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FM ELEC 2- PERSONAL FINANCE

CHAPTER 1: UNDESTANDING PERSONAL FINANCE

1. The Building Blocks to Achieving Personal Financial Success

2. The Economy Affects Your Personal Financial Success
3. Think Like an Economist When Making Financial Decisions
4. The Time Value of Money
5. Where to Seek Expert Financial Advice

Overview

Your financial literacy is your knowledge of facts, concepts, principles, and

technological tools that are fundamental to being smart about money. Financial
literacy empowers you. It improves your ability to handle day-to-day financial matters,
helps you avoid the consequences of poor financial decisions that could take years to
overcome, and helps you make informed and confident personal money decisions.
Personal finance is the study of personal and family resources considered important
in achieving financial success; it involves how people spend, save, protect, and
invest their financial resources. Topics in personal finance include financial and
career planning, budgeting, tax management, cash management, credit cards,
borrowing, major expenditures, risk management, investments, retirement planning,
and estate planning. A solid understanding of personal finance topics offers you a
better chance of success in facing the financial challenges, responsibilities, and
opportunities of life. Such successes might include paying minimal credit costs, not
paying too much in income taxes, purchasing automobiles at low prices, financing
housing on excellent terms, buying appropriate and fairly priced insurance, selecting
successful investments that match your needs, planning for a comfortable retirement,
and passing on your estate with minimal transfer costs.
Financial responsibility means that you are accountable for your future financial
well-being and that you strive to make good decisions in personal finance. Studying
personal finance will help you avoid financial mistakes and show you how to take
advantage of financial opportunities. The biggest barrier to achieving financial
success is to live like you are rich before you are.
Good decision making means you will control your personal financial destiny.

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Study Guide

The following are the learners’ guide to complete this module:

● Learner should make time to read and understand the given module;
● Some parts of the module is in worksheet type for the learners to
have deep exposure about the given topic;
● Other activities are encourage such as web searching, reading open
journals and other reading materials to generate more idea about
certain topic;
● Don’t hesitate to ask relevant questions for better understanding of
the topics.
● You can find help with your friends, cousins and even your parents
but make sure you are the one who will do this module. One on one
monitoring will be done.
● Monitoring of student’s progress will be implemented through mobile
technology (phone interview and graded recitation over phone calls).

Learning Outcomes

At the end of this module, you should be able to:

1. Use the building blocks to achieving financial success.

2. Understand how the economy affects your personal financial success.
3. Apply economic principles when making financial decisions.
4. Perform time value of money calculations in personal financial decision making.
5. Identify the professional qualifications of providers of financial advice.

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Topic Presentation

The Building Blocks to Achieving Personal Financial Success

Today’s marketplace provides a constant barrage of messages suggesting that you
can spend and borrow your way to financial success, security, and wealth. These
messages are very enticing for those starting out in their financial lives. In truth,
overspending and overuse of consumer credit actually impede financial success!
Many people think that being wealthy is a function of how much you earn or inherit. In
reality, it is much more closely related to your ability to understand the trade-off s and
decisions that generate wealth for you. A trade-off is giving up one thing for another.
For example, it is wise to give up some current spending in order to enjoy a
financially comfortable retirement. You have to do only a few things right in personal
finance during your lifetime, as long as you don’t do too many things wrong. Personal
finance is not rocket science. You can succeed very well in your personal finances by
making appropriate plans and taking sensible actions to implement those plans.

Spend Less So You Can Save and Invest More

First, recognize that financial objectives are rarely achieved without forgoing or
sacrificing current consumption (spending on goods and services). This restraint is
accomplished by putting money into savings (income not spent on current
consumption) for use in achieving future goals. Some savings are actually
investments (assets purchased with the goal of providing additional income from the
asset itself). By saving and investing, people are much more likely to have funds
available for future consumption. If you save for tomorrow, you will be happier today.
Saving for future consumption represents a good illustration of the human desire to
achieve a certain standard of living. This standard is what an individual or group
earnestly desires and seeks to attain, to maintain if attained, to preserve if
threatened, and to regain if lost. At any particular time, individuals actually
experience their level of living. In essence, your standard of living is where you
would like to be, and your level of living is where you actually are.

Financial Success and Happiness

Financial success is the achievement of financial aspirations that are desired,
planned, or attempted. Success is defined by the person that seeks it. Some define
financial success as being able to actually live according to one’s standard of living.
Many seek financial security, which provides the comfortable feeling that your
financial resources will be adequate to fulfill any needs you have as well as most of
your wants. Others want to be wealthy and have an abundance of money, property,
investments, and other resources. A fundamental truth of personal finance is that you
cannot build financial security or wealth unless you spend less than you earn. As a

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result, you cannot reach your standard of living without somewhat restricting your
level of living as you save and invest. That’s the trade-off.

Financial happiness encompasses a lot more than just making money. It is the
experience you have when you are satisfied with your money matters. People who
are happy about their finances are likely to be spending within a budget and taking
steps to achieve their goals, and this happiness spills over in a positive way to
feelings about their overall enjoyment of life. Financial happiness is in part a result of
practicing good financial behaviours. Examples of such behaviours include paying
bills on time, spending less than you earn, knowing where your money goes, and
investing some money for the future. The more good financial behaviours you
practice, the greater your financial happiness. In fact, simply setting financial goals
contributes to financial happiness.

Using the Building Blocks

Bridging the gap between one’s level of living and one’s desired standard of living
involves learning about how to achieve financial success. Figure 1.1 shows how the
building blocks of a financially successful life fi t together. Financial success and
happiness come from using the building blocks of personal finance, such as having a
foundation of regular income to provide basic lifestyle and savings, and establishing
a financial base using employee benefits and checking and savings accounts. Other
building blocks include setting financial goals, controlling expenditures, managing
income taxes, handling credit cards, and investing in mutual funds and retirement
plans.

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The Economy Affects Your Personal Financial Success

Your success in personal finance depends in part on how well you understand the
economic environment; the current stage of the business cycle; and the future
direction of the economy, inflation, and interest rates.

Where Are We in the Business Cycle?

An economy is a system of managing the productive and employment resources of
a country, state, or community. The U.S. federal government attempts to regulate the
country’s overall economy to maintain stable prices (low inflation) and stable levels of
employment (low unemployment). In this way, the government seeks to achieve
sustained economic growth, which is a condition of increasing production (business
activity) and consumption (consumer spending) in the economy—and hence
increasing national income. Government policies also affect the economy. For
example, tax cuts keep money in consumers’ pockets, which they are then likely to
spend. Tax increases, in contrast, depress consumer demand.
Business cycle/ economic cycle can be depicted as a wavelike pattern of rising
and falling economic activity; the phases of the business cycle include expansion,
peak, contraction (which may turn into recession), and trough.

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As illustrated in Figure 1.2, the phases of the business cycle are expansion (when
the economy is increasing), peak (the end of an expansion and the beginning of a
contraction), contraction (when the economy is falling), and trough (the end of a
contraction and beginning of an expansion).
The preferred stage of the economic cycle is the expansion phase, where production
is at high capacity, unemployment is low, retail sales are high, and prices and interest
rates are low or falling. Under these conditions, consumers find it easier to buy
homes, cars, and expensive goods on credit and businesses are encouraged to
borrow to expand production to meet the increased consumer demand. The stock
market also rises because investors expect higher profits.
As the demand for credit increases, short-term interest rates rise because more
borrowers want money. Consumers and businesses purchase more goods, exerting
upward pressure on prices. Eventually, prices and interest rates climb high enough to
stifle consumer and business borrowing, send stock prices down, and choke off the
expansion. The result is a period of negligible economic growth or even a decline in
economic activity. In such situations, the economy often contracts and moves toward
a recession. The federal government’s Business Cycle Dating Committee officially
defines a recession as “a recurring period of decline in total output, income,
employment and trade, usually lasting from six months to a year and marked by
widespread contractions in many sectors of the economy.” During recessions,
consumers become pessimistic about their future buying plans.
Eventually the economic contraction ends, and consumers and businesses become
more optimistic. The economy then moves beyond the trough toward expansion,
where levels of production, employment, and retail sales begin to improve (usually
rapidly), allowing the overall economy to experience some growth from its previously
weakened state. The entire business cycle may take six to eight years.

What Is the Future Direction of the Economy?

To make sound financial decisions, you need to know where we are in the business
cycle, how well the economy is doing, and where the economy might be headed. You
can do this by paying attention to some economic statistics that are regularly
reported in the news as. Your knowledge will guide your long-term financial strategy.
An economic indicator is any economic statistic, such as the unemployment rate,
GDP, or the inflation rate (terms discussed in the next few paragraphs), that suggests
how well the economy is doing and how well the economy might be doing in the
future.
Procyclic Indicator A procyclic (or procyclical) economic indicator is one that
moves in the same direction as the economy. Thus if the economy is doing well, this
number typically is increasing, however if we are in a recession this indicator is
decreasing. The gross domestic product is an example of a procyclic economic
indicator. The gross domestic product (GDP) is the broadest measure of the
economic health of the nation because it reports how much economic activity (all
goods and services) has occurred within the U.S. borders. Other examples of

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procyclic indicators are retail sales, industrial production, and number of employees
on nonagricultural payrolls.
Countercyclic Indicator A countercyclic (or countercyclical) economic indicator
is one that moves in the opposite direction as the economy. For example, the
unemployment rate is countercyclic because it gets larger as the economy gets
worse. Similarly, interest rates decline as the economy gets worse.
Leading Indicators Leading economic indicators are those that change before the
economy changes, thus they help predict how the economy will do in the future. The
stock market is a leading economic indicator because it usually begins to decline
before the overall economy slows down. Then the stock market advances before the
economy begins to pull out of a recession. Other examples of leading economic
indicators are the number of new building permits, average number of weekly initial
claims for unemployment insurance, and the consumer confidence index.
A widely watched leading economic indicator is the consumer confidence index. It
indicates the degree of optimism that consumers are expressing about the state of
the economy. It gives a sense of consumers’ willingness to spend. Growing
confidence suggests increased consumer spending.
Use Economic Information in Your Financial Decision Making
A point at which the economy is in the trough of a recession may be an excellent time
to invest in stocks because the economy will soon expand and stock prices will rise.
If economic indicators suggest that the economy is growing steadily, this may be a
good time to invest in common stock and mutual funds as values are likely to
continue to increase. If the economy begins to show clear signs of a slowdown, it
may be a good time to invest in fi xed-interest securities because interest rates are
sure to fall as the government lowers its own interest rates to boost the economy.
Also, this may be a good time to sell stocks as values are likely to decline as the
economy slows.

What Is the Future Direction of Inflation, Prices, and Interest Rates?

Inflation and interest rates typically move in the same direction. Inflation is a steady
rise in the general level of prices. Inflation is measured by the changing cost over
time of a “market basket” of goods and services that a typical household might
purchase. Inflation occurs when the supply of money (or credit) rises faster than the
supply of goods and services available for purchases. It also may be attributed to
excessive demand or sharply increasing costs of production.
Once expectations of inflation get too low, people anticipate falling prices. Deflation
is a broad, sustained decline in prices of goods and services that is hard to stop once
it takes hold. This causes less consumer spending, lower corporate profits, declining
home values, rising unemployment, and lower incomes. The value of assets falls
while debt payments become difficult.

How Inflation Affects Income and Consumption

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When prices are rising, an individual’s income must rise at the same rate to maintain
its purchasing power, which is a measure of the goods and services that one’s
income will buy. From an income point of view, inflation has significant effects.

Example:
Consider the case of Scott Marshall of Chicago, a single man who took a job in retail
management three years ago at a salary of $32,000 per year. Since that time, Scott
has received annual raises of $800, $900, and $1000, but he still cannot make ends
meet because of inflation. Although Scott received raises, his current income of
$34,700 ($32,000 + $800+$900+ $1000) did not keep pace with the annual inflation
rate of 4.0 percent ($32,000 x 1.04 $33,280; $33,280 x 1.04 $34,611; $34,611 x 1.04
$35,996). If Scott’s cost of living rose at the same rate as the general price level, in
the third year he would be $1296 ($35,996 - $34,700) short of keeping up with
inflation. He would need $1296 more in the third year to maintain the same
purchasing power that he enjoyed in the first year.

Personal incomes rarely keep up in times of high inflation. Your real income (income
measured in constant prices relative to some base time period) is the more important
number. It reflects the actual buying power of the nominal income (also called
money income) that you have to spend as measured in current dollars. Rising
nominal income during times of inflation creates the illusion that you are making more
money, when in actuality that may not be true. To compare your annual wage
increase with the rate of inflation for the same time period, you first convert your
dollar raise into a percentage, as follows:

For example, imagine that John Bedoin, a single parent and assistant manager of a
convenience store in Columbia, Missouri, received a $1600 raise to push his $37,000
annual salary to $38,600. Using Equation (1.1), John calculated his percentage
change in personal income as follows:

After a year during which inflation was 4.0 percent, he did better than the inflation
rate because his raise amounted to 4.3 percent. Measured in real terms, John’s raise
was 0.3 percent (4.3 4.0). In dollars, his real income after the raise can be calculated
by dividing his new nominal income by 1.0 plus the previous year’s inflation rate
(expressed as a decimal):

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Clearly, a large part of the $1600 raise John received was eaten up by inflation. To
John, only $115 ($37,115 $37,000) represents real economic progress, while $1485
($1600 $115) was used to pay the inflated prices on goods and services. The $115
real raise is equivalent to 0.31 percent ($115 $37,000) of his previous income,
reflecting the difference between John’s percentage raise in nominal dollars and the
inflation rate.

How Inflation Is Measured

Consumer price index (CPI) is a broad measure of changes in the prices of all
goods and services purchased for consumption by urban households. The prices of
more than 400 goods and services (a “market basket”) sold across the country are
tracked, recorded, weighted for importance in a hypothetical budget, and totaled. In
essence, the CPI is a cost of living index.
The index has a base time period—or starting reference point—from which to make
comparisons. The 2018 to 2020 time period represents the base period of 100. For
example, if the CPI were 212 on January 1, 2018, the cost of living would have risen
112 percent since the base period [(212 - 100) / 100 = 1.12 or 112%]. Similarly, if the
index rises from 212 to 220 on January 1, 2019, then the cost of living will have
increased by 3.8 percent over the year [(220 - 212) / 212 = 0.0377 or 3.8%].
Inflation pushes up the costs of the products and services we consume. If automobile
prices rose 20 percent over the past five years, for example, then it will take $28,800
now to buy a car that once sold for $24,000. Conversely, the purchasing power of the
car-buying dollar has fallen to 83.3 percent of its original power ($24,000 $28,800) fi
ve years ago. If your market basket of goods and services differs from that used to
calculate the CPI, you might have a very different personal inflation rate (the rate of
increase in prices of items purchased by a particular person). Inflation pushes up the
cost of borrowing, so monthly car payments and home mortgage rates increase when
inflation rises.

How Inflation Affects Borrowing, Saving, and Investing

Interest is the price of money. During times of high inflation, interest rates on new
loans for cars, homes, and credit cards rise. Even though nominal interest rates for
savers rise as well, the increases do not provide “real” gains if the inflation rate is
higher than the interest rate on savings accounts or certificates of deposit.
Smart investors recognize that the degree of inflation risk is higher for long-term
lending (5 or 20 years, for example) than for short-term lending (such as a year)
because the likelihood of error when estimating inflation increases when lots of time
is involved. Therefore, long-term interest rates are generally higher than short-term
interest rates. Similarly, stock market investors are negatively affected when inflation
causes businesses to pay more when they borrow, thereby reducing their profits, and
depressing stock prices. When inflation is at 5 percent annually, a dollar of profit that
a company will earn a year from now will be worth only 95 cents in today’s prices. If
instead inflation was only 2 percent, that dollar would be worth 98 cents today. Such
differences add up over many years. Throughout your financial life, you will want to

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factor the impact of inflation into your financial decisions in an effort to avoid its
negative effects.

Think Like an Economist When Making Financial Decisions

Understanding and applying basic economic principles will affect your financial
success. The most important of these are opportunity costs and marginal utility.
Opportunity Costs in Decision Making
The opportunity cost of a decision is the value of the next best alternative that must
be forgone. Examples of personal opportunity costs are time, effort, and health, and
examples of financial opportunity costs are interest, safety, and liquidity. Using the
concept of opportunity costs allows you to address the personal consequences of
choices because every decision inevitably involves trade-off s. For example, suppose
that instead of reading this book you could have gone to a movie or watched
television, but mainly you wanted to sleep. The lost benefit of that sleep—the next
best alternative—is the opportunity cost when you choose to read. Knowing the
opportunity cost of alternatives aids decision making because it indicates whether the
decision made is truly the best option.
In personal finance, opportunity cost reflects the best alternative of what one could
have done instead of choosing to spend, save, or invest money. For example, by
deciding to put $2000 into a stock mutual fund for retirement rather than keeping the
funds readily available in a savings account, you are giving up the option of using the
money for a down payment on a new automobile. Keeping the money in a savings
account has the opportunity cost of the higher return on investment that the stock
mutual fund might pay. This opportunity to earn a higher rate of return is a primary

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consideration when making low-risk investment decisions. Other challenging

opportunity cost decisions are renting versus buying housing, buying a new or used
car, buying or leasing a vehicle, working or borrowing to pay for college, purchasing
life insurance or not, and starting early or late to save and invest for retirement.
Another opportunity cost decision often is returning to college for a graduate degree.
Marginal Utility and Costs in Decision Making
Utility is the ability of a good or service to satisfy a human want. A key task in
personal finance is to determine how much utility you will gain from a particular
decision. For example, if you decide to spend $70 on a ticket to a concert, you might
begin by thinking about what you might gain from the expenditure. Perhaps you’ll
enjoy a nice evening, good music, and so on.
Marginal utility is the extra satisfaction derived from having one more incremental
unit of a product or service. Marginal cost is the additional (marginal) cost of one
more incremental unit of some item. When known, this cost can be compared with
the marginal utility received. Thinking about marginal utility and marginal cost can
help in decision making because it reminds us to compare only the most important
variables. It requires that we examine what we will really gain if we also experience a
certain extra cost.
To illustrate this idea, assume that you consider spending $150 instead of $90 (an
additional $60) for a front-row seat at the concert. What marginal utility will you gain
from that decision? Perhaps an ability to see and hear more or the satisfaction of
having one of the best seats in the facility. You would then ask yourself whether
those extra benefits are worth 60 extra dollars. In practice, people are inclined to
seek additional utility as long as the marginal utility exceeds the marginal cost.

The Time Value of Money

A dollar in your pocket today is worth more than a dollar received five years from
now. Why? Time is money.
The time value of money (TVM) is perhaps the single most important concept in
personal finance. It adjusts for the fact that dollars to be received or paid out in the
future are not equivalent to those received or paid out today. It is easy to understand
that a dollar received today is worth more than a dollar received five years from now
because today’s dollar can be saved or invested and in five years you expect it to be
worth more than a dollar. The time value of money involves two components: future
value and present value.
Two Common Questions in Personal Finance To illustrate the time value of
money, two questions in personal finance are commonly asked:
1. What will an investment (or a series of investments) be worth after a period of
time? This question asks for a future value.
2. How much has to be put away today (or as a series of investments) to provide
some dollar amount in the future? This question asks for a present value.

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As you can see from these two questions, comparisons between time periods cannot
be made without making adjustments to money values. Accordingly, time value of
money calculations compares future and present values by taking into account the
interest rate (or investment rate of return) and the time period involved.
The calculation of interest involves (1) the dollar amount, called the principal, (2) the
rate of interest earned on the principal, and (3) the amount of time the principal is
invested.
One way of calculating interest is called simple interest and is illustrated by the
simple interest formula where i prt where (1.3) p the principal set aside r the rate of
interest t the time in years that the funds are left on deposit.
If someone saved or invested $1000 at 8 percent for four years, he would receive
$320 in interest ($1000 x 0.08 x 4) over the four years.

Compounding
But something is missing here. The simple interest formula assumes that the interest
is withdrawn each year and only the $1000 stays on deposit for the entire four years.
Most people do not invest this way. Instead, they leave the interest earned in the
account so that it will earn additional interest. This earning of interest on interest is
referred to as compound interest. And compound interest is always assumed in time
value of money calculations.
Earning compound interest (or compounding) is the best way to build investment
values over time. Because of compound interest, money grows much faster when the
income from an investment is left in the account. In fact, the deposit of $1000 in our
example would grow to $4,661 after 20 years (the calculation is described in the
following paragraph).
The way to build wealth is to make money on your money, not simply to put money
away. Yes, you need to put money away first. But compounding over time is what
really builds wealth.

Two Types of Time Value of Money Calculations

Essentially there are two types of time value of money calculations: (1) converting
present values to future values (as illustrated in the preceding example) and (2)
converting future values to present values.

Calculating Future Values

Future value (FV) is the valuation of an asset projected to the end of a particular
time period in the future. You can calculate the future value of a lump sum or the
future value of a series of deposits.
Future Value of a Lump Sum Equation (1.4) can be used to calculate the future
value of a lump sum:

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Rule of 72 Reveals Number of Years for Principal to Double

The rule of 72 is a handy formula for figuring the number of years it takes to double
the principal using compound interest. You simply divide the interest rate that the
money will earn into the number 72.
For example, if interest is compounded at a rate of 7 percent per year, your principal
will double in 10.3 years (72 / 7); if the rate is 6 percent, it will take 12 years (72/ 6).
The rule of 72 (see Figure 1.5)

Calculating Present Values

Present value (or discounted value) is the current value of an asset (or stream of
assets) that will be received in the future. You can calculate the present value of a
lump sum to be received in the future or the present value of a series of payments to
be received in the future.
Present Value of a Lump Sum The present value of a lump sum is the current worth
of an asset to be received in the future. Alternatively, it can be thought of as the

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amount you would need to set aside today at a given rate of interest for a given time
period so as to have some desired amount in the future.

The present value formula is PV=FV/(1+i)n, where you divide the future value FV by a factor
of 1 + i for each period between present and future dates.

Problem
Suppose you are depositing an amount today in an account that earns 5% interest,
compounded annually. If your goal is to have $5,000 in the account at the end of six years, how
much must you deposit in the account today?

Solution
The following information is given:

future value = $5,000

interest rate = 5%

number of periods = 6

We want to solve for the present value.

present value = future value / (1 + interest rate)number of periods

or, using notation

PV = FV/ (1 + r)t

Inserting the known information,

PV = $5,000 / (1 + 0.05)6

PV = $5,000 / (1.3401)

PV = $3,731

We can use the present value table (or table of discount factors) to solve for the present value.

PV = FV (discount factor for r and t)

The discount factor, from the table, is 0.7462. Therefore,

PV = $5,000 (0.7462)

PV = $3,731

Where to Seek Expert Financial Advice

At various points in their lives, many people rely on the advice of a professional to
make financial plans and decisions. Often this consultation is focused on a narrow
area of their finances. Professional financial advisers, such as a family lawyer, tax
preparer, insurance agent, credit counselor, or stockbroker, can be helpful. Too often
these people are not impartial because they are salespeople for specific financial
services. They typically want to sell you something rather than have your best
interests at heart. People often find it helpful to obtain the services of more broadly
qualified financial experts.
A financial planner is an investment professional who evaluates the personal
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finances of an individual or family and recommends strategies to set and achieve

long-term financial goals. A good financial planner should be able to analyze a
family’s total needs in such areas as investments, taxes, insurance, education goals,
and retirement and pull all of the information together into a cohesive plan. The
planner may help a client select and prioritize goals and then rearrange assets and
liabilities to fi t the client’s lifestyle, stage in the life cycle, and financial goals. When
appropriate, planners should make referrals to outside advisers, such as attorneys,
accountants, trust officers, real estate brokers, stockbrokers, and insurance agents.
Effective financial advice helps you make better day-to-day financial decisions so you
have more to spend, save, invest, and donate.

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Assessment

To be posted in the Google Classroom

References

Garman, Thomas E. and Forgue, Raymond E. (2010). Personal Finance, Tenth

Edition. South-Western Cengage Learning

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