chapter 1 personal finance
chapter 1 personal finance FINC 2400 - 001
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This 9 page Class Notes was uploaded by Mary-Cynthia Okeke on Monday September 5, 2016. The Class Notes belongs to FINC 2400 - 001 at Auburn University taught by Sven Nicolai Thommesen in Fall 2015. Since its upload, it has received 48 views. For similar materials see Personal Finance in Finance at Auburn University.
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Date Created: 09/05/16
Personal Finance Chapter One Notes What is Personal finance? Personal finance is the process of planning your spending, financing and investing in optimizing your financial situation. A personal financial plan is a plan that specifies your financial goals and describes the spending, investing and financial plans that are intended to achieve the goals you’ve stated. Understanding personal finance helps you make informed decisions about your financial situation. For every spending decision you make, there is an opportunity cost i.e. what you give up as a result of that decision. It also helps you make good judgments about the guidance of your financial advisers. Components of Financial Plan Budgeting and tax planning. Managing your liquidity Financing your large purchases Insurance Investing your money Retirement and estate planning. Budget and Tax planning Budget planning is the process of predicting future expenses and savings. It requires you to determine how you would spend your money, the amount you need to spend and how much to save. Your spending decisions are very important as it would dictate how much of your income would be used for other things. The first step in budget planning is to assess your current financial position by evaluating your income, your expenses, your assets and your liabilities. Net worth is calculated by subtracting your liabilities from your assets. A key part of budget planning is estimating the typical expenses that you will incur each month. Underestimating your expenses mean you will need more cash inflows (money that you receive) than you expected to cover your cash outflows (money that you spend). Achieving a higher level of future wealth requires you to maintain a low spending rate today. Many financial decisions are affected by tax laws because some kinds of income are taxed at a higher rate than others. By understanding how your alternative financial choices would be affected by taxes, you can make financial decisions that have the most favorable effect on your cash flows. Liquidity Management Liquidity is a term used to describe how easy it is to convert assets to cash. It is important to have a plan for how you will cover your daily purchases. Expenses could range from coffee to major house repairs. Money management involves decisions regarding how much money to retain in a liquid form and how to allocate the funds among shortterm investments. Finding an effective liquidity level involves deciding how to invest your money so that you can earn a good return and also have access to cash if needed. Most times, you may be unable to avoid cash shortages because of unanticipated expenses. Credit management involves decisions about how much credit you need to support your spending and which sources of credit to use. Credit is commonly used to cover both large and small expenses when you’re short on cash and it enhances liquidity. However, credit should only be used when necessary as you would need to pay back borrowed funds and expenses. Financing your large expenses Loans are typically needed to finance large expenditures such as the purchase of a home or college tuition. Managing a loan includes finding how much you can afford to borrow, deciding on the length of the loan and selecting a loan that charges a competitive interest rate. Insurance planning Your assets have to be protected and to do that, Insurance planning is the best way to go. Insurance planning will help determines the types and amount of insurance that you need. Automobile insurance and home owner’s insurance protects your assets, health insurance reduces your medical expenses and disability insurance and life insurance protects your income. Investments Any funds that you have beyond what you need to maintain liquidity should be invested. Potential investments include stocks, bonds, mutual funds and real estate. Before you invest, you must determine how much of your funds you want to invest and what types of investments you're considering. Most investments are subject to risk (uncertainty surrounding potential return on an investment.) so you need to manage them so that your risk is limited to a tolerable level. Retirement and Estate planning Estate planning is the act of planning how your wealth will be distributed before or upon your death. Effective estate planning protects your wealth against unnecessary taxes and ensures that your wealth is distributed in the manner that you desire. Retirement planning involves determining how much money you should set aside each year for retirement and how you should invest those funds. Money contributed to retirement plans is protected from taxes until it is withdrawn from the account. Integration of Financial plan Components As you learn about the six components of a financial plan, it is highly important that you realize that any decision you make concerning any of the components affects the rest. It is important you understand how the components are integrated so you can recognize tradeoffs before you finalize your conclusions about any components. How budgeting affects other financial plan components Your budgeting decisions affect your liquidity management decisions because if you decide to spend all of your income, you will not be able to accumulate savings in your bank accounts. How managing liquidity affects your other financial components If you do not accumulate savings in your bank accounts, you may not have funds to make a down payment on a home in the future. How financing affects your other financial plan components Your financing decisions can affect your insurance decisions because if you borrow heavily, you will be making a large interest payment (cash outflows) periodically. How insurance planning affects your other financial plan components Your decisions to buy insurance to protect yourself and assets can affect your investing decisions because if you make large monthly insurance payments, there would be no extra cash to make other investments. How investing affects your other financial plan components Your investing decisions can affect your retirement planning decisions because if you make poor investment decisions, your wealth would suffer and may decline over time. How retirement planning affects your other financial components Your retirement planning decisions can influence your budget decisions because the more money you voluntarily contribute each month toward your retirement, the less money you have available for purchasing products and services today. How Psychology affects your Financial Plan Psychology has a major impact on human behaviour and decision making. Therefore, it plays a major role in your spending behaviour and your ability to implement an effective financial plan. Focus on immediate satisfaction and peer pressure Some people allow their desire for immediate satisfaction and their focus on peer pressure to dictate their financial planning decisions. They spend excessively and most times, expenses are usually impulsive. This type of behaviour may be referred to as “shopping therapy” because the act of shopping boosts the morale of some people. People who spend based on peer pressure most times, buy things they cannot afford to buy just because they see their friends buying expensive things. This decision will use up much of their monthly income and could prevent them from allocating their funds to other functions such as investing, liquidity management, insurance, etc. Focus on the future Other people have more discipline when deciding how to allocate their income or funds. They, most times, have a strong desire to avoid all sorts of liabilities to reduce the stress from the obligation of large debt payment. They recognise that by spending conservatively today, they will have more money available for other financial planning functions. Developing your Financial Plan There are six steps in developing a financial plan. Step 1: Establish your Financial goals Identify your financial goals. These goals do not have to be associated with finance. There are all sorts of goals, family, education or vacation. You need to set realistic goals so that you can have a strong likelihood of achieving them. A plan that requires you to invest all your funds will be considered useless if you can’t follow through. You may become discouraged and lose interest along the way. Financial goals could also be considered short term(15yrs) or long term(over 5 years) goals. For instance, a shortterm goal could be to get enough money to buy a new car in six months, an intermediate goal could be to pay off bank loans and a long term goal could be accumulating enough wealth to maintain a comfortable lifestyle over the years. However, goals differ from person to person and most times, depend on your current financial situation. Step 2: Consider your Financial position Your financial goals hinge greatly on your financial situation. Financial decisions always differ among people. Someone who has student loans will have different financial decisions than someone with five kids or a small business. Economic conditions also have a big effect on your financial decisions. The types of jobs that are available and salaries are all affected by the economy. It also affects the prices you pay for services such as rent, medical bills and so on. Step 3: identify and evaluate alternative plans that could achieve your goals. Now that you have established your financial goals, it is important that you have a financial plan to move you away from your current financial position. Pursuing additional education. Pursuing an additional education might enable you to achieve the necessary credentials to obtain the career and income level you need fulfil your financial goals. Selecting your major One of the most important education decisions is selecting your major. Your choice of major would influence your career type, your lifestyle and income over time. Selecting your college Your collection selection is crucial because the cost of an education varies among college. Hence, a wise selection is very necessary and it will enable you to complete your education at a relatively low cost. Building a strategy for wealth creation Along with planning for additional education, it is crucial for you to plan to save money for longterm financial goals. However, you can alternatively plan to save a portion of your income and invest those savings in a manner that earns a very high return so that you can accumulate a substantial amount in 12 years. Step 4: Select and implement the best plan for achieving your goals You need to analyze and select the plan that will be most effective in achieving your goals. Many alternative plans that could possibly achieve your goals involve tradeoffs. For instance, your long term goals may be starting a company of your own and to do that, you need to pursue a major in college such as business administration or economics. Doing this would mean spending time and money over the next few years to achieve the goal. Lots of people do not meet their financial goals due to unrealistic financial plans. The internet provides valuable information about making financial decisions. Step 5&6 :Revising and Evaluating your financial plan. After you develop and implement each component of your financial plan, you have to monitor your progress to ensure that the plan is working as you intended. Once you find that you are unable to follow your plan, then you need to revise it or better still make it more realistic. Financial goals also have to be modified as well.
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