AAEC 2104 Final Exam Study Guide
AAEC 2104 Final Exam Study Guide AAEC 2104
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This 61 page Study Guide was uploaded by Mara DePena on Sunday May 8, 2016. The Study Guide belongs to AAEC 2104 at Virginia Polytechnic Institute and State University taught by Dr. White in Spring 2016. Since its upload, it has received 29 views. For similar materials see Personal Financial Planning in Agricultural & Resource Econ at Virginia Polytechnic Institute and State University.
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AAEC 2104 FINAL EXAM STUDY GUIDE TABLE OF CONTENTS Introduction 2 Measuring Your Financial Health 6 The Time Value of Money 9 Income Taxes 10 Cash Management 13 Consumer Loans 21 Investing 29 Retirement 36 Insurance 41 Home and Automobiles 47 Property and Liability Insurance 53 Estate Planning 58 INTRODUCTION 2 WHAT IS FINANCIAL PLANNING? Budgets- The keystone of financial planning. Health expenses are the biggest causes of debt. You are booted off of your parents’ insurance when you are 26. Individual Retirement Account (IRA) should probably be set up before the end of the semester. Savings account should have 3-6 months of living expensives. Financial planning is an organized method of achieving your life goals. Identifying and managing risks and unexpected events. o Financial, property, health, disaster, etc. Improving the security of a household. Reducing your stress level. Improving your life style helps you do what you want to do. MAIN ASPECTS OF PERSONAL FINANCE Setting goals Budgeting and cash management Debt management o Credit cards, auto loans, mortgages, etc. Insurance planning o Life, health, auto, home, disability, long term care Investing o Stocks, bonds, mutual funds, asset allocation Income tax management Retirement planning o IRA, 401(k), SIMPLE, SEP, etc. Education planning o 529 plans, Hope/Lifetime credits Estate planning o POA, AMD, will, trusts, gifting o Controlling assets while alive and after we die A BIG PUZZLE All aspects are interrelated o Changes in one area filter through other areas Constantly changing o Laws and regulations o Life events o Changing goals Requires patience WHY PERSONAL FINANCIAL PLANNING? Money doesn’t come with instructions 3 It’s easier to spend than save People are ignorant If you don’t control your finances, they will control you To achieve your goals To reduce your stress WHAT YOU CAN ACCOMPLISH Manage the unplanned “Find money” Make big-ticket purchases Accumulate wealth for special expenses and goals Invest for retirement Cover assets Invest intelligently Maximize after-tax income THE FINANCIAL PLANNING PROCESS Financial planning is an ongoing process o As your life goals and situation Five basic steps to personal financial planning: o Evaluate your current financial position What do you own? (assets) What do you owe? (liabilities, debts) What do you earn? (income) What do you spend? (expenses) What are you spending it on? Requires careful record keepings Assets, liabilities, income, expenses o Define your financial goal Short term (less than 1 year) Intermediate (1-10 years) Long term (over 10 years) Over time, goals change, so revise them SMART goals Specific Measurable Attainable/achievable Rewarding Timeframe o Develop a plan of action Babe Ruth Rule- Have three different plans. Written, organized plan with deadlines Flexible Plan for life changes/the unexpected 4 Liquidity (cash on hand) Accessing cash quickly and easily Protection Prepare for the unexpected with insurance Managing taxes Keep more of what you earn o Implement your plan Put the plan into action Keep goals in mind and work towards them o Review your progress, re-evaluate your situation/goals, and revise your plan Review regularly THE LIFE CYCLE OF FINANCIAL PLANNING The early years o Expenses > income The earning years o Starting in the work force The golden years o Prime earning years The retirement years o Expenses are probably > income KEY PRINCIPLES OF PERSONAL FINANCE These principles form the foundation of personal finance 1. The best protection is knowledge o Keep up-to-date on financial matters o Ask, read, observe, etc. o Lots of sources of information o Avoid “mistakes of ignorance” 2. Nothing happens without a plan o Think before you act o Saving must be planned Pay yourself first (take 10% of paycheck in savings) o Time is your best friend 3. The time value of money o Money has a time value (RIO) Risk- you may not get paid in the future Inflation- money won’t buy you as much in the future Opportunity cost o $1 today is worth more than $1 in the future o Compound interest 4. Taxes affect personal finance decisions o They influence your actual earnings o Goal- maximize your after-tax return o Compare investment alternatives on an after-tax basis 5 o Don’t make decisions strictly based on taxes 5. Stuff happens- the importance of liquidity o Have funds available for the unexpected 3-6 months of living expenses o Without liquid funds Long-term investments must be liquidated Results in lower price, tax, consequences, or misses opportunities o With nothing to sell: Pay higher interest to borrow money quickly 6. Waste not, want not- smart spending matters o Fastest way to improve your financial situation- reduce your spending o Wants v. needs o Be a smart consumer o Comparison shop o Take care of your stuff 7. Protect yourself against major catastrophes o Have the right insurance before a tragedy occurs o Know your policy coverage Know what’s not covered o Insurance focus should be on major catastrophes which can be financially devastating 8. Risk-Return Trade-Off o Low risk <-> Low return o High risk <-> High return o Investors demand higher return for taking added risk o What is your risk tolerance? 9. Diversification reduces risks o Don’t put all your eggs in one basket o Place money in several types of investments o Reduce your risk exposure Smooths out your returns However, may reduce your potential returns 10. Just do it o Making the commitment to start is difficult Rest is easier o Time is one of your main investment allies Procrastination = enemy o Take action now MEASURING YOUR FINANCIAL HEALTH 6 WHERE ARE YOU TODAY? Balance sheet o List of all the stuff you own/owe On a given date o What you own and how you have paid for it o Terms: Assets- What you own Listed at fair market value Monetary- Cash, checking, savings, CDs, MMAs, emergency funds Investments (non retirement)- Stocks, bonds, mutual funds, real estate. Cash value of life insurance, annuities Retirement assets- Values of IRAs, 401(k), pensions Housing- Value of owned residences. Automobiles- Value of all autos Personal property- Collections, clothing, furnishings, etc. Liabilities- Your debts, what you owe TODAY Current liabilities- Due within 1 year. o Payables- Bills you owe but haven’t paid yet, credit card balances (principal only) Long-term or non-current liabilities- Principal remaining on each loan Net worth/equity- Your financial value Assets-liabilities Want it to be positive and to grow over time Income statement o Grant Hill Principle- Doesn’t matter how much you earn, but how much you spend o “Budget”- cash in and cash out o Income and expense statement o Tracks your money over a period of time o Cash accounting Record when the cash changes hands o Easier to do on a monthly basis, then do it annually o Helps identify ways to reduce spending, project a budget for the future, determine how much you can save/invest per month o Swamp issues- Issues you can’t change, and move on Budgeting o Crucial for your financial future o Projections of your income and expenses o Relatively simple o Review your goals 7 o Review your income statement o Estimate your income for the upcoming month Gross or net of income taxes Don’t double count income/payroll taces o Build savings and investments into your budget Before you look at your expenses Pay yourself first o Estimate expenditures for the month Based on experience and income statement Incorporate goals o Incorporate a “fudge factor” of 10-20% You will forget or underestimate something Multiple expenses by .1 and then add that in as other expenses (worst case scenario) o Find leaks in wallet o Compare actual expenses to budget o Revise budget and/or lifestyle o For on campus- room & board, divide by four o What if it comes out negative? Is your math correct? Can you reduce any expenditures? Look at top 5 Shop smart Do you need to change your lifestyle? Do you have savings to fall back on? o What if it comes out positive? Increase savings Invest for retirement Pay down debts Donate to church/charity Increase living expenses a little o Help? Spreadsheet Quicken, quickbooks Mint.com FINANCIAL HEALTH Need to look at everything o Balance sheet o Income statement o Financial ratios Track changes over time Identify potential problems Impact of change in goals Financial ratios 8 o Liquidity Months living expenses Monetary assets/monthly living expenses Doesn’t include savings/taxes Benchmark: Standard: 3-5 months o Debt payment Debt payment/income ratio Total debt payments/gross income Benchmark: Less than 38-40% Use total debt payments plus HO insurance and property taxes PITI- Principles and interest, taxes and insurance Try and keep consumer debt payments (auto, student, credit card) under 10% of your gross income o Savings ratio Not looking at total amount in savings, looking at how much added Savings+investment/gross income Record keeping- why? o Prepare taxes o Track finance over time and control spending o CYA (cover your ass)- in case of lawsuit, etc o Emergencies and the 5 D’s Disease, disability, divorce, disasters, death Drugs, dependence, dumbness, debt, etc o How? File cabinet, envelopes Computer- quicken, etc Accounting service o What to keep Tax records Investment records Insurance records The list goes on o Where? Home- final cabinet Fire-proof safe Safe deposit box o How long? Tax records- 3-7 years Debt records- for life of debt, plus 3 years Investment records- for life of investment + 3 Real estate records- for life 9 Estate planning records- for life, until revised FINANCIAL PLANNING PROFESSIONALS How the charge o Fee only Per hour or per project o Fee and commission o Fee offset Fees reduced by commissions o Commission only Bottom lines: o Work with someone you trust, someone who understands your goals, someone you understand THE TIME VALUE OF MONEY $1 today is worth more than $1 in the future o 3 main reasons: Risk You may not receive that $1 in the future Inflation Increase in the general price level Opportunity cost You can do things with that $1 today TIME VALUE PROBLEMS Future value (lump sum) Present value (lump sum) Annuities and loan payments Future value of annuities o Annuity- constant payment over a period of time o Dollars/year or dollars/month Present value of annuities Perpetuities-constant stream of payments, forever SECRETS TO TIME VALUE Lump sum- Only 1 cash flow, a one-time event Annuity- Series of cash flows Present value (PV)- What it is worth today Future value (FV)- What it will be worth in the future Rule of 72- Estimates how long it takes your money to double. Take the number 72 and divide it by the rate of return. TIME VALUE IN A TI-84 CALCULATOR Apps -> finance -> tVM calculator -> alpha -> enter (solve) N=total number of periods I=rate of return 10 PV=how much you are investing today (present value) PMT=payment FV=future value INCOME TAXES WHY DO WE PAY TAXES? Help fund national, state, local efforts o Cost of running the government o Infrastructure (bridges, roads, etc) o National defense o Police/fire protection o Government programs Your goal should be to maximize your after-tax income MARGINAL VS. AVERAGE TAX RATES US uses a progressive tax system o Tax rate increases with income Everyone starts out paying the same rate Marginal tax rate=taxes owed on the next dollar you earn Average tax rate=total taxes/taxable income o Somewhere around 17% TAKE-HOME PAY Gross income minus… o Federal income taxes withheld o State income taxes withheld o FICA (Social Security and Medicare) – 7.65% Filling out a W4 form o The more exemptions you list, the less income tax they withhold o Fill out when you start a job o Can make changes later AL’S TAX TIPS You can easily do your own taxes Get the instruction book and read the instructions Use IRS.gov for specific questions Some tax software is okay Round off to the nearest dollar Document numbers Check math When in doubt, read the instructions Keep copies of calculations GENERAL INFO Determine if you have to file o Single, not a dependent 11 Gross income > ~$10,300 o As a dependent Unearned income > $1050 or earned income > $6300 Determine which form to use o 1040 o 1040EZ o 1040A THE THEORY OF INCOME TAXES Look at IRS Form 1040 o Address and Personal Info Use IRS label if possible Name and address SSN Presidential election campaign ($3) o Doesn’t change your tax or refund! State income tax forms o Filing status Choose the appropriate one! o Exemptions Allowance for you and dependents o $4000 each Claim yourself o Unless you are a dependent Claim spouse and dependents o Dependents= qualifying child or relative Under 19; under 24 AND a full time student Any age if permanently disabled Didn’t pay more than half of their own support for the year Lived with you for at least half the year o Income List your gross income for the year by source. Wages, salaries, tips Interest earned, taxable and tax-exempt Dividends, ordinary, qualified Business or farm income o Schedule C or F Capital gain/loss from sale of assets o Schedule D IRA distributions, pensions, unemployment o Including Social Security benefits Other income (line 21) o Income from “odd jobs,” gambling, etc. o Adjustments 12 These reduce your total income Main adjustments for students/graduates o Moving expenses o Self-employment items o Traditional IRA contributions o Student loan interest payments (up to $2,500, if you are not a dependent) o Tuition and fees deduction o Tax and credits Standard v itemized deduction o Reduces your taxable income o Use the larger of the two Itemizable expenses o Medical and dental o State/local income taxes OR sales tax o Real estate, personal property taxes o Interest paid o Gifts to charity o Casualty and theft losses o Unreimbursed job expenses Deductions for exemptions o $4000 per exemption Taxable income Tax (using tax tables or brackets) Alternative minimum tax (AMT) Tax credits o Directly reduce your tax liability (dollar for dollar) Child/elder care Education credits o Payments All tax payments made during the year Income tax withheld Estimated tax payments o Primarily for businesses Earned income credit o For low income families Add to get total payments o Refund/Amount Owed Total payments > total tax refund LEGALLY REDUCING YOUR TAXES Reduce taxable income o Make 401k and 403b retirement contributions Increase adjustments o Make traditional IRA contributions 13 Not recommended for most students. o Student loan interest, moving expenses, etc. Standard v. itemized deductions o Take the larger of the two o For most students, use standard Increase itemized deductions Use any tax credits that might help Qualified dividends o Hold your stocks at least 60 days Tax-exempt income o Municipal bonds MORE ADVICE Don’t make decisions strictly on tax consequences. CASH MANAGEMENT LIQUIDITY VS. SAVINGS Liquidity- rapid cash needs o Regular bills and expenses o Enough to meet your usual needs Savings- emergency needs o Unexpected expenses and situations o 3-6 months of living expenses o Your financial safety net CASH MANAGEMENT Build your checking account o Enough money to meet your needs o Need to know your monthly budget o Direct deposit of paycheck into checking Then, build your emergency funds o Automatic savings From checking account o Replenish as necessary Then, use cash to pay down debts, invest, spend on yourself, donate, etc. WHERE TO KEEP YOUR MONEY In cash- not recommended Checking account (demand deposit) o Non-interest bearing o Interest bearing Savings account (time deposit) Money market deposit accounts o Similar to a savings account Variable rate of return, usually slightly higher 14 May have higher minimum balances and limits on withdrawals Certificates of Deposit (CDs) o Loan to a bank at stated interest rate and maturity o Early withdrawal penalties o Good place to park your money until you decide o Laddering your CDs Nice way to manage emergency funds Invest in a series of differing maturities Renew each CD for the longest maturity o You do not want your retirement accounts invested in CDs o A simple CD ladder- $4000 $1000 in a 3-month CD $1000 in a 6-month CD $1000 in a 9-month CD $1000 in a 1-year CD Every 3 months you have CDs maturing. Renew them all for 1 year maturity. In theory, higher returns for longer maturities Laddering provides higher average returns Money Market Mutual Funds (MMMF) o Mutual fund investing in very safe debt instruments o May have limited check-writing abilities o Fees involved- usually less than 1% of the investment o Not insured, but relatively safe o Slightly higher return than money market and checking and savings Best place to keep your money would be either savings accounts or CDs Asset Management Accounts o AKA sweeps account o Comprehensive financial account Checking, credit card, money market, mutual funds, loans o More aggressive account, higher fees and minimum balances o Not insured o Little bit higher risk, little bit higher return o At the end of every day they take your money and try to invest it elsewhere to earn some return. Then put your money back in with what they earned. US Series EE Bonds (AKA Savings Bonds) o Very safe, low return, low liquidity o Relatively horrible investments o Various denominations ($50-$10,000) o Not taxed at the state level 15 o Electronic version- pay face vale o Get the face value and accrued interest at maturity Get reduced amount if sold before maturity o Don’t keep up with inflation o Tax-exempt earnings if used for education expenses o Usually need to hold on for 15-20 years COMPARING DIFFERENT ACCOUNTS Compare on equal footing (after tax basis). Rate of return o Annual Percentage Yield (APY) Allows comparison of accounts with different compounding methords o After tax APY = pre tax APY x (1-Marginal tax bracket (MTB)) o Ex: A pays 6% return, 25% tax 6% x (1 - .25) = 4.5% o B pays 4%, tax exempt 4% x (1-0) = 4% Safety o FDIC or FSLIC- insurance. Up to $250,000 per depositor o May take a while to get your money o MMMFs- Not insured, but fairly safe Look at convenience, fees, customer service, etc. INSTITUTIONS Commercial banks o Full service, many locations o Online banking Convenience vs. fees Savings and Loans and Savings Banks o Primarily home loans (70%) and savings accounts Credit unions o Member owned o Not for profit- profits go to shareholders o Usually higher rates of return, lower interest rates o Usually slower with technology Online deposit accounts o Look for reliable companies o Primarily savings accounts o May be linked to credit card accounts o Drawbacks Time to access your funds Fees Brokerage firms o Asset management (sweeps) account o May have deposit accounts, credit/debit cards 16 o Don’t get one of these straight out of college WHAT TO LOOK FOR IN AN INSTITUTION Services and products o Ones you need/want Safety o Track record o Insurance Fees and charges Convenience and customer service CHECKING ACCOUNT Opening an account o Look at: Fees Monthly, per-check, online banking, overdraft, minimum balance Minimum balances Operating hours and locations ATMs Customer service Using o Deposit paycheck and other funds Direct deposit Keep receipts from ATM deposits o Write checks as needed Date, payee, amount, memo, signature o Record in your check register o Online banking Faster, easier, schedule your payments/savings Fees? o Don’t bounce checks! Fees will get ya! Balancing your check book o In checkbook register, mark off al deposits and checks that have cleared o Take ending balance from monthly statement o Subtract any checks that haven’t cleared o Adjusted balance = checkbook balance o If you take the difference between your adjusted balance and what is in your account and divide it by 9, if it comes out as an even number you most likely just mixed up a number. OTHER TYPES OF CHECKS Cashier’s check o From a bank or financial institution. o Very safe. o Write a check to the bank plus a fee 17 o They pay the check out of their funds Certified check o Personal check guaranteed by the bank Money order o Purchased at post office, convenience stores Traveler’s check o Specific denomination o Safe, replaceable o Booklet of checks that are smaller denominations OTHER FORMS OF CASH MANAGEMENT Electronic fund transfers o ATMs o Debit cards Smart cards and stored value cards o Money is transferred to an account “on the card” o Use it like a debit card until the funds are gone May be able to add more funds to the account o Single purpose vs. multi purpose o Pre-paid phone cards, gift cards, Hokie Passport May be limited to where it can be used CASH MANAGEMENT TIPS Budget, budget, budget Track your expenses Shop smart o Use a list, coupons, comparison shop Use checks until you learn your spending habits o Takes time, slows you down, creates paper trail o Record your expenses, balance your account Cash, debit cards, and smart cards are sneaky o Tend to spend more than if using checks CREDIT TYPES OF CREDIT Credit- When you buy something today, with the commitment of paying off your debt in the future. Consumer credit (all types except housing) o Any non-mortgage credit purchases o Auto loan, student loans, vacation loans, etc. Open/Revolving credit o Non-revolving- Borrow up to your limit and you’re done. o Borrow up to your credit limit, pay it off, borrow again. o Variable payback- Minimum payment to full amount. o Interest charges build on the outstanding balance. 18 o Credit cards Issued by a financial company Gives the holder the ability to borrow funds to purchase goods with Credit cards charge interest when funds are borrowed Normally used for short term financing Have advantages and disadvantages o Open accounts at stores o Operating lines of credit For purchasing operating inputs o Home equity line of credit Simple rules to keep in mind o Alex’s rule of 3 No more than 3 credit cards Even better- get on parent’s o Don’t spend money if you can’t pay it back o Pay your balance in full every month o Don’t make minimum payments Interest will sneak up on you SCHUMER BOX Read it! Allows you to compare loans side by side. Lays out everything associated with credit card. The average interest rate for college students is 18%-22%. Interest rates may be fixed or variable. o Variable rates are usually tied to an index. May change each month. Teaser rate- Short term low rates, as low as 0% APR. After stated term, it increases. Balance transfer- Moving balance from one card to another. Cash advance- Get credit card, go to store, get cash on spot. o Bad thing to do! o Borrow cash against your credit limit o Pay a cash advance fee (2-4%) o High APR on cash advances Default APR- Your APR if you miss a few payments. Goes up. Grace period- When you are not charged interest. Typically, 20-25 days after loan if you do not have outstanding balance. From time of initial purchase to first interest charges. You don’t need a card that has an annual fee. MAIN FACTORS Average daily balance method- Most common method to calculate the balance owed, add up each day’s balance, divide by number of days. TYPES OF OPEN CREDIT Bank credit cards 19 o Visa, Mastercard o May have nice perks Variations of bank credit cards o Premium or platinum cards o Affinity cards VT Alumni Association, etc. gets a percentage as a donation o Secured credit cards For those with bad credit Pledge something as collateral Credit limit= value of collateral Travel and entertainment cards o Not revolving, must pay entire balance each month Basically interest free o Probably has an annual fee Single-purpose cards o Used for only one store o Good way to limit spending Charge accounts o Use product/service today, pay at end of month Phone bill, electric, medical, hardware, feed/supply ADVANTAGES OF CREDIT CARDS Convenience Safer than carrying cash Great for emergencies Helps with record keeping o One monthly statement shows your purchases Internet shopping Helps build credit history if used wisely Extra warranties and consumer protection o $50 max for lost/stolen card if reported Use someone else’s money free for 30 days DISADVANTAGES OF CREDIT CARDS Typically spend more with credit card v cash Easy to lose track of your purchases Fees and interest charges o High interest rates Live above your means now, pay for it later o Commit future earnings to debt payments Destroy credit history if used unwisely Michael Jordan rule of finance (his number was 23) o It takes 23 years to pay back a 2-3% APR if you make minimum payments on a $2000 purchase 20 Richard Petty Rule o $5000 balance, $17,000 interest total o Takes 43 years to pay off o If invested instead, $550,000 GETTING A CREDIT CARD Shop around o CreditCards.com, BankRate.com Look at APR, fees, as well as the issuer 5 ‘s of Credit (lenders look at these) o Character- measured by credit score/history o Capacity- current income o Capital- value of your investment assets o Collateral- only for secured credit cards o Conditions- overall economy COLLEGE STUDENTS AND CREDIT CARDS New laws for those under 21: o Must have income o Co-signer/joint account TROUBLESHOOTING YOUR CREDIT CARD SITUATION Determine how long it will take to pay the balance in full. Switch to lowest APR card possible. Use savings to reduce credit card balances. o Not a good sign Pay credit card balances with home equity line. o Stop using your credit cards Work with your creditor. HOW TO USE CREDIT CARDS Only use when you have the cash in your checking account o Use it as a convenience, not a long term loan Pay your balance in full every month o Pay 0 in interest o Maybe carry a small balance 1-2 times per year to build your credit score o Make your minimum payment, though! Never make just the minimum payments! No cash advances! Have no more than 3 credit cards. o Al has 3. One for travel, one for online purchases, one he keeps in his wallet. Average American household has between $8,500-$10,000 in credit card debt Let your credit card company know you are leaving the country so they don’t freeze you. 21 Try not to use your debit card in other countries- use a credit card. Their security is not as good. CREDIT HISTORY Creditors report to Credit Bureaus o Credit limit o Outstanding balance o Payment history Late is defined as 30, 60, or 90 days late o Date opened o Judgments, collections, etc 75% have a mistake on them, and 25% have a critical mistake It’s all used to calculate your credit score Entitled to 1 free copy of your credit report per year Check 3-6 months before you apply to home loan, auto loan, credit card o If there is a mistake you can fix it online If you have a card for a long time, hold onto it or it will lower your credit score. Credit inquiry- When you gave someone else the right to check your credit score and they check it. This hurts your credit score. CREDIT BUREAUS AND REPORTS Experian TransUnion Equifax Free annual copy of your credit report (annualcreditreport.com) CreditKarma.com (100% free) CONSUMER LOANS Structured payback schedule; specified term. Anything not related to a house. o Auto o Student o Vacation o Personal Home Equity Loans/Lines of Credit o HEL o HELOC BASICS Single payment (borrow money today, at end of the term write one check) vs installment (paying on a regular basis) Secured- Guaranteed by collateral o Default on loan repossession, foreclosure o May still owe the lender money after the repossession 22 o Lenders usually lose money with loan defaults Lenders hate to foreclose and repossess! Make money by you paying interest Unsecured- No guarantee o For best customers (good credit history) o Probably higher APR because it is a higher risk to the lender Fixed vs. variable interest rate o Fixed rate stays constant for life of loan Periodic payments stay constant o Variable rate is tied to some index (prime, LIBOR) May change (up/down) monthly, annually, etc. Usually an annual and lifetime “cap” on the changes o 5-1 6% 2/5 5-1 fixed for five years, can change after that 6% 2/5 = max annual change of 2% Max lifetime change of 5% (6% + 5% = 11%) o 7/1 5% 4/2/5 7-1, fixed for first 7 years, can change annually after that 5% initial interest rate 4/2/5 at end of 7 years, interest can go from 5 to 9% max, 2% per year maximum, 5% maximum change (so 4 is initial change/max it can change, 2 is per year, 5 is most it will over lifetime) Typically changes your monthly payment Riskier for consumers LOAN CONTRACTS Legal document that spells out the terms o Who is involved o How much is borrowed o Repayment terms (APR, term, payments, etc.) o What is listed as collateral (security) o Acceleration clause Written into almost every contract that says at any point in time the lender can call a loan due, which means you’ve to pay for the rest today. Not usually enforced, but it can be! o Default actions Recourse claim- garnishing wages (max of 25% of your take home pay), repossession, etc. Deficiency clause 23 Responsible for full amount even after repo May include collection costs, etc. AUTO LOANS Usually secured by the auto. Terms 3-6 years o May see 7-9, way too long! o Longer term usually means higher APR Usually fixed rated Lender wants to see: o Credit score > 650 or 675 o Income/employment verification o Possibly a balance sheet When in doubt go for a longer term o The longer the time frame, the lower the payment you have to make STUDENT LOANS Federal direct/Stafford loans o Limits on how much you can borrow per year o No interest payments until after graduation o First payments are 6 months after graduation o Relatively low interest rates o If you go onto vet school, you defer payments until after you graduate. However, you need to tell them you are going to vet school! o Only time you don’t have to pay back federal loans is when you die. PLUS/PLUS Direct o P stands for parent! In parents’ name. o Usually higher borrowing limits o Interest rates tied to T-notes, capped at 8.5% o Begin payments immediately Perkins Loans o For students with “exceptional financial need” o Come from the school Private Loans o Higher interest rates o Probably unsubsidized STUDENT LOAN REPAYMENT Standard plan o 10 years, fixed payments of at least 50 a month Graduated plan o 10 years, payments start low and increase every two years Extended plans o 12-25 years, fixed or graduated payments 24 o Eligibility depends on situation Income-Based Repayment Plan (IBR) o Up to 25 years o Must qualify for “financial hardship” to participate o Maximum monthly payment= 15% of your monthly discretionary income AGI- 150% of your poverty guideline Payment changes as your income changes o After 25 years of payments, remaining balance may be forgiven Income-Contingent Repayment Plan (ICR) o Up to 25 years o Monthly payments based on household income, family size, amount of loans Recalculated each year o After 25 years, remaining debt is forgiven, may be treated as taxable income Income-Sensitive Repayment Plan o Up to 10 years, payments based on your income Pay as you earn plan o Must have financial hardship to qualify. o Monthly payments capped at 10% of discretionary income. Difference between AGI and 150% of your poverty level. Recalculated as your AGI changes. Payments are lower than for standard 10 year plan Will cost you more in the long run Up to 20 years Outstanding balance will be forgiven (and taxed) STUDENT LOAN CONSOLIDATION Al is a proponent! One big loan instead of several smaller ones. o One payment/month Fixed interest rate for life of loans. o Weighted average of your existing rates (rounded up to nearest 1/8 % ) o No cap anymore Must have graduated, left school, or dropped below ½ time to qualify o Must have grace period remaining Can stretch payments up to 30 years STUDENT LOAN- OTHER May qualify for deferment or forbearance o Postpones payments for a stated period Loan forgiveness o Teacher Loan Forgiveness o Public Service Loan Forgiveness 25 Vet Program o Feds will pay off up to $25,000/year o Must work in NIFA designated veterinarian shortage areas Maximum of 3 years STUDENT LOANS To pay down early or not o Yes! o But, does depend on APR and other opportunities o Not if you use the IBR, ICR, Public Service, or Vet Program plans To consolidate or not o Probably a good idea How long should I pay? o Standard loan is 10 years o Can stretch up to 25-30 years HOME EQUITY LOANS/LOCs Home equity loan- specific dollar amount, home equity line-like a credit card Equity= value of house – balance of loan Borrowing against the equity in your house o Up to 80-85% of your equity HEL (home equity loan) = borrowing a stated amount HELOC (home equity line of credit)= revolving credit up to a credit limit o Like a credit card, don’t use it then it doesn’t cost you anything o Tax deductible interest o Al likes it, but can lose your house if you don’t pay it off o Can use to pay off credit cards, but don’t use your credit card if you do! Interest is tax deductible Lower APR than other consumer loans House at risk if you default PAYDAY LOANS Don’t do it! Last resort of credit! Short term loans for “cash strapped” o Usually 1-2 weeks Fee involved each time Ex: Need $200 for two weeks o Borrow $200 from payday lender o Write a check for $230 to the lender (15% interest) o After 2 weeks, lender cashes the check APR in this example is 390% o 15% for 2 weeks x 26 2-week periods/yr COST OF INSTALLMENT LOANS 26 Simple interest method o Only way to go! o Pay interest on principal outstanding o Stated interest rate = APR Add-on or discount methods o Avoid them! o All interest is based on original loan amount o State interest rate < actual APR PRE-PAYMENTS ON LOANS Shortens life of loan, decreases payments over time Read the loan contract Paying at least the minimum monthly payment and a little bit extra First part of payment goes towards interest today, and the rest goes directly towards the principal Ask, is it allowed? Is there a penalty? Do extra payments go to the loan principal or to an Escrow account? Pre-payment penalties o May have a one time fee (ex. $25) o May have a fee per payment o May use the Rule of 78s for add-on loans Don’t worry about the calculation o Compare the penalties and fees to interest savings NEW MATH OF LOANS As APR increases o Monthly payment increases o Total interest expense increases As term (loan life) increases o Monthly payment decreases o Total interest expense increases Prepayments rapidly: o Decrease the total interest expense o Decrease the life of the loan SOURCES OF CONSUMER LOANS Commercial banks o Want a balance sheet, or three years of balance sheets o Income verification (pay stubs) o Credit score (should be above 700) o Good idea to go to the one where you have your checkings and savings Credit unions o Low interest rate o Can’t borrow quite as much, lower lending cap S&Ls 27 o Savings and loans o Primarily auto loans, student loans, and home mortgages Point of purchase o Test drive car, sales person makes a good deal so you talk to the business officer to set up a loan Payday lenders, check cashing firms, pawn shops o Run and hide!! o Extremely expensive, emergency sources GETTING LOANS How to increase the odds of getting a loan o Have a good credit score 3 ways to improve credit score Credit utilization (10-20%) 2-3 cards (1 as a student) Carry a balance o Make a large down payment But don’t eat into emergency funds! o Prove your cash flow ability o Pledge something for collateral o Get a co-signer o Choose a variable rate loan and/or shorter term Less risk for lender, but riskier for you o Look for someone to guarantee the loan Small Business Administrator, Farm Service Agency POWER PAYMENTS (GOOD IDEA) When you finish paying off a loan o Apply that same payment to another loan Example: 2 loans o A. Car loan, 7% APR, $480/mo o B. Student loan, $25,000 rem., 5% APR, $320/mo You just must your last payment on the car loan, what now? Put it towards your other loan! Put extra payments towards one with the higher interest rate. However, if you pay of your lowest balance you will finish faster. LOANS- AL’S ADVICE Use consumer debt wisely! o Don’t borrow for everyday spending needs. o Borrow for items that will improve your situation. Develop your budget o Determine how much you can afford to pay o Include the associated costs in your budget Do your homework o Comparison shop for the item o Shop around, look at 3 lenders before acting 28 o Determine how much you can afford to borrow Know how much you can afford to pay down o Don’t invade your emergency funds Make power payments Check your credit report before acting o Clean up any mistakes o Check 3-6 months before o 75% have mistakes Keep your consumer debt payments under 10-15% of your gross income o Total debt payments should be less than 40% of your gross income When in doubt o Choose the longer term Smaller monthly payment Prepay if you have cash available o Make payments on time 35% of your credit score is made up of this! Less than 30 days late o If you hit hard times, talk with your lenders Don’t hide! They prefer to work with you rather than against you HARD TIMES Talk with your creditors o Restructure the loan o Lower the interest rate o Forgive some interest o Work out a plan to minimize losses Use savings to pay down loans o Keep emergency funds Pay down your high-interest loans first o Or the loans with the smallest balance Consumer credit counseling service o Work with debt counselor Consolidate to lower-cost lenders o Debt consolidation loans Try to get lower monthly payments Roll your ST debts into longer term debts o Use a term loan to pay off credit card debts o Beware! Not a good sign. Looks bad down the road. REALLY HARD TIMES Bankruptcy o Tool for improving debt situation o Way of saying you can’t make your payments, you’re in too deep 29 o Not a good option in most cases o Does NOT affect Federal loans, like student loans Income tax liabilities Alimony o Pushes your responsibility onto responsible debt payers o Different kinds of bankruptcy (Chapter 7) Straight- For households. Most severe form of bankruptcy. Eliminates debt. Provides a chance to start over. May lose personal assets (varies). o Courts appoint a trustee o Sells assets and divides proceeds among creditors Stays on credit report for ten years (since last date of action) Last resort o Get legal advice first o Major decision, don’t jump into it Business Farm (Chapter 13) Wage-earner Buys you time Easier to qualify for o Limits on income, debt, etc Plan to repay your creditors o Typically over 3-5 year period Protects you from your creditors o Retain ownership of assets o No harassment from creditors or bill collectors o Includes federal debts Stays on your credit history for 7 years o From end of repayment Be careful! BOTTOM LINE Treat debt with respect Don’t borrow for regular expenses Don’t hamstring yourself by making too large of a down payment Keep your consumer debt payments (P&I) under 10-15% of your gross income Work with your creditors o In good times, and especially bad! 30 INVESTING KEY POINTS Know your goals and risk tolerance. o Are you investing to get cash? Because you don’t want to lose money? What? o How much risk are you willing to take? Pay yourself first. o Save 10% of your gross income. Brainless, painless investing o Dollar Cost Averaging One of the easiest, painfree, powerful investment strategies. Invest the same dollar amount every period. Extremely important. Don’t put all your eggs in one basket o Diversification o Asset allocation Review and revise your investments periodically o Rebalance o Reallocate ALEX’S 3 MAIN QUESTIONS Why do you want to invest? o What is your goal? When will you need the money? o The sooner you need it, the less risk you can take. How much risk are you comfortable taking? MUST KNOW YOUR GOALS Meet your basic needs first. o Liquidity, savings, debt management Match your investments to your goals o If your goal is security, invest in safe assets (money market accounts, savings) o If your goal is income, invest in “fixed income” (dividend paying stocks, bonds, rental property) o If your goal is growth (selling something for a higher price than you got it), invest in “equities” (general stock market) UNDERSTAND your investments RISK TOLERANCE Risk tolerance quiz (on scholar) If you lose sleep over your investments, reduce the level of risk. Main determinant is time o ST investments- Use safe assets o LT investments- Incorporate riskier assets. 31 MAIN ASPECTS OF INVESTMENTS Safety o Every aspect has some level of safety Income o Does it generate cash for you on a regular basis? Growth o Does it go up in value? o Primarily stock market, real estate as well o Need to sell to get that value Tax implications o Taxable, tax deductible, tax deferred, tax free o You are taxed on dividends o You are taxed on shares o You are taxed on growth if you sell o If you open an IRA and buy stocks, you are not taxed on those dividends o Traditional IRA- tax deductible investments o 401K- reduces taxable income (pre-tax, essentially tax deductible) o Tax deferred- Pushing taxes off until the future (as long as money is in retirement account). o Tax free- Roth IRA or Roth 401K. RETURNS FROM INVESTING Income Interest o Bonds pay you semiannually o CDs Dividends o Cash o Stock (DRIP- Dividend reinvestment plan. You get shares instead of cash.) Taxable as well You want to buy low and sell high o Semi-annually or quarterly basis o Taxable the year you receive it Capital gains o Capital gain = selling price – purchase price o Purchase price=tax basis o Either not taxed at all or taxed at a 10% level “Paper gains” o When you own stocks or an investment and it goes up in value but you haven’t sold it yet. o Unrealized gains. HISTORICAL RETURNS 32 High risk, high return T-bills, treasury bills- Risk free short term investments from the government. Keeps at right about the rate of inflation. Very low risk, very low return. More variation, more risk, higher return. DIVERSIFICATION Attempt to reduce your risk exposure. Investing in different assets within: o Different industries o Different economies Theory is that by spreading your investments over a wide range, you aren’t impacted when one investments goes south o Reduces the impact of extremes Reduces your risk exposure o Expected impact on returns? Key to diversifying: o Negative correlations o Invest in different industries o Invest in different assets (stocks vs bonds) SO WHAT CAN YOU INVEST IN? Individual stocks o Risky Bonds o Fairly safe CDs o Bad long term investment, barely keep up with inflation Mutual funds (active) o Most retirement plans. Nothing more than a group of people pooling their money together and somebody investing that money. That person has a set strategy they have to follow- they think they can beat the overall market. Actively trying to reach a certain goal. More you buy and sell, more expenses, less money you earn. Index mutual funds (passive) o Al likes these. One of the best ways to invest. Try to match one of the main investment indexes out there. Setting up mutual funds to mimic overall index and let it sit. Cheap. Asset allocation mutual funds o Have a date in their title. Year in that title is the endpoint of your goal. Relatively risky for next several years but more conservative as you get closer to your goal. Typically used with retirement. Real estate o Hold onto land about 7 years before you can make any money. 33 o Rental properties are a different story. Depend on economy and location. Business assets o Invest in a small business. Collectibles o Nah. Most of the time you don’t make money. STOCKS Corporate stocks o Piece of ownership of the company You can vote and have a say o Higher risk investment, higher return Stock market has averaged about 10-12% per year over time Making money o Dividends o Capital gains COMMON STOCK TERMS Ticker symbol- Stock market abbreviation for company Last (or close)- Last markey price from previous day. Hi/low- Highest and lowest market prices during the trading session. Change- Yesterday’s closing price minus previous day’s closing price. Sales (1000s)- Trading volume for that stock (shares) 52 Week Hi/Low- Highest/lowest prices during the past year. Div Yield (Dividend Yield)- Total annual dividend/current price or quarterly dividend/current price. o Income stocks have high dividend yields. o Growth stocks have no/low dividend yields. o Can fluctuate, set on annual basis. o You want dividend in your portfolio. DRIPs- Dividend reinvestment plans. Take dividends in stock rather than cash. o Instead of getting a check every quarter, it is automatically reinvested and you get more shares. Beta- Measure of volatility (risk). o Market beta is 1 (the average risk) o High beta=higher risk Typically between .5 and 2 Can be negative o Slope of the regression line for a firm’s stock return plotted against market return o Beta=Cov Firm,Marketriance Market o General rule: 1-age in percentage of stocks in portfolio Stock split- Attempt by firm to manipulate stock price o Convert existing shares into “new” shares 34 Ex: 2 for 1, 3 for 1, 1 for 2 2 for 1 split means you will receive two shares of “new” stock for each share of “old” stock you own If you own 100 shares before the split you will own 200 shares after the split o Changes your tax basis per share PICKI
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