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Managing Your

Personal Finances

2

O N L I N E E N R I C H M E N TC H A P T E R

Learning Goals

After reading this chapter, you should be able toanswer these questions:

1 How does the financial-planning process facilitatesuccessful personal financial management?

2 How do cash flow planning and management ofliquid assets contribute to your financial goals?

3 What are the advantages and disadvantages ofusing consumer credit?

4 What types of taxes are individuals responsible for?

5 What factors should you consider in deciding whatinsurance to purchase?

6 What personal goals are important when makinginvestment decisions?

7 How do investors open a brokerage account andmake securities transactions?

8 What emerging trends affect the way you manageyour personal finances?

3

Exploring Business CareersMark RitziHorizon Bank

At some point in your life, you may not want to live

in that cramped dorm room. You might look to leave

your parents’ house, where curfew is still 11:00 P.M.

The fraternity or sorority, with secret meetings and

weekend parties, might not be as appealing as it

once was. Even apartment living can wear thin, as

friends imply you are throwing money away. After all,

they say, a house is an investment, but an apartment?

Not so much. However, even a starter home can cost

$100,000 or more, and you are feeling guilty about

that $15 CD you bought last week. How can you—or

anyone—ever make that leap? Mark Ritzi can help.

As Vice President of Mortgage Banking at

Horizon Bank in Northwest Indiana, Ritzi has been

helping people figure out how to buy homes for

fifteen years. A purchase as large as a home requires

careful personal financial planning, and as Ritzi will

tell you, this planning often starts long before you

start paging through the real estate section of your

local paper.

One financial planning key is to establish good

credit early on and maintain it throughout your life.

Many people understand that although using credit

has benefits, such as convenience, purchasing power,

and establishment of a credit rating, it can be dan-

gerous if not used properly. Credit makes it very easy

for people to spend beyond their means, and prob-

lems with credit can lead to a poor credit rating.

What people may not be as familiar with, however, is

that a credit rating might affect things like getting a

mortgage or homeowners insurance. Ritzi helps peo-

ple understand how credit rating—a score that tells

financial institutions how reliable you are at paying

back credit—affects everything from interest rates on

credit cards to car loans to mortgages. “You have to

educate people. Here’s your credit score, here’s what

it probably should be, here’s where it needs to be,

and here’s how you can help it.”

Ritzi knows disclosing your financial mistakes can

be painful, so he tries to set potential mortgage ap-

plicants at ease. He wants them to know that he is on

their side in the application process. And, ultimately,

he wants to help them correct any past errors, avoid

future pitfalls, and end up in the home they want.

“The most fulfilling time is when I have a recent

graduate, someone who has never purchased a

home before, come to me and trust me with their

decision about how to do it. It is not a decision you

take lightly. My job is to provide people who haven’t

done this the opportunity to understand that by

making this decision now, other things can happen

down the road.”

Chapter 21 discusses the many facets of manag-

ing personal finances, from the importance of setting

a personal financial plan to ways to make sure it is

successful. Beyond credit, this chapter examines

issues of cash management, checking and savings

accounts, taxes, insurance, and investing.

3

Online Enrichment Chapter4

In today’s highly competitive world, everyone is more aware of the need for early financialplanning and its importance to his or her future security and success. Shifts in demographicshave skewed the economic picture for many families, making proper financial planningessential. Some of these changes are:

More families (now called sandwich families) find themselves caught in the middlefinancially, responsible for both their children (couples are having children later in life)and their aging parents (increasing longevity), at a time in their own lives whenthey’re ready to retire.Increasing numbers of blended families result from divorce and remarriage.A significant number of single individuals are solely responsible for their own finances.The average cost to raise a child to age 17 ranges between $184,320 and $284,460depending on family income levels and location.1

The average annual cost of a public college education is $5,491 and $21,235 per yearor more at a private college.2

More employees are responsible for their own retirement funds.People have an overwhelming amount of information to consider when choosing suit-able financial products.Changing financial obligations and world economics bring new challenges in prepar-ing for the future. They can also bring confusion, frustration, and worry about meetingfinancial goals.

This chapter provides an overview of the information and skills needed to meet the chal-lenge of managing your own finances. We demonstrate how the personal financial plan-ning process can help you manage your cash flow and meet your financial goals. We de-scribe various types of checking and savings instruments, and explain how to useconsumer credit wisely, manage taxes, and select insurance. Then we outline how to setinvestment goals, develop an investment strategy, and make securities transactions. Finally,we review emerging trends in personal finance.

Financial Planning: The First StepsIn today’s world, financial planning is for everyone, not just the wealthy, whether youhave too much money or too little. If you have enough money, planning can help youspend and invest it wisely. If your income seems inadequate, taking steps to controlyour financial situation could lead to an improved lifestyle.

Personal financial planning is the process of managing one’s personal financesto achieve financial goals. Once you have established those goals, you can begin gath-ering information, analyzing the information, and then developing, implementing,and monitoring a financial plan designed to meet your goals. Exhibit 1 illustrates thesteps in the personal financial-planning process.

Personal financial planning is a lifelong process. As your personal circumstanceschange, so will your needs and goals. By creating flexible plans and revising them ona regular basis, you will build a solid foundation for your financial future.

Before you set goals and develop financial plans for your future,you should assess your current financial situation. Just as corpora-tions summarize their financial position on their balance sheets,preparing a personal balance sheet will present a summary of yourfinancial position on a given day. Assets, the things you own, are val-ued at current market value on your balance sheet. Liabilities arewhat you owe. They are recorded as the amount you would have topay if you paid off the entire debt immediately. Net worth, total as-sets minus total liabilities, measures your wealth at a given point intime.

1 How does the financial-planning process facilitatesuccessful personalfinancial management?

concept check

What are the benefits of personal financial planning?

Describe the six steps in the personal financial-planningprocess. Develop four personal financial goals foryourself, two short-term (1 to 2 years) and two long-term (5 to 10 years).

How does a personal balance sheet help you track yourprogress toward your financial goals?

personal financial planningThe process of managing one’s personalfinances to achieve financial goals.

personal balance sheetA summary of a person’s financialposition on a given day; providesinformation about assets, liabilities, and net worth.

Completing a personal balance sheet at regular intervals, such as every six monthsor each year, will help you track your progress toward achieving your goals. You’ll beable to see how your assets are growing and your debt is—hopefully—going down.Exhibit 2 on page 6 is an example of the personal balance sheets for Jay Martin. As youcan see in the “change” column, he has significantly improved his net worth duringcalendar year 2008 by saving and investing more and paying off his auto loan.

Cash Management: Where’s the Money?Cash management is defined as the day-to-day handling of liquid assets. Liquidassets include cash, checking accounts, various savings instruments, and other as-sets that can be converted into cash quickly at little or no cost. A cash flow plan(often called a budget) is an important tool for cash management. It helps manageincome and expenses, and the savings and investment contributions needed to ac-complish one’s financial goals. The following steps will help you develop and use acash flow plan:

Establish your goals and calculate the savings you need to meet them. It is helpful toprioritize your goals because you may have more goals than money. Identifyeach goal, estimate how much money is needed to accomplish that goal, andspecify the time frame for achieving the goal.Estimate your income and expenses, including contributions to savings. Review yourmonthly income and estimate your monthly expenses. The monthly budgetworksheet in Exhibit 3 on page 7 illustrates how to monitor your income andexpenses, or you can create a spreadsheet covering several months. Track actualincome and expenses for a one-month period. Carry a pad of paper with you so youdon’t forget small expenditures you make, and record all income and expenses.At the end of the month, total the income and expenses for each category andenter them on the worksheet in Exhibit 3 in the “actual” column.

Managing Your Personal Finances 5

Exhibit 1 > Step Up To Achieve Your Financial Goals

6. Monitoring your plan. Regularly review and adjust your plan. Track the performance of the savings/investment components of the plan, and review and adjust the plan and your goals as necessary. Keeping up-to-date on the financial environment will help you monitor your plan effectively.

5. Implementing the plan. Put your plan into action. Complicated plans may require the help of financial-planning experts.

4. Developing a plan.There may be several ways to achieve your goals, so consider various alternatives before arriving at the plan that works best for you.

3. Analyzing the information. Review the data you have collected and revise your goals if necessary.

2. Gathering information. Objective and subjective information are both important components of the decision-making process.

1. Establishing financial goals. Sound financial goals are the basis of your financial plan, a road map that guides spending, saving, and investment decisions.

2 How do cash flow planningand management of liquidassets contribute to yourfinancial goals?

cash managementThe day-to-day handling of one’s liquidassets.

liquid assetsCash and other assets that can beconverted into cash, such as checkingaccounts, quickly at little or no cost.

cash flow planA cash management tool that includesa plan for managing income andexpenses, and the savings and invest-ment contributions needed toaccomplish one’s financial goals; often called a budget.

net worthAn individual’s wealth at a given pointin time, calculated as total assets minustotal liabilities.

Compare planned and actual income and expenses. Analyze each category that wasabove or below your estimate in the “planned” column and determine whetherthis was unusual. For example, if you needed a new suit for an unexpected inter-view you may have exceeded your clothing allocation for the month. But if youfind the situation to be normal, decide whether to cut back your spending or in-crease your budget for that item. Of course, if you add to that category, you willneed to reduce another by the same amount.Modify estimates for the next month and repeat the process. Depending on youranalysis, you may want to make changes to your original plan. It may takeseveral months before you are able to live within your cash flow plan so it is im-portant to be flexible. But within a short period you will be in control of yourspending and saving.

Checking AccountsChecking and savings accounts are the most common liquid assets held by consumers,and a checking account is necessary to manage your income and expenses. A check isa written order, drawn on a depository institution by a depositor, ordering the deposi-tory institution to pay on demand a specific amount of money to a person or firm


Exhibit 2 > Personal Balance Sheets

Name ______________________________________Date ________ Date _________

ASSETSLiquid assetsChecking accounts ___________________________________________________Savings/money market accounts ___________________________________________________Money market mutual funds ___________________________________________________Certificates of deposit (6 months) ___________________________________________________Cash on hand ___________________________________________________Other ____________________ ___________________________________________________Other investment assetsCertificates of deposit (>6 months) ___________________________________________________Mutual funds ___________________________________________________Stocks ___________________________________________________Bonds ___________________________________________________Other ____________________ ___________________________________________________Personal assetsAutomobile ___________________________________________________Furniture and appliances ___________________________________________________Clothing ___________________________________________________Other ____________________ ___________________________________________________Other ____________________ ___________________________________________________(1) Total assets ___________________________________________________

LIABILITIESBills past due ___________________________________________________Credit cards ___________________________________________________Auto loans ___________________________________________________Appliance/furniture loans ___________________________________________________Mortgage loans ___________________________________________________Education loans ___________________________________________________Other ____________________ ___________________________________________________Other ____________________ ___________________________________________________(2) Total liabilities ___________________________________________________NET WORTH (1–2) ___________________________________________________

Jay Martin12/31/07 12/31/08 Change

$ 1,230 $ 895 $ (335)385 1,546 1,161

76 153 77

500 1,000 5002,421 2,421

5,346 3,421 (1,925)3,460 8,000 4,5402,000 4,000 2,000

$ 12,997 $ 21,436 $ 8,439

$ 857 $ 472 $ (385)2,569 (2,569)

9,365 8,593 (772)

$ 12,791 $ 9,065 $ (3,726)$ 206 $ 12,371 $ 12,165

named on the check. Several types of checking accounts are available to meet the di-verse needs of consumers. These were briefly noted in Chapter 18.

Electronic Fund Transfers Regardless of the type of checking account you select, youwill probably be offered electronic fund transfer (EFT) services. EFT allows you 24-houraccess to cash through an automated teller machine (ATM) and point-of-sale (POS) trans-fers for retail purchases with a debit card. With an ATM card and personal identificationnumber (PIN), you can withdraw cash, make deposits, or transfer funds between accounts.You can pay for goods and services with a POS transfer using your debit card. It works


Exhibit 3 > Monthly Budget Worksheet

Name:

Planned Actual Variance

Month of

Income Wages (take-home pay) Support from relatives Loans Withdrawals from savings Other Other (1) Total Available Income

Expenses Fixed Expenses Housing Automobile payment Insurance Loan repayment Savings for goals Tuition and fees Other Subtotal, Fixed Expenses Flexible Expenses Food Clothing Personal care Entertainment and recreation Transportation Telephone Utilities (electricity, gas, water) Cable TV Medical and dental Books, magazines, educational supplies Gifts Other Other Subtotal, Flexible Expenses

(2) Total Expenses

Cash Surplus (Deficit) [(1)-(2)]

very much like a credit card with one important exception: The money for the purchaseis transferred immediately from your checking account to the vendor’s account.

Using these cards requires good management skills. With both ATM and POStransactions, be sure to enter withdrawals in your check register. Failure to maintainan accurate record of your account balance may result in bounced checks. Guard yourcards carefully so they are not stolen or fraudulently used. This is especially importantwith POS (debit) cards because they can be used without a PIN.

If your ATM or debit card is lost or stolen, federal regulations mandate that youmay be responsible for up to $50 if the loss is reported within two business days, upto $500 if you report it between three and 60 days, and for an unlimited amount if theloss is reported after 60 days.

Be aware of ATM fees charged by your bank and the institutions that own themachines you use. Even small fees for withdrawing cash add up quickly if you makeseveral withdrawals. You can usually reduce or eliminate ATM fees by using the ATMsat your own bank.

Overdraft Protection The Federal Reserve Board has been called upon to regulatebanks that offer “bounced-check protection” or “overdraft protection” targeted al-most exclusively to low- and moderate-income consumers. Overdraft protectionproducts can be a deliberate attempt to encourage consumers to use overdrafts as aform of high-cost credit—loans at outrageously high prices. Extremely expensive andoften deceptively advertised, bounce protection can cost consumers as much as$2,000 a year.

With bounce-protection plans, banks advertise to consumers that they will coveroverdrafts up to a set dollar limit. They then charge a bounced-check fee, often be-tween $20 and $35 per transaction, as well as a per-day interest rate on the negativebalance until the account has a positive balance. Bank customers are advised to viewany overdraft protection offer from their bank very carefully before opting for whatcould be a very expensive way to borrow money.

Balancing Your Checkbook This important task reveals possible mistakes you or thebank has made and helps you discover fraudulent debit-card withdrawals. It also helpsto avoid bouncing checks, which can be expensive and embarrassing. Exhibit 4 lists thesteps to follow in balancing your checkbook.


Exhibit 4 > Seven Easy Step to Balancing Your Checkbook

1. If you receive canceled checks, place them in numerical order.

2. Compare each check with the check entry on your bank statement and your checkbookrecord to make sure the amounts agree. Check off each correct item. Repeat the sameprocess for all other withdrawals such as ATM, debit card, and cash.

3. List and total all outstanding withdrawals (withdrawals deducted in your checkbook but notyet reflected on your bank statement).

4. Repeat Steps 2 and 3 for all your deposits.

5. Subtract the total amount of any outstanding checks from your bank statement and add anyoutstanding deposits to this balance to obtain your adjusted bank balance.

6. Subtract bank service charges and add interest earned to your checkbook balance to findyour adjusted checkbook balance.

7. Your adjusted bank balance and adjusted checkbook balance should be the same. If not,recheck your math and the deposits and withdrawals listed in your checkbook. If you cannotfind an error, you will need to consult with your bank to see if an error was made in youraccount.

Savings InstrumentsChecking accounts are appropriate for money you may need to ac-cess on a day-to-day basis, but savings instruments are a more appro-priate way to accumulate money for short-term goals (a new televi-sion or a vacation) and for unexpected expenses (emergencies andopportunities). Banks, thrift institutions, and credit unions offer avariety of savings instruments, as noted in Chapter 18.

Before selecting your savings vehicle, consider your goals andhow you will use it. Compare the interest rate you will receive withthose paid by other institutions. Rates are always changing, but fi-nancial institutions, the Internet, and magazines such as Kiplinger’sPersonal Finance and Money are excellent sources of information.

Using Consumer CreditWhat if you want (or need) to make a purchase before you have accumulated themoney? You might use a credit card or a loan to make the purchase, paying interest tothe lender for the privilege of borrowing the money. We have discussed how to setgoals and use various types of instruments to save for your future needs, but usingcredit to make purchases is the opposite of saving money to buy things. In this sec-tion, we will investigate the pros and cons of using consumer credit, look at varioustypes of credit, and learn how to build a positive credit rating.

The Pros and Cons of Using CreditThere are a number of very good reasons for using consumer credit:

Convenience.Immediate use of a good or service.Bargain prices on sale merchandise.Opportunity to establish a credit rating.Convenient record keeping.Payment for financial emergencies.Perks such as rebates and frequent-flyer miles.

Although not as numerous, there are also important disadvantages to using consumercredit:

It’s easy to overspend.Most types of credit cost money in the form of interest charges.Merchandise may cost more.The legal commitment to repay debt reduces future discretionary income.

The ability to overspend, especially because credit cards are so convenient to use, canbe the most devastating disadvantage. The financial and psychological stress created bythis debt forces some students to drop out of college altogether, or work long hours, oftencausing their grades to suffer. For many Americans, getting out of debt is a top priority.

The secret to using credit responsibly is your cash flow plan. Don’t use credit tobuy anything that does not fit into your plan. Use your credit card for convenience,using it instead of cash for purchases so that you have to write only one check for allyou buy. Then be sure to pay the total bill at the end of the month. Use a credit card forcredit (meaning that you will not pay it off monthly) only when really necessary,revising your cash flow plan to repay the debt as quickly as possible.

If you currently have outstanding debt, use a form like Exhibit 5 on page 10 toinventory your debt and develop a debt repayment strategy. For Becky Sampson,whose debt inventory is presented in this exhibit, an effective strategy might be toborrow from her personal line of credit (at 12 percent) to pay off her high-interest


3 What are the advantagesand disadvantages of usingconsumer credit?

concept check

What are the steps to follow when developing andusing a cash flow plan?

How do checking and savings accounts help to managecash?

What management skills are required to use electronicfunds transfers, ATM cards, and POS (debit) cardswisely?

loans—the credit-card balances (18 percent and 21 percent). But she must be carefulnot to run up her credit-card balances again after paying them off.

Credit CardsCredit cards are the most used type of open-end credit. Open-end credit is any typeof credit where once your application for credit is approved you may use it over andover again. Your line of credit is the maximum amount you can have outstanding atany one time. Some cards require the entire balance to be paid upon billing, but mostrequire a minimum monthly payment. Cards that do not require full payment uponbilling are called revolving credit cards. Some credit cards carry an annual feewhereas others do not.

When you receive your monthly bill and do not pay the entire balance, you arecharged interest. Some credit cards offer a grace period, a period of time after makinga purchase when interest is not owed if the entire balance is paid on time. Cards withno grace period will charge interest even if you pay the entire bill monthly.

Depending on how they are used, credit cards can be either one of the most or oneof the least expensive ways to make purchases. Individuals who pay off their entirecredit-card balance each month are called convenience users of credit cards. If they selectcards with a grace period and no annual fee, they have free use of money for the periodof time until the bill must be paid. On the other hand, credit-card users who pay onlythe minimum monthly payment can incur high interest charges, as Exhibit 6 shows.


Exhibit 5 > Debt Inventory

Name Date

CurrentAnnual Rate Monthly Latest

Type of Debt Creditor of Interest Payment Balance Due Comments

Auto Loans 1 23

Education Loans 12

Home Mortgage LoanHome Improvement LoanOther Installment Loans 1

2Single-Payment Loans 1

2Credit Cards 1

234567

Personal Line of CreditHome Equity Credit LineOverdraft Protection LineLoan on Life InsuranceMargin Loan from BrokerOther Loans 1

23

TOTALS

Becky Sampson 10/15/2008

University Federal Credit Union 8% $315 $6,893 Car will be

repossessed if loanis not repaid

MasterCard 18% $22 $716 $1,000 credit lineVisa 21% $40 $1,608 $2,000 credit line

First National Bank 12% — — $3,500 credit line

$377 $9,217

open-end creditAny type of credit where the borrowerapplies for the credit and then, if ap-proved, is allowed to use it over andover again; for example, credit cards.

line of creditFor credit cards, the maximum amounta person can have outstanding on acard at any one time.

revolving credit cardsCredit cards that do not require fullpayment upon billing.

grace periodThe period of time after a purchase ismade on a credit card during which in-terest is not owed if the entire balanceis paid on time.

Here are some other tips to help you pay off those credit cards:

Don’t wait until the last minute. Many issuers now use a “hair-trigger” for assessinglate fees. In some cases you could get hit with a penalty that can be as high as$40 if the payment is just a few hours late.Talk back. If you are a customer who carries a balance and pays on time, ask for alower interest rate and elimination of any fees. Tell the issuer you are tempted toswitch to another issuer who is offering zero percent interest. If the bank won’tbargain, shop for a new card.Check your statement. Credit-card fraud is widespread, so it is important to protectyour credit cards and review your monthly statement carefully. Federal legisla-tion limits your responsibility up to a maximum of $50 per card before youreport the problem. Even though your direct loss is rather low, the thief may tieup your total line of credit for months until the issue is resolved, and may useone card to get other cards. All credit card users pay indirectly for fraudulentcharges with higher interest rates and fees.

Other Card Tricks Minimum monthly payments used to be around 4 percent of theoutstanding balance. But today many credit-card issuers set them so low they do notcover the interest or added fees such as late-payment penalties, or fees for exceedingyour credit limit. So even though cardholders pay the minimum every month, theirbalance continues to grow.

Federal bank regulators have issued a new set of guidelines designed to preventthis “negative amortization.” The new rules, which apply to all banks, say that credit-card issuers must set the minimum monthly payment at an amount that will allowthe cardholder to pay off the debt within a “reasonable period of time.”

So although monthly minimum payments may actually increase, straining thebudgets of those cardholders who regularly pay the minimum due, it will free them ofdebt sooner.

LoansLoans differ from credit cards because they are closed-end agreements. You borrow anamount of money called the principal for a specific period of time and agree to pay itback by the end of the term, by paying in installments or as a lump sum. Interest ischarged on the amount of principal borrowed, and you may also be required to securethe loan with something of value. An auto loan is a good example of a secured install-ment loan: Payments on the loan are due in equal monthly installments, and if youdefault on the debt the lender, who initially files a lien against the auto, has the legalright to repossess the car. Loans are also used to finance a college education, fix up ahome, or purchase appliances.

Before you apply for a loan, shop around to get the best deal just as you would forany product you are purchasing. There are numerous sources of consumer loans.


Exhibit 6 > Minimum Payments Don’t Pay

Making minimum payments on your credit cards can cost you a bundle over a number of years.Here’s what would happen if you paid the minimum—or more—every month on a $2,705 cardbalance with an 18.38 percent interest rate.

Monthly Payments How Long To Pay Off Interest Paid

2% of balance 27 years, 2 months $11,0474% of balance 8 years, 5 months $2,7078% of balance 2 years, 1 month $594

principalThe total amount borrowed under aloan.

Banks and savings and loan associations offer relatively low interest rates to low-riskborrowers. Credit unions generally offer even lower interest rates, but you have to bea member of the credit union to get a loan there. Consumer finance companies spe-cialize in borrowers who are higher risk, and captive finance companies (Ford CreditCorp. and GMAC) offer credit when you are making a specific type of purchase.

A family member may charge the lowest interest rate, but if you decide to borrowmoney from Grandma, treat the transaction in a businesslike manner. Draft a loan re-payment agreement specifying the amount being borrowed, the interest rate to bepaid (if any), and how the debt will be repaid. Both Grandma and you should sign theagreement and keep a copy. This will help to avoid misunderstandings about theterms of the loan.

Three of the most important factors to consider when comparing loans are thedollar cost of credit (finance cost), the annual percentage rate of interest (APR), andthe monthly payment. According to the federal Truth-in-Lending Law, lenders mustcalculate the APR in a standardized way, so, other things being equal, a loan with alower APR will be less expensive.

But when the term of the loan varies, loans with the same APR will have differentmonthly payments and finance costs. As you can see from Exhibit 7, the longer theterm of the loan, the lower the monthly payment but the higher the finance cost. Se-lecting a shorter repayment term will save you money in the long run.

In addition to these factors, check a loan for prepayment penalties, additionalfees owed if you decide to repay the loan early, and security requirements, whichallow the lender to take back the collateral if you do not repay the loan accordingto the terms of the agreement. Also beware of add-ons a lender may offer. Forexample, credit life insurance will repay the loan if you die while the loan is stilloutstanding. Although this sounds like a good idea, consider whether you reallyneed life insurance for this purpose. And if you do, find out what the coveragewould cost from an insurance agent rather than the lender. The lender offersconvenience, but that convenience generally comes at a cost. It is not uncommonto pay far more for credit life insurance compared to a term life policy purchasedthrough an insurance agent.

Credit History and Credit RatingsDon’t do what Tom Smith did—finish college with $20,000 in student loans and$9,500 in credit-card debt. Tom is aware of all the temptations and traps that got himinto debt. A graduate of the University of California, Irvine, he became a College Out-reach Coordinator with Consumer Credit Counseling Service in California to share hisexperiences with other students in the hope it would help them avoid making thesame mistakes he did. Go to CollegeDebt.net (http://www.collegedebt.net) to startgetting out of debt.

One of the reasons for using credit is to build a good credit rating. Three nationalcredit bureaus—Equifax (800–685–1111), Experian (888–397–3742), and TransUnion(800–888–4213)—collect credit information and make it available for a fee to retailers,banks, and other organizations that are subscribers or approved recipients of this


Exhibit 7 > Comparisons of a $20,000, 8-Percent Loan

Number of Payments Monthly Payment Finance Cost

36 $627 $2,57248 488 3,42460 406 4,360

prepayment penaltiesAdditional fees that may be owed if aloan is repaid early.

security requirementsProvisions that allow a lender to takeback the collateral if a loan is not repaidaccording to the terms of theagreement.

credit life insuranceInsurance that will repay a loan if theborrower dies while the loan is stilloutstanding.

highly confidential information. Credit bureaus do not evaluate the data; they reportthe following types of credit information for each lender: the date the account wasopened; the highest amount of credit extended; the current outstanding balance; thenumber of times the account has been 30, 60, and 90 days overdue; and the numberof inquiries there have been for this account information. Negative account informa-tion can stay in the file for no more than seven years, 10 years in the case of bank-ruptcy. Information from the three credit bureaus does not always match so youshould check all three.

Lenders use information from your credit report as well as other information fromyour credit application to decide whether to grant credit and under what terms. The bet-ter “score” you receive, the more likely you are to be approved for a credit card or loanand to be offered lower rates of interest. Because the information in your credit bureaufile is so important, you should periodically check your own file for accuracy. If you are

applying for a loan, or have been in a dispute with a creditor, requesta copy of your credit report from all three major credit bureaus.

If you find inaccurate information in your credit file, report itto the credit bureau. The credit bureau must investigate your dis-pute within 30 days or remove the disputed item from your file. Ifthe investigation does not resolve your dispute, you may add a briefstatement to your file, which must be included in future reports. Inaddition, credit bureaus must prevent deleted information fromreappearing in a credit report, and creditors are liable if they neglectto correct errors.

Managing TaxesBecause the tax code is very complex and taxes represent the largest expenditurein the average American family’s budget, some knowledge of the subject is important.In this section we briefly discuss the four types of taxes that are paid directly by indi-viduals: income, Social Security and Medicare, sales, and property taxes.

Income TaxesThe federal income tax is a progressive tax, meaning the higher your taxable incomethe higher the percentage of your income that is paid in taxes. In 2006, taxpayers inthe lowest tax bracket paid 10 percent on the first $7,550 of taxable income ($15,100for married taxpayers filing jointly), whereas higher income taxpayers paid at rates of15, 25, 28, 33, and 35 percent.3 Because of the progressive structure and certain taxdeductions (the standard or itemized deduction and the personal exemption), peoplewith low incomes may pay little or no federal income taxes.

Pay-as-You-Go System The federal government expects us to pay both federalincome taxes and Social Security taxes (discussed later) as we earn income. This isaccomplished through tax withholding by employers, or by filing quarterly tax esti-mates on self-employment income, investment income, and other income that is notsubject to withholding. When you start a new job, your employer will ask you to fillout a W-4 form on which you report your filing status (similar to your marital status)and the number of withholding allowances you want to claim. The more withhold-ing allowances you claim, the less your employer will withhold from each paycheck.However, the goal is to have the right amount withheld, so use the W-4 worksheet forguidance.

Minimum Filing Requirements The federal government does not require all incomeearners to file federal income tax returns. If your income is below the minimum filingrequirement in a given year, you do not have to file. If you are entitled to a tax refund,however, you must file to receive the refund.


concept check

What are the advantages and disadvantages of con-sumer credit?

How can an inventory of your debt help you make bet-ter decisions about debt repayment?

What is a credit bureau, and what function does it per-form in the granting of credit?

4 What types of taxes areindividuals responsible for?

progressive taxAn income tax that is structured so thatthe higher a person’s taxable income,the higher the percentage of incomepaid in taxes.

filing statusThe marital status of a taxpayer speci-fied on the income tax return.

withholding allowancesAllowances claimed with an employerthat determine the amounts that arewithheld from each of the employees’paychecks.

Most taxpayers can take the standard deduction from their gross income. In2006 the standard deduction was $5,150 for single people and $10,300 for marriedcouples filing jointly.4 As an alternative to the standard deduction, the taxpayer canelect to itemize deductions. Taxpayers can also claim personal exemptions thatreduce the amount of their taxable income. You can take a personal exemption foryourself, your spouse, and each of your dependents. If you are a taxpayer who isclaimed as a dependent by someone else, however, you cannot claim the personalexemption. In 2006 a personal exemption was worth $3,952.5 (These figures changeevery year.)

Filing a Federal Income Tax Return Individuals may use one of three basic formswhen filing their income tax returns: the 1040EZ, the 1040A, and the 1040. The1040EZ and the 1040A are limited to taxpayers with relatively simple finances. Tax-payers can also use the TeleFile system to file their returns by punching in their dataon touch-tone phones, or file online at the Internal Revenue Service Web site athttp://www.irs.gov/efile/.

When completing a tax return, you start by listing your gross income, whichincludes earned income, income earned through employment (wages, tips, self-employment income), and unearned income (interest, dividends, other invest-ment income). Students must include scholarship and grant proceeds in their grossincome if these exceed the direct cost of the education. After totaling your grossincome from all sources, subtract any legal deductions you are eligible to take:adjustments to gross income, standard or itemized deductions, personal exemp-tions, and tax credits. You may claim adjustments for interest paid on studentloans, job-related moving expenses, and contributions to Individual RetirementArrangements (IRAs).

The Energy Policy Act of 2005 offers a tax credit for hybrid and alternative motorvehicles. A tax credit is subtracted directly from the total amount of federal tax owed,thus reducing or even eliminating the taxpayer’s tax obligation. The tax credit appliesto vehicles purchased or placed in service on or after January 1, 2006. Hybridvehicles have drive trains powered by both an internal combustion engine and arechargeable battery. The credit is available to the original purchaser of a new, qualify-ing vehicle, and many currently available hybrid vehicles may qualify for the taxcredit. Credit amounts vary depending on the model year and the make of thevehicle. If a consumer leases a qualifying vehicle, however, the leasing company mayclaim the credit.6

The tax-filing deadline is April 15. Tax returns filed on April 15, 2008, apply toincome earned in the calendar year 2007. If the 15th falls on a weekend, the filingdate is the next business day.

Tax Planning As long as your financial life is relatively simple, your biggest tax-plan-ning issues will be having the correct amount of money withheld and keeping the ap-propriate tax records. However, once you purchase a home, begin investing, and earna larger income, more sophisticated tax planning becomes important. You will proba-bly need a good accountant, perhaps someone who specializes in taxation. You shouldalso learn more about the federal income tax laws and keep up with the frequentchanges made to those laws.

Social Security and Medicare TaxesLike income taxes, Social Security and Medicare taxes are payroll taxes—taxesdeducted from each employee’s paycheck. Social Security taxes, often seen on a pay-roll stub as FICA (Federal Insurance Contributions Act), are paid at a uniform rate ona specified amount of earned income (the wage base). Both the percentage and thewage base can change annually.


standard deductionAn amount that most taxpayers can au-tomatically deduct from their gross in-come in computing their income tax;as an alternative the taxpayer is permit-ted to itemize deductions.

personal exemptionsDeductions that reduce the amount ofincome on which income tax is paid.Each taxpayer is entitled to a personalexemption, for himself, his spouse, andeach of his dependents; a personal ex-emption can be used only once.

earned incomeIncome that is earned fromemployment such as wages, tips, andself-employment income.

unearned incomeIncome that is not earned throughemployment such as interest, divi-dends, and other investment income.

Your employer matches your Social Security and Medicare paycheck withholdingwith company funds, and sends the total to the Internal Revenue Service (IRS). Self-employed people are responsible for paying both the employee’s and the employer’sshare of this tax by making quarterly estimated payments. They are then allowed todeduct one-half of their Social Security tax as an adjustment to their gross income ontheir federal income tax returns.

Sales and Property TaxesTwo additional taxes are sales tax and property tax. All but five states (Alaska,Delaware, Montana, New Hampshire, and Oregon) currently have a sales tax on retailgoods and some services. In certain states, items like food consumed in the home, pre-scription drugs, and services such as doctor’s fees, haircuts, and laundry bills are nottaxed. Generally, sales tax rates range from 4 to 7 percent for the state’s share with anadditional 1 to 2 percent added by some cities.

The biggest single property tax for most individuals is on realestate, including a home. Property tax (real estate tax) is generally di-vided among the city, the county, the school system (which gets thelargest portion), and in some cases the state government. The annualproperty tax (often paid in two installments) is calculated by multi-plying the appraised (or assessed) value of the property by the taxrate. A house appraised at $100,000 could be taxed at 2 percent of itsassessed value, resulting in an annual property tax of $2,000. Somestate and local governments also impose personal property taxes onitems such as automobiles, boats, and even the fixtures, furniture,and fittings belonging to a business.

Selecting InsuranceAlthough financial planning helps us meet our financial goals, we need to makeprovision for life’s other uncertainties. We could suffer major losses from a fire, aserious auto accident, an illness, or a premature death. Assessing these risks andpurchasing the appropriate insurance to protect against them is an importantpart of a sound financial plan. Insurance planning involves learning about varioustypes of insurance, such as property and liability insurance, health and disabilityincome insurance, and life insurance, and setting priorities for your individualinsurance needs.

Setting Insurance PrioritiesBefore buying an insurance policy you should first identify, evaluate, and prioritizeyour insurance needs. Start by identifying the types of insurable risks you face. Forexample, if you own a car, you face the risk of being in an accident that is your fault,injuring the other driver and damaging his or her car. Your own car could also bedamaged and you could be hurt. Some of the everyday insurable risks people faceinclude:

Property damage to personal property such as automobiles, homes, and boats.Liability losses due to negligent actions.Medical expenses due to illness or accidents.Loss of income due to disability or premature death.

The key to managing your insurance needs in a cost-effective way is to budget(have funds set aside) to cover minor losses, and to purchase property, health, and lifeinsurance to cover potential major losses.


concept check

What is a progressive tax? Explain why the federal in-come tax is progressive.

What are the standard or itemized deduction and thepersonal exemption? How do these amounts differ fortaxpayers who are dependents as compared with inde-pendent taxpayers?

Briefly describe three other types of taxes besides theincome tax.

5 What factors should youconsider in deciding whatinsurance to purchase?

Property and Liability InsuranceProperty insurance covers financial losses from damage to or destruction of the in-sured’s property as a result of specified perils, such as fire or theft. Liability insurancecovers financial losses from injuries to others and damage to or destruction of others’property when the insured is considered to be the cause. It also covers the insured’slegal-defense fees. The property and liability policies most often purchased by individ-uals are automobile insurance and homeowners/renters insurance.

Automobile Insurance Auto insurance covers financial losses from such perils as acci-dent, theft, fire, and liability lawsuits. The two main types of automobile insuranceare liability coverage and physical damage coverage. Automobile liability insuranceprotects the insured from financial losses caused by automobile-related injuries to oth-ers and damage to their property. Each policy specifies maximum payment limits. Forexample, a $50,000/$100,000/$25,000 policy will pay up to $50,000 for each personinjured in an accident but a total of no more than $100,000 per accident for personalinjuries, no matter how many people are involved. In addition, it will pay a maximumof $25,000 for damage to other people’s property.

All 50 states have financial responsibility laws that require drivers to show proofof liability insurance, the ability to pay the costs (up to a limit) of any accidents forwhich they are responsible.

Automobile physical damage insurance covers damage to or loss of the policy-holder’s vehicle from collision, theft, fire, or other perils. It includes collision coveragefor damage caused by crashing into another vehicle or object, and comprehensive(other-than-collision) coverage for losses due to perils such as fire, floods, theft, andvandalism.

Automobile insurance rates generally depend on the driver’s age, marital status,gender, area of residence, and driving record, as well as the characteristics of the auto-mobile being insured. Young male drivers who live in cities, have more than one traf-fic ticket, and drive expensive, high-horsepower automobiles are charged the highestrates. Historically this group is involved in the most accidents.

Homeowners/Renters Insurance It is advisable for homeowners and renters to purchaseinsurance for protection against property damage and liability losses. These policies coverlosses due to fire, riots, windstorms, lightning, hurricanes, vandalism, frozen water pipes,and even falling airplanes. Special federally subsidized insurance provides coverage forearthquakes and floods. Homeowners insurance covers both the dwelling and personalproperty (furniture, clothing, etc.) whereas renters insurance covers personal propertybut not the dwelling. A standard policy pays out the actual cash value (similar to mar-ket value), determined by subtracting the amount of depreciation from its replacementcost, for personal-property losses. Policies that provide replacement cost coverage,enough money to replace lost or damaged personal property, costs about 10 to 15 percentmore. Homeowners coverage on the dwelling provides replacement lost coverage.

Homeowners and renters should also carry liability coverage to protect againstfinancial losses arising from their liability for the injury of others. For example, if oneof your inebriated guests was injured in a fall after attending a party where you servedliquor, you could be legally liable for the subsequent medical expenses. Comprehen-sive personal-liability coverage purchased as part of a homeowner’s policy protectsagainst a wide range of occurrences, both on and off your property. But it does notprotect you when driving a motor vehicle, for slander or libel, or for professional mal-practice. The challenge of properly insuring a home-based business is described in theCatching the Entrepreneurial Spirit box.

Health InsuranceHealth insurance is a vital component of financial stability. Many families andindividuals obtain health insurance coverage through group policies offered as part of


automobile liability insuranceInsurance that protects the insuredfrom financial losses caused by automo-bile-related injuries to others anddamage to their property.

actual cash valueThe market value, determined by sub-tracting the amount of depreciationfrom its replacement cost, of personalproperty; the amount paid by standardhomeowners and renters insurancepolicies.

replacement cost coverageHomeowners and renters insurancethat pays enough to replace lost anddamaged personal property.

automobile physical damageinsuranceInsurance that covers damage to or lossof the policyholder’s vehicle from colli-sion, theft, fire, or other perils; includescollision coverage and comprehensive(other-than-collision) coverage.

comprehensive (other-than-collision)coverageAutomobile insurance that coversdamage to or loss of the policyholder’svehicle due to perils such as fire, floods,theft, and vandalism; part of automobilephysical damage insurance.

employment fringe-benefit plans. Group policies usually include comprehensivecoverage at low cost. If you leave your job, your group coverage will terminate,although a federal regulation called COBRA allows most employees and their familiesto continue group health coverage at their own expense for up to 18 months. Youshould also be aware that coverage through a parent’s policy usually ends around ages23 to 25.

There are two basic types of health insurance coverage, available in combina-tion and with variations. Traditional health insurance plans, called indemnity (fee-for-service) plans, reimburse the insured for medical costs covered by the in-surance policy. The policyholder may select the physician, hospital, and otherhealth care providers to obtain the required services. The patient pays for the ser-vices and files for reimbursement from their health insurance company. Theprimary advantage of this type of plan is a greater choice of health care providersfor the patient.

The fastest-growing segment of the health insurance market is managed careplans. They became popular in the late 1980s as a way to control the spiraling cost ofhealth care. Unlike traditional health insurance plans, managed care plans generallypay only for services provided by doctors and hospitals that are part of the plan. Theymay pay a smaller portion of the cost if the insured uses providers that are not part ofthe plan.

Major Medical Insurance Major medical insurance can be sold as a stand-aloneproduct or combined with a managed care plan. It typically covers a wide range of med-ical costs with few exclusions and high maximum limits ($250,000 to $1 million). Theinsured pays a deductible and a percentage of the covered expenses. This coinsurance(participation) is typically 15 to 25 percent. Most policies include a limit, or cap, onthe total amount the insured must pay.

Buying Peace of Mind

Alisha Gray-Johnson needed peace of mind. “Let’s say I’m organizingsomeone’s home and I accidentally shred something they really needed,”she says, referring to her business called Messless, a home-organizationconsultancy based in Highland Springs, Virginia. Such prudence setsGray-Johnson aside from most tiny businesses, which are underinsured.

“Of the 11 million home-based businesses in the United States, themajority could not survive fire, burglary, or a lawsuit,” says Claire Wilkin-son, vice president of global issues for the New York City-based InsuranceInformation Institute, an independent, nonprofit research organization.“There’s a general misconception out there that homeowners insurancewill cover a home-based business.” The truth is, a standard homeowner’spolicy will cover only up to $2,500 worth of business equipment. In theevent of fire or flood a business would face extensive losses as well as lossof income due to business interruption, or because of disability or injury.“People don’t think what might happen if their business had to shutdown for a number of weeks,” Wilkinson says.

Most businesses have insurance coverage needs that include build-ings, machinery, business personal property (records), human failure(fraud), employee protection, management protection, business in-come, and liability. Working with an agent who knows your business is

vital. “In many cases, [trade associations] can provide reduced insurancerates, and they’ve often already negotiated coverage that’s tailored toyour type of business,” Wilkinson says. “That can save you an enormousamount of time and energy.”

It’s not always easy to find just the right policy, however. WhenGray-Johnson shopped around for insurance in 2004, she found that in-surers didn’t know how to classify her business. And she still can’t findaffordable worker’s compensation insurance to cover her part-timehelp. Still, she says, she’s happy with her stand-alone business policypurchased through her homeowner’s insurance provider. For $230 ayear, the policy covers all of her equipment, liability for advertising er-rors, and provides up to $250,000 of coverage if her work were todamage someone’s home. Gray-Johnson was surprised to learn thatmany of her peers don’t carry insurance at all: “What if? What if? Whatif?” she says. “I’d rather be safe.”7

Critical Thinking Questions• Assess your exposure to risk for a home-based consulting business.• Make a comprehensive list of items you might need to cover for

your home-based business using a special business-owners policy.

CATCHING THE ENTREPRENEURIAL SPIRIT

Managing Your Personal Finances

COBRAA federal regulation that allows mostemployees and their families to con-tinue group health insurance coverageat their own expense for up to 18months after leaving an employer.

17

major medical insuranceHealth insurance that covers a widerange of medical costs with few exclu-sions and high maximum limits. The in-sured pays a deductible and a coinsur-ance portion.

coinsurance (participation)A percentage of covered expenses thatthe hol der of a major medical insur-ance policy must pay.

managed care plansHealth insurance plans that generallypay for services provided only bydoctors and hospitals that are part ofthe plan

indemnity (fee-for-service) plansHealth insurance plans that reimbursethe insured for medical costs coveredby the insurance policy. The policy-holder selects the health care providers.

Managed Care Plans Unlike traditional health insurance, managed care plans coverpreventive care. The insured typically pays a small co-payment ($10 to $20) eachtime he or she needs care. There is generally no cost for hospitalization. The mostcommon types of managed care plans are health maintenance organizations and pre-ferred provider organizations.

Health maintenance organizations (HMOs) provide comprehensive health careservices for a fixed periodic payment. Primary-care physicians (PCPs), also known as“gatekeepers,” are responsible for decisions about their patients’ health care and forreferrals to specialists when necessary. Except in the case of an emergency, the HMOwill not pay for care that is given by non-HMO providers.

Preferred provider organizations (PPOs) combine major medical insurance witha network of health care providers, contracted to provide services at discounted prices.If you choose to go to a physician who is not a preferred provider, your out-of-pocketcosts (deductibles and coinsurance) will be higher than if you receive care from a pre-ferred provider. In some plans you pay only a small co-payment (as with an HMO)if you use a preferred provider, thus reducing your paperwork as well as yourout-of-pocket cost.

Disability Income InsuranceSome insurable risks, such as a long-term illness, can have devastating financialconsequences. If you are unable to work due to illness or accident, disabilityincome insurance will replace a portion of your earnings, typically 60 to 70 per-cent of your monthly income. There is generally a waiting period (eliminationperiod) after the onset of the disability, ranging from 3 to 12 months, before insur-ance coverage payments begin. The shorter the waiting period, the more expensivethe insurance premiums will be. The policy will have a stated duration of benefits,the length of time the insurance coverage payments will continue. Under short-term policies, benefits are paid for periods ranging from 13 weeks to two years;long-term policies provide payments for periods of five years through the insured’slifetime.

One of the most important considerations in this type of insurance is the policy’sdefinition of disability. With some policies you are considered disabled if you cannotperform the functions of your own occupation; with others you are disabled only ifyou cannot work at all.

Life InsuranceLife insurance provides a specific amount of money upon the death of the policy-holder, which is paid to a beneficiary of the policy owner’s choice, or to the deceased’sestate if there is no named beneficiary. The primary reason to purchase life insuranceis to provide income for surviving family members, but life insurance can also be usedto save for the future. The most common types of life insurance are term life, wholelife, and universal life insurance.

Term life insurance provides the maximum amount of life insurance coveragefor the lowest premium. It covers the insured’s life for a fixed amount and a specifictime period, typically 5 to 20 years. It has no cash value (a dollar amount paid to thepolicy owner if the policy is canceled before the death of the insured). When thepolicy term ends, protection stops, unless the policy is renewed or a new policy ispurchased.

Whole life insurance (also called straight life, cash value, or continuous payinsurance) covers the insured for his or her entire life, as long as the premiums arepaid. In addition to death protection, it has a cash value that increases over the life ofthe policy. Whole life is much more expensive than term insurance and the interestrate used to determine its cash value is low—usually 4 to 6 percent. But it does providea way to save for the future.


health maintenance organizations(HMOs)Managed care organizations thatprovide comprehensive health careservices for a fixed periodic payment.

preferred provider organizations(PPOs)Networks of health care providers whoenter into a contract to provide servicesat discounted prices; combines majormedical insurance with a network ofhealth care providers.

disability income insuranceInsurance that will replace a portion ofyour earnings, typically 60 to 70 percentof your monthly income, if you areunable to work due to illness oraccident.

waiting period (elimination period)In disability income insurance, theperiod between the onset of the dis-ability and the time when insurancecoverage payments begin.

duration of benefitsIn disability income insurance, thelength of time the insurance coveragepayments will continue.

term life insuranceLife insurance that covers the insured’slife for a fixed amount and a specifiedtime period and has no cash value;provides the maximum amount of lifeinsurance coverage for the lowestpremium.

cash valueThe dollar amount paid to the owner ofa life insurance policy if the policy iscanceled before the death of the in-sured; term life insurance has no cashvalue.

whole life (straight life, cash value,continuous pay) insuranceLife insurance that covers the insuredfor his or her entire life, as long as thepremiums are paid; has a cash valuethat increases over the life of the policy.

Developed in the 1980s to help insurance companies competewith other financial institutions for investment funds, universallife insurance combines term life insurance with a tax-deferred sav-ings plan. The portion of the premium not used to pay for the termlife coverage, commissions, and other business expenses, is investedin short- and medium-term securities. It earns interest, at currentmarket rates, that contributes to the policy’s cash value. Exhibit 8offers some guidelines to consider when purchasing an insurancepolicy.

Making Investment DecisionsPeople invest money for a variety of reasons. Some want to save for a new home,their children’s education, or a vacation. Others invest to build up a nest egg tosupplement their retirement income. Investing is the process of committingmoney to various investment instruments in order to obtain future financial returns.It should be considered a long-term strategy, and as Chapter 20 describes, themost common investment instruments individuals use are stocks, bonds, and mu-tual funds.

Investment GoalsRealistic investment goals are based on the investor’s financial resources, age,family situation, and investment motives, so every investor needs to first ask them-selves: “What do I want to achieve with my investment program?” Setting invest-ment goals is the basis for developing a sound investment strategy. Your investmentgoals will relate to certain goals in your financial plan, such as saving for a home,your children’s education, and your retirement. Investment goals also play a role indetermining how conservative or aggressive you want to be in making investmentchoices.

Investors can tolerate different levels of risk, and it is important to determinehow much risk you can withstand when making investment decisions. The more


Exhibit 8 > Insurance Buying Guide

When purchasing an insurance policy:

• Review your insurance needs and circumstances.

• Comparison shop. Contact several companies and/or agents to compare benefits, cover-age, exclusions, and premiums.

• Be sure the insurance company you are considering is financially stable. To check on thestability of a company, visit the Insurer Ratings Directory.

• Do not make any quick decisions. Request a copy of the policy and compare it with policiesfrom different insurance companies.

• Do not be fooled into thinking you need several policies for additional coverage. You needonly one good policy.

• Be sure your application is complete and accurate, including all of your medical history, ifapplicable.

• Write a check, payable to the insurance company. Do not pay in cash.

• Your policy should arrive within 60 days. If you do not receive it, contact the company oragent.

• After you receive your policy, reread it to be sure everything is correct. Your agent orcompany should explain any terms that are not clear.

Source: “Things to Consider When Purchasingan Insurance Policy,” http://www.ambest.com(July 27, 2006).

6 What personal goals areimportant when makinginvestment decisions?

concept check

Distinguish between property and liability insurancecoverage. Why should families and individuals haveboth?

What are the primary differences between traditionalindemnity health insurance and managed care plans?

What are the two main reasons for buying life insur-ance? Which types of policies meet these needs?

universal life insuranceA combination of term life insuranceand a tax-deferred savings plan. Part ofthe premium is invested in securities, sothe cash value earns interest, at currentmarket rates, that contributes to thepolicy’s cash value.

investingThe process of committing money tovarious investment instruments in orderto obtain future financial returns.

risk you are willing to take, the higher the potential return on an investment. Theinvestment risk pyramid shown in Exhibit 9 illustrates the relationship between riskand reward.

The most common investment goals are income, growth, and safety. Investorswishing to supplement their income will choose securities that provide a steady, reliablesource of income from bond interest, stock dividends, or both. Good choices includelow-risk securities such as U.S. Treasury issues, high-quality corporate bonds, preferredstock, and common stock of large, financially sound corporations that regularly paydividends (called income stocks).

Another important investment goal is growth, increasing the value of the invest-ment. Many investors look for securities that are expected to increase in price overtime. Generally, they choose stocks that expect to continue above-average rates ofgrowth in earnings and price. For instance, the earnings of so-called growth stocksmight increase 15 to 20 percent or more at a time when the earnings of most commonstocks are increasing only 5 to 6 percent.


Exhibit 9 > Investment Risk Pyramid

Increasing risk of loss of principal

Increasing potential gain through appreciation

Growth stocks, growth mutual funds, income mutual funds Futures, derivatives,

commodities, naked puts/calls

Covered puts/calls, collectibles, speculative common stock, junkbonds

International mutual funds, global mutual funds, emerging market mutual funds, sector mutual funds, direct and indirect investment in real estate

Balanced mutual funds, blue chip stocks, zero-coupon bonds, high-grade preferred stock, high-grade corporate bonds, variable annuities

FDIC-insured accounts, MMMF, U.S. EE savings bonds, cash value life insurance, Treasury bills/notes/bonds

High-grade municipal bonds, personal residence equity, fixed annuities

Safety is yet another investment goal. Investors who opt for safety do not want torisk losing the money they’ve invested. They generally choose government and high-grade corporate bonds, preferred stocks, and mutual funds. They avoid common stockbecause of its frequent price fluctuations.

Developing an Investment StrategyThe secret to successful investing is to start investing early. But before putting moneyinto investments it is a good idea to establish an adequate emergency fund (liquid as-sets that are available to meet emergencies), obtain necessary insurance coverage, andreduce debt. Then diversify your investments and invest regularly.

Start Early to Enjoy the Benefits of Compounding Financial-planning practitionersand educators believe starting to invest early so returns can compound is the mostimportant element in a successful savings/investment program. Consider Jennifer, a27-year-old attorney who has already invested $32,000 for her retirement. With noadditional contributions to this investment and assuming a 10 percent annual return,Jennifer’s $32,000 will grow to $1,196,939 by the time she is 65 years old! If Jenniferhad waited until age 45 to start saving for her retirement, she would have to invest$20,898 a year for 20 years (a total of $417,960) in order to accumulate $1,196,939.

So start early and let your investments work for you, but remember that you needto protect your assets with the appropriate insurance. And because the interest youpay on debt is usually more than you can earn on your investments, it is important toreduce your debt first.

Diversify Another important element of a successful investment strategy isdiversification. This means you should invest in different classes of assets—cashequivalents, stocks, bonds, real estate—and purchase securities with different risk pat-terns and rates of return. A diverse portfolio, or collection of investments, is morelikely to meet your investment goals than a single security. A portfolio that includespreferred stocks paying high dividends and growth stocks paying modest dividendsincreases the potential of achieving both income and growth. Investing in 5 to 10 dif-ferent companies in different industries is another way to diversify. Diversification isan important method of spreading your risk and increasing your potential for achiev-ing your investment goals.

Invest Regularly Make investing to achieve your goals part of your cash flow plan.Decide how much to invest, then purchase the investments monthly, quarterly, or an-nually. Or, better yet, set up automatic transfers from your checking account to a mu-

tual fund or stock dividend reinvestment plan (DRIP) so that a pre-planned amount is regularly invested in the investment vehicles ofyour choice.

Most mutual funds welcome monthly contributions of $50 ormore through their automatic investment plans, and more stockcan now be purchased regularly in small increments. Originally,stock DRIPs were set up to automatically reinvest dividend incomepaid on stocks, but many companies have also made stock purchaseplans available to investors who own as little as one share of thecompany stock.

Securities Transaction BasicsThe traditional approach to investing in securities is through a stockbroker at a stockbrokerage firm. Investors should seek a broker who understands their investmentgoals and will help them pursue those objectives.


concept check

What is investment risk? What is the relationship be-tween risk and return?

What steps should be taken before starting an invest-ment program? Why?

Discuss three strategies for implementing a successfulinvestment plan.

emergency fundLiquid assets that are available to meetemergencies.

diversificationAn investment strategy that involvesinvesting in different classes of assets,such as cash equivalents, stocks, bonds,and real estate, and purchasing securi-ties with different risk patterns andrates of return.

portfolioA collection of investments.

dividend reinvestment plan (DRIP)A program in which dividends paid bya stock are automatically reinvested inthat stock along with any additionalstock purchases submitted by thestockholder.

7 How do investors open abrokerage account and makesecurities transactions?

Investors can open two basic types of accounts at a brokerage firm: cash accountsand margin accounts. With a cash account, purchases of securities are paid for in fullby the investor (cost of the securities plus brokerage commissions). In a marginaccount, the investor puts up as little as 50 percent of the cost of the securities, bor-rowing the balance from the broker and paying interest on the loan. The broker holdsthe securities as collateral for the loan.

Typically when an investor decides to buy or sell securities, they place an orderwith their broker who handles the transaction on their behalf. The broker transmitsa buy or sell order to the appropriate stock exchange, like the New York Stock Ex-change (NYSE), where it is sent to the exchange trading floor for execution. Tomake transactions in the Nasdaq/OTC market, the broker must find out via com-puter who deals in the security and contact the dealer, offering the best price tomake the transaction.

Stocks are usually bought and sold in blocks of 100 shares, called round lots. But ifan investor can’t afford 100 shares of a stock, he or she may purchase less than 100shares, called an odd lot. Because only round lots are traded on the exchanges, odd lotsare grouped together by brokers to make up a round lot. An extra fee is charged forodd-lot transactions.

Investors can place three types of orders when buying or selling securities. Amarket order is an order to buy or sell a security immediately at the best price available.A limit order is an order to buy a security at a specified price (or lower) or to sell at aspecified price (or higher). The trade is executed only if the requested limit is reached.With a stop-loss order, the stock is sold if the market price reaches or drops below aspecified level. A stop-loss order limits an investor’s losses in the event stock pricesrapidly decline.

Brokerage firms receive commissions for executing clients’transactions. Although brokers can charge whatever they want,most firms have fixed commission schedules for small transactions.The value of the transaction and the number of shares involvedhelps to determine the amount of brokerage commission you arecharged. Today many investors are using on-line brokerage firms toexecute their securities transactions.


concept check

Differentiate between cash and margin accounts.

What are the three types of orders investors can placeto trade securities?

Financial Gerontology: The Latest Addition to the Financial Services Industry

Baby boomers have an entire new service industry catering to theirneeds. Financial gerontology specializes in the financial challenges ofgetting older, like managing cash flow and paying for costly healthcare. About 100 people currently carry the designation “registered fi-nancial gerontologist” from the American Institute of Financial Geron-tology, launched in 2003 by the American Society of Aging andWidener University in Chester, Pennsylvania. Other certifications in ad-vising the aging population include those from the Society of CertifiedSenior Advisors in Denver, which offers programs on how to distinguishbetween Alzheimer’s and dementia, and American College in BrynMar, Pennsylvania, which grants the designation “Chartered Advisor forSenior Living.”

“The need for gerontology education and training being infused intothe financial-services profession is growing,” says Neal Cutler, a Widenerprofessor of financial gerontology who supervises the American Insti-tute’s curriculum. “People who are specializing in the mature market, orwant to expand into the mature market, want specialized training.”

Financial planners who take the courses have helped their clientsbuild significant portfolios. Now they want to help aging clients make

their money last. Acting almost as “geriatric counselors” these specialiststalk to clients about health care, access to medicine, counseling, andadvise aging clients and their families on the progression and financialimplications of diseases such as Alzheimer’s or Parkinson’s. Advisorsmust know the costs of nursing homes, assisted-living facilities, andhome aides, and help clients determine whether long-term care insur-ance or the family’s assets should be used to cover expenses. “We areseeing it more and more as our clients’ age that they need supportservices,” says Judith McGee, a financial advisor with Raymond JamesFinancial Services in Portland, Oregon. “There are many ways you canmake their lives easier and less costly.”8

Critical Thinking Questions• Describe the unique relationship financial gerontologists have with

their clients.• Why is this field of specialization so important to retirees and older

investors?

CUSTOMER SATISFACTION AND QUALITY

Trends in Personal FinanceIn this section we examine some of the trends that shape the way people spend, save,and invest their money. Because they are new to managing their own lives and fi-nances, students are especially vulnerable to falling into the credit card trap, butdoing so could put an end to college and profoundly affect their future. Find out whothe IRS is targeting with audits—and why. We also learn why Americans, especiallybaby boomers, are spending so much, causing savings levels to drop to their lowestlevels since the Great Depression. The Customer Satisfaction and Quality box on page22 discusses a new service industry–financial gerontology.

The Credit Card Drop-Out RateOn their own for the first time, college students suddenly have to manage their ownfinances. Funds may seem more than adequate with money from student loans, finan-cial aid, personal savings, and financial support from family. And then there are thecredit cards. You buy clothes, gas, beer, pizza, concert tickets—and before you knowit, you are unable to pay your credit card bills without using money set aside for yourbooks and tuition.

According to an advisor at a major university, more students drop out of collegedue to credit card debt than to academic failure. College students may be surprised athow much the little expenses add up. A cup of coffee at the local coffee shop beforeclasses each morning can total $46 a month, or nearly $200 a semester. Smoking iseven more costly—at $3.50 a pack, a pack-a-day habit can total over $400 a semester.It is easy to spend thousands of dollars a semester on incidentals.

The best way to prevent this is to adopt a budget early in your first semester andstick to it. Students who manage their spending and their available funds early onavoid the stress of being unable to pay their bills, working more and more hours be-tween classes in order to get out of debt. Use the monthly budget worksheet (Exhibit3) to prepare a realistic budget for yourself. A college degree does not guarantee anability to manage money wisely. It takes determination and control—before creditcard debt has you in its grip.9

Taxing QuestionsMore taxpayers than ever are choosing to file their taxes electronically, and manywonder whether e-filing increases their chances of getting audited. According to In-ternal Revenue officials, how you file your taxes doesn’t make a difference when theyare selecting returns to audit. Each return is scored by the IRS based on secret formu-las designed to spot problematical returns—such as those with a high probability ofunreported income.

E-filing “actually reduces the chances of you hearing from us” because e-filed re-turns are more accurate than paper returns, says Nancy Mathis, an IRS spokeswoman.The error rate on e-filed returns is only about 1 percent compared with about 20 percenton paper returns. The IRS’s e-filing system is designed to pick up common math errorsand transposed social security numbers that might otherwise result in unwelcomecommunications from the IRS.

So just how likely are you to get audited these days and what type of returns at-tract the IRS’s attention? The number of returns that are audited has surged in recentyears—about 1.2 million individual tax returns were audited in 2005, an increase of20 percent from the previous year—yet representing only 0.93 percent of all the re-turns filed that year.

The IRS is targeting high-income taxpayers with incomes of $100,000 and more,seeking abusive tax shelters or other tax avoidance schemes. Unreported incomeparked illegally in offshore accounts is another red flag. Self-employed workers whodeal mainly in cash and file their taxes under Schedule C also come under close IRS

8 What emerging trends affectthe way you manage yourpersonal finances?


scrutiny. If you find yourself facing an audit, go to the IRS Web site at (http://www.irs.gov) and type “frivolous” in the search box to learn which arguments toavoid when defending your return.11

American Spending Is Out of ControlRocketing home prices through 2005 made Americans feel wealthier, convincingthem they need not worry about saving. So they are spending more than ever—a potential problem for the 78 million Baby Boomers about to retire. Recent gov-ernment statistics show the national savings rate now stands lower than at anytime since the Great Depression, a period of enormous unemployment andsoup lines.

The Commerce Department reported that Americans’ personal savings plum-meted into negative territory in 2005. People not only spent all their after-taxincome but borrowed and dipped into their savings to finance their spending, burn-ing through $41.6 billion more than they earned. With the first wave of BabyBoomers turning 60 in 2006, analysts caution against what they see as perilous con-duct. “Americans seem to have the feeling that it is wimpish to save,” said DavidWyss, chief economist at Standard & Poor’s in New York. “The idea is to put money

away for old age and we are just not doing that.” The ManagingChange box highlights the financial challenge of meeting increas-ing college costs.

“Americans have been content to spend a lot more than is goodfor them or for the economy,” said Lyle Gramley, senior economicadvisor at Schwab Washington Research Group.

After five years of record setting home sales, in 2006 the hous-ing market began to decline due to rising mortgage rates. Weakersales means slower home price appreciation, which will slow con-sumer spending and help the savings rate bounce back into positiveterritory.12


concept check

How does credit card debt affect college drop-outrates? How can students prevent credit card debt fromcausing them to drop out of college?

How does the IRS select returns to audit? How doese-filing affect the chance of being audited?

What’s happening to America’s personal savings rate?Why?

MANAGING CHANGELeveling College Tuition Costs

College students may be in for a shock come senior year. Tuitioninflation, a factor many families do not budget for, can increase collegecosts as much as 13 percent from one year to the next. According toFinAid.org (http://www.finaid.org) students can expect to pay an av-erage of 8 percent tuition inflation every year. Over four years, thoseattending public schools could see tuition for their senior year increaseby roughly $1,425 more than they paid in their freshman year, andthose attending private schools can expect a whopping $5,500 jumpby senior year.

To help students and parents plan for the rising costs of higher edu-cation, many colleges are offering levelized-tuition programs, also calledfixed-rate tuition plans, tuition locks, or tuition-guarantee programs,which guarantee that the price paid for freshman year will be the sameamount paid every year thereafter. Paying one price for all four yearsmay sound like a sweet deal, but critics warn that the tuition rate duringfreshman year will likely be quite a bit steeper than the going rate.

Many public schools are dependent on funding from the stateand often don’t finalize tuition prices until after state budgeting deci-sions have been made in the spring. This gives students and parentsonly three to four months to come up with the cash to cover a tuitionhike. Other schools cut it even closer to the bone. “We don’t set

inflation rates until July, which is a month before classes start. That’sa bad time to tell parents ‘Whoops, your tuition has just gone up$40 or $50 a credit hour,’” says Diane Fleming, associate director forscholarships and financial aid for Central Michigan University inMount Pleasant, Michigan. “With our tuition-guarantee program,parents know what rate they’ll be getting for the next four or fiveyears.”

So how do these programs work? Most levelized-tuition programs,including the one at Central Michigan University, work on an averagingsystem that ensures one fixed rate for all four years of attendance re-gardless of the school’s budget. Freshmen pay a significantly higherlevel of tuition to take inflation into account, but by senior year they’repaying less than other students at the school. Before signing up for thistype of program parents should read the small print, know what hap-pens if their student needs to withdraw from school for a semester ortwo, or needs an extra year to graduate.10

Critical Thinking Questions• Describe the advantages and disadvantages of levelized-tuition

college payment plans.• Why might (or might not) this type of plan work for you? Explain.

25C H A P T E R 2 1 Managing Your Personal FinancesManaging Your Personal Finances 25

Summary of Learning GoalsFinancial planning is a six-step process that includes establishing financial goals,gathering objective and subjective information, analyzing the information, develop-ing a financial plan, implementing the plan, and monitoring your plan. The processstarts with your goals and provides a road map to meet those goals.

A cash flow plan manages income and expenses. Based on your financial goals, itincludes saving for those goals. With money set aside regularly to pay for these goals,you are more likely to achieve them. Liquid assets such as checking and savingsaccounts are important for day-to-day spending, to meet short-term goals, and forunexpected or emergency expenditures. Liquid assets can be held in safe, accessibleaccounts so the money is readily available when needed.

The benefits of consumer credit include convenience, the ability to purchase a goodor service when you need it or want to take advantage of bargains, establish a creditrating, convenient record keeping, meeting financial emergencies, and perks such asrebates and frequent-flyer miles. Using consumer credit has some important disadvan-tages including the ease of overspending, the cost of credit (interest charges), the pos-sibility that merchandise may cost more, and the reduction in future discretionaryincome due to the legal commitment to repay debt.

The major taxes paid by individuals are income, Social Security and Medicare, sales,and property taxes. Income and Social Security and Medicare taxes are called payrolltaxes because they are based on income and deducted from an employee’s paycheck.Sales tax is assessed on purchases made, and property tax is based on the value ofproperty owned, usually real estate.

The key to managing your insurance needs in the most cost-effective way is to budgetto cover minor losses and purchase insurance to cover potential major losses. Set asidemoney in savings so that you can pay for a minor loss when it happens, and buy goodinsurance policies to cover major losses.

Investment decisions should be based on your goals and your risk tolerance. Examplesof investment goals include the desire for income from interest and dividends, theneed for growth (capital gains), and the need for safety.

Investors must choose a brokerage firm and a stockbroker in that firm. Then theyopen a cash account or a margin account. In a cash account, all securities transactionsare paid in full by the investor. Margin accounts allow investors to put as little as 50percent of the price of the securities and borrow the rest from the broker. The investorgives an order to buy or sell securities to the broker, who sends it to the stock ex-change to be carried out or, in the case of an over-the-counter stock, finds the dealerwith the best price. Today many investors are using online brokerage firms to executetheir securities transactions.

Credit card debt can do more than just get a student into financial trouble. Somestudents are forced to quit school entirely and get a job to pay off their debt, a decisionwith a far-reaching impact on their lifelong earning potential and quality of life. E-fil-

1 How does the financial-planning process facilitatesuccessful personal finan-cial management?

2 How do cash flow planningand management of liquidassets contribute to yourfinancial goals?

3 What are the advantagesand disadvantages of usingconsumer credit?

4 What types of taxes areindividuals responsible for?

5 What factors should youconsider in deciding whatinsurance to purchase?

6 What personal goals areimportant when makinginvestment decisions?

7 How do investors open abrokerage account andmake securitiestransactions?

8 What emerging trends affectthe way you manage yourpersonal finances?


ing is the wave of the future but taxpayers want to know whether it raises red flags atthe IRS. An IRS spokeswoman explains why it is less likely to do so and what you cando to remain under the IRS auditing radar. Americans are spending more and savingless, especially as they get older and need their nest egg for retirement.

Key Terms

Preparing for Tomorrow’s Workplace: SCANS1. Use the six-step financial-planning process to develop a financial plan for your-

self for the next year. List your financial goals and gather the appropriate infor-mation needed to analyze your situation. Develop your plan and explain how itwill be implemented. (Resources, Information)

2. Use the steps detailed in this chapter to balance your most recent checking accountstatement. After completing this process, analyze your use of the checking account,EFT services, and so on. Are you satisfied with the way you are handling your ac-count? If not, what changes would you make in how you use it? (Information)

3. Team Activity College junior Andy Jung overused his credit cards last year. Hecurrently has the following outstanding debt on two credit cards plus an autoloan and a student loan:

MasterCard—$984 outstanding debt, $40 minimum monthly payment,18 percent interest rate, no annual fee, $25 late-payment fee, 2 percent cash-advance fee ($20 maximum), $1,000 line of credit.Visa—$569 outstanding debt, $17 minimum monthly payment, 14 percentinterest rate, $20 annual fee, $20 late-payment fee, 1.5 percent cash-advancefee ($20 maximum), $800 line of credit.Auto loan—$3,490 outstanding balance, $257 monthly payment, 8 percentinterest, 15 more payments.

actual cash value 16automobile liability insurance 16automobile physical damage

insurance 16cash flow plan 5cash management 5cash value 18COBRA 17coinsurance (participation) 17comprehensive (other-than-collision)

coverage 16credit life insurance 12disability income insurance 18diversification 21dividend reinvestment plan (DRIP) 21duration of benefits 18earned income 14emergency fund 21filing status 13grace period 10health maintenance organizations

(HMOs) 18indemnity (fee-for-service) plans 17investing 19line of credit 10liquid assets 5

major medical insurance 17managed care plans 17net worth 5open-end credit 10personal balance sheet 4personal exemptions 14personal financial planning 4portfolio 21preferred provider organizations

(PPOs) 18prepayment penalties 12principal 11progressive tax 13replacement cost coverage 16revolving credit cards 10security requirements 12standard deduction 14term life insurance 18unearned income 14universal life insurance 19waiting period (elimination

period) 18whole life (straight life, cash value,

continuous pay) insurance 18withholding allowances 13

Student loan—$15,490 outstanding balance, deferred payments, 7.5 percentinterest (unsubsidized).

Andy has $450 a month to use for debt repayment. Divide into small groups andadvise Andy on how best to pay off his debt obligations. Start by completing adebt inventory for Andy. Then write a one- to two-page memo explaining howAndy should allocate the $450. Support the rationale for your recommendations.(Interpersonal, Information)

4. You have just won $100,000 in your state lottery. In light of your personal situation(age, finances, family status, and so on), what types of securities would you choose,and why? Now you also have to find a broker to execute the transactions. Should youuse a traditional full-service brokerage, a discount broker, or an online brokerage?Using the Internet and personal-finance publications to gather information, comparethe services of these types of firms. Summarize the pros and cons of each and decidewhich best meets your needs. Justify your choice. (Information, Resources)

5. Team Activity Form a team of four or five classmates to evaluate employer fringe-benefit plans. Gather written information on the insurance and retirement bene-fits offered by at least two employers. This information may be available directlyfrom an employer, from your parents, or from senior classmates who areinterviewing with companies. After reviewing the information write a briefsummary evaluating the insurance and retirement plans offered, and what invest-ments are available through the retirement plans. Present your findings to theclass. (Interpersonal, Information)

6. Select three different financial institutions: one that you actually use for check-ing and/or savings and two others. Determine what checking and savingsaccounts are available that suit your needs and find out how these accounts arestructured (minimum opening deposits, minimum required balances, fees, andother limitations). Look at the institution’s complete list of fees, not just the costof the checking account. Get a written copy of all account descriptions and feesif possible. Which one would be best for you given your needs? Be sure to discussyour needs as well as the characteristics of the institutions. (Information)

7. How do you choose the best credit card and use it wisely? Compare three differentcredit cards. If you already have a credit card(s), use your own in addition to thoseoffered through local banks or flyers you see on campus. Compare annual fees,APRs, methods of calculating finance costs, grace periods, and other terms. Get awritten copy of the credit-card terms if possible. Which one would be best for yougiven your needs and the way you intend to use a credit card? Be sure to discussyour needs as well as the characteristics of the cards. (Information)

27C H A P T E R 2 1 Managing Your Personal Finances

Ethics ActivityYou are transferred into the auto insurance division of the largeproperty and casualty insurance company you work for in Califor-nia. After a successful three-month trial period, you are assured of asubstantial promotion and raise.

You quickly realize that an important criterion used by thedepartment in evaluating and quoting prospective clients on theirauto insurance policies is their zip code. This means that poor andminority drivers pay more for their insurance than wealthier drivers,regardless of their driving record. You also know this is in direct con-travention of a 1988 California proposition that stipulates that autoinsurance rates should be based primarily on three factors: thedriver’s age and safety record, the driver’s annual mileage, and thenumber of years of driving experience. Other factors, including zipcode, should be taken into account only after the driver’s experienceis considered.

Because you live in one of the city’s less wealthy neighborhoods,you realize that you are probably paying more for your auto insurance

than drivers in wealthier neighborhoods with worse driving recordsthan you. You are upset at what you consider unfair discrimination,nothing less than a form of insurance company “redlining.” Do youhave the courage to rock your professional boat or should you takethe path of least resistance and turn a blind eye to what is going on?

Using a Web search tool, locate articles about this topic and thenwrite responses to the following questions. Be sure to support yourarguments and cite your sources.

Ethical Dilemma: Should you express your outrage to manage-ment, quit and hope to find a job with a more ethical company thatoffers similarly promising prospects as your current position? Wouldyou report your company to the Insurance Commission? Or shouldyou keep quiet and just do your job, as you don’t know if you willbe able to easily find another job?

Sources: Dean Calbreath, “Ruling Rejects ZIP Codes As Primary Criterion,” San DiegoUnion-Tribune, August 10, 2006, http://www.signonsandiego.com; Brendan Coyne,“Report Finds Car Insurance Redlining Rampant in California,” The New Standard,December 21, 2005, http://www.newstandardnews.net.


Working the Net1. Financial planning was once considered a luxury for those wealthy enough to pay

fees for advice from a financial professional. Today, financial advice is just a clickaway courtesy of specialized Web sites that provide advice on student loans, saving,budgeting, and scholarships. Use the site’s calculators at FinAid (http://www. finaid.org) to plan your college living expenses.

2. At Bankrate (http://www.bankrate.com) you will find the current average rateson standard, gold, and platinum credit cards. To find the best rate for you, fill inthe required information based on your wants and needs in a credit card. Plan-ning to move? Use the site’s calculator to compare the cost of living between twocities. Summarize your findings.

3. Wells Fargo (http://www.wellsfargo.com) offers one-stop shopping for all yourbanking needs. Click on Student Loan Center and College Banking Center to seea full range of college finance options. What features are especially useful for stu-dents? Would this account suit you, and why?

4. Go to Tax Cut (http://www.taxcut.com) for information on taxes and tax prepa-ration software. Click on Tax Resources for information regarding tax planning,deductions, how to treat investment and dividend income, and family depen-dents. Also find and analyze one other topic that is of interest to you. Summarizeyour findings for the class.

5. Personal Investing 101: SmartMoney (http://www.smartmoney.com) provides in-formation to assist with personal investing. Go to My Portfolio to create your owninvestment portfolio. Click on Tools to find the information you need to track yourinvestments. Prepare a summary of your investment holdings for the class.

When Mita Sanghavi Goel and her husband wanted to buy a home, they borrowed$100,000 from her mother—at 4 percent interest. A loan from her mother saved Ms.Goel, a 33-year-old physician, from getting a jumbo mortgage which carries a higherinterest rate, and provided her mother with additional income to supplement hermodest earnings as a teacher’s aide. With home prices approaching record levels,relatives are more frequently being called upon to provide the cash necessary to helpkids buy their first home. Currently about one in four first-time buyers receives thedown payment for a home from a relative or friend, up from one in five more than adecade ago, according to a National Association of Realtors survey.

But what was once an informal practice—a gift or loan of a few thousand dollarswith a promise of repayment—is getting trickier. Rather than simply handing overcash, families are setting up structured, secured loans similar to bank mortgages, com-plete with filings at the county clerk’s office, and they are finding new ways to maxi-mize the tax and estate-planning advantages of such loans.

Intra-family mortgages, as they are known, were once the exclusive domain ofwealthy families who could afford the advisory services needed to structure theseloans. Now a small industry of financial advisers and mortgage experts that help par-ents act as mortgage bankers for their children has changed all that. The additionalcosts to structure a private loan—attorneys, accountants, and others outside thebank—should be offset against the benefits. Paying part or all of a home down pay-ment can help kids avoid expensive private mortgage insurance, or PMI, that banksgenerally require when borrowers can’t come up with 20 percent of a home’s salesprice.

In the case of Ms. Goel, a payment plan was set up through CircleLending, at acost of $599 and a $9 monthly administration fee after the first year. CircleLending

Creative Thinking Case >Mining The Family Fortunes

provides all necessary financing documents (such as a promissory note and mortgagepaperwork), records the mortgage with the local County Registry of Deeds, and setsup the payment schedule which can be seasonal or graduated if parents think thechild will earn more later.

One thing to be aware of when giving kids money is family misunderstandings.Ensuring that other siblings don’t feel slighted is critical. “You need to be fair withall your children, even if one needs more money immediately, or you’ll end upwith someone hating you,” says Buck Schottland, 59, a retired businessman inHobe Sound, Florida. Schottland recently gave his son several hundred thousanddollars to build a new home nearby, but his daughter in Virginia needed only athird as much. So he is working with financial advisers to combine a gift planwith other payments that will give the two children equal amounts at the end of20 years.

Critical Thinking QuestionsWhat socio-economic factors make intra-family mortgages necessary?What are the advantages to both parents and children of an intra-familymortgage?Assume you are the recipient of such a loan from your parents. How you wouldstructure the loan, including the length of the loan, interest rate, and other repay-ment terms, and why?

Sources: Diya Gullapalli, “When Mom And Dad Are the Bank,” Wall Street Journal, January 21, 2006, p. B1; Robert S. Bridges, “ParentsAs Bankers,” Financial Advisor http://www.fa-mag.com July 2006; Sam Ali, “Round Numbers, The Star Ledger http://www.nj.com March26, 2006; Circle Lending corporate Web site http://www.circlelending.com August 10, 2006.

Unlike firms like Morgan Stanley (see Chapter 20 video case), whose client baseincludes wealthy individuals and large, institutional investors, and Ameritrade, whoseclients conduct most of their brokerage business online, the Edward Jones Company(http://www.edwardjones.com) focuses on smaller individual investors and businessowners who want highly personalized, face-to-face service. The only major financial-services firm that exclusively targets retired investors, working investors, tax profes-sionals and attorneys, and small-business owners, Edward Jones’s approach appeals toinvestors in smaller communities as well as larger metropolitan areas. In fact, aboutthree-quarters of its offices are in major cities.

Edward Jones provides investment services to its targeted clientele through abranch-office network and a comprehensive IT system. Its more than 8,000 branch of-fices in all 50 states, plus another 700 in Canada and the United Kingdom, are locatedin neighborhoods where people live and work rather than in center-city high-rises.Account representatives focus on building long-term relationships with their clients.They also strive to ensure that clients are comfortable with and confident about theirinvestment decisions. As managing partner John Bachman says, “We want our peopletouching customers.”

The brokerage firm implements its strategy of one-on-one, personalized invest-ment services through three key elements:

Customizing financial strategies and solutions to each client’s needs and goals.Providing a Full Service Account (FSA) to simplify customers’ financial managementneeds.Focusing on customers who are interested in long-term, relatively high-quality,low-risk investments.

29Managing Your Personal Finances

Video Case >The Edward Jones Approach to Personal Finance


For instance, the company provides small-business owners with retirement planchoices, cash flow management, and information on legislative issues. For working in-vestors, the company focuses on managing personal finances, saving for retirement,and financing their children’s college education. Its stock reports are written in easy-to-understand language, and its fees are lower than most other full-service brokeragefirms.

Edward Jones’s Full Service Account helps clients simplify their financial lives.This cash and investment management account coordinates their savings and invest-ments into an organized portfolio that simplifies record keeping and streamlinestransactions. Investors can borrow money through an automatic line of credit andopen a money market account.

A third element of the company’s strategy is its focus on clients who are inter-ested in relatively high-quality, low-risk investments that are held for the long term.These investments include certificates of deposit; mutual funds; government, munici-pal, and corporate bonds; common stocks of companies with histories of sound man-agement and solid growth; retirement plans and individual retirement arrangements(IRAs); and life insurance products, including annuities.

Critical Thinking QuestionsIn what way does Edward Jones differentiate itself from its competition?How can Edward Jones’s strategy of one-on-one, personalized investment serviceshelp a customer develop a personal financial plan and an investment strategy?Suppose that you are looking for investment management services. Would you beinclined to become a client of the Edward Jones Company? Why or why not?

Sources: Adapted from the material in the Edward Jones video; Edward Jones Web site, http://www.edwardjones.com (August 7, 2006).

Hot Links Address BookFor helpful information on budgeting and credit counseling, go to http://www.studentcredit.com

For mortgage, personal loan, and bank interest rates visit the Web site http://www.banxquote.com

In too deep? For information on digging yourself out of debt, check out the Web sitehttp://www.center4debtmanagement.com

How good is your credit? Check your credit score at http://www.experian.com

Answers to your tax questions are available at the IRS Web site: http://www.irs.gov

Compare quotes and analyze your insurance needs at http://www.insurance.com

Need guidance on health care organizations? Visit http://www.healthfinder.gov/organizations

To help you plan your investment goals, use the personal finance and investing calculatorsat http://www.investorguide.com

To find answers to your consumer questions explore http://www.jdpower.com

31Managing Your Personal Finances

1. MSN Money Staff, “Raising YourQuarter-Million Dollar Baby,” http://www.moneycentral.msn.com (July31, 2006).

2. Kimberly Lankford, “Best Values inPublic Colleges,” February 2006,http://www.kiplinger.com (July 31,2006).

3. 2006 Federal Tax Rate Schedules,Internal Revenue Service, http://www.irs.gov (July 27, 2006).

4. “2006 Standard Deduction Tables,”Internal Revenue Service, http://www.irs.gov, (July 27, 2006).

5. “Withholding Exemptions 2006,”Internal Revenue Service, http://www.irs.gov (July 27, 2006).

6. “Hybrid Cars and AlternativeMotor Vehicles,” Internal RevenueService, http://www.irs.gov, (July 27,2006).

7. Sara Aase, “The Basics of BusinessInsurance,” June 29, 2006, http://www.forbes.com; and InsuranceInformation Institute Web site,http://www.iii.org (July 31, 2006).

8. Stacie Z. Berg, “For Older Americans,Money Advice Is Just a Start,” NewYork Times, July 2, 2006, pp. 3, 6;Colleen DeBaise, “Financial Plan-ners Target Boomers,” The WallStreet Journal, August 16, 2005,p. D2; “Gerontology Meets Finan-cial Planning,” The New York Times,July 7, 2006, International HeraldTribune Web site http://www.iht.com; American Institute of Fi-nancial Gerontology Web site,http://www.asaging.org August 11,2006.

9. Deborah Fowles, “Money and theCollege Student,” About.com http://

www.financialplan.about.com (July31, 2006).

10. Christina Couch, “Four SecretTuition Savers,” NestStep, http://www.nextstepmagazine.com (July29, 2006); Christina Couch, “TheSkinny on Levelized-Tuition Plans,”Bankrate.com, July 28, 2006, http://www.bankrate.com; and JosephHurley, “Prepaid College TuitionNo Longer a Big Bargain,” Bankrate.com, June 12, 2006, http://www.bankrate.com.

11. Tom Herman, “What Gets You Au-dited,” Wall Street Journal, April 16,2006, p. H7.

12. Martin Crutsinger, “Personal Sav-ings Rate Turns Negative,” SanDiego Union-Tribune,” January 31,2006, p. A8.

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