessen risk.
In addition to asset allocation, the amount
of time before you need your money is a
critical component in the type of invest-
ments you choose. Finally, your age is a
factor that influences investment choices.
You can also improve your investment
returns by evaluating all potential invest-
ments, monitoring the value of your invest-
ments, developing a plan if you experience
an economic crisis, and keeping accurate
and current records. Professional help and
your tax situation may also affect your
investment decisions.
LO11.4 Generally, U.S. government secu-
rities—Treasury bills, notes, bonds, and
Treasury Inflation-Protected Securities—are
chosen because most investors consider them
to be a safe harbor in troubled economic
times. Municipal bonds are also conserva-
tive investments and may provide tax-exempt
income.
LO11.5 Bonds are issued by corpora-
tions to raise capital. Investors purchase
corporate bonds for three reasons: (1) inter-
est income, (2) possible increase in value,
and (3) repayment at maturity. The method
used to pay bondholders interest depends
on whether they own registered bonds or
registered coupon bonds. Most corporate
bonds are bought and sold through full-
service brokerage firms, discount brokerage
firms, or the Internet. Investors pay com-
missions when bonds are bought and sold.
LO11.6 Today it is possible to obtain
information and trade bonds online via the
Internet. To determine the quality of a bond
issue, most investors study the ratings pro-
vided by Standard & Poor’s, Moody’s, Mer-
gent, Inc., and Fitch Ratings. Investors can
also calculate a current yield to evaluate a
decision to buy or sell bond issues. Finally,
business magazines and government sources
can be used to evaluate both government
and corporate bonds and the economy.
Chapter
Summary
Key Terms
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Page Topic Formula
352 Emergency
fund
Minimum emergency fund 5 Monthly expenses 3 3 months
366 Taxable
equivalent
yield
Taxable equivalent yield 5
Tax-exempt yield
________________
1.0 2 Your tax rate
369 Interest
calculation
for a bond
Amount of annual interest 5 Face value 3 Interest rate
370 Approximate
market value
Approximate market value 5 Dollar amount of annual interest ___________________________
Comparable interest rate
372 Current price
for a bond
Current price 5 Bond price quotation 3 Face value
373 Current yield
for a bond
Current yield 5 Annual interest amount ___________________
Current price
Key
Formulas
1. After performing a financial checkup, you realize that you have too much credit card
debt. What steps can you take to reduce the amount of money you owe on your credit
cards? (LO11.1)
2. Is it ethical to spend more than you earn month after month? What repercussions could
you encounter if you overspend on a regular basis? (LO11.1)
3. Explain the following statement: The potential return on any investment should be
directly related to the risk the investor assumes. (LO11.2)
4. Assume you are 30 years old, single, and are just beginning to invest. How can you
balance safety, risk, and growth when choosing investments? Which component do
you consider to be the most important? (LO11.2)
5. How does your age affect the type of investments you choose to obtain your financial
goals? (LO11.3)
6. Assume that you are choosing an investment for your retired parents. Would you
choose a bond issued by the federal government, a state or local government, or a cor-
poration? Justify your answer. (LO11.4)
7. In what circumstances would a $1,000 corporate bond be worth more than $1,000? In
what circumstances would the corporate bond be worth less than $1,000? (LO11.5)
8. You are considering two different corporate bonds. One is rated AAA by Standard &
Poor’s and pays 4.5 percent annual interest. The other bond is rated B by Standard &
Poor’s and pays 6.2 percent annual interest. What do these ratings mean? Which bond
would you choose and why? (LO11.6)
Discussion
Questions
1. For Ned Masterson, the last few years have been a financial nightmare. It all started
when he lost his job. Because he had no income, he began using his credit cards to
obtain the cash needed to pay everyday living expenses. Finally, after an exhaustive
job search, he has a new job that pays $42,000 a year. While his take-home pay is
$2,450 a month, he must now establish an emergency fund, pay off his $6,200 credit
card debt, and start saving the money needed to begin an investment program.
a. If monthly expenses are $1,750, how much money should Ned save for an
emergency fund?
b. Ned has decided that he will save $2,000 a year for the next five years in order to
establish a long-term investment program. If his savings and investments earn 4
percent each year, how much money will he have at the end of five years? (Use the
table in this chapter’s “Figure It Out!” box to answer this question.)
2. Betty Forrester is 55 years old, wants to diversify her investment portfolio, and must
decide if she should invest in tax-free municipal bonds or corporate bonds. The
Self-Test
Problems
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tax-free bonds are highly rated and pay 4.25 percent. The corporate bonds are more
speculative and pay 6.1 percent.
a. If Betty is in the 33 percent tax bracket, what is the taxable equivalent yield for the
municipal bond?
b. If you were Betty, would you choose the municipal bonds or corporate bonds?
Justify your answer.
3. Mary Glover purchased ten $1,000 corporate bonds issued by Avon Products. The
annual interest rate for the bonds is 6.5 percent.
a. What is the annual interest amount for each Avon Products bond?
b. If the bonds have a current bond price quotation of 112, what is the current price of
the bond?
c. Given the above information, what is the current yield for an Avon Products bond?
Solutions
1. a. The minimum emergency fund is $5,250.
Minimum emergency fund 5 Monthly expenses 3 3 months
5 $1,750 3 3
5 $5,250
b. Based on the information in the table in the “Figure It Out!” box, Ned will have
invested $10,000 at the end of five years. If his savings and investments earn
4 percent, he will have $10,832 at the end of five years that can be used to fund
additional investments. To solve this problem, you must use the table factor for
5 years and 4 percent, which is 5.416, and then multiply $2,000 3 5.416 5 $10,832.
2. a. The taxable equivalent yield for the municipal bond is
Taxable equivalent yield 5
Tax-exempt yield
________________
1.0 2 Your tax rate
5
0.0425
_________
1.0 2 0.33
5 0.063, or 6.3 percent
b. The taxable equivalent yield for the municipal bonds is 6.3 percent; the yield for the
corporate bonds is 6.1 percent. Also, it should be noted that the corporate bonds are
“speculative” and the interest income on the corporate bonds is taxable. In this case,
Betty should choose the tax-free municipal bonds because the yield is higher and
they are more conservative.
3. a. The annual interest for each bond is $65.
Amount of annual interest 5 Face value 3 Interest rate
5 $1,000 3 0.065
5 $65
b. The current price is $1,120.
Current price 5 Bond price quotation 3 Face value
5 112% 3 $1,000
5 1.12 3 $1,000
5 $1,120
c. The current yield is
Current yield 5
Annual interest amount
___________________
Current price
5
$65
______
$1,120
5 0.058 5 5.8 percent
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Problems
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1. Jane and Bill Collins have total take-home pay of $4,500 a month. Their monthly
expenses total $3,400. Calculate the minimum amount this couple needs to establish
an emergency fund. (LO11.1)
2. Use the information in the “Figure It Out!” box earlier in the chapter to complete the
following table. (LO11.1)
Annual
Deposit
Rate of
Return
Number
of Years
Investment Value
at the End of
Time Period
Total
Amount of
Investment
Total
Amount of
Earnings
$2,000 2% 10
$2,000 8% 10
$2,000 4% 30
$2,000 11% 30
3. Assume you are 45 years old, want to retire in 20 years, and currently have an invest-
ment portfolio valued at $240,000 invested in technology stocks. After talking with
a financial advisor, you feel you have “too many eggs in one basket,” and need to
diversify your investments. Based on this information, use the asset allocation method
described in this chapter and the table below to diversify your investment portfolio.
Then in a short paragraph explain why you chose these investments. (LO11.3)
Investment Alternative
Percentage You Would
Like in This Category
Stocks issued by large corporations (large cap)
Stocks issued by medium-sized corporations (midcap)
Stocks issued by small, rapidly growing companies (small cap)
Foreign stocks
Bonds
Cash
Other investments (specify type)
100%
4. Based on the following information, construct a graph that illustrates price movement
for a Washington Utilities bond fund. (LO11.3)
January $16.50 July $14.00
February $15.50 August $13.10
March $17.20 September $15.20
April $18.90 October $16.70
May $19.80 November $18.40
June $16.50 December $19.80
5. Assume you are in the 28 percent tax bracket and purchase a 3.50 percent municipal
bond. Use the formula presented in this chapter to calculate the taxable equivalent
yield for this investment. (LO11.4)
6. Assume you are in the 35 percent tax bracket and purchase a 3.75 percent municipal
bond. Use the formula presented in this chapter to calculate the taxable equivalent
yield for this investment. (LO11.4)
7. Assume that three years ago you purchased a corporate bond that pays 5.8 percent.
The purchase price was $1,000. What is the annual dollar amount of interest that you
receive from your bond investment? (LO11.5)
8. Twelve months ago, you purchased 10-year Treasury notes with a face value of
$1,000. The interest rate is 2.90 percent. What is the dollar amount of interest you will
receive each year? (LO11.5)
9. Assume that you purchased a $1,000 convertible corporate bond. Also assume the bond
can be converted to 38.4615 shares of the firm’s stock. What is the dollar value that the
stock must reach before investors would consider converting to common stock? (LO11.5)
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10. Five years ago, you purchased a $1,000 corporate bond issued by General Electric.
The interest rate for the bond was 4 percent. Today comparable bonds are paying 5
percent. (LO11.5)
a. What is the approximate dollar price for which you could sell your General
Electric bond?
b. In your own words, describe why your bond decreased in value.
11. In 1994, you purchased a $1,000 corporate bond issued by Boeing. At the time,
the interest rate for the bond was 6 percent. Today, comparable bonds are paying
4.30 percent. (LO11.5)
a. What is the approximate dollar price for which you could sell your Boeing bond?
b. In your own words, describe why your bond increased in value.
12. Determine the current yield on a corporate bond investment that has a face value of
$1,000, pays 4.60 percent, and has a current price of $950. (LO11.6)
13. Choose a corporate bond that you would consider purchasing. Then, using information
obtained on the Internet or in the library, answer the questions in “Your Personal Financial
Plan” sheet 37. Based on your research, would you still purchase this bond? (LO11.6)
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com .
Case in
Point A LESSON FROM THE PAST
Back in 2002, Mary Goldberg, a 34-year-
old widow, got a telephone call from a Wall
Street account executive who said that one
of his other clients had given him her name.
Then he told her his brokerage firm was
selling a new corporate bond issue in New
World Explorations, a company heavily
engaged in oil exploration in the western
United States. The bonds in this issue paid
investors 11.2 percent a year. He then said
that the minimum investment was $10,000
and that if she wanted to take advantage of
this “once in a lifetime” opportunity, she
had to move fast. To Mary, it was an oppor-
tunity that was too good to pass up, and
she bit hook, line, and sinker. She sent the
executive a check—and never heard from
him again. A few days later (and after her
check was paid by her bank), she went to
the library to research her bond investment.
Unfortunately, she found there was no such
company as New World Explorations, and
she had lost $10,000. Right then and there,
she vowed she would never invest in bonds
again. From now on, she would put her
money in the bank, where it was guaranteed.
Over the years, she continued to save and
deposit money in the bank and accumulated
more than $32,000. Things seemed to be
pretty much on track until one of her cer-
tificates of deposit (CD) matured. When
she went to renew the CD, the bank officer
told her interest rates had fallen and current
CD interest rates ranged between 0.50 and
1.5 percent.
Faced with the prospects of lower interest
rates, Mary decided to shop around for higher
rates. She called several local banks and got
pretty much the same answer. Then a friend
suggested that she talk to Peter Manning, an
account executive for Fidelity Investments.
Manning told her there were conservative
bonds that offered higher returns. But he
warned her that these investments were not
guaranteed. If she wanted higher returns, she
would have to take some risks.
While Mary wanted higher returns, she also
remembered how she had lost $10,000.
When she told Peter Manning about her
bond investment in the fictitious New World
Explorations, he pointed out that she had
made some pretty serious mistakes. For
starters, she bought the bonds over the phone
from someone she didn’t know, and she
bought them without doing any research. He
assured her that the bonds he would recom-
mend would be issued by real companies,
and she would be able to find information on
each of his recommendations at the library
or on the Internet. For starters, he suggested
the following two investments:
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1. America West Airlines corporate bonds
that pay 8.057 percent annual interest and
mature on July 2, 2020. This bond has a
current price of $1,160 and is rated BBB.
2. Berkshire Hathaway corporate bonds
that pay 3.40 percent annual interest
and mature on January 31, 2022. This
bond has a current price of $1,030 and
is rated AA.
Questions
1. According to Mary Goldberg, the
chance to invest in New World Explo-
rations was “too good to pass up,” and
she lost $10,000. Why do you think so
many people are taken in by get-rich-
quick schemes?
2. Using the information obtained in the
library or on the Internet, answer the
following questions about Peter Man-
ning’s investment suggestions.
a. What does the rating for the America
West Airlines bond mean?
b. What is the current yield for an
America West Airlines bond?
c. What does the rating for the Berk-
shire Hathaway bond mean?
d. What is the current yield for a Berk-
shire Hathaway bond?
3. Based on your research, which invest-
ment would you recommend to Mary
Goldberg? Why?
Assets (Jamie Lee and Ross combined) :
Checking account, $4,500
Savings account, $20,000
Emergency fund savings account, $21,000
IRA balance, $32,000
Cars, $8,500 (Jamie Lee) and $14,000 (Ross)
Liabilities (Jamie Lee and Ross combined) :
Student loan balance, $0
Credit card balance, $4,000
Car loans, $2,000
Income:
Jamie Lee, $45,000 gross income
($31,500 net income after taxes)
Ross, $80,000 gross income ($64,500 net
income after taxes)
Monthly Expenses :
Mortgage, $1,225
Property taxes, $400
Homeowner’s insurance, $200
IRA contribution, $300
Utilities, $250
Food, $600
Baby essentials (diapers, clothing, toys,
etc.), $200
Gas/Maintenance, $275
Credit card payment, $400
Car loan payment, $289
Entertainment, $125
INVESTING BASICS AND EVALUATING BONDS
Continuing
Case
The triplets are now three-and-a-half years old and Jamie Lee and Ross, both 38, are finally
beginning to settle down into a regular routine. The first three years were a blur of diapers,
feedings, baths, mounds of laundry, and crying babies!
Jamie Lee and Ross finally went out to a welcome dinner out on the town. Ross’s parents
were watching the triplets. They were having a conversation about their future and the
future of the kids. They figured college expenses will be $100,000, and their eventual
retirement was a major worry for both of them. They have dreamed of owning a beach
house when they retire. That could be another $350,000, 30 years from now. They won-
dered how could they possibly afford all of this.
They agreed that it was time to talk to an investment counselor, but they wanted to organize
all of their financial information and discuss their family’s financial goals before setting
up the appointment.
Current Financial Situation
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Questions
1. Describe the stage in the adult life cycle (Exhibit 1–1) that Jamie Lee and Ross are
experiencing right now. What are some of the financial activities that they should be par-
ticipating in at this stage?
2. After reviewing Jamie Lee and Ross’s current financial situation, suggest specific and
measurable short-term and long-term financial goals that can be implemented at this stage.
3. Using the investment goal guidelines, assess the validity of Jamie Lee and Ross’s
short- and long-term financial goals and objectives:
Financial Question Short-Term Goals Long-Term Goals
1. How much money do they need to satisfy their
investment goals?
2. How much risk are they willing to assume in an
investment program?
3. What possible economic or personal conditions
could alter their investment goals?
4. Considering their economic conditions, are their
investment goals reasonable?
5. Are they willing to make the sacrifices necessary
to ensure that they meet their investment goals?
4. Using the formula for allocating investments and the risk involved, assess how much
of Jamie Lee and Ross’s assets should be allocated in higher-risk growth investments?
How should the remaining investments be distributed and what is the associated risk?
5. Jamie Lee and Ross need to evaluate their emergency fund of $21,000. Will their pres-
ent emergency fund be sufficient to cover them should one of them lose their job?
6. Jamie Lee and Ross agree that by accomplishing their short-term goals, they can bud-
get $5,000 a year toward their long-term investment goals. They are estimating that
with the allocations recommended by their financial advisor, they will see an average
return of 7 percent on their investments. The triplets will begin college in 15 years and
will need $100,000 for tuition.
Using the time value of money calculations found in the “Figure It Out!” information
box found in this chapter, decide if Jamie Lee and Ross will be on track to reach their
long-term financial goals of having enough money from their investments to pay the
triplets’ tuition.
Directions The use of your Daily Spending Diary can provide an important foundation
for monitoring and controlling spending. This will allow the possibility of wiser use of your
money now and in the future. The Daily Spending Diary sheets are located in Appendix D
at the end of the book and in Connect Finance.
Questions
1. Explain how the use of a Daily Spending Diary could result in starting an investment
program.
2. Based on your Daily Spending Diary, describe actions that you might take to identify
and achieve various financial and investment goals.
“WHILE I HAVE A FAIRLY LARGE AMOUNT IN A SAVINGS
ACCOUNT, I SHOULD THINK ABOUT INVESTING SOME OF THIS
MONEY IN OTHER WAYS.”
Spending
Diary
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Establishing Investment Goals
Purpose: To determine specific goals for an investment program.
Financial Planning Activities: Based on short- and long-term objectives for your invest-
ment efforts, enter the items requested below. This sheet is also available in an Excel
spreadsheet format in Connect Finance.
Suggested Websites: www.fool.com money.cnn.com
35
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Description
of investment
goal
Dollar
amount
Date
needed
Possible
investments to
achieve this goal
Level of
risk (high,
medium, low)
What’s Next for Your Personal Financial Plan?
• Use the suggestions listed in this chapter to perform a financial checkup.
• Discuss the importance of investment goals and financial planning with other household members.
Suggested
App:
• The Motley
Fool
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384
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What’s Next for Your Personal Financial Plan?
• Identify current economic trends that might increase or decrease the risk associated with your choice of
investments.
• Based on the risk associated with the investments you chose, which investment would you choose to attain
your investment goals?
Assessing Risk for Investments
Purpose: To assess the risk of various investments in relation to your personal risk tolerance
and financial goals.
Financial Planning Activities: List various investments you are considering based on the
type and level of risk associated with each. This sheet is also available in an Excel spread-
sheet format in Connect Finance.
Suggested Websites: www.marketwatch.com www.fool.com
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Type of
investment
Loss of market
value
(market risk)
Type of Risk
Inflation risk Interest rate risk Liquidity risk
High risk
Moderate risk
Low risk
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Category 1: Information about the
Corporation
1. What is the corporation’s name, website address,
and phone number? __________________________
____________________________________________
2. What type of products or services does this firm
provide? ____________________________________
____________________________________________
3. Briefly describe the prospects for this company.
(Include significant factors like product develop-
ment, plans for expansion, plans for mergers, etc.)
____________________________________________
____________________________________________
____________________________________________
Category 2: Bond Basics
4. What type of bond is this? ____________________
5. What is the face value for this bond? ___________
6. What is the interest rate for this bond? __________
7. What is the dollar amount of annual interest for
this bond? __________________________________
8. When are interest payments made to
bondholders?
____________________________________________
9. Is the corporation currently paying interest as
scheduled? h Yes h No
10. What is the maturity date for this bond? ________
11. What is Moody’s rating for this bond? __________
12. What is Standard & Poor’s rating for this bond?
____________________________________________
13. What do these ratings mean? _________________
____________________________________________
____________________________________________
14. What was the original issue date? _____________
____________________________________________
15. Who is the trustee for this bond issue? _________
____________________________________________
16. Is the bond callable? If so, when? _____________
____________________________________________
17. Is the bond secured with collateral? If so, what?
h Yes h No
____________________________________________
Category 3: Financial Performance
18. What are the firm’s earnings per share for the last
year? ______________________________________
19. Have the firm’s earnings increased over the past
five years? __________________________________
20. What are the firm’s projected earnings for the
next year? __________________________________
21. Do the analysts indicate that this is a good time
to invest in this company? Why or why not?
____________________________________________
____________________________________________
22. Briefly describe any other information that you
obtained from Moody’s, Standard & Poor’s, or
other sources of information.
____________________________________________
____________________________________________
A Word of Caution
The above checklist is not a cure-all, but it does
provide some very sound questions that you should
answer before making a decision to invest in bonds.
If you need other information, you are responsible for
obtaining it and for determining how it affects your
potential investment.
Evaluating Corporate Bonds
Purpose: To determine if a specific corporate bond can help you attain your financial goals.
Financial Planning Activities: No checklist can serve as a foolproof guide for choosing a
corporate bond. However, the following questions will help you evaluate a potential bond
investment. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: bonds.yahoo.com www.bondsonline.com
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What’s Next for Your Personal Financial Plan?
• Talk with various people who have invested in government, municipal, or corporate bonds.
• Discuss with other household members why bonds might be a logical choice for your investment program.
Suggested
App:
• Yahoo!
Finance
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12 Investing in Stocks
Often people don’t invest in stocks because
it seems too complicated. In reality, it may
be easier than you think. By following the
three steps above, you can begin purchasing
stock. As an incentive, keep in mind that since
1926—a period of over 90 years—stocks have
returned an average annual return of almost
10 percent. Because stocks offer higher annual
returns, many financial experts recommend
stock investments for investors who are estab-
lishing a long-term investment program.
1
Save the money needed to purchase your first
stock.
Website: www.daveramsey.com/article/
the-secret-to-saving-money
2
Evaluate different stocks that match your per-
sonal investment goals.
Website: money.cnn.com
3
Research the services and fees offered by dif-
ferent brokerage firms.
Website: www.brokerstance.com
3 Steps to Financial
Literacy . . . Begin Investing
in Stocks
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Common and Preferred Stock
Why invest in stocks? To answer this question, consider the returns provided by stocks
over a long period of time. Since 1926, the average annual return for stocks is almost
10 percent as measured by the Standard & Poor’s 500 stock index—a bench mark of stock
market performance often reported on financial news programs. In fact, stock returns were
substantially higher than the returns provided by more conservative investments. 1 Simply
put, investors who want larger returns choose stocks. Certainly, there have been periods
when stocks declined in value. For proof, just ask any stock investor what happened to the
value of his or her stock investments during the recent economic crisis. Still, the key to
success with any investment program often is allowing your investments to work for you
over a long period of time. A long-term investment program allows you to ride through the
rough times and enjoy the good times. However, before you decide to invest your money,
you should realize the importance of evaluating a potential stock investment.
Many investors face two concerns when they begin an investment program. First, they
don’t know where to get the information they need to evaluate potential investments. In
reality, more information is available than most investors can read. Yet, as crazy as it
sounds, some investors invest in stocks without doing any research at all. As we begin
this chapter, you should know that there is no substitute for researching a potential stock
investment.
Second, beginning investors sometimes worry that they won’t know what the infor-
mation means when they do find it. Yet common sense goes a long way when evaluating
potential investments. For example, consider the following questions:
1. Is an increase in sales revenues a healthy sign for a corporation? (Answer: yes)
2. Should a firm’s profits increase or decrease over time? (Answer: increase)
LO12.1
Identify the most important
features of common and
preferred stock.
ACTION ITEM
I understand the three ways
investors can profit from
stock investments.
h Yes h No
1 “Money 101 Lesson 4: Basics of Investing,” CNN/Money ( http://money.cnn.com/magazines/moneymag/money101/
lesson4/index.htm ), accessed April 20, 2014.
CHAPTER 12 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO12.1 Identify the most important features of common and preferred stock.
LO12.2 Explain how you can evaluate stock investments.
LO12.3 Analyze the numerical measures that cause a stock to increase or decrease in
value.
LO12.4 Describe how stocks are bought and sold.
LO12.5 Explain the trading techniques used by long-term investors and short-term
speculators.
YOUR PERSONAL FINANCIAL PLAN SHEETS
38. Evaluating Corporate Stocks
39. Investment Broker Comparison
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Although the answers to these two questions are obvious, you will find more detailed
answers to these and other questions in this chapter. In fact, that’s what this chapter is all
about. We want you to learn how to evaluate a stock and to make money from your invest-
ment decisions.
Why Corporations Issue Common Stock
Common stock is the most basic form of ownership for a corporation. Corporations issue
common stock to finance their business start-up costs and help pay for expansion and their
ongoing business activities. Corporate managers prefer selling common stock as a method
of financing for several reasons.
A FORM OF EQUITY Important point: Stock is equity financing. Equity financing
is money received from the sale of shares of ownership in a business. One reason corpora-
tions prefer selling stock is because the money obtained from equity financing doesn’t
have to be repaid and the company doesn’t have to buy back shares from the stockholders.
On the other hand, a stockholder who buys common stock may sell his or her stock to
another individual.
DIVIDENDS NOT MANDATORY Important point: Dividends are paid out of
profits, and dividend payments must be approved by the corporation’s board of directors.
A dividend is a distribution of money, stock, or other property that a corporation pays to
stockholders. Dividend policies vary among corporations, but most firms distribute
between 30 and 70 percent of their earnings to stockholders. However, some corporations
follow a policy of smaller or no dividend distributions to stockholders. In general, these are
rapidly growing firms, like Amazon (online sales) or Google (online websites) or Face-
book (social networking), that retain a large share of their earnings for research and devel-
opment, expansion, or major projects. On the other hand, utility companies, such as Duke
Energy, and other financially secure enterprises may distribute 70 to 90 percent of their
earnings. Always remember that if a corporation has had a bad year, dividend payments
may be reduced or omitted.
VOTING RIGHTS AND CONTROL OF THE COMPANY In return for the
financing provided by selling common stock, management must make concessions to
stockholders that may restrict corporate policies. For example, corporations are required by
law to have an annual meeting at which stockholders have a right to vote, usually casting
one vote per share of stock. Stockholders may vote in person or by proxy. A proxy is a legal
form that lists the issues to be decided at a stockholders’ meeting and requests that stock-
holders transfer their voting rights to some individual or individuals. The common stock-
holders elect the board of directors and must approve major changes in corporate policies.
Why Investors Purchase Common Stock
Let’s begin with two basic assumptions. First, no one invests in stocks in order to lose
money. Second, every investor wants to earn a better-than-average return on stock invest-
ments. For more information about why people invest in stocks, read the next section.
THE PSYCHOLOGY OF STOCK INVESTING Why do people invest in
stocks? Good question! The simple answer is that investors want the larger returns that
stocks offer, even though they are aware of the potential for losses. Remember the statistics
that were presented at the beginning of this chapter. Historically, long-term stock investors
experience an average annual return of almost 10 percent. The bottom line: When com-
pared to current interest rates for savings accounts, certificates of deposit, and bonds, stock
investments offer a greater potential for larger returns.
common stock The most
basic form of corporate
ownership.
equity financing Money
received from the owners
or from the sale of shares of
ownership in a business.
dividend A distribution
of money, stock, or other
property that a corporation
pays to stockholders.
proxy A legal form that lists
the issues to be decided at
a stockholders’ meeting and
requests that stockholders
transfer their voting rights to
some individual or individuals.
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From a psychological standpoint, many investors have trouble making the decision to
buy or sell a stock. The following suggestions can be used to reduce anxiety when you
make stock investment decisions.
• Evaluate each investment. Too often, investors purchase or sell a stock without
doing their homework. A much better approach is to become an expert and learn all
that you can about the company (and its stock).
• Analyze the firm’s finances. Look at the company’s financial information, which
is available in the firm’s annual report or on many investment websites. Examine
trends for sales, profits, dividends, and other important financial data. More specific
information on how to evaluate a firm’s finances is provided later in this chapter.
• Track the firm’s product line. If the firm’s products become obsolete and the
company fails to introduce state-of-the art new products, its sales—and, ultimately,
profits—may take a nosedive.
• Monitor economic developments. An economic recovery or an economic recession
may cause the value of a stock investment to increase or decrease. Also, watch the
unemployment rate, inflation rate, interest rates, productivity rates, and similar
economic indicators.
• Be patient. The secret of success for making money with stocks is often time. If you
choose quality stocks based on quality research, and in some cases wait, eventually
your stock investments will provide average or even above-average returns. And
remember: There are no guarantees when investing in stocks. Larger returns are
always accompanied by increased risk when investing in stocks.
How do you make money by buying common stock? Basically, there are three ways:
income from dividends, dollar appreciation of stock value, and the possibility of increased
value from stock splits.
INCOME FROM DIVIDENDS While the corporation’s board members are under
no legal obligation to pay dividends, most board members like to keep stockholders happy
(and prosperous). Therefore, board members usually declare dividends if the corporation’s
profits are sufficient for them to do so. Since dividends are a distribution of profits, inves-
tors must be concerned about future profits.
Dividends for common stock may take the form of cash, additional stock, or company
products. However, the last type of dividend is extremely unusual. If the board of directors
declares a cash dividend, each common stockholder receives an equal amount per share.
Although dividend policies vary, most corporations pay dividends on a quarterly basis.
Notice in Exhibit 12–1 that Microsoft declared a quarterly dividend of $0.28 per share
to stockholders who owned the stock on the record date of May 15, 2014. The record date
record date The date
on which a stockholder
must be registered on the
corporation’s books in
order to receive dividend
payments.
Information about corporate dividends is available by using the Internet to access a corporation’s
website or other investment sites. The numbers above each of the columns correspond to the
numbered entries in the list of explanations that appear at the bottom of the exhibit.
1
Company
2
Amount of Dividend
3
Record Date
4
Payable Date
Microsoft $0.28 May 15, 2014 June 12, 2014
Exhibit 12–1
Dividend Information
1. The name of the company paying the dividend is Microsoft.
2. The dollar amount of the quarterly dividend is $0.28.
3. The record date is Thursday, May 15, 2014. Stockholders must be registered on the corporate
books by the record date in order to receive this quarterly dividend payment. The stock begins
selling “ex-dividend” Tuesday, May 13, 2014—two business days before the record date.
4. The dividend will be paid on June 12, 2014, to stockholders who own the stock on the record
date (May 15, 2014).
SOURCE: The Microsoft Corporation website at www.microsoft.com, accessed April 21, 2014.
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is the date on which a stockholder must be registered on the corporation’s books in order to
receive dividend payments. When a stock is traded around the record date, the company
must determine whether the buyer or the seller is entitled to the dividend. To solve this
problem, this rule is followed: Dividends remain with the stock until two business days
before the record date. On the second day before the record date, the stock begins selling
ex-dividend. Investors who purchase an ex-dividend stock are not entitled to receive divi-
dends for that quarter, and the dividend is paid to the previous owner of the stock.
For example, Microsoft declared a quarterly dividend of $0.28
per share to stockholders who owned its stock on Thursday, May 15,
2014. The stock went ex-dividend on Tuesday, May 13, 2014, two
business days before the May 15 date. A stockholder who purchased
the stock on Tuesday, May 13, or after was not entitled to this quar-
terly dividend payment. The actual dividend payment was paid on
June 12, 2014, to stockholders who owned the stock on the record
date. Investors are generally very conscious of the date on which
a stock goes ex-dividend, and the dollar value of the stock may go
down by the value of the dividend.
DOLLAR APPRECIATION OF STOCK VALUE The
price for a share of stock is determined by how much a buyer is
willing to pay for the stock. The price changes when information
about the firm or its future prospects is released to the general
public. For example, information about future sales revenues or
expected earnings can increase or decrease the price for the firm’s
stock. In most cases, you purchase stock and then hold on to that
stock for a period of time. If the price of the stock increases, you
must decide whether to sell the stock at the higher price or con-
tinue to hold it. If you decide to sell the stock, the dollar amount
of difference between the purchase price and the selling price rep-
resents your profit.
Let’s assume that on January 15, 2011, you purchased 100
shares of Johnson & Johnson stock at a cost of $65 a share. Your
cost for the stock was $6,500 plus $25 in commission charges,
for a total investment of $6,525. (Note: Commissions, a topic covered later in this
chapter, are charged when you purchase stock and when you sell stock.) Let’s also
assume you held your 100 shares until January 15, 2014 and then sold them for $95 a
share. During the three-year period you owned Johnson & Johnson shares, the com-
pany paid dividends totaling $7.24 per share. Exhibit 12–2 shows your return on the
investment. In this case, you made money because of dividend payments and through
an increase in stock value from $65 to $95 per share. As Exhibit 12–2 shows, your
total return is $3,674. Of course, if the stock’s value should decrease, or if the firm’s
board of directors reduces or votes to omit dividends, your return may be less than the
original investment.
POSSIBILITY OF INCREASED VALUE FROM STOCK SPLITS Inves-
tors can also increase potential profits through a stock split. A stock split is a procedure in
which the shares of stock owned by existing stockholders are divided into a larger number
of shares. In 2014, for example, the board of directors of Under Armour, the company that
develops, manufactures, and markets athletic clothing, approved a 2-for-1 stock split. After
the stock split, a stockholder who had previously owned 100 shares now owned 200 shares.
The most common stock splits are 2-for-1 or 3-for-1 .
Why do corporations split their stock? In many cases, a firm’s management has a the-
oretical ideal price range for the firm’s stock. If the market value of the stock rises above
the ideal range, a stock split brings the market value back in line. In the case of Under
stock split A procedure
in which the shares of
stock owned by existing
stockholders are divided into
a larger number of shares.
CAUTION! CAUTION!
One of the most common Internet stock
frauds is called “Pump and Dump.” Here’s
how it works: Glowing information about a
company appears on a company’s website,
in newsletters, or in chat rooms or blogs.
Based on this information, uninformed inves-
tors purchase the “hot” stock, creating high
demand and pumping up the price. When
the stock price peaks, the fraudsters behind
the scheme dump their shares and the stock
price falls.
To avoid this scam, the Securities and
Exchange Commission advises investors
to check any information that seems too
good to be true and to use multiple informa-
tion sources to research any stock before
investing.
SOURCE: “Pump&Dump.con,” The Securities
and Exchange Commission ( www.sec.gov ), accessed
April 23, 2014.
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Assumptions
100 shares of common stock purchased January 15, 2011, sold January 15, 2014; dividends of
$7.24 per share for the investment period.
Costs When Purchased Return When Sold
100 shares @ $65 5 $6,500 100 shares @ $95 5 $9,500
Plus commission 1 25 Minus commission 2 25
Total investment $6,525 Total return $9,475
Transaction Summary
Total return $ 9,475
Minus total investment 2 6,525
Profit from stock sale $ 2,950
Plus dividends 1 724
Total return for the transaction $ 3,674
Exhibit 12–2
Sample Stock Transaction
for Johnson & Johnson
Armour, the 2-for-1 stock split reduced the market value to one-half of the stock’s value on
the day prior to the split. The lower market value for each share of stock was the result of
dividing the dollar value of the company by a larger number of shares of common stock.
Also, a decision to split a company’s stock and the resulting lower market value make
the stock more attractive to the investing public. This attraction is based on the belief that
most corporations split their stock only when their financial future is improving and on the
upswing.
Be warned: There are no guarantees that a stock’s market value will go up after a split.
This is important to understand, because investors often think that a stock split leads to
immediate profits. Nothing could be further from the truth. Here’s why: The total mar-
ket capitalization—the value of the company’s stock multiplied by the number of shares
outstanding—does not change because a corporation splits its stock. A company that has a
market capitalization of $100 million before a 2-for-1 stock split is still worth $100 million
after the split. Simply put, there is twice as much stock, but each share is worth half of its
previous value before the stock split occurred. If a stock’s value does increase after a stock
split, it increases because of the firm’s financial performance after the split and not just
because there are more shares of stock.
Preferred Stock
In addition to or instead of purchasing common stock, you may purchase preferred stock.
Preferred stock is a type of stock that gives the owner the advantage of receiving cash
dividends before common stockholders are paid any dividends. This is the most important
priority an investor in preferred stock enjoys. Unlike the amount of the dividend on com-
mon stock, the dollar amount of the dividend on preferred stock is known before the stock
is purchased.
Preferred stocks are often referred to as “middle” investments because they represent an
investment midway between common stock and corporate bonds. When compared to cor-
porate bonds, the yield on preferred stocks is often higher than the yield on bonds. And
yet, because it is a type of equity financing, preferred stock is less secure than bonds (debt)
issued by the same company. When compared to common stocks, preferred stocks are safer
preferred stock A type of
stock that gives the owner
the advantage of receiving
cash dividends before
common stockholders are
paid any dividends.
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investments that offer more secure dividends. They are often purchased by individuals who
need a predictable source of income greater than that offered by common stock investments.
For all other investors, preferred stocks lack the growth potential that common stocks offer
and the safety of many corporate bond issues.
When compared to corporations selling common stock, preferred stock is issued less
often by only a few corporations. Keep in mind that dividends on preferred stock, as on
common stock, may be omitted by action of the board of directors. While preferred stock
does not represent a legal debt that must be repaid, if the firm is dissolved or declares bank-
ruptcy, preferred stockholders do have first claim to the corporation’s assets after creditors
(including bondholders).
PRACTICE QUIZ 12–1 PRACTICE QUIZ 12–1
1. Why do corporations sell stock? Why do investors purchase stock?
2. Why do corporations split their stock? Is a stock split good or bad for investors?
3. From an investor’s viewpoint, what is the difference between common stock and preferred stock?
Apply Yourself! Apply Yourself!
Talk with different people and ask them if they include common or preferred stocks in their investment program. Also,
ask them if they feel stocks could help you achieve your investment goals.
Evaluating a Stock Issue
Many people purchase investments without doing any research. They wouldn’t buy a
car without a test drive or purchase a home without comparing different houses, but for
some unknown reason they invest without doing their homework. The truth is that there is
no substitute for a few hours of detective work when choosing an investment. In reality,
it is important to evaluate not only the corporation that issues the individual stock you
are interested in purchasing, but also the industry in which the corporation operates. For
example, when the automobile industry encountered problems during the economic crisis,
most companies within this industry found that increasing sales and profits was difficult if
not impossible. Also, keep in mind that the nation’s and even the world’s economy—the
big picture—may impact the way a corporation operates and cause a corporate stock to
increase or decrease in value.
A wealth of information is available to stock investors, and a logical place to start the
evaluation process for stock is with the classification of different types of stock invest-
ments described in Exhibit 12–3 . Once you have identified a type of stock that may help
you obtain your investment goals, you may want to use the Internet to evaluate a potential
investment.
The Internet
In this section, we examine some websites that are logical starting points when evaluating
a stock investment, but there are many more than those described. Let’s begin with infor-
mation about the corporation that is available on the Internet.
ACTION ITEM
I know how to evaluate a
stock issue.
h Yes h No
LO12.2
Explain how you can evaluate
stock investments.
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Type of Stock Characteristics of This Type of Investment
Blue chip A stock, issued by large, stable corporations with a history of pay-
ing dividends, that generally attracts conservative investors.
Cyclical A stock that follows the business cycle of advances and declines in
the economy.
Defensive A stock that remains stable during declines in the economy.
Growth A stock issued by a corporation that has the potential of earning
profits above the average profits of all firms in the economy.
Income An investment that pays higher-than-average dividends.
Large cap A stock issued by a corporation that has a large amount of capital-
ization in excess of $10 billion.
Micro cap A stock issued by a company that has a capitalization of between
$50 million and $300 million or less.
Midcap A stock issued by a corporation that has a capitalization of between
$2 billion and $10 billion.
Penny A stock that typically sells for less than $5 per share (or in
some cases, less than $1 per share) and has a small amount of
capitalization.
Small cap A stock issued by a company that has a capitalization of between
$300 million and $2 billion.
Exhibit 12–3
Classification of Stock
Investments
When evaluating a stock
investment, investors often
classify stocks into these ten
categories.
Today most corporations have a website, and the information
these sites provide is especially useful. First, it is easily accessi-
ble. All you have to do is type in the corporation’s URL address
or use a search engine to locate the corporation’s home page.
Second, the information on the website may be more up to date
and thorough than printed material obtained from the corpora-
tion or outside sources. Once at the corporation’s home page,
look for a link to “investor relations” or “financial information.”
Just by clicking on a button, you can access information on the
firm’s earnings and other financial factors that could affect the
value of the company’s stock.
You can also use websites like Google, Yahoo!, and other
search engines to obtain information about stock investments.
Take a look at Exhibit 12–4 , which illustrates a portion of the
summary page taken from Yahoo! Finance for Facebook, the
world’s largest social networking site. In addition to the current
price, the Yahoo! Finance website provides even more specific
information about a particular company like Facebook. By click-
ing on the buttons under the headings for the quotes, charts,
news and info, company, analyst coverage, ownership, and
financials that are part of the screen for each corporation, you
can obtain even more information. How about picking a company like The Gap (symbol
GPS) or Coca-Cola (symbol KO) and going exploring on the Internet? To begin, enter the
web address for Yahoo! Finance ( finance.yahoo.com ). Then enter the symbol for one of the
did you know? did you know?
Saving the Planet One Investment Saving the Planet One Investment
at a Time! at a Time!
Experts predict that the next “great” Experts predict that the next “great”
investments will be companies that produce investments will be companies that produce
alternative fuels, fuel cells, hybrid vehicles, alternative fuels, fuel cells, hybrid vehicles,
and organic foods. To obtain information and organic foods. To obtain information
about investing in the companies that are about investing in the companies that are
developing environmentally friendly prod-developing environmentally friendly prod-
ucts and services, go to ucts and services, go to
www.sustainablebusiness.comwww.sustainablebusiness.com
www.greenchipstocks.comwww.greenchipstocks.com
www.ecobusinesslinks.comwww.ecobusinesslinks.com
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Exhibit 12–4 A Portion of the Opening Page from the Yahoo! Finance Website for Facebook
SOURCE: Reproduced with permission of Yahoo! Inc. © 2014 by Yahoo! Inc. Yahoo! and Yahoo! logo are trademarks of Yahoo! Inc.
above corporations in the Quote Lookup box and click the Go tab. You’ll be surprised at the
amount of information you can obtain with a click of your mouse.
You can also use professional advisory services like Standard & Poor’s Financial Ser-
vices ( www.netadvantage.standardandpoors.com ), Mergent Online ( www.mergentonline
.com ), and Value Line ( www.valueline.com ). While some of the information provided by
these services is free, there is a charge for the more detailed online information you may
need to evaluate a stock investment. For more information about professional advisory
services and the type of information they provide, read the next section.
In addition to Internet search engines and professional advisory services, you can
access personal finance websites like CNN Money ( money.cnn.com ) and Kiplinger’s
Personal Finance ( www.kiplinger.com ). Both websites provide a wealth of information
for the stock investor. While there are many websites that can help you learn more about
investing in stocks, the following three deserve special mention: The Street ( www.thestreet
.com ), MarketWatch ( www.marketwatch.com ), and MSN Money ( money.msn.com ).
Stock Advisory Services
In addition to the Internet, sources of information you can use to evaluate potential stock
investments are the printed materials provided by stock advisory services. The information
ranges from simple alphabetical listings to detailed financial reports.
Value Line, Standard & Poor’s reports, and Mergent are three widely used advisory
services that provide detailed research for stock investors. Here we will examine a detailed
report for Disney, one of the world’s leading entertainment companies, that is published in
The Value Line Investment Survey (see Exhibit 12–5 ).
While there is a lot of information about Disney in Exhibit 12–5 , it helps to break down
the entire Value Line report into different sections. For example:
• Overall ratings for timeliness, safety, and technical, along with price information and
projections for the price of a share of stock, are included at the top of the report.
• Detailed information about revenues per share, earnings per share, dividends, book
value, total revenues, net profit, capital structure, and other important financial
information is included in the middle and along the left side of the report.
• Information about the type of business and prospects for the future is provided
toward the bottom and in the right-hand corner.
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Exhibit 12–5 Value Line Report for Walt Disney Corporation
SOURCE: “Disney,” The Value Line Investment Survey (New York: The Value Line Publishing, LLC., 2014, p. 2329.
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W
ay back when, if
you owned stock
in a company,
you’d often find
a glossy annual report in your
mailbox. Nowadays, all you
may receive is a letter telling
you where to download the
report on the company’s Web
site. And truth be told, annual
reports are being supplanted by
the Form 10-K, the annual filing
required by the Securities and
Exchange Commission. Don’t
be put off by the form’s intimi-
dating appearance. We’ve high-
lighted some key sections—and
what to focus on in each.
Business. The first part of the
10-K provides a thorough look
at what the firm does or makes,
its divisions, and where in the
world its products are made
and sold. It also gives info on
key customers and competi-
tors, and where the company
stands in its industry. You may
even learn an interesting fact
or two—for example, that there
really were a Mr. Procter and
a Mr. Gamble, and that they
founded P&G in 1837.
Risk factors. Listed in order of
importance, these are the factors
that may adversely affect the
company’s business. Much of this
section, found just after the “Busi-
ness” description, may elicit a
big duh, such as P&G’s disclosure
that “our businesses face cost
fluctuations and pressures that
could affect our business results.”
But read carefully and you may
ferret out less-obvious risks, such
as a disproportionate share of
sales coming from a single prod-
uct or customer.
Management’s discussion
and analysis. In Part II of the
10-K, the company reports and
analyzes its performance over
the past year compared with
the previous year’s results.
Income statement. This is a
basic report of sales, expenses
and profits. Ideally, you want
to see a trend of rising sales
and earnings. A 10-K typically
shows three years of results,
as well as a five-year summary
in the section called “Selected
Financial Data.” Focus on the
trend in net earnings rather
than earnings per share, in part
because share buy-backs, which
cut the number of outstanding
shares, can skew earnings per
share and thus camouflage a
drop in overall profits.
Balance sheet. This is a snap-
shot of the company’s assets
(such as cash and inventory) and
its liabilities (such as outstand-
ing debt). Zero in on how much
long-term debt the firm carries
and whether retained profits, the
earnings a company reinvests in
its business, have grown in each
of the past three years. Great
companies have little or no
long-term debt on their balance
sheets—or they generate enough
profit annually to pay off that
debt within three to five years.
Notes to financial
statements. To some people,
the 10-K notes matter as much as
the statements. That’s because
Note 1 describes the accounting
methods used to prepare the
financial statements. If a com-
pany has made a change to its
methodology from the previous
year, that renders a comparison
of the current year’s financial
statements with the previous
year’s useless.
Auditor’s report. Look for this
key sentence: “In our opin-
ion, the financial statements
present fairly. . . the financial
position of the company.” That
means the company has hon-
estly described its finances over
the past year to the best knowl-
edge of the accounting firm
that is auditing the 10-K.
Nellie S. Huang
Make the Most of an Annual Report
You don’t have to be Warren Buffett to know what makes a company tick.
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. In this article, the type of information contained in a firm’s income statement and balance sheet—both
statements contained in an annual report or a Securities and Exchange Commission 10-K report—is
described. How can this information help you pick a stock that will help you attain your financial goals?
2. Often, financial experts suggest that investors should pay more attention to the notes that accompany a
firm’s financial statements because “that’s where they bury the bodies.” What type of information is con-
tained in the notes and why is it important?
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While other stock advisory services provide basically the same types of information
as that in Exhibit 12–5 , it is the investor’s job to interpret such information and decide
whether the company’s stock is a good investment.
Newspaper Coverage and Corporate News
Although some newspapers have eliminated or reduced the amount of financial coverage,
The Wall Street Journal and most metropolitan newspapers still contain some information
about stocks. Although not all newspapers print exactly the same information, they usually
provide the basic information. Stocks are listed alphabetically, so your first task is to move
down the table to find the stock you’re interested in. Then, to read the stock quotation,
you simply read across the table. Typical information provided by newspapers includes the
name of the company, stock symbol, and price information.
The federal government requires corporations selling new issues of securities to dis-
close in a prospectus information about corporate earnings, assets and liabilities, prod-
ucts or services, and the qualifications of top management. In addition to a prospectus, all
publicly owned corporations may send their stockholders an annual report that contains
detailed financial data. An electronic version of a corporation’s annual report is available
on a corporation’s Internet website. You can also obtain a print version of an annual report
from the corporation. For most corporations, all it takes is a call to a toll-free phone num-
ber, a written request to the corporation’s headquarters, or a visit to a corporation’s website.
In addition to corporate publications, you can access the Securities and Exchange Com-
mission website (www.sec.gov) to obtain financial and other important information that a
corporation has supplied to the federal government.
Finally, many periodicals, including Bloomberg Businessweek, Fortune, Forbes, Money,
Kiplinger’s Personal Finance, and similar publications, contain information about stock
investing.
PRACTICE QUIZ 12–2 PRACTICE QUIZ 12–2
1. Describe how each of the following sources of investment information could help you evaluate a stock investment.
Source of Information Type of Information How Could This Help
The Internet
Stock advisory services
A newspaper
Government publications
Business periodicals
2. What is the difference between a prospectus and an annual report?
3. Using Exhibit 12–5 , pick three financial measures and describe how they could help you evaluate a corporate stock.
Apply Yourself! Apply Yourself!
Go to the library or get on the Internet and use Standard & Poor’s, Value Line, or Mergent to research a stock that you
think would help you attain your investment goals.
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Numerical Measures That Influence
Investment Decisions
How do you determine whether the time is right to buy or sell a particular stock? Good
question! Unfortunately, there is no simple answer. In addition to the material in the previous
section, “Evaluating a Stock Issue,” many investors rely on numerical measures to decide
when to buy or sell a stock. We begin this section by examining the relationship between a
stock’s price and a corporation’s earnings.
Why Corporate Earnings Are Important
Many financial experts believe that a corporation’s ability or inability to generate earnings
in the future may be one of the most significant factors that account for an increase or
decrease in the value of a stock. Simply put, higher earnings generally equate to higher
stock prices. Unfortunately, the reverse is also true. If a corporation’s earnings decline,
generally the stock’s price will also decline. Corporate earnings are reported in the firm’s
annual report. You can also obtain informa-
tion about a corporation’s current earnings
by using a professional advisory service or
accessing the Yahoo! Finance website or one
of the other websites described in the last
section.
EARNINGS PER SHARE Many inves-
tors calculate earnings per share to evaluate the
financial health of a corporation. Earnings per
share are a corporation’s earnings divided by
the number of outstanding shares of a firm’s
common stock. See the “Earnings per Share”
example box to see how this works.
Most stockholders consider the amount
of earnings per share important because it is
a measure of the company’s profitability. No
meaningful average for this measure exists,
mainly because the number of shares of a firm’s
stock is subject to change via stock splits and
stock dividends. As a general rule, however, an
increase in earnings per share is a healthy sign
for any corporation and its stockholders.
PRICE-EARNINGS RATIO Another
calculation, the price-earnings ratio, can be
used to evaluate a potential stock investment.
earnings per share
A corporation’s earnings
divided by the number of
outstanding shares of a firm’s
common stock.
LO12.3
Analyze the numerical
measures that cause a stock
to increase or decrease in
value.
ACTION ITEM
I understand how financial
calculations can help me pick
a stock that will be profitable.
h Agree h Disagree
did you know? did you know?
The Dow Jones Industrial Average measures 30 different stocks
that are considered leaders in the economy. (Closing values as of end of
December for 2008, 2010, 2012, and April 15, 2014.)
2010
2008
2012
2014
(April 15)
$11,578
$8,776
8,
00
0
9,
00
0
12
,0
00
13
,0
00
14
,0
00
15
,0
00
16
,0
00
17
,0
00
10
,0
00
11
,0
00
$13,104
$16,253
SOURCE: The MarketWatch website at www.marketwatch.com , accessed April 23,
2014.
EXAMPLE: Earnings per Share
Assume General Mills’s 2013 earnings were $1,855 million. Also assume that Gen-
eral Mills—the company known for producing consumer food products—has 666
million shares of common stock. Earnings per share are $2.79 as illustrated below.
Earnings per share 5
Earnings____________________________
Number of shares outstanding
5
$1,855 million_____________
666 million
= $2.79
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The price-earnings (PE) ratio is the price of a share of stock divided by the corporation’s
earnings per share of stock.
price-earnings (PE)
ratio The price of a share
of stock divided by the
corporation’s earnings per
share of stock.
Starbucks This Year Next Year
Yearly earnings estimates $2.66 per share $3.17 per share
EXAMPLE: Price-Earnings (PE) Ratio
Consumer packaged goods manufacturer Procter & Gamble Corporation’s com-
mon stock is selling for $82 a share. Also assume Procter & Gamble’s earnings per
share are $3.72. The corporation’s price-earnings ratio is 22, as illustrated below.
Price-earnings (PE) ratio 5
Price per share
_________________
Earnings per share
5
$82
______
$3.72
5 22
The price-earnings ratio is a key factor that serious investors use to evaluate stock
investments. Generally, a price-earnings ratio gives investors an idea of how much they
are paying for a company’s earning power. The higher the price-earnings ratio, the more
investors are paying for earnings. For example, an investor might say that Procter & Gam-
ble is selling for 22 times its current earnings. A high price-earnings ratio (over 20) often
indicates investor optimism because of the expectation of higher earnings in the future.
Always remember the relationship between earnings and stock value. If future earnings do
increase, the stock usually becomes more valuable in the future. On the other hand, a low
price-earnings ratio (under 20) indicates that investors have lower earnings expectations. If
future earnings decrease or don’t maintain the same level of growth, the stock will become
less valuable in the future.
Like earnings per share, a corporation’s PE ratio is often reported on investment web-
sites. When researching a stock, comparing the PE ratios of one company to other compa-
nies in the same industry, to the market in general, or against the company’s own historical
PE ratios is usually helpful. Keep in mind that the PE ratio calculation is just another piece
of the puzzle when researching a stock for investment purposes.
PROJECTED EARNINGS Both earnings per share and the price-earnings ratio
are based on historical numbers. In other words, this is what the company has done in the
past. With this fact in mind, many investors will also look at earnings estimates for a corpo-
ration. The MSN Money website or similar financial websites provide earnings estimates
for major corporations. At the time of publication, for example, MSN Money provided the
following earnings estimates for Starbucks, the company that provides rich-brewed coffee,
espresso beverages, and complementary food products. 2
2 MSN Money (money.msn.com), accessed April 24, 2014.
From an investor’s standpoint, a projected increase in earnings from $2.66 per share to
$3.17 per share is a good sign. In the case of Starbucks, these estimates were determined
by surveying different analysts who track Starbucks. By using the same projected earn-
ings amount, it is possible to calculate a projected price-earnings ratio or a projected price
per share of stock. Of course, you should remember that these are estimates and are not
“etched in stone.” Changes that affect the economy, industry, or company’s sales and profit
amounts could cause analysts to revise the above estimates.
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Numbers, numbers, numbers! The truth is that if you are
going to be a good investor, you must learn the numbers
game. As mentioned in the text, many calculations can
help you gauge the value of a potential stock investment.
These same calculations can help you decide if the time is
right to sell a stock investment.
Now it’s your turn. Use the formulas in this section and
the following financial information for Bozo Oil Company to
calculate the earnings per share, price-earnings (PE) ratio,
and dividend yield:
After-tax income $6,250,000
Dividend amount $0.60
Price per share $30
Number of shares outstanding 5,000,000
Figure It Out!
Calculations Can Improve Investment Decisions! Calculations Can Improve Investment Decisions!
ANSWERS: earnings per share (EPS) 5 $1.25; price-earnings (PE) ratio 5 24; dividend yield 5 0.02 5 2%
Dividend Yield and Total Return
One of the calculations investors use most frequently to monitor the value of their invest-
ments is the dividend yield. The dividend yield is the annual dividend amount divided by
the stock’s current price per share.
dividend yield The annual
dividend amount divided by
the stock’s current price per
share.
EXAMPLE: Dividend Yield
Assume you own common stock issued by Wal-Mart Stores Inc., the world’s larg-
est retailer. A share of stock pays an annual dividend of $1.92 and is currently sell-
ing for $78 a share. The current dividend yield is 2.5 percent, as illustrated below.
Dividend yield 5
Annual dividend amount
______________________
Current price per share
5
$1.92
______
$78
5 0.025 5 2.5 percent
An increase in dividend yield is a healthy sign for any stock investment. A dividend
yield of 2.5 percent is better than a 2 percent dividend yield.
Although the dividend yield calculation is useful, you should also consider whether the
stock’s price per share is increasing or decreasing in dollar value. Total return is a calcula-
tion that includes not only the yearly dividend amount but also any increase or decrease in
the original purchase price of the investment. While this concept may be used for any
investment, let’s illustrate it by using the assumptions for GameStop—the video game and
electronics retailer.
total return A calculation
that includes the yearly
dividend amount as well as
any increase or decrease in
the original purchase price of
the investment.
EXAMPLE: Total Return
Assume you own 100 shares of GameStop stock that you purchased for $33 a
share and hold your stock for one year before deciding to sell it at the current mar-
ket price of $40 a share. During this one-year period, GameStop paid dividends
totaling $1.32 per share. Your total return is $832, as illustrated below.
Total return 5 Dividends 1 Capital gain
5 $132 1 $700 5 $832
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The dividend of $132 results from the payment of dividends for one year ($1.32 per-
share dividend 3 100 shares). The capital gain of $700 results from the increase in the
stock price from $33 a share to $40 a share ($7 per-share increase 3 100 shares 5 $700).
(Of course, commissions to buy and sell your stock, a topic covered in the next section,
would reduce your total return.)
Other Factors That Influence the Price of a Stock
The beta is a measure reported in many financial publications that compares the volatility
associated with a specific stock issue with the volatility of the Standard & Poor’s 500
stock index. The beta for the S&P is 1.0. The majority of stocks have betas between 0.5
and 2.0. Generally, conservative stocks have low betas while more speculative stocks have
betas greater than one.
beta A measure reported in
many financial publications
that compares the volatility
associated with a specific
stock issue with the volatility
of the Standard & Poor’s 500
stock index.
EXAMPLE: Beta Calculation for Google
Assume that the overall stock market increases by 10 percent and that Google
stock has a beta of 1.20. Based on the calculation below, Google is 20 percent
more volatile than the stock market and will increase 12 percent when the market
increases 10 percent.
Volatility for a stock 5 Increase in overall market 3 Beta for a specific stock
5 10 percent 3 1.20
5 12 percent
Because individual stocks generally move in the same direction as the stock market,
most betas are positive, but it is possible for a stock to have a negative beta. A negative beta
occurs when a corporation’s stock moves in the opposite direction compared to the stock
market as a whole.
Although little correlation may exist between the price of a stock and its book value,
book value is widely reported in financial publications. Therefore, it deserves mention.
The book value for a share of stock is determined by deducting all liabilities from the cor-
poration’s assets and dividing the remainder by the number of outstanding shares of com-
mon stock. For Southwest Airlines—a major passenger airline in the United States—book
value is $10.48, as illustrated below.
book value Determined by
deducting all liabilities from
the corporation’s assets and
dividing the remainder by
the number of outstanding
shares of common stock.
EXAMPLE: Book Value
Assume Southwest Airlines has assets of $19,345 million and liabilities of $12,009
million. The company has also issued 700 million shares of stock.
Book value 5
Assets 2 Liabilities
____________________________
Number of shares outstanding
5
$19,345 million 2 $12,009 million
______________________________
700 million
= $10.48 per share
Some investors believe they have found a bargain when a stock’s share price is about
the same as or lower than its book value. Be warned: Book value calculations may
be misleading, because the dollar amount of assets used in the above formula may be
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understated or overstated on the firm’s financial statements. From a practical standpoint,
most financial experts suggest that book value is just another piece of the puzzle and
you must consider other factors along with book value when evaluating a possible stock
investment.
With regard to stock prices, two other factors should be mentioned. First, predicting the
future value for a share of stock is a practical example of the time value of money concepts
presented in Chapter 1. The price that a successful investor is willing to pay for a share of
stock is determined by
• The amount of dividends you expect to receive in the future, or
• A potential increase in the price for a share of stock, and/or
• A combination of future dividends and a potential increase in the price of
the stock.
Second, always remember that the price for a share of stock is determined by what
another investor is willing to pay for it. While most successful investors use investment
research and financial calculations to choose stock investments, there are times when
investors may pay a high, inflated price for a share of stock. For example, the term stock
market bubble is used to describe a situation when stocks are trading at prices above their
actual worth. Often the high stock prices are driven by investor optimism and irrational
expectations. Unfortunately, stock market bubbles may burst because of an economic
slowdown, high unemployment rates, higher interest rates, and other factors that affect the
economy. The bubble for a specific stock can also burst when a company lowers estimates
for future earnings, a company reduces or omits dividend payments to stockholders, or
stockholders begin to sell the stock for any other reason.
stock market bubble
A situation in which stocks
are trading at prices above
their actual worth.
PRACTICE QUIZ 12–3 PRACTICE QUIZ 12–3
1. Explain the relationship between corporate earnings and a stock’s market value.
2. Write the formula for the following stock calculations, and then describe how this formula could help you make a
decision to buy or sell a stock.
Calculation What Is the Formula? Why Is This Calculation Useful?
Earnings per share
Price-earnings (PE) ratio
Dividend yield
Total return
Beta
Book value
Apply Yourself! Apply Yourself!
Use an Internet website to locate the current price for a share of stock and earnings per share for Microsoft (symbol
MSFT), 3M Company (symbol MMM), and Colgate-Palmolive (symbol CL).
Sheet 38 Evaluating Corporate Stocks S
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Buying and Selling Stocks
To purchase common or preferred stock, you generally have to work through a brokerage
firm. In turn, your brokerage firm must buy the stock in either the primary or secondary
market. In the primary market , you purchase financial securities, via an investment bank or
other representative, from the issuer of those securities. An investment bank is a financial
firm that assists corporations in raising funds, usually by helping to sell new security
issues.
New security issues sold through an investment bank can be issued by corporations that
have sold stocks and bonds before and need to sell new issues to raise additional financing.
New securities can also be initial public offerings. An initial public offering (IPO) occurs
when a corporation sells stock to the general public for the first time. In May 2014, Papa
Murphy’s—the U.S. company famous for high-quality “Take ’N’ Bake” pizza—used an
IPO to sell 5.8 million shares and raised approximately $70 million. 3 The money from the
IPO can be used for expansion or any other activity to create a larger and more successful
company.
Be warned: The promise of quick profits often lures investors to purchase IPOs. An
IPO is generally classified as a high-risk investment—one made in the hope of earning a
relatively large profit in a short time. Depending on the corporation selling the new secu-
rity, IPOs are usually too speculative for most people.
Once stocks are sold in the primary market, they can be sold time and again in the sec-
ondary market. The secondary market is a market for existing financial securities that are
currently traded among investors. The fact that stocks can be sold in the secondary market
improves the liquidity of stock investments because the money you pay for stock goes to
the seller of the stock.
Secondary Markets for Stocks
When you purchase stock in the secondary market, the transaction is completed on a secu-
rities exchange or through the over-the-counter market.
SECURITIES EXCHANGES A securities exchange is a marketplace where mem-
ber brokers who represent investors meet to buy and sell securities. Generally, the securi-
ties issued by nationwide corporations are traded at the New York Stock Exchange or
regional exchanges in the United States. There are also foreign securities exchanges—in
Tokyo, London, or Paris, for example.
The New York Stock Exchange (NYSE), now owned by the Intercontinental Exchange
Group, is one of the largest securities exchanges in the world. Most of the NYSE members
represent brokerage firms that charge commissions on security trades made by their repre-
sentatives for their customers. Other members are called specialists or specialist firms. A
specialist buys or sells a particular stock in an effort to maintain a fair and orderly
market.
Before a corporation’s stock is approved for listing on the NYSE, the corporation
must meet specific listing requirements. The various regional exchanges also have listing
requirements, but typically these are less stringent than the NYSE requirements. The stock
of corporations that cannot meet the NYSE requirements, find it too expensive to be listed
on the NYSE, or choose not to be listed on the NYSE is often traded on one of the regional
exchanges, or through the over-the-counter market.
THE OVER-THE-COUNTER MARKET Not all securities are traded on orga-
nized exchanges. Stocks issued by several thousand companies are traded in the over-the-
counter market. The over-the-counter (OTC) market is a network of dealers who buy and
primary market A
market in which an investor
purchases financial
securities, via an investment
bank or other representative,
from the issuer of those
securities.
investment bank A
financial firm that assists
corporations in raising funds,
usually by helping to sell new
security issues.
initial public offering
(IPO) Occurs when a
corporation sells stock to the
general public for the first
time.
secondary market A
market for existing financial
securities that are currently
traded among investors.
securities exchange A
marketplace where member
brokers who represent
investors meet to buy and
sell securities.
specialist Buys or sells a
particular stock in an effort to
maintain an orderly market.
over-the-counter (OTC)
market A network of
dealers who buy and sell the
stocks of corporations that
are not listed on a securities
exchange.
LO12.4
Describe how stocks are
bought and sold.
ACTION ITEM
I know how to buy and sell
stocks.
h Yes h No
3 The IPOScoop website ( www.iposcoop.com ), accessed April 25, 2014.
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sell the stocks of corporations that are not listed on a securities
exchange. Today these stocks are not really traded over the
counter. The term was coined more than 100 years ago when
securities were sold “over the counter” in stores and banks.
Most over-the-counter securities are traded through Nasdaq
(pronounced “nazzdack”). Nasdaq is an electronic marketplace
for stocks issued by approximately 3,300 different companies. 4
In addition to providing price information, this computerized
system allows investors to buy and sell shares of companies
traded on Nasdaq. When you want to buy or sell shares of a
company that trades on Nasdaq—say, Microsoft—your account
executive sends your order into the Nasdaq computer system,
where it shows up on the screen with all the other orders from
people who want to buy or sell Microsoft. Then a Nasdaq dealer
(sometimes referred to as a market maker ) sitting at a computer terminal matches buy and
sell orders for Microsoft. Once a match is found, your order is completed. They may also
complete buy or sell orders from their own inventory of shares that they maintain to meet
the demands of investors.
Brokerage Firms and Account Executives
An account executive , or stockbroker, is a licensed individual who works for a brokerage
firm and buys or sells investments for his or her clients. Before choosing an account exec-
utive, you should have already determined your financial objectives. Then you must be
careful to communicate those objectives to the account executive so that he or she can do a
better job of advising you. To help avoid a situation in which your account executive’s
recommendations are automatically implemented, you should be actively involved in the
decisions related to your investment program and you should never allow your account
executive to use his or her discretion without your approval. Watch your account for signs
of churning. Churning is excessive buying and selling of securities to generate commis-
sions. Finally, keep in mind that account executives generally are not liable for client losses
that result from their recommendations. In fact, most brokerage firms require clients to
sign a statement in which they promise to submit any complaints to an arbitration board.
This arbitration clause generally prevents a client from suing an account executive or a
brokerage firm.
Should You Use a Full-Service, Discount, or Online
Brokerage Firm?
Today a healthy competition exists between full-service, discount, and online brokerage
firms. While the most obvious difference between full-service, discount, and online firms
is the amount of the commissions they charge when you buy or sell stock and other secu-
rities, there are at least three other factors to consider. First, consider how much research
information is available. All three types of brokerage firms offer excellent research materi-
als, but you may have to pay for research information and access to professional advisory
reports if you choose a discount or online brokerage firm.
Second, consider how much help you need when making an investment decision. Many
full-service brokerage firms argue that you need a professional to help you make important
investment decisions. On the other side, many discount and online brokerage firms argue
that you alone are responsible for making your investment decisions. They are quick to point
out that the most successful investors are the ones involved in their investment programs.
Nasdaq An electronic
marketplace for stocks
issued by approximately
3,300 different companies.
account executive A
licensed individual who works
for a brokerage firm and buys
or sells securities for clients;
also called a stockbroker.
churning Excessive buying
and selling of securities to
generate commissions.
did you know? did you know?
“Wall Street” is a street name of historical
significance. Here’s the story: Back in the
17th century, Dutch settlers on the southern tip of
Manhattan Island erected a “wall” to protect their
colony. Even though the wall was never used for
defensive purposes, the name remains and is now
recognized as one of the most famous streets in the
financial world.
4 The Nasdaq website ( www.nasdaq.com ), accessed April 25, 2014.
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And they argue that they have both personnel and materials dedicated to helping you learn
how to become a better investor. Although there are many exceptions, the information below
may help you decide whether to use a full-service, discount, or online brokerage firm.
CAUTION! CAUTION!
To find out if other investors have lodged
complaints about an account executive
or a brokerage firm go to the Securities
and Exchange Commission website at
www.sec.gov .
• Full-service Beginning investors with little or no experience.
Individuals who are uncomfortable making investment decisions.
Individuals who are uncomfortable trading stocks online.
• Discount People who understand the “how to” of researching stocks and
prefer to make their own decisions.
Individuals who are uncomfortable trading stocks online.
• Online People who understand the “how to” of researching stocks and
prefer to make their own decisions.
Individuals who are comfortable trading stocks online.
Finally, consider how easy it is to buy and sell stock and other
securities when using a full-service, discount, or online brokerage
firm. Questions to ask include:
1. Can I buy or sell stocks using the Internet or over the
phone?
2. What is the typical commission for a stock transaction?
3. Do you have a toll-free telephone number for customer use?
4. Is there a charge for statements, research reports, and other
financial reports?
5. Are there any fees in addition to the commissions I pay
when I buy or sell stocks?
Computerized Transactions
Many people still prefer to use telephone orders to buy and sell
stocks, but a growing number are using computers to complete
security transactions. To meet this need, online, discount, and
most full-service brokerage firms allow investors to trade online.
As a rule of thumb, the more active the investor is, the more
sense it makes to use computers to trade online. Other reasons
that justify using a computer include the size of your investment
portfolio and the ability to manage your investments closely.
While buying and selling stock online can make the invest-
ment process easier and faster, you should realize that you are
still responsible for analyzing the information and making the
final decision to buy or sell a security. In fact, many investors
still prefer to have an account executive help make important
financial decisions. Finally, some investors are reluctant to trade
online because they are afraid they will make mistakes or the
computer will garble their accounts.
Sample Stock Transactions
Once you have decided on a particular stock transaction, it is
time to execute an order to buy or sell. Let’s begin by examining
three types of orders used to trade stocks.
did you know? did you know?
When you purchase stock, you have three
choices when it comes to holding your securities until
they are sold.
• Physical Certificate —The security is reg-
istered in your name on the corporate books
and you receive an actual stock certificate.
• Street Name Registration —The security is
registered in the name of the brokerage firm
on the corporate books and the brokerage
firm holds the security for you.
• Direct Registration —The security is regis-
tered in your name on the corporate books,
and either the company or its transfer agent
holds the security for you.
For more information about each type of stock
registration, go to www.sec.gov .
SOURCE: The Securities and Exchange website at www.sec.
gov , accessed April 22, 2014.
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A market order is a request to buy or sell a stock at the current market price. Payment
for stocks is generally required within three business days after the transaction. Today it is
common practice for investors to leave stock certificates with a brokerage firm. Because
the stock certificates are in the broker’s care, transfers when the stock is sold are much
easier. The phrase “left in the street name” is used to describe investor-owned securities
held by a brokerage firm. Investors can also use two other types of stock registration—see
the nearby “Did You Know?” feature about stock registration.
A limit order is a request to buy or sell a stock at a specified price. When you purchase
stock, a limit order ensures that you will buy at the best possible price but not above a
specified dollar amount. When you sell stock, a limit order ensures that you will sell at the
best possible price, but not below a specified dollar amount. For example, if you place a
limit order to buy eBay stock for $50 a share, the stock will not be purchased until the price
drops to $50 a share or lower. Likewise, if your limit order is to sell eBay for $50 a share,
the stock will not be sold until the price rises to $50 a share or higher. Be warned: Limit
orders are executed if and when the specified price or better is reached and all other previ-
ously received orders have been fulfilled.
Many stockholders are certain they want to sell their stock if it reaches a specified
price. A limit order does not guarantee this will be done. With a limit order, as men-
tioned above, orders by other investors may be placed ahead of your order. If you want
to guarantee that your order will be executed, you place a special type of limit order
known as a stop-loss order. A stop-loss order is an order to sell a particular stock at the
next available opportunity after its market price reaches a specified amount. This type
of order is used to protect an investor against a sharp drop in price and thus stop the
dollar loss on a stock investment. For example, assume you purchased General Motors
stock at $40 a share. Two weeks after you made that investment, General Motors
reports lower-than-expected sales revenues and profits and is facing multiple product
liability lawsuits because of faulty ignition switches. Fearing that the market value of
your stock will decrease, you enter a stop-loss order to sell your General Motors stock
at $30. This means that if the price of the stock decreases to $30 or lower, the account
executive will sell it. While a stop-loss order does not guarantee that your stock will be
sold at the price you specified, it does guarantee that it will be sold at the next avail-
able opportunity. Both limit and stop-loss orders may be good for one day, one week,
one month, or good until canceled (GTC).
Before you begin investing your “real” money, you may want to practice. Today, numer-
ous investment websites provide simulations that allow you to practice stock investing for
free. To find a stock investment simulation, use an Internet search engine like Google or
Yahoo! Enter the term “stock practice” or “virtual stock game,” select a site, follow the
rules, and use the practice to fine-tune your investment skills.
Commission Charges
Most brokerage firms have a minimum commission ranging from $5 to $25 for buying
and selling stock. Additional commission charges are based on the number of shares
and the value of stock bought and sold. Note: Some brokerage firms offer free trades,
but strings are attached. For example, free trades may be an introductory offer, good
for a limited time, or you may have to maintain a large balance in your investment
account.
Exhibit 12–6 shows the minimum amount to open an account and typical commissions
charged by discount and online brokerage firms. Generally, full-service and discount bro-
kerage firms charge higher commissions than those charged by online brokerage firms. As
a rule of thumb, full-service brokers may charge approximately 1 percent of the transac-
tion amount. In return for charging higher commissions, full-service brokers usually spend
more time with each client, help make investment decisions, and provide free research
information.
market order A request
to buy or sell a stock at the
current market price.
limit order A request
to buy or sell a stock at a
specified price.
stop-loss order An order
to sell a particular stock at
the next available opportunity
after its market price reaches
a specified amount.
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Long-Term and Short-Term Investment
Strategies
Once you purchase stock, the investment may be classified as either long term or short
term. Generally, individuals who hold an investment for a year or longer are referred to as
investors. Individuals who routinely buy and then sell stocks within a short period of time
are called speculators or traders.
Long-Term Techniques
In this section, we discuss the long-term techniques of buy and hold, dollar cost averaging,
direct investment programs, and dividend reinvestment programs.
BUY-AND-HOLD TECHNIQUE Many long-term investors purchase stock and
hold on to it for a number of years. When they do this, their investment can increase in
value in three ways. First, they are entitled to dividends if the board of directors approves
dividend payments to stockholders. Second, the price of the stock may go up, or appre-
ciate in value. To see how an investor using the buy-and-hold technique can earn profits
from dividends and an increase in stock value, review the Johnson & Johnson investment
illustrated in Exhibit 12–2 . Third, the stock may be split. Although there are no guarantees,
stock splits may increase the future value of a stock investment over a long period of time.
Brokerage Firm Minimum to Open an Account Internet Trades Broker-Assisted Trades
E*Trade $500 $9.99 $54.99
Charles Schwab $1,000 $8.95 $33.95
Fidelity $0 $7.95 $32.95
Scottrade $500 $7.00 $27.00
TD Ameritrade $0 $9.99 $44.99
Exhibit 12–6 Typical Commission Charges for Stock Transactions
PRACTICE QUIZ 12–4 PRACTICE QUIZ 12–4
1. What is the difference between the primary market and the secondary market? What is an initial public offering (IPO)?
2. Assume you want to purchase stock. Would you use a full-service broker or a discount broker? Would you ever trade
stocks online?
3. Explain the important characteristics of each of the following types of stock transaction orders:
a. Market order.
b. Limit order.
c. Stop-loss order.
Apply Yourself! Apply Yourself!
Prepare a list of at least five questions that could help you interview a prospective account executive.
Sheet 39 Investment Broker Comparison S
LO12.5
Explain the trading
techniques used by long-
term investors and short-
term speculators.
ACTION ITEM
I know the difference
between long-term and
short-term investment
techniques.
h Agree h Disagree
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DOLLAR COST AVERAGING Dollar cost averaging is
a long-term technique used by investors who purchase an equal
dollar amount of the same stock at equal intervals. Assume you
invest $2,000 in Johnson & Johnson’s common stock each year
for a period of seven years. The results of your investment pro-
gram are illustrated in Exhibit 12–7 . Notice that when the price
of the stock decreased in 2009, you purchased more shares. And
when the price of the stock increased in 2014, you purchased
fewer shares. The average cost for a share of stock, determined
by dividing the total investment ($14,000) by the total number
of shares, is $66.51 ($14,000 4 210.5 5 $66.51). Other applica-
tions of dollar cost averaging occur when employees purchase
shares of their company’s stock through a payroll deduction
plan or as part of an employer-sponsored retirement plan over
an extended period of time.
The two goals of dollar cost averaging are to minimize the
average cost per share and to avoid the common pitfall of buy-
ing high and selling low. In the situation shown in Exhibit 12–7 ,
you would lose money only if you sold your stock at less than the average cost of $66.51.
Thus, with dollar cost averaging, you can make money if the stock is sold at a price higher
than the average cost for a share of stock.
DIRECT INVESTMENT AND DIVIDEND REINVESTMENT PLANS
Today a large number of corporations offer direct investment plans. A direct investment
plan allows you to purchase stock directly from a corporation without having to use an
account executive or a brokerage firm. Similarly, a dividend reinvestment plan (often
called a DRIP) allows you the option to reinvest your cash dividends to purchase stock of
the corporation. For stockholders, the chief advantage of both types of plans is that these
plans enable them to purchase stock without paying a commission charge to a brokerage
firm. ( Note: A few companies may charge a small fee for direct and dividend reinvestment
plans, but the fee is less than the commissions most brokerage firms charge.) The fees,
dollar cost averaging A
long-term technique used
by investors who purchase
an equal dollar amount of
the same stock at equal
intervals.
direct investment plan A
plan that allows stockholders
to purchase stock directly
from a corporation without
having to use an account
executive or a brokerage
firm.
dividend reinvestment
plan A plan that allows
current stockholders the
option to reinvest or use their
cash dividends to purchase
stock of the corporation.
Year Investment Stock Price Shares Purchased
2008 $ 2,000 $ 58 34.5
2009 2,000 50 40.0
2010 2,000 63 31.7
2011 2,000 65 30.8
2012 2,000 70 28.6
2013 2,000 84 23.8
2014 2,000 95 21.1
Total $14,000 210.5
Average cost 5 Total investment 4 Total shares
5 $14,000 4 210.5
5 $66.51
Exhibit 12–7 Dollar Cost Averaging for Johnson & Johnson
digi – know? digi – know?
Is an ethical stock investment the right Is an ethical stock investment the right
investment for you? investment for you?
To answer that question, go to the follow- To answer that question, go to the follow-
ing websites to learn more about ethical ing websites to learn more about ethical
investment options. investment options.
www.ethicalinvesting.comwww.ethicalinvesting.com
www.ehow.com/how_4455055_practicewww.ehow.com/how_4455055_practice
-ethical-stock-market-investing.htmlethical-stock-market-investing.html
www.moneyextra.com/guides/ethicalwww.moneyextra.com/guides/ethical
-investments.html-investments.html
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Good question! Now for some answers. Stock
investors who are willing to do their homework can
make sense out of all the information and numbers
that are available. Below are some suggestions for
pulling it all together.
1. Learn why the information and numbers are impor-
tant. There are many sources—this chapter, self-help
investing books, and Internet sites—that will help you
learn the “how to” of researching a stock investment.
2. Develop a plan or system to help organize the data.
With so much information available, you need to orga-
nize the information so that it makes sense. One sug-
gestion is to use “Your Personal Financial Plan” sheet
38 (Evaluating Corporate Stock) located at the end of
this chapter as a starting point. You can customize this
sheet by adding or deleting questions that help you
establish a database of information for each potential
stock investment.
3. Use software and financial calculators to fine-tune
your investment selections. Many investment web-
sites have both software and financial calculators that
will help you evaluate a corporate stock. For example,
a financial calculator that provides detailed informa-
tion is MSN Money’s Stock Screener ( money
.msn.com ).
A final word of caution! Making informed investment
decisions takes hard work and time. While each of the
above suggestions will help you accumulate the infor-
mation you need to make a more informed decision, a
better approach is to use all three suggestions and any
other available information to get a more complete pic-
ture of a corporation and the investment potential for its
stock.
How Do I Pick a Winning Stock?
Personal Finance in Practice
minimum investment amounts, rules, and features for both direct investment and dividend
reinvestment vary from one corporation to the next. Also, with the direct investment and
dividend reinvestment plans, you can take advantage of dollar cost averaging, discussed in
the previous section. For corporations, the chief advantage of both types of plans is that
they provide an additional source of capital. As an added bonus, they are providing a ser-
vice to their stockholders. For more information about direct investment plans and divi-
dend reinvestment plans, go to www.directinvesting.com or www.dripinvesting.org .
Short-Term Techniques
Investors sometimes use more speculative, short-term techniques. In this section, we dis-
cuss buying stock on margin, selling short, and trading in options. Be warned: The meth-
ods presented in this section are risky; do not use them unless you fully understand the
underlying risks. Also, you should not use them until you have experienced success using
the more traditional long-term techniques described above.
BUYING STOCK ON MARGIN When buying stock on margin , you borrow part
of the money needed to buy a particular stock. The margin requirement is set by the Fed-
eral Reserve Board and is subject to periodic change. The current margin requirement is 50
percent. This requirement means you may borrow up to half of the total stock purchase
price. Although margin is regulated by the Federal Reserve, specific requirements and the
interest charged on the loans used to fund margin transactions may vary among brokerage
firms. Usually the brokerage firm either lends the money or arranges the loan with another
financial institution.
Investors buy on margin because the financial leverage created by borrowing money
can increase the return on an investment. Because they can buy up to twice as much stock
by buying on margin, they can earn larger returns. Suppose you expect the market price
of a share of ExxonMobil to increase in the next three to four months. Let’s say you have
enough money to purchase 100 shares of the stock. However, if you buy on margin, you
can purchase an additional 100 shares for a total of 200 shares.
margin A speculative
technique whereby an
investor borrows part of
the money needed to buy a
particular stock.
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In the preceding example, buying more shares on margin enables you to earn double
the profit (less the interest you pay on the borrowed money and customary commission
charges).
Keep in mind that the stock in a margin transaction serves as collateral for the loan. If
the value of a margined stock decreases to approximately 65 percent of the original price,
you will receive a margin call from the brokerage firm. After the margin call, you must
pledge additional cash or securities to serve as collateral for the loan. If you don’t have
acceptable collateral or cash, the margined stock is sold and the proceeds are used to repay
the loan. The exact price at which the brokerage firm issues the margin call is determined
by the amount of money you borrowed when you purchased the stock. Generally, the more
money you borrow, the sooner you will receive a margin call if the value of the margined
stock drops.
In addition to facing the possibility of larger dollar losses because you own more shares,
you must pay interest on the money borrowed to purchase stock on margin. Most bro-
kerage firms charge 1 to 3 percent above the prime rate. Normally, economists define the
prime rate as the interest rate that the best business customers must pay. Interest charges
can absorb the potential profits if the value of margined stock does not increase rapidly
enough and the margined stocks must be held for long periods of time.
SELLING SHORT Your ability to make money by buying and selling securities
is related to how well you can predict whether a certain stock’s price will increase or
decrease. Normally, you buy stocks and assume they will increase in value, a procedure
referred to as buying long. But not all stocks increase in value. In fact, the value of a stock
may decrease for many reasons, including lower sales, lower profits, reduced dividends,
product failures, increased competition, product liability lawsuits, and labor strikes. In
addition, the health of a nation’s economy can make a difference.
When stock prices are declining, you may use a procedure called selling short to make
money. Selling short is selling stock that has been borrowed from a brokerage firm and
must be replaced at a later date. When you sell short, you sell today, knowing you must buy
or cover your short transaction at a later date. To make money in a short transaction, you
must take these steps:
1. Arrange to borrow a stock certificate for a specific number of shares of a particular
stock from a brokerage firm.
2. Sell the borrowed stock, assuming it will drop in value in a reasonably short period
of time.
3. Buy the stock at a lower price than the price it sold for in step 2.
4. Use the stock purchased in step 3 to replace the stock borrowed from the brokerage
firm in step 1.
When selling short, your profit is the difference between the amount received when
the stock is sold in step 2 and the amount paid for the stock in step 3. For example,
assume that you think General Motors stock is overvalued at $40 a share. You also
selling short Selling stock
that has been borrowed from
a brokerage firm and must
be replaced at a later date.
EXAMPLE: Margin Transaction
If the price of ExxonMobil’s stock increases by $7 a share, your profit will be:
Without margin: $ 700 5 $7 increase per share 3 100 shares
With margin: $1,400 5 $7 increase per share 3 200 shares
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believe the stock will decrease in value over the next four to six months because of
lower sales revenues and profits and a large number of product liability lawsuits. You
call your broker and arrange to borrow 100 shares of General Motors stock (step 1). The
broker then sells your borrowed stock for you at the current market price of $40 a share
(step 2). Also assume that four months later General Motors stock drops to $32 a share.
You instruct your broker to purchase 100 shares of General Motors stock at the current
lower price (step 3). The newly purchased stock is given to the brokerage firm to repay
the borrowed stock (step 4).
EXAMPLE: Selling Short
Your profit from the General Motors short transaction was $800 because the price
declined from $40 to $32.
2 $4,000 Selling price 5 $40 price per share 3 100 shares (step 2)
2 $3,200 Purchase price 5 $32 price per share 3 100 shares (step 3)
2 $ 800 Profi t from selling short
There is usually no special or extra brokerage charge for selling short, since the bro-
kerage firm receives its regular commission when the stock is bought and sold. Before
selling short, consider two factors. First, since the stock you borrow from your broker is
actually owned by another investor, you must pay any dividends the stock earns before
you replace the stock. After all, you borrowed the stock and then sold the borrowed
stock. Eventually, dividends can absorb the profits from your short transaction if the
price of the stock does not decrease rapidly enough. Second, to make money selling
short, you must be correct in predicting that a stock will decrease in value. If the value
of the stock increases, you lose.
TRADING IN OPTIONS An option gives you the right—but not the obligation—to
buy or sell a stock at a predetermined price during a specified period of time. If you think
the market price of a stock will increase during a short period of time, you may decide to
purchase a call option. A call option is sold by a stockholder and gives the purchaser the
right to buy 100 shares of a stock at a guaranteed price before a specified expiration date.
With a call option, the purchaser is betting that the price of the stock will increase in value
before the expiration date. If the stock’s price does increase, the purchaser will be able to
purchase the stock for the lower price guaranteed by the call option and then sell it for
a profit.
It is also possible to purchase a put option. A put option is the right to sell 100 shares
of a stock at a guaranteed price before a specified expiration date. With a put option, the
purchaser is betting that the price of the stock will decrease in value before the expiration
date. If the stock’s price does decrease, the purchaser will be able to purchase stock at the
lower price and then sell the stock for a higher price that is guaranteed by the put option.
If these price movements do not occur before the expiration date, you lose the money you
paid for your call or put option.
Because of the increased risk involved in option trading, a more detailed discussion of
how you profit or lose money with options is beyond the scope of this book. Be warned:
Amateurs and beginning investors should stay away from options unless they fully under-
stand all of the risks involved. For the rookie, the lure of large profits over a short period of
time may be tempting, but the risks are real.
option The right to
buy or sell a stock at a
predetermined price during a
specified period of time.
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PRACTICE QUIZ 12–5 PRACTICE QUIZ 12–5
1. In your own words, describe the difference between an investor and a speculator.
2. Describe each of the following investment techniques:
a. Buy and hold.
b. Dollar cost averaging.
c. Direct investment.
d. Dividend reinvestment.
e. Margin.
f. Selling short.
g. Options.
Apply Yourself! Apply Yourself!
In a short paragraph, describe why you would use a long-term technique or a short-term technique to achieve your
investment goals.
YOUR PERSONAL FINANCE DASHBOARD
POSSIBLE ACTIONS TO TAKE
Beginning investors are often reluctant to begin invest-
ing because of three factors. First, they don’t have the
money to establish an investment program. Second,
they don’t know how to research different investment
alternatives. Third, they must use the services of a bro-
kerage firm in order to buy or sell stock.
YOUR SITUATION: Have you saved enough money
to open a brokerage account? Depending on the bro-
kerage firm, you will typically need between $500 and
$1,000 to open an account. Next, you should research
any potential investment. Finally, you should open an
account with a brokerage firm. The material in this chap-
ter along with information available on Internet websites
and material in the library will help.
SO
ME
MONEY AVAILABLE REA
D
Y
TO
IN
V
E
S
TH
A
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N
‘T
S
TA
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TE
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$ 0 $ 2000
$1000
$1500$ 500
HAVE YOU SAVED ENOUGH MONEY TO OPEN
A BROKERAGE ACCOUNT AND PURCHASE
YOUR FIRST STOCK?
S
A
V
IN
G
Reconsider the three steps required to begin invest-
ing in stocks that were described at the beginning of
the chapter.
Review the five suggestions to help you accumulate
the money needed to fund your investment
program—see Exhibit 11–1 for a refresher.
Review the material on “Evaluating a Stock Issue”
and “Numerical Measures That Influence Investment
Decisions” in this chapter.
Use the information in this chapter and Internet
research to choose a brokerage firm. Then open an
account so you can begin buying and selling stocks
that can help you achieve your financial goals.
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Chapter
Summary
Chapter
Summary
Chapter
SSummary
LO12.1 Corporations sell stock (a form
of equity) to finance their business start-up
costs and help pay for their ongoing busi-
ness activities. In return for providing the
money needed to finance the corporation,
stockholders have the right to elect the
board of directors. They must also approve
major changes to corporate policies.
People invest in stock because they want
the larger returns that stocks offer. Possible
reasons for stock investments include divi-
dend income, appreciation of value, and the
possibility of gain through stock splits. In
addition to common stock, a few corpora-
tions may issue preferred stock. The most
important priority an investor in preferred
stock enjoys is receiving cash dividends
before any cash dividends are paid to com-
mon stockholders.
LO12.2 A wealth of information is avail-
able to stock investors. A logical place to
start the evaluation process is with the clas-
sification of different types of stock invest-
ments that range from very conservative to
very speculative—see Exhibit 12–3 . Today,
many investors use the information avail-
able on the Internet to evaluate individual
stocks. Information is also available from
stock advisory services, the newspaper, the
corporations that issue stocks, business and
personal finance periodicals, and govern-
ment publications.
LO12.3 Many analysts believe that a
corporation’s ability or inability to gen-
erate earnings in the future may be one of
the most significant factors that account
for an increase or decrease in a stock’s
price. Generally, higher earnings equate
to higher stock prices, and lower earnings
equate to lower stock prices. Investors
can also calculate earnings per share and
a price-earnings ratio to evaluate a stock
investment. Whereas both earnings per
share and price-earnings ratio are historical
numbers based on what a corporation has
already done, investors can obtain earnings
estimates for most corporations. Other cal-
culations that help evaluate stock invest-
ments include dividend yield, total return,
beta, and book value. Stock prices are also
affected by what another investor will pay
for a share of stock.
LO12.4 A corporation may sell a new
stock issue with the help of an investment
banking firm. Once the stock has been sold
in the primary market, it can be sold time
and again in the secondary market. In the
secondary market, investors purchase stock
listed on a securities exchange or traded
in the over-the-counter market. Securities
transactions are made through a full- service
brokerage firm, a discount brokerage firm,
or an online brokerage firm. Whether you
trade online or not, you must decide if you
want to use a market, limit, or stop-loss
order to buy or sell stock. Most brokerage
firms charge a minimum commission for
buying or selling stock. Additional com-
mission charges are based on the number
and value of the stock shares bought or sold
and if you use a full-service or discount
brokerage firm or trade online.
LO12.5 Purchased stock may be classi-
fied as either a long-term investment or a
speculative investment. Long-term inves-
tors typically hold their investments for at
least a year or longer; speculators (some-
times referred to as traders) usually sell
their investments within a shorter time
period. Traditional trading techniques long-
term investors use include the buy-and-hold
technique, dollar cost averaging, direct
investment plans, and dividend reinvest-
ment plans. More speculative techniques
include buying stock on margin, selling
short, and trading in options.
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account executive 404
beta 401
book value 401
churning 404
common stock 388
direct investment
plan 408
dividend 388
dividend reinvestment
plan 408
dividend yield 400
dollar cost
averaging 408
earnings per share 398
primary market 403
proxy 388
record date 389
secondary market 403
securities exchange 403
selling short 410
specialist 403
stock market
bubble 402
stock split 390
stop-loss order 406
total return 400
equity financing 388
initial public offering
(IPO) 403
investment bank 403
limit order 406
margin 409
market order 406
Nasdaq 404
option 411
over-the-counter (OTC)
market 403
preferred stock 391
price-earnings (PE)
ratio 399
Key Terms
1. In your own words, describe how an investment in common stock could help you
obtain your investment goals. (LO12.1)
2. Assume you have $5,000 to invest and are trying to decide between two different com-
panies. One company is a tobacco company that has increased sales, profits, and div-
idends over the last five years. The second company manufactures high-tech “green”
products. The second company has only been in existence for three years and has seen
a slow increase in sales and profits and pays no dividends. You like the second com-
pany because it is a green company that could help to sustain the planet, but you like
the financials of the tobacco company. Which company would you choose? (LO12.2)
3. Explain the relationship between earnings per share, projected earnings, and the price
for a share of stock. (LO12.3)
Discussion
Questions
Key Formulas
Page Topic Formula
398 Earnings
per share
Earnings per share 5
Earnings
_________________________
Number of shares outstanding
399 Price-
earnings
(PE) ratio
Price-earnings (PE) ratio 5
Price per share
________________
Earnings per share
400 Dividend
yield
Dividend yield 5 Annual dividend amount _____________________
Current price per share
400 Total return Total return 5 Dividends 1 Capital gain
401 Volatility
for a stock
Increase in overall market 3 Beta for a specific stock
401 Book
value
Book value 5 Assets 2
Liabilities
_________________________
Number of shares outstanding
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1. Four years ago, Ken Guessford purchased 200 shares of Mountain View Manufactur-
ing. At the time, each share of Mountain View was selling for $30. He also paid a $24
commission when the shares were purchased. Now, four years later, he has decided it’s
time to sell his investment. The Mountain View share price when sold was $32.50. In
addition, he paid a $36 commission to sell his shares. He also received total dividends
of $1.80 per share over the four-year investment period.
a. What is the total amount of dividends Mr. Guessford received over the four-year
period?
b. What was the total return for Mr. Guessford’s investment?
2. Karen Newton is trying to decide between two different stock investments, and she
asks for your help. Information about each investment is below.
Company Price per Share Annual Dividend
Earnings
This Year
Projected
Earnings Next
Year
Number of
Shares
Outstanding
Jackson Utility
Construction
$22 $0.30 $34 million $39 million 20 million shares
West Coast
Homes
$46 $0.52 $182 million $142 million 130 million shares
Self-Test
Problems
a. Calculate the dividend yield for each company.
b. Calculate the earnings per share for each company.
c. Based on this information, which company would you recommend?
Solutions
1. a. Total dividends 5 $1.80 per share dividends 3 200 shares 5 $360.
b. Dividends 5 $1.80 per share dividends 3 200 shares 5 $360.
Purchase price 5 $30 per share 3 200 shares 5 $6,000 1 $24 commission 5 $6,024.
Selling price 5 $32.50 per share 3 200 shares 5 $6,500 2 $36 commission 5 $6,464.
Capital gain 5 $6,464 selling price 2 $6,024 purchase price 5 $440.
Total return 5 $360 dividends 1 $440 capital gain 5 $800.
2. a. The dividend yield for each company is
Jackson : Dividend yield 5
$0.30 annual dividend
__________________
$22 current price
5 0.014 5 1.4 percent
West Coast: Dividend yield 5
$0.52 annual dividend
__________________
$46 current price
5 0.011 5 1.1 percent
4. What is the difference between the dividend yield and total return calculations that
were described in this chapter? (LO12.3)
5. Prepare a list of questions you could use to interview an account executive about
career opportunities in the field of finance and investments. (LO12.4)
6. Prepare a chart that describes the similarities and differences among the long-term and
short-term investment strategies described in this chapter. (LO12.5)
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b. The earnings per share for each company are
Jackson : Earnings per share 5
$34,000,000 income
_________________
20,000,000 shares
5 $1.70
West Coast: Earnings per share 5
$182,000,000 income
__________________
130,000,000 shares
5 $1.40
c. On the surface, the financial amounts for West Coast Homes are impressive because
they are larger than the amounts for Jackson Utility Construction. But as the calcu-
lations for dividend yield and earnings per share illustrate, Jackson Utility Construc-
tion may be the better investment. Jackson’s dividend yield (1.4 percent) is higher
than West Coast’s dividend yield (1.1 percent). Also, the earnings per share for
Jackson are higher ($1.70) when compared to the earnings per share for West Coast
($1.40). Before making your choice, look at the projected earnings for next year.
Jackson’s earnings are increasing; West Coast’s earnings are projected to decline.
Given just the above information, Jackson Utility Construction may be the better
choice. What do you think?
1. Jamie and Peter Dawson own 220 shares of Duke Energy common stock. Duke Ener-
gy’s quarterly dividend is $0.28 per share. What is the amount of the dividend check
the Dawson couple will receive for this quarter? (LO12.1)
2. During the four quarters for 2015, the Browns received two quarterly dividend
payments of $0.18, one quarterly payment of $0.20, and one quarterly payment of
$0.22. If they owned 300 shares of stock, what was their total dividend income for
2015? (LO12.1)
3. Jim Johansen noticed that a corporation he is considering investing in is about to pay a
quarterly dividend. The record date is Thursday, March 15. In order for Jim to receive
this quarterly dividend, what is the last date that he could purchase stock in this corpo-
ration and receive this quarter’s dividend payment? (LO12.1)
4. Sarah and James Hernandez purchased 140 shares of Macy’s stock at $57 a share.
One year later, they sold the stock for $61 a share. They paid a broker an $8 commis-
sion when they purchased the stock and a $12 commission when they sold the stock.
During the 12-month period the couple owned the stock, Macy’s paid dividends that
totaled $1.00. Calculate the Hernandezes’ total return for this investment. (LO12.1)
5. Wanda Sotheby purchased 120 shares of Home Depot stock at $82 a share. One year
later, she sold the stock for $74 a share. She paid her broker a $34 commission when
she purchased the stock and a $39 commission when she sold it. During the 12 months
she owned the stock, she received $188 in dividends. Calculate Wanda’s total return on
this investment. (LO12.1)
6. In September, the board of directors of Chaparral Steel approved a 2-for-1 stock split.
After the split, how many shares of Chaparral Steel stock will an investor have if he or
she owned 400 shares before the split? (LO12.1)
7. Michelle Townsend owns stock in National Computers. Based on information in its
annual report, National Computers reported after-tax earnings of $9,700,000 and has
issued 7,000,000 shares of common stock. The stock is currently selling for $32 a
share. (LO12.3)
a. Calculate the earnings per share for National Computers.
b. Calculate the price-earnings (PE) ratio for National Computers.
Problems
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8. Analysts that follow JPMorgan Chase, one of the nation’s largest providers of finan-
cial services, estimate that the corporation’s earnings per share will increase from
$5.56 in the current year to $6.12 next year. (LO12.3)
a. What is the amount of the increase?
b. What effect, if any, should this increase have on the value of the corporation’s
stock?
9. Currently, Boeing pays an annual dividend of $2.92. If the stock is selling for $128,
what is the dividend yield? (LO12.3)
10. Ford Motor Company has a 1.35 beta. If the overall stock market increases by
6 percent, how much will Ford change? (LO12.3)
11. Casper Energy Exploration reports that the corporation’s assets are valued at
$185,000,000, its liabilities are $80,000,000, and it has issued 6,000,000 shares of
stock. What is the book value for a share of Casper stock? (LO12.3)
12. For four years, Marty Campbell invested $4,000 each year in Harley-
Davidson. The stock was selling for $36 in 2011, $45 in 2012, $52 in 2013,
and $70 in 2014. (LO12.5)
a. What is Marty’s total investment in Harley-Davidson?
b. After four years, how many shares does Marty own?
c. What is the average cost per share of Marty’s investment?
13. Bob Orleans invested $3,000 and borrowed $3,000 to purchase shares in Verizon
Communications. At the time of his investment, Verizon was selling for $45 a
share. (LO12.5)
a. If Bob paid a $30 commission, how many shares could he buy if he used only his
own money and did not use margin?
b. If Bob paid a $60 commission, how many shares could he buy if he used his
$3,000 and borrowed $3,000 on margin to buy Verizon stock?
c. Assuming Bob did use margin, paid a $60 total commission to buy his Verizon
stock and another $60 to sell his stock, and sold the stock for $52 a share, how
much profit did he make on his Verizon stock investment?
14. After researching Valero Energy common stock, Sandra Pearson is convinced the
stock is overpriced. She contacts her account executive and arranges to sell short
300 shares of Valero Energy. At the time of the sale, a share of common stock had a
value of $56. Three months later, Valero Energy is selling for $47 a share, and Sandra
instructs her broker to cover her short transaction. Total commissions to buy and sell
the stock were $36. What is her profit for this short transaction? (LO12.5)
To reinforce the content in this chapter, more problems are pro-
vided at connect.mheducation.com .
RESEARCH INFORMATION AVAILABLE FROM VALUE LINE
This chapter stressed the importance of
evaluating potential investments. Now it’s
your turn to try your skill at evaluating a
potential investment in the Walt Disney
Company. Assume you could invest $10,000
in the common stock of this company. To
help you evaluate this potential invest-
ment, carefully examine Exhibit 12–5 ,
which reproduces the research report about
Disney from Value Line. The report was
published in February 2014.
Questions
1. Based on the research provided by
Value Line, would you buy Disney
stock? Justify your answer.
2. What other investment information
would you need to evaluate Disney
common stock? Where would you
obtain this information?
3. On February 7, 2014, Disney stock
was selling for $75 a share. Using the
Case in Point
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The triplets are now entering high school and Jamie Lee and Ross are comfortable with
their financial and investment strategies. They budgeted throughout the years and are on
track to reach their long-term investment goals of paying the triplets’ college tuition and
accumulating enough to purchase a beach house to enjoy when Jamie and Ross retire.
Recently, Ross inherited $50,000 from his uncle’s estate. Ross would like to invest in
stocks to supplement their retirement income goals.
Jamie Lee and Ross have been watching a technology company that has an upcoming ini-
tial public offering and several other stocks for well-established companies, but they are
unsure which stocks to invest in and are also wondering if their choices will fit their mod-
erate risk investment strategies. They want to make the best decisions they can to maximize
chances they will benefit from positive investment returns.
Questions
1. What is the benefit to Jamie Lee and Ross of investing in a company’s IPO? Will they
be guaranteed a large return from this investment? At this life stage, would you recom-
mend that Jamie Lee and Ross invest in an IPO? Why or why not?
2. Jamie Lee’s father suggested that they purchase stock in a company that he has held
shares in for decades. They want to take advantage of the stock tip, but Jamie Lee and
Ross are trying to decide between purchasing the company’s common stock and pre-
ferred stock. What are the advantages to each type of stock?
3. Currently, the economy is in the recovery stage. Referring to Exhibit 12–3 , what types
of stock would you suggest for Jamie and Ross to invest in considering their life stage
and current moderate investment strategies? What characteristics are associated with
the types of investments you suggested?
4. Suppose Jamie Lee and Ross are evaluating corporate stocks to add to their investment
portfolio. Using “Your Personal Financial Plan” sheet 38, select a company from your
own personal experiences, such as an automobile or technology company, and research
the information needed to complete the worksheet.
a. Do you suggest that Jamie Lee and Ross invest in this company? Provide support
for your evaluation based on “Your Personal Financial Plan” sheet 38 research find-
ings for that company.
b. If they should invest in that company, how much of their $50,000 inheritance should
they allocate toward the purchase of shares in that company?
c. Regardless of your position on whether they should invest in your chosen company,
if Jamie Lee and Ross went ahead and purchased shares of stock in that company,
how many shares could they purchase with the $50,000?
d. What would be the total transaction cost if they purchased the shares online? (List
the source for your answer.)
INVESTING IN STOCKS
Continuing
Case
Internet or a newspaper, determine the
current price for a share of Disney.
Based on this information, would your
Disney investment have been profit-
able? ( Hint: Disney’s stock symbol
is DIS.)
4. Assuming you purchased Disney
stock on February 7, 2014, and based
on your answer to question 3, how
would you decide if you want to hold
or sell your Disney stock? Explain
your answer.
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“INVESTING IN STOCK IS NOT POSSIBLE. I’M BARELY ABLE TO
PAY MY VARIOUS LIVING EXPENSES.”
Directions Your Daily Spending Diary will help you manage your expenses to create
a better overall spending plan. Once you know and try to control your spending, you will
likely be able to have funds available for various types of investments. The Daily Spending
Diary sheets are located in Appendix D at the end of the book and in Connect Finance.
Questions
1. What information from your daily spending records could help you achieve your
financial goals?
2. Based on your observations of our society and the economy, what types of stocks
might you consider for investing now or in the near future?
Spending
Diary
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N Evaluating Corporate Stocks
Purpose: To identify a corporate stock that might help you attain your investment goals.
Financial Planning Activities: No checklist can serve as a foolproof guide for choosing a
common or preferred stock. However, the following questions will help you evaluate a potential
stock investment. Use stock websites on the Internet and/or use library materials to answer
these questions about a corporate stock that you believe could help you obtain your invest-
ment goals. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: finance.yahoo.com www.marketwatch.com money.msn.com
Category 1: The Basics
1. What is the corporation’s name?
____________________________________________
2. What are the corporation’s website address and
telephone number? __________________________
____________________________________________
3. Have you read the latest annual report and quar-
terly report? h Yes h No
4. What information about the corporation is avail-
able on the Internet? _________________________
____________________________________________
5. Where is the stock traded (NYSE or Nasdaq)?
____________________________________________
6. What types of products or services does this firm
provide? ____________________________________
7. Briefly describe the prospects for this company.
(Include significant factors like product devel-
opment, plans for expansion, plans for mergers,
etc.) ________________________________________
Category 2: Dividend Income
8. Is the corporation currently paying dividends? If
so, how much? ______________________________
9. What is the dividend yield for this stock?
____________________________________________
10. Have dividends increased or decreased over the
past three years? ____________________________
____________________________________________
11. How does the dividend yield for this investment
compare with other potential investments?
____________________________________________
Category 3: Financial Performance
12. What are the firm’s earnings per share for the last
year? __________________________________
13. Have the firm’s earnings increased over the past
three years? ________________________________
14. What is the firm’s current price-earnings ratio?
____________________________________________
15. How does the firm’s current price-earnings (PE)
ratio compare with that of firms in the same
industry? __________________________________
16. Describe trends for the firm’s price-earnings ratio
over the past three years. Do these trends show
improvement or decline in investment value? ____
_________________________________
17. What are the firm’s projected earnings for the
next year? _________________________________
18. Have sales increased over the last five years?
____________________________________________
19. What is the stock’s current price?
____________________________________________
20. What are the 52-week high and low for this
stock? _____________________________________
21. Does your analysis indicate that this is a good
stock to buy at this time?
____________________________________________
22. Briefly describe any other information that you
obtained from Mergent, Value Line, Standard &
Poor’s, or other sources of information.
A Word of Caution
When you use a checklist, there is always a danger of
overlooking important relevant information. Quite sim-
ply, it is a place to start. If you need more information,
you are responsible for obtaining it and for determining
how it affects your potential investment.
What’s Next for Your Personal Financial Plan?
• Identify additional factors that may affect your decision to invest in this corporation’s stock.
• Develop a plan for monitoring an investment’s value once a stock is purchased.
Suggested
App:
• Yahoo!
Finance
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Purpose: To compare the benefits and costs of different investment brokers.
Financial Planning Activities: Compare the services of an investment broker based on the
factors listed below. This sheet is also available in an Excel spreadsheet format in Connect
Finance.
Suggested Websites: www.brokerage-review.com www.brokerstance.com
www.stockbrokers.com
Broker Number 1 Broker Number 2
Broker’s name
Brokerage firm
Address
Phone
Website
Years of experience
Education and training
Areas of specialization
Certifications and licenses held
Employer’s stock exchange and financial mar-
ket affiliations
Information services offered
Minimum commission charge
Commission on 100 shares of stock at $50 per
share
Fees for other investments:
• Corporate bonds
• Government bonds
• Mutual funds
Other fees:
• Annual account fee
• Inactivity fee
• Other
What’s Next for Your Personal Financial Plan?
• Using the information you obtained, choose a brokerage firm that you feel will help you attain your investment
goals.
• Access the website for the brokerage firm you have chosen and answer the questions on page 405 in your text.
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3 Steps to Financial
Literacy . . . Begin Investing
in Mutual Funds
13
Investing in
Mutual Funds
For many investors, mutual funds have
become the investment of choice. In fact, you
can choose from almost 11,000 different funds.
So how do you choose the right fund to help
you attain your long-term investment goals? To
help answer that question, read the material in
this chapter. At the end of the chapter, “Your
Personal Finance Dashboard,” along with other
end-of-chapter learning activities, will help you
improve your ability to pick the right funds to
develop a long-term investment program and
achieve your financial goals.
1
Learn about different types of funds.
Website: www.mfea.com
2
Research the services and fees offered by dif-
ferent brokerage firms.
App: Vanguard
3
Evaluate different funds that will help achieve
your investment goals.
Website: finance.yahoo.com
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If you ever thought about buying stocks or bonds but decided not to, your reasons were
probably like most other people’s: You didn’t know enough to make a good decision, and
you lacked enough money to diversify your investments among several choices. These
same two reasons explain why people invest in mutual funds. A mutual fund pools the
money of many investors—its shareholders—to invest in a variety of securities. 1 For a fee,
a professional fund manager or team of managers that work for an investment company
invest money from investors in stocks, bonds, money market securities, or some combina-
tion of these securities appropriate to a fund’s investment objective.
Mutual funds are an excellent choice for many individuals. In many cases, they can also
be used for retirement accounts, including traditional individual retirement accounts, Roth
IRAs, and 401(k) and 403(b) retirement accounts.
An investment in mutual funds is based on the concept of opportunity costs, which
we have discussed throughout this text. Simply put, you have to be willing to take some
chances if you want to get larger returns on your investments. But a “real risk” is asso-
ciated with investing in funds. The fact that fund investments can decrease in value does
underscore the need to understand the risk associated with all investments, including
mutual funds.
Why Investors Purchase Mutual Funds
For many investors, the notion of investing their money in a mutual fund may be a new
idea, but mutual funds have been around for a long time. Fund investing began in Europe
in the late 1700s and became popular in the United States before the Great Depression in
1929. After the depression, government regulation increased, the number of funds grew, and
the amount invested in funds continued to increase. New types of funds, including index
funds, aggressive growth funds, and social responsibility (or green) funds, were created
mutual fund Pools the
money of many investors—its
shareholders—to invest in a
variety of securities.
1 The Mutual Fund Education Alliance ( www.mfea.com ), accessed May 20, 2014.
LO13.1
Explain the characteristics of
mutual fund investments.
CHAPTER 13 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO13.1 Explain the characteristics of mutual fund investments.
LO13.2 Classify mutual funds by investment objective.
LO13.3 Evaluate mutual funds.
LO13.4 Describe how and why mutual funds are bought and sold.
YOUR PERSONAL FINANCIAL PLAN SHEETS
40. Evaluating Mutual Fund Investment Information
41. Mutual Fund Evaluation
ACTION ITEM
I understand the reasons
investors invest in mutual
funds.
h Agree h Disagree
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to meet the needs of a larger and more demanding group of investors. During this same
time period, the cost of investing in funds decreased while the popularity of fund invest-
ing increased. Experts often say that one man, John Bogle, was the driving force behind
attempts to make fund investing affordable for the average American. When he introduced
the Vanguard 500 Index Fund in 1976, he gave investors a low-cost way to invest in funds
while providing investment diversification. Today, the Vanguard Group he founded is one
of the largest fund companies that competes with other companies in the fund industry.
Despite the accusations of fraud and mutual fund scandals in the first part of the 21st
century and poor fund performance and investor losses during the last economic crisis,
mutual funds are still the investment of choice for many investors. The following statistics
illustrate how important mutual fund investments are to both individuals and the nation’s
economy:
1. Over 96 million individuals own mutual funds in the United States. 2
2. The number of funds grew from 361 in 1970 to almost 11,000 by 2013. 3
3. The combined value of assets owned by investment companies in the United States
totals $17 trillion. 4
No doubt about it, the mutual fund industry is big business. And yet you may be wondering
why so many people invest in mutual funds.
The Psychology of Investing
in Funds
The major reasons investors purchase mutual funds are profes-
sional management and diversification. Most investment com-
panies do everything possible to convince you that they can do
a better job of picking securities than you can. Sometimes these
claims are true, and sometimes they are just so much hot air.
Still, investment companies do have professional fund managers
with years of experience who devote large amounts of time to
picking just the “right” securities for their funds’ portfolios. Be
warned: Even the best portfolio managers make mistakes. So
you must be careful and evaluate a fund before investing your
money.
The diversification mutual funds offer spells safety, because
a loss incurred with one investment contained in a fund may be
offset by gains from other investments in the fund. For exam-
ple, consider the diversification provided in the portfolio of the
Invesco Dividend Income Fund, shown in Exhibit 13–1 . An
investment in the $517 million Invesco Dividend Income Fund
represents ownership in over 50 different companies included in
the fund’s investment portfolio. Investors enjoy diversification
coupled with Invesco’s stock-selection expertise. For beginning
investors or investors without a great deal of money to invest,
the diversification offered by funds is especially important
because there is no other practical way to purchase the individ-
ual stocks issued by a large number of corporations. A fund like the Invesco Dividend
Income Fund, on the other hand, can provide a practical way for investors to obtain diver-
sification because the fund can use the pooled money of a large number of investors to
purchase shares of many different companies.
2 The Investment Company Institute (www.ici.org), accessed May 20, 2014.
3 Ibid.
4 Ibid.
did you know? did you know?
Who owns mutual funds?
SOURCE: The Investment Company Fact Book at www.ici.org,
accessed May 20, 2014.
24%
Less than
35 years old
32%
35 to 44
years old
23%
45 to 54
years old
12%
55 to 64
years old
9%
65 years old
and over
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Characteristics of Funds
Today funds may be classified as closed-end funds, exchange-traded funds, or open-end
funds.
CLOSED-END, EXCHANGE-TRADED, OR OPEN-END MUTUAL
FUNDS Approximately 600, or about 6 percent, of all mutual funds are closed-end
funds offered by investment companies. 5 A closed-end fund is a mutual fund whose shares
are issued by an investment company only when the fund is organized. As a result, only a
certain number of shares are available to investors. After all the shares originally issued
have been sold, an investor can purchase shares only from another investor who is willing
to sell. Closed-end funds are actively managed by professional fund managers and shares
are traded on the floors of stock exchanges or in the over-the-counter market. Like the
prices of stocks, the prices of shares for closed-end funds are determined by the factors of
supply and demand, by the value of stocks and other investments contained in the fund’s
portfolio, and by investor expectations.
closed-end fund A
mutual fund whose shares
are issued by an investment
company only when the fund
is organized.
5 The Investment Company Institute ( www.ici.org ), accessed May 20, 2014.
Top Industries % of Total Assets
Electric utilities 12.42
Multi-utilities 10.22
Packaged foods and meats 8.03
Pharmaceuticals 7.29
Integrated telecommunication services 6.94
Aerospace and defense 5.94
Integrated oil and gas 5.70
Tobacco 4.66
Regional banks 3.54
Semiconductors 3.36
Top Equity Holdings I % of Total Assets
Lockheed Martin Corp . 4.21
Pepco Holdings Inc. 3.40
Kraft Foods Group Inc. 3.20
Total SA 2.87
Altria Group Inc. 2.81
Duke Energy Corp. 2.65
AGL Resources Inc. 2.55
General Mills Inc. 2.48
Federated Investors Inc. 2.48
Johnson & Johnson 2.43
Holdings are subject to change and are not buy/sell recommendations.
SOURCE: Invesco ( www.invescoaim.com ), accessed May 20, 2014.
Exhibit 13–1
Types of Securities
Included in the Portfolio
of the Invesco Dividend
Income Fund
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An exchange-traded fund (ETF) is a fund that invests in the stocks or other securities
contained in a specific stock or securities index. While most investors think of an ETF as
investing in the stocks contained in the Standard & Poor’s 500 stock index, the Dow Jones
Industrial Average, or the Nasdaq 100 Index, many different types of ETFs available today
attempt to track all kinds of indexes, including:
• Midcap stocks.
• Small-cap stocks.
• Fixed-income securities.
• Stocks issued by companies in specific industries.
• Stocks issued by corporations in different countries.
Like a closed-end fund, shares of an exchange-traded fund are traded on a securities
exchange or in the over-the-counter market. With both types of funds, an investor can
purchase as little as one share of a fund. Also like a closed-end fund, prices for shares in
an ETF are determined by supply and demand, the value of stocks and other investments
contained in the fund’s portfolio, and by investor expectations.
Although exchange-traded funds are similar to closed-end funds, there is an important
difference. Most closed-end funds are actively managed, with portfolio managers making the
selection of stocks and other securities contained in a closed-end fund. An exchange-traded
fund, on the other hand, invests in the securities included in a specific index. Exchange-
traded funds tend to mirror the performance of the index, moving up or down as the indi-
vidual securities contained in the index move up or down. Therefore, there is less need for
a portfolio manager to make investment decisions. Because of passive management, fees
associated with owning shares are generally lower than those of both closed-end and open-
end funds. In addition to lower fees, other advantages to investing in ETFs include:
• There is no minimum investment amount, because shares are traded on an exchange
and not purchased from an investment company.
• Shares can be bought or sold through a brokerage firm any time during regular
market hours at the current price.
• You can use limit orders and the more speculative techniques of selling short and
buying on margin—all discussed in Chapter 12—to buy and sell ETF shares.
Although increasing in popularity, approximately 1,300, or about 12 percent of all funds,
are exchange-traded funds. 6
Approximately 9,000, or about 82 percent of all mutual funds, are open-end funds. 7 An
open-end fund is a mutual fund whose shares are issued and redeemed by the investment
company at the request of investors. Investors are free to buy and sell shares at the net asset
value. The net asset value (NAV) per share is equal to the current market value of securities
contained in the mutual fund’s portfolio minus the mutual fund’s liabilities divided by the
number of shares outstanding.
exchange-traded fund
(ETF) A fund that invests in
the stocks or other securities
contained in a specific stock
or securities index, and
whose shares are traded on
a securities exchange or over
the counter.
open-end fund A mutual
fund whose shares are
issued and redeemed by the
investment company at the
request of investors.
net asset value (NAV)
The current market value
of the securities contained
in the mutual fund’s
portfolio minus the mutual
fund’s liabilities divided
by the number of shares
outstanding.
6 Ibid.
7 Ibid.
EXAMPLE: Net Asset Value
The investments contained in the New American Frontiers Mutual Fund have a cur-
rent market value of $980 million. The fund also has liabilities that total $10 million.
If this mutual fund has 40 million shares, the net asset value per share is $24.25, as
shown below.
Net asset value 5
Value of the fund’s portfolio 2 Liabilities
____________________________________
Number of shares outstanding
5
$980 million 2 $10 million
________________________
40 million shares
5 $24.25 NAV per share
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For most open-end funds, the net asset value is calculated at the close of trading each day.
In addition to buying and selling shares on request, most open-end funds provide their
investors with a wide variety of services, including payroll deduction programs, automatic
reinvestment programs, automatic withdrawal programs, and the option to change shares
in one fund to another fund within the same fund family—all topics discussed later in this
chapter.
COSTS: LOAD FUNDS COMPARED TO NO-LOAD FUNDS Before
investing in mutual funds, you should compare the cost of this type of investment with the
cost of other investment alternatives, such as stocks or bonds. With regard to cost, mutual
funds are classified as load funds or no-load funds. A load fund (sometimes referred to as
an A fund ) is a mutual fund in which investors pay a commission every time they purchase
shares. The commission, often referred to as the sales charge, may be as high as 8.5 per-
cent of the purchase price for investments.
load fund A mutual fund
in which investors pay a
commission (as high as
8.5 percent) every time they
purchase shares.
EXAMPLE: Sales Charge Calculation
The Davis Opportunity mutual fund charges a sales load of 4.75 percent. If you
invest $10,000, you must pay a $475 commission to purchase shares. After paying
the commission, the amount available for investment is $9,525, as shown below.
Load charge 5 Dollar amount of investment 3 Load stated as a percentage
5 $10,000 3 4.75 percent 5 $475
Amount available for investment 5 Investment amount 2 Load charge
5 $10,000 2 $475 5 $9,525
Many exceptions exist, but the average load charge for mutual funds is between 3 and
5 percent. In fact, two specific exceptions should be noted. First, investment companies
offering front-end load funds often waive or lower fees for shares purchased for retirement
accounts. Second, load funds are often lower for investors who make large purchases. 8
The “stated” advantage of a load fund is that the fund’s sales force (account executives,
financial planners, or employees of brokerage divisions of banks and other financial insti-
tutions) will explain the mutual fund, help you determine which fund will help you achieve
your financial objectives, and offer advice as to when shares of the fund should be bought
or sold.
A no-load fund is a mutual fund in which the individual
investor pays no sales charge. No-load funds don’t charge com-
missions when you buy shares because they have no salespeo-
ple. If you want to buy shares of a no-load fund, you must make
your own decisions and deal directly with the investment com-
pany. The usual means of contact is by telephone, the Internet,
or mail. You can also purchase shares in a no-load fund from
many discount brokers, including Charles Schwab, TD Ameri-
trade, and E*Trade.
As an investor, you must decide whether to invest in a load
fund or a no-load fund. Some investment salespeople have
claimed that load funds outperform no-load funds. But many
financial analysts suggest there is generally no significant dif-
ference between mutual funds that charge commissions and
no-load fund A mutual
fund in which the individual
investor pays no sales
charge.
8 The Investment Company Fact Book at www.ici.org , accessed May 20, 2014.
digi – know? digi – know?
Where can I find out more information Where can I find out more information
about mutual fund fees? about mutual fund fees?
For more information about the different For more information about the different
types of fees that mutual funds charge, types of fees that mutual funds charge,
you can use an Internet search engine you can use an Internet search engine
like Google or Yahoo! and enter “mutual like Google or Yahoo! and enter “mutual
fund fees.” You can also learn about mutual fund fees.” You can also learn about mutual
fund fees at the Securities and Exchange fund fees at the Securities and Exchange
Commission website at Commission website at www.sec.gov/answers/www.sec.gov/answers/
mffees.htmmffees.htm . .
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those that do not. 9 Since no-load funds offer the same investment opportunities load funds
offer, you should investigate them further before deciding which type of mutual fund is
best for you.
Instead of charging investors a fee when they purchase shares in a mutual fund, some
mutual funds charge a contingent deferred sales load (sometimes referred to as a back-
end load, a B fund, or a redemption fee ) when shares are sold. Typically, these fees range
from 1 to 5 percent, depending on how long you own the mutual fund before making a
withdrawal. For example, you may pay a 5 percent contingent deferred sales load if you
withdraw money the first year after your initial investment. In most cases, this fee declines
every year until it disappears if you own shares in the fund for more than five years.
contingent deferred
sales load A 1 to 5 percent
charge that shareholders pay
when they sell shares in a
mutual fund.
9 Bill Barker, “The Truth about Mutual Fund Loads,” The Motley Fool ( www.fool.com ), accessed May 21, 2014.
EXAMPLE: Contingent Deferred Sales Load
Assume you withdraw $6,000 from B shares that you own in the Oppenheimer
Capital Income Fund within a year of your purchase date. If you purchase shares
with a contingent deferred sales load, you must pay a 5 percent fee for any with-
drawals during the first year. Your fee is $300. After deducting the fee, you will
receive $5,700, as shown below.
Contingent deferred sales load 5 Amount of withdrawal
3 Fee stated as a percentage
5 $6,000 3 5 percent 5 $300
Amount you receive 5 Amount of withdrawal 2 Contingent deferred sales fee
5 $6,000 2 $300 5 $5,700
COSTS: MANAGEMENT FEES AND OTHER CHARGES Mutual fund
fees are important because they reduce your investment return and are a major factor to
consider when choosing a fund. For example, the investment companies that sponsor funds
charge management fees. This fee, which is disclosed in the fund’s prospectus, is a fixed
percentage of the fund’s net asset value on a predetermined date. Today annual manage-
ment fees range between 0.25 and 1.5 percent of the fund’s net asset value. While fees vary
considerably, the average is 0.5 to 1 percent of the fund’s net asset value.
The investment company may also levy a 12b-1 fee (sometimes referred to as a distri-
bution fee ) to defray the costs of marketing a mutual fund, commissions paid to a broker
who sold you shares in the fund, and shareholder service fees. Approved by the Securities
and Exchange Commission, annual 12b-1 fees are calculated on the value of a fund’s net
assets and cannot exceed 1 percent of a fund’s assets per year. Note: For a fund to be called
a “no-load” fund, its 12b-1 fee must not exceed 0.25 percent of its assets.
Unlike the one-time sales load fees that mutual funds charge to purchase or sell shares,
the 12b-1 fee is often an ongoing fee that is charged on an annual basis. Note that 12b-1
fees can cost you a lot of money over a period of years. Assuming there is no difference in
performance offered by two different mutual funds, one of which charges a 12b-1 fee while
the other doesn’t, choose the latter fund. The 12b-1 fee is so lucrative for investment com-
panies that a number of them have begun selling Class C shares
that often charge a higher 12b-1 fee and no sales load or contingent
deferred sales load to attract new investors. (Note: Some invest-
ment companies may charge a small contingent deferred sales load
for Class C shares if withdrawals are made within a short time—
usually one year.) When compared to Class A shares (commissions
charged when shares are purchased) and Class B shares (commis-
sions charged when withdrawals are made over the first five years),
12b-1 fee A fee that
an investment company
levies to defray the costs of
advertising and marketing a
mutual fund.
CAUTION! CAUTION!
Many financial planners recommend that you
choose a mutual fund with an expense ratio
of 1 percent or less.
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Chapter 13 Investing in Mutual Funds 429
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Class C shares, with their ongoing, higher 12b-1 fees, may be more expensive over a long
period of time.
Together, all the different management fees and fund operating costs are often referred
to as an expense ratio . Since it is important to keep fees and costs as low as possible, you
should examine a fund’s expense ratio as one more fact to consider when evaluating a
mutual fund.
The investment company’s prospectus must provide all details relating to manage-
ment fees, sales fees, 12b-1 fees, and other expenses. Exhibit 13–2 reproduces the sum-
mary of expenses (sometimes called a fee table ) taken from the Davis Opportunity Fund.
Notice that this fee table has two separate parts. The first part describes shareholder
transaction expenses. For this fund, the maximum sales charge is 4.75 percent. The sec-
ond part describes the fund’s annual operating expenses. For this fund, the expense ratio
is 0.98 percent for Class A shares.
By now, you are probably asking yourself, “Should I purchase Class A shares, Class B
shares, or Class C shares?” There are no easy answers, but your professional financial
advisor or broker can help you determine which class of shares of a particular fund best
suits your financial needs. You can also do your own research to determine which fund
is right for you. Factors to consider include whether you want to invest in a load fund or
no-load fund, management fees, 12b-1 fees, and expense ratios. As you will see later in this
chapter, a number of sources of information can help you evaluate investment decisions.
To reinforce the material on the costs of investing in funds, Exhibit 13–3 summarizes
information for load charges, no-load charges, and Class A, Class B, and Class C shares.
In addition, it reports typical management fees, contingent deferred sales loads, and 12b-1
charges.
expense ratio The amount
that investors pay for all of a
mutual fund’s management
fees and operating costs.
Class A Shares Class B Shares Class C Shares
SHAREHOLDER FEES
(fees paid directly from your investment)
Maximum sales charge (load) imposed on purchases
(as a percentage of offering price)
4.75% None None
Maximum deferred sales charge (load) imposed on redemptions
(as a percentage of the lesser of the net asset value of the shares
redeemed or the total cost of such shares. Only applies to Class
A shares if you buy shares valued at $1 million or more without a
sales charge and sell the shares within one year of purchase)
0.50% 4.00% 1.00%
Redemption fee (as a percentage of total redemption proceeds) None None None
ANNUAL FUND OPERATING EXPENSES
(expenses that you pay each year as a percentage of the value
of your investment)
Management fees 0.55% 0.55% 0.55%
Distribution and/or service (12b-1) fees 0.22% 1.00% 1.00%
Other expenses 0.21% 0.40% 0.23%
Total annual fund operating expenses 0.98% 1.95% 1.78%
Expenses may vary in future years.
SOURCE: Excerpted from the Davis Opportunity Fund Prospectus ( www.davisfunds.com ), accessed May 1, 2014, Davis Funds, P.O. Box 8406, Boston,
MA 02266.
Exhibit 13–2 Summary of Expenses Paid to Invest in the Davis Opportunity Fund
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430 Chapter 13 Investing in Mutual Funds
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Type of Fee or Charge Customary Amount
Load fund Up to 8.5 percent of the purchase.
No-load fund No sales charge.
Contingent deferred
sales load
1 to 5 percent of withdrawals, depending on how long you
own shares in the fund before making a withdrawal.
Management fee 0.25 to 1.5 percent per year of the fund’s net asset value.
12b-1 fee Cannot exceed 1 percent of the fund’s assets per year.
Expense ratio The amount investors pay for all fees and operating costs.
Class A shares Commission charge when shares are purchased.
Class B shares Commission charge when money is withdrawn during the first
five years.
Class C shares No commission to buy or sell shares of a fund, but may have
higher, ongoing 12b-1 fees.
Exhibit 13–3
Typical Fees Associated
with Mutual Fund
Investments
PRACTICE QUIZ 13–1 PRACTICE QUIZ 13–1
1. Closed-end, exchange-traded, and open-end mutual funds are available today. Describe the differences between
each type of fund.
2. What is the net asset value (NAV) for a mutual fund that has assets totaling $730 million, liabilities totaling $10 million,
and 24 million shares outstanding?
3. In the table below, indicate the typical charges for each type of mutual fund.
Fee Typical Charge
Load fund
No-load fund
Contingent deferred sales load
Management fee
12b-1 fee
4. What is an expense ratio? Why is it important?
Apply Yourself! Apply Yourself!
Use the Internet or library research to find a fund you think will help you attain a long-term investment goal. Then deter-
mine the fund’s load charge (if any), management fee, and expense ratio.
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Chapter 13 Investing in Mutual Funds 431
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Classifications of Mutual Funds
The managers of mutual funds tailor their investment portfolios to the investment objec-
tives of their customers. Usually a fund’s objectives are plainly disclosed in its prospectus.
For example, the objective of the Vanguard Mid-Cap Growth Fund is described as follows:
This actively managed mid-capitalization option invests primarily in the stocks of mid-size
domestic companies that the fund’s investment managers believe have stronger earnings
and revenue growth prospects than the average midcap company. Investors who are seeking
exposure to the midcap arena of the U.S. stock market and who are willing to endure the
volatility that can come from an investment in stocks may wish to consider this fund as an
option for their portfolio. 10
Although categorizing almost 11,000 funds may be helpful, note that different sources
of investment information may use different categories for the same fund. In most cases,
the name of the category gives a pretty good clue to the types of investments included
within the category. The major fund categories are described as follows:
Stock Funds
• Aggressive growth funds seek rapid growth by purchasing
stocks whose prices are expected to increase dramatically
in a short period of time. Turnover within an aggressive
growth fund is high because managers are buying and
selling stocks of small growth companies. Investors in
these funds experience wide price swings because of the
underlying speculative nature of the stocks in the fund’s
portfolio.
• Equity income funds invest in stocks issued by
companies with a long history of paying dividends. The
major objective of these funds is to provide income
to shareholders. These funds are attractive investment
choices for conservative or retired investors.
• Global stock funds invest in stocks of companies
throughout the world, including the United States.
• Growth funds invest in companies expecting higher-than-
average revenue and earnings growth. While similar to
aggressive growth funds, growth funds tend to invest in
larger, well-established companies. As a result, the prices
for shares in a growth fund are less volatile compared to
aggressive growth funds.
• Index funds invest in the same companies included in an
index like the Standard & Poor’s 500 stock index, the
Dow Jones Industrial Average, or the Nasdaq 100 Index. Since fund managers pick
the stocks issued by the companies included in the index, an index fund should
provide approximately the same performance as the index. Also, since index funds
are cheaper to manage, they often have lower management fees and expense ratios.
• International funds invest in foreign stocks sold in securities markets throughout
the world; thus, if the economy in one region or nation is in a slump, profits can
still be earned in others. Unlike global funds, which invest in stocks issued by
companies in both foreign nations and the United States, a true international fund
invests outside the United States.
LO13.2
Classify mutual funds by
investment objective.
ACTION ITEM
I can identify the types of
mutual funds that will help
me achieve my investment
goals.
h Yes h No
10 The Vanguard Group website at www.vanguard.com , accessed May 22, 2014.
did you know? did you know?
The figures below represent the percentage
of types of funds chosen by U.S. investors to
attain their financial goals.
SOURCE: The Investment Company Institute (www.ici.org),
accessed May 22, 2014.
0 10 20 30 40 50
Money market
funds
Bond funds
World equity
funds
Domestic equity
funds
18%
22%
14%
38%
Hybrid funds 8%
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432 Chapter 13 Investing in Mutual Funds
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• Large-cap funds invest in the stocks of companies with total
capitalization of $10 billion or more. Large-capitalization
stocks are generally stable, well-established companies and
are likely to have minimal fluctuation in their value.
• Midcap funds invest in companies with total capitalization
of $2 billion to $10 billion whose stocks offer more security
than small-cap funds and more growth potential than funds
that invest in large corporations.
• Regional funds seek to invest in stock traded within one
specific region of the world, such as the European region,
the Latin American region, and the Pacific region.
• Sector funds invest in companies within the same industry.
Examples of sectors include Health and Biotech, Science &
Technology, and Natural Resources.
• Small-cap funds invest in smaller, lesser-known companies
with a total capitalization of between $300 million and
$2 billion. Because these companies are small and
innovative, these funds offer higher growth potential. They
are more speculative than funds that invest in larger, more
established companies.
• Socially responsible funds avoid investing in companies that may cause harm
to people, animals, and the environment. Typically, these funds do not invest in
companies that produce tobacco, nuclear energy, or weapons or in companies
that have a history of discrimination. These funds invest in companies that have a
history of making ethical decisions, establishing efforts to reduce pollution, and
other socially responsible activities.
Bond Funds
• High-yield (junk) bond funds invest in high-yield, high-risk corporate bonds.
• Intermediate corporate bond funds invest in investment-grade corporate debt with
maturities between 5 and 10 years.
• Intermediate U.S. government bond funds invest in U.S. Treasury securities with
maturities between 5 and 10 years.
• Long-term corporate bond funds invest in investment-grade corporate bond issues
with maturities in excess of 10 years.
• Long-term (U.S.) government bond funds invest in U.S. Treasury securities with
maturities in excess of 10 years.
• Municipal bond funds invest in municipal bonds that provide investors with tax-free
interest income.
• Short-term corporate bond funds invest in investment-grade corporate bond issues
with maturities that are less than 5 years.
• Short-term (U.S.) government bond funds invest in U.S. Treasury issues with
maturities that are less than 5 years.
• World bond funds invest in bonds and other debt securities offered by foreign
companies and governments.
Other Funds
• Asset allocation funds invest in different types of investments, including stocks,
bonds, fixed-income securities, and money market instruments. These funds seek
high total return by maintaining precise amounts within each type of asset.
• Balanced funds invest in both stocks and bonds with the primary objectives of
conserving principal, providing income, and providing long-term growth. Often the
percentage of stocks, bonds, and other securities is stated in the fund’s prospectus.
did you know? did you know?
Socially responsible investing Socially responsible investing
(SRI) is becoming more popular because . . . (SRI) is becoming more popular because . . .
• Today there are almost 150 SRI funds. • Today there are almost 150 SRI funds.
• Often SRI funds outperform traditional • Often SRI funds outperform traditional
funds. funds.
• SRI funds help you align your invest- • SRI funds help you align your invest-
ments with your personal values. ments with your personal values.
For more information on socially responsi- For more information on socially responsi-
ble and ethical investing, go to the US SIF ble and ethical investing, go to the US SIF
website at website at www.ussif.orgwww.ussif.org . .
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CAUTION! CAUTION!
Although some employers reduced or elimi-
nated matching provisions during the recent
economic crisis, some employers still match
employee contributions. In fact, during a job
interview you may want to ask about the
employer’s matching provisions for a 401(k) or
403(b) retirement account.
Chapter 13 Investing in Mutual Funds 433
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• Fund of funds invest in shares of other mutual funds. The main advantage of a
fund of funds is increased diversification and asset allocation, because this type of
fund purchases shares in many different funds. Higher expenses and extra fees are
common with this type of fund.
• Lifecycle funds (sometimes referred to as lifestyle funds or target-date funds ) are
popular with investors planning for retirement by a specific date. Typically, these
funds initially invest in risk-oriented securities (stocks) and become increasingly
conservative and income oriented (bonds and CDs) as the specified date approaches
and investors are closer to retirement.
• Money market funds invest in certificates of deposit, government securities, and
other safe and highly liquid investments.
A family of funds exists when one investment company manages a group of mutual funds.
Each fund within the family has a different financial objective. For instance, one fund may
be a long-term government bond fund and another a growth stock fund. Most investment
companies offer exchange privileges that enable shareholders to switch among the mutual
funds in a fund family. For example, if you own shares in the Franklin Biotechnology Dis-
covery Fund, you may, at your discretion, switch to the Franklin Balance Sheet Investment
Fund. Generally, investors may give instructions to switch from one fund to another within
the same family in writing, over the telephone, or via the Internet. The family-of-funds con-
cept allows shareholders to conveniently switch their investments among funds as different
funds offer more potential, financial reward, or security. Charges for exchanges, if any,
generally are small for each transaction. For funds that do charge, the fee may be as low as
$5 per transaction.
Choosing the Right Fund for a Retirement Account
Assume you have just secured a new job, and your new employer offers you the opportu-
nity to participate in the company’s 401(k) or 403(b) retirement plan. In this situation, you
must weigh at least three considerations that can affect your financial future.
1. Do you want to participate in the retirement account? The answer to this question
is a definite “yes” for two reasons. The reasons are simple: Employer-sponsored
retirement accounts—as explained in the next chapter—provide a way to reduce
the amount of current income tax that is withheld from your paycheck. So there
are immediate tax savings. A second reason for participating in a retirement plan
is because many employers will match your contributions. A common match
would work like this: For every $1.00 the employee contributes, the employer
contributes an additional $0.50. All monies—both the employee’s and employer’s
contributions—are then invested in mutual funds that are selected by the employee.
2. Which mutual funds do you want to invest in? Most retirement plans allow you to
choose the mutual funds for your plan from a number of different fund options.
When making your choices keep in mind your long-term goals and the time value
of money concept that was discussed in Chapter 1. The time
value of money concept is especially important because the
investments in your plan will grow because you (and your
employer) continue to contribute money to your retirement
account and quality investments should increase in value
over a long period of time.
3. What is your stage in life? The actual choice of investments
for your retirement account should be determined by your
age, how long before you retire, and your tolerance for risk.
Typically, younger workers choose more risk-oriented funds
that have greater potential for growth over a long period
of time. Older workers closer to retirement tend to choose
more conservative funds with less risk.
family of funds A group
of mutual funds managed by
one investment company.
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434
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F
R
O
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T
H
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P
A
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S
O
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.
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F
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SOURCE: Reprinted by permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. What are the primary reasons why employers are attempting to reduce the fees that employees pay to par-
ticipate in an employer-sponsored 401(k) retirement plan?
2. The survey conducted by Aon Hewitt found a big increase in the number of employer-sponsored plans that
offer “institutional class” funds. Based on the information in this Kiplinger article, what are the advantages
of shares in an institutional class fund for employers?
3. Assume you are an employee leaving your job. Should you keep your money in your former employer’s
employer-sponsored 401(k) retirement plan or roll it into an IRA? Explain your answer.
A
n Aon Hewitt
survey found
that more than
75% of employ-
ers had attempted to cut
401(k) expenses in the past
two years. What’s behind
the trend? The Department of
Labor’s fee disclosure require-
ment shone a spotlight on fees
for a lot of employers, and it
has made more people aware
of what they’re paying for. A
second motivation is employ-
ers’ legal obligation to act in
their employees’ best interest,
known as their fiduciary duty.
Employers want to make sure
they provide the best invest-
ments at the best price.
The survey also found a
big increase in the number
of plans that offer “institu-
tional class” funds. Why?
Employers can use their pur-
chasing power to invest in
funds used by professionals
that are not broadly available
to individual investors outside
of 401(k) plans. Ultimately,
the funds can provide better
returns and lower fees.
More companies are
charging a record-keeping
fee instead of a fee based on
a percentage of assets. How
does that benefit employees?
When employees are charged
a flat rate of $50 a year, a typ-
ical participant with a starting
salary of $75,000 ends up with
$200,000 more in retirement
than he or she would have had
if a yearly fee of as little as
0.25% of assets were imposed.
A flat fee is a little more equita-
ble, too. Whether a person has a
balance of $100 or $100,000, he
or she has access to the same
technology, the same phone
lines. Why should the employee
who has more money pay more
for those tools and resources?
Are employees who leave
their jobs better off keep-
ing their money in their
former employer’s 401(k),
rather than rolling it into
an IRA? That can be a good
idea for a number of reasons.
You have investment prod-
ucts that have lower fees.
You also have the power of
fiduciary responsibility through
an employer plan that you
wouldn’t have in a typical retail
IRA. In an employer plan,
there are people who have to
monitor these funds to make
sure that fees are competitive
and returns are good.
What should employees
do if they’re dissatisfied
with their 401(k)? Do a lit-
tle legwork to make sure your
employer is choosing the right
funds. Plan administrators who
are doing the right thing and
have documented why they’re
choosing the funds on their
menu have no reason to fear.
But if they can’t say for sure
why they’ve chosen particular
funds, then that makes for a
difficult conversation.
Sandra Block
Employers Trim Their 401(k) Fees
Lower expenses and cheaper share classes are good news for workers
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Chapter 13 Investing in Mutual Funds 435
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Regardless of the type of funds you choose for your retirement plan, it is important to
evaluate each fund before making your choices. The information in the next section will
help you choose the right funds. Once your choices are made, it is also important to con-
tinue to monitor each of your funds to determine if you are on the right track to achieve
your financial objectives.
PRACTICE QUIZ 13–2 PRACTICE QUIZ 13–2
1. How important is the investment objective as stated in a mutual fund’s prospectus?
2. Identify one mutual fund in each of the three categories (stocks, bonds, and other) and describe the characteristics
of the fund you select and the type of investor who would invest in that type of fund.
General Fund Type Fund Name Characteristics of Fund Typical Investor
Stock
Bond
Other
3. How can choosing the right fund help you save for retirement?
Apply Yourself! Apply Yourself!
Using the information in this section, pick a type of mutual fund that you consider suitable for each of the following
investors and justify your choice:
1. A 24-year-old single investor with a new job that pays $32,000 a year.
2. A single parent with two children who has just received a $400,000 inheritance, has no job, and has not worked out-
side the home for the past five years.
3. A husband and wife who are both in their mid-60s and retired.
How to Make a Decision to Buy or Sell
Mutual Funds
Often the decision to buy or sell shares in mutual funds is “too easy” because investors
assume they do not need to evaluate these investments. Why question what the profes-
sional portfolio managers decide to do? Yet professionals do make mistakes. And, some-
times, economic and financial conditions beyond the control of a fund manager cause a
fund’s value to decrease. And yet you should realize that the responsibility for choosing the
right mutual fund rests with you.
Fortunately, a lot of information is available to help you evaluate a specific mutual fund.
To help you sort out all the research, statistics, and information about mutual funds and
give you some direction as to what to do first, read the suggestions in the nearby “Personal
Finance in Practice” box. Then answer one basic question: Do you want a managed fund
or an index fund?
LO13.3
Evaluate mutual funds.
ACTION ITEM
I know how to evaluate a
mutual fund.
h Yes h No
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4. Find a fund with an objective that matches your objective.
Financial publications, professional advisory services, and
personal finance magazines may help you identify funds
with objectives that match your investment objectives.
5. Evaluate, evaluate, and evaluate any mutual fund before
buying or selling. Possible sources of information
include the Internet, professional advisory services, the
fund’s prospectus, the fund’s annual report, financial
publications, and newspapers—all sources described
in the remainder of this section.
6. Continue to evaluate your funds after your investment.
Evaluate your investments on a regular basis. If necessary,
sell funds that no longer are helping you achieve your
financial objectives or that you think will decrease in value.
Here are some suggestions for beginning a mutual fund
investment program.
1. Perform a financial checkup. Before investing, you
should make sure your budget is balanced and you
have established an emergency fund.
2. Obtain the money you need to purchase mutual funds.
Although the amount will vary, $250 to $2,000 is usually
required to open an account with a brokerage firm or
an investment company.
3. Determine your investment objectives. Without invest-
ment objectives, you cannot know what you want to
accomplish. For more information on the importance of
objectives, review the material in Chapter 11.
Mutual Funds: Getting Started
Personal Finance in Practice
Managed Funds versus Index Funds
Most mutual funds are managed funds. In other words, there is a professional fund manager
(or team of managers) who chooses the securities that are contained in the fund. The fund
manager also decides when to buy and sell securities in the fund. To help evaluate a fund,
you may want to determine how well a fund manager manages during both good and bad
economic times. The benchmark for a good fund manager is the ability to increase share
value when the economy is good and retain that value when the economy is bad. For exam-
ple, most funds increased in value in the years after the recent economic crisis. Many funds
provided investors with a 10, 20, or 30 percent or higher annual return. And yet the question
remains whether these same funds can retain their value when there is another economic
crisis. One important consideration is how long the present fund
manager has been managing the fund. If a fund has performed well
under its present manager over a 5-year, 10-year, or longer period,
there is a strong likelihood that it will continue to perform well
under that manager in the future. On the other hand, if the fund has a
new manager, his or her decisions may affect the performance of the
fund. Managed funds may be open-end funds or closed-end funds.
Instead of investing in a managed fund, some investors choose to invest in an index
fund. Why? The answer to that question is simple: Over many years, the majority of man-
aged mutual funds fail to outperform the Standard & Poor’s 500 stock index—a bench-
mark of stock market performance often reported on financial news programs. The exact
statistics vary, depending on the year, but a common statistic often found in mutual fund
research is that the Standard & Poor’s 500 stock index outperforms 50 to 80 percent of all
mutual funds. 11
Because an index mutual fund is a mirror image of a specific index like the Standard &
Poor’s 500, the Nasdaq Composite, the Wilshire 5000 Total Market, or similar indexes, the
dollar value of a share in an index fund also increases when the index increases. Unfortu-
nately, the reverse is also true. If the index goes down, the value of a share in an index fund
goes down. Index funds, sometimes called “passive” funds, have managers, but they simply
buy the stocks or bonds or securities contained in the index.
11 “Index Investing: Index Funds,” Investopedia ( www.investopedia.com ), accessed May 26, 2014.
CAUTION! CAUTION!
Don’t forget the role of the fund manager in
determining a fund’s success.
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A second and very important reason why investors choose index funds is the lower
expense ratio charged by these passively managed funds. As mentioned earlier in this chap-
ter, the total fees charged by a mutual fund is called the expense ratio. If a fund’s expense
ratio is 1.25 percent, then the fund has to earn at least that amount on its investment hold-
ings just to break even each year. With very few exceptions, typical expense ratios for
an index fund are 0.50 percent or less. And while lower fees may not sound significant,
don’t be fooled. Over a long period of time, even a small difference can become huge. For
example, assume two different investors each invest $10,000. One investor chooses an
index fund that has annual expenses of 0.20 percent; the other chooses a managed fund
that has annual expenses of 1.22 percent. Both funds earn 10 percent a year. After 35 years,
the index fund is worth $263,683 while the managed fund is worth $190,203. That’s a
difference of $73,480. Thus, even though the two funds earned the same 10 percent a year,
the difference in annual expenses made a substantial difference in the amount of money
each investor had at the end of 35 years. 12 Index funds may be open-end funds, closed-end
funds, or exchange-traded funds.
Should you choose a managed fund or an index fund? Good question. The answer
depends on which managed fund you choose. If you pick a managed fund that has better
performance than an index, then you made the right choice. If, on the other hand, the
index (and the index fund) outperforms the managed fund—which happens as often as 50
to 80 percent of the time—an index fund is a better choice. With both investments, the key
is how well you can research a specific investment alternative using the sources of infor-
mation that are described in the remainder of this section.
The Internet
Many investors have found a wealth of information about mutual fund investments on the
Internet. Basically, you can access information three ways. First, you can obtain current
market values for mutual funds by using one of the Internet search engines, such as Yahoo!
The Yahoo! Finance page ( finance.yahoo.com ) has a box where you can enter the symbol
of the mutual fund you want to research. If you don’t know the symbol, you can enter in
the name of the mutual fund in the Quote Lookup box. The Yahoo! Finance website will
respond with the correct symbol. In addition to current market values, you can obtain a
price history for a mutual fund, a profile including information about current holdings,
performance data, risk, and purchase information.
Second, most investment companies that sponsor mutual funds have a web page. To
obtain information, all you have to do is access one of the Internet search engines and
type in the name of the fund or enter the investment company’s Internet address (URL) in
your computer. Generally, statistical information about performance of individual funds,
procedures for opening an account, promotional literature, and different investor services
are provided. Be warned: Investment companies want you to become a shareholder. As a
result, the websites for some investment companies read like a sales pitch. Read between
the glowing descriptions and look at the facts before investing your money.
Finally, professional advisory services, covered in the next section, offer online research
reports for mutual funds. A sample of the information available from the Morningstar web-
site for the T. Rowe Price Value Fund is illustrated in Exhibit 13–4. Note that information
about the fund symbol, Morningstar Risk Measures, and past growth record is provided. In
many cases, more detailed information is provided by professional advisory services like
Morningstar, Inc. ( www.morningstar.com ) and Lipper Analytical Services, Inc. ( www.lip-
perweb.com ) for a small fee for premium services. While the information available on the
Internet is basically the same as that in the printed reports described later in this section,
the ability to obtain up-to-date information quickly without having to wait for research
materials to be mailed or to make a trip to the library is a real selling point.
12 Bankrate.com, “Index Funds vs. Actively Managed Funds” ( www.bankrate.com ), accessed January 21, 2012.
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Professional Advisory Services
As pointed out in the last section, a number of subscription services provide detailed infor-
mation on mutual funds. Lipper Analytical Services, Morningstar, Inc., and Value Line are
three widely used sources of such information. Exhibit 13–5 illustrates the type of infor-
mation provided by Morningstar, Inc., for the Oakmark Global Select I Fund. Although the
Morningstar report is just one page long, it provides a wealth of information designed to
Exhibit 13–4 Information about the T. Rowe Price Value Fund Available from the Morningstar Website
SOURCE: Morningstar, Inc. ( www.morningstar.com ), accessed May 26, 2014. Morningstar, Inc., 225 W. Wacker Drive, Chicago, IL 60606.
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Exhibit 13–5 Mutual Fund Research Information for the Oakmark Global Select I Fund Provided by
Morningstar, Inc.
SOURCE: Morningstar Mutual Funds, February 2014, Morningstar, Inc., 225 W. Wacker Drive, Chicago, IL 60606.
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help you decide if this is the right fund for you. Notice that the
information is divided into various sections. At the top, a small
box entitled “Historical Profile” contains information about
financial return, risk, and rating. Notice that this Oakmark fund
is rated five stars, Morningstar’s highest rating. The report also
provides historical financial and statistical information toward
the top of the page. The middle section of the report provides
information about the fund’s performance, risk, and portfolio
analysis. In the last section at the very bottom, the “Morning-
star’s Take” section summarizes the analyst’s research.
As you can see, the research information for this fund is
pretty upbeat. However, other research firms like Lipper Ana-
lytical Services and Value Line, as well as Morningstar, Inc.,
will also tell you if a fund is a poor performer that offers poor
investment potential.
In addition, various mutual fund newsletters provide finan-
cial information to subscribers for a fee. All of these sources are
rather expensive, but their reports may be available from broker-
age firms or libraries.
The Mutual Fund Prospectus and
Annual Report
An investment company sponsoring a mutual fund must give potential investors a prospec-
tus. You can also request a prospectus by mail, by calling a toll-free phone number, or by
accessing the investment company website.
According to financial experts, the prospectus is usually the first piece of information
investors receive, and they should read it completely before investing. Although it may
look foreboding, a commonsense approach to reading a fund’s prospectus can provide
valuable insights. In addition to information about objectives and fees, the prospectus
should provide the following:
• A statement describing the risk factor associated with the fund.
• A description of the fund’s past performance.
• A statement describing the type of investments contained in the fund’s portfolio.
• Information about dividends, distributions, and taxes.
• Information about the fund’s management.
• Information on limitations or requirements, if any, the fund must honor when
choosing investments.
• The process investors can use to buy or sell shares in the fund.
• A description of services provided to investors and fees for services, if any.
• Information about how often the fund’s investment portfolio changes (sometimes
referred to as its turnover ratio ).
Finally, the prospectus provides information about how to open a mutual fund account
with the investment company.
If you are a prospective investor, you can request an annual report by mail or by calling
a toll-free telephone number, or you can view it on the Internet. Once you are a share-
holder, the investment company will send you an annual report. A fund’s annual report
contains a letter from the president of the investment company, from the fund manager,
or both. The annual report also contains detailed financial information about the fund’s
assets and liabilities, performance, statement of operations, and statement of changes in
net assets. Next, the annual report includes a schedule of investments. Finally, the fund’s
annual report should include a letter from the fund’s independent auditors that provides an
opinion as to the accuracy of the fund’s financial statements.
did you know? did you know?
Morningstar’s “Star” Ratings
Morningstar rates mutual funds from one (the
lowest rating) to five (the highest rating) stars on
how well they’ve performed in comparison to similar
funds. Within each Morningstar category, only the top
10 percent of funds receive the five-star rating. And
the bottom 10 percent of all funds receive the one-
star rating. All the other funds within each category
are given ratings of two, three, or four stars depending
on past performance.
SOURCE: Morningstar, Inc. ( www.morningstar.com ), accessed
May 20, 2014.
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Financial Publications and Newspapers
Investment-oriented magazines like Bloomberg Businessweek, Forbes, Kiplinger’s Personal
Finance, and Money are excellent sources of information about mutual funds. Depending
on the publication, coverage ranges from detailed articles that provide in-depth information
to simple listings of which funds to buy or sell. And many investment-oriented magazines
now provide information on the Internet about mutual funds. The material in Exhibit 13–6
was obtained from the Kiplinger website, and is a partial listing of 25 different funds that
were recommended in the Kiplinger 2014 retirement guide. Information is provided about
its choices for best funds and ETFs and includes:
• The fund name and symbol.
• The fund’s one-year return.
• The fund’s five-year return.
• The fund’s expense ratio.
• A description of the fund.
In addition to mutual fund information in financial publications, a number of mutual
fund guidebooks are available at your local bookstore or public library.
Although many newspapers have reduced or eliminated mutual fund coverage, many
large metropolitan newspapers and The Wall Street Journal often provide news and
KIPLINGER 25
U.S. Stock Funds 1-Yr. Return 5-Yr. Return Expense Ratio Description
Akre Focus (AKREX) 33.5% — 1.36% Chuck Akre invests in high-quality firms run by
smart executives.
Artisan Value (ARTLX) 18.6 22.5% 1.04 Large, out-of-favor, bargain-priced companies
find a home here.
Baron Small Cap (BSCFX) 29.7 25.9 1.31 Fund favors undervalued, steady growers with a
competitive edge.
Davenport Equity Opportunities
(DEOPX)
26.5 — 1.01 Managers like growing midsize firms run by
execs who act like owners.
Dodge & Cox Stock (DODGX) 32.9 25.9 0.52 Nine managers are value investors who go
where others fear to tread.
Homestead Small Co Stock
(HSCSX)
28.9 31.5 0.91 Seeks small, out-of-favor companies poised to
turn around.
Mairs & Power Growth (MPGFX) 25.8 24.8 0.67 Managers look for attractively priced, growing
large companies.
Fidelity New Millennium (FMILX) 34.2 27.5 0.87 Portfolio holds a mix of large and small, old and
new companies.
T. Rowe Price Sm-Cap Value
(PRSVX)
24.7 25.7 0.81 The manager prizes unloved and undervalued
small companies.
Vanguard Dividend Growth
(VDIGX)
23.3 20.4 0.29 Reliable companies with rising dividends offer
growth and stability.
Vanguard Selected Value
(VASVX)
33.1 26.2 0.43 Two separate management teams buy underval-
ued midsize firms.
Wells Fargo Advantage
Discovery (STDIX)
36.1 29.1 1.28 The fund targets midsize firms with rapid
profit growth.
SOURCE: Nellie S. Huang, “Three Plans to Help You Reach Your Goals,” Kiplinger Retirement Planning 2014, the Kiplinger website ( www.kiplinger.com ),
accessed May 25, 2014.
Exhibit 13–6 Information about Funds Recommended in the 2014 Kiplinger Retirement Guide
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information about mutual funds. Typical coverage includes information about the name of
the fund family and fund name, the current net asset value for a fund, net change, and year-
to-date percentage of return. Much of this same information (along with more detailed
information) is also available on the Internet.
PRACTICE QUIZ 13–3 PRACTICE QUIZ 13–3
1. In your own words, describe the difference between a managed fund and an index fund. Which one do you think
could help you achieve your investment goals?
2. Describe how each of the following sources of investment information could help you evaluate a mutual fund
investment.
Source of Information Type of Information How This Could Help
The Internet
Professional advisory services
Mutual fund prospectus
Mutual fund annual report
Financial publications
Newspapers
Apply Yourself! Apply Yourself!
Choose the Alger International Growth Fund (symbol ALGAX), the Gabelli Asset Fund (symbol GATAX), or the Calvert
Long-Term Income Fund (symbol CLDAX) and use the Internet or library sources to report the type of fund, one-year
return, net asset value, and Morningstar rating for the fund. Hint: You may want to use the Yahoo! Finance website at
finance.yahoo.com or the MSN Money website at money.msn.com .
Sheet 40 Evaluating Mutual Fund
Investment Information
Sheet 41 Mutual Fund Evaluation
S
I
S
The Mechanics of a Mutual Fund
Transaction
For many investors, mutual funds have become the investment of choice. In fact, you prob-
ably either own shares or know someone who owns shares in a mutual fund—they’re that
popular! They may be part of a 401(k) or 403(b) retirement account, a SEP IRA, a Roth
IRA, or a traditional IRA retirement account, all topics discussed in Chapter 14. They can
also be owned outright in a taxable account by purchasing shares through a registered
sales representative who works for a bank or brokerage firm or an investment company
that sponsors a mutual fund. Although there are exceptions, most individuals invest in
mutual funds to achieve long-term financial objectives. When you invest your money, you
are counting on the time value of money concept to help build your nest egg. Remember
that in Chapter 1 time value of money was defined as the increases in an amount of money
as a result of interest earned. For example, saving or investing $2,000 instead of spending
it today results in a future amount greater than $2,000. If the $2,000 is used to purchase
shares in a fund, your shares can increase in value and you can also receive income from
LO13.4
Describe how and why
mutual funds are bought
and sold.
ACTION ITEM
I am aware of the purchase
and withdrawal options for a
mutual fund.
h Yes h No
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your investment that can be reinvested to purchase more shares. As you will see later in this
section, it’s easy to purchase shares in a mutual fund. For $250 to $2,000 or more, you can
open an account and begin investing. And there are other advantages that encourage inves-
tors to purchase shares in funds. Unfortunately, there are also disadvantages. Exhibit 13–7
summarizes the advantages and disadvantages of fund investments.
One advantage of any investment is the opportunity to make money on the investment.
In this section, we examine how you can make money by investing in funds. We consider
how taxes affect your fund investments. Then we look at the options used to purchase
shares in a fund. Finally, we examine the options used to withdraw money from a fund.
Return on Investment
As with other investments, the purpose of investing in a closed-end fund, exchange-traded
fund, or open-end fund is to earn a financial return. Shareholders in such funds can receive
a return in one of three ways. First, all three types of funds pay income dividends. Income
dividends are the earnings a fund pays to shareholders from its dividend and interest
income. Note: Many exchange-traded funds often pay dividends on a monthly or quarterly
basis. Second, investors may receive capital gain distributions. Capital gain distributions
are the payments made to a fund’s shareholders that result from the sale of securities in the
fund’s portfolio. Both amounts generally are paid once a year. Note: The majority of
exchange-traded funds don’t usually pay end-of-the-year capital gain distributions. Third,
as with stock and bond investments, you can buy shares in funds at a low price and then
sell them after the price has increased. For example, assume you purchased shares in the
Fidelity Stock Selector All Cap Fund at $31.00 per share and sold your shares two years
later at $35.50 per share. In this case, you made $4.50 ($35.50 selling price minus $31.00
purchase price) per share. With this financial information and the dollar amounts for
income dividends The
earnings a fund pays to
shareholders from its
dividend and interest income.
capital gain distributions
The payments made to
a fund’s shareholders
that result from the sale
of securities in the fund’s
portfolio.
Advantages
• Diversification.
• Professional management.
• Ease of buying and selling shares.
• Multiple withdrawal options.
• Distribution or reinvestment of dividends and capital gain distributions.
• Switching privileges within the same fund family.
• Services that include toll-free telephone numbers, complete records of all transactions, and
savings and checking accounts.
Disadvantages
• Purchase/withdrawal costs.
• Ongoing management fees and 12b-1 fees.
• Poor performance that may not match the Standard & Poor’s 500 stock index or some
other index.
• Inability to control when capital gain distributions occur and complicated tax reporting issues.
• Potential market risk associated with all investments.
• Some sales personnel are aggressive and/or unethical.
Exhibit 13–7
Advantages and
Disadvantages of
Investing in Mutual
Funds
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Percent of
total return
5
Dollar amount of total return
_____________________________
Original cost of your investment
5
$170
_______
$1,220
5 0.139 5 13.9%
Now it’s your turn. Use the following financial informa-
tion for the Northeast Utility Fund to calculate the dollar
amount of total return and percent of total return over a
12-month period.
Number of shares, 100
Purchase price, $14.00 a share
Income dividends, $0.30 a share
Capital gain distribution, $0.60 a share
Sale price, $15.25 a share
Calculation
Calculation
Formula Your Answer
Dollar
amount of
total return
Percent of
total return
In Chapter 12, we defined total return as a calculation that
includes not only the yearly dollar amount of income but
also any increase or decrease in market value. For mutual
funds, you can use the following calculation to determine
the dollar amount of total return:
Income dividends
1 Capital gain distributions
1 Change in share price when sold
Dollar amount of total return
For example, assume you purchased 100 shares of
Majestic Growth Fund for $12.20 per share for a total
investment of $1,220. During the next 12 months, you
received income dividends of $0.20 a share and capital gain
distributions of $0.30 a share. Also, assume you sold your
investment at the end of 12 months for $13.40 a share. As
illustrated below, the dollar amount of total return is $170:
Income dividends 5 100 3 $0.20 5 $ 20
Capital gain distributions 5 100 3 $0.30 5 1 30
Change in share price 5 $13.40 2 $12.20
5 $1.20 3 100 5 1 120
Dollar amount of total return $ 170
To calculate the percentage of total return, divide the dollar
amount of total return by the original cost of your mutual
fund investment. The percentage of total return for the
above example is 13.9 percent, as follows:
Calculating Total Return for Mutual Funds Calculating Total Return for Mutual Funds
Figure It Out!
income dividends and capital gain distributions, you can calculate a total return for your
mutual fund investment. Before completing this section, you may want to examine the
actual procedure used to calculate the dollar amount of total return and percentage of total
return in the nearby “Figure It Out!” box.
When shares in a fund are sold, the profit that results from an increase in value is
referred to as a capital gain. Note the difference between a capital gain distribution and a
capital gain. A capital gain distribution occurs when the fund distributes profits that result
from the fund selling securities in the portfolio at a profit. On the other hand, a capital gain
is the profit that results when you sell your shares in the mutual fund for more than you
paid for them. Of course, if the price of a fund’s shares goes down between the time of
your purchase and the time of sale, you incur a capital loss.
Taxes and Mutual Funds
Taxes on reinvested income dividends, capital gain distributions, and profits from the sale
of shares can be deferred if fund investments are held in your retirement account. Assum-
ing all qualifications are met, you can even eliminate taxes on reinvested income, capital
gain distributions, and profits from the sale of shares for funds held in a Roth individual
retirement account. For mutual funds held in taxable accounts, income dividends, capital
ANSWERS: The total return is $215 and the percent of total return is 15.4%.
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gain distributions, and financial gains and losses from the sale of
funds are subject to taxation. At the end of each year, investment
companies are required to send each shareholder a statement
specifying how much he or she received in income dividends
and capital gain distributions. Although investment companies
may provide this information as part of their year-end statement,
most funds also use IRS Form 1099 DIV. The following infor-
mation provides general guidelines on how mutual fund transac-
tions are taxed when held in a taxable account:
• Income dividends are reported on your federal tax return
and are taxed as income.
• Capital gain distributions that result from the fund selling
securities in the fund’s portfolio at a profit are reported
on your federal tax return. Capital gain distributions are
taxed as long-term capital gains regardless of how long
you own shares in the fund. 13
• Capital gains or losses that result from your selling shares
in a mutual fund are reported on your federal tax return.
How long you hold the shares determines if your gains or
losses are taxed as a short-term or long-term capital gain.
(See Chapter 3 for more information on capital gains and
capital losses, or visit the IRS website at www.irs.gov .)
Two specific problems develop with taxation of mutual
funds. First, almost all investment companies allow you to reinvest income dividends and
capital gain distributions from the fund to purchase additional shares instead of receiving
cash. Even though you didn’t receive cash because you chose to reinvest such distributions,
they are still taxable and must be reported on your federal tax return as current income.
Second, when you purchase shares of stock, corporate bonds, or other investments, you
decide when you sell. Thus, you can pick the tax year when you pay tax on capital gains or
deduct capital losses. Mutual funds, on the other hand, buy and sell securities within the
fund’s portfolio on a regular basis during any 12-month period. At the end of the year,
profits that result from the mutual fund’s buying and selling activities are paid to share-
holders in the form of capital gain distributions. Unlike the investments you manage, you
have no control over when the mutual fund sells securities and when you will be taxed on
capital gain distributions. Because capital gain distributions are taxable, one factor to con-
sider when choosing a mutual fund is its turnover. For a mutual fund, the turnover ratio
measures the percentage of a fund’s holdings that have changed or “been replaced” during
a 12-month period of time. Simply put, it is a measure of a fund’s trading activity. Caution: A
mutual fund with a high turnover ratio can result in higher income tax bills. A higher turnover
ratio can also result in higher transaction costs and fund expenses.
To ensure having all of the documentation you need for tax reporting purposes, it is
essential that you keep accurate records. The same records will help you monitor the value
of your fund investments and make more intelligent decisions with regard to buying and
selling these investments.
Purchase Options
You can buy shares of a closed-end fund or exchange-traded fund through a stock exchange or
in the over-the-counter market. You can purchase shares of an open-end, no-load fund by con-
tacting the investment company that manages the fund. You can purchase shares of an open-
end load fund through a salesperson who is authorized to sell them, or through an account
executive of a brokerage firm or directly from the investment company that sponsors the fund.
13“Dividends and Other Distributions,” Internal Revenue Service ( www.irs.gov ), accessed May 24, 2014.
turnover ratio A ratio that
measures the percentage of
a fund’s holdings that have
changed or “been replaced”
during a 12-month period
of time.
did you know? did you know?
CHARACTERISTICS OF MUTUAL
FUND OWNERS
56.7 million The number of U.S. households
that own mutual funds
92 percent The percentage of shareholders
who are saving for retirement
51 percent The percentage of shareholders
who are saving for emergencies
47 percent The percentage of shareholders
who own funds to reduce taxable
income
25 percent The percentage of shareholders
who are saving for education
SOURCE: The Investment Company Institute ( www.ici.org ),
accessed May 23, 2014.
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You can also purchase both no-load and load funds from mutual fund supermarkets
available through most brokerage firms. A mutual fund supermarket like Fidelity, Charles
Schwab, or TD Ameritrade offers at least two advantages. First, instead of dealing with
numerous investment companies that sponsor funds, you can make one toll-free phone call
or use the Internet to obtain information, purchase shares, and sell shares in a large number
of mutual funds. Second, you receive one statement from one brokerage firm instead of
receiving a statement from each investment company or brokerage firm you deal with. One
statement can be a real plus because it provides the information you need to monitor the
value of your investments in one place and in the same format.
Because of the unique nature of open-end fund transactions, we will examine how
investors buy and sell shares in this type of mutual fund. To purchase shares in an open-end
mutual fund, you may use four options:
• Regular account transactions.
• Voluntary savings plans.
• Contractual savings plans.
• Reinvestment plans.
The most popular and least complicated method of purchasing shares in an open-end
fund is through a regular account transaction. When you use a regular account transaction,
you decide how much money you want to invest and when you want to invest, and then you
simply buy as many shares as possible.
The chief advantage of the voluntary savings plan is that it allows you to make smaller pur-
chases than the minimum purchases required by the regular account method described above.
At the time of the initial purchase, you declare an intent to make regular minimum purchases
of the fund’s shares. Although there is no penalty for not making purchases, most investors feel
an “obligation” to make purchases on a periodic basis, and, as pointed out throughout this text,
small monthly investments are a great way to save for long-term objectives. For most volun-
tary savings plans, the minimum purchase ranges from $25 to $100 for each purchase after the
initial investment. Funds try to make investing as easy as possible. Most offer payroll deduc-
tion plans, and many will deduct, upon proper shareholder authorization, a specified amount
from a shareholder’s bank account. Also, many investors can choose voluntary savings plans
as a vehicle to invest money contributed to a 401(k), 403(b), or individual retirement account.
Not as popular as they once were, contractual savings plans (sometimes referred to as
periodic payment plans) require you to make regular purchases over a specified period of
time, usually 10 to 15 years. These plans are sometimes referred to as front-end load plans
because almost all of the commissions are paid in the first few years of the contract period.
Also, you may incur penalties if you do not fulfill the purchase requirements. For example,
if you drop out of a contractual savings plan before completing the purchase requirements,
you sacrifice the prepaid commissions. In some cases, contractual savings plans combine
mutual fund shares and life insurance to make these plans more attractive. Many financial
experts and government regulatory agencies are critical of contractual savings plans. As a
result, the Securities and Exchange Commission and many states have imposed new rules
on investment companies offering contractual savings plans.
You may also purchase shares in an open-end fund by using the fund’s reinvestment
plan. A reinvestment plan is a service provided by an investment company in which income
dividends and capital gain distributions are automatically reinvested to purchase additional
shares of the fund. Most reinvestment plans allow shareholders to use reinvested money to
purchase shares without having to pay additional sales charges or commissions. Reminder:
When your dividends or capital gain distributions are reinvested, you must still report these
transactions as taxable income.
All four purchase options allow you to buy shares over a long period of time. As a result,
you can use the principle of dollar cost averaging, which was explained in Chapter 12.
Dollar cost averaging allows you to average many individual purchase prices over a long
period of time. This method helps you avoid the problem of buying high and selling low.
With dollar cost averaging, you can make money if you sell your fund shares at a price
higher than their average purchase price.
reinvestment plan A
service provided by an
investment company in
which shareholder income
dividends and capital gain
distributions are automatically
reinvested to purchase
additional shares of the fund.
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Withdrawal Options
Because closed-end funds and exchange-traded funds are listed on stock exchanges or
traded in the over-the-counter market, an investor may sell shares in such a fund to another
investor. Shares in an open-end fund can be sold on any business day to the investment
company that sponsors the fund. In this case, the shares are redeemed at their net asset
value. All you have to do is give proper notification and the fund will send you a check.
With some funds, you can even write checks to withdraw money from the fund.
In addition, most funds have provisions that allow investors with shares that have a min-
imum asset value (usually at least $5,000) to use four options to systematically withdraw
money. First, you may withdraw a specified, fixed dollar amount each investment period
until your fund has been exhausted. Normally, an investment period is three months.
A second option allows you to liquidate or “sell off” a certain number of shares each
investment period. Since the net asset value of shares in a fund varies from one investment
period to the next, the amount of money you receive will also vary.
A third option allows you to withdraw a fixed percentage of asset growth. If no asset
growth occurs, no payment is made to you. Assuming you withdraw less than 100 percent
of asset growth, your principal continues to grow.
A final option allows you to withdraw all asset growth that results from income divi-
dends and capital gain distributions earned by the fund during an investment period. Under
this option, your principal remains untouched.
EXAMPLE: Withdrawal Calculation
You arrange to receive 60 percent of the asset growth of your mutual fund invest-
ment. In one investment period, the asset growth amounts to $3,000. For that
period, you will receive a check for $1,800, as shown below.
Amount you receive 5 Investment growth 3 Percentage of growth withdrawn
5 $3,000 3 60 percent 5 $1,800
PRACTICE QUIZ 13–4 PRACTICE QUIZ 13–4
1. In your own words, describe the advantages and disadvantages of mutual fund investments.
2. In the table below indicate how each of the key terms affects a mutual fund investment and how each would be taxed.
Key Term
Type of Return on a Mutual Fund
Investment Type of Taxation
Income dividends
Capital gain distributions
Capital gains
3. How would you purchase a closed-end fund? An exchange-traded fund?
4. What options can you use to purchase shares in or withdraw money from an open-end mutual fund?
Apply Yourself! Apply Yourself!
Use the Internet to obtain a prospectus for a specific mutual fund that you believe would be a quality long-term invest-
ment. Then describe the purchase and withdrawal options described in the fund’s prospectus.
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448 Chapter 13 Investing in Mutual Funds
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YOUR PERSONAL FINANCE DASHBOARD
POSSIBLE ACTIONS TO TAKE
Reconsider the three steps required to begin invest-
ing in mutual funds that were described at the begin-
ning of the chapter.
Reconsider the suggestions for beginning a mutual
fund investment program in the “Personal Finance in
Practice” box in this chapter.
Review the material in the section “How to Make a
Decision to Buy or Sell Mutual Funds.”
Choose a specific fund and use the Internet or library
research to complete “Your Personal Financial Plan”
sheet 41 (Mutual Fund Evaluation) located at the end
of this chapter.
Because of professional management and diversifica-
tion, beginning investors often choose mutual funds.
Still you must choose the right fund that will help you
achieve your financial objectives. Then you must evalu-
ate each fund alternative before investing your money.
YOUR SITUATION: Are you ready to invest in mutual
funds? The first step is to save the money you need
to begin investing. Typically most brokerage firms and
investment companies require investors to have $250
to $2,000 to open an account. The second step is to
evaluate each mutual fund alternative before investing
your money.
$1000
SO
ME
MONEY AVAILABLE REA
D
Y
TO
IN
V
E
S
TH
A
V
E
N
‘T
S
TA
R
TE
D
$ 0 $ 2000
$1500$ 500
HAVE YOU SAVED ENOUGH MONEY
TO INVEST IN MUTUAL FUNDS?
S
A
V
IN
G
LO13.1 The major reasons investors
choose mutual funds are professional
management and diversifi cation. Mutual
funds are also a convenient way to invest
money—especially for retirement accounts.
There are three types of funds: closed-end
funds, exchange-traded funds, and open-
end funds. A closed-end fund is a fund
whose shares are issued only when the
fund is organized. An exchange-traded fund
(ETF) is a fund that invests in the stocks
contained in a specifi c stock index or secu-
rities index. Both closed-end and exchange-
traded funds are traded on a stock exchange
or in the over-the-counter market. An open-
end fund is a mutual fund whose shares
are sold and redeemed by the investment
company at the net asset value (NAV) at the
request of investors.
Mutual funds can also be classified as A
shares (commissions charged when shares
are purchased), B shares (commissions
charged when money is withdrawn during
the first five years), and C shares (no com-
mission to buy or sell shares, but often
higher, ongoing fees). Other possible fees
include management fees and 12b-1 fees.
Together all the different management fees
and operating costs are referred to as an
expense ratio.
LO13.2 The managers of funds tailor
their investment portfolios to the invest-
ment objectives of their customers. The
major fund categories are stock funds and
bond funds. There are also funds that invest
in a mix of different stocks, bonds, and
other securities that include asset alloca-
tion funds, balanced funds, fund of funds,
lifecycle funds, and money market funds.
Today many investment companies use
a family-of-funds concept, which allows
shareholders to switch among funds as dif-
ferent funds offer more potential, financial
reward, or security. It is also possible to
participate in a retirement plan and choose
different funds to obtain your financial
objectives.
LO13.3 The responsibility for choosing
the “right” mutual fund rests with you, the
Chapter
Summary
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investor. Often, the first question investors
must answer is whether they want a man-
aged fund or an index fund. With a managed
fund, a professional fund manager (or team
of managers) chooses the securities that
are contained in the fund. Some investors
choose to invest in an index fund, because
over many years, index funds have outper-
formed the majority of managed funds. To
help evaluate different mutual funds, inves-
tors can use the information on the Internet,
from professional advisory services, from
the fund’s prospectus and annual report, in
financial publications, and in newspapers.
LO13.4 The advantages and disadvan-
tages of mutual funds have made mutual
funds the investment of choice for many
investors. For $250 to $2,000 or more,
you can open an account and begin invest-
ing. The shares of a closed-end fund or
exchange-traded fund are bought and sold on
organized stock exchanges or the over-the-
counter market. The shares of an open-end
fund may be purchased through a salesper-
son who is authorized to sell them, through
an account executive of a brokerage firm,
from a mutual fund supermarket, or from the
investment company that sponsors the fund.
The shares in an open-end fund can be sold
to the investment company that sponsors
the fund. Shareholders in mutual funds can
receive a return in one of three ways: income
dividends, capital gain distributions when
the fund buys and sells securities in the
fund’s portfolio at a profit, and capital gains
when the shareholder sells shares in the
mutual fund at a higher price than the price
paid. To ensure having all of the documenta-
tion you need for tax reporting purposes, it is
essential that you keep accurate records. A
number of purchase and withdrawal options
are available for mutual fund investors.
Key Terms
capital gain
distributions 443
closed-end fund 425
contingent deferred sales
load 428
exchange-traded fund
(ETF) 426
no-load fund 427
open-end fund 426
reinvestment plan 446
turnover ratio 445
12b-1 fee 428
expense ratio 429
family of funds 433
income dividends 443
load fund 427
mutual fund 423
net asset value
(NAV) 426
Page Topic Formula
426 Net asset
value
Net asset value 5
Value of the fund’s portfolio 2 Liabilities
__________________________________
Number of shares outstanding
427 Load charge Load charge 5 Dollar amount of investment 3 Load stated as a percentage
428 Contingent
deferred
sales load
Contingent deferred sales load 5 Amount of withdrawal
3 Fee stated as a percentage
Amount you receive 5 Amount of withdrawal
2 Contingent deferred sales fee
444 Total
return
Income dividends
1 Capital gain distributions
1 Change in share price when sold
Dollar amount of total return
444 Percent of
total return
Percent of total return 5 Dollar amount of total return ___________________________
Original cost of your investment
447 Withdrawal
calculation
Investment growth 3 Percentage of growth withdrawn
Key
Formulas
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1. For many investors, mutual funds have become the investment of choice. In your own
words, describe why investors purchase mutual funds. (LO13.1)
2. Describe the type of fees that you would pay to purchase a load fund.
What annual fees would you typically pay for your mutual fund
investment? (LO13.1)
3. Assume your employer offers you the opportunity to participate in the company’s
401(k) retirement plan. (LO13.2)
a. Would you participate in the company’s retirement plan? Justify your answer.
b. Assume you decide to participate in the employer-sponsored plan. What
factors would you consider when choosing the funds for your retirement
plan?
4. This chapter explored a number of different classifications or types of mutual
funds. (LO13.2)
a. Based on your age and current financial situation, which type of mutual fund seems
appropriate for your investment needs? Explain your answer.
b. As people get closer to retirement, their investment goals often change. Assume you
are now 45 and have accumulated $110,000 in a retirement account. In this situa-
tion, what type of mutual funds would you choose? Why?
c. Assume you are now 60 years of age and have accumulated $400,000 in a
retirement account. Also assume you would like to retire when you are 65.
What type of mutual funds would you choose to help you reach your investment
goals? Why?
5. Choose either the Invesco Charter (symbol CHTRX) mutual fund or the Fidelity Fifty
(symbol FFTYX) mutual fund. Then describe how each of the following sources of
information could help you evaluate one of these funds. (LO13.3)
a. The Internet.
b. Professional advisory services.
c. The fund’s prospectus.
d. The fund’s annual report.
e. Financial publications.
f. Newspapers.
6. Visit the Yahoo! Finance website and evaluate one of the following mutual funds. To
complete this activity, follow these steps: (LO13.3)
a. Go to finance.yahoo.com .
b. Choose one of the following three funds, enter its symbol, and click on the Quote
Lookup button: Oppenheimer International Bond Fund (OIBAX), Janus Enterprise
Fund (JAENX), or the Fidelity Select Biotechnology Portfolio (FBIOX).
c. Print out the information for the mutual fund that you chose to evaluate.
d. Based on the information included in this research report, would you invest in this
fund? Explain your answer.
7. Obtain a mutual fund prospectus to determine the options you can use to purchase and
redeem shares. (LO13.4)
a. Which purchase option would appeal to you? Why?
b. Assuming you are now of retirement age, which withdrawal option would appeal
to you?
Discussion
Questions
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1. Three years ago, Mary Applegate’s mutual fund portfolio was worth $410,000. Now,
because of the recent economic crisis, the total value of her investment portfolio has
decreased to $296,000. Even though she has lost a significant amount of money, she
has not changed her investment holdings, which consist of either aggressive growth
funds or growth funds.
a. How much money has Ms. Applegate lost in the last three years?
b. Given the above information, calculate the percentage of lost value.
c. What actions would you take to get your investment back in shape if you were Mary
Applegate?
2. Twelve months ago, Gene Peterson purchased 200 shares in the no-load Fidelity
Growth Company Fund—a Morningstar five-star fund that seeks capital appreciation.
His rationale for choosing this fund was that he wanted a fund that was highly rated.
Each share in the fund cost $110. At the end of the year, he received dividends of $0.70
and a capital gain distribution of $8.12 a share. At the end of 12 months, the shares in
the fund were selling for $118.
a. How much did Mr. Peterson invest in this fund?
b. At the end of 12 months, what is the total return for this fund?
c. What is the percentage of total return?
Solutions
1. a. Dollar loss 5 $410,000 Value three years ago 2 $296,000 Current value
5 $114,000
b. Percent of dollar loss 5 $114,000 4 $410,000 Value three years ago
5 0.278 5 27.8 percent
c. While Ms. Applegate has several options, any decision should be based on careful
research and evaluation. First, she could do nothing. While she has lost a sub-
stantial portion of her investment portfolio ($114,000, or 27.8 percent), it may be
time to hold on to her investments if she believes the economy is improving or the
value of her shares will increase. Second, she could sell (or exchange) some or all
of her shares in the aggressive growth or growth funds and move her money into
more conservative money market or government bond funds, or even certificates of
deposit. Finally, she could buy more shares if she believes the economy is beginning
to improve. Because of depressed prices for quality funds, this may be a real buying
opportunity. Deciding which option for Ms. Applegate to take may depend on the
economic conditions at the time you answer this question.
2. a. Total investment 5 Price per share 3 Number of shares
5 $110 3 200 5 $22,000
b. Income dividends 5 $0.70 Dividend per share 3 200 shares 5 $140
Capital gain distribution 5 $8.12
Capital gain distribution 3 200 shares 5 $1,624
Change in share value 5 $118 ending value 2 $110 beginning value 5 $8 a share gain
Total increase in value 5 $8 gain per share 3 200 shares 5 $1,600 gain
Total return 5 $140 Income dividends 1 $1,624 Capital gain distribution
1 $1,600 Change in share value 5 $3,364
c. Percent of dollar gain 5
$3,364 gain
________________
$22,000 investment
5 0.153 5 15.3 percent
Self-Test
Problems
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1. The Western Capital Growth mutual fund has
Total assets, $750,000,000
Total liabilities, $7,200,000
Total number of shares, 24,000,000
What is the fund’s net asset value (NAV)? (LO13.1)
2. Jan Throng invested $31,000 in the Invesco Charter mutual fund. The fund charges a
5.50 percent commission when shares are purchased. Calculate the amount of com-
mission Jan must pay. (LO13.1)
3. As Bart Brownlee approached retirement, he decided the time had come to invest
some of his nest egg in a conservative fund. He chose the Franklin Utilities Fund.
If he invests $46,000 and the fund charges a 4.25 percent load when shares are pur-
chased, what is the amount of commission that Bart must pay? (LO13.1)
4. Mary Canfield purchased shares in the New Dimensions Global Growth Fund.
This fund doesn’t charge a front-end load, but it does charge a contingent deferred
sales load of 4 percent for any withdrawals during the first five years. If Mary with-
draws $7,500 during the second year, how much is the contingent deferred sales
load? (LO13.1)
5. The value of Mike Jackson’s shares in the New Frontiers Technology Fund is
$11,400. The management fee for this particular fund is 0.80 percent of the total
asset value. Calculate the management fee Mike must pay this year. (LO13.1)
6. Betty and James Holloway invested $71,000 in the Financial Vision Social Responsi-
bility Fund. The management fee for this fund is 0.60 percent of the total asset value.
Calculate the management fee the Holloways must pay. (LO13.1)
7. As part of his 401(k) retirement plan at work, Ken Lowery invests 5 percent of his
salary each month in the Capital Investments Lifecycle Fund. At the end of this year,
Ken’s 401(k) account has a dollar value of $36,400. If the fund charges a 12b-1 fee
of 0.75 percent, what is the amount of the fee? (LO13.1)
8. When Jill Thompson received a large settlement from an automobile accident,
she chose to invest $146,000 in the Vanguard 500 Index Fund. This fund has an
expense ratio of 0.17 percent. What is the amount of the fees that Jill will pay this
year? (LO13.1)
9. The Yamaha Aggressive Growth Fund has a 1.83 percent expense ratio. (LO13.1)
a. If you invest $55,000 in this fund, what is the dollar amount of fees that you
would pay this year?
b. Based on the information in this chapter and your own research, is this a low,
average, or high expense ratio?
10. Jason Mathews purchased 300 shares of the Hodge & Mattox Energy Fund. Each
share cost $14.15. Fifteen months later, he decided to sell his shares when the share
value reached $17.10. (LO13.4)
a. What was the amount of his total investment?
b. What was the total amount Mr. Mathews received when he sold his shares in the
Hodge & Mattox fund?
c. How much profit did he make on his investment?
11. Three years ago, James Matheson bought 200 shares of a mutual fund for $23 a
share. During the three-year period, he received total income dividends of $0.92 per
share. He also received total capital gain distributions of $0.80 per share. At the end
of three years, he sold his shares for $29 a share. What was his total return for this
investment? (LO13.4)
12. Assume that one year ago, you bought 120 shares of a mutual fund for $33 a share,
you received a $0.60 per-share capital gain distribution during the past 12 months,
and the market value of the fund is now $38 a share. (LO13.4)
a. Calculate the total return for your $3,960 investment.
b. Calculate the percentage of total return for your $3,960 investment.
Problems
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13. Over a four-year period, LaKeisha Thompson purchased shares in the Oakmark I
Fund. Using the following information, answer the questions that follow. You may
want to review the concept of dollar cost averaging in Chapter 12 before completing
this problem. (LO13.4)
Year Investment Amount Price per Share Number of Shares*
February 2011 $1,500 $45.00
February 2012 $1,500 $43.00
February 2013 $1,500 $57.00
February 2014 $1,500 $65.00
*Carry your answer to two decimal places.
a. At the end of four years, what is the total amount invested?
b. At the end of four years, what is the total number of shares purchased?
c. At the end of four years, what is the average cost for each share?
14. During one three-month period, Matt Roundtop’s mutual fund grew by $6,000. If he
withdraws 35 percent of the growth, how much will he receive? (LO13.4)
RESEARCH INFORMATION AVAILABLE FROM MORNINGSTAR
This chapter stressed the importance of
evaluating potential investments. Now it is
your turn to try your skill at evaluating a
potential investment in the Oakmark Global
Select I Fund. Assume you could invest
$10,000 in shares of this fund. To help you
evaluate this potential investment, carefully
examine Exhibit 13–5, which reproduces
the Morningstar research report for the
Oakmark Global Select I Fund. The report
was published February 2014.
Questions
1. Based on the research provided by
Morningstar, would you buy shares in
the Oakmark Global Select I Fund? Jus-
tify your answer.
2. What other investment information would
you need to evaluate this fund? Where
would you obtain this information?
3. On May 23, 2014, shares in the Oak-
mark Global Select I Fund were selling
for $16.78 per share. Using the Internet
or a newspaper, determine the current
price for a share of this fund. Based on
this information, would your investment
have been profitable? ( Hint: The sym-
bol for this fund is OAKWX.)
4. Assuming you purchased shares in the
Oakmark Global Select I Fund on
May 23, 2014, and based on your
answer to question 3, how would you
decide if you want to hold or sell your
shares? Explain your answer.
Case in
Point
INVESTING IN MUTUAL FUNDS
Jamie Lee and Ross did several weeks’ worth of research trying to choose the right stock to
invest in. After all, the $50,000 inheritance was a lot of money and they wanted to make the
most informed investment choices they could. They discovered, by doing their homework,
the various companies’ stocks that they were looking to invest in did not seem like they
were going to have the promising future that Jamie Lee and Ross were hoping for. They
were aware that they were taking a chance with any investment instrument, but they were
both nervous about “putting all of their eggs in one basket” and wanted to be more confi-
dent in making their investment choices. But how could they be more assured?
Continuing
Case
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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Assets (Jamie Lee and Ross combined) :
Checking account, $7,500
Savings account, $83,000 (including the
$50,000 inheritance)
Emergency fund savings account, $45,000
House, $410,000
IRA balance, $78,000
Life insurance cash value, $110,000
Investments (stocks, bonds), $230,000
Cars, $18,500 (Jamie Lee) and $24,000
(Ross)
Liabilities (Jamie Lee and Ross
combined) :
Mortgage balance, $73,000
Student loan balance, $0
Credit card balance, $0
Car loans, $0
Income:
Jamie Lee, $45,000 gross income
($31,500 net income after taxes)
Ross, $135,000 gross income ($97,200
net income after taxes)
Monthly Expenses
Mortgage, $1,225
Property taxes, $500
Homeowner’s insurance, $300
IRA contribution, $300
Utilities, $250
Food, $600
Gas/Maintenance, $275
Entertainment, $300
Life insurance, $375
They decided to speak to their professional investment advisor, who suggested that invest-
ing in mutual funds may be the way to lessen the risk by joining a pool of other investors
in a variety, or bundle, of securities chosen by the mutual fund manager. This way, Jamie
Lee and Ross could lessen the pressure of choosing the right company, and minimize the
chances of losing all of their investment money by diversifying their portfolio.
A mutual fund sounded like the sensible investment choice for them, but which mutual
fund would best match their investment strategy? Jamie Lee and Ross are in their mid-40s
and well on their way to reaching their long-term investment goals, as they committed to
reaching their objectives early in their marriage. They set their sights on having the trip-
lets graduate from college debt-free and saving enough to purchase a beach house when
they retire. They are looking for a mutual fund that will provide investment income while
maintaining the moderate risk investment path that they are on, as they have some time to
go before retirement.
Questions
1. It has been suggested by Jamie Lee and Ross’s professional investment counselor that
they perform a financial checkup as the first step in investing in mutual funds, even
though they are investing $50,000 that was inherited from Ross’s late uncle’s estate.
Is it a good time to invest the inheritance, or should Jamie Lee and Ross balance their
budget first?
2. Jamie Lee and Ross have been reading quite a lot about stock funds while researching
the classifications of mutual funds. At Jamie Lee and Ross’s stage in life, what dif-
ferent types of stock funds would be recommended for them to invest their $50,000
inheritance in? Why?
3. The investment advisor recommended looking into managed funds, which could help
remove from Jamie Lee and Ross the burden of decision making about when to buy
and sell. But Ross was considering index funds, which have a lower management
expense. Using your text as a guide, compare managed funds and index funds.
Current Financial Situation
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Managed Funds Index Funds
Which fund would you recommend for Ross and Jamie Lee? Why?
4. Jamie Lee and Ross are ready to evaluate a mutual fund more closely. Choose a
mutual fund that has been mentioned in your Chapter 13 text or one that has been
recommended by a friend or family member, and complete “Your Personal Financial
Plan” sheet 41. Would you recommend this mutual fund for Jamie Lee and Ross? Why
or why not?
Directions Monitoring your daily spending will allow you to better consider financial
planning alternatives. You will have better information and the potential for better control
if you use your spending information for making wiser choices. The Daily Spending Diary
sheets are located in Appendix D at the end of the book and in Connect Finance.
Questions
1. Are there any spending items that you might consider revising to allow you to increase
the amount you invest?
2. Based on your investment goals and the amount available to invest, what types of
mutual funds would you consider?
“I MUST CHOOSE BETWEEN SPENDING MONEY ON SOMETHING
NOW OR INVESTING FOR THE FUTURE.”
Spending
Diary
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What’s Next for Your Personal Financial Plan?
• Talk with friends and relatives to determine what sources of information they use to evaluate mutual funds.
• Choose one source of information and describe how the information could help you attain your investment
objectives.
Evaluating Mutual Fund Investment
Information
Purpose: To identify and assess the value of various mutual fund investment information
sources.
Financial Planning Activities: Obtain samples of several items of information that you
might consider to guide you in your investment decisions. This sheet is also available in an
Excel spreadsheet format in Connect Finance.
Suggested Websites: www.morningstar.com www.kiplinger.com www.mfea.com
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Criteria Evaluation Source 1 Source 2 Source 3
Information source
Website
Overview of
information provided
(main features)
Cost, if any
Ease of access
Evaluation
• Reliablility
• Clarity
• Value of
information
compared to cost
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Category 1: Fund Characteristics
1. What is the fund’s ticker symbol? What is the
fund’s name?
____________________________________________
2. What is the fund’s Morningstar rating?
____________________________________________
3. What is the minimum investment?
____________________________________________
4. Does the fund allow telephone or Internet
exchanges? u Yes u No
5. Is there a fee for exchanges? u Yes u No
Category 2: Costs
6. Is there a front-end load charge? If so, how much
is it? _______________________________________
7. Is there a contingent deferred sales load? If so, how
much is it? ____________________________________
8. How much is the annual management fee?
____________________________________________
9. Is there a 12b-1 fee? If so, how much is it?
____________________________________________
10. What is the fund’s expense ratio?
____________________________________________
Category 3: Diversification
11. What is the fund’s objective?
____________________________________________
12. What types of securities does the fund’s portfolio
include?
____________________________________________
13. How many different securities does the fund’s
portfolio include?
____________________________________________
14. How many types of industries does the fund’s
portfolio include?
____________________________________________
15. What are the fund’s five largest holdings?
____________________________________________
Category 4: Fund Performance
16. How long has the fund manager been with the fund?
____________________________________________
17. How would you describe the fund’s performance
over the past 12 months?
____________________________________________
18. How would you describe the fund’s performance
over the past five years?
____________________________________________
19. How would you describe the fund’s performance
over the past 10 years?
____________________________________________
20. What is the current net asset value for this fund?
____________________________________________
21. What is the high net asset value for this fund over
the last 12 months?
____________________________________________
22. What is the low net asset value for this fund over
the last 12 months?
____________________________________________
23. What do the experts say about this fund?
____________________________________________
Category 5: Conclusion
24. Based on the above information, do you think an
investment in this fund will help you achieve your
investment goals? u Yes u No
25. Explain your answer to question 24.
A Word of Caution
When you use a checklist, there is always a danger
of overlooking important relevant information. This
checklist is not a cure-all, but it does provide some
very sound questions that you should answer before
making a mutual fund investment decision. Quite sim-
ply, it is a place to start. If you need other information,
you are responsible for obtaining it and for determining
how it affects your potential investment.
Mutual Fund Evaluation
Purpose: No checklist can serve as a foolproof guide for choosing a mutual fund. However,
the following questions will help you evaluate a potential investment in a specific fund.
Financial Planning Activities: Use mutual fund websites and/or library materials to answer
these questions about a mutual fund that you believe could help you attain your investment
objectives. This sheet is also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.morningstar.com finance.yahoo.com www.marketwatch.com
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What’s Next for Your Personal Financial Plan?
• Identify additional factors that may affect your decision to invest in this fund.
• Develop a plan for monitoring an investment’s value once a mutual fund(s) is purchased.
Suggested
App:
• Morningstar
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14 Starting Early: Retirement and Estate Planning
For every 10 years you delay in starting to
save for retirement, you will need to save three
times as much each month to catch up. That’s
why, no matter how young you are, the sooner
you begin saving for retirement, the better.
Whether you are 18 or 58, take steps toward a
more secure financial future. At the end of the
chapter, “Your Personal Finance Dashboard”
will provide additional information on planning
your retirement income.
1
Conduct a financial analysis of your situation.
Review assets, housing, life insurance, retire-
ment funds, and other investments.
App: RetirePlan
2
Estimate the annual amount you will need to
live comfortably during your retirement years.
App: Retirement Income Calculator
3
Develop a plan to create a retirement fund with
a future amount based on your result in Step 2.
Website: money.cnn.com/retirement
3 Steps to Financial
Literacy . . . Planning to Live
Off of Preretirement Earnings
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Planning for Retirement: Start Early
Your retirement years may seem a long way off right now. However, the fact is, it’s never
too early to start planning for retirement. Planning can help you cope with sudden changes
that may occur in your life and give you a sense of control over your future.
A recent poll from Harris Interactive reported that 95 percent of people ages 55 to 64
years old plan to do at least some work after they retire. Another survey reported that future
retirees expect to continue to learn and to pursue new hobbies and interests. Someday,
when you retire, you too may desire an active life.
If you have not done any research on the subject of retirement, you may have some mis-
conceptions about the “golden years.” Here are some myths about retirement:
• You have plenty of time to start saving for retirement.
• Saving just a little bit won’t help.
• You’ll spend less money when you retire.
• Your retirement will only last about 15 years.
• You can depend on Social Security and a company pension plan to pay your basic
living expenses.
• Your pension benefits will increase to keep pace with inflation.
• Your employer’s health insurance plan and Medicare will cover all your medical
expenses when you retire.
LO14.1
Analyze your current assets
and liabilities for retirement
and estimate your retirement
living costs.
ACTION ITEM
I have plenty of time before
I start saving for retirement.
h True h False
CHAPTER 14 LEARNING OBJECTIVES
In this chapter, you will learn to:
LO14.1 Analyze your current assets and liabilities for retirement and estimate your
retirement living costs.
LO14.2 Determine your planned retirement income and develop a balanced budget
based on your retirement income.
LO14.3 Analyze the personal and legal aspects of estate planning.
LO14.4 Distinguish among various types of wills and trusts.
YOUR PERSONAL FINANCIAL PLAN SHEETS
42. Retirement Plan Comparison
43. Forecasting Retirement Income
44. Estate Planning Activities
45. Will Planning
46. Trust Comparison
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Some of these statements were once true but are no longer true today. You may live for
many years after you retire. If you want your retirement to be a happy and comfortable
time of your life, you’ll need enough money to suit your lifestyle. You can’t count on
others to provide for you. That’s why you need to start planning and saving as early as
possible. It’s never too late to start saving for retirement, but the sooner you start, the better
off you’ll be. (See Exhibit 14–1 .)
Saving Smart for Retirement
Long-term financial security starts with a savings plan. If you save on a regular basis,
you will have money to pay your bills, make major purchases, meet your living expenses
during your retirement, and cope with emergencies. Here are a few tips on how to start
saving early.
• Start now. Don’t wait. Time is critical.
• Start small, if necessary. Money may be tight, but even small amounts can make
a big difference given enough time; the right kind of investments; and tax-favored
investments such as company retirement plans, IRAs, and SEPs.
• Use automatic deductions from your payroll or your checking account for deposit
in mutual funds, IRAs, or other investments.
• Save regularly. Make saving for retirement a habit.
• Be realistic about investment returns. Never assume that a year or two of high
market returns will continue indefinitely. The same goes for market declines.
• If you change jobs, keep your retirement account money in your former employer’s
plan or roll it over into your new employer’s plan or an IRA.
• Don’t dip into retirement savings unless it is absolutely necessary.
As you think about your retirement years, consider your long-range goals. What does
retirement mean to you? Maybe it will simply be a time to stop working, sit back, and
relax. Perhaps you imagine traveling the world, developing a hobby, or starting a second
career. Where do you want to live after you retire? What type of lifestyle would you like
to have? Once you’ve pondered these questions, your first step in retirement planning is to
determine your current financial situation. That requires you to analyze your current assets
and liabilities.
Conducting a Financial Analysis
As you learned in Chapter 2, an asset is any item of value that you own—cash, property,
personal possessions, and investments—including cash in checking and savings accounts, a
house, a car, a television, and so on. It also includes the current value of any stocks, bonds,
and other investments that you may have as well as the current value of any life insurance
and pension funds.
Your liabilities, on the other hand, are the debts you owe: the remaining balance on a
mortgage or automobile loan, credit card balances, unpaid taxes, and so on. If you subtract
EXAMPLE: Starting Early
Suppose that you want to have at least $1 million when you retire at age 65. If you
start saving for retirement at age 25, you can meet that goal by putting about $127
per month into investment funds that grow at a rate of about 11 percent each year.
If you wait until you’re 50, the monthly amount skyrockets to $2,244.
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Get an early start on your plan for retirement.
SAVER ABE (THE EARLY SAVER) SAVER BEN (THE LATE SAVER)
Age Years Contributions
Year-End
Value Age Years Contributions
Year-End
Value
25 1 $ 2,000 $ 2,188 25 1 $ 0 $ 0
26 2 2,000 4,580 26 2 0 0
27 3 2,000 7,198 27 3 0 0
28 4 2,000 10,061 28 4 0 0
29 5 2,000 13,192 29 5 0 0
30 6 2,000 16,617 30 6 0 0
31 7 2,000 20,363 31 7 0 0
32 8 2,000 24,461 32 8 0 0
33 9 2,000 28,944 33 9 0 0
34 10 2,000 33,846 34 10 0 0
35 11 0 37,021 35 11 2,000 2,188
36 12 0 40,494 36 12 2,000 4,580
37 13 0 44,293 37 13 2,000 7,198
38 14 0 48,448 38 14 2,000 10,061
39 15 0 52,992 39 15 2,000 13,192
40 16 0 57,963 40 16 2,000 16,617
41 17 0 63,401 41 17 2,000 20,363
42 18 0 69,348 42 18 2,000 24,461
43 19 0 75,854 43 19 2,000 28,944
44 20 0 82,969 44 20 2,000 33,846
45 21 0 90,752 45 21 2,000 39,209
46 22 0 99,265 46 22 2,000 45,075
47 23 0 108,577 47 23 2,000 51,490
48 24 0 118,763 48 24 2,000 58,508
49 25 0 129,903 49 25 2,000 66,184
50 26 0 142,089 50 26 2,000 74,580
51 27 0 155,418 51 27 2,000 83,764
52 28 0 169,997 52 28 2,000 93,809
53 29 0 185,944 53 29 2,000 104,797
54 30 0 203,387 54 30 2,000 116,815
55 31 0 222,466 55 31 2,000 129,961
56 32 0 243,335 56 32 2,000 144,340
57 33 0 266,162 57 33 2,000 160,068
58 34 0 291,129 58 34 2,000 177,271
59 35 0 318,439 59 35 2,000 196,088
60 36 0 348,311 60 36 2,000 216,670
61 37 0 380,985 61 37 2,000 239,182
62 38 0 416,724 62 38 2,000 263,807
63 39 0 455,816 63 39 2,000 290,741
64 40 0 498,574 64 40 2,000 320,202
65 41 0 545,344 65 41 2,000 352,427
$20,000 $62,000
Value at retirement * $545,344 Value at retirement * $352,427
Less total contributions 2 20,000 Less total contributions 2 62,000
Net earnings $525,344 Net earnings $290,427
*The table assumes a 9 percent fixed rate of return, compounded monthly, and no fluctuation of the principal. Distributions from an IRA are subject to
ordinary income taxes when withdrawn and may be subject to other limitations under IRA rules.
SOURCE: The Franklin Investor (San Mateo, CA: Franklin Distributors Inc., January 1989).
Exhibit 14–1 Tackling the Trade-Offs: Saving Now versus Saving Later—The Time Value of Money
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Retirement probably seems vague and far off at this stage
of your life. Besides, you have things to buy right now. Yet
there are some crucial reasons to start preparing now for
retirement.
• You’ll have to pay for more of your own retirement
than earlier generations. The sooner you get started,
the better.
• You have one huge ally—time. Let’s say that you
put $1,000 into an IRA at the beginning of each
year from age 20 through age 30 (11 years) and
then never put in another dime. The account earns
7 percent annually. When you retire at age 65 you’ll
have $168,514 in the account. A friend doesn’t start
until age 30, but saves the same amount annually
for 35 years straight. Despite putting in three times
as much money, your friend’s account grows to only
$147,913.
• You can start small and grow. Even setting aside a
small portion of your paycheck each month will pay
off in big dollars later.
• You can afford to invest more aggressively. You have
years to overcome the inevitable ups and downs of
the market.
• Developing the habit of saving for retirement is easier
when you are young.
SOURCE: U.S. Department of Labor ( www.dol.gov/ebsa ), accessed
May 29, 2014.
The Psychology of Planning for Retirement While You Are
Still Young
Personal Finance in Practice
your liabilities from your assets, you get your net worth. Ideally, your net worth should
increase each year as you move closer to retirement.
It’s a good idea to review your assets on a regular basis. You may need to make adjust-
ments in your saving, spending, and investments in order to stay on track. As you review
your assets, consider the following factors: housing, life insurance, and other investments.
Each will have an important effect on your retirement income.
HOUSING A house will probably be your most valuable
asset. However, if you buy a home with a large mortgage that
prevents you from saving, you put your ability to meet your
retirement goal at risk. In that case you might consider buying
a smaller, less expensive place to live. Remember that a smaller
house is usually easier and cheaper to maintain. You can use the
money you save to increase your retirement fund.
LIFE INSURANCE At some point in the future, you may
buy life insurance to provide financial support for your children
in case you die while they are still young. As you near retire-
ment, though, your children will probably be self-sufficient.
When that time comes, you might reduce your premium pay-
ments by decreasing your life insurance coverage. This would
give you extra money to spend on living expenses or to invest
for additional income.
OTHER INVESTMENTS When you review your assets, you’ll also want to evaluate
any other investments you have. When you originally chose these investments, you may
have been more interested in making your money grow than in getting an early return from
them. When you are ready to retire, however, you may want to use the income from those
investments to help cover living expenses instead of reinvesting it.
Estimating Retirement Living Expenses
Next you should estimate how much money you’ll need to live comfortably during your
retirement years. (See the nearby “Personal Finance in Practice” box.) You can’t predict
digi – know? digi – know?
Kiplinger.com’s retiree tax map ( Kiplinger.com’s retiree tax map ( kiplinger.kiplinger.
com/tools/retiree_mapcom/tools/retiree_map ) is a state-by-state ) is a state-by-state
guide that can help determine the most guide that can help determine the most
tax-friendly states for you and your assets tax-friendly states for you and your assets
in retirement. You can sort the map by in retirement. You can sort the map by
such categories as states that don’t tax such categories as states that don’t tax
Social Security benefits and states that Social Security benefits and states that
impose their own estate tax. impose their own estate tax.
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exactly how much money you’ll need when you retire. You can, however, estimate what
your basic needs will be. To do this, you’ll have to think about your spending patterns and
how your living situation will change when you retire. For instance, you probably will
spend more money on recreation, health insurance, and medical care in retirement than you
do now. At the same time, you may spend less on transportation and clothing. Your federal
income taxes may be lower. Also, some income from various retirement plans may be taxed
at a lower rate or not at all. As you consider your retirement living expenses, remember to
plan for emergencies. Look at Exhibit 14–2 for an example of retirement spending patterns.
The place where you choose to live during retirement can
have a significant impact on your financial needs. Use
vacations in the years before you retire to explore areas
you think you might enjoy. If you find a place you really like,
go there at different times of the year. That way you’ll know
what the climate is like. Meet people who live in the area
and learn about activities, transportation, and taxes.
ETHICAL AND PSYCHOLOGICAL ASPECTS OF
MOVING
Consider the downside of moving to a new location. You
may find yourself stuck in a place you really don’t like
after all. Moving can also be expensive and emotionally
draining. You may miss your children, your grandchildren,
and the friends and relatives you leave behind. Be realistic
about what you’ll have to give up as well as what you’ll
gain if you move after you retire.
AVOIDING RETIREMENT RELOCATION PITFALLS
Some retired people move to the location of their dreams
and then discover that they’ve made a big mistake
financially. Here are some tips from retirement specialists
on how to uncover hidden taxes and other costs before
you move to a new area:
• Contact the local chamber of commerce to get
details on area property taxes and the local economy.
• Contact the state tax department to find out about
income, sales, and inheritance taxes as well as
special exemptions for retirees.
• Read the Sunday edition of the local newspaper of
the city where you’re thinking of moving.
• Check with local utility companies to get estimates
on energy costs.
• Visit the area in different seasons, and talk to local
residents about the various costs of living.
• Rent for a while instead of buying a home
immediately.
What are your findings?
Your Retirement Housing
Personal Finance in Practice
Exhibit 14–2
How an “Average”
Older (65 1 ) Household
Spends Its Money
Retired families spend a
greater share of their income
for food, housing, and
medical care than nonretired
families.
Total expenditures approximately $39,173 5 100 percent in 2011.
Housing
35.0%
$13,706
Transportation
14.7%
$5,751
Food
13.1%
$5,158
Medical care
12.2%
$4,769
Reading, education,
entertainment
7.2%
$2,824
Personal insurance
and pensions
5.1%
$1,985 Other expenses
3.7%
$1,449
Cash contributions
6.1%
$2,392
Clothing
2.9%
$1,129
SOURCE: U.S. Bureau of Labor Statistics, Consumer Expenditure Survey, September 2013 ( www.bls.gov/cex/
csxann11 ), accessed May 29, 2014.
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Don’t forget to take inflation into account. Estimate high when calculating how much
the prices of goods and services will rise by the time you retire (see Exhibit 14–3 ). Even a
3 percent rate of inflation will cause prices to double every 24 years.
Exhibit 14–3
The Effects of Inflation
over Time: The Time
Value of Money
$6,756
$4,564
$3,083
In 30
Years
In 20
Years
In 10
Years
$8,000
$6,000
$4,000
$2,000
0
This chart shows you what $10,000 today will be worth in 10, 20, and 30 years assuming a
fairly conservative 4 percent rate of inflation.
The prices of goods and services rarely remain the same for any significant period of time
because of inflation. How much will $10,000 be worth in 30 years, assuming a 4 percent rate
of inflation? What can you do to counteract the effects of inflation?
PRACTICE QUIZ 14–1 PRACTICE QUIZ 14–1
1. What are the three assets you should review on a regular basis during retirement?
2. What expenses are likely to increase during retirement?
3. What expenses are likely to decrease during retirement?
Apply Yourself! Apply Yourself!
Survey friends, relatives, and other people to get their views on retirement planning. Prepare a written report of your
findings.
Your Retirement Income
The four major sources of retirement income are employer pension plans, public pension
plans, personal retirement plans, and annuities.
Employer Pension Plans
A pension plan is a retirement plan that is funded, at least in part, by an employer. With this
type of plan, your employer contributes to your retirement benefits, and sometimes you
contribute too. (See the nearby “Figure It Out!” box.) These contributions and earnings
remain tax-deferred until you start to withdraw them in retirement.
LO14.2
Determine your planned
retirement income and
develop a balanced budget
based on your retirement
income.
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ACTION ITEM
I’ll need 70 to 90 percent of
preretirement earnings to
live comfortably during my
retirement.
h Yes h No
Private employer pension plans vary. If the company you work for offers one, you
should know when you become eligible to receive pension benefits. You’ll also need to
know what benefits you’ll receive. Ask these questions during your interview with a pro-
spective employer and start participating in the plan as soon as possible. Most employer
plans are one of two basic types: defined-contribution plans or defined-benefit plans.
DEFINED-CONTRIBUTION PLAN A defined-contribution plan , sometimes
called an individual account plan, consists of an individual account for each employee to
which the employer contributes a specific amount annually. This type of retirement plan
does not guarantee any particular benefit. When you retire and become eligible for bene-
fits, you simply receive the total amount of funds (including investment earnings) that have
been placed in your account.
Several types of defined-contribution plans exist. With a money-purchase plan, your
employer promises to set aside a certain amount of money for you each year. The amount
is generally a percentage of your earnings. Under a stock bonus plan, your employer’s con-
tribution is used to buy stock in the company for you. The stock is usually held in a trust
until you retire. Then you can either keep your shares or sell them. Under a profit-sharing
plan, your employer’s contribution depends on the company’s profits.
In a 401(k) plan , also known as a salary-reduction plan, you set aside a portion of your
salary from each paycheck to be deducted from your gross pay and placed in a special
account. Your employer will often match your contribution up to a specific dollar amount
or percentage of your salary. For example, as one of the retirement benefits, McGraw-Hill
Education (the publisher of your textbook) offers its employees a 401(k) savings plan.
Under this plan, employees can contribute up to 25 percent of their pay with a maximum
contribution limit of $17,500 in 2014. The company matches up to the first 6 percent of the
employee’s pretax contributions.
The funds in 401(k) plans are invested in stocks, bonds, and mutual funds. As a result,
you can accumulate a significant amount of money in this type of account if you begin con-
tributing to it early in your career. In addition, the money that accumulates in your 401(k)
plan is tax-deferred, meaning that you don’t have to pay taxes on it until you withdraw it.
If you’re employed by a tax-exempt institution, such as a hospital or a nonprofit orga-
nization, the salary-reduction plan is called a Section 403(b) plan. As in a 401(k) plan,
the funds in a 403(b) plan are tax-deferred. The amount that can be contributed annually
to 401(k) and 403(b) plans is limited by law, as is the amount of annual contributions to
money-purchase plans, stock bonus plans, and profit-sharing plans.
Employee contributions to a pension plan belong to you, the employee, regardless of
the amount of time that you are with a particular employer. What happens to the contri-
butions that the employer has made to your account if you change jobs and move to
another company before you retire? One of the most important aspects of such plans is
vesting. Vesting is the right to receive the employer’s pension plan contributions that
you’ve gained, even if you leave the company before retiring. After a certain number of
years with the company, you will become fully vested, or entitled to receive 100 percent
of the company’s contributions to the plan on your behalf. Under some plans, vesting
may occur in stages. For example, you might become eligible to receive 20 percent
of your benefits after three years and gain another 20 percent each year until you are
fully vested.
DEFINED-BENEFIT PLAN A defined-benefit plan specifies the benefits you’ll
receive at retirement age, based on your total earnings and years on the job. The plan does
not specify how much the employer must contribute each year. Instead your employer’s
contributions are based on how much money will be needed in the fund as each participant
in the plan retires. If the fund is inadequate, the employer will have to make additional
contributions.
defined-contribution
plan A plan—profit sharing,
money purchase, Keogh,
or 401(k)—that provides an
individual account for each
participant; also called an
individual account plan.
401(k) plan A plan under
which employees can defer
current taxation on a portion
of their salary; also called a
salary-reduction plan.
vesting An employee’s right
to at least a portion of the
benefits accrued under an
employer pension plan, even
if the employee leaves the
company before retiring.
defined-benefit plan
A plan that specifies the
benefits the employee
will receive at the normal
retirement age.
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CARRYING BENEFITS FROM ONE PLAN TO ANOTHER Some pen-
sion plans allow portability, which means that you can carry earned benefits from one pen-
sion plan to another when you change jobs. Workers are also protected by the Employee
Retirement Income Security Act of 1974 (ERISA), which sets minimum standards for pen-
sion plans. Under this act the federal government insures part of the payments promised by
defined-benefit plans.
Public Pension Plans
Another source of retirement income is Social Security, a public pension plan established
by the U.S. government in 1935. The government agency that manages the program is
called the Social Security Administration.
SOCIAL SECURITY Social Security is an important source of retirement income for
most Americans. The program covers 97 percent of all workers, and almost one out of
Calculate how much you would have in 10 years if you saved $2,000 a year at an annual compound interest rate of
10 percent, with the company contributing $500 a year.
Figure It Out!
Saving for Retirement Saving for Retirement
Contributions 10% Interest Total
Annual contribution of 10% of
a $20,000 salary $2,000.00
Company annual contribution
matching $0.50 of 5% of the
salary 500.00
1st Year
2nd Year
3rd Year
4th Year
5th Year
6th Year
7th Year
8th Year
9th Year
10th Year
Total
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CAUTION! CAUTION!
Safeguard your Social Security card. You are
limited to three replacement cards in a year
and 10 during your lifetime.
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every six Americans currently collects some form of
Social Security benefit. Social Security is actually a
package of protection that provides benefits to retirees,
survivors, and disabled persons. The package protects
you and your family while you are working and after
you retire. Nevertheless, you should not rely on Social
Security to cover all of your retirement expenses. Social
Security was never intended to provide 100 percent of
your retirement income.
Who Is Eligible for Social Security Benefits?
The amount of retirement benefits you receive from
Social Security is based on your earnings over the
years. The more you work and the higher your earn-
ings, the greater your benefits, up to a certain maximum
amount.
The Social Security Administration provides you an
annual history of your earnings and an estimate of your
future monthly benefits. The statement includes an esti-
mate, in today’s dollars, of how much you will get each
month from Social Security when you retire—at age
62, full retirement age, or 70—based on your earnings to date and
your projected future earnings.
To qualify for retirement benefits you must earn a certain num-
ber of credits. These credits are based on the length of time you
work and pay into the system through the Social Security tax, or
contribution, on your earnings. You and your employer pay equal
amounts of the Social Security tax. Your credits are calculated on a
quarterly basis. The number of quarters you need depends on your
year of birth. People born after 1928 need 40 quarters to qualify for
benefits.
Certain dependents of a worker may receive benefits under the Social Security pro-
gram. They include a wife or dependent husband aged 62 or older; unmarried children
under 18 (or under 19 if they are full-time students no higher than grade 12); and unmar-
ried, disabled children aged 18 or older. Widows or widowers can receive Social Security
benefits earlier.
Social Security Retirement Benefits Most people can begin collecting Social Secu-
rity benefits at age 62. However, the monthly amount at age 62 will be less than it would be
if the person waits until full retirement age. This reduction is permanent.
In the past, people could receive full retirement benefits at age 65. However, because
of longer life expectancies, the full retirement age is being increased in gradual steps.
For people born in 1960 and later, the full retirement age will be 67. If you postpone
applying for benefits beyond your full retirement age, your monthly payments will
increase slightly for each year you wait, but only up to age 70.
Social Security Information For more information about
Social Security, you can visit the Social Security website. It
provides access to forms and publications and gives links to
other valuable information. To learn more about the taxability
of Social Security benefits, contact the Internal Revenue Service
at 1-800-829-3676 and ask for Publication 554, Social Security
and Equivalent Railroad Retirement Benefits.
CAUTION! CAUTION!
This chart shows the percentage of final earnings Social
Security is estimated to replace. Will you have enough to
make up the difference?
Your Retirement “Gap”
Preretirement
Salary
Percent of Income
Replaced by Social
Security
The “Gap”
You and Your
Employer Must Fill
$20,000 45% 35%
30,000 40 40
40,000 33 47
60,000 25 55
$100,000 15 65
SOURCE: TIAA-CREF.
did you know? did you know?
The estimated average monthly Social
Security benefit payable to retirees in 2014
was $1,294.
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CAUTION! CAUTION!
Withdrawals from a regular IRA prior to age
59½ may be subject to a 10 percent pen-
alty. From a Roth IRA, contributions may be
withdrawn at any age without penalty if the
account has been open for five years.
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OTHER PUBLIC PENSION PLANS Besides Social Security, the federal gov-
ernment provides several other special retirement plans for federal government workers
and railroad employees. Employees covered under these plans are not covered by Social
Security. The Veterans Administration provides pensions for survivors of people who died
while in the armed forces. It also offers disability pensions for eligible veterans. Many
state and local governments provide retirement plans for their employees as well.
Personal Retirement Plans
In addition to public and employer retirement plans, many people choose to set up per-
sonal retirement plans. Such plans are especially important to self-employed people
and other workers who are not covered by employer pension plans. Among the most
popular personal retirement plans are individual retirement accounts (IRAs) and Keogh
accounts.
INDIVIDUAL RETIREMENT ACCOUNTS An individual retirement account
(IRA) is a special account in which the person sets aside a portion of income for retirement.
Several types of IRAs are available:
• Regular IRA: A regular (traditional or classic) IRA lets you make annual
contributions until age 70½. The contribution limit was $5,500 per year in
2014 and after ($6,500 if 50 or over). Depending on your tax filing status
and income, the contribution may be fully or partially tax-deductible. The tax
deductibility of a traditional IRA also depends on whether you belong to an
employer-provided retirement plan. For example, in 2014, if you were covered
by a retirement plan at work and you filed a joint return, then your tax-deductible
contribution was reduced if your adjusted gross income was between $96,000 and
$116,000.
• Roth IRA: Annual contributions to a Roth IRA are not tax-deductible, but the
earnings accumulate tax-free. You may contribute the amounts discussed above
if you’re a single taxpayer with an adjusted gross income (AGI)
of less than $129,000. For married couples the combined AGI
must be less than $191,000. You can continue to make annual
contributions to a Roth IRA even after age 70½. If you have a
Roth IRA, you can withdraw money from the account tax-free
and penalty-free after five years if you are at least 59½ years
old or plan to use the money to help buy your first home. You
may convert a regular IRA to a Roth IRA. Depending on your
situation, one type of account may be better for you than
the other.
• Simplified Employee Pension (SEP) Plan: A simplified employee pension (SEP)
plan, also known as a SEP IRA, is an individual retirement account funded by
an employer. Each employee sets up an IRA account at a bank or other financial
institution. Then the employer makes an annual contribution of up to $50,000. The
employee’s contributions, which can vary from year to year, are fully tax-deductible,
and earnings are tax-deferred. A business of any size, even the self-employed,
can establish a SEP IRA. The SEP IRA is the simplest type of retirement plan if a
person is self-employed.
• Spousal IRA: A spousal IRA lets you make contributions on behalf of your
nonworking spouse if you file a joint tax return. The contributions are the same as
for the traditional and Roth IRAs. As with a traditional IRA, this contribution may
be fully or partially tax-deductible, depending on your income. This also depends
on whether you belong to an employer-provided retirement plan.
• Rollover IRA: A rollover IRA is a traditional IRA that lets you roll over, or transfer,
all or a portion of your taxable distribution from a retirement plan or other IRA.
individual retirement
account (IRA) A special
account in which the
employee sets aside a
portion of his or her income;
taxes are not paid on the
principal or interest until
money is withdrawn from the
account.
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Chapter 14 Starting Early: Retirement and Estate Planning 469
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You may move your money from plan to plan without
paying taxes on it. To avoid taxes, however, you must
follow certain rules about transferring the money from
one plan to another. If you change jobs or retire before
age 59½, a rollover IRA may be just what you need. It
will let you avoid the penalty you would otherwise have
to pay on early withdrawals.
• Education IRA: An education IRA, also known as a
Coverdell Education Savings Account, is a special IRA with certain restrictions.
It allows individuals to contribute up to $2,000 per year toward the education of
any child under age 18. The contributions are not tax-deductible. However, they do
provide tax-free distributions for education expenses. Exhibit 14–4 summarizes the
various types of IRA.
Whether or not you’re covered by another type of pension plan, you can still make IRA
contributions that are not tax- deductible. All of the income your IRA earns will compound
tax-deferred, until you begin making withdrawals. Remember, the biggest benefit of an IRA
lies in its tax-deferred earnings growth. The longer the money accumulates tax- deferred,
the bigger the benefit.
IRA Withdrawals When you retire, you can withdraw the money from your IRA by
one of several methods. You can take out all of the money at one time, but the entire
amount will be taxed as income. If you decide to withdraw the money from your IRA in
Type of IRA IRA Features
Regular IRA • Tax-deferred interest and earnings
• Annual limit on individual contributions
• Limited eligibility for tax-deductible contributions
• Contributions do not reduce current taxes
Roth IRA • Tax-deferred interest and earnings
• Annual limit on individual contributions
• Withdrawals are tax-free in specific cases
• Contributions do not reduce current taxes
Simplified Employee
Pension Plan (SEP
IRA)
• “Pay yourself first” payroll reduction contributions
• Pretax contributions
• Tax-deferred interest and earnings
Spousal IRA • Tax-deferred interest and earnings
• Both working spouse and nonworking spouse can contribute up to the
annual limit
• Limited eligibility for tax-deductible contributions
• Contributions do not reduce current taxes
Rollover IRA • Traditional IRA that accepts rollovers of all or a portion of your taxable
distribution from a retirement plan
• You can roll over to a Roth IRA
Education IRA • Tax-deferred interest and earnings
• 10% early withdrawal penalty is waived when money is used for
higher-education expenses
• Annual limit on individual contributions
• Contributions do not reduce current taxes
Exhibit 14–4
Various Types of IRA
IRAs can be a good way to
save money for retirement.
What are the features of the
Education IRA?
did you know? did you know?
In 2013, IRA assets totaled over $6 trillion.
Almost 40 percent of households owned
IRAs.
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SOURCE: Reprinted with permission from Kiplinger’s Personal Finance. Copyright © 2014. The Kiplinger Washington Editors, Inc.
1. What saving options are available for retirement accounts if you max out on your 401(k) or Roth IRA?
2. What might be an advantage of investing some of your savings in a taxable account?
3. What are the advantages and disadvantages of investing some of your savings in variable annuities?
I
n a word, yes. Or at
least consider investing a
portion of your 401(k) con-
tribution in the Roth. Con-
tributions to a Roth 401(k) won’t
reduce your tax bill now. While
pretax salary goes into a regular
401(k), aftertax money funds
the Roth. But as with Roth IRAs,
withdrawals from Roth 401(k)s
are tax- and penalty-free as long
as you’ve had the account for
five years and are at least 59½
when you take the money out.
Because there are no income
limits on Roth 401(k) contribu-
tions, these accounts provide a
way for high earners to invest
in a Roth without converting a
traditional IRA. In 2014, you can
contribute up to $17,500 to a
Roth 401(k), a traditional 401(k)
or a combination of the two.
Workers 50 or older can con-
tribute up to $23,000 annually.
If you get matching funds from
your employer, they go into a
traditional pretax 401(k) account.
Consider the benefits. Younger
workers stand to gain the most
from investing in a Roth 401(k)
because they will enjoy many
years of tax-free growth.
But older workers can bene-
fit, too. Consider this example
from Fidelity Investments:
Tom and Elaine, both 45, con-
tribute $5,000 to their 401(k)
plans. Tom contributes to a
traditional 401(k) plan, while
Elaine contributes to a Roth.
They don’t take withdrawals
until they’re 75. If their tax
rates and investment returns
remain equal, Tom will end up
with $27,404, after paying taxes
on the withdrawal, while Elaine
will have $38,061 tax-free (this
example assumes a 7% annual
rate of return and a 28% tax
bracket). Even if Tom invested
the $1,400 in tax savings he
enjoyed by investing pretax
money in the taxable account,
he’d still lag Elaine by $2,616.
If you expect your tax
bracket to decline when you
retire, the Roth 401(k) loses
some of its appeal, but it’s still
the superior option for many
savers—even those who are
close to retirement, says Stu-
art Ritter, financial planner
for T. Rowe Price. If you take
withdrawals from taxable and
tax-deferred accounts and leave
the money in the Roth for
decades, tax-free earnings will
continue to pile up.
If you plan to withdraw
money from the Roth within
ten years and you expect your
tax bracket to drop significantly
in retirement, then you might
come out ahead with a tradi-
tional 401(k) plan, Ritter says.
But you’d lose the flexibility to
take tax-free withdrawals for
major expenses, such as home
repairs or medical bills. And
a large withdrawal from a tax-
deferred account will increase
your taxable income, which
could affect everything from
taxes on your Social Security
benefits to the size of your Medi-
care premiums. Those worries
disappear with a Roth because
withdrawals are tax-free.
Although the rules require
owners to take distributions
from Roth 401(k)s starting at age
70½, you can get around that by
simply rolling the Roth account
tax-free into a Roth IRA.
Convert your 401(k)? The law
now allows employees to con-
vert funds from a traditional
401(k) plan to a Roth 401(k), if
the plan allows it. About 50%
of large employers offer a Roth
401(k), according to human
resources consultant Aon
Hewitt. Of those employers,
27% allow in-plan conversions,
and an additional 16% expect to
add that option this year.
You’ll have to pay taxes in
the year you convert, just as
you would if you converted a
traditional IRA to a Roth. Plus,
a large conversion could bump
you into a higher tax bracket.
Note that unlike converting
from a traditional IRA to a
Roth, you can’t change your
mind and undo a 401(k) conver-
sion to a Roth.
Sandra Block
“My Employer Now Offers a Roth Option
in Our 401(k). Should I Invest in It?”
F
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F
.
.
.
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ip
li
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r’
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er
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installments, you will have to pay tax only on the amount that
you withdraw. A final alternative would be to place the money
that you withdraw in an annuity that guarantees payments over
your lifetime. See the discussion of annuities later in this section
for further information about this option.
KEOGH PLANS A Keogh plan , also known as an H.R. 10
plan or a self-employed retirement plan, is a retirement plan spe-
cially designed for self-employed people and their employees. Keogh plans have limits on
the amount of annual tax-deductible contributions as well as various other restrictions.
Keogh plans can be complicated to administer, so you should get professional tax advice
before using this type of personal retirement plan.
LIMITS ON PERSONAL RETIREMENT PLANS With the exception of Roth
IRAs, you cannot keep money in most tax-deferred retirement plans forever. When you
retire, or by age 70½ at the latest, you must begin to receive “minimum lifetime distri-
butions,” withdrawals from the funds you accumulated in the plan. The amount of the
distributions is based on your life expectancy at the time the distributions begin. If you
don’t withdraw the minimum distributions from a retirement account, the IRS will charge
you a penalty.
Annuities
What do you do if you have funded your 401(k), 403(b), Keogh, and profit-sharing plans
up to the allowable limits and you want to put away more money for retirement? The
answer may be an annuity. You will recall from Chapter 10, an annuity is a contract pur-
chased from an insurance company that provides for a sum of money to be paid to a person
at regular intervals for a certain number of years or for life.
You might purchase an annuity with the money you receive from an IRA or company
pension. You can simply buy an annuity to supplement the income you’ll receive from
either of these types of plans.
You can choose to purchase an annuity that has a single payment or installment pay-
ments. You will also need to decide whether you want the insurance company to send the
income from your annuity to you immediately or begin sending it to you at a later date. The
payments you receive from an annuity are taxed as ordinary income. However, the interest
you earn from the annuity accumulates tax-free until payments begin.
Living on Your Retirement Income
As you plan for retirement, you’ll estimate a budget or spending plan. When the time to
retire arrives, however, you may find that your expenses are higher than you expected. If
that’s the case, you’ll have some work to do.
First, you’ll have to make sure that you’re getting all the income to which you’re enti-
tled. Are there other programs or benefits for which you might qualify? You’ll also need
to think about any assets or valuables you might be able to convert to cash or sources of
income.
You may have to confront the trade-off between spending and saving again. For exam-
ple, perhaps you can use your skills and time instead of money. Instead of spending money
on an expensive vacation, take advantage of free and low-cost recreation opportunities,
such as public parks, museums, libraries, and fairs. Retirees often receive special discounts
on movie tickets, meals, and more.
Keogh plan A plan
in which tax-deductible
contributions fund the
retirement of self-employed
people and their employees;
also called an H.R. 10 plan
or a self-employed retirement
plan.
did you know? did you know?
About 16 percent of U.S. households, or 19
million, have Roth IRAs compared with 36
million owners of traditional IRAs.
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WORKING DURING RETIREMENT Some people decide to work part-time
after they retire. Some even take new full-time jobs. Work can provide a person with a
greater sense of usefulness, involvement, and self-worth. It may also be a good way to add
to your retirement income.
DIPPING INTO YOUR NEST EGG When should you take money out of your
savings during retirement? The answer depends on your financial circumstances, your age,
and how much you want to leave to your heirs. (Your heirs are the people who will have
the legal right to your assets when you die.) Your savings may be large enough to allow you
to live comfortably on the interest alone. On the other hand, you may need to make regular
withdrawals to help finance your retirement.
EXAMPLE: Dipping into Your Nest Egg
If you have $10,000 in savings that earns 5.5 percent interest, compounded
quarterly, you could take out $68 every month for 20 years before reducing those
savings to zero. If you have $40,000, you could withdraw $224 every month for
30 years.
Starting
Amount
of Nest
Egg
YOU CAN REDUCE YOUR NEST EGG TO ZERO BY
WITHDRAWING THIS MUCH EACH MONTH FOR THE
STATED NUMBER OF YEARS . . .
Or You Can
Withdraw This
Much Each
Month and Leave
Your Nest Egg
Intact
10
Years
15
Years
20
Years
25
Years
30
Years
$ 10,000 $ 107 $ 81 $ 68 $ 61 $ 56 $ 46
15,000 161 121 102 91 84 69
20,000 215 162 136 121 112 92
25,000 269 202 170 152 140 115
30,000 322 243 204 182 168 138
40,000 430 323 272 243 224 184
50,000 537 404 340 304 281 230
60,000 645 485 408 364 337 276
80,000 859 647 544 486 449 368
100,000 1,074 808 680 607 561 460
NOTE: Based on an interest rate of 5.5 percent per year, compounded quarterly.
SOURCE: Select Committee on Aging, U.S. House of Representatives.
Exhibit 14–5
Dipping into Your Nest
Egg
If you dip into your retirement nest egg, you should consider one important question:
How long will your savings last if you make regular withdrawals?
Whatever your situation is, once your nest egg is gone, it’s gone. As shown in Exhibit 14–5 ,
dipping into your nest egg is not wrong, but do so with caution.
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Estate Planning
The Importance of Estate Planning
Many people think of estates as belonging only to the rich or elderly. The fact is, however,
everyone has an estate. Simple defined, your estate consists of everything you own. During
your working years your financial goal is to acquire and accumulate money for both your
current and future needs. Many years from now, as you grow older, your point of view will
change. Instead of working to acquire assets, you’ll start to think about what will happen to
your hard-earned wealth after you die. In most cases you’ll want to pass that wealth along
to your loved ones. That is where estate planning becomes important.
What Is Estate Planning?
Estate planning is the process of creating a detailed plan for managing your assets so that
you can make the most of them while you’re alive and ensure that they’re distributed wisely
after your death. It’s not pleasant to think about your own death. However, it is a part of
estate planning. Without a good estate plan, the assets you accumulate during your lifetime
might be greatly reduced by various taxes when you die.
Estate planning is an essential part of both retirement planning and financial planning.
It has two phases. First, you build your estate through savings, investments, and insurance.
Second, you ensure that your estate will be distributed as you wish at the time of your
death. If you’re married, your estate planning should take into account the needs of your
spouse and children. If you are single, you still need to make sure that your financial affairs
are in order for your beneficiaries. Your beneficiary is a person you’ve named to receive a
portion of your estate after your death.
When you die, your surviving spouse, children, relatives, and friends will face a period
of grief and loneliness. At the same time, one or more of these people will probably be
responsible for settling your affairs. Make sure that important documents are accessible,
understandable, and legally proper.
Legal Documents
An estate plan typically involves various legal documents, one of which is usually a will.
When you die, the person who is responsible for handling your affairs will need access
LO14.3
Analyze the personal and
legal aspects of estate
planning.
ACTION ITEM
I believe estate planning is
only for the rich and famous.
h Agree h Disagree
estate Everything one
owns.
estate planning A definite
plan for the administration
and disposition of one’s
property during one’s lifetime
and at one’s death.
PRACTICE QUIZ 14–2 PRACTICE QUIZ 14–2
1. What are four major sources of retirement income?
2. What are the two basic types of employer pension plans?
3. What are the most popular personal retirement plans?
4. What is the major difference between a regular IRA and a Roth IRA?
5. What might you do if your expenses during retirement are higher than you expected?
Apply Yourself! Apply Yourself!
Read newspaper or magazine articles to determine what expenses are likely to increase and decrease during retirement.
How might this information affect your retirement planning decisions?
Sheet 42 Retirement Plan Comparison
Sheet 43 Forecasting Retirement Income
S
S
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to these and other important documents. The documents must be reviewed and verified
before your survivors can receive the money and other assets to which they’re entitled. If
no one can find the necessary documents, your heirs may experience emotionally painful
delays. They may even lose part of their inheritance. The important papers you need to
collect and organize include:
• Birth certificates for you, your spouse, and your children.
• Marriage certificates and divorce papers.
• Legal name changes (especially important to protect adopted children).
• Military service records.
• Social Security documents.
• Veteran’s documents.
• Insurance policies.
• Transfer records of joint bank accounts.
• Safe-deposit box records.
• Automobile registration.
• Titles to stock and bond certificates.
PRACTICE QUIZ 14–3 PRACTICE QUIZ 14–3
1. What is estate planning?
2. What are the two stages in planning your estate?
3. List some important documents you will need to collect and organize.
Apply Yourself! Apply Yourself!
Contact several lawyers in your area to find out how much they would charge to prepare a simple will. Are their fees
about the same?
Sheet 44 Estate Planning Activities
Legal Aspects of Estate Planning
Wills
One of the most important documents that every adult should have is a written will. A will
is the legal document that specifies how you want your property to be distributed after your
death. If you die intestate —without a valid will—your legal state of residence will step in
and control the distribution of your estate without regard for any wishes you may have had.
You should avoid the possibility of dying intestate. The simplest way to do that is to
make sure that you have a written will. By having an attorney help you draft your will, you
may forestall many difficulties for your heirs. Legal fees for drafting a will vary with the
size of your estate and your family situation. A standard will costs between $300 and $400.
Make sure that you find an attorney who has experience with wills and estate planning.
Types of Wills
You have several options in preparing a will. The four basic types of wills are the simple
will, the traditional marital share will, the exemption trust will, and the stated amount will.
The differences among them can affect how your estate will be taxed.
LO14.4
Distinguish among various
types of wills and trusts.
ACTION ITEM
I can free myself from man-
aging my assets by setting
up a trust.
h Yes h No
will The legal declaration
of a person’s mind as to
the disposition of his or her
property after death.
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SIMPLE WILL A simple will leaves everything to your spouse. Such a will is gener-
ally sufficient for people with small estates. However, if you have a large or complex
estate, a simple will may not meet your objectives. It may also result in higher overall
taxation, since everything you leave to your spouse will be taxed as part of his or her estate.
TRADITIONAL MARITAL SHARE WILL The traditional marital share will
leaves one-half of the adjusted gross estate (the total value of the estate minus debts and
costs) to the spouse. The other half of the estate may go to children or other heirs. It can
also be held in trust for the family. A trust is an arrangement by which a designated person,
known as a trustee, manages assets for the benefit of someone else. A trust can provide a
spouse with a lifelong income and would not be taxed at his or her death.
EXEMPTION TRUST WILL With an exemption trust will, all of your assets go to
your spouse except for a certain amount, which goes into a trust. This amount, plus any
interest it earns, can provide your spouse with lifelong income that will not be taxed. The
tax-free aspect of this type of will may become important if your property value increases
considerably after you die.
STATED AMOUNT WILL The stated amount will allows you to pass on to your
spouse any amount that satisfies your family’s financial goals. For tax purposes you could
pass the exempted amount of $5.34 million (in 2014). However, you might decide to pass on
a stated amount related to your family’s future income needs or to the value of personal items.
WILLS AND PROBATE The type of will that is best for your particular needs
depends on many factors, including the size of your estate, inflation, your age, and your
objectives. No matter what type of will you choose, it’s best to avoid probate. Probate is
the legal procedure of proving a valid or invalid will. It’s the process by which your estate
is managed and distributed after your death, according to the provisions of your will. A
special probate court generally validates wills and makes sure that your debts are paid. You
should avoid probate because it’s expensive, lengthy, and public. As you will read later, a
living trust avoids probate and is also less expensive, quicker, and private.
Formats of Wills
Wills may be either holographic or formal. A holographic will is a handwritten will that
you prepare yourself. It should be written, dated, and signed entirely in your own hand-
writing. No printed or typed information should appear on its pages. Some states do not
recognize holographic wills as legal.
A formal will is usually prepared with the help of an attorney. It may be typed, or it
may be a preprinted form that you fill out. You must sign the will in front of two witnesses;
neither person can be a beneficiary named in the will. The witnesses must then sign the
will in front of you.
A statutory will is prepared on a preprinted form, available from lawyers, stationery
stores, or Internet sites. Using preprinted forms to prepare your will presents serious risks.
The form may include provisions that are not in the best interests of your heirs. Therefore,
it is best to seek a lawyer’s advice when you prepare your will.
Writing Your Will
Writing a will allows you to express exactly how you want your property to be distributed
to your heirs. If you’re married, you may think that all the property owned jointly by you
and your spouse will automatically go to your spouse after your death. This is true of some
assets, such as your house. Even so, writing a will is the only way to ensure that all of your
property will end up where you want it.
intestate Without a valid
will.
trust A legal arrangement
through which one’s assets
are held by a trustee.
probate The legal
procedure of proving a valid
or invalid will.
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SELECTING AN EXECUTOR An executor is someone who is willing and able to
perform the tasks involved in carrying out your will. These tasks include preparing an
inventory of your assets, collecting any money due, and paying off your debts. Your exec-
utor must also prepare and file all income and estate tax returns. In addition, he or she will
be responsible for making decisions about selling or reinvesting assets to pay off debt and
provide income for your family while the estate is being settled. Finally, your executor
must distribute the estate and make a final accounting to your beneficiaries and to the pro-
bate court.
SELECTING A GUARDIAN If you have children, your
will should also name a guardian to care for them in the event
that you and your spouse die at the same time and the children
cannot care for themselves. A guardian is a person who accepts
the responsibility of providing children with personal care after
their parents’ death and managing the parents’ estate for the
children until they reach a certain age.
ALTERING OR REWRITING YOUR WILL Sometimes you’ll need to change the
provisions of your will because of changes in your life or in the law. Once you’ve made
a will, review it frequently so that it remains current. Here are some reasons to review
your will:
• You’ve moved to a new state that has different laws.
• You’ve sold property that is mentioned in the will.
• The size and composition of your estate have changed.
• You’ve married, divorced, or remarried.
• Potential heirs have died, or new ones have been born.
Don’t make any written changes on the pages of an existing will. Additions, deletions, or
erasures on a will that has been signed and witnessed can invalidate the will. If you want to
make only a few minor changes, adding a codicil may be the best choice. A codicil is a
document that explains, adds, or deletes provisions in your existing will.
A Living Will
At some point in your life you may become physically or mentally disabled and unable to
act on your own behalf. If that happens, you’ll need a living will. A living will is a document
in which you state whether you want to be kept alive by artificial means if you become
terminally ill and unable to make such a decision. Many states recognize living wills.
Exhibit 14–6 is an example of a typical living will.
To ensure the effectiveness of a living will, discuss your intention of preparing such a
will with the people closest to you. You should also discuss this with your family doctor.
Sign and date your document before two witnesses. Witnessing shows that you signed of
your own free will.
Give copies of your living will to those closest to you, and have your family doctor place
a copy in your medical file. Keep the original document readily accessible, and look it over
periodically—preferably once a year—to be sure your wishes have remained unchanged.
To verify your intent, redate and initial each subsequent endorsement.
Most lawyers will do the paperwork for a living will at no cost if they are already
preparing your estate plan. You can also get the necessary forms from nonprofit advo-
cacy groups. Partnership for Caring: America’s Voices for the Dying is a national nonprofit
organization that operates the only national crisis and information hotline dealing with
end-of-life issues. It also provides living wills, medical powers of attorney, and similar
documents geared to specific states. Working through end-of-life issues is difficult, but
executor Someone willing
and able to perform the tasks
involved in carrying out your
will.
guardian A person who
assumes responsibility
for providing children with
personal care and managing
the deceased’s estate for
them.
codicil A document that
modifies provisions in an
existing will.
living will A document that
enables an individual, while
well, to express the intention
that life be allowed to end if he
or she becomes terminally ill.
did you know? did you know?
Who can be an executor? Any U.S. citizen
over 18 who has not been convicted of a
felony can be named the executor of a will.
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it can help avoid forcing your family to make a decision in a hospital waiting room—or
worse, having your last wishes ignored.
POWER OF ATTORNEY Related to the idea of a living will is power of attorney.
A power of attorney is a legal document that authorizes someone to act on your behalf. If
you become seriously ill or injured, you’ll probably need someone to take care of your
needs and personal affairs. This can be done through a power of attorney.
LETTER OF LAST INSTRUCTION In addition to a traditional will, it is a good
idea to prepare a letter of last instruction. This document is not legally binding, but it can pro-
vide your heirs with important information. It should contain your wishes for your funeral
arrangements as well as the names of the people who are to be informed of your death.
Trusts
Basically, a trust is a legal arrangement that helps manage the assets of your estate for your
benefit or that of your beneficiaries. The creator of the trust is called the trustor, or grantor.
The trustee might be a person or institution, such as a bank, that administers the trust.
A bank charges a small fee for its services in administering a trust. The fee is usually based
on the value of the assets in the trust.
Individual circumstances determine whether establishing a trust makes sense. Some of
the common reasons for setting up a trust are to:
• Reduce or otherwise provide payment of estate taxes.
• Avoid probate and transfer your assets immediately to your beneficiaries.
• Free yourself from managing your assets while you receive a regular income from
the trust.
• Provide income for a surviving spouse or other beneficiary.
• Ensure that your property serves a desired purpose after your death.
power of attorney A
legal document authorizing
someone to act on one’s
behalf.
Exhibit 14–6
A Living Will
Declaration made this _____ day of __________ (month, year)
I, ____________________, being of sound mind, willfully and voluntarily make known my desire that
my dying shall not be artificially prolonged under the circumstances set forth below, do hereby
declare
If at any time I should have an incurable injury, disease, or illness regarded as a terminal
condition by my physician and if my physician has determined that the application of
life-sustaining procedures would serve only to artificially prolong the dying process and that my
death will occur whether or not life-sustaining procedures are utilized, I direct that such
procedures be withheld or withdrawn and that I be permitted to die with only the administration
of medication or the performance of any medical procedure deemed necessary to provide me
with comfort care.
In the absence of my ability to give directions regarding the use of such life-sustaining
procedures, it is my intention that this declaration shall be honored by my family and physician
as the final expression of my legal right to refuse medical or surgical treatment and accept the
consequences from such refusal. I understand the full import of this declaration, and I am
emotionally and mentally competent to make this declaration.
Signed
City, County, and State of Residence
The declarant has been personally known to me, and I believe him or her to be of sound mind.
Witness
Witness
Some people who become terminally ill cannot make decisions on their own behalf. What is
the basic purpose of a living will?
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Types of Trusts
There are many types of trusts, some of which are described in detail in this section. You’ll
need to choose the type of trust that’s most appropriate for your particular situation. An estate
attorney can advise you about the right type of trust for your personal and family needs.
All trusts are either revocable or irrevocable. A revocable trust is one in which you
have the right to end the trust or change its terms during your lifetime. An irrevocable
trust is one that cannot be changed or ended. Revocable trusts avoid the lengthy process of
probate, but they do not protect assets from federal or state estate taxes. Irrevocable trusts
avoid probate and help reduce estate taxes. However, by law you cannot remove any assets
from an irrevocable trust, even if you need them at some later point in your life.
CREDIT-SHELTER TRUST A credit-shelter trust is one that enables the spouse of
a deceased person to avoid paying federal taxes on a certain amount of assets left to him or
her as part of an estate. Perhaps the most common estate planning trust, the credit-shelter
trust has many other names: bypass trust, “residuary” trust, A/B trust, exemption equiva-
lent trust, or family trust. It is designed to allow married couples, who can leave everything
to each other tax-free, to take full advantage of the exemption that allows $5.34 million (in
2014) in every estate to pass free of federal estate taxes. The surviving spouse’s estate in
excess of $10.68 million (in 2014) faces estate tax of 40 percent.
DISCLAIMER TRUST A disclaimer trust is appropriate for couples who do not yet
have enough assets to need a credit-shelter trust but may have in the future. With a dis-
claimer trust, the surviving spouse is left everything, but he or she has the right to disclaim,
or deny, some portion of the estate. Anything that is disclaimed goes into a credit-shelter
trust. This approach allows the surviving spouse to protect wealth from estate taxes.
LIVING TRUST A living trust, also known as an inter vivos trust, is a property man-
agement arrangement that goes into effect while you’re alive. It allows you, as a trustor, to
receive benefits during your lifetime. To set up a living trust, you simply transfer some of
your assets to a trustee. Then you give the trustee instructions for managing the trust while
you’re alive and after your death. A living trust has several advantages:
• It ensures privacy. A will is a public record; a trust is not.
• The assets held in trust avoid probate at your death. This eliminates probate costs
and delays.
• It enables you to review your trustee’s performance and make changes if necessary.
• It can relieve you of management responsibilities.
• It’s less likely than a will to create arguments between heirs upon your death.
• It can guide your family and doctors if you become terminally ill or unable to make
your own decisions.
Read the nearby “Personal Finance in Practice” box, “The Psychology of Living Trust
Offers,” to make sure that living trust offers are trustworthy.
Setting up a living trust costs more than creating a will. However, depending on your
particular circumstances, a living trust can be a good estate planning option.
TESTAMENTARY TRUST A testamentary trust is one established by your will that
becomes effective upon your death. Such a trust can be valuable if your beneficiaries are
inexperienced in financial matters. It may also be your best option if your estate taxes will
be high. A testamentary trust provides many of the same advantages as a living trust.
Taxes and Estate Planning
Federal and state governments impose various types of taxes that you must consider in
estate planning. The four major types of taxes are estate taxes, estate and trust federal
income taxes, inheritance taxes, and gift taxes.
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Misinformation and misunderstanding about estate taxes
and the length or complexity of probate provide the perfect
cover for unethical salespeople, who have created an indus-
try out of older people’s fears that their estates could be
eaten up by costs or that distribution of their assets could
be delayed for years. Some unethical businesses are adver-
tising seminars on living trusts or sending postcards invit-
ing consumers to call for in-home appointments to learn
whether a living trust is right for them. In these cases, it’s not
uncommon for the salesperson to exaggerate the benefits
or appropriateness of the living trust and claim—falsely—
that locally licensed lawyers will prepare the documents.
Other businesses are advertising living trust “kits”: con-
sumers send money for these do-it-yourself products but
receive nothing in return. Still other businesses are using
estate planning services to gain access to consumers’
financial information and to sell them other financial prod-
ucts, such as insurance annuities.
What’s a consumer to do? It’s true that, for some peo-
ple, a living trust can be a useful and practical tool. But for
others, it can be a waste of money and time. Because state
laws and requirements vary, “cookie-cutter” approaches
to estate planning aren’t always the most efficient way to
handle your affairs. Before you sign any papers to create a
will, a living trust, or any other kind of trust:
• Explore all your options with an experienced and
licensed estate planning attorney or financial advisor.
Generally, state law requires that an attorney draft the
trust.
• Avoid high-pressure sales tactics and high-speed
sales pitches by anyone who is selling estate
planning tools or arrangements.
• Avoid salespeople who give the impression that
AARP is selling or endorsing their products. AARP
does not endorse any living trust products.
• Do your homework. Get information about your local
probate laws from the Clerk (or Registrar) of Wills.
• If you opt for a living trust, make sure it’s properly
funded—that is, that the property has been
transferred from your name to the trust. If the
transfers aren’t done properly, the trust will be
invalid and the state will determine who inherits
your property and serves as guardian for your minor
children.
• If someone tries to sell you a living trust, ask whether
the seller is an attorney. Some states limit the sale of
living trust services to attorneys.
The Psychology of Living Trust Offers: Is It Ethical?
Personal Finance in Practice
ESTATE TAXES An estate tax is a federal tax collected on
the value of a person’s property at the time of his or her death.
The tax is based on the fair market value of the deceased person’s
investments, property, and bank accounts, less an exempt amount
of $5.34 million in 2014; this tax is due nine months after a death.
ESTATE AND TRUST FEDERAL INCOME TAXES In
addition to the federal estate tax return, estates and certain trusts
must file federal income tax returns with the Internal Revenue
Service. Taxable income for estates and trusts is computed in
the same manner as taxable income for individuals. Trusts and
estates must pay quarterly estimated taxes.
INHERITANCE TAXES Your heirs might have to pay a
tax for the right to acquire the property that they have inherited.
An inheritance tax is a tax collected on the property left by a
person in his or her will.
Only state governments impose inheritance taxes. Most states collect an inheritance tax,
but state laws differ widely as to exemptions and rates of taxation. A reasonable average for
state inheritance taxes would be 4 to 10 percent of whatever the heir receives.
GIFT TAXES Both the state and federal governments impose a gift tax, a tax col-
lected on money or property valued at more than $14,000 (in 2014) given by one person
to another in a single year. One way to reduce the tax liability of your estate is to reduce
the size of the estate while you’re alive by giving away portions of it as gifts. You’re free
to make such gifts to your spouse, children, or anyone else at any time. (Don’t give away
assets if you need them in your retirement!)
did you know? did you know?
Charitable gifts can be an Charitable gifts can be an
important tool in estate planning. important tool in estate planning.
Giving to charity supports a cause and Giving to charity supports a cause and
offers benefits such as reduced taxes and offers benefits such as reduced taxes and
increased interest income. The National increased interest income. The National
Philanthropic Trust is an independent Philanthropic Trust is an independent
public charity dedicated to increasing public charity dedicated to increasing
philanthropy in our society. For more philanthropy in our society. For more
information, visit information, visit www.nptrust.orgwww.nptrust.org . .
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PRACTICE QUIZ 14–4 PRACTICE QUIZ 14–4
1. What is a will?
2. What are the four basic types of wills?
3. What are the responsibilities of an executor?
4. Why should you name a guardian?
5. What is the difference between a revocable and an irrevocable trust?
6. What are the four major types of trusts?
7. What are the four major types of taxes to consider in estate planning?
Apply Yourself! Apply Yourself!
Discuss with your attorney the possibility of establishing a trust as a means of managing your estate.
Sheet 45 Will Planning
Sheet 46 Trust Comparison
S
S
YOUR PERSONAL FINANCE DASHBOARD
YOUR SITUATION: Have you figured out how much money you should save for retirement? Most financial advisors
suggest that you will need 70 to 90 percent of preretirement earnings to live comfortably. Are you taking advantage of
retirement savings programs at work, especially those where your employer matches contributions? Have you made
sure that your investments are diversified?
POSSIBLE ACTIONS TO TAKE
Reconsider your responses to the “Action Items” (in
the text margin) in the chapter to determine actions
you might take to improve your retirement and estate
planning activities.
Reevaluate your retirement and estate planning goals
to make sure they reflect what is important to you
and your family.
Consider information from several sources when
making retirement and estate planning decisions.
Consult older friends and relatives, bankers, and tax
advisors.
Use future value and present value computations to
help you achieve your retirement and estate planning
goals. Calculators are available at www.dinkytown
.net , www.moneychimp.com/calculator , and www
.rbccentura.com/tools .
A dashboard is a tool used by organizations to monitor
key performance indicators, such as delivery time, prod-
uct defects, or customer complaints. As an individual,
you can use a personal finance dashboard to assess
your own financial situation.
You have several retirement savings opportunities avail-
able to you—from IRAs and SEPs to 401(k)s and 403(b)s.
These options are especially important now that tradi-
tional pensions and other employer-funded retirement
plans have become increasingly rare.
D
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FINANCIALLY SEC
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PERCENT OF PRERETIREMENT EARNINGS
0 % 100 %
20 % 80 %
10 % 90 %
30 % 70 %
50 %40 % 60 %
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LO14.1 The difference between your
assets and your liabilities is your net worth.
Review your assets to ensure they are suf-
ficient for retirement. Then estimate your
living expenses. Some expenses are likely
to decrease while others will increase.
LO14.2 Your possible sources of income
during retirement include employer pension
plans, public pension plans, personal retire-
ment plans, and annuities. If your income
approximates your expenses, you are in
good shape; if not, determine additional
income needs and sources.
LO14.3 The personal aspects of estate
planning depend on whether you are single
or married. Never having been married
does not eliminate the need to organize
your financial affairs. Every adult should
have a written will. A will is a way to trans-
fer your property according to your wishes
after you die.
LO14.4 The four basic types of wills
are the simple will, the traditional marital
share will, the exemption trust will, and the
stated amount will. Types of trusts include
the credit-shelter trust, the disclaimer trust,
the living trust, and the testamentary trust.
Federal and state governments impose
various types of estate taxes; you can prepare
a plan for paying these taxes.
Chapter
Summary
Key Terms
codicil 476
defined-benefit
plan 465
defined-contribution
plan 465
estate 473
estate planning 473
living will 476
power of attorney 477
probate 475
trust 475
vesting 465
will 474
executor 476
401(k) plan 465
guardian 476
individual retirement
account (IRA) 468
intestate 474
Keogh plan 471
1. How will your spending patterns change during your retirement years? Compare your
spending patterns with those shown in Exhibit 14–2 . (LO14.1)
2. Obtain Form SSA-7004 from your local Social Security office. Complete and mail the
form to receive a personal earnings and benefits statement. Use the information in this
statement to plan your retirement. (LO14.2)
3. Prepare a written report of personal information that would be helpful to you and your
heirs. Be sure to include the location of family records, your military service file, and
other important papers; medical records; bank accounts; charge accounts; location of
your safe-deposit box; U.S. savings bonds, stocks, bonds, and other securities; prop-
erty owned; life insurance; annuities; and Social Security information. (LO14.3)
4. Visit Metropolitan Life Insurance Company’s web page at www.lifeadvice.com . Using
this information, prepare a report on the following: ( a ) Who needs a will? ( b ) What
are the elements of a will (naming a guardian, naming an executor, preparing a will,
updating a will, estate taxes, where to keep your will, living will, etc.)? ( c ) How is this
report helpful in preparing your own will? (LO14.3)
5. Make a list of the criteria you will use in deciding who will be the guardian of your
minor children if you and your spouse die at the same time. (LO14.3)
Discussion
Questions
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1. Beverly Foster is planning for her retirement. She has determined that her car is worth
$10,000, her home is worth $150,000, her personal belongings are worth $100,000,
and her stocks and bonds are worth $300,000. She owes $50,000 on her home and
$5,000 on her car. Calculate her net worth.
2. Calculate how much money an average older (65 1 ) household with an annual income
of $39,173 spends on food each year. ( Hint: Use Exhibit 14–2 .)
3. On December 31, 2014, George gives $14,000 to his son and $14,000 to his son’s
wife. On January 1, 2015, George gives another $14,000 to his son and another
$14,000 to his son’s wife. George made no other gifts to his son or his son’s wife in
2014 and 2015. What is the gift tax?
Solutions
1. Assets Liabilities
Car $ 10,000 Mortgage $ 50,000
Home $150,000 Car 5,000
Personal
belongings
$100,000 Total liabilities $ 55,000
Stocks and
bonds
$300,000
Total assets $560,000
Net worth 5 Assets 2 Liabilities
5 $560,000 2 $55,000 5 $505,000
2. An average older household with an annual income of $39,173 spends about 13.1 percent
of their income on food. Thus $39,173 3 13.1% 5 $5,158.
3. There is no gift tax in 2014 or in 2015 since George gifted $14,000 to his son and
son’s wife in each of the two years.
Self-Test
Problems
1. Shelly’s assets include money in checking and saving accounts, investments in stocks
and mutual funds, and personal property such as furniture, appliances, an automobile,
a coin collection, and jewelry. Shelly calculates that her total assets are $165,200.
Her current unpaid bills, including an auto loan, credit card balances, and taxes, total
$21,300. Calculate Shelly’s net worth. (LO14.1)
2. Prepare your net worth statement using the Assets 2 Liabilities 5 Net worth
equation. (LO14.1)
3. Ted Riley owns a 2012 Lexus worth $40,000. He owns a home worth $275,000. He
has a checking account with $800 in it and a savings account with $1,900 in it. He has
a mutual fund worth $110,000. His personal assets are worth $90,000. He still owes
$25,000 on his car and $150,000 on his home, and he has a balance on his credit card
of $1,600. What is Ted’s net worth? (LO14.1)
4. Calculate approximately how much money an older (65 1 ) household with an annual
income of $45,000 spends on housing each year. ( Hint: Use Exhibit 14–2 .) (LO14.1)
5. Using Exhibit 14–2 , calculate approximately how much money the household from
problem 4 spends on medical care. (LO14.1)
6. Ruby is 25 and has a good job at a biotechnology company. She currently has $10,000
in an IRA, an important part of her retirement nest egg. She believes her IRA will
grow at an annual rate of 8 percent, and she plans to leave it untouched until she retires
at age 65. Ruby estimates that she will need $875,000 in her total retirement nest egg
by the time she is 65 in order to have retirement income of $20,000 a year (she expects
that Social Security will pay her an additional $15,000 a year). (LO14.2)
Problems
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a. How much will Ruby’s IRA be worth when she needs to start withdrawing money
from it when she retires? ( Hint: Use Exhibit 1–A in the Chapter 1 Appendix.)
b. How much money will she have to accumulate in her company’s 401(k) plan over
the next 40 years in order to reach her retirement income goal?
7. Gene and Dixie, husband and wife (ages 35 and 32), both work. They have an adjusted
gross income of $50,000 in 2014, and they are filing a joint income tax return. Both
have employer-provided retirement plans at work. What is the maximum IRA contri-
bution they can make? How much of that contribution is tax-deductible? (LO14.2)
8. You have $100,000 in your retirement fund that is earning 5.5 percent per year, com-
pounded quarterly. How many dollars in withdrawals per month would reduce this nest
egg to zero in 20 years? How many dollars per month can you withdraw for as long as
you live and still leave this nest egg intact? ( Hint: Use Exhibit 14–5 .) (LO14.2)
Problems 9, 10, and 11 are based on the following scenario:
In 2014, Joshua gave $14,000 worth of Microsoft stock to his son. In 2015, the Mic-
rosoft shares are worth $23,000.
9. What was the gift tax in 2014? (LO14.4)
10. What is the total amount removed from Joshua’s estate in 2015? (LO14.4)
11. What will be the gift tax in 2015? (LO14.4)
12. In 2014, you gave a $12,000 gift to a friend. What is the gift tax? (LO14.4)
Problems 13, 14, and 15 are based on the following scenario:
Barry and his wife Mary have accumulated over $3.5 million during their 50 years of
marriage. They have three children and five grandchildren.
13. How much money can they gift to their children in 2014 without any gift tax
liability? (LO14.4)
14. How much money can Barry and Mary gift to their grandchildren in 2014 without
any gift tax liability? (LO14.4)
15. What is the total amount of estate removed from Barry and Mary’s estate
in 2014? (LO14.4)
16. The date of death for a widow was 2014. If the estate was valued at $7.5 million and
the estate was taxed at 40 percent, what was the heir’s tax liability? (LO14.4)
17. Joe and Rachael are both retired. Married for 55 years, they have amassed an estate
worth $4.4 million. The couple has no trust or other type of tax-sheltered assets. If
Joe or Rachael dies in 2014, how much federal estate tax would the surviving spouse
have to pay, assuming that the estate is taxed at the 40 percent rate? (LO14.4)
Case in
Point PLANNING FOR RETIREMENT
Is a bad day fishing better than a good day
at the office? Yes, according to a retired dad,
Chuck. With his company pension, at least
he didn’t have to worry about money. In
the good old days, if you had a decent job,
you’d hang on to it, and then your compa-
ny’s pension combined with Social Security
payments would be enough to live com-
fortably. Chuck’s son, Rob, does not have
a company pension and is not sure whether
Social Security will even exist when he
retires. So when it comes to retirement, the
sooner you start saving, the better.
Take Maureen, a salesperson for a com-
puter company, and Therese, an accountant
for a lighting manufacturer. Both start
their jobs at age 25. Maureen starts sav-
ing for retirement right away by investing
$300 a month at 9 percent until age 65. But
Therese does nothing until age 35. At 35
she begins investing the same $300 a month
at 9 percent until age 65. What a shocking
difference! Maureen has accumulated $1.4
million, while Therese has only $553,000
in her retirement fund. The moral? The
sooner you start, the more you’ll have for
your retirement. Women especially need to
start sooner, because they typically enter
the workforce later, have lower salaries,
and, ultimately, have lower pensions.
To reinforce the content in this chapter, more problems are
provided at connect.mheducation.com.
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Laura Tarbox, owner and president of Tar-
box Equity, explains how to determine
your retirement needs and how your bud-
get might change when you retire. Tarbox
advises that the old rule of thumb—that
you need 60 to 70 percent of preretirement
income—is too low an estimate. She cau-
tions that most people will want to spend
very close to what they were spending
before retiring. There are some expenses
that might be lower, however, such as cloth-
ing for work, dry cleaning, and commuting
expenses. Other expenses, though, such
as insurance, travel, and recreation, may
increase during retirement.
Questions
1. In the past, many workers chose to stay
with their employers until retirement.
What was the major reason for employ-
ees’ loyalty?
2. How did Maureen amass $1.4 million
for retirement, while Therese could
accumulate only $553,000?
3. Why do women need to start early to
save for retirement?
4. What expenses may increase or
decrease during retirement?
Continuing
Case STARTING EARLY: RETIREMENT AND ESTATE PLANNING
Jamie Lee and Ross, now in their 50s, have plenty of time on their hands now that the trip-
lets are away at college. They both realize that time has flown by; more than 24 years have
passed since they married!
Looking back over the years, they realize that they have worked hard in their careers,
Jamie Lee as the proprietor of a cupcake café and Ross, self-employed as a web page
designer. They enjoyed raising their family and strived to be financially sound as they
looked forward to a retirement that is just around the corner. They saved regularly and
invested wisely over the years. They rebounded nicely from the recent economic crisis
over the past few years, as they watched their investments closely and adjusted their strat-
egies when they felt it necessary. They purchase vehicles with cash and do not carry credit
card balances, choosing to use them for convenience only. The triplets are pursuing their
master’s degrees and have tuition covered through work-study programs at the university.
Jamie Lee and Ross are just a few short years from realizing their goals of retiring at 65
and purchasing the home at the beach!
Current Financial Situation
Assets (Jamie Lee and Ross combined) :
Checking account, $5,500
Savings account, $53,000
Emergency fund savings account, $45,000
House, $475,000
IRA balance, $92,000
Life insurance cash value, $125,000
Investments (stocks, bonds), $750,000
Cars, $12,500 (Jamie Lee) and $16,000
(Ross)
Liabilities (Jamie Lee and Ross
combined) :
Mortgage balance, $43,000
Credit card balance, $0
Car loans, $0
Income:
Jamie Lee, $45,000 gross income
($31,500 net income after taxes)
Ross, $135,000 gross income ($97,200
net income after taxes)
Monthly Expenses
Mortgage, $1,225
Property taxes, $500
Homeowner’s insurance, $300
IRA contribution, $300
Utilities, $250
Food, $600
Gas/Maintenance, $275
Entertainment, $300
Life insurance, $375
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Questions
1. As Jamie Lee and Ross review their assets, can you tell them which will be valuable to
them for income as retirement approaches?
2. Jamie Lee and Ross estimate that they will have $1 million in liquid assets to withdraw
from at the start of their retirement. They plan to be in retirement for 30 years. Using
Exhibit 14–5 how much do you think Jamie Lee and Ross can withdraw each month
and still leave their next egg intact? How much can they withdraw each month that
will reduce their nest egg to zero?
3. Jamie Lee and Ross have been hearing many stories recently about acquaintances who
are passing away without leaving a will, which made Jamie Lee and Ross anxious to
review their estate plan with an attorney. They do not want to think about eventually
passing on, but they know it is an essential part to careful financial planning. It was
suggested that they assemble all of their legal documents in a place where their heirs
would be able to access them if necessary. What documents would you suggest that
Jamie Lee and Ross make accessible?
4. Jamie Lee and Ross are now having the attorney draw up a will for each of them.
What is the purpose of having a will? Do they need to have an attorney to draft a will?
What type of will would you recommend they have, based on their marital/family
status?
Spending
Diary
Directions The consistent use of a Daily Spending Diary can provide you with ongoing
information that will help you manage your spending, saving, and investing activities.
Taking time to reconsider your spending habits can result in achieving better satisfaction
from your available finances. The Daily Spending Diary sheets are located in Appendix D
at the end of the book and in Connect Finance.
Analysis Questions
1. What portion of your available finances involve saving or investing for long-term
financial security?
2. What types of retirement and estate planning activities might you start to consider at
this point of your life?
“KEEPING TRACK OF MY DAILY SPENDING GETS ME TO START
THINKING ABOUT SAVING AND INVESTING FOR RETIREMENT.”
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What’s Next for Your Personal Financial Plan?
• Survey local businesses to determine the types of retirement plans available to employees.
• Talk to representatives of various financial institutions to obtain their suggestions for IRA investments.
Retirement Plan Comparison
Purpose: To compare benefits and costs for different retirement plans: 401(k), 403(b), 457,
IRA, Roth IRA, SEP IRA, etc.
Financial Planning Activities: Analyze advertisements and articles, and contact your
employer and financial institutions to obtain the information requested below. This sheet is
also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.lifenet.com www.aarp.org www.financialengines.com
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Type of plan
Name of financial institution
or employer
Address
Phone
Website
Type of investments
Minimum initial deposit
Minimum additional deposits
Employer contributions
Current rate of return
Service charges/fees
Safety insured? By whom?
Amount of coverage
Payroll deduction available?
Tax benefits
Penalty for early withdrawal:
• IRS penalty (10%)
• Other penalties
Other features or restrictions
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Estimated annual retirement living expenses
Estimated annual living expenses
if you retired today $ ________________________
Future value for _____ years until retirement at
expected annual income of _____ %(use future
value of $1, Exhibit 1–A of Chapter 1 Appendix) 3 _______________________
Projected annual retirement living expenses
adjusted for inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (A) $ _______________________
Estimated annual income at retirement
Social Security income $ ________________________
Company pension, personal retirement
account income $ ________________________
Investment and other income $ ________________________
Total retirement income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (B) $ _______________________
Annual shortfall of income after retirement (subtract B from A) . . . . . . . . . (C) _______________________
Additional amount required to fund the income
shortfall at retirement
Expected annual rate of return on funds
before retirement ________________________
Expected years in retirement ________________________
Expected annual rate of return on invested
funds after retirement ________________________
Additional amount needed at retirement to fund the shortfall . . . . . . . . . . . (D) $ _______________________
Future value factor of a series of deposits for _____ years until
retirement and an expected annual rate of return before retirement
of _____ % (use Exhibit 1–B of Chapter 1 Appendix) equals (E) $ _______________________
Annual deposit required to accumulate the amount needed
(D 4 E) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ _______________________
What’s Next for Your Personal Financial Plan?
• Survey retired individuals or people close to retirement to obtain information on their main sources of retire-
ment income.
• Make a list that suggests the best investment options for an individual retirement account.
Forecasting Retirement Income
Purpose: To determine the amount needed to save each year to have the necessary funds
to cover retirement living costs.
Financial Planning Activities: Estimate the information requested below. This sheet is also
available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.ssa.gov www.pensionplanners.com www.choosetosave.org
Suggested
App:
• RetirePlan
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Suggested
App:
• ACTEC
Wealth
Advisor
Estate Planning Activities
Purpose: To develop a plan for estate planning and related financial activities.
Financial Planning Activities: Respond to the following questions as a basis for making and
implementing an estate plan. This sheet is also available in an Excel spreadsheet format in
Connect Finance.
Suggested Websites: www.nolo.com www.brightline.com www.law.cornell.edu
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Are your financial records,
including recent tax forms,
insurance policies, and
investment and housing
documents, organized
and easily accessible?
Do you have a safe-deposit
box? Where is it located?
Where is the key?
Location of life insurance
policies. Name and address of
insurance company and agent.
Is your will current? Location
of copies of your will. Name
and address of your lawyer.
Name and address of your
executor.
Do you have a listing of the
current value of assets owned
and liabilities outstanding?
Have any funeral and burial
arrangements been made?
Have you created any trusts?
Name and location of financial
institution.
Do you have any current
information on gift and
estate taxes?
Have you prepared a letter of
last instruction? Where is it
located?
What’s Next for Your Personal Financial Plan?
• Talk to several individuals about the actions they have taken related to estate planning.
• Create a list of situations in which a will would need to be revised.
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What’s Next for Your Personal Financial Plan?
• Create a list of items that you believe would be desirable to include in a will.
• Obtain the cost of a will from a number of different sources.
Will Planning
Purpose: To compare costs and features of various types of wills.
Financial Planning Activities: Obtain information for the various areas listed based on your
current and future situation; contact attorneys regarding the cost of these wills. This sheet is
also available in an Excel spreadsheet format in Connect Finance.
Suggested Websites: www.netplanning.com www.estateplanninglinks.com the.nnepa.com
Type of will
Features that would be
appropriate for my current or
future situation
Cost
Attorney, address, phone
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Suggested
App:
• Trusts &
Estates
Plus
What’s Next for Your Personal Financial Plan?
• Talk to legal and financial planning experts to contrast the cost and benefits of wills and trusts.
• Talk to one or more lawyers to obtain information about the type of trust recommended for your situation.
Trust Comparison
Purpose: To identify features of different types of trusts.
Financial Planning Activities: Research features of various trusts to determine their value
to your personal situation. This sheet is also available in an Excel spreadsheet format in
Connect Finance.
Suggested Websites: www.brightline.com www.lifenet.com
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Type of trust Benefits
Possible value for my
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Education Financing,
Loans, and
Scholarships
The desire to pursue higher education has grown steadily since the 1940s. According
to the Census Bureau, in 1940 approximately 5 percent of the population held a bache-
lor’s degree. Today, that percentage has grown to greater than 30 percent. The increase in
demand for education has created an expansion in many areas, including the number of
higher education institutions, the development of different types of degree programs, and
specialization in occupations. All of these have contributed to the overall higher cost of a
college education.
What is driving the increase in demand for education? Some of the main drivers appear
to be higher projected salaries with additional education and reduced potential for unem-
ployment. Numerous studies have shown a correlation between additional education and
higher salaries. In addition, lower unemployment rates are correlated with higher educa-
tion levels (see Exhibit A–1 ). However, along with additional education come the oppor-
tunity costs associated with it: lost wages while in school, and the associated tuition and
living costs. Paying for these educational pursuits is the primary focus of this appendix.
A
Exhibit A–1 Education Pays
Education pays in lower unemployment rates and higher earnings
2.2
2.3
3.4
4.0
7.0
7.5
11.0
1,623
1,714
1,329
1,108
777
727
651
472
Doctoral degree
Professional degree
Master’s degree
Bachelor’s degree
Associate’s degree
Some college,
no degree
High school diploma
Less than a
high school diploma
All workers: 6.1% All workers: $827
Median weekly earnings in 2013 ($)Unemployment rate in 2013 (%)
5.4
NOTE: Data are for persons age 25 and over. Earnings are for full-time wage and salary workers.
SOURCE: U.S. Bureau of Labor Statistics, accessed June 18, 2014.
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Increasing Costs of Education
As college enrollments have swelled, increases in tuition, espe-
cially over the last decade, have been significant. Not only are
there major increases in the numbers of traditional students
coming straight from high school, but the number of those who
are returning to school to “retool” and change careers has risen
greatly as well. A common issue for many of these students is
finding ways to pay for tuition, books, school fees, and living
expenses while they pursue an education.
For some students, being accepted into their “dream college” can be a euphoric expe-
rience. The more earthbound question is how do you pay for the education? This question
should clearly be asked before students apply to schools, but school endowments and addi-
tional assistance available frequently add to the challenge of determining the full costs
until the college applications are accepted and the financial aid process begins.
The majority of students fund their education through a combination of loans, scholar-
ships, grants, savings, and current earnings. Loans have specific repayment terms, but
scholarships and grants do not need to be repaid and thus are sometimes referred to as
“free money.” Yet nothing in life is free, as the saying goes, and although there are no
repayment requirements, you will have to put in some time and effort to find these scholar-
ships. Information about scholarships will be provided later in this appendix.
FAFSA (Free Application for Federal
Student Aid)
The very first step to funding your education, whether with loans or certain grants, is com-
pleting and submitting the FAFSA (Free Application for Federal Student Aid) form. Most
state and institutional aid programs require this form to be filed before they consider provid-
ing any type of funding. After the FAFSA has been processed, you will receive notification
of your expected family contribution (EFC). For dependent students being claimed on their
parents’ tax return, the amount of parental income, assets, and college savings accounts will
be important factors in determining the amount of the EFC. For an independent student,
individual assets will also be carefully considered in determining eligibility for aid.
The schools that the student designates on the FAFSA will receive notification that
the FAFSA has been processed. Once the admission application is accepted, the schools
will take the FAFSA information and prepare a financial aid package. The goal is to
evaluate each student’s situation and provide the best possible selection of aid. In many
cases, the aid package will not cover the full cost of attendance. In addition, the federal
student aid may be reduced based on other aid that has been awarded (scholarships,
state aid, etc.).
The financial aid package received from the school will often include a combination of
grants, loans, and work-study options. The student will be sent an award letter with each
portion designated (see Exhibit A–2 ). The family should carefully consider their ability to
fund the expected family contribution and repay the loans offered in the aid package. These
aid types will now be reviewed with the goal of understanding the repayment requirements
and the terms of acceptance of each.
Scholarships
Scholarships do not have to be repaid. Scholarships awarded from organizations outside
the school have to be reported on the FAFSA or to the financial aid office, if awarded later.
did you know? did you know?
The average student loan balance in 2013
was $33,000, up from $15,000 in 2005.
SOURCE: Federal Reserve Bank of New York, 2014 Q1, Quarterly
Report on Household Debt and Credit, accessed June 18, 2014.
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Big-name scholarships (e.g., Coca-Cola and Prudential) receive an extraordinary number of
applicants, but there are many other places to consider. Examples include rotary clubs,
churches, professional associations, and local or regional businesses. Although the reward
amounts may be smaller, they might add up to big dollars and some may have the benefit of
being renewed in subsequent years. Special attention should be spent on knowing the deadlines
for each scholarship. Carefully research the type of candidate they are interested in helping and
tailor your information to show how you qualify, much like you would do with a résumé.
Grants
Grants also do not need to be repaid. They can be used to pay for education, training,
books, tuition, or any school-related expenses. Students who have demonstrated financial
need may receive grants. The most common type is the Federal Pell Grant, which offers
a maximum of $5,645 for the 2014–15 academic year. The maximum amount can change
each year and has increased significantly in the past few years. For the most up-to-date
numbers, visit studentaid.ed.gov . The Pell Grant will only be disbursed for a maximum
of 12 semesters. Another grant that is available is the Federal Supplemental Educational
Opportunity Grant (FSEOG). It can be worth up to $4,000 annually. You must receive a
Pell Grant to be eligible for the FSEOG. This grant is typically provided to students who
have demonstrated exceptional financial need.
The Teacher Education Assistance for College and Higher Education (TEACH) Grant
may also be available depending upon the types of courses taken and the student’s future
career. This grant provides up to $4,000 annually and requires a signed TEACH Grant
agreement that the student will fulfill his or her teaching requirement within eight years of
graduation or leaving school.
Another relatively new grant is the Iraq and Afghanistan Service Grant. These are avail-
able to students whose parents have died as a result of military service in Iraq or Afghani-
stan after 9/11. The grant offers a maximum of $5,317.44 for the 2014–15 academic year.
Cost of Attendance
Tuition and fees
Room and meals
Books and personal
Travel
Total Cost of Attendance (1)
$22,000
8,000
3,500
700
$34,200
Expected Family Contribution
Student
Parent
Total Family Contribution (2)
$ 2,000
5,000
$ 7,000
Calculated Financial Need (1 1 2) $27,200
Your college grant
Your college scholarship
Federal Perkins Loan
Federal Unsubsidized Stafford Loan
Parent PLUS Loan Option
Fall 20XX
$1,000
$1,500
$2,000
$5,500
$3,600
Spring 20XX
$1,000
$1,500
$2,000
$5,500
$3,600
Exhibit A–2 Sample Financial Aid Award Package
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In addition to these federal grants, many states offer institutional grants that are distributed
through the schools’ financial aid offices. Certain colleges and schools also provide grants
to women and minority groups, and for certain degree programs, to encourage enrollment.
Loans
Education loans are often a substantial part of the financial aid package. These types of loans
have also become a significant part of outstanding consumer debt. The Federal Reserve
Bank of New York and the U.S. Department of Education reported that the total amount of
student loans distributed annually in recent years was $100 billion. Additionally, they have
reported that total student loan balances outstanding are more than $1.11 trillion, an amount
that is almost double the total amount owed on consumer credit cards. 1
Federal education loans that are available today originate from the Direct Loan Pro-
gram. Each college’s financial aid office disburses the funds provided by the U.S. Depart-
ment of Education. The interest rates and fees can change annually and are adjusted by the
federal government. The current (2014–2015) range for interest rates for federal loans is
between 4.66 percent and 7.21 percent. 2 Interest rates are expected to rise in the future. The
rates are adjusted annually on July 1 for the coming academic year.
Education loans are typically divided into four main categories:
1. Stafford Loans
a. Stafford Loans were initially called the Federal Guaranteed Student Loan
Program. In 1988, the loans were renamed to honor U.S. Senator Robert
Stafford, based on his work with higher education.
b. Stafford Loans are the most frequently disbursed loan. They are typically disbursed
directly from the financial aid office directly to the student. (Note: The Stafford
Loan can also be disbursed through a private lender, which will be discussed later.)
c. One key element to the Stafford Loan is how the interest accrues while the
student is in school. In cases of extreme financial need, the federal government
will pay the interest payments during the time that the student is in school
and for certain grace periods. This type of loan is commonly referred to as
a subsidized loan. Subsidized loans are no longer available for graduate or
professional education programs.
d. The more common Stafford Loan makes paying the interest the responsibility
of the borrower while in school and during the grace period. This type of loan
is commonly referred to as an unsubsidized loan. Two options exist for paying
the interest: Pay the interest while still enrolled in school or have the interest
added to the balance of the loan. The borrower must carefully calculate the cost
of allowing this interest to be added to the loan. This process is commonly called
negative amortization and occurs when the amount of the loan exceeds the
original amount borrowed. This not only adds to the amount of the loan but can
extend the time for repayment.
e. The maximum amounts allowed for Stafford Loans vary considerably based on
many factors, including the student’s current year in school, type of schooling,
cumulative amount of subsidized and unsubsidized loans, and dependency status.
The federal website with the most up-to-date information is studentaid.ed.gov .
2. Perkins Loans
a. Perkins Loans are named after Carl D. Perkins, a former member of the U.S.
House of Representatives from Kentucky. Mr. Perkins was an advocate for higher
education, as well as a strong supporter of education for underprivileged students.
1 2014 Q1, Quarterly Report on Household Debt and Credit ( www.newyorkfed.org ), accessed June 18, 2014.
2 http://studentaid.ed.gov/types/loans/interest-rates .
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b. The Perkins Loan is typically provided to students who have demonstrated
exceptional financial need. This program is administered by individual schools,
which serve as the lender using money provided by the federal government. This
type of loan is provided only in a subsidized form; it offers a very low interest
rate, a long repayment schedule of 10 years, and a slightly longer grace period to
begin repayment.
c. Although each school’s financial aid office will determine the amount each
student receives, there are still annual and cumulative limits for this loan.
Currently, the maximum Perkins Loan allowed for undergraduate students
is $5,500 per academic year, with a cumulative maximum of $27,500. For
graduate students, the annual maximum is $8,000, with a cumulative maximum
of $60,000.
3. Parent Loans (PLUS loans), formerly known as the Parent Loan for Undergraduate
Students
a. There are times when parents of dependent children want to contribute
financially to help with educational expenses. If they do not currently have
funds to contribute, they may apply for a loan. After July 1, 2010, all new PLUS
loans are provided by the government and can only be obtained by contacting
the financial aid office of the school, not a private lender. Currently, there is no
maximum amount; however, the parent may only borrow amounts not covered
by the student’s current financial aid package, up to the total cost of attending the
school.
b. For PLUS loans, the parent is responsible for repaying the loan. The parent’s
creditworthiness is a factor in determining whether the loan will be granted.
If the parent does not qualify, the student may have the option of taking out
additional unsubsidized Stafford Loans.
c. One variant of the PLUS loan program is the Grad PLUS loan that allows
graduate students to borrow for educational expenses.
d. PLUS loans and Grad PLUS loans have higher interest rates than Stafford and
Perkins Loans, so they should be considered very carefully.
4. Private Student Loans (also called Alternative Student Loans)
a. Private student loans should also be considered very carefully. They tend to have
higher interest rates than the government programs. In addition, the interest
rates are commonly variable, which can make the payments more challenging to
manage.
b. The three most common reasons that borrowers choose private student loans are
1. To fund additional education expenses above the limits that the other
programs provide.
2. There is no requirement for a FAFSA form to be completed. The loan is
based upon the creditworthiness of the borrower.
3. To provide additional flexibility to the borrower in terms of repayment or
deferral while the student is in school.
In addition to traditional student loans, a new form of nontraditional lending has also
begun to be used to fund education expenses. It is known as social lending or peer-to-peer
lending. This newest form of student loan comes from the private sector. The basic premise
is that borrowers can post relevant information and stories regarding why they need money,
and prospective lenders or individuals can view the information and choose to fund these
aspirations. A large majority of social lending has been in the form of short-term lending,
covering periods of six months to three years. Student lending has been slow to catch on,
primarily due to the time frame for repayment. Now, however, a few websites have started to
offer longer repayment periods. Examples of social lending sites are www.greennote.com ,
www.prosper.com , and www.lendingclub.com.
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CAUTION! CAUTION!
Repayment plans based upon income will
result in
1. Paying more interest than a standard
repayment plan.
2. Providing income documentation each
year to reassess your payments for the
coming year.
3. Taxable income for any amount forgiven at
the end of the repayment period.
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Repaying Your Loans
Acquiring the funds to attend school is only the beginning of the financial aid process. The
more lengthy part of the process is the repayment. Many of the different types of loans
have differing grace periods before the first payment is due.
• Stafford Loans require repayment to begin six months after the student no longer
attends school or has dropped below half-time enrollment.
• Perkins Loans require repayment to begin nine months after the student no longer
attends school or has dropped below half-time enrollment.
• Federal PLUS loans, which are typically taken out by parents or graduate students,
require repayment to begin 60 days after the loan is disbursed. The repayment
can sometimes be deferred while the student is in school, but the interest will still
accrue, much like an unsubsidized Stafford Loan.
Once repayment begins, federal borrowers have numerous options to consider regard-
ing repaying the loan. The most common plans are as follows:
1} Standard Repayment. This is one of the most common repayment plans. A fixed
monthly amount is paid for a repayment term not to exceed 10 years.
2} Extended Repayment . Students elect this option to lower the monthly payment
amounts. The length of the repayment term is up to 25 years. One point to consider
is the increase in the amount of total interest that will be paid over this time period.
3} Graduated Repayment. This repayment plan allows newly graduated students
to make lower payments as they start their careers and then slowly increase the
amount of the monthly payment over the life of the loan.
4} Income-Contingent Repayment . This repayment plan is designed to provide the
borrower with some leniency in terms of the amount to be repaid. The monthly
payments are recalculated annually, based on the most recent reported income as
well as the total debt amount. The length of the repayment is up to 25 years. If the
borrower follows through with the entire repayment plan, any remaining balance
will be forgiven. One thing to keep in mind is that the forgiven amount will be
considered taxable income to the borrower.
5} Income-Sensitive Repayment . This repayment plan is similar to the income-
contingent repayment plan. The income-sensitive plan allows the borrower the
option to set his or her monthly payment based on a percentage of gross monthly
income. The length of this repayment is limited to 10 years.
6} Income-Based Repayment (IBR ). This repayment plan is currently calculated as
15 percent of discretionary income. To calculate discretionary income, take your
adjusted gross income (see Chapter 3) and subtract 150 percent of the poverty line for
your state and family size. The plan provides a reduction to the previously discussed
Income-Contingent and Income-Sensitive Repayment Plans. This program provides
forgiveness beyond a 25-year time period, if all prior payments
were timely. This newer repayment plan was included in the
College Cost Reduction and Access Act of 2007.
7} Pay-As-You-Earn (PAYE) Repayment. This is the newest
repayment option. The repayment amount is capped at
10 percent of discretionary income (see IBR Plan to
calculate). This program provides forgiveness beyond a
20-year time period (10 years for those employed in public
service), if all prior payments were timely. The plan does
require proof of a partial financial hardship to qualify for
the more favorable terms compared to the IBR Plan.
All seven plans are available for student loans, but only the first
three plans are available for PLUS loans to parents.
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Exhibit A–3
Percentage of Balances
90 1 Days Delinquent
0
2
4
6
8
10
12
P
e
rc
e
n
t
Student Loans Credit Cards Mortgage Auto Loan
Percentage of Balances 901 Days Delinquent
2004
2009
2014
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Consolidation Loan
Another attractive repayment option for borrowers is the option to combine their student
loans into one loan and thus have one convenient monthly payment. Just like the Extended
Repayment Plan, this method will lower the total monthly payment amount and increase
the length of the loan up to 30 years. Remember to carefully consider the increase in the
amount of total interest that will be paid over this time period. Unless you are struggling to
make the individual loan payment amounts, typically there is no advantage to consolidat-
ing loans other than ease of administration (i.e., one payment).
Private loans may have the option of refinancing to obtain a lower interest rate based on
an improved credit situation for the borrower. However, in most cases, a federal consoli-
dated loan does not offer this option.
Student Loan Default Statistics
The ease of obtaining money and the ever-increasing student loan balances that new
graduates must begin to repay have created many challenges. These issues, combined
with a significant number of graduates who are all vying for a smaller pool of available
jobs, have created some very unfortunate side effects relating to students’ abilities to
repay loans. The percentage of student borrowers who are more than 90 days late on their
student loan payments has increased significantly in the last decade (see Exhibit A–3 ).
Default rates on student loans have increased dramatically for students who have
attended all types of higher education: public, private, and for-profit schools. Student
loans will not typically be included in bankruptcy. There are no limitations on the num-
ber of years that the lender can seek repayment. For federal student loans, the govern-
ment can garnish wages, take tax refunds, or take other federal benefits for which you
might be eligible. Careful consideration should be given to the costs associated with
repaying loans.
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Loan Deferment
Loan deferments allow you to temporarily stop making payments on existing student loans.
The most common reasons for the deferments are re-enrollment in school, demonstrated
financial hardship, unemployment, and military deployment.
Loan Forgiveness
Loan forgiveness is the option to have all or a portion of your student loan forgiven (paid
off on your behalf ). The most common forgiveness options are for volunteer work and
public or military service.
The Public Service Loan Forgiveness Program was established by the College Cost
Reduction and Access Act of 2007. Under this program, full-time qualifying public service
employees who make 120 qualifying loan payments on eligible federal Direct Loans will
have the balance of their federal Direct Loans forgiven. Eligibility for the public service
provision includes working for the government or for an organized nonprofit organization,
service in the Peace Corps or AmeriCorps, or even working for a private organization that
provides public service.
Many of these organizations also have specific programs to allow a portion of the loan
to be canceled even sooner. For example,
• The Peace Corps provides partial cancellation of Perkins Loans (15 percent for each
year of service, up to 70 percent in total).
• AmeriCorps volunteers who serve for 12 months can receive $4,725 to be used
toward cancellation of their loan.
• Military service also offers a cancellation program. Students who enlist in the Army
National Guard may be eligible for up to $10,000 of cancellation of student loans.
• In addition, there are a variety of other programs for teachers who serve in low-
income areas, work with students with disabilities, or work in high-need schools.
Law students can find loan forgiveness programs for serving with nonprofit or
public interest organizations. Medical students may be eligible for loan forgiveness
for performing certain medical research or working in low-income or remote areas.
It is strongly advised that you review each program’s requirements for eligibility,
conditions of employment, and repayment to ensure that you are a good candidate
for the program.
Loan Cancellation (Discharge)
In very special circumstances, student loans may be permanently canceled. The most com-
mon situations include:
• Death.
• Total and permanent disability.
• Fraud by the school (e.g., in the event of forged promissory notes, the school owes
the lender a refund).
• Bankruptcy (very rare because the bankruptcy court would need to establish that
repayment would create a significant hardship).
Work-Study Programs
Aside from loans, there are other ways to earn money to pay for educational expenses.
The Federal Work-Study Program is available at many schools. It is commonly included
as part of the financial aid package. Students who decline this option are expected to fund
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the amount from another source. Some students like the options that the program offers;
they can work on campus without needing additional transportation, apply to a variety of
positions that interest them, and get to know faculty and staff that they may want to work
with on teaching or research assignments. Some students decline the option in favor of
higher-paying jobs off-campus. You should consider very carefully the opportunity costs
with this decision (fuel costs, commuting time, wardrobe needs, etc.) .
Decision Making for Financial Aid
Navigating the process of financing an education can be very daunting and time consum-
ing, but the rewards are very high. Finding the money for school and repaying the loans
in a manner that works best for your personal situation can lead to long-term success,
improved credit scores, higher salaries, and a lower potential for future unemployment.
One excellent source for choosing a school and the financial aid package for your needs is
the College Affordability and Transparency Center ( collegecost.ed.gov ). This is a one-stop
website where you can evaluate a college based on net price, average student debt, state
funding, graduation rates, and much more. It is very important for your financial future that
you find the most affordable education that fits your budget, future career, and long-term
financial goals.
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did you know? did you know?
An elevator speech is a short, persuasive,
focused summary of your experiences and
skills used when networking and in other settings.
This talk should be conversational (not forced),
memorable, and sincere. The use of an engaging idea
or question can help keep the conversation going.
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B Developing a Career Search Strategy
“Only two days until the weekend.” “Just 10 more minutes of sleep!” “Oh no!” “ Excel-
lent!” These are some common responses to “It’s time to get up for work.”
Have you ever wondered why some people find great satisfaction in their work while others
only put in their time? As with other personal financial decisions, career selection and profes-
sional growth require planning. The average person changes jobs, or even careers, five or more
times during a lifetime. Most likely you will reevaluate your choice of work on a regular basis.
The Career Planning Process
Career planning activities may be viewed using the following steps:
1} Personal assessment —to determine interests and values, and to identify talents and
abilities.
2} Employment market analysis —to assess geographic, economic, technological, and
social influences on employment opportunities.
3} Application process —in which you prepare a résumé and create a cover letter.
4} Interview process —in which you practice your interview skills, research the
organization, and send a follow-up message to the organization.
5} Employment acceptance —when you assess the salary and other financial factors as
well as the organizational environment of your potential employer.
6} Career development and advancement —in which you develop plans to enhance
career success behaviors and build strong work relationships.
CAREER ACTIVITY 1
For each of the six steps of the career planning process, write: ( a ) a goal you
have now or might have in the future and ( b ) an action you might take regarding
this career planning area.
Using Career Information Sources to
Identify Career Trends
While careers have dwindled in some sectors of our economy,
opportunities in other sectors have grown. Service industries
that are expected to have the greatest employment potential
include computer technology, health care, business services,
social and government services, sales and retailing, hospitality
and food services, management and human resources, educa-
tion, and financial services.
Many career information sources are available; these include:
1} Career development offices have information and
services for career planning and assistance in creating a
résumé and preparing for an interview.
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Appendix B Developing a Career Search Strategy 503
2} Online sources are available to assist you with all aspects of career planning.
Consider an Internet search to gather information about résumés, effective
interviewing, or creating a career portfolio. Also available is the Occupational
Outlook Handbook ( www.bls.gov/ooh/ ), which provides detailed information on
most careers.
3} Informational interviews are very effective for obtaining career information.
A planned discussion with a person in a field of interest to you will help you learn
about the job duties, required training, and the person’s feelings about the career.
Most people like to talk about their work experiences. Before the interview, plan to
ask questions such as:
• How did you get your current position? Did other jobs lead to this one?
• In what ways do you find your work most satisfying? What are your main
frustrations?
• What tasks and activities are required in your work?
• What are the most important qualifications for working in this field? What
training and education are needed?
• What advice would you give a person who is considering this type of work?
CAREER ACTIVITY 3
Create a list of your work, volunteer, and school activities. Describe how each
could apply to a future work situation.
CAREER ACTIVITY 2
Select a career information source. Prepare a brief summary of key ideas that
could be valuable to you in the future.
did you know? did you know?
Résumés often include vague words such
as “competent,” “creative,” “flexible,”
“motivated,” or “team player.” Instead, give specific
examples of your experiences and achievements to
better communicate these capabilities.
Obtaining Employment
Experience
Most people possess more career skills than they realize. Your
involvement in school, community, and work activities provides
a foundation for employment experiences. The following oppor-
tunities offer work-related training:
1} Part-time employment can provide experience and
knowledge for a career field.
2} Volunteer work in community organizations or agencies can help you acquire skills,
establish good work habits, and make contacts.
3} Internships allow you to gain experience needed to obtain employment in a field.
4} Campus projects offer work-related experiences to help you obtain career skills
through campus organizations, course assignments, and research projects.
Identifying Job Opportunities
Some of the most valuable sources of job information include:
1} Job advertisements in newspapers, professional periodicals, and online posting
boards are a common source. However, most available jobs may not be advertised
to the general public, so you need to also consider other job search activities.
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504 Appendix B Developing a Career Search Strategy
2} Career fairs, on campus and at convention centers, allow you to contact several
firms in a short time. At a career fair, you will be asked a couple of questions to
determine if you qualify for a longer interview. Prepare for job fairs by being
ready to quickly communicate your potential contributions to an organization.
Knowing something about the organization will help distinguish you from other
applicants.
3} Employment agencies match job hunters with employers. Often the hiring
company pays the fee. Be wary when asked to pay a fee in advance. Government
employment services may be contacted through your state employment service or
state department of labor.
4} Business contacts advise people about careers. Friends, relatives, and others are
potential business contacts. Networking is the process of making and using contacts
to obtain and update career information.
5} Job creation involves developing a position that matches your skills with
organizational needs. As you develop skills you enjoy, you may be able to create a
demand for yourself.
6} Other job search sources include ( a ) visits to companies to make face-to-face
contacts; ( b ) business directories and websites to obtain names of organizations that
employ people with your qualifications; and ( c ) alumni who work in your field.
did you know? did you know?
A combination résumé blends the
chronological and functional types. With this
format, you first highlight skills and experience relevant
to the position. This is followed by your employment
history section, which reports specific experiences
that match the requirements for the job.
CAREER ACTIVITY 4
Using one or more of the sources of available jobs, select a position that you
might apply for in the future. How well do your qualifications match those
required for the job?
Developing a Résumé
Marketing yourself to prospective employers usually requires a résumé, or personal infor-
mation sheet.
Résumé Elements
A résumé is a summary of your education, training, experience, and other qualifications
with these main components:
1} The personal data section presents your name, address, telephone number, and
e-mail address. Do not include your birth date, sex, height, and weight unless this
information applies to a specific job qualification.
2} A career objective is designed to clearly focus you to a specific employment
situation. Your career objective is usually omitted from the résumé and
communicated in your cover letter. Also, consider a summary
section with a synopsis of your main skills and capabilities.
3} The education section should include dates, schools
attended, fields of study, and degrees earned.
4} The experience section lists organizations, dates of
involvement, and responsibilities for previous employment,
relevant school activities, and community service.
Highlight computer skills, technical abilities, and other
specific competencies. Use action verbs to connect your
experience to the needs of the organization. Focus this
information on results and accomplishments.
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Appendix B Developing a Career Search Strategy 505
• Achieved
• Administered
• Coordinated
• Created
• Designed
• Developed
• Directed
• Edited
• Facilitated
• Initiated
• Implemented
• Managed
• Monitored
• Organized
• Planned
• Produced
• Researched
• Supervised
• Trained
• Updated
5} The related information section may include honors, awards, and other activities
related to your career field.
6} The references section lists people who can verify your skills. These individuals
may be teachers, past employers, supervisors, or business colleagues. References
are usually not included in a résumé; however, have this information available when
requested.
Résumé Preparation
No exact formula exists; however, a résumé must be presented in a professional manner.
Many candidates are disqualified by poor résumés. The use of bulleted items, bold type,
and short sentences improves readability. Be sure to read your résumé on a phone or tablet
since many hiring managers review applications on a mobile device. Limit your résumé
to one page. Send a two-page résumé only if you have enough material to fill three pages;
then use the most relevant information to prepare an impressive two-page presentation.
One key to successful résumé writing is the use of action words to demonstrate what
you have accomplished or achieved. Examples of strong action words include:
Other words and phrases that commonly impress prospective employers include foreign
language skills, computer experience, achievement, research experience, flexible, team
projects, and overseas study or experience. Instead of just listing your ability to use vari-
ous software packages (such as Excel or PowerPoint), describe how these tools were used
to research information or to present findings for a specific project. For best results, seek
assistance from counselors, the campus placement office, and friends to find errors and
suggest improvements (see Exhibit B–1).
When preparing a résumé, consider using the STAR principle to communicate your
experiences and achievements:
S Situation, or the setting Example: Fundraising coordinator for
campus organization
T Task, your duties Example: Prepared a plan to raise funds
for social service agency
A Actions you took Example: Administered a team that solic-
ited donations on campus
R Result, the outcome Example: Resulted in donating over
$2,000 to a homeless shelter
On your résumé, this experience could be presented in this manner:
• Coordinated fundraising campaign for campus organization to raise funds for social
service agency, resulting in soliciting and donating over $2,000 to a homeless
shelter.
The STAR principle is also useful when communicating your background in an
interview.
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506 Appendix B Developing a Career Search Strategy
Exhibit B–1 Résumé Makeover
…also consider
including relevant
class experiences,
such as:
• Coordinated team
research project to
identify health care
opportunities in
Asian markets.
CHAD BOSTWICK
bostwc@unsoark.edu
Phone: (407)555-1239
SCHOOL ADDRESS
234B Weber Drive (Apt. 6)
Jasper, MO 54321
HOME ADDRESS
765 Cannon Lane
Benton, KS 67783
BEFORE:
CAREER OBJECTIVE
An entry-level position
in medical or health
care administration.
BEFORE:
Researched overdue
accounts, created
collection method for
faster accounts
receivable turnover,
assisted in training
billing clerks.
BEFORE:
Newsletter editor,
University of South
Arkansas chapter
of Financial
Management
Association,
January–June 2016.
CAREER SUMMARY
Customer service specialist in health care industry. Effective training, technology
capabilities. Qualified in team building and innovation development. Planned and
implemented strategies to increase customer satisfaction by over 20 percent.
EDUCATION
Bachelor of Science in Business Administration and Health Care Marketing,
University of South Arkansas, June 2016.
Associate of Arts, Medical Technician Assistant, Arrow Valley Community
College, Arlington, Kansas, June 2014.
ORGANIZATIONAL EXPERIENCE
Patient account clerk, University Hospital, Jasper, Missouri,
November 2014 – present
• Researched accounts to reduce uncollectible amounts by 12 percent
• Created collection method to improve accounts receivable turnover
• Trained newly hired billing clerks in database applications
Sales data clerk, Jones Medical Supply Company, Benton, Kansas,
January–August 2014
• Maintained inventory records, processed customer records
• Supervised quality control of entry-level data clerks
CAMPUS ACTIVITIES
Newsletter editor, University of South Arkansas chapter of Financial Management
Association, January–June 2016
• Managed editorial staff to research, design, and publish online newsletter
• Researched and prepared news stories on financial industry trends
Tutor for business statistics and computer lab, 2014–2016
• Coordinated review sessions for exams and homework assignments
• Developed problems and case studies to supplement course materials
HONORS
College of Business Community Service Award, University of South Arkansas,
June 2016
Arrow Valley Health Care Society Scholarship, June 2014
EXAMPLE: Your Social Résumé Strategy
Résumés have become online “living entities” through LinkedIn, Twitter, and other
social media networks. Your interactions with hiring managers may include
• A LinkedIn profile highlighting career achievements and competencies to
enhance your employment potential.
• Twitter use to communicate unique skills and a personal brand by linking pro-
spective employers to your website.
• QR codes on your résumé or business card to link to a personal website,
blog, or other online location communicating your career activities.
• Instagram and Pinterest postings of photos, videos, and other visuals to
communicate career competencies, expertise, and achievements.
• Showing what others have to say about you. Recommendations on LinkedIn
can provide a foundation for further discussion in the job application process.
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Appendix B Developing a Career Search Strategy 507
Creating a Cover Letter
A cover letter, designed to express your interest in a specific job, accompanies your résumé
and consists of three main sections:
1} The introductory paragraph gets the reader’s attention. Indicate your reason for
writing by referring to the employment position. Communicate what you have to
offer the organization. If applicable, mention the person who referred you.
2} The development paragraphs highlight aspects of your background that specifically
qualify you for the position. At this point, elaborate on experiences and training.
Connect your skills and competencies to specific organizational needs.
3} The concluding paragraph should request action. Ask for an interview to discuss
your qualifications in detail. Include your contact information, such as telephone
numbers and the times when available. Close your letter by summarizing your
benefits to the organization.
Create a personalized cover letter for each position addressed
to the appropriate person in the organization. A poorly prepared
cover letter guarantees rejection (see Exhibit B–2).
In recent years, job applicants are increasingly using a tar-
geted application letter instead of a résumé and cover letter.
After researching a position and company, you can communicate
how your specific skills and experiences will benefit the organi-
zation. Once again, your goal is to emphasize achievements and
accomplishments so you will be invited for an interview.
Résumé Submission
Traditionally, résumés have been mailed or hand delivered. When presenting a résumé in
person, you have an opportunity to observe the company environment and make a positive
impression about your career potential. Today, most résumés are submitted online.
Most résumé posting sites are free. Never pay a large fee; scam artists have set up phony
websites with an online payment system to defraud people. Only post to sites with jobs in
the geographic region of interest to you, and for which you qualify.
Résumés sent by e-mail should be addressed to a specific person with a subject line
referencing the specific job. Your e-mail should include a cover letter to introduce your-
self and to encourage the recipient to read your résumé. Properly format your résumé and
include it in the body of the e-mail or attach it as a PDF.
Follow up with a call or e-mail to reinforce your qualifications and interest. Ask about
how and when to follow up on your status in the job search process.
did you know? did you know?
The Q letter (Q for qualifications) provides a
side-by-side comparison of your experiences
and abilities with the job requirements. The two
coordinated lists allow you to be quickly rated as a
viable candidate for the position.
CAREER ACTIVITY 6
Go to a website that posts résumés. Obtain information on the process involved
in posting your résumé online.
CAREER ACTIVITY 5
Outline the main sections of a résumé that you might create for a job offer in the
next couple of years. Conduct an Internet search to find a résumé format that you
might use.
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508 Appendix B Developing a Career Search Strategy
Career Portfolios
In addition to a résumé, many job applicants prepare a career portfolio. This collection of
documents and other items provides tangible evidence of your abilities and skills. A career
portfolio may include the following items:
1} Documentation —a résumé, sample interview answers, a competency summary, and
letters of recommendation.
2} Creative works —ads, product designs, packages, brand promotions, and video clips
on a DVD, USB drive, or your personal website.
3} Research project samples —research findings, PowerPoint presentations, website
designs, marketing plans, and photos of project activities.
4} Employment accomplishments —published articles, sales results data, financial
charts, and news articles of community activities.
A career portfolio can present your abilities and experiences in a tangible manner. In
addition, these materials will communicate your initiative and uniqueness. The cover page
of your portfolio should connect your abilities to the needs of the organization.
A digital portfolio can be developed on a website with graphics and links. Be sure your
home page is not cluttered and is organized to quickly find desired information.
Exhibit B–2
Sample Cover Letter
Dear Ms. Cabral:
Experience in providing superb customer service for global organizations is the basis
of my application for the client relations position. Brenda Kelly in your accounting
department recommended that I contact you. An ability to connect with people from
varied cultures along with my studies in international relations and global business
provides a strong foundation for this position. In addition, I have taken several courses
in international business along with an internship in the exporting department of an
electronics company.
My previous work in cross-cultural environments provides your organization with a
person who is able to:• adapt to varied business settings and meet the diverse needs of clients.
• use language skills to handle customer relations with international customers.
• prepare cross-cultural marketing materials for current and potential clients.
• implement social media promotions using Facebook, Twitter, and YouTube.
• prepare content and develop features for the organization’s website.
• effectively manage multiple projects to meet required deadlines.
• build relationships that cultivate trust and enhance organizational credibility.
In my past work, I developed an ability to create and implement a strategy for
effectively using technology to manage a client database. Ongoing learning about
technology is a high priority for me, which occurs in work environments, at
professional conferences, and through observations of market trends.
As a result of my experiences and skills, detailed on my résumé, I believe I will make
an important contribution to your organization. I look forward to discussing my
qualification in greater detail. You may contact me at 555-963-4556
or at jhopkinsl@internet.com.
Sincerely,
Jerry Hopkins
5678 Collins RoadWest Barrington, NY 14332jhopkinsl@internet.com
May 23, 2015
Ms. Hanna Cabral Human Resources DirectorGlobal Translation Services3400 Superior BoulevardJamestown, NY 13456
CAREER ACTIVITY 7
Select a potential job. Create a cover letter for that position. Conduct an online
search to obtain additional suggestions for effective cover letters.
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Appendix B Developing a Career Search Strategy 509
The Job Interview
The interview phase is limited to candidates who possess the desired qualifications.
Preparing for the Interview
Prepare by obtaining additional information about the organization. The best sources
include the library, the Internet, observations during company visits, analysis of company
EDUCATION AND TRAINING QUESTIONS
What education and training qualify you for this job?
Why are you interested in working for this company?
In addition to going to school, what activities have helped you expand your interests and
knowledge?
WORK AND OTHER EXPERIENCE QUESTIONS
In what types of situations have you done your best work?
Describe the supervisors who motivated you most.
Which of your past accomplishments are you proud of?
Have you ever had to coordinate the activities of several people?
Describe some people whom you have found difficult to work with.
Describe a situation in which your determination helped you achieve a specific goal.
PERSONAL QUALITIES QUESTIONS
What are your major strengths?
What are your major weaknesses? What have you done to overcome your weaknesses?
What do you plan to be doing 5 or 10 years from now?
Which individuals have had the greatest influence on you?
What traits make a person successful?
How well do you communicate your ideas orally and in writing?
How would your teachers and your past employers describe you?
Exhibit B–3
Common Interview
Questions
CAREER ACTIVITY 8
List the various items (be specific) that you might include in your career portfolio.
EXAMPLE: Your Career Brand
Your professional image, or “brand,” should
• Communicate unique skills, experiences, and competencies.
• Provide a vision of your potential contribution to an employer.
• Have a consistent message online, in print, and elsewhere.
• Involve ongoing actions that communicate your image, such as “collabora-
tor” or “international expert.”
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510 Appendix B Developing a Career Search Strategy
products, informal conversations with employees, and discussions with people knowl-
edgeable about the company or industry. Research the company’s operations, competi-
tors, recent successes, planned expansion, and personnel policies to help you discuss your
potential contributions to the company.
Another preinterview activity is preparing questions you will ask, such as:
• What do employees like most about your organization’s working environment?
• What challenges are most often encountered by new employees?
• What training opportunities are available to employees who desire advancement?
• What qualities do your most successful employees possess?
• What actions of competitors are likely to affect the company in the near future?
Successful interviewing requires practice. Use a video or
work with friends to develop confidence when interviewing.
Organize ideas, speak clearly and calmly, and communicate
enthusiasm. Prepare specific answers regarding your strengths.
Campus organizations and career placement offices may offer
opportunities for interview practice.
When interviewing, keep in mind that proper dress and
grooming are vital. Dress more conservatively than current
employees. A business suit is usually appropriate. Avoid trendy
and casual styles, and don’t wear too much jewelry.
Confirm the time and location of the interview. Take copies
of your résumé, your reference list, and paper for notes. Arrive
about 10 minutes earlier than your appointed time.
did you know? did you know?
Forbes.com reports that executive recruiters
agree on the three true job interview
questions: (1) Can you do the job? (to assess your
strengths); (2) Will you love the job? (to assess your
motivation); and (3) Can we tolerate working with you?
(to assess your organizational fit).
did you know? did you know?
In situational interviewing, candidates for
a sales position may be asked to interact
with a potential customer. Prospective employees for
Southwest Airlines participate in a “job audition.” This
starts the moment they apply, with extensive notes from
the initial phone call. During the flight to the interview,
gate agents, flight attendants, and other company
employees are instructed to pay special attention to
the candidate’s behaviors. Thus, the candidate is being
observed constantly in situations similar to the job setting.
The process also includes giving a talk to a large group.
Bored or distracted audience members are disqualified.
This selection process has been shown to reduce
employee turnover and increase customer satisfaction.
EXAMPLE: Preparing for a Skype Interview
1. Prepare as you would for any other interview.
2. Test your computer connection in advance; avoid WiFi use.
3. Eliminate visual distractions that might be seen by the interviewer.
4. Locate the webcam at eye level to avoid distorted face angles.
5. Go online early to communicate punctuality and readiness.
6. Maintain eye contact with the webcam to project confidence and professionalism.
7. Tape notes and questions on a wall behind the camera to avoid looking down.
The Interview Process
Interviews may include situations or questions to determine
how you react under pressure. Answer clearly in a controlled
manner. Career counselors suggest having a “theme” for inter-
view responses to focus your key qualifications. Throughout the
interview come back to the central idea that communicates your
potential contributions to the organization.
Behavioral interviewing, also called competency-based
interviewing, is frequently used to evaluate an applicant’s
on-the-job potential. In these questions, you might be asked
how you would handle various work situations. Behavioral
interview questions typically begin with “Describe . . .” or “Tell
me about . . .” to encourage interviewees to better explain their
work style.
In situational interviewing, you are asked to participate in
role-playing, similar to what may be encountered on the job.
For example, you might be asked to resolve a complaint with a
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Appendix B Developing a Career Search Strategy 511
customer or negotiate with a supplier. This interview experience is used to evaluate your
ability to work in various organizational environments.
Avoid talking too much, but answer each question completely, maintaining good eye
contact. Stay calm during the interview. Remember, you are being asked questions about a
subject about which you are the world’s expert—YOU! Finally, thank the interviewer for
the opportunity to discuss the job and your qualifications.
did you know? did you know?
The main factors college graduates consider
when choosing an employer are enjoyment
of the work, integrity of the organization, potential for
advancement, benefits, and job location.
EXAMPLE: Asking for the Job
Near the conclusion of an interview, show your enthusiasm and desire for the posi-
tion by asking for the job:
• “I believe my experiences would contribute to the continued success of your
organization. Is there any additional information you need for making me an
offer for the job?”
• “Based on my abilities in the area of _____ , am I the appropriate fit for this
position?”
• “This job is of great interest to me. What additional information would con-
vince you that I’m the right person?”
• “Since my background and skills seem very appropriate for the position,
what is the next step in the hiring process?”
After the Interview
Most interviewers conclude by telling you when you can expect to hear from them. While
waiting, do two things. First, send a follow-up letter or e-mail within a day or two express-
ing your appreciation for the opportunity to interview. If you don’t get the job, this thank-
you letter can make a positive impression to improve your chances for future consideration.
Second, do a self-evaluation of your interview performance. Write down the areas to
improve. Try to remember the questions you were asked that differed from your expected
questions. Remember, the more interviews you have, the better you will present yourself
and the better the chance of being offered a job.
CAREER ACTIVITY 9
Have someone ask you sample interview questions and then point out the
strengths and weaknesses of your interview skills.
Job Offer Comparison
The financial aspects of a job should be assessed along with some organization factors.
1} Salary and financial factors —Your rate of pay will be affected by the type of work
and your experience. The position may also include
employee benefits. These include insurance, retirement
plans, vacation time, and other special benefits for
employees. Many organizations offer recreational
facilities, discounts, and other advantages for workers.
2} Organizational environment —While the financial
elements of a job are very important, also consider the
working environment. Leadership style, dress code, and
the social atmosphere should be investigated. Talk with
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512 Appendix B Developing a Career Search Strategy
While many career planning actions from the past are still valid, you should consider others to compete in a changing
employment market.
When you want to . . . Previously, people would . . . Today, you can also . . .
Obtain career planning assistance. Talk with others in career fields in which they
were interested.
Acquire guidance from online contacts, vid-
eos, and webinars.
Develop potential career contacts. Go to professional meetings, seminars, and
community events.
Use social media, such as LinkedIn, to con-
nect with professional contacts.
Follow up with networking
contacts .
Talk by phone or send an e-mail. Stay in contact on Linkedln and through
other social media networks.
Gain entry-level career experience. Pursue part-time employment, volunteer
work, and community service activities.
Participate in virtual volunteering, online
communities, and online tutorials.
Identify employment opportunities. Obtain leads from contacts, media, and posi-
tions in their current organization.
Connect through your online network to
enhance other sources of employment.
Create a cover letter. Highlight experiences related to the specific
job or organizational needs.
Create a Q letter with bulleted items to com-
municate your specific experiences for a
position.
Communicate your key skills
on a résumé.
Include a career objective on their résumé. Use a career profile or summary of skills and
abilities.
Submit a résumé. Mail or drop off at a company’s office to
make a personal contact.
Send by e-mail or post on a website.
Prepare for an interview. Talk to others for interview tips; participate in
mock interviews.
Create a video to have others critique your
poise and professionalism.
Conduct company research. Talk to people who have worked at the orga-
nization or who have done business with
them.
Use Linkedin, Twitter, Facebook, and blogs
to study the company and people who will
interview you.
Participate in an interview. Meet face to face. Take part in a Skype interview or a video
conference.
Follow up after an interview. Send a handwritten note or e-mail to express
appreciation and to reinforce their interest in
the available position.
Send a work sample, evidence of your expe-
rience, such as a news article or report, or
link to your e-portfolio.
Achieve career advancement
training.
Participate in on-the-job training, profes-
sional seminars, graduate study.
Participate in webinars and online courses.
Develop and promote a personal
brand.
Use business cards to communicate their
organization and title.
Develop an online presence with a summary
of unique experiences and competencies;
use a personal website to convey your
potential work contribution.
Your online presence can be a valuable asset for your career planning activities. Be sure to avoid actions that might present you in
less than a professional manner. To communicate an appropriate online image, consider these actions:
• DO get connected on Linkedln.com and other professional networking sites.
• DON’T put items online that create an inappropriate image; search your name to assess online presence.
• DO use keywords for capabilities and experiences expected in the industry in which you work.
• DON’T post your résumé online arbitrarily; select websites appropriate for your specific job search.
• DO regular follow-ups with online contacts; share current news and ideas on industry trends.
• DON’T join online groups in which you will not be an active participant.
• DO create a blog to enhance your online image and to communicate areas of expertise.
Additional career planning information is available at: www.jobhuntersbible.com www.rileyguide.com jobsearch.about.com
college.monster.com www.careerbuilder.com www.monster.com www.career-success-for-newbies.com “Smart Career
Planning” and “Career Planning Forum” on Linkedln.com
(NOTE: about.me allows you to connect a personal website, blog, and social media sites in one location.)
Exhibit B–4 Updating Your Career Activities
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Appendix B Developing a Career Search Strategy 513
Career Strategies in a Weak Job Market
In times of weak economic conditions, obtaining employment can be difficult. What
actions would be useful to take when attempting to seek employment or maintain your
current position? Consider the following:
• Acknowledge stress, anxiety, frustration, and fear. Eat properly and exercise to avoid
health problems.
• Assess your financial situation. Determine sources of emergency funds to pay
needed expenses. Cut unnecessary spending.
• Evaluate your current and future employment potential. Consider work and
community experiences that you have which are not on your résumé.
• Maintain a focus with a positive outlook. Your ability to communicate confidence
and competency will result in more job offers.
• Connect with others in professional and social settings.
• Consider part-time work, consulting, and volunteering to exercise your skills,
develop new contacts, and expand your career potential.
An ability to obtain and maintain employment in difficult economic times will serve
you in every type of job market. Exhibit B–4 provides suggestions for guidelines for updat-
ing your career activities based on recent market trends and technological developments.
people who have worked in the organization. Advancement potential might also be
evaluated. Training programs may be available. These opportunities can be very
beneficial for your long-term career success.
CAREER ACTIVITY 10
Prepare a list of factors that you would consider when accepting a job. Talk to
other people about what they believe to be important when accepting a job.
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514
C Consumer Agencies and Organizations
The following government agencies and private organizations can offer information
and assistance on various financial planning and consumer purchasing topics when you
want to:
• Research a financial or consumer topic.
• Obtain information for planning a purchase decision.
• Seek assistance to resolve a consumer problem.
Section 1 provides an overview of federal, state, and local agencies and other organiza-
tions you may contact for information related to various financial planning and consumer
topics. Section 2 covers state consumer protection offices that can assist you in local matters.
Section 1
Most federal agencies may be contacted online; websites are noted below. In addition,
consumer information from several federal government agencies may be accessed at
www.usa.gov/topics/consumer.shtml .
Information on additional government agencies and private organizations available to
assist you may be obtained in the Consumer Action Handbook, available at no charge at
publications.usa.gov/USAPubs.php .
Exhibit C-1 Federal, State, and Local Agencies and Other Organizations
Topic Area Federal Agency
State, Local Agency; Other
Organizations
Advertising
False advertising
Product labeling
Deceptive sales practices
Warranties
Federal Trade Commission
1-877-FTC-HELP
( www.ftc.gov )
State Consumer Protection Office
c/o State Attorney General or
Governor’s Office
National Fraud Information Center
( www.fraud.org )
Air Travel
Air safety
Airport regulation
Airline route
Federal Aviation Administration
1-800-FAA-SURE
( www.faa.gov )
International Airline Passengers
Association
1-800-527-5888
( www.iapa.com )
Appliances/Product Safety
Potentially dangerous products
Complaints against retailers,
manufacturers
Consumer Product Safety Commission
1-800-638-CPSC
( www.cpsc.gov )
Council of Better Business Bureaus
1-800-955-5100
( www.bbb.org )
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Appendix C Consumer Agencies and Organizations 515
Exhibit C-1 (continued)
Topic Area Federal Agency
State, Local Agency; Other
Organizations
Automobiles
New cars
Used cars
Automobile repairs
Auto safety
Federal Trade Commission
1-877-FTC-HELP
( www.ftc.gov )
National Highway Traffic Safety
Administration
1-800-424-9393
( www.nhtsa.gov )
National Automobile
Dealers Association
1-800-252-6232
( www.nada.org )
Center for Auto Safety
(202) 328-7700
( www.autosafety.org )
Banking and Financial Institutions
Checking accounts
Savings accounts
Deposit insurance
Financial services
Federal Deposit Insurance Corporation
1-877-275-3342
( www.fdic.gov )
Comptroller of the Currency
(202) 447-1600
( www.occ.treas.gov )
Federal Reserve Board
(202) 452-3693
( www.federalreserve.gov )
National Credit Union Administration
(703) 518-6300
( www.ncua.gov )
State Banking Authority
(www.usa.gov/topics/consumer/
banking )
Credit Union National Association
(608) 232-8256
( www.cuna.org )
American Bankers Association
(202) 663-5000
( www.aba.com )
Treasury Direct U.S. Savings Bonds
1-800-US-BONDS
( www.savingsbonds.gov )
Career Planning
Job training
Employment information
Coordinator of Consumer Affairs
Department of Labor
(202) 219-6060
( www.dol.gov )
State Department of Labor or State
Employment Service
Consumer Credit
Credit cards
Deceptive credit advertising
Truth-in-Lending Act
Credit rights of women, minorities
Consumer Financial Protection Bureau
(855) 411-2372
( www.consumerfinance.gov )
Federal Trade Commission
1-877-FTC-HELP
( www.ftc.gov )
Clearpoint Credit Counseling
1-800-251-2227
( www.cccsatl.org )
National Foundation for Credit
Counseling
(301) 589-5600
( www.nfcc.org )
Environment
Air, water pollution
Toxic substances
Environmental Protection Agency
1-800-438-4318 (indoor air quality)
1-800-426-4791 (drinking water safety)
( www.epa.gov )
Clean Water Action
(202) 895-0420
( www.cleanwater.org )
Food
Food grades
Food additives
Nutritional information
U.S. Department of Agriculture
1-800-424-9121
( www.usda.gov )
Food and Drug Administration
1-888-463-6332
( www.fda.gov )
Center for Science in the Public Interest
(202) 332-9110
( www.cspinet.org )
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516 Appendix C Consumer Agencies and Organizations
Topic Area Federal Agency
State, Local Agency; Other
Organizations
Funerals
Cost disclosure
Deceptive business practices
Federal Trade Commission
1-877-FTC-HELP
( www.ftc.gov )
National Funeral Directors Association
1-800-228-6332
( www.nfda.org )
Housing and Real Estate
Fair housing practices
Mortgages
Community development
Department of Housing and Urban
Development
1-800-669-9777
( www.hud.gov )
National Association of Realtors
1-800-874-6500
( www.realtor.com )
( www.move.com )
National Association of Home
Builders
1-800-368-5242
( www.nahb.com )
Insurance
Policy conditions
Premiums
Types of coverage
Consumer complaints
Federal Trade Commission
1-877-FTC-HELP
( www.ftc.gov )
National Flood Insurance Program
1-888-CALL-FLOOD
(www.floodsmart.gov)
State Insurance Regulator
American Council of Life Insurance
( www.acli.com )
Insurance Information Institute
1-800-331-9146
( www.iii.org )
Investments
Stocks, bonds
Mutual funds
Commodities
Investment brokers
Securities and Exchange Commission
(202) 551-6551
( www.sec.gov )
Commodity Futures Trading
Commission
(202) 418-5000
( www.cftc.gov )
Investment Company Institute
(202) 293-7700
( www.ici.org )
Financial Industry Regulatory Authority
(301) 590-6500
(www.finra.org)
National Futures Association
1-800-621-3570
( www.nfa.futures.org )
Securities Investor Protection Corporation
(202) 371-8300
( www.sipc.org )
Legal Matters
Consumer complaints
Arbitration
Department of Justice
Office of Consumer Litigation
(202) 514-2401
(www.justice.gov/civil/cpb/cpb_home
.html)
American Arbitration Association
(212) 484-4000
( www.adr.org )
American Bar Association
1-800-285-2221
( www.abanet.org )
Internet/Mail Order
Damaged products
Deceptive business practices
Illegal use of U.S. mail
Internet Crime Complaint Center
( www.ic3.gov )
U.S. Postal Service
1-800-ASK-USPS
( www.usps.gov )
Direct Marketing Association
(212) 768-7277
( thedma.org )
Exhibit C-1 (continued)
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Appendix C Consumer Agencies and Organizations 517
Topic Area Federal Agency
State, Local Agency; Other
Organizations
Medical Concerns
Prescription medications
Over-the-counter medications
Medical devices
Health care
Food and Drug Administration
1-888-463-6332
(www.fda.gov )
Public Health Service
1-800-621-8335
( www.usphs.gov )
American Medical Association
1-800-336-4797
( www.ama-assn.org )
Public Citizen Health Research Group
(202) 588-1000
( www.citizen.org/hrg )
Retirement
Old-age benefits
Pension information
Medicare
Social Security Administration
1-800-772-1213
( www.ssa.gov )
AARP
(202) 434-2277
( www.aarp.org )
Taxes
Tax information
Audit procedures
Internal Revenue Service
1-800-829-1040
1-800-TAX-FORM
( www.irs.gov )
Department of Revenue (in your state
capital city)
The Tax Foundation
(202) 464-6200
( www.taxfoundation.org )
National Association of Enrolled Agents
1-800-424-4339
( www.naea.org )
Telemarketing
900 numbers Federal Communications Commission
1-888-225-5322
( www.fcc.gov )
National Consumers League
(202) 835-3323
( www.nclnet.org )
Utilities
Cable television
Utility rates
Federal Communications Commission
1-988-225-5322
( www.fcc.gov )
State utility commission (in your state
capital)
Section 2
State, county, and local consumer protection offices provide consumers with publications,
online information, and complaint handling assistance. In addition, agencies regulating
banking, insurance, securities, and utilities are available in each state; these may be located
with an online search.
Consumer’s Resource Handbook publications.usa.gov/USAPubs.php
State consumer offices National Association of Attorneys General ( www.naag
.org ) or search “( state ) consumer protection agency”
State departments of insurance www.naic.org/state_web_map.htm
State tax departments www.taxadmin.org/fta/link/
www.aicpa.org/yellow/yptsgus.htm
To save time, call or e-mail the office before sending in a complaint. Determine if the
office handles the type of complaint you have or if complaint forms are available.
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518
D Daily Spending Diary
Effective short-term money management and long-term financial security are dependent
on spending less than you earn. The use of a Daily Spending Diary will provide informa-
tion to better understand your spending patterns and to help you achieve desired financial
goals.
The following sheets should be used to record every cent of your spending each day
in the categories provided. You can indicate the use of a credit card with (CR). Or you
can create your own format to monitor your spending. Various apps (see below) are also
available for this purpose.
This experience will help you better understand your spending habits and identify
desired changes you might want to make in your spending activities. Your comments
should reflect what you have learned about your spending and can assist with changes you
might want to make. Ask yourself, “What spending amounts can I reduce or eliminate?”
Many people who take on this task find it difficult at first, and may consider it a waste
of time. However, nearly everyone who makes a serious effort to keep a Daily Spending
Diary has found it beneficial. The process may seem tedious at first, but after a while
recording this information becomes easier and faster. Most important, you will know
where your money is going. Then you will be able to better decide if that is truly how you
want to spend your available financial resources. A sincere effort with this activity will
result in very beneficial information for monitoring and controlling your spending. At the
end of each chapter, questions are provided to guide your daily spending related to the
topic covered in the chapter.
Using a Daily Spending Diary can help to:
• Reveal hidden aspects of your spending habits so you can better save for the future.
• Create and achieve financial goals.
• Revise buying habits and reduce wasted spending.
• Control credit card purchases.
• Improve recordkeeping for measuring your financial progress and filing your taxes.
• Plan for major expenditures encountered during the year.
• Start an investment program with the money you save through controlled spending.
The following Daily Spending Diary sheets are also available in an Excel format in
Connect Finance.
Various apps are available for you to monitor your daily spending; these include:
• Spending Tracker
• Track Every Coin
• Mint
• Level Money
• Spendee
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Final PDF to printer
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C H A P T E R 1
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Index
A
Accelerated benefits, 331
Accidental death benefit, 330
Account executives, 404
Activity accounts, 125
Actual cash value (ACV), 262
Add-on interest method, 164
Adjustable-rate mortgages (ARMs),
232–233
Adjusted gross income (AGI)
exemptions to, 80–81
explanation of, 78
Adjustments to income, 86
Adoption tax credit, 83
Adult life cycle, 4
Affordable Care Act. See Patient
Protection and Affordable Care
Act of 2010
Age
credit decisions and, 157
investment risk and, 361
life insurance and, 322
Aggressive growth funds, 431
Alternative minimum tax (AMT), 83
Alternative student loans, 496
AmeriCorps, 499
Amortization
explanation of, 231
negative, 233, 495
Annual Credit Report Request Form, 158
Annual percentage rate (APR),
161, 162, 164
Annual percentage yield (APY), 120, 121
Annual reports, 396, 440
Annuities. See also Life insurance
costs of, 337–338
deferred, 336–337
explanation of, 336, 471
fixed, 336, 340
function of, 337, 339
future value of, 34–35
immediate, 336
index, 337
present value of, 36
for retirement income, 471
tax issues related to, 338, 340
variable, 336, 337, 339
Appraisals, home, 227, 237
Asset allocation, 359–360
Asset allocation funds, 432
Asset management accounts, 109
Assets, 49, 50
Attorneys, for consumer complaint
resolution, 206
Audits, Internal Revenue Service, 93–94
Auto brokers, 199–200
Automatic teller machines (ATMs), 109,
110, 167
Automobiles. See Motor vehicle
insurance; Motor vehicles
Average tax rate, 81
B
Balanced funds, 432
Balance sheets, 48–51
Banking services, online and mobile,
109–110
Bank of America, 171
Bank reconciliation, 128, 130
Bankruptcy
declaring personal, 173
effects of, 176
explanation of, 7–8
federal legislation related to,
174–176
Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005,
175–176
Banks
commercial, 112–113, 148
investment, 403
mutual savings, 113
online and mobile, 109–110
Bank statements, 128
Basic health insurance coverage, 288.
See also Health insurance
Behavioral interviewing, 510
Beneficiaries
explanation of, 473
on life insurance policies, 329
Beta, 401
Bill payment
credit scores and, 159
online, 124–125
Blank endorsement, 128
Bloomberg Businessweek, 110 , 397, 441
Blue chip stocks, 393
Blue Cross, 295
Blue Shield, 295
Bodily injury liability, 264–265
Bond funds, 432
Bond indenture, 367
Bonds
corporate, 367–371
government, 365–367
information sources for, 371–372,
374–375
municipal, 366
overview of, 364–365
quotations for, 372
ratings for, 372–374
yield calculations for, 373–374
Book value, 401–402
Borrowing, 108. See also Consumer
credit; Credit cards; Loans
Brand comparison, 190
Broad form, renter’s insurance, 258–259
Brokerage firms
explanation of, 113
full-service, discount and online,
404–405
Budgets
balancing, 350
characteristics of successful, 59
emergency fund for, 55
explanation of, 54
financial goals for, 54
fixed expenses for, 55–56
income estimates for, 55
recording spending amounts for, 57–58
review of, 58–59
savings allocations for, 55
selecting system for, 59
steps to develop, 56
variable expenses on, 57
Budget variance, 57
Bump-up CDs, 115
Business contacts, 504
Business failure risk, 357
Buy-and-hold technique, 407
Buy-downs, 233
Buyer agents, 227
C
Callable CDs, 118
Call feature, 368
Capacity, 152
Capital, 152
Capital gain distributions, 443–444
Capital gains
on bonds, 366
explanation of, 96
Capitalized cost, 198
Car-buying services, 199–200
Career fairs, 504
Career portfolios, 508
Careers
financial planning and, 22
trends in, 502–503
Career search
cover letters and, 507–508
employment experience and, 503
identifying career trends and, 502–503
identifying job opportunities and,
503–504
job interviews and, 509–511
job offer comparison and, 511, 513
portfolio development and, 508
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Index 529
résumé development and, 504–507
steps in, 502, 512
in weak job market, 513
Car title loan companies, 114
Cash cards. See Debit cards
Cash flow
explanation of, 51–52
net, 53–54
Cash flow statements, 52–54
Cashier’s checks, 127
Cash inflow, 51
Cash machines. See Automatic teller
machines (ATMs)
Cash outflows, 52, 53
Cash value, 327
Casualty losses, 79
Certificates of deposit (CDs)
explanation of, 115
management of, 118
tax-deferred fixed annuities vs., 340
types of, 115, 117–118
Certified checks, 127
Certified pre-owned (CPO) vehicles, 197
Chapter 7 bankruptcy, 174–176
Chapter 13 bankruptcy, 176
Character, 152
Charitable contributions, 79
Charles Schwab, 446
Check-cashing outlets (CCOs), 114
Checking accounts
evaluation of, 126–127
management of, 127–128
types of, 118, 125–126
Children, 96–97. See also Education
financing
Churning, 404
Claims, insurance, 254
Class-action suits, 206
Closed-end credit, 144
Closed-end funds, 425, 445–447
Closing, home purchase, 234–236
Closing costs, 234
Codicils, 476
Coinsurance, 288
Collateral, 153
College Affordability and Transparency
Center, 500
College Cost Reduction and Access Act
of 2007, 499
Collision insurance, 266
Commercial banks
function of, 112–113
as source of consumer credit, 148
Commission charges, stock transaction,
406–407
Commodity Futures Trading
Commission, 516
Common areas, 226
Common stocks
dividends from, 388–390
explanation of, 388
issuing rationale for, 388
purchasing rationale for, 388–391
Competency-based interviewing, 510
Compounding, 120, 121. See also
Future value
Comprehensive form, renter’s
insurance, 259
Comprehensive physical damage
coverage, 266–267
Comptroller of the Currency, 515
Condominium fees, 226
Condominiums, 226
Consolidated Omnibus Budget
Reconciliation Act of 1986
(COBRA), 287
Consolidation loans, 498
Consumer Action Handbook, 514
Consumer complaints
related to credit issues, 169–171
steps to resolve, 203–206
Consumer credit. See also Debt
advantages of, 142–143
billing errors and disputes and, 166
closed-end, 144
complaints related to, 169–171
cost of, 160–165
credit cards and, 145–147 ( See also
Credit cards)
disadvantages of, 143
ethical concerns related to, 353
explanation of, 141
identity theft and, 166–169
importance of, 141
loans and, 148–150 ( See also Loans)
management of, 171–176
open-end, 145
sources of, 147–150
use and misuse of, 142
volume of, 144, 145
Consumer credit applications
affordability issues and, 151
cosigning in, 169
credit capacity rules and, 151
credit reports and, 153–155
credit scores and, 155–156
creditworthiness factors and, 157
denial of, 157, 159
five Cs of credit and, 151–153, 158
sample questions on, 156
Consumer Credit Counseling Service
(CCCS), 173
Consumer credit finance charges
add-on interest and, 164
inflation and, 164
lender risk vs. interest rate and,
162–163
minimum monthly payment
trap in, 165
open-ended credit and, 164
simple interest formula for, 163–164
term vs. interest costs and, 162
Consumer Credit Reporting Reform
Act, 170
Consumer debt. See Debt
Consumer finance companies, 148
Consumer Financial Protection Bureau
(CFPB), 171, 515
Consumer Leasing Act, 169
Consumer price index (CPI), 7
Consumer Product Safety Commission, 514
Consumer protection, for purchase
complaints, 206
Consumer purchases
complaints related to, 203–205
legal options related to, 205–207
motor vehicle, 195–203
online, 190, 191
research-based, 192–193
service contracts and, 192
strategies for, 189–192
tax considerations and, 95
warranties for, 191–192
Consumer Reports, 199
Contingency clause, 228
Contingent deferred sales load, 428
Conventional mortgages, 231. See also
Mortgages
Conversion term insurance, 327
Convertible bonds, 368
Cooperative housing, 226
Coordination of benefits (COB)
provision, 287
Coordinator of Consumer Affairs, 515
Copayments, 291
Corporate bonds. See also Bonds
explanation of, 367
functions of, 367–388
provisions for repayment of, 368–369
reasons to purchase, 369–371
transactions for, 370–371
types of, 368
Corporate earnings, 398–399
Correspondence audits, 94
Cosigning loans, 169
Cost-of-living protection, 331
Counteroffers, 227
Coverage, insurance, 250
Coverdell Education Savings Accounts,
97, 469
Cover letters, 507, 508
Credit. See Consumer credit; Loans
Credit bureaus, 153, 166
Credit Card Accountability
Responsibility and Disclosure Act
of 2009 (CARD Act), 170–171
Credit card companies, 113
Credit cards. See also Consumer credit;
Consumer credit applications
debit cards vs., 124, 147
debit management for, 350–351
finance charges for, 145–146
function of, 145
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530 Index
Credit file. See Credit reports
Credit life insurance, 329
Credit Repair: How to Help Yourself
(Federal Trade Commission), 160
Credit reports
availability of, 154
credit scores in, 155–157
function of, 153
information in, 153–155, 158
legal rights related to, 155
unfavorable data in, 155
Credit scores
determination of, 155–157
methods to improve, 158–160
methods to protect, 166
Credit-shelter trusts, 478
Credit unions, 113, 148
Current liabilities, 50
Current ratio, 51
Cyclical stocks, 393
D
Daily spending diary, 518–526
Dashboard, 23
Davis Opportunity Fund, 429
Debentures, 368
Debit cards
credit cards vs., 124, 147
explanation of, 110, 124
prepaid, 110, 125
Debt. See also Consumer credit;
Credit cards; Loans
bankruptcy declaration and, 173–176
collection practices for, 172–173
financial counseling services for,
173, 174
taxes and, 95
warning signs of problems with, 171–172
Debt-payments ratio, 51
Debt-payments-to-income ratio, 151
Debt ratio, 51
Debt-to-equity ratio, 151
Declining balance method, 164
Decreasing term insurance, 327
Deductibles
explanation of, 251
health insurance, 294
Deductible taxes, 79
Deeds, 234–235
Defective goods/services, 166
Defensive stocks, 393
Deferred annuities, 336–337
Deficit, 53, 57
Defined-benefit plans, 465
Defined-contribution plans, 465
Deflation, 7
Dental expense insurance, 289
Deposit institutions, 108, 112
Deposit insurance, 122–123
Deposit tickets, checking account, 128
Digital budgets, 59
Direct deposit, 62
Direct investment plans, 408–409
Disability income insurance
determining individual needs for, 307
explanation of, 285, 305–306
sources of, 306
trade-offs in, 306–307
Disclaimer trusts, 478
Discount brokerage firms, 404–405
Discounting. See Present value
Discretionary income, 53
Discrimination, in credit applications, 157
Distribution fees, 428
Diversification, mutual funds and, 424
Dividend reinvestment plans (DRIPs),
408–409
Dividends
common stock, 388–390
income, 443–444
policy, 325
Dividend yield, 400–401
Dollar cost averaging, 408, 446
Double indemnity, 330
Dread disease insurance, 289
Dual agents, 227
Duplexes, 225
E
Earned income, 78
Earnest money, 228
Earnings, higher education and, 492
Earnings per share, 398
Earthquake insurance, 257, 258
Economic conditions
career search and, 513
financial services and, 110
global, 4
Economics, 4
Edmund’s New Car Prices, 199
Edmund’s Used Car Prices, 199
Education
cost of, 493
demand for higher, 492
earnings and, 492
Education financing
Coverdell Education Savings
Accounts as, 97
decisions related to, 500
529 plans as, 97
401(k) plans as, 97–98
Free Application for Federal Student
Aid and, 493
grants and, 494–495
loans and, 495–499
sample award package for, 494
scholarships and, 493–494
work-study programs and, 499–500
Education IRAs, 469
EE savings bonds, 118–119
Electronic banking, 109–110
Electronic Deposit Insurance Estimator
(EDIE), 122
Electronic Fund Transfer Act, 170
Electronic payments, types of, 124–125
Emergency fund, 55, 352
Emergency road service coverage, 267
Employee Benefits Security
Administration (EBSA), 286
Employee Retirement Income Security
Act of 1974 (ERISA), 337, 466
Employer disability insurance, 306
Employer pension plans, 464–466
Employer self-funded health plans, 297
Employment agencies, 504
Endorsement, 128, 258
Endowment life insurance, 329
Environmental Protection Agency
(EPA), 515
Equal Credit Opportunity Act (ECOA),
157, 170
Equity financing, 388
Equity income funds, 431
Escrow accounts, 236
Estate, 473
Estate planning
explanation of, 473
legal documents and, 473–474
taxes and, 478–479
trusts and, 477–478
wills and, 474–477
Estate taxes, 479
Estimated payments, tax, 85
Ethical issues
in health care, 303, 310
in living trusts, 479
related to credit, 270, 353
E*Trade Bank, 109
Exchange-traded funds (ETFs), 426, 447
Exclusions, 78
Executors, 476
Exemptions, 80–81
Exemption trust wills, 475
Expense ratio, 429
Expense risk charge, 338
Expenses
budgeting for, 55–57
fixed, 53
health care, 80, 95
job-related, 80, 95
retirement, 462–464
variable, 53
Express warranties, 191
Extended repayment plans, 497
Extended warranties, 192
F
Face value, 367
Fair Credit and Charge Card Disclosure
Act, 169
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Fair Credit Billing Act (FCBA) (1975),
166, 170
Fair Credit Reporting Act (FCRA)
(1971), 154, 155, 170, 270
Fair Debt Collection Practices Act
(FDCPA), 172–173
Family of funds, 433
Federal Aviation Administration
(FAA), 514
Federal Communications
Commission, 517
Federal Deposit Insurance Corp. (FDIC),
121, 122, 515
Federal Housing Authority (FHA), 232
Federal income taxes. See also Taxes
adjusted gross income and, 78
audits of, 93–94
choosing forms for, 85
common errors in filing, 93
computing taxes owed for, 81–83
deadlines and penalties for, 84
electronic filing of, 90
estimated payments on, 84
exemptions and, 80–81
filing procedure for, 85
filing status for, 85
Form 1040, 85–88
online filing of, 88–91
payment of, 83–84
planning strategies for, 95–98
preparation assistance for, 91–92
refunds of, 87–88
sources for assistance with filing, 91–92
steps to complete, 85–88
taxable income and, 78–80
tax-planner calendar for, 91
tax preparation services for, 92–93
tax preparation software for, 89
tax rate schedules for, 90
withholding, 83–84
Federal Pell Grant, 494
Federal Reserve Bank of New York, 495
Federal Reserve Board, 515
Federal Supplemental Educational
Opportunity Grant (FSEOG), 494
Federal Trade Commission (FTC), 160,
166, 172, 514–516
Federal Work-Study Program, 499–500
Fee table, 429
FICO credit scores, 155–156
Fidelity Investments, 446
Field audits, 94
50-20-30 rule, 61
Finance charges, 160–161
Finance companies, 113
Financial aid. See Education financing
Financial aid websites, 493
Financial analysis, retirement planning
and, 460–462
Financial documents table, 70
Financial goals
budgeting and, 54
guidelines for setting, 9, 10
intermediate, 9
long-term, 9
money management and, 60, 62
reference sheet for, 29
short-term, 9
SMART approach, 9, 54
types of, 9
Financial institutions
comparison of, 111–112
identifying problematic, 113–114
types of, 108, 112–113
Financial planning. See Personal
financial planning
Financial plans, 3, 336. See also
Personal financial plans
Financial ratios, 51
Financial records, 46, 47
Financial responsibility law, 264
Financial services
comparison of, 111–112
economic conditions and, 110
to manage daily money needs,
107–108
online and mobile banking as, 109–110
payment methods and, 124–128
prepaid debit cards as, 110
savings plans and, 115–123 ( See also
Savings plans)
types of, 108–109
Financial statements. See Personal
financial statements
Financial supermarkets, 113
The Financial Times, 110
Financing
equity, 388
for home purchases, 229–236
( See also Mortgages)
for motor vehicles, 200–201
Fitch Ratings, 372
529 plans, 98
Fixed annuities, 336, 337, 340
Fixed expenses
on budgets, 55–56
explanation of, 53
Fixed-rate, fixed-payment mortgages,
231–232
Flat tax, 98
Flexible-rate mortgages, 232–233
Flexible spending accounts (FSAs),
95, 298, 299
Flood insurance, 257–258
Food and Drug Administration (FDA),
305, 515, 517
Forbes, 110 , 397, 441
Foreign tax credit, 83
Formal wills, 475
Fortune, 110 , 397
401(k) plans, 97, 434, 465, 470
403(b) plans, 465
Fraud
in health care costs, 310
identity theft as, 129
motor vehicle repair, 202
Free Application for Federal Student Aid
(FAFSA), 493
Front-end load plans, 446
Frugality, 351
Full-service brokerage firms, 404–405
Full warranties, 191–192
Funds of funds, 433
Future value
explanation of, 11, 13
of series of deposits, 13–14
of series of equal amounts, 34–35
of single amount, 13, 33–34
Future value table, 12
G
General obligation bonds, 366
Gift cards, 125, 147
Gift taxes, 479
Global economy, influence of, 4, 6
Global stock funds, 431
Goals. See Financial goals
Government bonds, 365–367.
See also Bonds
Government-guaranteed financing
programs, 232
Grace period, 330, 497
Graduated repayment plans, 497
Grantors, 477
Grants, higher-education, 494–495
Gross income, 53
Group health insurance, 285–287.
See also Health insurance
Group life insurance, 328
Growth funds, 431
Growth stocks, 393
Guaranteed insurability option, 331
Guardians, 476
H
Hazards, 250
Health care costs
bankruptcy and, 174
efforts to contain, 310–311
expenses related to, 80, 95
factors contributing to, 310
statistics related to, 308–310
Healthfinder, 304
Health information technology, 311
Health information websites,
304–305
Health insurance. See also Disability
income insurance
basic coverage in, 288–289
COBRA and, 287
decisions in choice of, 294
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Health insurance—Cont.
deductibles and coinsurance
provisions in, 294
dental expenses and, 289
dread disease policies and, 289
explanation of, 285
group, 285–287
health maintenance organizations,
296, 297
hospital indemnity policies and, 289
individual, 287
internal limits vs. aggregate limits in, 294
long-term care insurance and,
289–292
Medicaid, 300
Medicare, 298–301
Patient Protection and Affordable
Care Act and, 300–305
policy provisions, 291
preferred provider organizations,
296–297
private, 295–298
reimbursement vs. indemnity plans
and, 293
trade-offs in, 293–294
vision care and, 289
Health Insurance Portability and
Accountability Act of 1996
(HIPAA), 285, 286
Health maintenance organizations
(HMOs), 296, 297
Health reimbursement accounts (HRAs),
298, 299
Health savings accounts (HSAs), 95,
297–299
HH savings bonds, 119
Hidden inflation, 7
Highballing, 200
Higher education. See Education;
Education financing
High-yield bond funds, 368, 432
Holographic wills, 475
Home equity conversion mortgages, 233
Home equity loans, 233
Home health care agencies, 297
Home inspections, 227, 228
Homeownership, taxes and, 95
Homeowner’s insurance. See also
Insurance
choosing coverage amount for, 262
cost factors of, 263–264
coverage provided by, 255–257
damage coverage in, 261
discounts on, 263
earthquakes and, 258
floods and, 257–258, 261
personal liability coverage in, 257
personal property coverage in, 255–257
selecting companies for, 263–264
specialized coverage and, 257–258
types of policies for, 259–260
Home purchases. See also Housing
affordability of, 226
down payments for, 229
final steps in transactions for, 234–236
financing for, 229–234 ( See also
Mortgages)
location decisions for, 226–227
price negotiation for, 227–228
renting vs., 219, 221
Home sales
home preparation for, 236–237
by owner, 238
by real estate agent, 238
selling price determination for,
237–238
Hospital expense insurance, 288
Hospital indemnity insurance, 289
Household inventory, 256, 257
Housing. See also Home purchases;
Home sales
lifestyle and, 219
renting vs. buying decisions for,
219–224
retirement and, 462, 463
types of, 225–226
H.R.10 (Keogh) plans. See Keogh plans
Hybrid cars, 197
I
I bonds, 119
Identity theft
actions for suspected, 166–169
explanation of, 129
Immediate annuities, 336
Implied warranties, 192, 236
Impulse buying, 189
Income. See also Retirement income
adjusted gross, 78
on budgets, 55, 58
on cash flow statement, 53
discretionary, 53
earned, 78
gross, 53
investment, 78, 358
from mutual fund dividends, 443–444
passive, 78
from stock dividends, 389–390
taxable, 78–80
tax-deferred, 78
tax-equivalent, 95–96
tax-exempt, 78
Income-based repayment (IBR) plans, 497
Income-contingent repayment plans, 497
Income-sensitive repayment plans, 497
Income stocks, 393
Incontestability clause, 329–330
Indemnity policies, 293
Index annuities, 337
Indexed CDs, 117
Index funds, 431, 436–437
Individual checking accounts, 127
Individual retirement accounts (IRAs),
468–469, 471
Inflation
cost of credit and, 164–165
explanation of, 6
financial planning and, 6–7
hidden, 7
retirement planning and, 464
savings plans and, 120
Inflation risk, 356
Inheritance taxes, 479
Initial public offering (IPO), 403
Insolvency, 51
Insurable risk, 250
Insurance. See also specific types of
insurance
disability income, 305–307
earthquake, 257, 258
explanation of, 249–250
flood, 257–258
health, 285–305
homeowner’s, 255–264
life, 321–340
methods to lower cost of, 265
motor vehicle, 264–271
personal property, 255–256
planning for, 251–253
premiums for, 249, 250, 269–270, 285
property and liability, 254–255
renter’s, 224, 258–259
risk management methods and,
250–252
risk types and, 250, 252
setting goals for, 251–252
title, 234
umbrella policies, 257
Insurance companies
comparing rates offered by, 269–270
explanation of, 249–250
health insurance, 295
life, 113, 148, 325–326, 332
use of credit information by, 270
Insurance policies, 150, 249
Insured, 250
Insurers, 249, 250
Interest
add-on, 164
calculation of, 11–13
deductible, 79
simple, 163–164
on U.S. Treasury securities, 365, 366
Interest-adjusted indexes, 334
Interest-earning checking accounts, 118,
126, 127
Interest-only mortgages, 233
Interest rate risk, 356–357
Interest rates
annual percentage rate, 161, 162, 164
basics of, 11–13, 32–33
on bonds, 365–366, 369
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disclosure requirements related to, 157
financial planning and, 7
financial service decisions and, 111
lender risk vs., 162–163
mortgages and, 230–231
risk-based pricing and, 157
variable, 163
Intermediate corporate bond funds, 432
Intermediate financial goals, 9
Internal Revenue Service (IRS), 517
audits by, 93–94
estates and trust filings with, 479
Form 1099 DIV, 445
taxpayer assistance by, 91–92
International funds, 431
Internet
bond research on, 371–372
consumer purchasing on, 190, 191
mutual fund research on, 437, 438
protecting credit information on,
167, 169
stock research on, 392–394
Internet Crime Complaint Center, 516
Interviews
informational, 503
job, 509–511
Intestate, 474
Invesco Dividend Income Fund, 424, 425
Investment assets, on balance sheet, 50
Investment banks, 403
Investment decisions
numerical measures that influence,
398–401
stock, 392–401
Investment income, 78
Investment programs
getting money needed to start,
352–353
goals for, 349–350
performing financial checkup for,
350–352
seeking professional help for, 363
time value of money and, 353–355
your role in, 361–363
Investment risk
age factor and, 361
asset allocation and, 359–360
time factor and, 360–361
Investments. See also specific types of
investments
age and, 361
asset allocation and, 359–360
in bonds, 364–374
for current income, 8
evaluating potential, 361
fear of, 262
growth of, 358
income from, 78, 358
keeping records of your, 363
liquidity of, 358
monitoring your, 362–363
in mutual funds ( See Mutual funds)
reasons for, 8
risk factors in, 356–358
safety and risk of, 355–356
as source of income, 358
tax considerations related to, 95–97
tax-exempt, 95–96
time factor and, 360–361
Invoice price, 199
Iraq and Afghanistan Service Grant, 494
IRAs. See Individual retirement
accounts (IRAs)
Irrevocable trusts, 478
Itemized deductions, 78–80
J
Job advertisements, 503
Job creation, 504
Job interviews, 509–511
Job-related expenses, 80, 95
Joint checking accounts, 127
K
Kelley Blue Book, 199
Keogh plans, 97, 471
Kiplinger’s Personal Finance, 397 , 441
L
Labeling, 190
Large-cap funds, 432
Large-cap stocks, 393
Leases, 222–223
Leasing, motor vehicle, 197–199
Legal aid society, 206
Legal documents, 473–474
Legal issues
for consumer credit, 155, 157, 160,
169–171
for consumer purchase complaints,
205–207
for motor vehicle insurance, 268
for rental properties, 222–223
for trusts, 477–478
for wills, 474–477
Levison, Clare K., 351
Liabilities
on balance sheet, 50
explanation of, 50, 254
Liability insurance, 254–255
Liability risks, 250
Lifecycle funds, 433
Life expectancy, 322
Life income option, 335
Life insurance. See also Annuities
comparison of types of, 328
credit, 329
determining need for, 322–323
endowment, 329
estimating your requirements for,
323–325
explanation of, 321
group, 328
guidelines to purchase, 332–335
life expectancy and, 322
policy provisions for, 329–331
purpose of, 321–322
retirement planning and, 462
riders to, 330–331
settlement options for, 334–335
switching, 335
term, 326–327
types of companies that sell, 325–326
whole life, 327–328
Life insurance agents, 332, 333
Life insurance companies, 113, 148,
325–326, 332
Limited installment payment
option, 335
Limited payment policies, 327
Limited warranties, 191–192
Limit orders, stock, 406
Line of credit, home equity, 233
Lipper Analytical Services, 438
Liquid assets, 49
Liquid CDs, 117
Liquidity
investment, 358
savings plans and, 121
Liquidity ratio, 51
Living benefits, 331
Living trusts, 478, 479
Living wills, 476–477
Loan funds, 427–428
Loans. See also Mortgages
affordability of, 151
applying for, 151–157
cash advances as, 149, 150
cosigning, 169
cost of, 160–166
denial of, 157–160
expensive, 149
function of, 148
home equity, 149–150, 233
inexpensive, 149
length of term of, 162
management of, 171–176
medium-priced, 149
motor vehicle, 200–201
preapproval for, 200
problematic sources of, 113–114
secured, 163
student, 495–499
subsidized, 495
unsubsidized, 495
Location
homeowner’s insurance costs and, 263
purchasing decisions based on,
189–190
Long-term capital gains, 96
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Long-term care insurance (LTC)
checklist for, 292
explanation of, 289, 291
method to deal with, 290
Long-term corporate bond funds, 432
Long-term financial goals, 9
Long-term government bond funds, 432
Long-term liabilities, 50
Lowballing, 200
Lump-sum payment option, 335
M
Major medical expense insurance,
288–289
Managed funds, 436–437
Management fees, mutual fund, 428–430
Manufactured homes, 226
Margin, 409–410
Marginal tax rate, 81
Market orders, stock, 406
Market risk, 357–358
Maturity date, 367, 370
Mediation, for consumer purchasing
issues, 205
Medicaid, 300
Medical/dental expenses, 78–79
Medical expense insurance, 285. See
also Health insurance
Medical payments coverage, 257–258
Medicare, 298–301
Medigap (MedSup) insurance, 299
MedlinePlus, 304
Mental budgets, 59
Mergent, Inc., 372, 394
Micro cap stocks, 393
Midcap funds, 432
Midcap stocks, 393
Minimum monthly payment, 165
Misstatement of age provision, 330
Mobile commerce, 147
Mobile homes, 226, 259
Mobile payments, 125
Money
managing daily needs for, 107
tips for stretching your, 61
Money factor, 198
Money magazine, 397, 441
Money management
budgeting and, 54–59 ( See also Budgets)
components of, 45–46
explanation of, 45
financial goal achievement and, 60, 62
financial ratios and, 51
personal financial statements and, 48–54
recordkeeping for, 46–47
savings techniques for, 62
SWOT analysis and, 58
Money market accounts, 118
Money market funds, 113, 433
Money orders, 127
Moody’s Investor Service, 372
Morningstar Inc., 437–439
Mortgage bonds, 368
Mortgage companies, 113
Mortgages
adjustable-rate, 232–233
applying for, 229
buy-downs and, 233
down payments for, 229
explanation of, 229
factors in obtaining, 229–230
fixed-rate, fixed-payment, 231–232
government-guaranteed, 232
interest-only, 233
interest rates and, 230–231
legal protections related to, 157
qualifying for, 229, 230
refinancing, 234
reverse, 233
second, 233
subprime, 229
types of, 231–233
Motor vehicle insurance. See also
Insurance
bodily injury coverage in, 264–266
comprehensive physical damage
coverage in, 266–267
cost of, 268–271
financial responsibility laws and, 264
medical payments coverage in,
265–266
no-fault, 267
property damage coverage and,
266–268
rental reimbursement coverage in, 267
towing/emergency road service
coverage in, 267
uninsured motorist protection
in, 266
Motor vehicles
buying vs. leasing, 197–199
certified pre-owned, 197
evaluation of alternatives for, 194,
196–198
hybrid, 197
loans for, 200–201
maintenance costs for, 201, 202
new vs. used, 196–197
operating costs for, 201
postpurchase activities for, 201–202
preshopping activities for, 195–196
price negotiation for, 198–201
repair fraud for, 202
servicing sources for, 201–202
warranties for, 192
Moving expenses, 80
MSN Money website, 399
Multiunit dwellings, 225
Multiyear level term insurance, 326
Municipal bond funds, 432
Municipal bonds, 366
Mutual fund investment decisions
financial publications and newspapers
for, 441–442
Internet research for, 437, 438
managed funds vs. index funds and,
436–437
overview of, 435
professional advisory services for,
438–440
prospectus and annual reports for, 440
for retirement accounts, 433–435
Mutual funds
asset allocation, 432
balanced, 432
bond funds, 432
closed-end, 425
exchange-traded, 426
explanation of, 423
family of funds, 433
fees associated with, 428–430
fund of funds, 433
lifecycle, 433
load vs. no-load, 427–428
money market, 433
open-end, 426–427
overview of, 423–424
psychology of investing in, 424
purchase options for, 445–446
return on investment of, 443–444
stock funds, 431–432
tax considerations for, 444–445
transaction mechanics for, 442–447
withdrawal options for, 447
Mutual savings banks, 113
N
Nasdaq, 404
Nasdaq Composite Index, 436
National Association of Attorneys
General, 517
National-brand products, 190
National Credit Union Administration
(NCUA), 122, 515
National Flood Insurance Program,
257–258, 516
National Guard, 499
National Highway Traffic Safety
Administration, 515
National Insurance Consumer Helpline
(NICH), 331
Negative amortization, 233, 495
Negative equity, 200
Negligence, 250
Net asset value (NAV), 426
Net cash flow, 53–54
Net pay, 53
Net worth, 50–51
Newspapers, as financial information
source, 397
NIH Health Information Page, 304–305
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No-fault insurance, 267
No-load funds, 427–428, 445
Non-deposit institutions, 108, 113
Nonforfeiture clause, 330
Nonparticipating (nonpar) policies,
325, 326
O
Occupational Outlook Handbook, 503
Office audits, 94
Online bill payments, 124–125
Online brokerage firms, 404–405
Online payments, 124–125
Open dating, 190
Open-end credit, 144, 145, 164
Open-end funds, 426–427, 445–446
Opportunity costs. See also Time value
of money
explanation of, 10–11
financial, 11–15
personal, 11
Options, stock, 411
Orman, Suze, 361
Overdraft protection, 127
Over-the-counter (OTC) market, 403–404
P
Parent Loans (PLUS loans), 496, 497
Participating (par) policies, 325, 326
Partnership for Caring: America’s Voice
for the Dying, 476
Passive income, 78
Patient Protection and Affordable Care
Act of 2010
enrollment statistics and, 302–303
explanation of, 285, 300
provisions of, 300–302
shared responsibility and, 303–304
Pawnshops, 114
Pay-as-you-earn repayment (PAYE), 497
Payday loan companies, 114
Payment caps, 233
Payment methods
checking accounts, 125–128
electronic, 124–125
evaluation of, 126–127
function of, 108
miscellaneous, 127
Payment schedule, motor vehicle
leasing, 198
Payroll deduction, 62
Peace Corps, 499
Peer-to-peer lending, 496
Peer-to-peer payments, 125
Pell Grant, 494
Penny stocks, 393
Pensions. See Retirement
Peril, 250
Periodic payment plans, 446
Perkins, Carl D., 495
Perkins Loans, 495–497
Personal catastrophe policies, 257
Personal finance dashboard, 23
Personal finances
data sheet for, 28
goal-setting for, 29
recordkeeping for, 46, 47
Personal financial planning
activities related to, 7–8
adult life cycle and, 4
advantages of, 4
career choice and, 22
for couples, 21
economic factors for, 4, 6–7
explanation of, 3
information sources for, 18
life situation and, 3–5
opportunity costs and time value of
money, 10–15
process for, 15–18
taxes in, 75–98
values and, 4
Personal financial plans
annuities in, 336
creating and implementing, 19–20
health insurance in, 285
life insurance in, 321–322
property and liability insurance in,
254–255
review and revision of, 20, 22
steps to create, 15–18
Personal financial statements
balance sheet, 48–51
case flow statement, 51–54
function of, 48
Personal identification number (PIN), 124
Personal money management. See
Personal financial planning
Personal possessions, on balance
sheet, 50
Personal property coverage, in
homeowner’s insurance, 255–256
Personal property floater, 257
Personal risks, 250
Physical budgets, 59
Physician expense insurance, 288
PLUS loans, 496, 497
Point-of-service (POS) plans, 296–297
Points, mortgages and, 231
Police reports, 167
Policies, insurance, 249, 250
Policy dividends, 325
Policyholders, 249, 250
Policy loan provisions, 330
Portability, 466
Power of attorney, 477
Prefabricated homes, 226
Preferred provider organizations (PPOs),
296–297
Preferred stock, 391–392
Premiums, insurance, 249, 250,
269–270, 285
Prepaid debit cards, 110, 125
Prepaid legal services, 206
Present value
to determine loan payments, 37
explanation of, 11, 14
of series of deposits, 15
of series of equal payments, 36
of single amount, 14, 35
Present value table, 12
Price comparison, in consumer
purchases, 190
Price-earnings (PE) ratio, 398–399
Price negotiation
for home purchases, 227–228
for motor vehicles, 198–201
Price-to-rent ratio, 224
Pricing
comparison, 190
risk-based, 157
unit, 190
Primary market, for stocks, 403
Private-label products, 190
Private student loans, 496
Probate, 475
Projected earnings, 399
Promotional CDs, 118
Property damage liability, 266–268
Property risks, 250
Property taxes, 76, 237
Prospectus, mutual fund, 440
Proxy, 388
Public assistance, 157
Public Health Service, 517
Public pension plans, 466–468
Public Service Loan Forgiveness
Program, 499
Purchase agreements, home, 227
Purchases. See Consumer purchases
Pure risk, 250
R
Rate caps, 233
Rate of return
after-tax savings, 122
explanation of, 120
Ratios, financial, 51
Real estate, 50. See also Housing
Real estate agents, 227, 238
Real Estate Settlement Procedures Act
(RESPA), 235
Record date, 389–390
Recordkeeping
daily spending diary, 518–526
investment, 363
legal documents, 473–474
money management, 46–47
system for financial, 46, 47
tax, 81
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Refinancing, home, 234
Regional funds, 432
Registered bonds, 369
Registered coupon bonds, 369
Regular checking accounts, 125
Regular IRAs, 468, 469
Reimbursement policies, 293
Reinvestment plans, 446
Renewable term insurance, 326
Rental housing. See also Housing
activities related to, 220
advantages of, 221–222
buying vs., 219–220, 224
cost of, 223
disadvantages of, 222
leasing arrangements for, 222–223
selection of, 221
Rental reimbursement coverage, 267
Renter’s insurance, 224, 258–259
Rent-to-own centers, 114
Replacement cost, 262
Replacement value, 262
Research
for consumer purchases, 192–193
for motor vehicle purchases, 195–196
Residual value, 198
Restrictive endorsement, 128
Résumés
cover letters for, 507, 508
elements of, 504–505
preparation of, 505–506
submission of, 507
Retirement. See also Estate planning
conducting a financial analysis for,
460–462
housing costs during, 462, 463
living expenses during, 462–464
myths about, 459–460
saving for, 460
working during, 472
Retirement income
allocation of, 463
annuities for, 471
employer pension plans for, 464–466
individual retirement accounts for,
468–469, 471
living on your, 471–472
part-time employment as, 472
public pension plans for, 466–468
use of savings as, 472
Retirement plans
403(b) plans, 465
defined-benefit, 465
defined-contribution, 465
individual, 468–469, 471
Keogh plans as, 97, 471
401(k) plans as, 97–98, 465, 470
mutual funds selection for, 433–435
Roth IRAs as, 97, 468, 469
Social Security, 466–467
traditional IRAs as, 97
Return-of-premium term insurance, 327
Return on investment, mutual fund,
443–444
Revenue bonds, 366
Reverse mortgages, 233
Revocable trusts, 478
Riders, to life insurance policies,
330–331
Rising-rate CDs, 115
Risk
avoidance of, 250–251
business failure, 357
evaluation of, 18
explanation of, 250
inflation, 356
insurable, 250
interest rate, 356–357
investment, 355–356, 359–363
lender, 162–163
liability, 250
management of, 8, 250–252
market, 357–358
personal, 250
reduction of, 251
shifting of, 251
speculative, 250
Risk-based pricing, disclosure issues
related to, 157
The Road to Wealth (Orman), 361
Rollover IRAs, 468–469
Roth IRAs, 97, 468, 469
Roth 401(k), 470
S
Safe deposit boxes, 46, 47
Safety. See Risk
Salary-reduction plans. See 401(k) plans
Sales taxes, 75–76
Savers credit, 83
Saving
budgeting for, 55
calculating amounts for, 62
function of, 108
methods for, 116
for retirement, 460
selecting technique for, 62
Savings and loan associations (S&Ls),
113, 148
Savings bonds, United States, 118–119
Savings plans
certificates of deposit, 115, 117–118
comparison of, 124–128
deposit insurance and, 122–123
evaluation of, 120–123
interest-earning checking accounts, 118
money market accounts/funds, 118
online and mobile, 109–110
rate of return on, 120, 122
restrictions and fees for, 123
U.S. savings bonds, 118–119
Savings ratio, 51
Scholarships, 493–494
Secondary market, for stocks, 403–404
Second mortgages, 233
Second-to-die life insurance, 331
Sector funds, 432
Secured loans, 163
Securities and Exchange Commission
(SEC), 516
Securities exchange, 403
Security deposits, 223
Self-employment taxes, 96
Self-insurance, 251
Selling short, 410–412
Serial bonds, 368–369
Service contracts, 192
Set-price dealers, 199
Settlement costs, 234
Short-term capital gains, 96
Short-term corporate bond funds, 432
Short-term financial goals, 9
Short-term government bond funds, 432
Simple interest, 163–164
Simple interest formula, 163–164
Simple wills, 475
Simplified employee pension (SEP)
plans, 468, 469
Single-family dwellings, 225
Sinking fund, 368
Situational interviewing, 510–511
Skimming, 167
Small-cap funds, 432
Small-cap stocks, 393
Small claims court, 205–207
SMART approach, 9, 54
Smart cards, 125, 147
Smartphones, 147
Social lending, 496
Socially responsible funds, 432
Social Security Administration,
467, 517
Social Security benefits, 306, 466–467
Special endorsement, 128
Specialists, stock, 403
Speculative investments, 355
Speculative risk, 250
Speculators, 407
Spending
keeping track of, 61
review of, 58–59
Spending diary, 518–526
Spending plans. See Budgets
Spousal IRAs, 468, 469
Sprauve, Anthony, 155
Stafford, Robert, 495
Stafford Loans, 495, 497
Standard deduction, 78–80
Standard & Poor’s Corporation, 372, 394
Standard & Poor’s 500 stock index, 387,
401, 436
Standard repayment plans, 497
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Index 537
Stated amount wills, 475
State taxes
on estates, 478–479
method to file, 88
Statutory wills, 475
Sticker price, 199
Stock advisory services, 394–395, 397
Stock funds, 431–432
Stockholders, voting rights of, 388
Stock investment decisions
corporate earnings and, 398–399
dividend yield and total return and,
400–401
informational websites for,
393–394, 399
information sources for, 392–397
long-term strategies for, 407–409
short-term strategies for, 409–411
Stock investment strategies
buy-and-hold, 407
buying on margin, 409–410
direct investment and dividend
reinvestment plans, 408–409
dollar cost averaging, 408
selling short, 410–411
trading in options, 411
Stock life insurance companies,
325–326
Stock market bubble, 402
Stocks
common, 388–391
factors influencing price of, 398–402
initial public offering of, 403
investment in, 387–388
over-the-counter market for,
403–404
preferred, 391–392
primary market for, 403
psychology of investing in, 388–389
rationale for investment in, 388–391
secondary market for, 403–404
Stock splits, 390–391
Stock transactions
brokerage firms for, 404
commission charges for, 406, 407
computerized, 405
full-service, discount or online
brokerage firms for, 404–405
secondary markets for, 403–404
types of, 405–406
Stop-loss orders, 306
Stop-loss provisions, 289
Stop-payment orders, 128
Store-brand products, 190
Stored-value cards, 125, 147
Straight life policies. See Whole life
insurance
Student loans
cancellation of, 499
categories of, 495–496
consolidation, 498
default rate on, 498
deferment of, 499
explanation of, 495
forgiveness of, 499
repayment of, 497
Sublets, 223
Subprime crisis, 229
Subsidized loans, 495
Suicide clause, 330
Summary plan description (SPD), 286
Surplus, 53, 57
Surrender charges, 337, 338
Survivorship life insurance, 331
SWOT analysis, 58
T
T. Rowe Price Value Fund, 437, 438
Take-home pay, 53
Target-date funds, 433
Targeted application letters, 507
Taxable equivalent yield, 366–367
Taxable income, 78–80
Tax audits, 93–94
Tax code, changes in, 98
Tax credits, 82, 83, 87
Tax deductions, 78–80, 82
Tax-deferred income, 78
Tax-equivalent income, 95–96
Taxes. See also Federal income taxes
annuities and, 338, 340
calculation of, 82–83
consumer purchases and, 95
deadlines and penalties for, 84
deductible, 79
on earnings, 76
estate, 478–479
flat, 98
gift, 479
inheritance, 479
investment decisions and, 95–97
making payments on, 83–84
mutual funds and, 444–445
planning strategies for, 95–98
property, 76, 237
recordkeeping for, 81
retirement and education plans and,
97–98
sales, 75–76
savings plans and, 121
state and local, 79
value-added, 98
on wealth, 76
when traveling, 77
Tax-exempt income, 78
Tax-planner calendar, 91
Tax preparation services, 92–93
Tax preparation software, 89
Tax rate, 81
Tax shelters, 78
TD Ameritrade, 446
Teacher Education Assistance for
College and Higher Education
(TEACH) Grant, 494
Temporary life insurance. See Term life
insurance
Term life insurance, 326–327. See also
Life insurance
Testamentary trusts, 478
Theft. See Identity theft
Theft losses, 79
Time value of money
explanation of, 11
future value and, 11
future value of series of deposits and,
13–14
future value of series of equal
amounts, 34–35
future value of single amount and,
13, 33–34
insurance cost and, 335
interest rates and, 11–13, 32–33
investments and, 353–355
methods to calculate, 11–14, 39
present value and, 11
present value of series of deposits
and, 15
present value of series of equal
payments and, 36
present value of single amount and,
14, 35
present value to determine loan
payments and, 37
replacement cost and, 262
retirement savings and, 461
Time value of money table, 12
Title insurance, 234
Towing/emergency road service
coverage, 267
Townhouses, 225
Trade-offs. See Opportunity costs
Traders, stock, 407
Traditional IRAs, 97
Traditional marital share wills, 475
Travel and entertainment (T&E)
cards, 147
Traveler’s checks, 127
Traveling, taxes and, 77
Treasury bills, 365, 366
Treasury bonds, 365, 366
Treasury Inflation-Protected Securities
(TIPS), 365, 366
Treasury notes, 365, 366
Trustees, 367, 475, 477
Trustors, 477
Trusts
explanation of, 109, 475
reasons for, 477
types of, 478
Truth in Lending Act, 164, 169
Turnover ratio, 445
12b-1 fees, 428–429
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538 Index
U
Umbrella policies, 257
Underwriting, 270
Uninsured motorist protection, 266
Unit pricing, 190
Universal life insurance, 328
Unsubsidized loans, 495
Upside-down equity, 200
U.S. Department of Agriculture, 515
U.S. Department of Education, 495
U.S. Department of Housing and Urban
Development (HUD), 516
U.S. Department of Justice, 516
U.S. Department of Labor, 515
U.S. savings bonds, 118–119
U.S. Treasury securities, 365
Used motor vehicles. See also Motor
vehicles
comparison of, 196–197
price negotiation for, 199
warranties for, 192
V
Value-added tax (VAT), 98
Value Line, 394, 438
Value Line Investment Survey, 394 , 395
Values, 4
Vanguard Mid-Cap Growth Fund, 431
VantageScore, 156
Variable annuities, 336, 337, 339
Variable expenses, 53
Variable interest rates, 163
Variable life policies, 327–328
Variable-rate mortgages, 232–233
Vesting, 465
Veterans Administration (VA), 232, 468
Vision care insurance, 289
Volunteer work, 503
W
Wage loss insurance, 267
Waiver of premium disability benefit,
330
Walk-throughs, 234
The Wall Street Journal, 110 , 397, 441
Warranties
explanation of, 191–192
implied, 192, 236
Warranty deeds, 234–235
Warranty of merchantability, 192
Warranty of title, 192
Websites
for bond information, 372
for financial aid information, 493
for government agencies, 514–517
for health information, 304–305
for stock information, 393–394, 399
Wellness programs, 286
Whole life insurance, 327–328
Wills
aspects of writing, 475–476
explanation of, 474
formats of, 475
living, 476–477
probate and, 475
types of, 474–475
Wilshire 5000 Total Market, 436
Witholding, tax, 84–85
Workers’ compensation, 306
Work-study programs, 499–500
World bond funds, 432
Written budgets, 59
Y
Yahoo! Finance, 393–394, 437
Yield
annual percentage, 120, 121
bond, 370
Z
Zero-coupon CDs, 117
Zoning laws, 226–227
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Cover
Focus on Personal Finance
Dedication
Focus on . . . the Authors
New to This Edition
Focus on . . . Learning
Online Support for Studentsand Instructors
Brief Table of Contents
Contents
1 Personal Financial Planning in Action
Making Financial Decisions
Your Life Situation and Financial Planning
Financial Planning in Our Economy
Financial Planning Activities
Developing and Achieving Financial Goals
Types of Financial Goals
Goal-Setting Guidelines
Opportunity Costs and the Time Value of Money
Personal Opportunity Costs
Financial Opportunity Costs
A Plan for Personal Financial Planning
Step 1: Determine Your Current Financial Situation
Step 2: Develop Your Financial Goals
Step 3: Identify Alternative Courses of Action
Step 4: Evaluate Your Alternatives
Step 5: Create and Implement Your Financial Action Plan
Step 6: Review and Revise Your Plan
Career Choice and Financial Planning
Appendix: Time Value of Money
2 Money Management Skills
A Successful Money Management Plan
Components of Money Management
A System for Personal Financial Records
Personal Financial Statements
Your Personal Balance Sheet: The Starting Point
Your Cash Flow Statement: Inflows and Outflows
A Plan for Effective Budgeting
Step 1: Set Financial Goals
Step 2: Estimate Income
Step 3: Budget an Emergency Fund and Savings
Step 4: Budget Fixed Expenses
Step 5: Budget Variable Expenses
Step 6: Record Spending Amounts
Step 7: Review Spending and Saving Patterns
Money Management and Achieving Financial Goals
Selecting a Saving Technique
Calculating Savings Amounts
3 Taxes in Your Financial Plan
Taxes in Your Financial Plan
Planning Your Tax Strategy
Types of Tax
The Basics of Federal Income Tax
Step 1: Determining Adjusted Gross Income
Step 2: Computing Taxable Income
Step 3: Calculating Taxes Owed
Step 4: Making Tax Payments
Step 5: Deadlines and Penalties
Filing Your Federal Income Tax Return
Who Must File?
Which Tax Form Should You Use?
Completing the Federal Income Tax Return
How Do I File My State Tax Return?
How Do I File My Taxes Online?
What Tax Assistance Sources Are Available?
Tax Preparation Services
What If Your Return Is Audited?
Tax Planning Strategies
Consumer Purchasing
Investment Decisions
Retirement and Education Plans
Changing Tax Strategies
Flat or VAT Tax?
4 Financial Services: Savings Plans and Payment Accounts
Planning Your Use of Financial Services
Managing Daily Money Needs
Sources of Quick Cash
Types of Financial Services
Online and Mobile Banking
Prepaid Debit Cards
Financial Services and Economic Conditions
Sources of Financial Services
Comparing Financial Institutions
Types of Financial Institutions
Problematic Financial Businesses
Comparing Savings Plans
Regular Savings Accounts
Certificates of Deposit
Interest-Earning Checking Accounts
Money Market Accounts and Funds
U.S. Savings Bonds
Evaluating Savings Plans
Comparing Payment Methods
Electronic Payments
Checking Accounts
Evaluating Checking and Payment Accounts
Other Payment Methods
Managing Your Checking Account
5 Consumer Credit: Advantages, Disadvantages, Sources, and Costs
What Is Consumer Credit?
The Importance of Consumer Credit in Our Economy
Uses and Misuses of Credit
Advantages of Credit
Disadvantages of Credit
Summary: Advantages and Disadvantages of Credit
Types of Credit
Closed-End Credit
Open-End Credit
Credit Cards
Sources of Consumer Credit
Loans
Applying for Credit
Can You Afford a Loan?
General Rules of Credit Capacity
The Five Cs of Credit
Your Credit Report
Credit Scores
Other Factors Considered in Determining Creditworthiness
What If Your Application Is Denied?
What Can You Do to Improve Your Credit Score?
The Cost of Credit
Finance Charge and Annual Percentage Rate
Tackling the Trade-Offs
Calculating the Cost of Credit
Protecting Your Credit
Billing Errors and Disputes
Identity Crisis: What to Do If Your Identity Is Stolen
Protecting Your Credit from Theft or Loss
Protecting Your Credit Information on the Internet
Cosigning a Loan
Complaining about Consumer Credit
Consumer Credit Protection Laws
Consumer Financial Protection Bureau
Managing Your Debts
Warning Signs of Debt Problems
Debt Collection Practices
Financial Counseling Services
Declaring Personal Bankruptcy
6 Consumer Purchasing Strategies and Wise Buying of Motor Vehicles
Consumer Buying Activities
Practical Purchasing Strategies
Warranties
Research-Based Buying
Major Consumer Purchases: Buying Motor Vehicles
Phase 1: Preshopping Activities
Phase 2: Evaluating Alternatives
Phase 3: Determining Purchase Price
Phase 4: Postpurchase Activities
Resolving Consumer Complaints
Step 1: Initial Communication
Step 2: Communicate with the Company
Step 3: Consumer Agency Assistance
Step 4: Legal Action
Legal Options for Consumers
Small Claims Court
Class-Action Suits
Using a Lawyer
Other Legal Alternatives
Personal Consumer Protection
7 Selecting and Financing Housing
Evaluating Renting and Buying Alternatives
Your Lifestyle and Your Choice of Housing
Renting versus Buying Housing
Rental Activities
Home-Buying Activities
Step 1: Determine Home Ownership Needs
Step 2: Find and Evaluate a Home
Step 3: Price the Property
The Finances of Home Buying
Step 4: Obtain Financing
Step 5: Close the Purchase Transaction
Home Buying: A Summary
A Home-Selling Strategy
Preparing Your Home for Selling
Determining the Selling Price
Sale by Owner
Listing with a Real Estate Agent
8 Home and Automobile Insurance
Insurance and Risk Management
What Is Insurance?
Types of Risk
Risk Management Methods
Planning an Insurance Program
Property and Liability Insurance in Your Financial Plan
Home and Property Insurance
Homeowner’s Insurance Coverages
Renter’s Insurance
Home Insurance Policy Forms
Home Insurance Cost Factors
How Much Coverage Do You Need?
Factors That Affect Home Insurance Costs
Automobile Insurance Coverages
Motor Vehicle Bodily Injury Coverages
Motor Vehicle Property Damage Coverage
No-Fault Insurance
Other Automobile Insurance Coverages
Automobile Insurance Costs
Amount of Coverage
Motor Vehicle Insurance Premium Factors
Reducing Vehicle Insurance Premiums
9 Health and Disability Income Insurance
Health Insurance and Financial Planning
What Is Health Insurance?
Health Insurance Coverage
Types of Health Insurance Coverage
Major Provisions in a Health Insurance Policy
Health Insurance Trade-Offs
Coverage Trade-Offs
Which Coverage Should You Choose?
Private Health Care Plans and Government Health Care Programs
Private Health Care Plans
Government Health Care Programs
Health Insurance and the Patient Protection and Affordable Care Act of 2010
The Affordable Care Act and the Individual Shared Responsibility Provision
Disability Income Insurance
The Need for Disability Income
Sources of Disability Income
Disability Income Insurance Trade-Offs
Your Disability Income Needs
High Medical Costs
Why Does Health Care Cost So Much?
What Is Being Done about the High Costs of Health Care?
What Can You Do to Reduce Personal Health Care Costs?
10 Financial Planning with Life Insurance
What Is Life Insurance?
The Purpose of Life Insurance
The Principle and Psychology of Life Insurance
How Long Will You Live?
Do You Need Life Insurance?
Estimating Your Life Insurance Requirements
Types of Life Insurance Companies and Policies
Types of Life Insurance Companies
Types of Life Insurance Policies
Selecting Provisions and Buying Life Insurance
Key Provisions in a Life Insurance Policy
Buying Life Insurance
Financial Planning with Annuities
Why Buy Annuities?
Costs of Annuities
Tax Considerations
11 Investing Basics and Evaluating Bonds
Preparing for an Investment Program
Establishing Investment Goals
Performing a Financial Checkup
Getting the Money Needed to Start an Investment Program
How the Time Value of Money Affects Your Investments
Factors Affecting the Choice of Investments
Safety and Risk
Components of the Risk Factor
Investment Income
Investment Growth
Investment Liquidity
Factors That Reduce Investment Risk
Asset Allocation and Diversification
Your Role in the Investment Process
Conservative Investment Options: Government Bonds
The Psychology of Investing in Bonds
Government Bonds and Debt Securities
Conservative Investment Options: Corporate Bonds
Why Corporations Sell Corporate Bonds
Why Investors Purchase Corporate Bonds
A Typical Bond Transaction
The Decision to Buy or Sell Bonds
The Internet
Financial Coverage for Bond Transactions
Bond Ratings
Bond Yield Calculations
Other Sources of Information
12 Investing in Stocks
Common and Preferred Stock
Why Corporations Issue Common Stock
Why Investors Purchase Common Stock
Preferred Stock
Evaluating a Stock Issue
The Internet
Stock Advisory Services
Newspaper Coverage and Corporate News
Numerical Measures That Influence Investment Decisions
Why Corporate Earnings Are Important
Dividend Yield and Total Return
Other Factors That Influence the Price of a Stock
Buying and Selling Stocks
Secondary Markets for Stocks
Brokerage Firms and Account Executives
Should You Use a Full-Service, Discount, or Online Brokerage Firm?
Computerized Transactions
Sample Stock Transactions
Commission Charges
Long-Term and Short-Term Investment Strategies
Long-Term Techniques
Short-Term Techniques
13 Investing in Mutual Funds
Why Investors Purchase Mutual Funds
The Psychology of Investing in Funds
Characteristics of Funds
Classifications of Mutual Funds
Stock Funds
Bond Funds
Other Funds
Choosing the Right Fund for a Retirement Account
How to Make a Decision to Buy or Sell Mutual Funds
Managed Funds versus Index Funds
The Internet
Professional Advisory Services
The Mutual Fund Prospectus and Annual Report
Financial Publications and Newspapers
The Mechanics of a Mutual Fund Transaction
Return on Investment
Taxes and Mutual Funds
Purchase Options
Withdrawal Options
14 Starting Early: Retirement and Estate Planning
Planning for Retirement: Start Early
Saving Smart for Retirement
Conducting a Financial Analysis
Estimating Retirement Living Expenses
Your Retirement Income
Employer Pension Plans
Public Pension Plans
Personal Retirement Plans
Annuities
Living on Your Retirement Income
Estate Planning
The Importance of Estate Planning
What Is Estate Planning?
Legal Documents
Legal Aspects of Estate Planning
Wills
Types of Wills
Formats of Wills
Writing Your Will
A Living Will
Trusts
Types of Trusts
Taxes and Estate Planning
Appendixes A �Education Financing, Loans, and Scholarships
B Developing a Career Search Strategy
C Consumer Agencies and Organizations
D Daily Spending Diary
Photo Credits
Index
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