Personal Finance 123 Lecture 1 - Introduction
Tonight’s Trivia
The dollar bill - $ - Origin is
in beginnings of international trade…
Finally, $ 100
Overview of Class in the
broadest terms:
Unit 1:
Financial Planning Process – record keeping,
goal setting
Cash Flow Management
-
Budgeting
-
Credit
-
Time vale of
money
-
Taxes
Unit 2:
“Big Buys” – buying a car,
buying a house. Purchases that represent long term commitments.
Unit 3:
Insurance – life, car, home, health,
disability
Interesting point:
I was talking to a person who
does financial planning for a living… He
said the subject of Life Insurance is interesting in terms of the way it comes
up. It’s dependent on the age of the
client:
Age 20-40 The client doesn’t even
bring it up, the financial planner has to bring it up.
Age 40-60 - the client brings it up by saying,
“if I die”.
Age 60-over – the client brings it up,
saying “when I die”.
Unit 4: Investments
Investments ----
2 primary principles: (a) DIVERSIFY (b) trade-off between return and risk.
Types of Investments:
Cash Equivalents, Stocks, Mutual Funds,
Exchange Traded Funds, Bond Funds, Other Asset
Classes: Real Estate, Hedge funds.
Now, a couple of topics for tonight:
A. Financial planning: Find out where
you are… Make Goals * Reasonably obtainable, and *Clearly stated. Look at options … Make a plan… Assess how
you’re doing…
B. Interest Rates
A dollar today is worth more
than a dollar tomorrow. Which would you
rather have?
For instance, would you
prefer $100 today or $120 a year from now?
(notice it may matter who is making the offer…
if you don’t trust them, you’ll take the money now. This is the concept of RISK).
What makes up an “interest
rate”? Let’s talk about 3 variables:
1.inflation. (inflation is
measured by “CPI” – Consumer Price Index).
Consumer Price Index is a comparison of the price of a “basket of goods”
over time. Inflation is the ENEMY of
savings, because the goods cost more in the future.
For example, if your savings
account is earning 5% interest, and inflation is 4%, then, in “real terms”,
you’re only earning 1%.
Thus, REAL RETURN = NOMINAL
RETURN – INFLATION RATE.
(nominal
return is just the quoted interest rate return).
In general, when inflation is
higher, interest rates also have to be higher so that the investor can earn a
“real return”.
In the rare times when
inflation is higher than the interest rate earned (the nominal rate), then the
investor is actually losing purchasing power (his money will buy less). This is a negative “real return”.
2. Also in any interest rate
is the concept of RISK. Thus, the
interest rate offered to you may differ from the interest rate offered to
me. This is sometimes called the “risk premium”.
For example, you and I are
both buying a car, and, we are both trying to finance the purchase.
You have a great credit
report. (Credit reports often report a
single number – your “credit score” or your “FICA score” which is between 300
and 820).
Let’s say your credit score
is 795. Mine is 640. The finance company will conclude that it is
MORE LIKELY for me to default than you to default. The loan to me is RISKIER. The finance company will charge me a higher
rate of interest.
3.Liquidity preference.
In general, people would prefer to have access to their money now. Thus, in most cases, when offering CD’s
(certificates of deposit), a bank will have to offer a higher interest rate for
the longer term of the CD. Look on www.bankrate.com . You will notice that the
interest rates on 5 year CD’s are higher than the interest rates on 1 year
CD’s. Why? The 5-year CD “locks up” your money for a
longer time frame.
What if this isn’t true? What if, for some reason, the interest rates
on longer term CDs are LOWER than shorter term CD’s. This rarely happens, and, when it does, it is
called “an inverted yield curve.”
C. Time Value of Money
Now we know a dollar today is
worth more than a dollar tomorrow. How
do we quantify that?
This refers to the “time
value of money”.
Examples: If I had $1,000 today, and, invested it at 5%
compounded annually, how much would I have at the end of 5 years?
This question is easy to work
today because of computers. We will work
these types of questions using Excel.
There are three types of
questions:
Present Value (If I’m going
to need $20,000 in 5 years, how much will I need to
invest NOW if I can earn 6%).
Future Value (I have $3,000
now, how much WILL I HAVE in 3 years if I invest the money at 9% compounded
annually?)
Annuity – Annuity is like a
car note or a house note. It assumes
periodic payments, or periodic receipts of cash.
Example of an annuity
problem: I want to finance $10,000 on my
new car. I want to finance the car for
60 months at 12% annual interest. How
much WILL MY MONTHLY PAYMENT be?
D. Taxes – Federal and State
Income Taxes, Gift Taxes, Estate Taxes.
Taxes are an important part
of most financial planning decisions:
Ex. Buying a house vs. renting
an apartment.
Ex. Credit card debt vs. Home Equity debt.
Ex. Retirement plans, 401 k
plans, IRA’s and Roth IRAs – the income from these retirement plans is TAX
DEFERRED or TAX FREE.