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
