0133856739_PDF_IM

Instructor’s Manual for

Personal Finance: Turning Money into Wealth Seventh Edition

Sonya Britt Kansas State University

Copyright 2016 Pearson Education, Inc.

Vice President, Product Management: Donna Battista Acquisitions Editor: Kate Fernandes Program Manager: Kathryn Dinovo Team Lead, Project Management: Jeff Holcomb Project Manager: Meredith Gertz

Copyright © 2016, 2013, 2010 Pearson Education, Inc.. or its affiliates. All Rights Reserved. Manufactured in the United States of America. This publication is protected by copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise. For information regarding permissions, request forms, and the appropriate contacts within the Pearson Education Global Rights and Permissions department, please visit www.pearsoned.com/permissions/. PEARSON, ALWAYS LEARNING, and MYFINANCELAB™ are exclusive trademarks, in the U.S. and/or other countries, of Pearson Education, Inc. or its affiliates. Unless otherwise indicated herein, any third-party trademarks that may appear in this work are the property of their respective owners, and any references to third-party trademarks, logos, or other trade dress are for demonstrative or descriptive purposes only. Such references are not intended to imply any sponsorship, endorsement, authorization, or promotion of Pearson’s products by the owners of such marks, or any relationship between the owner and Pearson Education, Inc. or its affiliates, authors, licensees, or distributors.

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ISBN-13: 978-0-13-385673-6 ISBN-10: 0-13-385673-9

Contents Chapter 1 The Financial Planning Process .............................................................................1 Chapter 2 Measuring Your Financial Health and Making A Plan ........................................15 Chapter 3 Understanding and Appreciating the Time Value Of Money ..............................31 Chapter 4 Tax Planning and Strategies .................................................................................53 Part 1 Continuing Case: Cory and Tisha Dumont ...................................................................71 Chapter 5 Cash or Liquid Asset Management ......................................................................83 Chapter 6 Using Credit Cards: The Role of Open Credit .....................................................99 Chapter 7 Student and Consumer Loans: The Role of Planned Borrowing .......................121 Chapter 8 The Home and Automobile Decision .................................................................141 Part 2 Continuing Case: Cory and Tisha Dumont .................................................................163 Chapter 9 Life and Health Insurance ..................................................................................177 Chapter 10 Property and Liability Insurance ........................................................................205 Part 3 Continuing Case: Cory and Tisha Dumont .................................................................225 Chapter 11 Investment Basics ...............................................................................................231 Chapter 12 Investing in Stocks .............................................................................................249 Chapter 13 Investing in Bonds and Other Alternatives ........................................................265 Chapter 14 Mutual Funds: An Easy Way to Diversify .........................................................283 Part 4 Continuing Case: Cory and Tisha Dumont .................................................................301 Chapter 15 Retirement Planning ...........................................................................................311 Chapter 16 Estate Planning: Saving Your Heirs Money and Headaches .............................333 Part 5 Continuing Case: Cory and Tisha Dumont .................................................................347 Chapter 17 Financial Life Events—Fitting the Pieces Together ..........................................357

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©2016 Pearson Education, Inc.

CHAPTER 1 THE FINANCIAL PLANNING PROCESS

CHAPTER CONTEXT: THE BIG PICTURE This chapter introduces the financial planning process and is the first chapter in the four-chapter section entitled “Part 1: Financial Planning.” This section of the text introduces the financial planning process, demonstrates the use of quantitative tools for measuring financial well-being, explains the importance of considering the time value of money in the financial planning process, and shows the impact of taxes on financial decisions. Chapter 1 establishes the foundation of the text by convincing students of the need for financial planning, the steps to be followed, and the benefits to be gained. Basic “principles” of financial management logic are introduced and serve to integrate the remainder of the text. CHAPTER SUMMARY This chapter establishes the importance of financial planning as a continuing process for achieving current and future financial, or lifestyle, objectives. A five-step process for personal financial planning is introduced. Setting financial goals is established as the cornerstone of the financial plan. The three stages of the financial life cycle provide a framework for considering the evolution of a financial plan in response to changing goals. Finally, the relationships among education, earnings potential, career choice, and career management are established. The chapter concludes by introducing the ten principles that guide financial planning and integrate the remainder of the text. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Explain why personal financial planning is so important.

2.

Describe the five basic steps of personal financial planning. a. liquidity

3.

Set your financial goals. a. estate planning b. inflation

4.

Explain how career management and education can determine your income level. 1


2 Keown Personal Finance, Seventh Edition

5.

Explain the personal finance lessons learned in the recent economic downturn.

6.

List the ten principles of personal finance. a. compound interest b. diversification

CHAPTER OUTLINE I.

Facing Financial Challenges A. How might student loan debt affect your future? B. Why isn’t personal financial planning easy? C. What can you accomplish as a result of this text and course? 1. Manage the unplanned 2. Accumulate wealth for special expenses 3. Save for retirement 4. “Cover your assets” 5. Invest intelligently 6. Minimize your payments to Uncle Sam

II.

The Personal Financial Planning Process A. Step 1: Evaluate Your Financial Health B. Step 2: Define Your Financial Goals 1. Specifically define and write down your financial goals 2. Attach a cost to each goal 3. Set a date for when the money is needed to accomplish the goal C. Step 3: Develop a Plan of Action 1. Flexibility 2. Liquidity 3. Protection 4. Minimization of taxes D. Step 4: Implement Your Plan E. Step 5: Review Your Progress, Reevaluate, and Revise Your Plan

III.

Establishing Your Financial Goals A. What are the time horizons for financial goals? 1. Short term 2. Intermediate term 3. Long term B. Why is it important to prioritize, rank, and reevaluate goals so that they become the cornerstone of your financial plan? C. The Life Cycle of Financial Planning 1. Stage 1: The Early Years—A Time of Wealth Accumulation 2. Stage 2: Approaching Retirement—The Golden Years 3. Stage 3: The Retirement Years


Chapter 1: The Financial Planning Process 3

IV.

Thinking About Your Career A. Choosing a Major and a Career 1. Conduct a serious self-assessment to determine skills and interests 2. Research career alternatives to identify careers that value your skills, interests, and abilities 3. Learn more by talking to professionals or academic advisors or using the Internet 4. Choose a career, but don’t ignore earnings potential B. Getting a Job 1. Three reasons to start early 2. Be prepared for the interview, including the most common questions C. Being Successful in Your Career 1. Do your best work 2. Project the right image 3. Understand and work within the power structure 4. Gain visibility for your contributions 5. Take new assignments to gain experience and organizational knowledge 6. Be loyal and supportive of your boss 7. Acquire new skills, particularly skills that are hard to duplicate 8. Develop a strong network of contacts—for future opportunities 9. Uphold and maintain ethical standards—ethical violations end careers D. What Determines Your Income? 1. Earnings determine standard of living 2. Education determines income level E. Keeping a Perspective—Money Isn’t Everything

V.

Lessons from the Recent Economic Downturn A. Recessions can cause worry, stress, and concern for the future B. Avoid overspending, not saving, and acquiring too much debt C. Fund an emergency fund D. Start thinking about and funding retirement at an early age

VI.

Ten Principles of Personal Finance A. Principle 1: The Best Protection Is Knowledge B. Principle 2: Nothing Happens Without a Plan C. Principle 3: The Time Value of Money D. Principle 4: Taxes Affect Personal Finance Decisions E. Principle 5: Stuff Happens, or the Importance of Liquidity F. Principle 6: Waste Not, Want Not—Smart Spending Matters G. Principle 7: Protect Yourself Against Major Catastrophes H. Principle 8: Risk and Return Go Hand in Hand I. Principle 9: Mind Games, Your Financial Personality, and Your Money J. Principle 10: Just Do It!

VII.

Behavioral Insights A. Principle 9: Mind games, your financial personality, and your money



VIII.

Action Plan A. Principle 10: Just do it!

APPLICABLE PRINCIPLES In future chapters, relevant principles considered will be listed to facilitate review and discussion. Because the principles are introduced in this chapter, it is important that students become familiar with the concepts as a foundation for future study and application throughout the text. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Ask students to identify the most difficult step in the financial planning process. In other words, what causes the most uncertainty—getting started, taking action, or evaluating progress and taking the necessary corrective action? Encourage students to defend their answers or use personal examples to justify their choices. How are procrastination and lack of time factors at any step in the process?

2.

You can think of a financial plan as a “financial road map to guide you through life.” Develop a visual display that illustrates this concept and the five steps of the financial planning process. Try to incorporate examples that illustrate how the “new roads” on the map may change over the life cycle.

3. Provide opportunities for students to use Worksheet 1, Personal Financial Goals Worksheet (Figure 1.2 on page 8), to identify short-, intermediate-, and long-term goals relevant to, and realistic for, their personal and financial lifestyle. Anticipated cost could be based on a “guesstimate” or actual research; however, this project could be revisited in Chapter 3, when future value calculations could be incorporated to yield more accurate cost and savings estimates. Discuss how these goals might change in the future. Why might they change? Relate the discussion to why people need and should want a financial plan. 4. Interview three heads of household, each from a household representing a different stage of the life cycle or socioeconomic status. Inquire about their financial planning process and their strategies to identify and save for short-term, intermediate-term, and long-term goals. Report your findings. 5. Visit your campus career counseling office to learn about the services available to assist you with your career search and your job search. What career management services, if any, are available after you graduate?



6. As a foundation for your financial planning, visit the U.S. Department of Labor Career Guide to Industries at www.bls.gov/oco/cg to determine the earnings, benefits, and employment outlook for a position in your career field. What educational requirements are necessary for entry and advancement in the field? 7. To help students relate to their own fear of finance and comfort with money, ask the class to recall (1) their earliest memories of money and its meaning, (2) their personal “awareness” of their socioeconomic status relative to other classmates/friends, and (3) the approximate age when both occurred. Continue the exercise by asking students to identify one word they associate with money (common examples include love, freedom, independence, security, anger, envy, etc.). Conclude the discussion by integrating the themes around the text statement, “either you control your finances, or they control you—it’s your choice.” 8. As a group project, have each member of the group visit a financial professional (e.g., benefits officer, stockbroker, insurance company representative, loan officer, banker, financial planner). Present the list of ten principles that form the foundations of personal finance. Ask the professional to pick the three to five principles that he or she considers to be most important to personal financial success. Share the results in your group and prepare an essay or oral report of your findings. Which principles appear to be most important? REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1. Why is financial planning, or just plain money management, a challenge for most people? Financial planning, or just plain money management, is a problem for most people for several reasons. First, the skills required don’t just happen—they have to be learned. Second, learning the skills isn’t always easy. Classes may not be readily available in high school; good habits may not be taught, demonstrated, or even discussed at home; and financial management topics and vocabulary can be intimidating. Furthermore, a “fear of finance” may develop from family disagreements about money and a lack of financial knowledge. Your salary will not increase as a result of financial planning, but having a financial plan will help you better allocate the money you earn toward the financial goals that are really important to you both today and in the future. Everyone needs to plan their finances by establishing, tracking, and achieving various financial and personal goals for their current and future situation. 2. How does Step 5 of the financial planning process contribute to the idea that “financial planning is an ongoing process”? Step 5 focuses on a review of progress toward goal achievement, a reevaluation of the current financial situation and the need for new or different goals, and the revision of the plan in response to these changes. Because your life situation and life goals will change over ©2016 Pearson Education, Inc.


time, “financial planning is an ongoing process” that keeps your road map up-to-date with your direction of travel. 3. What three characteristics are required to define financial goals? Once identified, why is it important to rank goals? As the foundation of your plan, financial goals should be specific, realistic, and a reflection of your financial and life situation. To define financial goals ask yourself (1) what, (2) how much, and (3) when. In other words, formalize the goal by writing it down, calculating the cost, and determining when the money will be needed. Setting and ranking goals helps you to decide which ones are most important and if you are truly willing to make the commitment to achieve them. 4. Explain the time horizon for short-term, intermediate-term, and long-term goals. Give an example of each. Short-term, intermediate-term, and long-term goals are similar in that all represent important financial objectives to be accomplished in the future. They differ in time horizon. Short-term goals, such as paying off a credit card, can be accomplished in less than one year. Intermediate-term goals require from 1 to 10 years, such as saving enough money for a down payment on a home. The most common long-term goal, which takes decades of savings, is to retire comfortably, that is, not slinging burgers at a fast-food joint or standing for hours as a greeter at a “big box” store for extra income. 5. List and characterize the stages of the financial life cycle. What three financial concerns are addressed across all three stages? Three stages make up the financial life cycle: • Stage 1: The Early Years—A Time of Wealth Accumulation sets the stage for the family and financial lifestyle. It is the longest stage. Buying a home, managing debt, saving for future goals, investing, planning for taxes, purchasing insurance, and beginning an estate plan characterize this stage. Marrying at a later age than normal, divorce, or remarriage may complicate the financial tasks associated with Stage 1. • Stage 2: Approaching Retirement—The Golden Years focuses on final efforts to accomplish retirement plans and to create wealth. Insurance protection and estate plans must be reviewed. Goals, such as paying for a home and children’s education, are achieved. Corporate downsizing, voluntary career changes, responsibility for aging parents, or death of a spouse could interrupt plans for accumulating a retirement nest egg or other wealth. • Stage 3: The Retirement Years focuses on preserving wealth through management of savings and assets. Insurance needs may change, with increasing concerns for medical or nursing home care. Estate planning efforts to reduce taxes and to protect assets for heirs may be important. Remarriage or postponed first marriage that resulted in children born later in life, responsibility for aging parents, or chronic health care needs could complicate wealth preservation after retirement or necessitate part-time employment.



Insurance planning, tax and estate planning, and saving for goals, including periodic reassessment of the retirement goals, are three financial concerns that span the life cycle. 6. Define career planning. How is it related to financial planning? Career planning is a process of learning about yourself and the job market to identify a career field that capitalizes on your skills and interests, provides necessary financial support for your lifestyle, allows the needed balance between work and personal life, and is personally enjoyable and satisfying. The objective of financial planning is to use the income generated from employment and investments (e.g., earned and unearned income) to accomplish the desired lifestyle and standard of living. For most people, their lifestyle is based on their employment earnings. The job pays, and it pays to be happy in the job! 7. List three reasons why college seniors returning to campus for the fall semester should have a résumé already prepared. College seniors should return to campus with a résumé because • The hectic fall schedule will likely prevent you from immediately preparing a résumé. • Starting your job search immediately conveys to employers that you are organized and serious about employment—attributes important to potential employers. • Many companies begin recruiting in the fall. 8. What do you think will be the five most important strategies for success in your career field? Although individual student answers will vary, recommended strategies that are universally applicable include the following: • Do your best work. • Project the right image. • Understand and work within the power structure. • Gain visibility for your contributions. • Expand your knowledge of the operation through new assignments. • Show loyalty and support for your boss. • Continually improve your skills, particularly skills that are hard to duplicate. • Develop a strong network of contacts, for future opportunities including a new job. • Uphold and maintain ethical standards. Ethical violations end careers. 9. Why is financial knowledge the best protection when faced with daily financial decisions? Having a solid foundation of financial knowledge offers protection by doing the following: 1. Enabling you to protect yourself from incompetent advisors 2. Providing you with the impetus to plan for the future 3. Giving you the ability to make intelligent financial and investment decisions 4. Allowing you to apply the principles of personal finance to a wide variety of situations 10. Explain why it is important to review past economic downturns when studying personal finance.



Understanding how economic downturns affect individuals and families indicates how vulnerable Americans are to losses in income and assets. The study of downturns also shows how important personal finance topics are in the daily lives of families. By looking at economic events and how such events shape consumer perceptions, it may be possible to plan in such a way that minimizes future downturns. People tend to have short memories. By studying the past, it is possible to prepare for the future. 11. What are the two reasons investors demand compensation when saving money or making an investment? Explain how Principles 3 and 8 affect the choice to delay consumption. Why might investors who ignore these principles lose money? Investors want compensation for • Postponing consumption. In other words, they are delaying the benefit from spending their money today. • Risk associated with the investment. They want a higher expected return in exchange for choosing an investment with additional risk. Inflation will reduce the purchasing power of investors’ money, so investors should require a rate of return that is greater than the average rate of inflation. Wealth is created by investing savings and allowing the investments to grow over time, which means delaying consumption! Further, the amount of risk prudently undertaken should be in direct correlation to the amount of return available and the length of time the consumption can be delayed. Investors who ignore these principles are more likely to lose money. Principles 3 and 8 address the investors’ decisions to defer spending. Simply stated, investors require a base amount of compensation to cover the loss of purchasing power due to inflation. In addition, they require extra compensation for relinquishing control of their money for longer periods of time or in riskier investments. And the longer the time horizon, or future date when the investment funds are needed, the more risk the investor can take. PROBLEMS AND ACTIVITIES ANSWERS 1.

Studying personal financial planning might help you to accomplish the following: • Manage unplanned events and avoid the problem of going to the coin-operated laundry because your washer is beyond repair and you have no emergency funds for buying a new one. • Accumulate wealth for special goals and avoid the problem of never taking that trip to Australia that you once promised yourself. • Realistically plan for retirement by estimating future costs and the necessary current savings to meet that goal. This will avoid the problem of having to work during your “golden years” or having to sell your home because you can no longer afford it. • Use insurance to “cover your assets” to avoid the problem of driving a car with a badly dented fender because you couldn’t afford the repair bill.



• •

Invest intelligently to avoid the problems associated with poor choices in investment advisors and investment products. Minimize taxes to avoid the problem of paying more taxes than necessary on your income or your investments.

2.

Steps in the financial planning process, and examples related to financial tasks, include: • Step 1: Evaluate your financial health. Task: Record all expenses for a month to compare income and expenses. • Step 2: Define your financial goals. Task: Pay off credit card(s) by the end of this school term. • Step 3: Develop a plan of action. Task: Develop a budget matching income and projected expenses for the remainder of this academic year. • Step 4: Implement the plan. Task: Reduce expenses in problem areas so amounts do not exceed budgeted projections. • Step 5: Review progress on the plan, reevaluate the plan, and revise the plan or start over with a new one. Task: Based on this year, develop a revised budget for next year based on projected income and expenses.

3.

Answers will vary; however, the following are representative: • Pay off credit card(s) by the end of this academic year. • Save $X for a trip during winter break, spring break, etc. • Limit spending on X (recreation, clothing, music, etc.) to $X. • Don’t ask parents for any extra money during this term. • Live debt free this term. Use credit cards only for an emergency. • Don’t carry a balance on credit card(s); pay off the bill each month.

4.

Answers will vary; however, the following is representative: It is important to me to gain financial independence and to manage my money well. That is why I set the goal to stop asking my parents for extra money during this term. This goal reflects my lifestyle and my desire to handle my money more responsibly. The goal will guide my actions by serving as a reminder to think before I spend. That way I won’t spend more than I can afford to pay for with my available funds. My success will be easy to evaluate. If by the end of the term I have not had to “beg” for more money, I will know I have met my goal.

5.

Answers will vary; however, the following is representative: Because the accumulation-of-wealth stage extends into the mid-50s, financing the cost of education could remain important to me should I choose to continue my education or for the education of others who are important to me (spouse, child, etc.). It is not until Stage 2: Approaching Retirement – The Golden Years that the goal of educating children is usually accomplished. During Stage 3: The Retirement Years, estate planning issues are significant, and leaving part of my estate to fund education for my grandchildren could become important.



6.

Answers will be unique to the individual student.

7.

Principle 5 states, stuff happens. Having funds set aside for emergencies is crucial so that when stuff happens, you have the ability and liquidity to meet your need. Liquidity refers to the speed and ease with which you could access those dollars when needed. However, some stuff that happens is simply too expensive for your savings to cover—for example, a tragic auto accident in which you become disabled. Having insurance, with adequate protection for a reasonable price, could cover more of your losses. Basically, the two types of events from which everyone needs protection are the ones we cannot afford or the ones we simply cannot foresee. Principle 7 addresses this protection issue. Instructor’s Note: Although answers will vary, students might currently be protecting themselves with health, auto, renter’s, life, or disability insurance. Some will likely have no insurance but need to consider the implications for their financial future.

DISCUSSION CASE 1 ANSWERS 1.

Financial planning is critical to financial success as the process is repeated throughout the life cycle in response to changing financial and life situations. Through financial planning, goals are accomplished, and new goals are identified. The five-step process begins and ends with evaluation. In the first step, you do a check-up of your financial health as a basis for planning. In the fifth step, you assess your progress on the plan, review your financial health, and revise the plan for future efforts. The middle three steps consist of clarifying financial goals, developing a plan to reach those goals, and putting that plan into action.

2.

As newlyweds, short-term goals important to Jeremiah and Bethany might include paying off any debt they brought to the marriage, reviewing their insurance coverage, and beginning to save for an emergency fund, or other goal. Because she is still in school, purchasing a major item may not be important. Within the next 1 to 10 years, Jeremiah and Bethany must consider funds for a home purchase as well as other assets to support their lifestyle. With children come additional financial planning needs for savings, insurance, and estate planning. Retirement savings will be a long-term goal. Without more knowledge of their financial and life situation, other goals cannot be identified.

3.

The four principles of flexibility, liquidity, protection, and minimization of taxes should guide the development of any financial plan. Without a plan, nothing happens, AND spending is easier than saving. Financial security comes from balancing what you earn with what you spend to meet the needs of today and tomorrow. Financial planning is critical to making that happen. Principle 4 cautions that the tax implications of earning and investing require Jeremiah and Bethany to consider how to maximize the money available after paying their taxes. Principles 5 and 7 parallel the other principles of plan development. Unexpected events in life demand access to cash and flexibility in the budget, or financial plan, to accommodate those costs. Liquidity ensures access to savings without a loss of value. Likewise, planning ahead by purchasing insurance protection provides coverage in



the event the loss exceeds what can comfortably be paid from personal savings due to a major (or minor) catastrophe. 4.

Five tips to help Bethany prepare for job interviews include the following: • Review the commonly asked questions shown in Table 1.3; prepare and practice a succinct answer for each. • Use the library, the Internet, or other sources to learn about the company. • Make a good impression by getting a good night’s sleep, dressing appropriately, and arriving early. • Look and act confident but relaxed. • Thank the interviewer and immediately send a follow-up letter.

5.

Young professionals can ensure success in their chosen careers by (1) updating and maintaining marketable skills, especially those that are not easy to duplicate; (2) understanding and using the organizational power structure to their benefit, including being loyal and supportive of the boss; (3) building a visible reputation for good work, a willingness to take on new challenges, and an image that fits the organization; and (4) developing a strong network of people knowledgeable of their character and capabilities. Doing a good job and working within the organizational mission is always important. Although ethical behavior has always been a professional expectation, recent national attention on the “transparency” of corporate and individual actions has increased the importance of ethical behavior. A loss of confidence by the boss or other co-workers in individual professional integrity can end a career.

6.

Principle 10, just do it, means that Jeremiah and Bethany must make a commitment and avoid procrastination—both critical strategies for success in financial or career planning. Furthermore, positive reinforcement from making progress toward their goals and taking control of their careers and their finances should provide momentum to keep them committed and successful! Granted, they may not be able to achieve all of their goals, but sound planning and evaluation (or self-assessment) can help them set and achieve realistic goals for their situation.


The Delgados are in the accumulation stage of the financial life cycle. This stage is the foundation for the efforts that continue during the latter two stages. It is crucial to have a sound financial plan, based on important goals and controlled spending, to guide them. The longer financial goals are postponed, the more impossible they may seem—another reason for continued inaction and procrastination. Establishing a financial plan is the first step toward action and success. Professional financial advice could benefit the Delgados; however, Principles 1 and 2 offer a caution. Building personal financial knowledge will enable the Delgados • to avoid financial professionals more concerned about their interests than the Delgados’ ©2016 Pearson Education, Inc.


• •

interests, to fully appreciate the need for and the benefits to be gained from financial planning, and to more effectively use their knowledge to respond to changes in the financial environment (e.g., changes in economic conditions or interest rates).

Financial knowledge may also help the Delgados avoid the sunk cost effect of throwing good money after bad. Professionals might suggest replacing some of their financial products, such as insurance policies, or perhaps not continuing to save money in a low earning savings account but investing for a higher return. Understanding more about financial planning principles and products may help the Delgados recognize the benefit of this advice. The same could be true with mental accounting, as the Delgados may need to change their views on savings for different goals, or using windfall money such as a tax refund or employee bonus. Too often, windfall money is “mad money” to be spent, when the best use could be saving for a goal or reducing credit card debt. 2.

$556,895 = $241,080 × 3 × 0.77

3.

Nicholas and Marita can more easily fund the children’s education if they • start early and understand how investments grow over time to build wealth (Principle 3); • understand the relationships among inflation, investment returns, risk and the length of time until the money is needed (Principle 8); and • recognize that investments with higher risk typically yield higher returns and vice versa—lower risk investments typically yield a lower return (Principle 8). To follow these principles, Nicholas and Marita should start investing immediately (even small amounts) in different investments with different risk-return characteristics. As they get closer to the time the children enter college, they should protect their investments and earnings by moving the funds to less risky investment or savings alternatives.

4.

Answers will vary but should include the following three components: • Definition or clarification of the goal (e.g., all costs, tuition only, room and board only, or other variations on costs for a public/state-supported university, private university, community college, or other educational experience) • Future, or inflation-adjusted, cost • Future time, or number of years until the funds will initially be needed An example might be stated as follows: Based on today’s average state-supported university cost for tuition, room and board, and miscellaneous expenses, our goal is to accumulate half of the total inflation-adjusted cost for Jarred and the twins, 16 and 18 years, respectively, in the future. Jarred and the twins will be expected to fund the remaining half of their college expenses through personal savings, employment, or scholarships.



5.

Answers will vary, and could reflect most of the short-term and intermediate-term goals listed in Figure 1.2. The only goals specifically identified by Nicholas and Marita are two long-term goals: • Help fund the children’s education • Retire early and travel

6.

Just like the twins were unexpected, Principle 5 reminds Nicholas and Marita that other unexpected events in life require adequate liquid funds, or investments that could be readily turned to cash without a loss. Having some assets with good liquidity avoids the loss associated with a forced quick sale of assets that are not so liquid. Liquid funds may help with an emergency expense, but large property damage or personal losses (e.g., for medical care, disability, or death) require insurance. With three kids, there is bound to be at least one fender bender! Principle 7 says protect yourself by having the right kind of insurance at the right price. Trying to save and buy insurance while providing for a family of five may tempt Nicholas and Marita to put off saving for longer-term goals like college and retirement, but Principle 6 reminds them that smart spending—for big and little purchases— will help them avoid wasting money needed for more important family needs and goals.


CHAPTER 2 MEASURING YOUR FINANCIAL HEALTH AND MAKING A PLAN

CHAPTER CONTEXT: THE BIG PICTURE As the second chapter in the four-chapter section entitled “Part 1: Financial Planning,” this chapter introduces the processes and financial statements associated with financial planning and budgeting. The fundamentals of record keeping and statement analysis are discussed. Also introduced in this chapter are the financial ratios and how they are used to gauge financial health. These financial statements and formulas lay the foundation for understanding the overall picture of financial planning and Part II: Managing Your Money. An important message to students in this chapter is the importance of starting a financial plan early in the life cycle. Time is one of the biggest allies for a successful plan. CHAPTER SUMMARY This chapter establishes the importance of good record keeping and the use of financial statements. Balance sheets and income statements are the basis for most financial analysis, including the calculation of ratios to measure financial health. The financial ratios discussed measure liquidity, debt, and savings. Strategies for developing and using a cash budget are explained within the broader context of financial planning. The benefits of budgeting, whether for individuals in financial trouble or for those seeking more control over their money, are considered. Lastly, the role of professional financial planners, their services and their costs are presented. Financial planners can validate an existing plan or devise a financial plan. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Calculate your level of net worth or wealth using a balance sheet. a. personal balance sheet b. assets c. liabilities d. net worth or equity e. fair market value f. tangible asset g blue book h. insolvent

15



2.

Analyze where your money comes from and where it goes using an income statement. a. income statement b. variable expenditure c. fixed expenditure d. budget

3.

Use ratios to identify your financial strengths and weaknesses. a. current ratio b. month’s living expenses covered ratio c. emergency fund d. debt ratio e. long-term debt coverage ratio f. savings ratio

4.

Set up a record-keeping system to track your income and expenditures.

5.

Implement a financial plan or budget that will provide for the level of savings needed to achieve your goals.

6.

Decide if a professional financial planner will play a role in your financial affairs.

CHAPTER OUTLINE I.

Using a Balance Sheet to Measure Your Wealth A. Assets: What You Own 1. Monetary assets: cash, checking, and savings 2. Investments: stocks, bonds, and mutual funds 3. Retirement plans: IRAs, 401(k), and Keogh 4. Housing: primary residence 5. Automobiles 6. Personal property: furniture, electronics, and jewelry 7. Other assets: business ownership and collections B. Liabilities: What You Owe 1. Current debt: credit cards, utility bills, insurance premiums, or past due bills 2. Long-term debt: home mortgage, auto loans, and student loans, cash value life insurance loans, bank loans, or installment loans C. Net Worth: A Measure of Your Wealth 1. Insolvency: do you owe more than you own? 2. How age affects net worth guidelines 3. Uses of a balance sheet D. Sample Balance Sheet for Larry and Louise Tate

II.

Using an Income Statement to Trace Your Money A. Personal Income Statement: The Financial Motion Picture 1. Tracks what you take in (income) and what you spend over some period of time


Chapter 2: Measuring Your Financial Health and Making a Plan 17

2. Cash basis: statement based entirely on actual cash flows B. Income: Where Your Money Comes From 1. Sources of income: wages, tips, royalties, salary, bonuses, and commissions 2. Income is the amount earned, not necessarily amount received. 3. Calculate take-home pay, or the money available to spend. C. Expenditures: Where Your Money Goes 1. Fixed expenses: mortgage, rent, and cable TV 2. Variable expenses: food, entertainment, and clothing 3. Major expenditure categories: taxes, food, housing, medical care and transportation D. Preparing an Income Statement: Louise and Larry Tate 1. Use the balance sheet and income statement together to learn more 2. Use the information gained as a foundation for setting budget, or spending, goals III.

Using Ratios: Financial Thermometers A. Question 1: Do I Have Enough Liquidity to Meet Emergencies? 1. Current ratio 2. Month’s living expenses covered ratio 3. Emergency fund B. Question 2: Can I Meet My Debt Obligations? 1. Debt ratio 2. Long-term debt coverage ratio C. Question 3: Am I Saving as Much as I Think I Am? 1. Savings ratio 2. Savings as the top priority

IV.

Record Keeping A. Why is record keeping an important part of the planning process? 1. Accurate record keeping is important for preparing taxes, tracking expenses, and providing information for others in case of an emergency. 2. Record keeping involves tracking your personal financial dealings and storing your financial records in an accessible manner. B. Track all expenditures, including cash, to generate a monthly income statement 1. Use a ledger or computer program to record all transactions. 2. Keep all receipts and records dealing with taxes for 6 years.

V.

Putting It All Together: Budgeting A. Developing a Cash Budget 1. Examine last year’s total income and make adjustments for the current year. 2. Estimate your tax liability. 3. Identify all fixed expenditures. 4. Identify all variable expenditures. 5. Look for ways to reduce your variable expenses. 6. Calculate the amount available for savings. B. Implementing the Cash Budget



1. 2. 3.

Try the budget for a month. Adjust the plan or your expenses as necessary to maintain the plan. Try the envelope system.

VI.

Hiring a Professional A. What Planners Do 1. Make your own plan and have it checked by a professional to find the flaws. 2. Work with a professional and use him/her as a reference tool. 3. Let the professional do it all. 4. Remember Principle 1: The Best Protection Is Knowledge. B. Choosing a Professional Planner 1. Pick a competent planner with accreditation(s) from a professional organization(s). 2. Pick a planner who has experience, offers advice tailored to you, and readily offers referrals to other clients. 3. Understand the four ways planners are paid and consider this when choosing a planner. 4. Contact professional organizations or review their Web sites to get recommendations.

VII.


VII.


APPLICABLE PRINCIPLES Principle 1: The Best Protection Is Knowledge Whether you’re paying a commission-based planner, a fee-only planner, or a planner using some other combination fee structure, you need some knowledge to evaluate the advice given. The planner may have a conflict of interest in that the best product for you may not net the most commission dollars. You are at a disadvantage if you lack the knowledge to tell the difference between sound advice and a sales pitch. Principle 2: Nothing Happens Without a Plan Without a financial map and a starting point, even the wealthiest people would fail when trying to save money. Principle 5: Stuff Happens Budgets must be flexible because, if an unforeseen event occurs and your budget is not flexible, then the incident will have destroyed most of the plan. Adaptability is key when developing a working budget. If the plan is adaptable, then the plan can change as your situation changes.



Principle 8: Risk and Return Go Hand in Hand Emergency funds should be kept in a liquid account. Because the investor incurs less risk, liquid accounts provide a lower return. Liquidity and risk management, not return, are the key reasons for an emergency fund. But access to credit, insurance coverage, and other household characteristics (e.g., multiple earners, consistency of earnings, job stability) should be considered in the decision as to how much of the emergency funds are in lower earning accounts. Principle 9: Mind Games, Your Financial Personality, and Your Money Consider keeping reminders of your goals in your wallet. It will help you focus on the future versus your immediate desire. Make sure you understand and consider the “time value of money” in your decision making. Principle 10: Just Do It! Once you have tracked your expenses and established a budget, be sure to follow through with your plans. Use apps to help you keep track of your spending or keep your receipts and track your expenses manually. Be sure to incorporate saving as a normal expenditure each month. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Using Worksheet 6 (see Checklist 2.1) as a guide, talk to your parents about their recordkeeping system. Offer to assist with organizing the household financial records. Do they have a balance sheet, income statement, or budget to track financial well-being? If not, offer the worksheets from the text as a starting point. Do they handle all financial matters alone or with the help of professionals? What assistance have they received and from whom?

2.

Use Worksheet 7 to track your actual income and expenses for 1 month and then to develop a budget or spending plan for future months. Analyze your income and expenses to determine your spending patterns and any needed changes. (If you don’t actually earn an income, consider your monthly college allowance or periodic withdrawals from summer savings.) See how long you can follow the budget. Should you consider an envelope system for some expenses? (Also, consider using the worksheet to project your finances when moving off campus, accepting a job after graduation, or changing jobs.)

3.

Watch a short video on the Mint.com Web site on how to set up a Mint account. Explore the Web site to determine who funds the program. Read one or more of the personal finance blogs and write a one-page essay on what your learned from the Web site and blog(s).

4.

According to this chapter, “planning and budgeting require control.” Talk to several friends, family members, or acquaintances about the strategies they routinely or occasionally use to control spending and saving. What’s the best advice they could give to a novice financial



manager? Have they automated spending or saving decisions? Share your findings as an oral or written report. 5.

Ask students to reflect on the assets owned by their grandparents, their parents, and themselves. How does the ownership of the seven categories of assets change throughout the financial lifecycle? How does the ownership of different assets change as a percentage of total net worth over the financial life cycle?

6.

Discuss with the class why one financial ratio may be more informative to one household, given the unique financial situation, while another ratio may be more significant to another. For example, how might the household profile differ for a month’s living expenses covered ratio of 0.75, 3.5, or 8.0? What recommendations might be made in response to this ratio, and how might household characteristics affect the interpretation of the ratio?

7.

Write a one-page essay that explains at least four reasons why you believe that people do not budget or develop even a simple plan for balancing income and expenses, including saving for goals. Review Worksheet 1 or Worksheet 2 for examples of financial objectives and goals for which households are most or least prepared.

REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1. What are the steps of the budgeting and planning process? Describe what happens in each step. The first step is to evaluate your financial health, which would include preparing a balance sheet, income statement, and financial ratios. Step two is to define your financial goals. You will need to determine what is important to you, identify the cost of achieving the goal, and determine how much savings is needed to achieve the goal. Step three is to develop a plan of action by adjusting your spending to meet your goals. In step four of the budgeting and planning process, you will implement your plan by taking action to achieve your plan. This could include setting up an automatic savings plan with your bank. Finally, the last step is to continually review your progress, reevaluate, and revise your plan as needed. 2. Why is net worth a measure of financial health? What is the purpose of a personal balance sheet? The balance sheet is often used to diagnose financial health. If the net worth is negative, then the household’s financial health is considered poor. But if the net worth is highly positive, then the household would be considered to be in excellent financial health. By using the information, the household can make sound financial decisions about adjusting savings or expenses to meet identified financial or personal goals.



A balance sheet determines financial position, or net worth. It compares assets owned and liabilities incurred to determine the current level of wealth or net worth. As the name suggests, the two sides balance—the assets minus the liabilities equals the net worth. 3. What information must you gather to develop an accurate balance sheet? What can you learn by annually updating the balance sheet? Calculation of an accurate balance sheet is based on an accurate assessment of the value of all assets and a complete listing of all current and long-term liabilities. Annual updates to the balance sheet help you track your progress toward your goals and to monitor your financial situation, or financial well-being. For example, if you have added several shortand long-term liabilities during the year, the balance sheet will help you detect the overall impact of those decisions. Reflecting on your net worth, may help you decide that regardless of how good the deal, or how pressing the need may appear, continuing to commit income to credit may delay, or derail, your savings for goals. 4.

Define and give examples of the seven categories of assets. How do you determine the current value of your assets? The seven categories of assets are 1. Monetary: This is the most liquid of all assets, which are held as cash or in a form that can quickly be turned into cash with little or no loss of value. Examples include cash, checking and saving accounts, and money market funds. 2. Investment: These assets are considered financial holdings for generating wealth and are less liquid than monetary assets. They include stocks, bonds, mutual funds, and their derivatives. 3. Retirement plans: The individual or his/her employer accumulates these assets to meet future retirement goals. Examples include an IRA, 401(k) or 403(b) plan, Keogh plan, or other company pension plan. 4. Housing: This is a tangible asset that is used by the owner and is considered illiquid. Examples include house and land and usually represent the most valuable asset for most individuals. 5. Automobiles and other vehicles: These are illiquid, tangible assets that depreciate. 6. Personal property: These are tangible assets that are basically illiquid and consist of all possessions, such as furniture, electronics, jewelry, and automobiles. 7. Other assets: Any other assets or monies owed to you but not included in a previous category. Use the fair market value, or “what a willing buyer would pay a willing seller,” to determine the current value of assets. For example, the fair market value of an auto would be entered as an asset, while the corresponding outstanding balance to pay off the auto loan, if applicable, would be a long-term liability.

5.

What is a financial liability? How do you determine the amount owed on current and longterm liabilities? Give examples of each.



A financial liability is the owing or borrowing of money. A current liability is an unpaid bill or debt that will be completely paid off within the next 12 months, such as a 6-month, unsecured loan, a utility bill, or your credit card paid in full each month. In contrast, a longterm liability requires payments that extend beyond the 12-month time frame, like an auto loan, student loan, or home mortgage. Because a balance sheet represents a given date, current liabilities represent all current bills due and payable at that time. Long-term liabilities are represented by the outstanding balance(s) to pay off the loan(s) or mortgage. 6.

Why is net worth a relative and not an absolute measure? For example, why might insolvency be of less concern for a college student than for the student’s parents? The absolute value of net worth can be compared by the same household from year to year, and this comparison is recommended to track progress toward goals. Because household situations, characteristics, and financial goals vary within and across the life cycle stages, net worth is a relative measure for some comparisons. For example, a young professional in Stage 1, Wealth Accumulation, may initially be insolvent until more assets are acquired and student loan debt is reduced. This situation may be unavoidable for the investment in education. However, if the parents are in Stage 2, Approaching Retirement, insolvency would represent a much direr situation and suggest that financial goals are not being met and that the household could experience significant difficulty in meeting future goals.

7.

What information do you need to calculate an accurate income statement? What are likely to be the four largest expenses? In order to accurately complete an income statement, the household must compile all financial records to account for all income and all expenses during the targeted time period. These records include all statements of income, such as wages, salaries, royalties, tips, commissions, dividends, and interest. All amounts will be totaled and recorded in the income portion of the income statement. Also, all fixed and variable expenses must be recorded in the expense portion of the income statement. Checkbook registers, all receipts, and any records of cash expenditures should be reviewed. Taxes, food, housing, medical care, and transportation are the biggest expenses for the average household. However, there may be variations in medical care or transportation expenses depending on the life cycle stage.

8.

Explain the practical difference between a fixed and a variable expense. Over which type of expense does a household have greater control? The practical difference between fixed and variable expenses is that a fixed expense does not change from month to month, whereas a variable expense may change. Also, with a fixed expense, the creditor usually controls the payment amount. Typically, these expenses are established by a contractual obligation, such as a rental contract, auto lease agreement, or home mortgage. The consumer has greater control over variable expenses through the choice of whether to spend or how much to spend. For example, recreation, utilities, or clothing expenses may be controlled, or in some cases, foregone by the consumer. Granted the consumer has a choice not to sign a contract and incur another, or larger, fixed expense.



But once signed, there may be little or no option for reducing the payment. Recall from the text—a major portion of financial planning is taking control of your situation. 9.

Why are financial ratios important diagnostic tools? What three potential problem areas do they highlight? Ratios analyze the information included in the balance sheet and income statement and make it more useable. Results of the ratio analysis can be compared to a preset target or to previous ratio trends for the household. Ratios diagnose if the household is maintaining liquidity, meeting obligations, or saving enough for future expenses.

10. Why are both the current measures and the trends of the ratios over time important measures of financial well-being? Current ratio results can be compared to the recommended standards to diagnose the present household situation. However, some ratios are expected to trend up or down, depending on household circumstances or progression through the life cycle. Tracking the ratios over time offers additional insights about the household financial situation. 11. Explain the debt coverage ratio and the inverse of the ratio. Why is the inverse ratio intuitively more informative? The long-term debt coverage ratio compares total income available for living expenses to total long-term debt payments. A ratio of less than 2.5 would be of concern as it suggests that the amount of income available would not meet the required long-term debt repayment at least 2.5 times. The inverse of the ratio intuitively offers more insight as it reflects the percentage of total income available for living expenses that is required to meet debt repayment. From another perspective, as the inverse ratio increases, say from 40 percent to 48 percent, less and less income (now only 52 percent as compared to 60 percent) is available for variable expenses. 12. List the three most important reasons for keeping accurate financial records. The three most important reasons for keeping accurate records are as follows: • Tax preparation takes less time and is more accurate if neat, up-to-date financial records are maintained. • Expense control is easier if the household maintains records to track expenses thoroughly. • Understanding the household’s financial situation is dependent on accurate and complete records should someone else need information in case of an emergency. Without an accurate record-keeping system, it is easy to feel a lack of control over financial affairs. The most obvious problem that can arise is overspending. Without accurate records, it is very difficult to accurately assess financial well-being—both for the short- and longterm.



13. Where should you keep the following records: non-tax-related checks or credit card slips, a listing of all bank accounts, your investment earnings statements, and copies of your will? Regarding keeping the following records: • Non-tax related checks or credit card receipts over a year old should be shredded, to avoid identity theft, and discarded. If less than a year old, they should be kept in a home file. • Listing of all bank accounts should be kept in a bank safety deposit box. • Investment earnings statements should be kept in a home file. • A copy of the will should be kept in a home file and in the safety deposit box. 14. If there is no legal requirement to be a financial planner, how might Principle 1: The Best Protection Is Knowledge affect your decision to seek professional assistance? What accreditations might you look for when shopping for a planner? Despite the advanced training, planners who generate all or some of their compensation from commissions may function as a salesperson for certain products. Personal finance knowledge is one of the best protections, as noted in Principle1, when choosing professional financial assistance or any of the myriad of financial products required over the life cycle. Knowledge about how to choose a planner (e.g., understanding the scope of services/products needed, recognizing accreditations, and learning about the planner’s practice and experience) is also important. Look for accreditations like PFS, CFP, or ChFC that require testing and experience to earn the designation. PROBLEM AND ACTIVITY ANSWERS 1.

Net worth = assets – liabilities = ($90,000 + $20,000 + $10,000) – ($50,000 + $4,000 + $150) = $65,850 The Lees have a positive net worth of $65,850. This means that if they sold all of their assets and paid off all their debt, they would still have money left over.

2.

Debt ratio =

total liabilities $54,150 = = 0.4513 or 45.13% total assets $120, 000

The ratio tells Mary Jane and Mike that 45 percent of their assets are financed with borrowing. The Lees should track this ratio to make sure it goes down as they age. 3.

After accounting for all expenses, Ed and Marta’s income statement shows $200 available on a monthly basis for savings. Savings ratio =

income available for savings $200 = = 0.0615 or 6.15% income available for living expenses $3, 250



The ratio tells Ed and Marta that approximately 6 percent of their income is available for savings. This amount is significant compared to average, but lower than the oftenrecommended level of 10 percent. The ratio should be compared with past savings ratios and target savings ratios to determine if Ed and Marta are on track to reach their goals.

4.

Current ratio =

monetary assets $6, 000 = = 4.00 current liabilities $1,500

The ratio tells Ojai and Kaya that their monetary assets could pay their current expenses four times. However, this ratio is not truly accurate because it does not include the monthly auto loan payment. The auto loan is not considered a current liability because it will not be satisfied within 12 months. 5.

monetary assets $3,125 = = 3.57 current liabilities $875 With Faith’s available monetary assets, she could meet her current liabilities approximately 3.5 times, which is good. Financial advisors suggest a ratio above 2, with a trend for the ratio to be increasing. income available for savings $738 Savings ratio = = = 0.3075 or 30.75% income available for living expenses $2, 400 Faith is to be commended for her savings rate, but it is lower than the often-recommended level of 10 percent, and Faith’s records show no annual expenditures for recreation. She may have underestimated her living expenses, especially given her monthly credit card and cash expenditures. Accurate ratios depend on accurate records. Current ratio =

Months living expense covered ratio =

monetary assets $3,125 = = 1.38 months annual living expenses 12 $2, 262

An emergency fund equal to 3 to 6 months of expenses is traditionally recommended. Availability of credit to offset committing such a large sum to low earning liquid accounts may reduce the emergency fund. But Faith could meet expenses for just over one month—a precarious financial situation that can only be remedied through increased savings. Debt ratio =

total liabilities $55,100 = = 0.52 or 52% total assets $105,975

The debt ratio suggests that 52 percent of Faith’s assets are financed through borrowing. As is typical, her mortgage represents the bulk of her liabilities as well as her assets. Over time, this ratio is likely to decline; however, an increasing trend would be cause for concern. ©2016 Pearson Education, Inc.


Long-term debt coverage ratio =

income available for living expenses $2, 400 = = 3.02 times long-term debt payments $795

The long-term debt ratio of 3.02 exceeds the recommended minimum of 2.5, which implies that Faith could meet her mortgage and auto payments, her only long-term debt obligations, three times from her current income. The reciprocal of the ratio offers another useful insight on Faith’s financial situation. Of every take-home dollar, Faith has committed 33 percent, or 33 cents, to service long-term debt obligations. Although her long-term debt ratio is high enough not to raise a caution flag, before taking on additional debt she should seriously consider the impact of having less than 67 percent of her take home pay to meet all other expenses. On first inspection, Faith seems to be financially sound. However, based on a review of the ratios and the information provided, Faith should consider the following: • Improving her recordkeeping. She has omitted budget categories that might typically occur (e.g., recreation) and has a lot of “unaccounted for” spending on her credit cards and with cash. • Increasing her savings for an emergency fund and financial goals (e.g., specific goals, retirement, etc.) • Decreasing her spending to increase savings or increasing her income. The latter may not be an option, and the impact of the tax “bite” should not be ignored. • Identifying financial goals and developing a financial plan • Keeping her liabilities low and not adding more debt without first checking her ratios 6.

A budget is a plan for controlling cash flows, specifically income, expenses, and savings. This budget should accurately match a household’s abilities with its financial goals. With a well-planned budget, money will seem to go further, and they will be able to do more with what they have. A strong budget also prepares someone for the future and the unforeseen events that the future holds. A successful budget can only be derived from accurate record keeping; if someone does not know where they are, the best map in the world will not help them get where they want to go. Once an accurate picture of a household’s current financial status is developed through the use of an income statement and balance sheet, one can set goals and plan for the future. With the help of a budget and accurate record keeping, even someone who is not a financial wizard can achieve financial success.

7.

Dario needs to track his expenses for a month to identify how he is spending his money and then evaluate his true needs and wants. He may consider implementing an envelope system for variable expenses that he may have troubles sticking to, such as entertainment and food. Dario may also want to consider using an automated budgeting system, such as Mint, which sends him reminders as he is approaching his spending limit.

8.

According to common practice, an emergency fund should equal approximately 3 to 6 months’ living expenses. However, an exact amount should also be based on job stability, life-cycle stage, credit availability, and lifestyle. For the Potinsky household, the figure



should range between $9,750 and $19,500. To avoid having a large sum in a liquid account earning little interest, they should have some funds available, with the remainder invested with higher earnings. In case of an emergency, they could use credit immediately and then liquidate other assets to repay the bill—assuming all accounts are not charged to the limit. 9.

Student responses will vary, but an example of a $41,000 income would yield an emergency fund ranging from $6,662 to $13,325. $41,000.00 –$8,200.00 –$4,100.00 –$2,050.00 $26,650.00

Starting salary Taxes (20% × $41,000) Retirement (10% × $41,000) Additional savings (5% × $41,000) assumption for example Income to meet living expenses

Assuming another 5 percent of income is saved and the target for the emergency fund is 3 to 6 months, then ⎛ $26,650 ⎞ 3 Months = ⎜ ⎟ × 3 = $6,662.50 ⎝ 12 ⎠ ⎛ $26,650 ⎞ 6 Months = ⎜ ⎟ × 6 = $13,325.00 ⎝ 12 ⎠ The time frame for saving this amount could vary widely, contingent on the individual financial situation and commitment to savings. But again, using the 5 percent additional savings assumption, it should take 3 to 6 years to accumulate the requisite amount by simply dividing the goal by the annual savings amount. DISCUSSION CASE 1 ANSWERS 1.

In order to get an accurate financial picture, Donovan and Rudabeh should prepare an income statement and balance sheet. Donovan and Rudabeh should keep records to develop an income statement and a balance sheet. They will need to document all sources of income. Expense records should include all fixed and variable living expenses, as well as records of all short- and long-term debt payments. Knowledge of their liabilities and assets will enable them to calculate net worth. Based on the income statement and the balance sheet, they can track their ratios to further diagnose their financial situation. With accurate record keeping, they will be able to prepare a budget to control their income and expenses to accomplish future goals.



2.

Their net worth is calculated on a balance sheet by subtracting total liabilities from total assets. $55,000.00 –$32,000.00 $23,000.00

Total Assets Total Liabilities Net Worth

Their income surplus, or income available for savings, is calculated on the income statement by subtracting their total annual living expenses, long-term debt payments, and taxes from their total annual income. Because net income is given, income taxes have already been subtracted. $65,000.00 –$55,000.00 $10,000.00 3.

Net Income Expenses Surplus Income

Assuming their income stopped, Donovan and Rudabeh could meet their current level of living expenses for slightly more than 2.5 months. Months living expense covered ratio =

monetary assets $12, 000 = = 2.62 months annual living expenses 12 $4,583

Depending on availability of credit, job and income stability, life cycle stage, and lifestyle, an emergency fund equal to 3 to 6 months of expenses is recommended. Their monetary savings is inadequate for their emergency needs; furthermore, the total amount is earmarked for the house purchase and is not really available for emergency needs. Debt ratio =

total liabilities $32, 000 = = 0.58 or 58% total assets $55, 000

Donovan and Rudabeh currently have 58 percent of their assets financed—a high proportion considering that they do not own their home. They should track this ratio over time to ensure that it does not continue upward. 4.

Student answers will vary but should include the following. Accurate and recent financial statements are always recommended when determining financial health. Further, past records should be kept as a method for spotting and analyzing financial trends. Also, a list of personal and financial goals would aid in analyzing Donovan and Rudabeh’s financial direction.

5.

To develop their budget, Donovan and Rudabeh need to follow the steps below. • Locate and examine their most recent annual personal income statement. If this is not available, they should accumulate all records to track past income and expenses. • Estimate their tax liability.



• • • • • • 6.

Identify and calculate all sources of fixed expenses (e.g., mortgage, auto loan). Identify and calculate all sources of variable expenses (e.g., food, entertainment). Identify areas for possible reduction in the variable expense category. Determine amount available for savings by subtracting anticipated living expenditures from anticipated take-home pay. Compare anticipated monthly savings with target savings levels required to achieve financial goals. Adapt the budget in accordance with their goals through efforts to earn more, spend less, or downsize the goals.

Principle 6 would be applicable in this situation because of their limited assets and knowledge. Donovan is cautious, but Rudabeh “likes” the idea, therefore they need to carefully balance want with need. Given their anticipated raises, it would be too easy to take the additional money for granted and jump into a housing situation that becomes untenable. A financial planner could help them plan for the purchase of a home and suggest ways to reduce expenses so that they could save more. They could go it alone, but professional advice at a reasonable price could prove to be money well spent, thus enhancing the “smartness” of their purchase.


Tim and Jill should expect to provide the planner with sufficient information to develop an income statement and balance sheet. Both will provide useful insights into the Taylors’ situation and serve as a foundation for calculating the Taylors’ financial ratios. Armed with this information, the planner and the Taylors can project a budget for meeting their short-, intermediate-, and long-term goals. These assessments will be necessary to ensure a smooth transition into retirement and to help the Taylors enjoy the future without worrying about their finances or being forced back into employment.

2.

Knowing the total of their investment assets can be useful in two ways. First, the information can be used to develop a balance sheet to determine their current net worth. It will be important for them to track this periodically to ensure that they are not depleting their assets too quickly. Second, they can use the investment information to project future income and prepare a budget. By preparing a realistic budget to match their income, Tim and Jill will be able to live the “good life,” not overspend their assets, and leave enough money to help pay for their grandchildren’s education. They also will be able to manage their assets better by balancing their goals with their budget.

3.

An income statement can help the Taylors monitor their past income and expenses. Both are likely to change as they transition into retirement. Knowledge of past expenses could be very helpful as they plan for future retirement years. Based on this information, they can develop a cash budget to ensure that they meet expenses and leave the desired amount to their grandchildren without outliving their assets.



4.

Develop a budget in accordance with their goals. Track expenses to control spending. When a lifestyle change occurs, it is very easy to change past spending habits that fostered a strong financial position. By identifying and pricing their goals, tracking their net worth, and budgeting to control spending, Tim and Jill will know exactly how much of the “good life” they can realistically afford. It is always wise to provide for the future by preparing in the present.

5.

Whether or not Tim and Jill continue to work with a financial planner depends on their financial knowledge, time, and commitment. Given their successful, independent, management of their financial situation to date, they may want to develop their own plan and have it reviewed by a planner as confirmation that they are on the right track. But successfully managing a large investment portfolio takes a great deal of time and knowledge. They may prefer to find a reputable planner with appropriate credentials and experience. It will be important for them to shop around to find someone with whom they feel comfortable. A fee-only planner might be the best choice, especially if their current investments are doing well and the Taylors are not interested in making big changes that would generate sales, and commissions, for the planner.

6. The Taylors should track their expenses more closely because overspending without replacement income can be disastrous. In the event of an unexpected bad financial situation or a long downturn in the economy, they would not have the time or resources to rectify their misfortune and achieve their goals. Their big five expenses are likely to be the same as the average U.S. household—taxes, food, housing, medical care, and transportation. Most retirement benefits will be taxable, as will other investment earnings. Depending on the age of the house or appliances, repairs or replacements may be necessary.


CHAPTER 3 UNDERSTANDING AND APPRECIATING THE TIME VALUE OF MONEY

CHAPTER CONTEXT: THE BIG PICTURE This is the third chapter in the four-chapter section of the text entitled “Part 1: Financial Planning.” This section introduces building blocks that are fundamental to the remainder of the text and serve as a foundation for financial planning. The first chapter focused on the importance of the financial planning process, while the second focused on quantitative tools for measuring financial well-being and strategies for developing a budget based on financial goals. This chapter introduces another quantitative concept, the time value of money. Because applications of this concept are made in subsequent chapters on taxes, consumer credit, mortgages, life insurance, investments, and retirement planning, it is critical that the students understand the calculations as well as the logic underlying the time value of money concepts. CHAPTER SUMMARY Compound interest and the time value of money are two important factors to consider when developing a financial plan. This chapter explains the concept of the time value of money under three assumptions: (1) a single payment, “lump sum”; (2) a terminating fixed stream of payments, “annuity”; and (3) a never-ending fixed stream of payments, “perpetuity.” Calculations and applications for present value and future value are illustrated using either a financial calculator or the interest factor tables. Using compound interest to generate returns is dependent on three factors: length of the investment period, amount invested, and the rate of return, or interest rate. The use of these factors to determine the return on an investment is discussed and illustrated with calculations. Finally, amortized loans and perpetuities are discussed and calculated. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Explain the mechanics of compounding. a. compound interest b. principal c. present value (PV) d. annual interest rate (i) e. future value (FV) 31



f. g. h. i.

reinvesting future-value interest factor (FVIFi,n) compound annually rule of 72

2.

Understand the power of time and the importance of the interest rate in compounding.

3.

Calculate the present value of money to be received in the future. a. discount rate b. present-value interest factor (PVIFi,n)

4.

Define an annuity and calculate its compound or future value. a. annuity b. compound annuity c. future-value interest factor for an annuity (FVIFAi,n) d. present-value interest factor for an annuity (PVIFAi,n) e. amortized loan f. perpetuity

CHAPTER OUTLINE I.

Compound Interest and Future Values A. How Compound Interest Works 1. The compound interest equation—FV = PV(1 + i) (a) PV = the present value, in today’s dollars, of a sum of money (b) i = the annual interest (or discount) rate (c) FV = the future value of the investment at a future point in time 2. Reinvesting—how to earn interest on interest B. The Future-Value Interest Factor—FVIF = (1 + i)n 1. This is the future-value interest factor for (i) and (n). 2. Appendix A factor table C. The Rule of 72 1. Estimates how many years an investment will take to double in value D. Compound Interest with Nonannual Periods 1. The shorter the compounding period, the quicker the investment grows. 2. Effective annual interest rate E. Using an Online or Handheld Financial Calculator 1. The TI BAII Plus financial calculator keys (a) N = stores (or calculates) the total number of payments or compounding periods (b) I/Y = stores (or calculates) the interest (either compound or discount) rate (c) PV = stores (or calculates) the present value (d) FV = stores (or calculates) the future value (e) PMT = stores (or calculates) the dollar amount of each annuity payment


Chapter 3: Understanding and Appreciating the Time Value of Money 33

(f) 2.

CPT = is the compute key

Calculator Clues (a) Set calculator to one payment “annual” per year. (b) Set to display at least four decimals, due to how small percentages are in decimal format. (c) Set to “end” mode because most annuity payments are made or received at the end of the period. (d) Every problem has at least one positive number and one negative number. (e) Be sure to enter a zero for any unused variable. (f) Enter the interest rate as a percent rather than a decimal.

II.

Compounding and the Power of Time and Interest A. The Power of Time: money saved now is much more valuable than money saved later. B. Don’t ignore the bottom line, but also consider the average annual return. C. The Importance of the Interest Rate 1. Historical returns 2. The “Daily Double”

III.

Present Value—What’s It Worth in Today’s Dollars? A. Discount rate, or the interest rate used to bring future dollars back to present dollars B. Present-value interest factor (PVIFi,n) C. PV = FVn(PVIFi,n) or FVn /(1 + i)n D. Appendix B factor table

IV.

Annuities—a series of fixed (equal) payments recurring at fixed intervals A. Compound Annuities 1. A series of fixed investments for which to find a future value 2. Future-value interest factor for an annuity (FVIFAi,n) 3. FVn = PMT(FVIFAi,n) 4. Appendix C factor table B. Present Value of an Annuity 1. A series of fixed investments for which to find a present value 2. Present-value interest factor for an annuity (PVIFAi,n) 3. PV = PMT(PVIFAi,n) 4. Appendix D factor table C. How the Interest Rate and Time Work Together D. Amortized Loans 1. Loan obligation paid off in equal installments 2. Examples include car loans and home mortgages E. Amortized Loans with Monthly Payments Using a Financial Calculator F. Perpetuities—an annuity that last forever

VI.




D. Loss aversion VII.

Action Plan A. Principle 10: Just do it! B. Begin saving for retirement C. Automate payments to savings D. Account for inflation E. Save your raises F. Calculate the cost of buying on time

APPLICABLE PRINCIPLES Principle 1: The Best Protection Is Knowledge A little knowledge about compound interest can pay big rewards over time, as well as protect you from inappropriate investment advice. Principle 3: The Time Value of Money Money invested will generate a return, and if those returns are reinvested, subsequent returns will be generated. This is compounding. Conversely, due to inflation, money will be worth less in the future. To avoid this loss in purchasing power, investment returns must exceed the rate of inflation. Principle 9: Mind Games, Your Financial Personality, and Your Money What seems like a long time away is not always that far away. Starting early is important to achieving long-term goals, such as retirement. Principle 10: Just Do It! When looking to compound interest to make money, there is no time like the present. This principle helps remind you that your best ally is time. Don’t forget that the returns generated by reinvested interest will continue to increase over time. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1. Ask older friends or relatives about the cost of specific items (e.g., a gallon of gas, a cup of coffee) during their youth. Also inquire about their average wages in the past. Compare the amounts given to current expenses and income levels. Explain your findings using the time value of money concepts. 2. Have students identify examples of perpetuities. Discuss how the total amount received from the perpetuity increases if the recipient lives longer than anticipated, even though the installment amount remains the same. 3. Have students develop and solve a future-value, a present-value, a future value of an annuity,



and a present value of an annuity problem. Establish the three known variables in each problem and solve for the fourth. Do not always solve for the same variable. Explain the results. 4. Individually or as a group, have students visit a local financial institution and record the interest rates and minimum balance requirements for the various financial products it offers. Using the information gathered, determine how much interest you would earn if you deposited $2,500 in each type of account. For each, calculate your total return subtracting any applicable service charges. 5. Assume you can save $4,000 a year (about $80 per week) after graduation. Set a financial goal for yourself and specify the time frame and cost. Calculate the interest rate required to achieve the goal. Is it possible to achieve your goal, with moderate risk, in today’s financial market? If not, describe the changes that could be made to bring the goal closer to reality. 6. Investigate a specific financial planning issue or decision that involves the use of the time value of money concepts. Describe why it is necessary to make a time value of money calculation. Examples: Determining how much retirement income to withdraw per year over your life expectancy, calculating loan payments, calculating present pension plan contributions needed to fund future benefits, calculating future value of an IRA or 401(k), calculating present value (purchasing power) of money to be received in the future. REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1. What is compound interest? How is compound interest related to the time value of money? Compound interest is interest paid on interest. First, interest is earned on the original amount of principal; then, as the interest is reinvested (by leaving it alone and not spending it), additional interest is earned on the amount reinvested plus the interest on the principal. The more frequently interest is added, or compounded, the faster a given sum of money will grow. Compounding can be done annually, semiannually, quarterly, monthly, or even daily. Relationship to Time Value of Money: Time value of money calculations are based on the growth of a sum of money over a period of time, also known as compounding. In order to solve a time-value calculation, you must know (or assume) an interest rate at which money will compound.



2. What is “future value” and why is it important to calculate? Future value is the value of a certain sum of money at a certain future point in time. This value is of great importance because it allows us to project how much “growth” a certain rate of return will provide. When comparing a portfolio’s estimated future value to the estimated purchasing power of each dollar within the portfolio, the future value serves as a gauge to estimate future standard of living. 3. Describe how you can use the Rule of 72 to make financial planning decisions. The Rule of 72 provides a “ballpark estimate” of how long it takes for a sum of money to double in value. To calculate how long doubling will take, divide the expected annual interest rate into 72; e.g., 72 divided by 6 percent = 12 years. The answer tells the approximate time it will take for a given sum (e.g., $5,000) to double (e.g., $10,000). The Rule of 72 can also be used to project how prices will double through inflation. For example, at 4 percent inflation, prices will double every 18 years (72/4 = 18). 4. What variables are used in solving a time value of money problem with no periodic payments? Which of these variables equals zero when solving a simple present- or futurevalue problem with no periodic payments? Why? The four variables are as follows: • FV—the future value of a sum of money held for N years • N— the number of periods (e.g., years) of compounding • I/Y—the annual interest rate, commonly referred to as either the compound (FV) or discount (PV) rate • PV—the present (current) value of a sum of money To solve a time value of money problem, you must know (or assume) values for three of the above four variables and solve for the fourth. When solving for an annuity there is a fifth variable to be used: • PMT—the periodic payment made or received during the annuity period. However, when solving for a straight present- or future-value, there is no periodic payment being made; therefore, the PMT variable is zero. Note: To solve a time value of money problem using the interest factor tables rather than the time value of money function keys, you must locate the factor using the interest rate and number of periods. This factor replaces both the interest rate and number of period inputs. Once the factor has been determined, it is simply multiplied by the investment amount. This alternative may be used whether the investment is a periodic payment, a present value, or a future value by using the various factor tables.



5. Explain the concept of the time value of money. Explain two ways this concept is relevant in financial planning. The time value of money is the concept that a dollar received today is worth more than a dollar received tomorrow. Therefore, you can’t compare dollar amounts in two separate time periods without adjusting the value of today’s payment forward in time or the later payment backward in time using an interest rate. Importance of concept answers may vary by student; however, the following are representative. To determine how money invested today will grow to fund future financial goals: • Calculate the growth of a single investment—future value • Calculate the growth of a series of investments—future value of an annuity To make an “apples to apples” comparison of money received in different time periods (e.g., past, present, or future): • Calculate the present worth of a single sum of money to be received in the future— present value. • Calculate the present worth of a series of payments to be received in the future—present value of an annuity. To determine the necessary return on an investment held for a number of years: • Determine the present investment requirement to reach a certain goal in the future— required discount rate. 6. What two factors most affect how much people need to save to achieve their financial goals? Interest rate: the amount earned on an investment Time: the number of years during which compounding occurs 7. Why do you think that Albert Einstein once called compound interest the “eighth wonder of the world”? Einstein knew that, given sufficient time, compound interest could truly work wonders. Over time, even small dollar amounts can grow into incredible sums. The sooner money is saved, the more time it has to grow. Compound interest (interest earned on interest) will greatly increase the initial sum invested, especially if money is left to grow for several decades or, in Peter Minuit’s case, centuries. 8. Why might an investor require a greater expected return for an investment of longer maturity? Do you feel you can forecast inflation 2 years from now with greater accuracy than inflation in 20 years? Investors require a greater return because of the increased uncertainty of the future purchasing power of their investment as the time horizon lengthens. It is almost human ©2016 Pearson Education, Inc.


nature to err on the side of having too much; therefore, the further we try to project our needs, the greater the “average need” becomes. 9. Why might you use the anticipated rate of inflation as the discount rate when calculating present value? The most common discount rate is the inflation rate. Using the inflation rate as the discount rate allows for “apples to apples” comparison of the future purchasing power or value of today’s dollars. People are typically more concerned with the relative “purchasing power” of money rather than the absolute “value” of the money. 10. Why is the interest rate in a time value of money calculation sometimes referred to as the discount rate? Why is it also called “inverse compounding”? The process of using present value of money calculations to convert future sums of money into present dollars by “backing out the interest” is called discounting. Therefore, the interest rate used in present value of money calculations is referred to as the discount rate. Discounting is also called “inverse compounding” because, instead of adding interest to a present sum to determine its future value, the interest is “backed-out” of a future sum to determine its present value. 11. Explain in terms of the future-value interest factor why, given a certain goal, that as the period of time to invest increases, the required periodic investment decreases. The future-value interest factor gives a numeric representation of the power of compounding. This shows that as the investment horizon lengthens the total return becomes more a factor of compound interest and less a factor of subsequent investments. 12. What is the primary difference between an annuity and a compound annuity? An annuity typically is defined as a series of equal dollar payments received, whereas a compound annuity is a series of equal dollar payments paid. 13. What is the relationship between present-value and future-value interest factors and present and future interest factors for annuities? Interest factors for annuities are calculated by summing up a number of consecutive presentor future-value interest factors. For example, the future-value interest factor for an annuity of “n” years is simply the sum of individual future-value interest factors for the years 1 through n. Using an annuity factor (rather than individual factors for each year) greatly simplifies what would otherwise be a very tedious math calculation.



14. Define an amortized loan and give two common examples. An amortized loan is one that is paid off in equal periodic payments over time. Two common examples are car loans and home mortgages. 15. Why is it necessary to use a negative present value when solving for N (the number of payments) or I/Y (the rate of return)? Similarly, why does the answer have a negative sign if positive payments were used when solving for a future value on a calculator? The sign, either + or –, used when entering a time value of money equation dictates the direction of the cash flow. Conventionally, all cash outflows or “payments” carry a negative sign, and all cash inflows or receipts carry an implied positive sign. In other words, if the money is flowing away from the investor, then a negative sign is used, but when money is flowing toward the investor, the sign is positive. When using a calculator to solve for N (number of payments) or I/Y (annual interest rate), the calculator requires at least one cash flow in each direction. If the sign is incorrectly entered in the HP BAII Plus, then the calculator will return an “Error 5” message. 16. What is a perpetuity? Name an example of a perpetuity (payments or receipt of income) in personal finance. A perpetuity is a series of equal dollar payments made at the end of a specified time period for an infinite number of time periods. The best example of a perpetuity is a scholarship. PROBLEM AND ACTIVITY ANSWERS 1.

After 18 years, her prize money will have grown to $999,000. The 8% future-value interest factor is closest to 4 (FVIF = 3.996) at the end of year 18. The Rule of 72 can also be used. By dividing the known variable (8%) into 72, the answer is 9, but because you are quadrupling your money, rather than doubling it, you will need to multiply the answer of 9 by 2. Using a financial calculator with PV = -$250,000, FV = $1 million, PMT = $0, and I/Y = 8% results in N being 18.01 years.

2.

It will take approximately 9 years for Linda’s investment to increase in value to $7,755. Factor Table A solution PV $5,000 PMT n/a (FVIF5 %, 9)

1.551

FV

$7,755

Calculator solution PV -$5,000 PMT $0 I/Y 5% N ? FV $7,755 CPT N 8.996 ≈ 9



3.

Paul must earn approximately $30,910 in year ten to maintain equivalent purchasing power. Factor Table A solution PV $23,000 PMT n/a

4.

(FVIF3 %,10)

1.344

FV

$30,912

Calculator solution PV -$23,000 PMT $0 I/Y 3% N 10 FV ? CPT FV $30,910

Assuming annual compounding, Anthony and Michelle will have $81,411 in 25 years. Factor Table A solution PV $15,000 PMT n/a (FVIF7%,25)

5.427

FV

$81,405


Assuming semiannual compounding, they will have approximately $83,774 in 25 years. Factor Table A solution PV $15,000 PMT n/a (FVIF3.5%, 50)

5.745

FV

$86,175

Calculator solution PV -$15,000 PMT $0 I/Y 7%/2 N 25*2 FV ? CPT FV $83,774

Note: For the table solution, you need to average the FVIF for 3 percent and 4 percent to get an approximation for solving for a 3.5 percent rate of return. The difference attributable to the increased compounding frequency is $2,363 = $83,774 – $81,441. Therefore, the shorter the compounding period, the larger the resultant value if all other variables are held constant. 5.

Assuming a one-year period the future value is $5,500. Factor Table A solution PV $5,000 PMT n/a (FVIF10%,1)

1.100

FV

$5,500




Assuming a 20-year period the future value is approximately $33,638. Factor Table A solution PV $5,000 PMT n/a

6.

(FVIF10%, 20)

6.727

FV

$33,635

Calculator solution PV -$5,000 PMT $0 I/Y 10% N 20 FV ? CPT FV $33,637.50

Based on a 5 percent return Ahmed will fall short of his goal with only $8,862 saved. Factor Table A solution PV $6,000 PMT n/a (FVIF5%,8)

1.477

FV

$8,862


Ahmed requires an annual rate of approximately 7 percent to achieve his goal. Factor Table A solution PV $6,000 PMT n/a (FVIF7%,8)

1.718

FV

$10,308

Calculator solution PV -$6,000 PMT $0 I/Y ? N 8 FV $10,283 CPT I/Y 6.97% ≈ 7%

Note: Using a calculator to determine the required rate is easiest; however, in this instance the time value of money factor can be determined by using the equation ($10,283 / $6,000). This results in a factor of 1.714 and is approximately equal to the (FVIF7%,8) 1.718. 7.

This problem is easiest solved using a calculator. Calculator solution PV -$1,000,000 PMT $0 I/Y ? N 2014 – 1967 = 47 FV $9,905,971.09 CPT I/Y 5.0%



8.

Derek’s trust is worth approximately $8,880 today if he is to receive $20,000 at age 35. Factor Table B solution FV $20,000 PMT n/a (PVIF7%, 12)

0.444

PV

$8,880

Calculator solution PV ? PMT $0 I/Y 7% N 12 FV $20,000 CPT PV -$8,880

Derek’s trust is worth approximately $6,331 today if he is to receive $20,000 at age 40. Factor Table B solution FV $20,000 PMT n/a

9.

(PVIF7%, 17)

0.317

PV

$6,340

Calculator solution PV ? PMT $0 I/Y 7% N 17 FV $20,000 CPT PV -$6,331

Your immediate lottery payout would be approximately $573,500 (50,000 × 11.470). Factor Table D solution FV n/a PMT $50,000 (PVIFA6%, 20)

11.470

PV

$573,500

Calculator solution PV ? PMT -$50,000 I/Y 6% N 20 FV $0 CPT PV $573,496.06

10. Richard would be able to withdrawal approximately $54,897 ($500,000 / 9.108) at the end of each year. Factor Table D solution FV n/a PMT $54,896.79 (PVIFA7%, 15)

9.108

PV

$500,000

Calculator solution PV -$500,000 PMT ? I/Y 7% N 15 FV $0 CPT PMT $54,897.31

11. Step 1: You would have approximately $374,220 ($2,275 * 164.491) at the time you retire. Note: Since the match is 50 percent on only the first 3 percent, the matching contribution is only 1.5 percent, rather than 2.5 percent if there was no limit on matching contributions.



Total annual contribution = (0.05 * $35,000) + (0.015 * $35,000) = $2,275 Factor Table C solution PV n/a PMT $2,275

Calculator solution PV $0 PMT -$2,275 I/Y 10% (FVIFA10%, 30) 164.491 N 30 FV $374,217.03 FV ? CPT FV $374,223.90 Step 2: The approximate monthly payment is using the Factor Table D is $3,308.03. Using the calculator and assuming monthly compounding (therefore resetting the payments per year [P/Y] = 12), results in a PMT of $3,284.02. Factor Table D solution FV n/a PMT ? (PVIFA10%, 30) 9.9427*12=113.124 PV Solve for PMT

$374,217.03 $3,308.03

Calculator solution PV -$374,223.90 PMT ? I/Y 10% N 30 FV 0 CPT PMT $3,284.08

Solving for payment using the Factor Table D requires you to multiply the factor for 10 percent and 30 years by 12 because you are assuming monthly compounding. This gives you the factor of 113.124. To solve for payment take 374,217.03/113.124 to get a payment of $3,308.03. 12. Using Appendix C and the formula FV = PMT(FVIFAi %, n years) solves for the following: Annual investment answers (Table C factors) • 20 years—$5,000 × 45.762 (FVIFA8%, 20 years) = $228,810 • 30 years—$5,000 × 113.282 (FVIFA8%, 30 years) = $566,410 • 40 years—$5,000 × 295.052 (FVIFA8%, 40 years) = $1,475,260 Annual investment answers (using calculator) • N = 20, PMT = -$5,000, PV = 0, I/Y =8% • N = 30, PMT = -$5,000, PV = 0, I/Y =8% • N = 40, PMT = -$5,000, PV = 0, I/Y =8%

Therefore, FV = $228,810 Therefore, FV = $566,416 Therefore, FV = $1,295,283

Monthly investment answers (multiply Table C factor by 12 for estimate) • 20 years—$417 × 549.144 (FVIFA8%, 20 years) = $228,993 • 30 years—$417 × 1,359.384 (FVIFA8%, 30 years) = $566,863 • 40 years—$417 × 3,540.624 (FVIFA8%, 40 years) = $1,476,440 Monthly investment answers (using calculator) • N = 20*12, PMT = -$417, PV = 0, I/Y =8/12 • N = 30*12, PMT = -$417, PV = 0, I/Y =8/12


Therefore, FV = $245,622 Therefore, FV = $621,480


•

N = 40*12, PMT = -$417, PV = 0, I/Y =8/12

Therefore, FV = $1,455,750

The difference in dollar amount saved between an annual investment and a monthly investment is $16,812 in 20 years, $55,064 in 30 years, and a $160,467 in 40 years. Reducing the compounding period and increasing the number of investments made during the year can greatly magnify the power compound interest has to drive total returns. 13.

(a) Factor Table A solution PV $6,000 PMT n/a (FVIFA6%, 5)

1.338

FV

$8,028

Calculator solution PV -$6,000 PMT n/a I/Y 6% N 5 FV ? CPT FV $8,029.35

(b) Factor Table A solution PV $6,000 PMT n/a (FVIFA3%, 10)

1.344

FV

$8,064

Calculator solution PV -$6,000 PMT $0 I/Y 6%/2 N 5*2 FV ? CPT FV $8,063.50

(c) Factor Table A solution PV $6,000 PMT n/a (FVIFA12%, 5)

1.762

FV

$10,572

Factor Table A solution PV $6,000 PMT n/a (FVIFA6%, 10)

1.791

FV

$10,746

Calculator solution PV -$6,000 PMT $0 I/Y 12% N 5 FV ? CPT FV $10,574.05 Calculator solution PV -$6,000 PMT $0 I/Y 12%/2 N 5*2 FV ? CPT FV $10,745.09

(d) Factor Table A solution PV $6,000 PMT n/a (FVIFA6%, 12)

2.012

Calculator solution PV -$6,000 PMT $0 I/Y 6% N 12



FV

$12,072

FV CPT FV 14. Your account will be worth $135,012 in 35 years. Factor Table A solution PV $3,500 PMT n/a (FVIF11%, 35)

43.9455

FV

$153,809.25

? $12,073.18


Note: For the table solution, you need to average the FVIF for 30 years and 40 years to get an approximation for solving for 35 years. Your account will be worth $227,503 in 40 years. Factor Table A solution PV $3,500 PMT n/a (FVIF11%, 40)

64.999

FV

$227,496.50


15. If Sarah’s rate of return were 4 percent, she would have to deposit $506,831 today to reach her retirement goal. If her rate of return increased to 14 percent, she would be able to reach her goal in a little more than 10 years. Factor Table B solution FV $2,000,000 PMT n/a (PVIF4%, 35)

0.258

FV

$516,000

Factor Table B solution PV $516,000 PMT n/a (PVIF)

?

FV

$2,000,000

Calculator solution PV ? PMT $0 I/Y 4% N 35 FV $2,000,000 CPT PV -$506,831 Calculator solution PV -$506,831 PMT $0 I/Y 14% N ? FV $2,000,000 CPT N 10.48 years



Note: For the table solution, you need to average the FVIF for 30 years and 40 years to get an approximation for solving for 35 years. You then need to use Appendix B and the formula PV = FV (PVIFi %, n years) to solve: $516,000 = $2,000,000 (PVIFi %, n years) $516,000 / $2,000,000 = (PVIFi %, n years) = 0.258 Looking at the 14 percent column in Appendix B, the 0.258 PVIF is associated with a time of 10 to 11 years. 16. Kirk must earn 15 percent to be able to reach his goal. Factor Table B solution PV -$4,510 PMT n/a (PVIF)

?

FV

$12,000

Calculator solution PV -$4,510 PMT $0 I/Y ? N 7 FV $12,000 CPT I 15%

Note: For the table solution, you need to use Appendix B and the formula PV = FV (PVIFi %, n years) to solve: $4,510 = $12,000 (PVIFi %, n years) $4,510 / $12,000 = (PVIFi %, n years) = 0.376 Looking at the 7 period row in Appendix B, the 0.376 PVIF is associated with an interest rate of 15 percent. 17. Lance’s rate of return was negative 5.28 percent. Factor Table B solution PV -$7,600 PMT n/a (PVIFA)

?

FV

$5,200

Calculator solution PV -$7,600 PMT $0 I/Y ? N 7 FV $5,200 CPT I -5.28%

Note: For the table solution, you need to use Appendix B and the formula PV = FV (PVIFi %, n years) to solve: $7,600 = $5,200 (PVIFi %, n years) $5,200 / $7,600 = (PVIFi %, n years) = 0.684 (reverse the numbers in the formula since you are dealing with a negative rate of return)



Looking at the 7 period row in Appendix B, the 0.684 PVIF is associated with an interest rate of 5 to 6 percent. Because you switched the present value and future value in the equation, you know that the rate of return is actually negative 5 to 6 percent. 18. The better choice is to accept the $100,000 today because the present value of the $300,000 discounted at 11 percent for 13 years is only $77,254. Factor Table A solution FV $300,000 PMT n/a (PVIF11%, 13)

0.258

PV

$77,400

Calculator solution FV -$300,000 PMT $0 I/Y 11% N 13 CPT PV $77,254.28

19. The rate of return on this investment was 24.09 percent. Factor Table B solution PV $0.12 PMT n/a (PVIFA)

?

FV

$9,000

Calculator solution PV -$0.12 PMT $0 I/Y ? N 52 FV $9,000 CPT I 24.09%

Note: For the table solution, you need to use Appendix B and the formula PV = FV (PVIFi %, n years) to solve: $0.12 = $9,000 (PVIFi %, n years) $0.12 / $9,000 = (PVIFi %, n years)

= 0.000

Looking at the 50 period row in Appendix B for an approximation, the 0.000 PVIF is associated with an interest rate of greater than 17 percent. Without a financial calculator, it is not possible to obtain a more precise answer using the tables. 20. If you invest $5,000 in an account earning 8 percent, you will have $1,932,528 in 45 years. If you wait 10 years to begin saving, you will have $861,584 by the time you retire. Factor Table C solution PV n/a PMT $5,000 (FVIFA8%, 45) FV

Calculator solution PV $0 PMT -$5,000 I/Y 8% 434.40 N 45 $2,172,000.00 FV ? CPT FV $1,932,528.09



Factor Table C solution PV n/a PMT $5,000 (FVIFA8%, 35) FV

Calculator solution PV $0 PMT -$5,000 I/Y 8% 204.167 N 35 $1,020,835.00 FV ? CPT FV $861,584.02

Note: For the table solution, you will need to average the factor amount between 40 and 50 years in part one and 30 and 40 years in part two. 21. Your monthly student loan payment will be about $225. Factor Table D solution PV $25,000 PMT ? 9.108*12 = 109.30 (FVIF7%, 15) PMT

$228.73

Calculator solution PV -$25,000 PMT ? I/Y 7%/12 =. 5833% N 15*12 = 180 FV 0 CPT PMT $224.71

22. You will be able to pay off your loan in 143 months. Calculator solution PV $50,000 PMT -$600 I/Y 10%/12 = 0.8333% N ? FV 0 CPT N 142.86 or 143 months Note: Since the table only goes to 50 periods, using the table is not a realistic solution for this problem.



23. It will take a little more than 37 months to pay off the loan off. You paid a total of 37.14 monthly payments of $100, for a total of $3,714 of which $3,000 went toward principle, so $714 went toward interest. Calculator solution PV -$3,000 PMT $100 I/Y 14%/12 = 1.167 N ? FV $0 CPT N 37.14 months Note: Since this problem is solving for the number of months, using the table is not a realistic solution. 24. (Annuity number of monthly payments— using a financial calculator) Chris Griffin has a $5,000 debt balance on his Visa card that charges 18.9 percent compounded monthly, and his minimum monthly payment is 3 percent of his debt balance, which is $150. How many months (round up) will it take Chris to pay off his credit card if he pays the current minimum payment of $150 at the end of each month? If Chris made monthly payments of $200 at the end of each month, how long would it take to pay off his credit card (round up)? Calculator solution PV $5,000 PMT -$150 I/Y 18.9%/12 = 1.575 N ? FV $0 CPT N 47.64 or 48 months Calculator solution PV $5,000 PMT -$200 I/Y 18.9%/12 = 1.575 N ? FV $0 CPT N 32.03 or 33 months Note: Since this problem is solving for the number of months, using the table is not a realistic solution. DISCUSSION CASE 1 ANSWERS 1.

If Jinhee contributes just 5 percent of her salary ($1,850) and earns another $1,850 (100 percent) from her employer’s match, she will save a total of $3,700 a year. • At 8 percent, she’d have $958,510.90 = ($3,700 × 259.057 (FVIFA8%, 40 years)) • At 10 percent, she’d have $1,637,594.10 = ($3,700 × 442.593 (FVIFA10%, 40 years)). ©2016 Pearson Education, Inc.


The employer match is “free money” that shouldn’t be passed up. It is in Jinhee’s best interest to start saving immediately. 2.

Approximately $2,198.49 is required to be saved per year. Factor Table C solution PV n/a PMT $2,198.49

Calculator solution PV $0 PMT ? I/Y 6% (FVIFA6%, 3) 3.184 N 3 FV $7,000 FV $7,000 CPT PMT -$2,198.77 Total interest earned = $7,000 – ($2,198.77 × 3) = $403.69 Approximately $177.95 is required to be saved per month (using a financial calculator). PV $0 PMT ? I/Y 6%/12 = 0.5% N 3*12 = 36 FV $7,000 CPT PMT $177.95 Total interest earned = $7,000 – ($177.95 × 36) = $593.80 By making monthly payments Jinhee will earn $190.11 ($593.80 – $403.69) more interest. 3.

The value of Jinhee’s trust fund value at age 60 is approximately $190,300. Factor Table C solution PV $25,000 PMT n/a

4.

(FVIF7%, 30)

7.612

FV

$190,300

Calculator solution PV -$25,000 PMT 0 I/Y 7% N 30 FV ? CPT FV $190,306.38

Paul’s annual payment would be approximately $12,950. Factor Table D solution Calculator solution PV $100,000 PV $100,000 PMT $12,950 PMT ? I/Y 5% (FVIF5%, 10) 7.722 N 10 FV n/a FV 0 CPT PMT -$12,950.46



Paul’s monthly payment would be approximately $1,060.66 (using a financial calculator). PV PMT I/Y N FV CPT PMT

$100,000 ? 5%/12 = 0.4167% 10*12 = 120 0 -$1,060.66

Paying the loan on a monthly basis would result in an interest savings of $2,225.40 [($12,950.46 × 10) – ($1,060.66 × 120)] over the life of the loan. 5.

Student answers will vary, but these are representative: • “Max out” tax-deferred savings in employer plans. • Increase interest rate earned on investments. • Repay high interest debt as soon as possible. • Shop for a low-rate mortgage.

DISCUSSION CASE 2 ANSWERS (using a financial calculator) 1.

The approximate monthly payment using the calculator is $2,147.29. PV PMT I/Y N FV CPT PMT

2.

-$400,000 ? 5%/12 = .4167% 30*12 = 360 0 $2,147.29

His retirement income will last for 195 months (16.3 years) or until approximately age 72. His portfolio needs to generate $3,000 in income per month ($5,800 – $2,800 retirement annuity). PV -$400,000 PMT $3,000 I/Y 5%/12 = .4167% N ? FV 0 CPT N ≈ 195 months Now his retirement income will last for 945 months (78.8 years) or until approximately age 135. His portfolio only needs to cover $1,700 per month ($4,500 – $2,800).



PV PMT I/Y N FV CPT N 3.

-$400,000 $1,700 5%/12=.4167% ? 0 ≈ 945 months

Factoring in the Social Security benefit and using his current projected expense level of $5,800, he will deplete his portfolio at age 80. Step 1: The value of the portfolio remaining at age 67 is $165,992.44 PV PMT I/Y N FV CPT FV

-$400,000 $3,000 5%/12 = 0.4167% 11*12 = 132 ? $165,992.44

Step 2: Using the future value from above as the new present value calculates that Doug’s portfolio will last an additional 156 months or 13 years. PV PMT I/Y N FV CPT N 4.

-$165,992.44 $1,450 5%/12 = 0.4167% ? 0 ≈ 156 months

Yes, prices will double by the time he is 80 years old. Using the Rule of 72, you determine that, at 3 percent inflation, it takes 24 years for prices to double. The can of soda will cost $2.43 in 30 years assuming 3 percent annual inflation. Factor Table A solution PV $1 PMT n/a (FVIF3%,30)

2.427

FV

$2.43

Calculator solution PV -$1 PMT 0 I/Y 3% N 30 FV ? CPT FV $2.43


CHAPTER 4 TAX PLANNING AND STRATEGIES

CHAPTER CONTEXT: THE BIG PICTURE This chapter, the last in the section entitled “Part 1: Financial Planning,” introduces the tax implications involved in personal financial planning. This chapter discusses the tax structure, major tax features, tax calculations, and federal income tax forms as they pertain to financial planning. Taxes deplete both earned and investment income, and effective financial planning attempts to limit tax losses as much as possible. This chapter helps students understand how to receive as much benefit from their investment as possible, while showing them how to reduce their overall tax liability. CHAPTER SUMMARY This chapter considers the important role of tax laws and regulations within the context of financial planning and investment management. Other non-income-based taxes, such as sales taxes and property taxes, are also introduced. The “pay-as-you-go” tax collection methods are addressed to help students better understand their role as taxpayers. This chapter also introduces the concept of taxable income and illustrates specific tax calculations. Tax rates, tax forms, and tax features are outlined and discussed to promote better tax planning as a component of the financial plan. Also discussed are strategies for filing late or amended returns, for preparing for an audit, and for seeking tax preparation assistance. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Identify and understand the major federal income tax features that affect all taxpayers. a. Progressive or graduated tax b. Tax brackets c. Personal exemptions d. Deductions e. Itemized deductions f. Standard deductions g. Taxable income h. Adjusted gross income (AGI) i. Marginal tax rate or marginal tax bracket j. Tax-deferred k. Capital asset 53



l. Capital gain/capital loss m. Capital gains tax n. Bracket creep 2.

Describe other taxes that you must pay. a. Social Security b. Medicare

3.

Understand what is taxable income and how taxes are determined. a. Dependent b. Total or gross income c. Active income d. Portfolio or investment income e. Passive income f. Adjusted gross income (AGI) g. IRA h. Home equity loan i. Exemption j Child tax credit k. American opportunity credit l. Lifetime Learning tax credit m. Child and dependent care credit n. Earned income credit o. Adoption credit

4.

Choose the tax form that’s right for you, file, and survive an audit if necessary. a. Schedules b. Audit

5.

Calculate your income taxes. a. Keogh plan

6.

Minimize your taxes. a. Trust b. 401(k) plan

CHAPTER OUTLINE I.

The Federal Income Tax Structure A. Marginal Versus Average Rates B. Effective Marginal Tax Rate C. Capital Gains and Dividend Income 1. Principle 3: The time value of money 2. Long-term capital gains on homes 3. Filing status


Chapter 4: Tax Planning and Strategies 55

D. Cost of Living Increases in Tax Brackets, Exemptions, and Deductions E. Paying Your Income Taxes II.

Other Taxes A. Other Income-Based Taxes 1. Social Security or FICA 2. State and local income taxes B. Non-Income-Based Taxes 1. Excise taxes 2. Real estate and property taxes 3. Sales taxes—a regressive tax 4. Gift and estate taxes

III.

Calculating Your Taxes A. Step 1: Determining Gross or Total Income B. Step 2: Calculating Adjusted Gross Income (AGI) 1. Gross income – adjustments = adjusted gross income 2. An adjustment for (almost) everyone: Interest on student loans C. Step 3: Subtracting Deductions 1. Itemizing deductions 2. The standard deduction 3. The choice: Itemizing or taking the standard deduction D. Step 4: Claiming Your Exemptions E. Step 5: Calculating Your Taxable Income, and, from That, Calculating Your Base Income Tax F. Step 6: Subtract Your Credits and Determining Your Taxes Due 1. Child credit 2. The American Opportunity and the Lifetime Learning credit 3. Other tax credits

IV.

Other Filing Considerations A. Choosing a Tax Form B. Electronic Filing 1. Direct deposit 2. Free file C. Filing Late and Amended Returns 1. Filing late 2. Amending returns D. Being Audited E. Help in Preparing Taxes

V.

Model Taxpayers: The Taylors File Their Federal Tax Return A. Determining Gross or Total Income (line 22) B. Subtracting Adjustments to Gross or Total Income and Calculating Adjusted Gross Income (line 37) C. Subtracting Deductions (line 40)



D. Claiming Exemptions (line 42) E. Calculating Total Tax (line 61) VI.

Tax Strategies to Lower Your Taxes A. Maximize Deductions 1. Using tax-deferred retirement programs 2. Using your home as a tax shelter 3. Shifting and bunching deductions B. Look to Capital Gains and Dividend Income C. Shift Income to Family Members in Lower Tax Brackets D. Receive Tax-Exempt Income E. Defer Taxes to the Future

VII.

Behavioral Insights—Principle 9 Applied

VIII.

Action Plan—Principle 10, Just Do It! A. Make your withholding match up with your income. B. Make it easy on yourself—use tax software. C. Keep track of your deductions. D. Know your cost basis.

APPLICABLE PRINCIPLES Principle 3: The Time Value of Money If you can defer paying your taxes, you can invest those dollars to earn a return. Because a dollar today is worth more than a dollar tomorrow, your tax bill is being reduced each day that the money remains invested for you. Principle 4: Taxes Affect Personal Finance Decisions The amount of tax paid is based on income, expenses, and tax-planning decisions from the previous year. Given that the average American spends more than one-quarter of each year earning enough to pay the annual federal, state, and local taxes, it is very important not to overpay. Consider the tax implications when making every financial decision. Principle 9: Mind Games, Your Financial Personality, and Your Money Considering what is really “free” money is an important aspect of tax planning. Calculate your total tax liability for the year, and then determine the best strategy for reducing that amount and how to spread it out over the year. Principle 10: Just Do It With the help of free tax software programs, filing your own taxes does not have to be challenging or expensive. Be sure to keep good records to help with your tax filing each year, though!



SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Ask the class to develop a list of tax benefits to promote socially desirable actions. Consider examples such as the tax benefits of home ownership, continued education, or adoption. What are implications for taxpayers, the economy, or society?

2.

Survey the class about their experiences filing federal tax returns. How many students have completed and filed their returns? How many leave the responsibility to their parents or others? How many have never filed? Discuss which forms they used and why.

3. In groups, review Figure 4.1 and complete one of the following projects: a. Is the advice to “defer income and accelerate deductions” always a good tax planning strategy? Given the projected demands on Social Security and the possibility of rising marginal tax rates, is that good advice for the next few years? b. Select different dates and research the marginal tax brackets and income ranges for each. What social, political, or economic events were cited to explain the rates? Did specific events trigger changes in the rates? Were presidents applauded or criticized for rate changes that occurred during their administrations? Have groups report their findings to the class. 4. Have the class write a one-page paper discussing why taxes are withheld directly from your pay rather than collected on an annual basis. Also, explain how the amount of taxes withheld is determined. 5. Have students save all of their sales receipts for 1 month. At the end of the month, calculate the total sales tax paid and annualize the amount by multiplying it by 12. Compare this amount to your total state income tax withheld or paid for the previous year. If everything remained the same and you were able to itemize deductions on your federal taxes, would you be better off itemizing your state income tax or sales tax? 6. Ask students to call a certified public accountant (CPA) or enrolled agent and explain that they are a student currently studying taxes. Ask the accountant to explain three of the most commonly recommended tax saving strategies and three of the most commonly audited tax return sections. Students should prepare a report on their findings. 7. Invite a CPA or other tax preparation professional to visit the class and present suggestions for (1) record keeping to facilitate tax preparation and (2) record keeping to prepare for a future audit. Ask about their experiences with good and bad record keepers. What are the direct and indirect costs to the consumer? 8. Have students ask their parents about their taxes. Do they follow any of the five taxreduction strategies presented in this chapter? Have students talk to them about the benefit of following one or more of these strategies and summarize their findings in a short paper. ©2016 Pearson Education, Inc.


REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1. How is adjusted gross income different from taxable income? Adjusted gross income (AGI) is defined as a person’s taxable income from all sources minus specific adjustments. AGI is used to determine taxable income, which is income that is subject to taxation. Taxable income is derived by calculating AGI and then subtracting deduction (either the standard or itemized amount) and exemption (reductions for the earner and dependents) amounts from AGI. The three factors that affect taxable income are: a) Adjusted gross income (gross income minus allowable expenses designated as adjustments) b) Deductions (standard deduction amount established by the IRS or itemized deductions) c) Exemptions (IRS-allowed reduction for the earner and each dependent) The tax rate is applied to the taxable income or the difference between income and deductions. 2. If someone is in the 28 percent marginal tax bracket, is that person’s entire income taxed at 28 percent? Why or why not? No. Part of the taxable income will be taxed at the 10 percent tax rate, part of the taxable income will be taxed at the 15 percent tax rate, part of the taxable income will be taxed at the 25 percent tax rate, and the remaining amount of taxable income falling into the 28 percent tax bracket will be taxed at that rate. The amount of taxable income falling into each bracket will vary by filing status. 3. Briefly explain each filing status. How does filing status affect who must file income taxes? How does filing status affect the standard deduction amount? The date of determination for appropriate tax filing status is the last day of the year for which the taxes are being filed. • Single Status: Tax filer in unmarried and does not claim any dependent children. •

Married Filing Jointly (or surviving spouse): Tax filers are legally married at the end of the year or was widowed (widowered) during the most recent two years.

•

Married Filing Separately: Tax filers are legally married, but for some financial or personal (separated, planning on divorce) reason choose to file separate returns. Note: the tax laws are written to discourage this practice.

•

Head of Household: Tax filer in unmarried but claims a dependent child or other relative who lived with the filer for more than half the year and for which the filer provided 50 percent or more financial support.



4. What is meant by “bracket creep”? What method is employed by the IRS to control “bracket creep”? “Bracket creep” refers to the increase in taxes caused by increases in wages to keep pace with inflation. To control bracket creep, the IRS makes annual cost of living, or inflation, adjustments to the marginal tax bracket, the personal exemption, and the standard deduction amounts. 5. List the four methods used for collecting income taxes. How is tax withholding affected by the W-4 form? The primary method for the collection of income tax is “pay-as-you-go.” This means that the taxes are paid as you earn the money rather than once at the end of the year. This is done to keep the public from “feeling the bite” if the taxes were collected all at once. The three other methods are (1) quarterly tax payments, (2) withholdings from investment earnings, and (3) withholdings of gambling or prize winnings. The W-4 tax form provides employers information about a filer’s tax-filing status and any dependents. Therefore, making sure that the form is accurate will assist the employer to make the most appropriate withholding—enabling the filer to neither under- nor overpay taxes. 6. In addition to federal income taxes, what other income-based taxes does the federal government collect? Are these taxes progressive or regressive and how are the taxes calculated? The federal government also collects Social Security and Medicare taxes. The FICA taxes total 7.65 percent of income: 6.20 percent for Social Security up to annually adjusted income caps, and 1.45 percent for Medicare with no cap on income. Applied as a flat tax rate, this tax is neither progressive nor regressive. The tax is not progressive, as the rate does not increase for higher incomes. FICA is not regressive. It does not consume a higher overall percentage of the income earned by those with lower incomes, such as a regressive state sales tax would. 7. List and describe four non-income-based taxes. Be sure to categorize each tax as either progressive or regressive. The non-income based taxes include: • Excise taxes—these taxes are imposed on certain items and are sometimes used to control consumption (e.g., alcohol, tobacco, and gasoline). • Sales taxes—these state taxes are imposed on most, if not all, purchases and are flat taxes in relation to the sales value but could be considered regressive in relation to income level. • Property taxes—these local taxes are based on the assessed value of the item taxed (e.g., real estate and automobiles). If the assertion is that as income increase, then housing values increase, then this tax could be considered progressive. • Gift and estate taxes—these taxes are imposed on the transfer of money or property from one taxpayer to another. Various limits are established to determine the amount of tax ©2016 Pearson Education, Inc.


imposed or if any tax is applicable on the transfer. Gift taxes and estate taxes are both progressive, meaning that as the value of the gift increases, the tax rate also increases. A fairly general description of a progressive tax is a tax rate that increases on a percentage basis as the value of the taxable item increases. Primary examples include personal and corporate income tax and estate tax. Conversely, a flat tax is designed to tax at the same rate regardless of the value of the taxable item. Examples include sales tax, most property tax, and Social Security tax. Finally, a regressive tax is more of an income comparison definition which states that the tax is regressive if takes a larger percentage of the income of low-income people than of highincome people. 8. What are the three primary types of taxable income, as defined by the IRS? The three types of income that make up gross income, according to the IRS, are • Active—income earned from wages or business • Investment—income earned from investments or securities • Passive—income earned from activities in which the taxpayer does not significantly participate 9. What is taxable income, and what is the formula for determining taxable income? Taxable income is the amount of income subject to taxation by either the federal, state, or local government. Gross Income – Adjustments to Income = Adjusted Gross Income (AGI) AGI – Deductions – Exemption(s) = Taxable Income 10. What are the major categories of adjustments to gross income? For a taxpayer in the 25 percent marginal tax bracket, how much would adjustments totaling $10,000 save in taxes? Five primary categories of adjustments to income include the following: • Retirement expenses or traditional IRA tax-deferred contributions: Limited to $5,500 in 2014 if not covered by a retirement plan at work; other income limitations apply if covered by a plan at work. Note that these contribution limits do not include any applicable age 50-and-over catch-up provisions. • Interest paid on student loans • Moving expenses: Note: Limited to moves to a new location at least 50 miles farther from your home than your previous job. • Self-employed benefit expenses: Limited to 50 percent of Social Security and Medicare taxes. • Alimony paid: Provided certain requirements are met. • Health Savings Accounts (HSAs) • Unreimbursed grade-school educator expenses



Assuming that the entire $10,000 savings doesn’t change the marginal tax rate of the filer, then the filer would save $2,500. 11. List the six most common itemized deductions, and describe the limits set on each. The six categories of itemized deductions are as follows: • Medical and dental expenses—health insurance premiums and expenses not reimbursed for medical treatment, hospital care, and prescription drugs are tax deductible. However, the deduction is limited to the amount that these expenses exceed 7.5 percent of AGI. • Tax expenses—all state and local income taxes, as well as real estate and personal property taxes are deductible. In certain situations, state sales taxes are also deductible. • Interest expenses—interest paid on mortgages, home equity loans, and investment loans are all tax deductible. However, the tax deduction is limited to home equity loans up to $100,000. The deductibility of interest paid on investment accounts is also limited to the amount of investment income earned. • Charitable gifts—all charitable gifts to a qualified organization are tax deductible. If a single gift is over $250, a receipt is required for verification. • Casualty and theft loss—applicable to taxpayers with huge losses or very low income. Regulations regarding exclusions, insurance reimbursement, and limitations based on AGI further restrict the use of this deduction. • Miscellaneous—deduction for various job-related, tax preparation, and investmentrelated expenses. Only the amount that exceeds 2 percent of AGI is actually deductible. 12. What “tests” must be met to qualify as a dependency exemption? As a personal exemption? Dependents must pass the relationship or household member test. Almost any relation short of cousin qualifies. If the person being claimed as a dependent is not related, then that person must have lived with the tax-filer for the entire year. Everyone who files an income tax return is eligible to claim a personal exemption unless the filer is being claimed as a dependent on another filer’s return. 13. What is the American Opportunity Credit, and what are the eligibility requirements for receiving the credit? How does the credit differ from the Lifetime Learning Credit? The American Opportunity Tax Credit (AOTC) is a refundable federal credit designed to help offset undergraduate college education expenses. The credit provides up to $2,500 in tax credits of the first $4,000 of qualifying educational expenses. The credit will only be available through 2017 (unless Congress acts to extend the credit). The Lifetime Learning tax credit differs from the AOTC in terms of eligibility. Claiming the Lifetime Learning tax credit is contingent on meeting the following criteria: • Student is enrolled at an accredited vocational school, college, or university or is continuing education as a working adult; hence, this credit is not available during the first two years of enrollment;



• • • •

Maximum tax credit of $2,000 per year for tuition and book expenses (not room and board) for the household, calculated as a credit of 20 percent of the first $10,000 of eligible expenses; Parent(s) must pay the tuition and list the student as a dependent; Financial aid and scholarship funds can reduce the amount of the credit; Income restrictions, based on modified AGI adjusted annually for inflation, apply for a phase-out range and elimination of the credit.

Other credits a household might claim, if applicable and contingent on income restrictions, include the child credit, the child and dependent care credit, the earned income credit, or the adoption credit. 14. What is the maximum allowable taxable income for filing a 1040A or 1040EZ income tax form? Taxable income must be less than $100,000 to file the 1040A or 1040EZ forms. 15. Electronic filing of tax returns offers distinct advantages. What are they? What precautions must be taken when using Free File? Electronic filing of federal tax forms, either by a professional or the taxpayer, offers the following advantages: • Faster refunds through direct deposit or checks in the mail • More accurate returns as the IRS computers check submitted forms for errors or omissions prior to electronic confirmation • Quick electronic acknowledgement from the IRS; TeleFilers receive a confirmation number while still on the phone • Elimination of paperwork to file • Easy payment options by electronic bank account withdrawal or credit card charge • Expedited filing as the IRS forwards the necessary information to the appropriate agency in 37 states and the District of Columbia • FreeFile provides free tax filing for qualified persons provided they access the site through the IRS.gov Web site 16. What federal income tax form is used when filing a late or amended return, and what is the procedure that must be followed? To file a late return, the taxpayer must submit an IRS Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, and enclose a check for the estimated taxes owed. If the taxpayer does not enclose a check, then the IRS will charge interest on the estimated taxes. If the taxes due exceed 10 percent of the annual tax bill, then the IRS imposes a late penalty of one-half percent per month on the late taxes. Form 1040X, Amended U.S. Individual Income Tax Return is used to correct a mistake, claim an overlooked deduction, or to take advantage of a retroactive IRS change. Note the



limitation for filing an amended return is 3 years after the original tax due date that you filed. Amendments to the state and local returns may also be necessary. 17. In addition to random selections, what are the four most common “signals” the IRS looks for when selecting taxpayers for audits? The most common “signals” that the IRS looks for when selecting taxpayers to audit include the following: • Previously audited, particularly if an error was discovered • Income over $100,000 • Deductions in excess of 44 percent of income • Schedule C for self-employment income • Schedule C expenses greater than one-third of Schedule C income 18. What are the five general tax reduction strategies? Give a brief synopsis of each. The five general tax-reduction strategies are the following: • Maximize deductions by (1) using tax-deferred retirement programs to reduce taxable earnings, (2) using your home as a tax shelter (i.e., mortgage interest deductibility; avoidance of capital gains; home equity loan interest deductibility), and (3) shifting and bunching deductions over multiple years to increase the itemized deduction. • Take advantage of reduced tax rates on long-term capital gains, which are taxed at a lower rate than the marginal tax bracket rate. • Shift income from a family member in a higher tax bracket to a family member in a lower marginal tax bracket to reduce the taxes paid and to allow the asset to grow faster. Transferring an asset from a taxpayer in the 30 percent marginal tax bracket to another family member in the 15 percent bracket would reduce the tax liability by 15 percent. Transfers can be complicated and require a gift or trust. • Receiving tax-exempt income, such as interest from municipal bonds, does not create a tax liability. • Deferring taxes into future tax periods allows the taxpayer to avoid taxation today. Money that would have been required to pay taxes can continue to earn interest or dividends. PROBLEM AND ACTIVITY ANSWERS 1.

The Lees’ marginal tax bracket is 15 percent as shown in Table 4.1. 2014 $68,000.00 $0.00 –$12,400.00 –$15,800.00 $39,800.00

Gross Income Adjustments Standard Deduction, Married filing jointly Exemptions (x4) Taxable income



2014 $1,815.00 +$3,247.50 $5,062.50 – $2,000.00 $3,062.50

Liability (10% bracket) Liability (15% bracket) Total tax liability Tax credits (Child tax) Final tax liability

Average tax rate 2014: Total Tax Liability = Total Income 2.

$3,062.50 = 4.50% $68,000

Assuming the 25 percent marginal tax bracket, Investors A, B, and C will not pay the same amount of taxes on their investment proceeds ($225, $375, and $225, respectively). Investors A and C will have more money available than Investor B, as shown below. Investors A and C will have $1,500 × (1 – 0.15) = $1,275 available after paying the federal income tax based on preferential rate of 15 percent for qualified dividends and long-term capital gains. Investor B will have only $1,500 × (1 – 0.25) = $1,125 after paying the 25 percent federal income tax because no preferential rate is available for interest income. For taxpayers in the 15 percent marginal tax bracket, the rate for qualified dividend income or long-term capital gains drops to 0 percent, while the interest income would be taxed as ordinary income. Using the formulas above, Investors A, B, and C would pay $0, $225, and $0, respectively, as a result of their dividend income, interest income, and long-term capital gains income.

3.

Until the end of the second calendar year following the death of a spouse, a surviving spouse may choose to continue file “jointly” if certain criteria are met. To use this filing status, Sukeeta must have • a dependent child living with her, • paid more than half the cost of keeping her home, • and must not have remarried. It is in Sukeeta’s best interest to continue filing “jointly” as the standard deduction is higher and the tax rates are lower for larger amounts of income. After the two years have passed, Sukeeta may file as Head of Household rather than Single status for the reasons cited above.

4.

The couple could claim exemptions of $19,750 ($3,950 × 5) in 2014, based on two exemptions for the couple and three for the dependent children.

5.

The Mayberrys must use Form 1040. Although they meet the income requirements to use the 1040EZ or 1040A, itemizing deductions is not allowed on any Form except the 1040.



6.

Note: Students will need to obtain tax bracket information for head of household returns (e.g., http://www.forbes.com/sites/kellyphillipserb/2013/10/31/irs-announces-2014-taxbrackets-standard-deduction-amounts-and-more/). The single parent taxpayer’s total 2014 tax liability is $2,740.00, assuming the $1,000 child tax credit is the only credit available to the taxpayer and the filer uses the Head of Household status.

7.

2014 $46,250.00 $0.00 –$9,100.00 –$7,900.00 $29,250.00

Gross Income Adjustments Standard Deduction, Head of household Exemptions (x2) Taxable income

2014 $1,295.00 +$2,445.00 $3,740.00 – $1,000.00 $2,740.00

Liability (10% bracket) Liability (15% bracket) Total tax liability Tax credits (Child tax) Final tax liability

The estimated 2014 tax liability using the standard deduction is $4,565.00. The estimated 2014 tax liability using itemized deductions is $4,542.50. Standard $55,100.00 $0.00 –$12,400.00 –$7,900.00 $34,800.00

Itemized $55,100.00 $0.00 –$13,750.00 –$7,900.00 $33,450.00

Gross Income Adjustments Deduction Exemptions (x2) Taxable income

Standard $1,815.00 +$2,497.50 $4,312.50 – $0.00 $4,312.50

Itemized $1,815.00 +$2,295.00 $4,110.00 – $0.00 $4,110.00

Liability (10% bracket) Liability (15% bracket) Total tax liability Tax credits Final tax liability

Itemized deductions = (Mortgage Interest) + (Real Estate and State Income Taxes) $13,750.00 = $7,900.00 + $5,850.00 (Note: $800 in job-related expenses are not deductible because they do not exceed the 2 percent of the $55,100 (AGI), or $1,102 threshold.)



Shameka and Curtis will save money by claiming the itemized deductions. In general, it almost always wiser to deduct the larger of the standard or itemized deduction amounts to reduce the tax liability. 8.

Assuming that Salem Marcos can itemize her deductions on her federal income taxes, she would pay less federal taxes by itemizing the sales tax paid. State income tax = $41,250 × 0.03 = $1,237.50 Sales tax = $1,300.00 Although the benefit may not be worth the effort to track the sales tax, she would save 25 percent of the $62.50 difference, which is $15.63.

9.

Lifetime Learning tax credit = $8,500 × 0.2 = $1,700 The maximum annual tax credit is limited to $2,000 (20 percent of the first $10,000 spent for tuition and related expenses).

10. Gordon’s total estimated tax liability in 2014 is $6,700. Gross Income = $51,800.00 = $40,000 + $4,000 + $7,800 $51,800.00 $0.00 –$6,200.00 –$3,950.00 $41,650.00

Gross Income Adjustments Standard Deduction, Single Exemption Taxable income

$907.50 $4,173.75 +$1,187.50 $6,268.75 – $0.00 $6,268.75

Liability (10% bracket) Liability (15% bracket) Liability (25% bracket) Total tax liability Tax credits Final tax liability

His 2014 average tax rate is 12.10 percent, based on an estimated tax liability of $6,268.75. 11. Aliza’s total tax liability for 2014 is $14,808.25. 2014 $55,000.00 $907.50 $4,173.75 +$4,525.00 $9,606.25 – $0.00 $9,606.25

Taxable income Liability (10% bracket) Liability (15% bracket) Liability (25% bracket) Total tax liability Tax credits Final tax liability



Other 2014 tax liabilities: • Social Security = $68,000 × 0.0620 = • Medicare = $68,000 × 0.0145 = Total additional tax liability

+ $4,216.00 + $ 986.00 $ 5,202.00

Note: Because Aliza is self-employed, her Social Security and Medicare tax liability is actually doubled because she is responsible for both the employee and employer portions of the tax. However, Aliza would also receive a tax deduction for the employer portion of the tax. 12. To prepare for the audit Mrs. Hubbard should • Reexamine the areas where the IRS raised questions. • Gather all supporting documents (e.g., checks, receipts, and records). • Anticipate probable questions and develop responses. • Hire an accountant or tax attorney, if necessary. If the audit turns out unfavorably, Mrs. Hubbard can • Appeal with the auditor, by presenting additional material. • Appeal with the auditor’s manager. • File a formal appeal with the IRS. • Go to tax court. 13. To reduce future estate taxes, the Potters should consider “shifting income to family members in lower tax brackets.” Establishing trusts and giving gifts can accomplish this. The Potters could each give $14,000 per year ($28,000 as a couple) to other people or an unlimited sum to charity for tax year 2014. As long as the gift value is below the threshold, neither the giver nor the recipient will pay any taxes on the gift. Furthermore, the income earned on the gift-asset will be taxed at the lower rate of the recipient, allowing the gift to grow faster than if the Potters had maintained possession. DISCUSSION CASE 1 ANSWERS 1.

Yes, Martha’s unreimbursed medical expenses are deductible on the Neals’ return. Martha qualifies as a dependent because she • Passes the relationship or household member test. • Does not have earnings greater than the exemption amount. • Provides less than half of her support, or living expenses. • Is a U.S. citizen.

2.

Although Martha qualifies as a dependent, thus triggering lower income tax filing thresholds, she does not have additional income; therefore, her Social Security income is inadequate to require filing of a separate tax return.

3.

There are two tax advantages associated with Holly’s education expenses. First, they can claim a Lifetime Learning tax credit equal to 20 percent of qualifying expenses of $5,450, or



a $1,090 credit, as the Neals’ income is below the income phase-out for the credit. Second, the $590 in interest payments is an adjustment to income for the tax year, because the Neals’ income is less than the phase out level for eligibility. 4.

The Neals will be able to deduct any expenses exceeding 7.5% of AGI. $56,900.00 (Gross Income = W2 inc. + 1099 inc. + gambling winnings) – $5,000.00 (Adjustment for IRA Contribution) – $590.00 (Adjustment for Student Loan Interest) $51,310.00 (AGI) The amount that exceeds the AGI threshold is $3,848.25 (0.075 x $51,310). Consequently, the Neals will be able to include $2,951.75 ($6,800.00 – $3,848.25) of medical expenses in their calculation of itemized deductions.

5.

Yes, the Neals can claim their $5,000 traditional IRA contribution as an adjustment to income. Because neither spouse is covered by a work plan, but the “working spouse” earned more than $5,000, they were actually eligible to contribute and claim the amount as an adjustment to income. The maximum allowable contribution was $5,500 per person ($11,000 for a married couple).

6.

The Neals would not benefit from itemizing their deductions. Their itemized deduction of $11,231.75 is less than the standard deduction amount in 2014 ($12,400). $2,951.75 (Allowable Medical Expenses, from question 4) +$2,280.00 (State Taxes Withheld) +$6,000.00 (Mortgage Interest) $11,231.75 (Total Itemized Deductions)

7.

The Neals’ net estimated tax liability (after claiming any tax credits), using the tax rate calculation, is $2,061.50 for 2014.

8.

2014 $56,900.00 - $5,590.00 -$12,400.00 -$11,850.00 $27,060.00

Gross Income Adjustments Standard Deduction (from Q6) Exemption (x3) Taxable income

2014 $1,815.00 +$1,336.50 $3,151.50 - $1,090.00 $2,061.50

Liability (10% bracket) Liability (15% bracket) Total tax liability Tax credits (from Q3) Final tax liability

The Neals should always compare their final tax liability to how much they had withheld. If the result is that they had too much withheld then, in essence, they provided the government with a short-term interest free loan. However, if they did not have enough withheld then ©2016 Pearson Education, Inc.


they could face a hardship paying the additional tax liability. The best planning practice is to accurately estimate the tax liability for the coming year and increase or decrease employer withholdings to match. DISCUSSION CASE 2 ANSWERS 1.

FICA tax liabilities = $6,120 • Anya’s Social Security tax liability = $40,000 x 0.124 = $4,960 • Anya’s Medicare tax liability = $40,000 x 0.029 = $1,160 Half of her FICA taxes ($3,060) are an adjustment to income because she is self-employed.

2.

Austin’s Salary: $32,500 Anya’s Salary: $40,000 Investment Income: $500 Total Income: $73,000 As shown on Line 27 of Form 1040, one-half of Anya’s self-employment taxes are deductible when calculating AGI: $73,000 - $3,060 = $69,940 Self-employed health insurance premiums are also deductible (see Line 29 of Form 1040). As such, $69,940 - $2,200 = $67,740 = AGI

3.

No, the moving expenses are not deductible, because the Goulds did not move more than 50 miles in association with taking a new job.

4.

The Goulds should itemize their deductions, because their itemized deduction of $18,015 far exceeds the standard deduction. However, to determine the miscellaneous deductible expense they must first calculate their adjustable gross income (AGI) (see Q2). Total medical expenses = $5,100 ($1,500 + $3,600) $67,740 x 0.075 (floor) = $5,080.50; therefore $5,100 – $5,080.50 = $19.50 Total business, investment, and tax planning expenses = $3,750 ($1,450 + $2,300) $67,740 x 0.020 (floor) = $1,354.80; therefore $3,750 – $1,354.80 = $2,395.20 To calculate their itemized deductions, add the categories as follows: • State Tax Expense $4,000.00 • Medical Expenses $19.50 (See equation above) • Real Estate Taxes $900.00 • Mortgage Interest Expense $7,200.00 • Charitable Contribution $3,500.00 • Business, Investment, and Tax Planning Expense $2,395.20 (See equation above)



Total Deductions

$18,014.70

5.

The Goulds’ will need to file a 1040 “long form” because it is to their advantage to itemize the deductions, and the 1040 form is the only form that also allows for additional schedules to be filed, such as the Schedule A - Itemized Deductions, Schedule B - Interest and Dividend Income, Schedule C - Business Income and Schedule D - Capital Gains and Losses.

6.

The Goulds’ should be eligible to claim the child tax credit for each of their two boys given that their income does not exceed the $110,000 limit for a married couple filing jointly.


CONTINUING CASE: CORY AND TISHA DUMONT PART I: FINANCIAL PLANNING 1.

The Dumonts are in the early years of the accumulation of wealth stage of the financial life cycle. During this longest stage of the life cycle, the Dumonts will establish their lifestyle and build a foundation for the two later stages. This phase is characterized by the following: • Family formation • Goal setting • Home buying • Debt planning • Savings accumulation (emergency fund, home down payment, children’s education fund, and retirement) • Insurance planning (medical, disability, liability, property, life) • Estate planning

2.

Cory and Tisha’s short-term goals (less than one year) might include the following: • Begin savings to accumulate an emergency fund. • Continue saving for home down payment. • Continue payments on debt and credit cards. • Start saving for retirement. • Review property, health, disability, life and liability insurance needs and purchase as needed. • Write a will. Cory and Tisha’s intermediate-term goals (1 to 10 years) might include the following: • Accumulate emergency fund. • Save for Chad’s and Haley's college education. • Continue saving for home down payment and purchase home. • Pay off debt and credit cards. • Replace autos. • Continue saving for retirement. • Review property, health, disability, life and liability insurance as their family situation changes. • Review estate plans as family situation changes. Cory and Tisha’s long-term goals (greater than 10 years) might include the following: • Save for and pay for Chad’s and Haley’s college educations. • Save for and fund retirement plans to maintain current standard of living. • Review property, health, disability, life and liability insurance needs as family situation changes. • Review estate plans as family situation changes.

71

Copyright ©2016 Pearson Education, Inc.


3.

See completed Worksheet 5, A Simplified Income Statement. All lines are single entries from the case, except the following: Line A = $77,100 or $98,000 – $8,100 pre-tax deductions of $3,200 insurance and $2,250 and $2,650 401(k) contributions, respectively, for Cory and Tisha Line D = $24,000 (rent) + $3,900 (utilities) + $1,800 (cell phones) + $2,520 (furniture) Line G = $4,860 (auto payments) + $2,400 (transportation expense) + $695 (property tax) Line J = $2,200 (auto) + $720 (life) + $600 (renters) Line K = $2,400 (charity) + $10,000 (day care) + $2,400 (miscellaneous) + $1,200 (credit cards) + $2,352 (student loan repayment)

4.

See completed Worksheet 4, Balance Sheet—Calculating Your Net Worth. NOTE: Because no 401(k) retirement account balances are given, students may enter the annual contribution amounts. This is an opportunity to discuss (1) the lack of understanding of the plans as acknowledged by Cory and Tisha and the failure to determine the balance; (2) the change in market value of the accounts regardless of the amount of the annual contributions; and (3) the idea that although the account values should be entered, retirement assets should be protected for this long-term goal, not considered an asset to be accessed for other purposes barring a dire situation.

5.

a. To calculate the current ratio: Monetary Assets = Current Liabilities

$4,400 = 3.39 $1,300

This ratio is greater than two, as recommended. In other words, the Dumonts’ available monetary assets are more than three times enough to pay off their short-term liabilities (i.e., credit card debt). It is important to track the trend of this ratio over time; it should be increasing, not decreasing. If the ratio is declining, efforts should be made (1) to increase savings to build monetary assets and/or (2) to pay off current liabilities more quickly to avoid increasing current liabilities. Because the Dumonts have not provided details about other current bills (e.g., utilities, insurance premiums, or other bills to be paid), calculation of the current ratio may not be realistic. Current liabilities are defined as debts that must be paid off within the next year. With payments of only $100, it will take Cory and Tisha more than a year to repay the credit card bill. However, credit cards were designed for short-term borrowing with full repayment. For too many people, credit cards have become continual revolving installment loans. In reality, the Dumonts should view their credit cards as a current liability, or debt to be repaid within the year. b. To calculate the month's living expenses covered ratio: Monetary Assets = Annual Living Expenditures/12

$4,400 = $75,497/12

$4,400 = 0.70 months $6,291


Part 1: Continuing Case: Cory and Tisha Dumont 73

If all other sources of income stopped, the Dumonts have enough monetary assets to cover their living expenses for less than one month. The traditional rule of thumb is that a household should have liquid assets to cover 3 to 6 months of expenses. This rule ignores the potential earnings from alternative investments or the availability of credit capacity. Consequently, some flexibility in the amount of emergency funds, such as 3 months or less, may be appropriate. The Dumonts have no funds earmarked for emergencies. They do not have access to a home equity line and are carrying credit card balances. Cory and Tisha would be wise to decrease spending and to increase their savings. Some dollars should be designated for an emergency, whether relatively minor, such as auto repair, or major, such as the loss of employment. As a measure of their “cash on hand,” the month’s living expenses covered ratio suggests that the Dumonts have little reserves to continue their lifestyle in the event of a loss of income. c. To calculate the debt ratio: Total Debt or Liabilities = Total Assets

$27,725 = 0.35 or 35% $78,300

Slightly more than a third of the Dumonts’ assets are financed. In other words, they truly own approximately 65 percent of their total assets; the remainder will not be paid for until some future date. This ratio will likely increase as they use credit to buy a home and other assets to support their lifestyle. However, they should continue to track the trend of debt-toasset accumulation, as the ratio should decline as the Dumonts age. d. To calculate the long-term debt coverage ratio: Total Income Available for Living Expenses = Total Long-Term Debt Payments

$67,900 = 6.21 $10,932

Long-term debt represents any amount that cannot easily be repaid in one year. The Dumonts are only paying $100 per month on their $1,300 credit card balances and $196 per month on Cory’s $8,200 student loan debt. These debts will not be repaid in one year. The car and furniture loans each run for another 36 and 30 months, respectively. All the Dumonts’ debts can be defined as long term. Payments for one year total $10,932. A ratio of less than 2.5 suggests the need for caution, but the Dumonts’ ratio of 6.21 well exceeds this level. This ratio will likely decline as they use credit to buy a home and other assets to support their lifestyle. e. To calculate the savings ratio: Income Available for Savings & Investment = Total Income Available for Living Expenses

–$7,597 = –0.11 or round to 0% $67,900



The Dumonts’ are not currently saving any of their after-tax income if their budget estimates are correct. This percentage is very low, particularly for a young family trying to save for a house down payment. The trend should be tracked over time to ensure that it is increasing. 6.

The ratios suggest that Cory and Tisha are in relatively good financial health for a young family with the exception of their savings ratio. They have limited credit use to maintain financial flexibility. In other words, a large percentage of their budget is not committed to pay off debt. Liquidity, as measured through the availability of monetary assets to meet current liabilities and living expenses is less than adequate. To improve their financial health, they should review their spending habits and make necessary adjustments to accomplish the following: • Continue to repay their debt without taking on more debt obligations until after they have purchased their home. • Increase their savings for an emergency fund, the house down payment, and other financial goals, such as educating the children.

7.

Tisha and Cory have $2,500 in savings but have not acknowledged those funds for an emergency. The traditional rule of thumb is that a household should have 3 to 6 months of expenses, or for the Dumonts between $18,874 and $37,749 based on monthly expenses of ($75,497/12). This rule ignores the potential earnings from alternative investments, as liquid accounts offer little return. Home equity credit lines or other available credit lines also can substitute for some emergency needs or supplement emergency funds. This frees more dollars for other, less liquid investments with higher returns. However, because the Dumonts do not have access to a home equity line and they are carrying credit card balances, they need to increase their savings. An emergency fund of 3 months or less, in combination with available credit and adequate insurance protection, should be sufficient. The stability of employment, the regularity of income (e.g., regular salary versus irregular commissions), and the fact that both are employed also should be considered.



8.

Cory and Tisha would need to save $1,537 at the end of each year to accumulate $40,000 for Chad’s college expenses, assuming a 9 percent return. Without scholarships, their annual savings will need to increase to $3,843 to fund Chad’s total education expenses of $100,000. Factor Table C solution PV n/a PMT $1,537.34 (FVIFA9%, 14)

26.019

FV

$40,000

Factor Table C solution PV n/a PMT $1,537.34

9.

(FVIFA9%, 14)

26.019

FV

$100,000

Calculator solution PV $0 PMT -? I/Y 9% N 14 FV $40,000 CPT PMT –$1,537.33 Calculator solution PV $0 PMT -? I/Y 9% N 14 FV $100,000 CPT PMT –$3,843.35

Cory and Tisha would need to save $1,111.92 at the beginning of each year to accumulate $40,000 for Haley’s college expenses. Without scholarships and assuming a cost of $110,000, their annual beginning of year contribution would need to increase to $3,057.79. Calculator Solution PV $0 PMT -? 9% I/Y N 16 FV $40,000 CPT PMT –$1,111.92

Calculator solution PV $0 PMT -? I/Y 9% N 16 FV $110,000 CPT PMT –$3,057.79

NOTE: Instructors may need to remind students to change their calculator mode from “end” to “beginning” to solve the first part of this problem, and then back again to “end” to solve for the end of year payments, or savings. If using a calculator, the end of year savings contribution would be $3,332.99. If using the factor from Appendix C, as shown below, the end of year savings contribution would be $3,333.03 to yield $110,000 for Haley’s education. Factor Table C solution PV n/a PMT $3,333.03 (FVIFA9%, 16) 33.003

Calculator solution PV $0 PMT -? I/Y 9%



FV

$110,000

N FV CPT PMT

16 $110,000 –$3,332.99

10. With a 7 percent after-tax return, the Great Basin Balanced Mutual Fund would be worth $5,930.63 in 14 years when Chad enters college and $6,789.98 when Haley turns 18. The fund would be worth $55,783.82 in 37 years when Tisha retires at age 67, assuming the higher 9 percent after-tax return. Calculator solution for when Chad enters college PV –$2,300 PMT $0 I/Y 7% N 14 FV ? CPT FV $5,930.63

Calculator solution for Calculator solution for when Haley turns 18 Tisha’s Retirement Age of 67 PV –$2,300 PV –$2,300 PMT $0 PMT $0 I/Y 7% I/Y 9% N 16 N 37 FV ? FV ? CPT FV $6,789.98 CPT FV $55,783.82

The Great Basin Balanced Mutual Fund has yielded an annualized rate of return of 10.8 percent, ignoring any income return, which according to Tisha has been negligible and in some years nothing. annualized = (ending value – beginning value) + income return x 1 / N rate of return beginning value annualized = ($2,300 – $1,000) + 0 × rate of return $1,000

1/12

annualized = 1.3 × 0.0833 = 0.1083 or 10.8% rate of return 11. At the current rate of 6 percent, the $13,000 fund would be worth $15,483 in 3 years, $17,397 in 5 years, and $19,547 in 7 years. At 8 percent, the fund would be worth $16,376, $19,101, and $22,280 in 3, 5, and 7 years, respectively. Assuming an 6 percent return PV –$13,000 PMT $0 I/Y 6% N 3 FV ? CPT FV $15,483.21

Assuming an 8 percent return PV –$13,000 PMT $0 I/Y 8% N 3 FV ? CPT FV $16,376.26

PV PMT

PV PMT

–$13,000 $0


–$13,000 $0


I/Y N FV CPT FV

6% 5 ? $17,396.93

I/Y N FV CPT FV

8% 5 ? $19,101.27

PV PMT I/Y N FV CPT FV

–$13,000 $0 6% 7 ? $19,547.19

PV PMT I/Y N FV CPT FV

-$13,000 $0 8% 7 ? $22,279.72

12. The account would grow by $1,040 assuming an 8 percent rate of return. There would be no capital gain tax due if the Dumonts do not sell the fund this year. If they do sell the shares, their earning would be taxed at the long-term capital gains rate, which is 0 percent for people in the 15 percent tax bracket. Factor Table A solution PV $13,000 PMT n/a (FVIF8%,1)

1.080

FV

$14,040

Calculator solution PV –$13,000 PMT $0 I/Y 8% N 1 FV ? CPT FV $14,040

13. Leaving the account with the former company would give Cory a retirement nest egg of $14,480. If Cory could guarantee a 10 percent annual return by choosing his own investments, the $2,500 account would be worth $77,282 at retirement. As long as the funds remain in a tax-deferred account, no taxes will be due until the time of withdrawal. Assumes 5 percent return PV $2,500 PMT NA I/Y 5% N 36 FV ? CPT FV –$14,479.54 14. – – –

$98,000.00 $652.00 $97,348.00 $12,400.00 $15,800.00 $69,148.00

Assumes 10 percent return PV $2,500 PMT NA I/Y 10% N 36 FV ? CPT FV –$77,281.70

Gross Income for 2014 Adjustments to Income for the Student Loan Interest Paid Adjusted Gross Income (AGI) Standard Deduction Personal Exemptions (4 × $3,950 for 2014) Taxable Income



a. The Dumonts should not itemize deductions, as the standard deduction amount exceeds their total itemized deductions. Their only possible itemized deductions include state income taxes, property taxes, and charitable donations. Home ownership, with itemized deductions for home mortgage interest and real estate taxes, should allow the Dumonts to exceed their standard deduction. b. The adjustment for student loan interest paid can be claimed whether or not the taxpayer itemizes deductions, another benefit for taxpayers like the Dumonts. Unless the Dumonts have significant salary increases, they should be eligible to claim up to the maximum $2,500 of interest payments for future years, including any voluntary payments of interest. The adjustment effectively reduces the Dumonts’ income taxes by $97.80 as shown below. Federal tax savings from student loan interest adjustment = $652 × 0.15 = $97.80 c. Cory will have a total of $3,442.50 deducted from his salary for FICA. He will pay $2,790 (0.0620 × $45,000) for Social Security and $652.50 (0.0145 × $45,000) for Medicare. Tisha will pay $3,286 (0.0620 × $53,000) for Social Security and $768.50 (0.0145 × $53,000) for Medicare, or a total of $4,054.50 for FICA. Together, the Dumonts will pay a total of $7,497 for FICA. d. Based on 2014 tax rates, the Dumonts' federal tax liability on $69,148.00 of taxable income is $9,464.70, based on the following calculation. Tax liability in 10% tax bracket = $18,150 × 0.10 = $1,815.00 Tax liability in 15% tax bracket = $50,998 × 0.15 = $7,649.70 TOTAL = $9,464.70 e. Because the children are under age 17, Cory and Tisha are eligible for the $1,000 tax credit for each child. In addition to the income taxes deducted and submitted by their employers during the year, any applicable credits will be subtracted from the Dumonts' tax liability to determine if they are due a refund or must pay additional taxes. 15. Tisha estimated their tax liability as $22,000 annually. Their actual projected 2014 taxes totaled $14,961.70 ($7,464.70 federal tax liability (after the credits); $7,497 FICA tax liability), for a difference of $7,038.30, assuming they live in a state with no income taxes. Their lower actual projected tax liability adds to their available income. This money can be saved toward their various financial goals. They could adjust W-4 withholdings and increase monthly cash flow by approximately $587. 16. The marginal tax rate represents the percentage of taxes paid on the last dollar earned. For the Dumonts, this is 15 percent in 2014. Extending this concept to the effective marginal tax rate combines the marginal rates for all taxes paid on income (assuming state and city marginal tax rates are applicable), as illustrated below. Effective marginal tax rate = Federal marginal rate + state marginal rate + city marginal rate + Social Security tax rate



Using this formula, the Dumonts’ effective marginal tax rate would be 22.65 percent (15.00 + 0.00 + 0.00 + 7.65). Both the marginal and effective marginal tax rates assume the worst-case tax scenario, as both ignore the progressive nature of the income tax system and consider only the tax rate on the last dollars earned. This is necessary to provide a constant and reliable measure for tax planning purposes. The average tax rate assesses the federal taxes paid as a percentage of gross income, or for the Dumonts in 2014, 9.66 percent based on $9,464.70/$98,000. Allowing for bracket creep, salary increases will push the Dumonts into higher marginal tax brackets. However, increased tax deductions available after they purchase a home as well as other tax planning strategies will allow the Dumonts to reduce their taxable income—the final determinant of their marginal tax bracket.



Worksheet 5 - Simplified Income Statement Worksheet Your Take-Home Pay A. B. C.

Total Income Total Income Taxes After-Tax Income Available for Living Expenditures or Take-Home Pay (line A minus line B)

A. - B.

89900 22000

= C.

67900

+ E.

32220 6900

+ + + + + +

F. G. H. I. J. K.

3300 7955 2400 850 3520 18352

= L.

75497

= M.

-7597

Your Living Expenses D. E. F. G. H. I. J. K. L. M.

Total Housing Expenditures Total Food Expenditures Total Clothing and Personal Care Expenditures Total Transportation Expenditures Total Recreation Expenditures Total Medical Expenditures Total Insurance Expenditures Total Other Expenditures Total Living Expenditures (add lines D through K) Income Available for Savings and Investment (line C minus line L)



W

4

WORKSHEET

Balance Sheet - Calculating Your Net Worth Assets Cash Checking Savings/CDs Money Market Funds Other Monetary Assets A. Monetary Assets

Value + + + + A. =

Mutual Funds Stocks Bonds Life Insurance (cash-value) Cash Value of Annuities Investment Real Estate (REITs, partnerships) Other investments B. Investments B.

$100 $1,800 $2,500

$4,400 $15,300

+ + + + + + =

$17,100

401(k) and 403(b) Company Pension Keogh IRA Other Retirement Plans C. Retirement Plans

+ + + + C. =

$2,500 $2,500

Primary Residence 2nd Home Time-Shares/Condominiums Other Housing D. Housing (market value)

+ + + D. =

$0

Automobile 1 Automobile 2 Other Automobiles E. Automobiles

+ + E. =

Collectibles Boats Furniture Other Personal Property F. Personal Property

+ + + F. =

Money Owed You Market Value of Your Business Other G. Other Assets

+ + G. =

$0

H. Total Assets (add lines A through G)

H. =

$78,300

$1,800

$14,800 $7,800 $22,600 $19,700


$12,000 $31,700


W

4

WORKSHEET

Balance Sheet - Calculating Your Net Worth (continued) Liabilities or Debts I. Current Bills (unpaid balance)

Value I. =

Visa Master Card Other Credit Cards J. Credit Card Debt

+ + J. =

$1,300 $1,300

First Mortgage 2nd Home Mortgage Home Equity Loan Other Housing Debt K. Housing

+ + + K. =

$0

Automobile 1 Automobile 2 Other Automobile Loans L. Automobile Loans

+ + L. =

$0

$12,925

$12,925

College Loans Loans on Life Insurance Policies Bank Loans Installment Loans Other M. Other Debts

+ + + + M. =

$13,500

N. Total Debt (add lines I through M)

N. =

$27,725

Net Worth H. Total Assets N. Less: Total Debt O. Equals: Net Worth

H. + N. O. =

$78,300 $27,725 $50,575


$8,200

$5,300

CHAPTER 5 CASH OR LIQUID ASSET MANAGEMENT

CHAPTER CONTEXT: THE BIG PICTURE This chapter introduces the process of liquid asset management and is the first chapter in the four-chapter section entitled “Part 2: Managing Your Money.” This section of the text introduces different strategies for controlling the financial plan through cash management, credit management, and management of large expenses. Cash management lays the foundation for maintaining adequate liquidity to meet everyday expenses and avoiding the sale of other assets to meet emergency expenses. Specifically, this chapter introduces the principles of liquid asset management and describes the alternatives available for cash management and liquid investments. Students are encouraged to evaluate critically the products and to tailor choices to best match their needs. CHAPTER SUMMARY This chapter establishes the importance of implementing an effective cash management plan. A basic premise of the chapter is the importance of maintaining some liquid assets to be used in the event of an emergency. Cash management institutions, their features, and the characteristics of the accounts offered are summarized. Rates of return on different cash management and liquid investment alternatives are discussed. Strategies for selecting and using cash management vehicles, such as the checking account, are discussed. An explanation of the benefits of automating cash management with electronic funds transfers and online banking concludes this chapter. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Manage your cash and understand why you need liquid assets. a. Cash management b. Liquid assets

2.

Automate your savings.

83



3.

Choose from among the different types of financial institutions that provide cash management services. a. Deposit-type financial institutions b. Non-deposit-type financial institutions c. Online banking

4.

Compare the various cash management alternatives. a. Demand deposit b. NOW (negotiable order of withdrawal) account c. Savings account d. Money market deposit account (MMDA) e. Certificate of deposit (CDs) f. Money market mutual funds (MMMFs) g. Asset management accounts h. U.S. Treasury Bills or T-Bills i. Denomination j. U.S. savings bond

5.

Compare rates on the different liquid investment alternatives. a. Annual percentage yield (APY) b. After-tax return c. Federal Deposit Insurance Corporation (FDIC) d. National Credit Union Association

6.

Establish and use a checking account. a. Direct deposit b. Safety deposit box c. Overdraft protection d. Stop payment e. Cashier’s check f. Certified check g. Money order h. Traveler’s checks

7.

Transfer funds electronically and understand how electronic funds transfers (EFTs) work. a. Electronic funds transfer (EFT) b. Automated teller machine (ATM), or cash machine c. Personal identification number (PIN) d. Debit card e. Smart cards


Chapter 5: Cash or Liquid Asset Management 85

CHAPTER OUTLINE I.

Managing Liquid Assets A. The reservoir effect B. Risks associated with liquid assets 1. Risk-return trade-off 2. Spending risk

II.

Automating Savings: Pay Yourself First A. Automatic deposit B. Payroll deduction

III.

Financial Institutions A. “Banks” or Deposit-Type Financial Institutions 1. Commercial banks 2. Savings and loan associations 3. Savings banks 4. Credit unions B. Non-Deposit-Type Financial Institutions 1. Mutual funds 2. Stock brokerage firms C. Online and Mobile Banking 1. Instant access 2. Transfers 3. Pay bills D. What to Look for in a Financial Institution 1. Service 2. Safety 3. Cost

IV.

Cash Management Alternatives A. Checking Accounts 1. Demand deposits 2. Negotiable order of withdrawal accounts B. Savings Accounts 1. Passbook accounts 2. Statement accounts C. Money Market Deposit Accounts D. Certificates of Deposit E. Money Market Mutual Funds F. Asset Management Account G. U.S. Treasury Bills, or T-bills H. U.S. Savings Bonds 1. Denominations 2. Tax advantages



V.

Comparing Cash Management Alternatives A. Comparable Interest Rates B. Tax Considerations C. Safety 1. Federal Deposit Insurance Corporation (FDIC) 2. Money market mutual funds

VI.

Establishing and Using a Checking Account A. Choosing a Financial Institution B. The Cost Factor 1. Monthly fee 2. Minimum balance 3. Charge per check 4. Balance-dependent scaled fees C. The Convenience Factor 1. Safety-deposit boxes 2. Overdraft protection 3. Stop payments D. The Consideration Factor E. Balancing Your Checking Account F. Other Types of Checks 1. Cashier’s check 2. Certified check 3. Money order 4. Traveler’s check

VII.

Electronic Funds Transfers (EFTs) A. Automated Teller Machines (ATMs) B. Debit Cards C. Smart Cards D. Prepaid Debit or Gift Cards E. Fixing Mistakes—Theirs, Not Yours

VI.


VII.

Action Plan A. Principle 10: Just do it! B. Create an emergency fund. C. Be careful when you bank online. D. If possible, have bills paid automatically. E. Use online alerst to your advantage.



APPLICABLE PRINCIPLES Principle 3: The Time Value of Money The earlier you start saving, the greater the effect compound interest has on the investment return. Start saving immediately; time is your greatest ally—even if you can afford only a few dollars. Principle 5: Stuff Happens or the Importance of Liquidity Unforeseen events require you to have liquid assets to protect your other investments. Rather than being forced to sell the investment at a loss to cover the emergency expense, you can simply pay in cash. Principle 8: Risk and Return Go Hand in Hand Because liquid assets, such as a savings account or money market mutual fund, can be easily converted to cash, they have very little or no risk. But these accounts also don’t provide a high return. Nevertheless, low-risk, high-liquidity investments are an integral part of your cash management plan. Just don’t keep too many assets in these accounts. Principle 9: Mind Games, Your Financial Personality, and Your Money Saving for emergencies is not exciting, but the excitement that comes from an unexpected emergency is not welcomed. Automating your savings help reduce the temptation not to save regularly for emergencies. Principle 10: Just Do It Establish a savings habit by having savings automatically deducted from your paycheck. The “if you don’t see it, you won’t spend it” adage has a lot of truth to it and can eventually pay great rewards—even when considering the low returns associated with liquid accounts. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Ask students to list several reasons why starting to save immediately after employment (or other life cycle event such as marriage, birth of a child, or divorce) can be difficult. Discuss the reasons why saving, regardless of the amount, is beneficial and should be strongly encouraged.

2.

Have the class do online research to compare “Web-based” banks to traditional “brick and mortar” institutions. Ask students to compare the types of accounts offered, the fees imposed, the rates of return, the services available, and the privacy of client data. With the class, discuss the drawbacks associated with “Web-based” banks and why these institutions would or would not be a viable alternative for individual banking needs. For interest, divide the class into small groups, with each representing a bank of their choice.



3.

Compare your current bank or credit union checking account to at least two others according to the “three Cs” criteria. Be sure to include one Internet-only bank in the comparison. Describe which is the best account for you and why.

4.

Shop for a new liquid asset account appropriate for your needs (e.g., bank account, CD, money market mutual fund). Describe the purchase process (e.g., dollar cost, “paperwork”) and your anticipated future use(s) for this money.

5.

Review your latest savings account statement. Find the annual percentage yield (APY) paid on your account and compare it to the “quoted rate.” What method is used to determine the account balance in which interest is credited? What was your after-tax and real (after inflation) rate of return?

6.

Banks charge billions of dollars per year in overdraft, insufficient funds, or “bounced” check fees. As a group project, survey several local financial institutions to determine their fees and overdraft protection charges. Now try to determine the effective interest rate for each bank on a $100 check that causes an account to be overdrawn for 1 week.

7.

As a group project, develop a chart noting the cost of making a transaction at an ATM machine owned by your bank and at a machine owned by another bank. Compare the costs reported by the members of the group. How can these fees be avoided? How do they relate to the “three Cs” criteria for choosing a financial institution?

REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1.

What are liquid assets? How does this category of assets relate to Principles 5: Stuff Happens, or the Importance of Liquidity and Principle 8: Risk and Return Go Hand in Hand? Liquidity is the ability to easily convert certain financial products, such as checking accounts, money market funds, and CDs, into cash. It is important to have liquidity because, as Principle 5 says, “Stuff Happens.” By keeping some funds in liquid assets, money is available to cover financial emergencies, such as unemployment or car repairs. That way, long-term investments (e.g., stock) do not have to be sold at an inopportune time, perhaps at an unfavorable price. Liquid assets are also used to hold money needed to pay normal household living expenses (e.g., rent, utilities). Unfortunately Principle 8 refers to the riskreturn trade-off because with higher liquidity comes lower return. So there will be some loss of earnings potential with highly liquid accounts.



2.

What factors have affected the alternatives available to consumers for cash management? The two factors are (1) less government regulation (deregulation) and (2) increased competition between banks and other financial institutions.

3.

Give two examples of both deposit-type and non-deposit-type financial institutions. Describe their similarities. Deposit-type institutions (a.k.a., banks) provide traditional checking and savings accounts and offer the most variety in financial services, including safe deposit boxes, credit cards, and a wide array of savings and loan options. • Commercial banks • Savings and loan associations • Savings banks (a.k.a., mutual savings banks, credit unions) Non-deposit-type financial institutions have more recently (since deregulation in the early 1980s) begun to offer similar services to compete with banks, while banks have begun to offer services traditionally provided by nondeposit institutions (e.g., securities purchases). • Mutual funds • Stock brokerage firms • Insurance firms Thus, over the past two decades, traditional lines between the two types of financial institutions have blurred considerably.

4.

What is a credit union, and what are some of its distinguishing features? A credit union is a nonprofit, depositor-owned financial institution made up of members with some type of common bond (e.g., employment, religion, college affiliation). Credit unions offer a wide range of competitive financial services (e.g., loans, checking accounts). Characteristics of credit unions include the following: • Due to “affiliation requirement,” only about half of Americans are eligible to join. • They are often smaller and more efficient than commercial banks. • Fees and minimum balances tend to be lower than banks. • Loans tend to be made at more favorable rates. • Some do not provide home mortgages. • Very convenient: often located at members' place of employment.

5.

What is a NOW account? What are its advantages and disadvantages? NOW stands for “negotiable order of withdrawal.” NOW accounts are checking accounts in which you earn interest on your balance. Generally, you must maintain a certain minimum balance in order for interest to be paid. • Advantage: Extra income provided by an interest-bearing account • Disadvantage: Owners must generally place more money in a checking account than needed to pay bills in order to meet minimum balance requirements. There is an



opportunity cost associated with interest that could have been earned on alternative, higher-paying investments. 6.

List three characteristics of certificates of deposit (CDs). The characteristics of CDs include the following: • CDs pay a fixed rate of interest for a specified period of time. • Generally, the longer the time period until maturity, the higher the rate of return. • If money is withdrawn prior to maturity, an early withdrawal penalty may be assessed. • CD rates vary from bank to bank and between banks and other financial institutions.

7.

Describe and compare a money market deposit account (MMDA) and a money market mutual fund (MMMF). A money market deposit account (MMDA) is a bank product that provides a variable rate of interest that fluctuates with market conditions. Up to three checks per month can be written against the account without incurring additional charges. Often, a minimum balance of $1,000 or more is required to open an MMDA, and the accounts are FDIC insured. A money market mutual fund (MMMF) is an investment company product (not FDIC insured) and also provides a variable rate of interest. The issuer pools the funds of many investors and invests the fund portfolio in short-term debt instruments issued by government entities or large corporations. Limited check writing is also available (checks must exceed a certain amount, such as $250 or $500). Minimum initial deposits vary. MMMFs almost always pay a slightly higher yield than bank MMDAs.

8.

Describe how an asset management account works and what financial services are included. What are the disadvantages associated with this type of account? Asset management accounts are a comprehensive financial services package offered by brokerage firms that provide a single consolidated monthly financial statement and coordinate the flow of cash between MMMFs and other investments in the account. That way, no money sits idle without earning interest. Components of an asset management account can include a checking account, a credit card, securities such as stocks or bonds, a MMMF, and automatic loan payments. Interest and dividends earned on investments are swept into the MMMF daily to immediately earn additional interest. However, not everything about these accounts is beneficial. Their annual cost is about $50 to $125, which may or may not be worth the benefits provided. Another disadvantage is that these accounts typically have fairly high minimum balances and, of course, you must pay a commission to purchase any investments.

9.

Describe and compare two common federal government debt instruments: Treasury bills and U.S. Series EE savings bonds. Treasury bills (T-bills) are short-term federal government debt instruments with maturities ranging from 3 months to 12 months. The minimum denomination to purchase a T-bill is ©2016 Pearson Education, Inc.


$10,000. T-bills are purchased at an amount less than the face value received at maturity. The difference between the purchase price and the face value is the interest paid to an investor. T-bills are taxable on federal tax returns but are free from state or local taxes. EE bonds are issued in denominations ranging from $50 to $10,000. They are purchased at half of their face value. Like T-bills, interest grows until maturity, and they are state tax free. Rates for both products vary with market conditions. Interest may be exempt from federal tax if EE bonds are used to pay college tuition and fees and income limits are met. 10. Who would benefit the most from investing in tax-exempt securities? Why? Generally, the higher the investors’ marginal tax bracket, the more they’ll benefit from taxexempt investments, such as municipal bonds. This is because taxes affect the real rate of return on investments by taking away some of the yield earned by investors in taxable securities. To decide on the best investment alternative (taxable versus tax-exempt), investments should be compared on an equivalent after-tax basis. 11. What factors should you consider when choosing a financial institution? The factors are typically referred to as the three Cs: 1. Cost (e.g., return item charges, service charges, minimum balance requirements) 2. Convenience (e.g., location, hours, available services) 3. Consideration (e.g., personal service, safety) 12. What is overdraft protection? How do the new federal rules affect the way overdraft protection works? Overdraft protection is an automatic loan made to your checking account whenever your account does not contain enough cash to cover the checks or debits you have drawn against it. Your bank will charge a fee each time the overdraft protection is used. New federal rules require customers to opt-in/agree to this service versus being automatically enrolled into the plan. 13. What are electronic funds transfers (EFTs)? Describe and compare three different types of EFTs. EFTs are financial transactions that take place electronically. In other words, money is moved quickly between accounts without the use of paper (e.g., checks). Three types of EFTs are ATMs, debit cards, and smart cards. • ATMs—an acronym for automatic teller machines, ATMs provide cash withdrawals through the use of credit or debit cards. They are convenient and available worldwide. Fees of up to $4 can be charged per transaction, making ATMs an expensive way to get money if used frequently. • Debit Cards—a cross between a credit card and a checking account, a debit card allows you to spend money on deposit in a specific account linked to them. Unless you have overdraft protection, you can’t spend more than you have in the account. ©2016 Pearson Education, Inc.


•

Smart Cards—smart cards magnetically store a specific dollar value that is put into the card when users deposit funds with the issuer. Smart cards can then be used to purchase services from vendors who honor them. Frequent issuers include universities, restaurants, and copy machine services (e.g., Kinko’s).

14. Describe the function of a smart card. Why is it important to protect your smart card? Smart cards are preloaded with funds that can be used to purchase products. When the preloaded money is spent, more money must be transferred to the card before it can be used. Smart cards may also store personal information, such as your student identification number, driver’s license, or insurance information, so it is important to protect your smart card from possible theft. PROBLEM AND ACTIVITY ANSWERS 1.

Student answers may vary; however, the following are some characteristics of liquid assets: • Can quickly be turned into cash without loss of principal • Considered low-risk assets (compared to other investments) • Provide a relatively low expected rate of return • Useful for holding funds that you expect to use in the near future • A good place to put an emergency fund of three to six months’ expenses • Very sensitive to interest rate changes taking place in the economy Some disadvantages of having too much money too liquid are: • Low overall return due to low investment risk • Risk of spending due to ease of access Some disadvantages of having too little money too liquid are: • Higher liquidation cost in the event of an emergency • Greater amount of time to receive the money • Increased risk of not having access

2.

Examples could include the following: • Money saved for large upcoming expenses (e.g., car insurance) • Money being held for upcoming tuition payments • Money being held for upcoming house down payment • Money being held for unexpected emergency expenses • Money being held for upcoming income tax payment • Money being held until more permanent investment decisions are made

3.

The primary advantage of automating your savings is best addressed with Principle 10: Just Do It. According to this idea, it is easier to spend than save. If you automate your savings, then you are creating an expense for your savings plan, and you are not as likely to neglect it. ©2016 Pearson Education, Inc.


4.

Tony’s account balance of $150,000 is completely covered, but Cynthia’s account is over the insurance limit by $4,000. She should consider moving some of this money into the joint account or to another institution. The joint account is also fully insured because the $60,000 balance is well under the limit, even if she were to move the $4,000 from her individual account.

5.

The biggest benefit to mixing-and-matching is flexibility. However, by combining the best account types and providers, you can also maximize returns and features, while minimizing service charges and other fees. Also, by having money in various places, you are less likely to jeopardize FDIC or NCUA coverage.

6.

2.04% Annual Percentage Rate = ($200 / $9,800) $10,000.00 Value at maturity – $9,800.00 Discounted purchase price $200.00 Total interest earned

7.

Use the following formula: After-tax return = taxable return (1 – marginal tax bracket) • At the 15 percent marginal tax rate, the after-tax yield on the 4.65 percent corporate bond is 4.65% × (1 – 0.15) = 4.65% × 0.85 = 3.95%. Thus, the corporate bond is a better alternative than the 3.25% tax-free municipal bond, ignoring state taxes. • At the 33% marginal tax rate, the after-tax return of the 4.65 percent corporate bond is 4.65% × (1 – 0.33) = 4.65% × 0.67 = 3.12%. In this case, the 3.25% tax-free municipal bond is a better alternative than the 4.65 percent corporate bond, ignoring state taxes.

8.

Monetary returns are based on a constant $50,000 balance and annual compounding. Nominal After-tax: 1.5% × (1 – 0.28) Inflation Real (actual): 1.08% – 2%

= = = =

Rate 1.50% 1.08% 2.50% –1.42%

$ Return $750.00 $540.00 $1,250.00 –$710.00

The implication is that it is difficult to do any more than keep up with taxes and inflation with liquid assets. Therefore, only the amount needed for financial emergencies and shortterm goals should be placed in assets with such a low risk-return ratio. Additional funds should be invested elsewhere for a higher return. $50,000 is too much money to be earning a low real rate of return, unless specific circumstances dictate otherwise.



9.

The corporate bond is better than the municipal bond for all tax brackets. After-tax = nominal × (1 – marginal tax bracket) 10% MTB 2.73% = 3.03% (1 – 0.10) 15% MTB 2.58% = 3.03% (1 – 0.15) 25% MTB 2.27% = 3.03% (1 – 0.25) 28% MTB 2.18% = 3.03% (1 – 0.28) 33% MTB 2.03% = 3.03% (1 – 0.33) 38% MTB 1.88% = 3.03% (1 – 0.38) 39.6% MTB 1.83% = 3.03% (1 – 0.396)

10. Student answers may vary but should be drawn from the following lists. • Advantages 1. Personal financial management support from financial planning programs 2. Convenience 3. Efficiency—easy access if Internet savvy; availability of specific services such as online “bill-pay” 4. Effectiveness—additional online services such as stock quotes, personal financial management software 5. Higher return—given the lack of “overhead” bank without physical location typically can pay higher rates of return • Disadvantages 1. Increased start-up time 2. Adapting to Internet banking may have a steep learning curve for some 3. Not feeling comfortable 4. Little or no direct customer-service DISCUSSION CASE 1 ANSWERS 1.

Examples could include the following: For retirement • Participate in employer 401(k) plan. • Obtain employer match of 401(k) plan contribution. • Sign up for U.S. savings bond purchase program. For savings • Deposit paycheck directly into savings account. • Authorize automated money market mutual fund or CD deposits. For convenience • Deposit paycheck directly into checking or savings account. • Join credit union savings plan.



2.

Shu should consider the “3 Cs” when selecting an account: • Cost—fees, minimum balances, per-check charges, etc. • Convenience—location, availability of specific services, etc. • Consideration—personal attention, services provided, etc. It is advisable to compare the characteristics of at least three different accounts and select the one that comes closest to her personal criteria for a liquid asset account.

3.

Without an emergency fund, Shu might have to borrow funds to handle an emergency (e.g., use of credit cards) or liquidate a long-term investment at an inopportune time. The rule of thumb is three to six months of expenses; therefore, Shu should keep $4,800 ($1,600 × 3) to $9,600 ($1,600 × 6) in liquid assets not subject to fluctuations in the value of principal.

4.

Wen’s after-tax monthly income is $4,000, so an emergency fund of $12,000 to $24,000 may be advisable. However, this is based on his earnings rather than his expenses, so this maybe erring to the high end, which may not be a bad thing given his employment history. Instead, Wen has nearly 9 months of after-tax income earning a relatively low rate of return. In the 25 percent marginal tax bracket, he’ll net only 1.5 percent after taxes, and after accounting for 3.0 percent inflation, the return is less than zero. Wen should reinvest the excess $11,000 in a higher-yielding asset designed to be compatible in maturity with one of his financial goals.

5.

For handling monthly expenses, Shu’s options include a standard checking account, a bank money market deposit account, and a money market mutual fund. All of these accounts have advantages and disadvantages. MMDAs have a limit of three checks per month, and MMMFs have minimum dollar requirements on check amounts, which makes neither of these accounts very suitable for paying monthly bills. However, the basic checking account does not generate a very high return. For short-term savings, typically liquidity is more important than return; therefore, the lowest cost, most flexible account would be best for her monthly expense account. Conversely, for the account Shu is using to save for her car, either of the money market accounts would provide more return without sacrificing accessibility. Neither the minimum check amount nor the monthly check writing limitation is of consequence given that she will theoretically be making only one withdrawal—at the time of purchase. So choosing the highest yielding account would be best.

6.

Cashier’s checks can be preferable to certified checks because they are purchased from a bank and drawn on the bank’s funds. Whereas a certified check is a check drawn on your account and the institution “certifies” that the check is good by placing a hold on your account for that specific check amount. There can be instances, though very rare, that the institution, probably due to an account closure, may not honor a certified check.



DISCUSSION CASE 2 ANSWER To balance his checkbook, Jarod should follow the steps in Figure 5.1, Worksheet for Balancing Your Checking Account, as outlined below or Worksheet 8, Worksheet for Balancing Your Checking Account. Step 1: In reviewing the bank statement, Jarod noted three entries that were not recorded in his checkbook register: $4.50 service charge; a $30 ATM withdrawal; and a $39 check card purchase. Subtracting these from the $1,645.11 balance on his register resulted in an adjusted balance of $1,571.61. Step 2: The statement deposits and Jarod’s checkbook register agree. Step 3: No additional deposits were made since the date of the statement. Step 4: Four checks were outstanding, for a total of $219.28, as listed below: 1079 $37.87 1083 $125.00 1085 $47.25 1086 $9.16 Step 5: Enter $1,797.39 from the statement. Step 6: Enter 0. Step 7: Add entries from steps 5 and 6, or $1,797.39. Step 8: Enter (subtract) the total of the outstanding checks, or $219.28. Step 9: Calculate the Adjusted Statement Balance of $1,578.11. Compare this amount to the adjusted checkbook register balance from Step 1, or $1,571.61. Because the numbers are out of balance—the checkbook is under by $6.50—Jarod has other problems that he can discover by completing the remaining Steps A, B, and C. A) Because the account balanced last month, there should not be outstanding checks from the past, and all deposits have been included. B) The final step is to check the math. Upon review, Jarod made two common mistakes. 1. For check number 1076 he subtracted $59.75 rather than $69.75; resulting in a $10 overstatement. 2. For check number 1078 he transposed $320.20 for $302.20; resulting in an $18 understatement. Making the appropriate correction for these mistakes, results in a July 29 balance of $1,579.61; unfortunately, now Jarod is over by $1.50.



C) In one final check of the statement Jarod notices that he neglected to enter the $1.50 ATM charge associated with his $50.00 withdrawal on June 29th. Making the final correction leaves his checkbook with a balance of $1,578.11, in perfect agreement with his bank statement.


CHAPTER 6 USING CREDIT CARDS: THE ROLE OF OPEN CREDIT

CHAPTER CONTEXT: THE BIG PICTURE This chapter is the second in a four-chapter section titled “Part 2: Managing Your Money.” This section of the text introduces strategies for managing cash, credit, and large expenditures as a part of the financial plan. The chapter focuses on the selection, use, and management of credit card accounts; the next chapter considers consumer loans. Creditworthiness, credit scoring, credit bureaus, and federal credit legislation are also introduced in this chapter. A common theme across the two credit chapters, and an important message to students, is the need (1) to develop a working knowledge of consumer credit products, (2) to choose and use products that meet individual needs, and (3) to monitor credit use and implement strategies to avoid credit overuse. The importance of limiting the use of credit to planned borrowing is stressed. CHAPTER SUMMARY This chapter provides an overview of key concepts students need to know to select, use, and manage credit cards and open credit. Different types of credit cards and the various factors that affect the costs of using different types of cards are explained. Advantages and disadvantages of using credit cards are reviewed. Creditworthiness, FICO credit scoring, and the functions of the credit bureau are considered. The chapter concludes with strategies for controlling and managing identity theft, fraudulent account use, credit overuse, and bill paying problems. Federal consumer protection laws related to securing credit, using credit, and credit reporting are also reviewed. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Know how credit cards work. a. Credit b. Consumer credit c. Open credit or revolving credit d. Annual percentage rate (APR) e. Method of determining the balance or balance calculation method f. Average daily balance method g. Previous balance method h. Adjusted balance method i. Grace period 99


100

Keown Personal Finance, Seventh Edition

j. k. l. m. n. o.

Annual fee Merchant’s discount fee Cash advance fee Late fee Over-the-limit fee Penalty rate

2.

Understand the costs of credit.

3.

Describe the different types of credit cards. a. Bank credit card b. Premium or prestige card c. Affinity card d. Secured credit card e. Travel and entertainment (T&E) card f. Single-purpose card g. Traditional charge account

4.

Know what determines your credit card worthiness and how to secure a credit card. a. Credit bureau b. Credit scoring c. Identity theft

5.

Manage your credit cards and open credit.

CHAPTER OUTLINE I.

A First Look at Credit Cards and Open Credit A. Interest Rates B. Calculating the Balance Owed C. Buying Money: The Cash Advance D. Grace Period E. Annual Fee F. Additional Fees

II.

The Pros and Cons of Credit Cards A. The Advantages of Credit Cards B. The Drawbacks of Credit Cards


Chapter 6: Using Credit Cards: The Role of Open Credit

C. What the CARD Act Means for you—the new credit card rules 1. Notification of rate increase 2. Notification of schedule for payoff 3. No interest rate increases for the first year 4. Increases rates apply only to new charges 5. Restrictions on over-the-limit transactions 6. Caps on high-fee cards 7. Protections for underage consumers 8. Standard payment dates and times 9. Payments directed to highest interest balances first 10. Fee limits 11. No inactivity fees III.

Choosing a Source of Open Credit A. Bank Credit Cards B. Bank Card Variations 1. Classes—Standard, Gold, Premium, Titanium 2. Affinity 3. Secured C. Travel and Entertainment (T&E) Cards D. Single-Purpose Cards E. Traditional Charge Account F. The Choice: What’s Best for You

IV.

Getting a Credit Card A. Credit Evaluation: The Five Cs of Credit 1. The Key to Getting Credit: Your Credit Score 3.0 2. Determining creditworthiness B. Your Credit Score 1. How your credit score is computed—FICO and VantageScore 3.0 2. What’s in your credit report 3. The factors that determine your credit score 4. Monitoring your credit score C. Consumer Credit Rights 1. The credit bureau and your rights 2. If your credit card application is rejected 3. Resolving billing errors 4. The Consumer Financial Protection Bureau (CFPB) D. Identity Theft 1. How do you know if you’re a victim of identity theft?

V.

Controlling and Managing Your Credit Cards and Open Credit A. Reducing Your Balance B. Protecting Against Fraud C. Trouble Signs in Credit Card Spending D. If You Can’t Pay Your Credit Card Bills


101

102


VI.


VII.


APPLICABLE PRINCIPLES Principle 1: Knowledge Is the Best Protection Understanding the time value of money is critical in repaying debt. You want to be careful not to double the price of consumer purchases just because you forgot to pay the bill in full. Principle 9: Mind Games, Your Financial Personality, and Your Money It’s easy to spend money you don’t have to think about for 30 days or more. Consider using credit only for planned purchases so that you don’t lose track of expenses compared to income. Principle 10: Just Do It! Credit cards have several advantages. Having available credit to cover unexpected emergency expenses means that you can have little or no cash held in low-yielding, liquid accounts. Instead, emergency funds can be invested in a higher-yielding account that could be sold before the credit card bill came due. But if your credit cards are charged to the credit limit, credit cannot substitute for available, liquid emergency-fund dollars. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Survey the class to determine the number of credit users, convenience users, and convenience and credit users. Did the students select cards with the most appropriate features for their use? If not, how were the cards selected? How might the students’ choice of cards change after graduation and full-time employment?

2.

Working in small groups, collect credit card marketing information or the summary of account information sent to cardholders for three to five different cards. Be sure to protect the identity of the recipients. Or use selected card information from one or more categories reported on www.cardtrak.com. Use the information to complete one or more of the following activities. a. Summarize the card information into a chart showing the purchase balance calculation method, annual percentage rate (APR) of interest for purchases, grace period, annual fee, and minimum finance charge. Compare the results. b. Summarize the card information pertaining to cash advances into a chart showing grace period, interest rate, and transaction fee for cash advances. Compare the results.



c. d. e. f. g.

103

Summarize the card information pertaining to additional or penalty fees into a chart. Consider the penalty APR as well as fees for late payment, exceeding the credit limit, or a bounced check. Compare the results. Summarize the additional benefits, or “perks,” that are available, such as insurance programs, car rental discounts, traveler assistance, and so on. Compare the results. Select the card that would be most appropriate for a credit user. Justify your choice. Select the card that would be most appropriate for a convenience user. Justify your choice. Review the information requested on the application. Explain how the information relates to the “five Cs of credit.”

3.

Conduct, or have students conduct, an Internet search on college student credit card usage and average balances. Discuss the findings in class, but balance that discussion with consideration of why it is important for students to have access to credit cards. Poll the class on the number of students who are or are not using credit. How many believe that they must pay interest on the account to establish a good credit score (a common misperception among students)?

4.

Some credit card issuers are beginning to assess fees and other charges on convenience users. Ask your friends and peers if they think a convenience credit card user (Note: you may need to define this term for them) should be charged for the privilege of using a credit card. Place their specific responses and group responses into categories. Use this information to create a short report for class.

5.

Interview individuals who represent the three stages of the financial life cycle about their credit card usage. How many cards do they have? What kind or class of cards (rebate, premium, affinity, T&E, or single purpose) do they have? How often do they use their cards and typically for what purchases? What is their available line of credit? Classify them as convenience users, credit users, or convenience and credit users. Summarize your findings in an oral or written report, noting differences in credit card use across the financial life cycle. Be sure to protect the identity of the recipients, and ensure them that all responses are confidential.

6.

Review the factors, and their weightings, used by Fair Isaac to calculate a credit score. Ask 10 to 20 people what factors they think should be considered in the score calculation. Be prepared to record factors identified, and to compare the response to the actual list. Did your respondents identify the correct factors, or were their responses significantly different? Were they surprised by the factors and weightings actually used? Did the factors identified vary with the age and credit experience of the respondent?

7.

Visit the FACT Act–supported Web site at www.annualcreditreport.com to determine how to check your credit report and the information needed. For fun, see if you can locate some of the imposter Web sites. What information suggested that the imposter site was a legitimate FACT Act–supported site? What information suggested that it was a fake?


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8.

Some students are strongly opposed to having a credit card. Sometimes this opposition is based on family values and sometimes on fear. Other students argue that in today’s world it is almost impossible to live without a credit card and that credit is often better than cash. Ask a group of students their opinions on the use of credit. What percentage of the students fall into the credit card avoidance category, and what percentage think a credit card is essential? What is your opinion on this issue? Use this information as the basis for a short class discussion and debate.

9.

Research the background and passage of one of the consumer credit laws discussed in the chapter. Explain why this protection was needed, and describe what practices prompted the passage of this legislation. What changes resulted?

10. Credit card fraud is considered almost incidental to the potentially more damaging and costly problem of identity theft. Check the Internet for recent statistics on the number of consumers affected, the potential costs involved, and the personal impact of this crime. 11. Visit the Consumer Financial Protection Bureau Web site (www.consumerfinance.gov). Based on the public information available, describe what role the bureau plays in providing consumer education, federal consumer law enforcement, and supervision of the consumer financial marketplace. REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1.

Define the term credit. How is credit different from open credit? What is revolving credit? Credit involves any agreement to pay in the future for goods, services, or cash received today. Consumer credit refers to any such agreement, excluding mortgages, made by a consumer for personal, and not business, purposes. Open credit and revolving credit are different names for the same service—an open line of credit with a specified limit that is continuously available to the consumer as long as an agreed-upon payment is submitted monthly. Charges and payments “revolve” over time (e.g., credit cards, store charge agreements).

2.

Describe how a lender calculates the annual percentage rate (APR) when issuing credit. Why is the APR such an important tool when shopping for credit? The annual percentage rate (APR) is the simple interest paid over the life of a loan. The APR is calculated by taking into account all costs, including interest, the cost of credit reports, the cost of all associated fees, other expenses, and the method of interest calculation. By including all relevant costs, consumers can better judge the “real” cost of credit from one lender to another.



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Explain the differences in the three balance calculation methods used by credit card issuers. Given similar account activity, which will result in the lowest monthly interest charge and the highest monthly interest charge? Credit card issuers commonly use three balance calculation methods: • Average daily balance method, as the name implies, is the mathematical average calculated from summing the individual daily balances and dividing by the number of days in the billing period. Some methods include new purchases when determining the daily balance, while others exclude the new purchase amounts. • Previous balance method bases the interest calculation on the balance at the end of the previous billing cycle, ignoring both payments and charges made during the current cycle. • Adjusted balance method bases the interest calculation on the balance at the end of the previous billing cycle after deducting payments during the current cycle. With similar account activity, using the previous balance method results in the highest interest charge, whereas the adjusted balance method yields the lowest charge. The average daily balance method is higher when new purchases are included.

4.

What is a grace period? Why would a grace period be canceled or eliminated? A grace period is a period of 21 to 25 days from the date of the bill during which interest is not charged on the outstanding balance. In three situations, the grace period is eliminated: • For about one-fourth of cards, interest charges start from the day of purchase. • For cash advances, interest charges start immediately—for almost all cards. • For accounts carrying a balance from the previous month, no grace period is allowed for current purchases—almost all cards.

5.

List and briefly describe the most common fees and penalties imposed by credit card issuers. The most common fees and penalties imposed by credit card issuers include the following: • The annual fee is a fixed annual charge imposed on a credit user. • A merchant’s discount fee is typically a fixed percentage of sales that a merchant pays to a credit card issuer. • Cash advance fees are a charge for making a cash advance. • Late fees are charges imposed as a result of not paying on time. • Over-the-limit fees are imposed whenever a credit user spends more than the credit limit. • A penalty rate is a higher interest rate assessed on your account if the minimum payment is not paid on time. This rate may be applied in addition to the late payment fee.

6.

List five benefits, or advantages, associated with credit card or open credit use. What is the major disadvantage? Advantages of credit card use include the following (which five are cited by students will vary):


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• • • • • • • • •

Convenience of shopping in person, by phone, or over the Internet, without the risk of carrying cash Availability of a temporary source of emergency funds Use of the good, service, or cash before it’s fully paid for Convenience of a complete, itemized bill for a month’s worth of shopping Opportunity to buy a needed item before an anticipated price increase Interest-free use of funds, for cards with a grace period, from date of purchase to payment Convenience of making reservations or guaranteeing reservations for late arrival Form of identification Availability of a variety of free benefits

Disadvantages include the following (one cited by students will vary): • Loss of spending control • High interest charges for unpaid balances • Credit repayment commits future income and limits financial flexibility 7.

List and briefly describe the eleven credit card rules resulting from the CARD Act of 2009. The following rules resulted from the CARD Act of 2009: • Credit card companies must tell you when they plan to raise your interest rate or other fees. Credit issuers must provide 45 days’ notice before increasing interest rates, changing fees, changing account terms, or make other significant changes. • Credit card companies must disclose how long it will take to pay off an outstanding balance. • Credit card companies can no longer increase interest rates during the first 12 months after an account is opened. Although, if you are 60 days late paying the credit card bill, the rate can be increased. • Increased interest rates apply only to new charges, which means that if you carry a balance, the old interest rate applies to the old balance. • You must now tell the credit card company that you wish to allow transactions that will take you over your credit limit; without pre-permission, the transaction will be denied. If you have not given permission, and the charge does go through, the credit card may not charge penalties or additional fees. • Credit card companies can no longer issue high fee cards. Total fees, such as an annual fee, cannot total more than 25 percent of the initial credit limit. • Most consumers under age 21 will require a co-signer in order to open a credit card account or show documentation that their income is high enough to qualify for credit. • Credit card companies must now mail or deliver credit card statements at least 21 days before a payment is due. • When making a credit card payment (more than the minimum), the credit card company must apply the excess amount, over the minimum, to the balance with the highest interest rate.



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Credit card companies can no longer charge fees in excess of $25 unless one of your last six payments was late (resulting in a $35 charge) or the credit card company can show that its costs associated with late payments exceeds $25. Credit card companies are no longer allowed to charge inactivity fees.

Explain the differences in a bank credit card, a premium or prestige credit card, an affinity credit card, and a secured credit card. What are credit card classes? A premium or prestige card, an affinity card, and a secured card are all variations of a bank credit card. A bank credit card is a credit card issued by a bank or large corporation, in cooperation with the Visa or MasterCard franchise organization. Visa or MasterCard offer a system for credit authorization, billing, and advertising, while the issuing bank or corporation sets the policies for interest, grace periods, fees, and other related services or benefits. Bank credit cards may be characterized by the following: • The credit limit of the cardholder is referenced through the four-level card class system. A credit limit as high as $100,000 or more and additional benefits (e.g., emergency medical or legal services) or rebates characterize a premium or prestige card, such as a Platinum or Titanium card. At the low end of the spectrum are standard cards followed by Gold cards with a higher credit limit and user benefits. • An affinity card benefits the issuing organization or charity through a rebate of a small part of the annual fee or a percentage of the annual purchase amount. Although holders of these cards want to support the issuing organization or charity, the cards generally carry more expensive fees and rates of interest. • Collateral, such as a CD or a savings account, is required by the bank to issue a secured credit card. If the bill is not paid on time, the bank can claim the assets securing the account. People who are a bad credit risk and could not otherwise qualify for a credit card use secured cards.

9.

Although they are called “credit cards,” T&E cards and single-purpose cards are uniquely different from bank credit cards. What are the differences? What do they have in common with a traditional charge account? Travel and Entertainment (T&E) cards require full payment of the balance each month; bank credit cards offer revolving credit or the option to pay the balance over an extended period of time. The only consumer advantage is the interest-free grace period, but a high annual fee is a disadvantage. Most bank credit cards offer an interest-free grace period, assuming no balance is carried forward, and many charge no annual fee. Single purpose cards can only be used for purchases at the issuing company (e.g., ExxonMobil), unlike a bank card that can be accepted at a variety of business establishments around the world. Like T&E cards, traditional charge accounts expect full payment at the end of the month. Single purpose cards may also expect full payment, while some companies allow for revolving credit. Unlike T&E cards, neither single purpose cards nor traditional charge accounts require an annual fee. Also unlike T&E cards, both single purpose cards and traditional charge accounts limit the user to the one issuing company. Finally, traditional


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charge accounts offer the user convenience and availability of the product or service prior to payment but are not based on a “card.” 10. What is (are) the most important decision factor(s) in choosing a credit card for a credit user, a convenience user, and convenience and credit user? A credit user carries a balance, so finding the lowest possible interest rate is most important. A convenience user wants the convenience offered by the card but pays the bill in full each month. Interest rate is irrelevant, but no or low annual fee, a long interest-free grace period, and added free benefits from the card are important. The convenience and credit user wants the best of both—low interest for when a balance is carried, a long interest-free grace period for when the bill is paid monthly, and no annual fee to keep other costs low. 11. Explain how the CARD Act of 2009 has changed the way college students apply for and access credit cards. The CARD Act bans credit card companies from providing free goods and services within 1,000 feet of a college or university campus. In addition, card issuers are no longer allowed to issue cards to anyone under age 21, unless the person qualifies for credit independently or if someone older than age 21 co-signs the application. It is important to note that credit card companies may still solicit applications from students under age 21 if the student has been prescreened. 12. Explain the five Cs of credit and how they relate to individual creditworthiness. The “five Cs” of credit to determine creditworthiness include the following: 1. Character: reflects stability in your lifestyle (e.g., residence, job) and your previous handling of credit. Responsibly handling debt repayment in the past increases creditworthiness. 2. Capacity: reflects the relationship between earnings and debt. Having the capacity to take on and repay more debt given your current debt/income situation increases creditworthiness. 3. Capital: reflects the level of savings and investments held. Managing income to meet current debt obligations and still save to accumulate assets increases creditworthiness. 4. Collateral: reflects the availability of assets for security, should you default on the loan. Collateral that is worth more increases creditworthiness. 5. Conditions: reflect the possible impact the current economic situation might have on your ability to repay the debt. Favorable conditions that do not negatively affect job security or earning potential increase creditworthiness. 13. What is a credit (FICO or VantageScore) score? How does a credit score affect the availability and cost of credit? Credit bureaus collect, maintain, and provide information to lenders. The credit bureau confirms information provided on the lender’s credit application as well as supplying additional data from other creditors or public court records. Some lenders use the credit-



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bureau-provided information to calculate their own credit score, while other lenders simply purchase scores from the credit bureau. Either way, most scores are calculated using models developed by Fair Isaac Corporation, hence the name FICO score, although credit bureaus may use their own proprietary, or “brand name,” for the score. Lenders use the numerical score, or FICO score, to determine the access to and cost of credit. The higher the score, the greater the availability of credit and the lower the interest rates charged. With lower scores, interest rates increase and at some predetermined score, credit is denied. 14. What factors are considered in the calculation of the FICO score? Briefly explain each. Five factors are considered in the FICO score calculation: • Payment history, 35 percent of the score, reflects the pattern of payments for other credit accounts. • Amount owed and available credit, 30 percent of the score, reflects the amount currently owed on all credit accounts, including mortgage, as well as the percentage of available credit currently used. For example, do your credit card balances reflect 25 percent of your available credit lines or 85 percent? • Length of credit history, 15 percent of your score, reflects how long accounts have been open and if accounts have continued with the same creditors. • Types of credit used, 10 percent of your score, reflects the ability to manage money across a variety of account types (e.g., credit card, retail accounts, auto loan, mortgage, student loan). • New credit, 10 percent of your score, reflects your efforts to acquire new accounts. Recent attempts to add multiple accounts will lower your score. 15. List the protections against identity theft offered by the FACT Act. How does Principle 10: Just Do It! apply to these protections? The FACT Act offers consumers the following protections against identity theft: • Access to one free credit report annually from each of the three major credit bureaus: Experian, Equifax, and Trans Union. • Designation of a fraud alert on your account and improved security of your credit rating by calling one of the credit bureaus. • With the fraud alert in place, creditors must take additional precautions to ensure that you are in fact opening the account by confirming your identity. • Electronic receipts cannot show the entire account number, but only the last five digits. Requesting your credit report from all three bureaus or calling to establish a fraud alert takes consumer action—only you can “Just Do It.” Invoking these protections requires you to act, not procrastinate! 16. What other protection to your credit information does the Fair Credit Reporting Act provide? The Fair Credit Reporting Reform Act of 1996 provides the following protection of your credit information:


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• Consumers must be informed of the name of a credit bureau providing information that causes credit denial. • Consumers have access to their report information and the right to challenge incorrect information. • Written permission is required from consumers before an employer or prospective employer can access credit report information. • Consumers may sue creditors for not correcting reporting errors. 17. Describe the steps involved when attempting to resolve a billing error. The Fair Credit Billing Act provides procedures for resolving billing errors. A credit user may withhold payment for the item in question while the issue is under investigation. The first step in resolving a billing error is to notify the card issuer in writing within 60 days of the statement date. The letter must include your name, address, account number, and a description of the error. The letter should be sent to the billing inquiry address on the credit card. The issuer will notify you within 30 days that an investigation has begun. The issuer has 90 days or two billing cycles to complete the investigation. Upon completion, your account will either be credited or you will receive an explanation why the complaint is not deemed to be legitimate. If you are still not satisfied, you may contact a regulatory agency or file a claim in small claims court. 18. What are the warning signs of identity theft? What steps can you take to avoid it? Identity theft occurs when fraud or other crimes are committed by someone using your name, address, Social Security number, bank or credit card account number, or any other personal information. Identity theft occurs from lost/stolen wallets, information retrieved from household mail or trash, or from a change of address form used by thieves to divert household mail. Phone or e-mail solicitations for personal or other account information as part of a survey or to confirm account activity are examples of thieves collecting personal information under the “pretext,” or guise, of some other purpose. Active accounts that are not actually your accounts but are listed on your credit report may be one indication of identity theft. Other indicators include the following: • A new credit card that you did not apply for. • Credit denial or unfavorable credit terms on a new account for no apparent reason or change in your financial situation. • Inquiries from debt collectors or businesses for products/services you did not purchase. • Undelivered bills or other mail that you expected. 19. List four ways to avoid credit card fraud. To guard against credit card fraud: • Save all credit card charge receipts, compare them to the monthly statement, and then destroy them to avoid someone getting your card number from a receipt. • Don’t disclose your account number over the phone unless you initiated the purchase. • Never disclose your account number over a public phone. • Never leave a store without your card.



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20. Develop a list of five to eight warning signs that someone may be having trouble with credit or may be a credit card abuser. Warning signs of credit card abuse include the following (five to eight items listed by students will vary): • Paying only the minimum monthly payment each month. • Reaching, or exceeding, the maximum spending limit on one or more cards. • Charging group expenses (e.g., dinner out with friends) on your card in exchange for the cash paid by your friends. • Failing to keep an accurate record of current credit card charges. • Using credit cards for impulse purchases as well as necessities such as food, rent, or other credit payments. • Getting cash advances to cover expenses when your checking account runs low. • Being turned down for a new credit card or having an old card canceled. • Using savings to pay off credit card bills. • Failing to know how much interest you are accumulating on the account, or how the interest affects your monthly bill. • Worrying about your credit card bill before or after it comes in the mail. 21. Aside from paying more by increasing income and reducing spending, list three other strategies for dealing with overuse of credit cards. Strategies for dealing with excessive credit card use include the following (three strategies listed by students may vary): • Planning a budget to ensure that credit card payments are made and additional charges are not made • Shopping for the least expensive credit card that best meets your usage habits • Using savings to pay off the credit card balance—only if it is cost effective and does not become a habit • Using a secured loan or home equity loan to pay off credit card debt that is charging a higher interest rate PROBLEM AND ACTIVITY ANSWERS 1.

The annual percentage rate of interest paid on the account, the balance calculation method, the grace period, and the other additional fees (e.g., cash advance, late payment, over-thelimit) and penalties (especially rates) paid on the account affect the cost of credit cards. These same basic account features affect the cost of other open lines of credit.

2.

Mitch is correct. Interest charges on ATM cash advances start immediately, whether or not there is an outstanding balance. The interest rate on cash advances is often higher than for purchases, and cash advances usually carry an additional fee. Assuming he had no outstanding balance, Ted could have made the same purchases directly on the credit card, paid the bill when due, and paid no interest at all. If he really did need cash, getting the


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minimum amount would have reduced the associated costs. On the other hand, if Ted is carrying a balance on the card, interest charges would begin immediately on the purchases made, but he would avoid the cash advance fee and the higher rate of interest. The best advice is to avoid cash advances and charge no more than can be paid off each month. 3.

Yes, shopping for the lowest possible interest rate is important. In this example, a 4 percent rate difference could mean as much as a $3.33 difference (for previous balance method shown below), in interest charged—for an account with little activity and a low balance. 14% 16% 18% Average Daily Balance $6.42 $7.33 $8.25 Previous Balance $11.67 $13.33 $15.00 Adjusted Balance $1.17 $1.33 $1.50

4.

The advantages of using credit cards include the following: • Convenience or ease of shopping • Emergency use • The ability to consume before you pay • Consolidation of bills • Prepurchase in anticipation of price increases • Source of interest-free credit • Safe way to make reservations • Source of identification • May be a source of free benefits Disadvantages include: • It’s possible to lose control of spending. • They are expensive. • You’ll have less income to spend in the future.

The CARD Act of 2009 adds to the advantages because notifications of major rate increases occur well in advance of the actual change so spending modification can occur; there are restrictions on over-the-limit fees; and there are standard payment dates and times with notification of how long it will take to pay off the balance if only the minimum payments are made. 5.

A consumer sent each of the following cards might have the associated characteristics: • Bank credit card— previous credit, features from the “5 Cs” • Premium or prestige credit card—high income, strong credit report • Affinity credit card—membership in the issuing group or previous supporter of the charity; graduate of issuing college • Secured credit card—bad or weak credit report



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It will take Rachel 47 months, or almost four years, to pay off the $8,000 balance, assuming no new charges on this card. Calculator solution PV $8,000 PMT -$240 I/Y 18%/12 = 1.50 N ? FV 0 CPT N 46.55 As a typical credit user, Rachel might consider finding a card with the lowest possible interest rate and doing a balance transfer. However, she must be cautious of acquiring too much new credit or of closing the existing account—both factors that could lower her credit score. If a new, lower interest card would be her only new credit, she could save interest and possibly increase her score because her $8,000 balance would represent a lower percentage of her total available credit.

7.

The following credit issues are matched with the appropriate consumer credit law: • Controls debt collection procedures and practices: Fair Debt Collection practices Act of 1978 • Prohibits credit discrimination because of race, age or national origin: Equal Credit Opportunity Act (amended 1977) • Established APR and required disclosure of all credit-related costs: Truth in Lending Act of 1968 • Requires credit contracts to be written in plain English: Truth in Lending Act (amended in 1982) • Requires a “rejection letter” or written explanation of any adverse action taken: Equal Credit Opportunity Act of 1975 • Limits marketing of credit cards to the mailing of application packets and prohibits the mailing of unrequested credit cards: Truth in Lending Act (amended 1971) • Payment for defective goods purchased with a credit card can legally be withheld: Fair Credit Billing Act of 1975 • Limits fraudulent card use to $50 payment by the cardholder: Truth in Lending Act (amended 1971) • Ensures that divorced individuals receive credit: Equal Credit Opportunity Act of 1975 • Provides annual access to one free credit report from each major credit bureau: Fair and Accurate Credit Transactions Act (FACT Act) of 2003 • Reduces credit card late fees to $25: Credit Card Act of 2009 • Limits the issuance of credit cards to consumers under age 21: Credit Card Act of 2009 • Requires clear and simple disclosures related to international money transfers: DoddFrank Wall Street Reform and Consumer Protection Act


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8.


Using the financial calculator solves for the following: Calculator solution 10 yrs. PV $0 PMT -$1,200 I/Y 8% N 10 FV ? CPT FV $17,383.88 Calculator solution 15 yrs. PV $0 PMT -$1,200 I/Y 8% N 15 FV ? CPT FV $32,582.54 Calculator solution 20 yrs. PV $0 PMT -$1,200 I/Y 8% N 20 FV ? CPT FV $54,914.36


The CARD Act of 2009 banned credit card companies from issuing cards to anyone under age 21, unless the person can show proof that they can repay the loan independently. Because Maria works only during the summer, she would fail this test. It is unlikely that she can obtain a credit card without her parent’s help at this time. However, once she turns 21, she will more easily be able to obtain a credit card, if she has no bad credit history to suggest mismanagement.

2.

A unique advantage of a credit card for college students is the opportunity to build a positive credit history for the future. Use of the card in an emergency situation away from home is another distinct advantage for college students. Other advantages of credit card use include the following: • Convenience of in-person (without cash), phone, or Internet shopping • Use of the good, service, or cash before it’s fully paid for • Convenience of a complete, itemized bill for a month’s worth of shopping • Opportunity to buy a needed item before an anticipated price increase • Interest-free use of funds, only applicable for cards with a grace period • Convenience of making reservations or guaranteeing reservations for late arrival



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Form of identification Availability of a variety of free benefits

To ensure building a solid credit history for the future, it is particularly important that college students avoid the disadvantages associated with credit cards, such as loss of spending control, accumulation of high interest charges for unpaid balances, and overcommitment of future income to pay off debt. 3.

It is recommended that the average consumer use no more than three credit cards. The versatility of a bank credit card should meet all of Maria’s needs. If her parents did not feel comfortable with this option, a more conservative alternative would be a single purpose gas company card. This would insure Maria access to gas or automotive service but prevent other spending.

4.

In addition to considering specific information about the interest rate, method of balance calculation, grace period, annual fee, and other associated fees and benefits, Maria should consider the following characteristics unique to each of her credit card products: • Visa: Standard Visa with costs and features determined by the issuing bank; wide merchant acceptance; need to comparison shop for lowest cost card. • Gold MasterCard: Premium or prestige card with exceptionally high credit limit; high income and established credit history required to qualify for account • Discover: Carries no annual fee and rebates small percentage of annual purchase amount to the cardholder; ussued by only one bank; more limited acceptance among merchants • University-sponsored Visa: Affinity card, which typically carries a higher annual fee and interest rate; small percentage of annual fee or purchase amount rebated to the university; otherwise, similar features to a “regular” Visa • American Express: T&E card that does not offer revolving credit; full payment of the balance required each month; high annual fee • Secured MasterCard: Similar features to a standard MasterCard, except security deposit (e.g., savings account, CD) required by issuing bank to be used for payment in case of cardholder default. Typically used by consumers with a poor credit rating. • Gas Card: Single purpose card with purchases limited to the issuing company

5.

Maria should seriously consider the Visa card. Depending on the interest rate, method of balance calculation, grace period, annual fee, and other associated fees and benefits, she may want to consider other standard class Visa or MasterCard applications to find the cheapest alternative. No annual fee, an interest-free grace period, a low interest rate, and a low fee structure would be ideal. Discover is another possibility with distinct advantages of no annual fee and the consumer rebate. However, acceptance may be more limited because Discover is issued by only one bank. The gas card would ensure access to gas or automotive services, but these purchases could likely be charged on a Visa or MasterCard. The other bank card variations are inappropriate for her needs.


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6.


Maria should compare the following costs when choosing a credit card: • Interest rate charged on the card, or the APR. A lower interest rate is preferred. • Method used to calculate the monthly balance on which interest is charged. The previous balance is most expensive; the average daily balance method is most common. • Grace period for new purchases when no interest is charged. A longer grace period is preferred. • Annual fee for using the card. No fee, or a low fee, is preferred. • Additional fees for cash advances, late payments, or charging over the approved credit limit. Lower fees are preferred. Given Maria’s situation, a card with no annual fee, an interest-free grace period, an average daily balance method with a low interest rate, and a low fee structure would be ideal.

7.

Once Maria receives the card, she should very carefully compare the actual account information with that promised in the “preapproved” offer. The credit card issuer might have sent her a card with less favorable rates after evaluating her credit history and the information submitted on the application. If the card account is less favorable than what she was initially offered, she should not activate the card and should contact the company to close the account.

8.

Maria will need to make a monthly payment of $151 to pay off the balance in 24 months assuming only those two additional $600 purchases on the card.

9.

Except in an emergency situation, charge no more than can be paid off monthly. Avoid interest and other fees by never carrying a balance forward.

10. It is legal for current and prospective employers to review a person’s credit report, with permission. If Maria’s future employer uses credit history to screen applicants, she might be negatively impacted in the job market if she builds high revolving balances, has incurred late fees, or has other negative information in her credit report. These credit behaviors are often seen as potentially negative indicators of employee performance. To safeguard her report from inaccurate information, or information that does not apply to her, she should take advantage of the free credit reports offered through the FACT Act. 11. Maria’s best fraud and identity theft protection, in addition to checking her free credit reports offered through the FACT Act, is really common sense safety, as listed below: • Save all receipts and compare them to the monthly bill. • Shred all receipts and statements that she discards to safeguard her credit card number. • Shred or carefully tear up all credit card offers received. • Only give her credit card number over the phone if she initiated the sale. She should never use a public or pay phone for such transactions. • Ignore all “pretexting” inquiries by phone or Internet. She should never provide personal or account information, unless fully assured that the inquiry is legitimate and the transfer of information is safe.



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Never leave her card behind at a business. Monitor the arrival of her account statements to ensure they are not lost, stolen, or misdirected by thieves through a change of address scheme.


Because Garth carries an unpaid balance from one month to the next he is classified as a credit user. Garth should focus on the APR offered by a credit card issuer and choose one with the lowest possible interest rate. He should also find a card with a low cash advance fee.

2.

Although the format may vary, all credit reports include four types of information that Lindsey and Garth will need to review for accuracy: • Personal identification information such as name, address, Social Security number, birth date, and employment information • Trade lines or credit accounts including the type of account, creditor name, account number, balance, date opened, payment history and current payment status of the account • Inquiries for the last 2 years by anyone accessing the account, including “voluntary” inquiries from creditors, representing accounts Garth has attempted to open, as well as “involuntary” inquiries from creditors making preapproved offers • Public record and collection reports such as legal actions recorded in state and county courts (e.g., bankruptcies, foreclosures, judgments, liens, wage attachments, or suits) or overdue debts pursued by collection agencies

3.

A secured credit card is a regular bank card backed by collateral. This is not an appropriate card for Garth because there is no indication that Garth’s credit is bad enough to stop him from obtaining another card or that he cannot make monthly credit card payments. It is very doubtful that Garth could qualify for a Titanium card, the highest class of credit card that offers the highest credit limits and perks to cardholders.

4.

Garth is most likely going to be hit with cash advance fees and late fees on occasion. Because he is sometimes late in making payments, he may also incur penalty rates that can significantly increase the cost of credit. These types of fees and penalties work to increase Garth’s total cost of credit, making his purchases more expensive than they should be.

5.

The rate charged on a credit card account is a significant determinant of the cost of using that card. Garth may encounter offers with one or more of the following rates: • Fixed rate—a constant rate of interest applied to the calculation of interest for the account. With at least 45 days prior notice, provided in writing to the cardholder, the credit card company can change the fixed rate. • Variable rate—a fluctuating rate tied to changes in another interest rate specified by the credit card company, such as the prime rate of interest plus X percent. • Teaser rate—an exceptionally low introductory rate initially charged on the account to attract new users. The teaser rate is available for 3 to 12 months but then jumps to a higher rate.


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•

Penalty rate—a significantly higher rate of interest applied to an account when the cardholder does not pay the minimum payment on time. The penalty rate would be in addition to a late payment fee and may be applied to the account for an extended period of time.

6.

To maximize the benefit from transferring his credit card balance to another card, Garth should follow these guidelines: • Comparison shop to find the card offer with the best possible interest rate/fee structure. • Determine the length of the grace period of no interest on transferred balances (if any) and the length of the lower, “teaser rate” period. • Pay as much as possible on the account to reduce the balance before the low rate expires. • Ask how long the transfer process will take to ensure no missed payments on the original card. • Don’t transfer a balance to a card with a balance because he will likely lose any grace period for the transferred balance. • Maintain the old credit account for the benefit to his FICO score, but use it only when he can definitely afford to pay the bill in full so as not to incur interest charges. • Do not open additional credit accounts because opening too many accounts in a short time frame would likely reduce his FICO score.

7.

After Garth’s latest credit card application was rejected, he should consider the following three courses of action: • Within 60 days of the credit denial, Garth can submit his rejection letter to request a free copy of his credit report from the credit reporting service used by the credit card company. He should carefully review the report for accuracy and correct any inaccurate information. He could be the victim of identity theft. • If he really needs another card, he could apply with another credit card company, as every lender uses different criteria for screening and evaluating applicants. Rejection from one company does not mean Garth could not get another credit card. However, he should consider the impact on his FICO score. • Contact a representative of the credit card company, or if a local bank, the credit card manager to determine why he was rejected. Garth will then need to take the necessary steps to correct the problem, such as correcting inaccurate information in his credit history or changing his credit use and payment practices.

8.

Using Table 6.5 and assuming a monthly payment of 5 percent of the balance, Garth can pay off the balance in 23 months. Garth will need to make a monthly payment of $271 to pay-off the balance in 12 months, assuming no additional purchases on the card. Using a calculator: $3,000 PV 12 N 15/12 = I/Y CPT PMT = $270.77 or $271 rounded



9.

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Because 15 percent of the FICO score is typically based on length of credit history, Garth may not want to close his older accounts. Other factors to consider include the other types of credit used (10 percent of the score) and the amount of debt outstanding relative to the total credit availability (30 percent of the score). Obviously, keeping a higher FICO score should not be the only considerations. If the accounts have annual fees, while other available accounts do not, closing the accounts could be a good idea, particularly if he has other long running accounts. Also, if he will be tempted to abuse the available credit limits, closing the accounts is a better idea than risking credit overuse.

10. Although Garth should make every effort to control his credit card usage to a reasonable monthly payment or time period to eliminate his debt, unforeseen problems may occur. Should Garth have problems with his credit card payments, he could consider the following options: • Check to be sure he has the least expensive credit card available given his card usage and payment history. • Use savings to pay off current credit card debt, but only in an extreme situation, as this defeats the idea of saving for future goals. • Explore the availability of other credit options, such as a secured loan, home equity loan, or other loan that would be less expensive than the credit card.


CHAPTER 7 STUDENT AND CONSUMER LOANS: THE ROLE OF PLANNED BORROWING CHAPTER CONTEXT: THE BIG PICTURE This chapter is the third in the four-chapter section titled “Part 2: Managing Your Money.” It is the second chapter on the use of credit as a financial tool, and expands on the topic of credit management and misuse. The chapter focuses primarily on the characteristics of and costs associated with different types of loans; strategies to shop effectively for the most inexpensive credit source are highlighted. Important messages for students in this chapter include the use of credit knowledge to comparison shop for credit, the need to monitor credit usage as a part of the overall financial plan, and the need to develop an awareness of different strategies for dealing with credit overuse or bill-paying problems. CHAPTER SUMMARY This chapter is a primer on different types of consumer loans, associated loan costs, and the numerous sources of consumer loans. Strategies are presented to reduce direct loan costs to borrowers, which also reduce the lender’s risk. Planned borrowing as a component of the larger household financial plan is considered, including the tax implications of using savings instead of credit. Two measures for determining a comfortable debt level are introduced, as are strategies for managing debt when credit is overused. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Understand the various consumer loans. a. Consumer loan b. Single-payment or balloon loan c. Bridge or interim loan d. Installment loan e. Loan amortization f. Secured loan g. Unsecured loan h. Fixed interest rate loan i. Variable or adjustable interest rate loan j. Prime rate k. Convertible loan l. Security agreement 121 ©2016 Pearson Education, Inc.

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m. n. o. p. q. r. s. t.

Default Automobile loan Note Insurance agreement clause Acceleration clause Deficiency payments clause Recourse clause Home equity loan or second mortgage

2.

Calculate the cost of a consumer loan. a. APR or annual percentage rate b. Loan disclosure statement c. N-ratio method d. Rule of 78s or Sum of the Year’s Digits

3.

Pick an appropriate source for your loan.

4.

Control your debt. a. Credit or debt counselor b. Debt consolidation loan c. Bankruptcy

5. Understand the alternatives for financing your college education. a. Student loan CHAPTER OUTLINE I.

Consumer Loans—Your Choices A. First Decision: Single-Payment Versus Installment Loans B. Second Decision: Secured Versus Unsecured Loans C. Third Decision: Variable-Rate Versus Fixed-Rate Loans D. Fourth Decision: The Loan’s Maturity—Shorter- Versus Longer-Term Loans E. Understand the Terms of the Loan: The Loan Contract 1. Insurance agreement clause 2. Acceleration clause 3. Deficiency payments clause 4. Recourse clause F. Special Types of Consumer Loans 1. Home equity loans 2. Advantages of home equity loans 3. Disadvantages and dangers of home equity loans 4. Automobile loans


Chapter 7: Student and Consumer Loans: The Role of Planned Borrowing 123

II.

Cost and Early Payment of Consumer Loans A. Cost of Single-Payment Loans 1. Simple interest method 2. Discount method B. Payday Loans—A Dangerous Kind of Single-Payment Loans C. Cost of Installment Loans 1. Simple interest method 2. Add-on method D. Early Payment of an Add-On Loan

III.

Getting the Best Rate on Your Consumer Loans A. Inexpensive Sources B. More Expensive Sources C. Most Expensive Sources D. Keys to Getting the Best Rate E. Should You Borrow or Pay Cash?

IV.

Controlling Your Use of Debt A. Debt Limit Ratio B. Debt Resolution Rule C. Controlling Consumer Debt D. What to Do if You Can’t Pay Your Bills 1. Go to your creditor 2. Go to a credit counselor 3. Other options 4. Bankruptcy as the last resort E. Chapter 13: The Wage Earner’s Plan F. Chapter 7: Straight Bankruptcy

V.

Student Loans and Paying for College A. So Many Choices—Schools and Majors B. Borrowing Less and Borrowing Smarter C. Paying for Your College Education 1. Saving for College 2. Borrowing Money—Federal Student Loans and Private Loans 3. Compare Financial Aid and College Costs D. Manage Your Money Responsibly E. Repaying Your Loans 1. Repayment Plans 2. Deferment 3. Forbearance

VI. Behavioral Finance – Principle 9: Applied


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VII. Action Plan – Principle 10: Just Do It! A. Mind your loans B. Watch your grace period closely – and don’t miss your first payment C. Keep connected D. Know your repayment choices and pick that one that fits you E. If you have problems – deal with them F. Go after your most expense loan first G. To consolidate or not to consolidate APPLICABLE PRINCIPLES Principle 1: The Best Protection Is Knowledge Knowledge of credit costs can save a lot of money, as is very apparent with short-term “feefinancing,” applied to payday loans. Consumers using these loans should consider the applicable interest rate that the fee represents. Loan costs should persuade consumers to look for another source of financing, or better yet, to control their spending and avoid the need altogether. Unfortunately, those using payday loans often have no other lending alternatives and may not control their finances to include even a small emergency fund. Principle 8: Risk and Return Go Hand in Hand This principle affects the cost of credit for both the borrower and the lender. Fixed-rate loans generally cost more for the borrower than variable-rate loans because the lender is bearing more risk and therefore demands a higher return. Borrower strategies to reduce the risk for the lender (e.g., strong credit rating, variable interest rate, short loan term, collateral, and larger down payment) reduce costs associated with the loan. Principle 9: Mind Games, Your Financial Personality, and Your Money Behavioral Finance tells us that people value their current possessions more than they would be willing to pay for an equivalent item. Understanding the true value of possessions will aid in identifying the cost of emotions in valuation of personal items. Principle 10: Just Do It! It is likely that students will graduate with student loans. Tips for making life with student loans as good as possible include making sure you understand the loan details, keeping your contact information updated with the lender, and understanding the repayment options. General tips for managing consumer loans include dealing with problems before they get out of control and paying off the most expensive loan first.



SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1. Review the methods recommended for dealing with credit overuse with the class. Which methods would students feel most comfortable using? Which methods would they feel uncomfortable using? Why? Ask them to explore how credit counseling, debt consolidation loans, or bankruptcy might affect their financial future. 2. Ask students to visit and review the websites for three to five major credit counseling services, including the National Foundation for Consumer Credit (www.nfcc.org). What services are provided? How are they provided, in person, by telephone, by Internet? What costs, if any, are involved? What information is available to help someone with credit problems? Ask the students to choose the service they would use. What factors affected their choice? 3. “Because they force you to plan your purchase and your repayment, consumer loans tend to be called ‘planned borrowing.’” To help students understand the use of credit and credit repayment within the context of the household financial plan, discuss the factors that contribute to “unplanned borrowing” and credit misuse. Encourage students to defend their answer, or use personal examples to justify their responses. Do payday loans qualify as planned borrowing among their typical users—consumers with poor credit scores, consumers with marginal income, or college students? 4. To increase student interest in this chapter, introduce the topic by reporting the latest statistics for local or national personal bankruptcy filings. Ask students to research bankruptcy and its causes. What are the bankruptcy filing rates among young adults? How does this compare to other stages of the life cycle? What are the primary factors that lead to bankruptcy? What are the implications for getting credit after filing for bankruptcy? 5. Require students to visit a bank, a credit union, and a retail outlet that offer credit and ask for a copy of the contract for a consumer installment loan or purchase. Compare the contracts for an explanation of the credit terms as well as the various contract clauses identified in this chapter. How do interest rates vary for secured and unsecured loans? Do they offer fixedand adjustable-rate loans? What method(s) of interest calculation do they use? Prepare a report of your findings. 6. Have students visit the FAFSA Web site (www.fafsa.ed.gov) to learn about the different student loans available through the government. How do you qualify for federal loans? Using FAFSA’s online calculator, determine how much your monthly payment will be if you borrow $10,000 and use the standard repayment period of 10 years with an interest rate of 6.8 percent.


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7. Have students visit several payday lenders to learn about their lending process, limits, and fees. Do the lenders compete on cost or convenience? Do they serve college students with little or no income? Prepare a report of your findings. 8. Require students to interview the financial manager at an auto dealership to learn about the available financing options. Because the auto purchased will serve as collateral and the vehicle trade-in value can be the down payment, how does the interest rate and term of the loan affect, or reduce, the lender’s risk? How can the consumer get the best auto financing deal? Discuss the debt resolution rule in light of the increasing length of auto loans. 9. Using the student’s anticipated entry-level take-home pay, have them calculate the maximum nonmortgage debt payment they can safely handle. What are the implications given their actual or anticipated debt for credit cards, auto loan, or school loans? Can they afford additional borrowing for furniture, appliances, travel, or other needs? (Assume that takehome pay would be 75 percent of projected gross salary.) 10. Have students interview their parents or other family members to describe their feelings about and use of credit. Use Checklist 7.1 as a discussion guide. (If you are discussing with two or more members, consider having them answer the questions separately.) 11. Have students visit www.paydayloaninfo.org to see how payday loans are regulated in your state. Write a brief report detailing the maximum loan amount and annual percentage rate allowed in your state. Explain the different restrictions that apply to members of the military. REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1.

How does a single-payment or balloon loan differ from an installment loan? What is a bridge loan? A single-payment, or balloon, loan is paid back in one lump-sum payment on the date of loan maturity. The balloon payment is the total of the amount borrowed and all interest charged for the life of the loan, generally less than one year. In contrast, an installment loan is repaid through a series of smaller payments. A bridge loan, such as a single payment balloon loan, provides short-term funding until longer-term or additional financing is available. The name, bridge or interim loan, refers to the fact that this loan fills an interim time or bridges the need for financing from one time period to another, when another loan is available. The subsequent financing would pay off the bridge loan.

2.

Describe the differences between a secured and unsecured loan. How does Principle 8: Risk and Return Go Hand in Hand apply?



Collateral, or an asset identified as security for a loan, differentiates a secured from an unsecured loan. An unsecured loan, because it has no available collateral for repossession in the event of loan default, carries a higher interest rate. As explained by Principle 1, the lender requires a higher return in exchange for the greater risk of having only the borrower’s promise to pay. In contrast, with a secured loan the collateral could be repossessed, therefore offering more “safety” for the lender and a lower interest rate for the borrower. 3.

Describe a variable- or adjustable-rate loan. List four features that should be compared when shopping for this type of loan. What is a convertible loan? Variable or adjustable interest rate loans subject the consumer to fluctuations in the current market interest rates, which could mean higher or lower payments over the life of the loan. Typically, loan rates are tied to the prime rate or the rate on Treasury securities, often plus some margin. Consumers are protected by periodic caps on interest rates as well as a lifetime cap that establishes a maximum rate over the life of the loan. A loan with the interest rate tied to longer-term market rates typically offers more rate stability than one tied to shorter-term rates, as the latter tend to change more often. When shopping for these loans, consumers should compare the following: • The interval between rate adjustments (e.g., monthly, quarterly, annually) • The volatility of the market interest rate on which the loan rate is based (e.g., 6-month Treasury bill rate or the 20-year Treasury bond rate) • Periodic rate cap or maximum amount the rate can change in one adjustment interval • Lifetime cap or maximum amount the rate can increase over the life of the loan Convertible loans offer the borrower the benefit of a lower variable-rate loan with the option to convert to a fixed rate loan at specified future dates. Although not as commonly available, convertible loans offer initially lower costs and the option to convert to a fixed rate loan, although it could be at a rate higher than that available when the loan was initially established.

4.

Are the initial rates lower on a fixed-rate loan or a variable-rate loan? Why? Variable rates loans are typically lower than the fixed rate equivalent because the borrower rather than the lender is assuming the interest rate risk (the risk that interest rates could rise during the loan period).

5.

Credit contracts often include the acceleration clause, the deficiency payments clause, and the recourse clause to give the lender options for collecting the debt. Explain each clause. What is the purpose of the insurance agreement clause? The following clauses deal with consumer default on a loan contract: • Acceleration clause declares the entire balance of the loan due immediately if one payment is missed. The collateral will be repossessed and sold if funds are not available to pay off the loan.


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• Deficiency payments clause establishes the right of the creditor to bill the consumer for the difference in the amount of the outstanding loan balance (plus collection, selling, and legal costs) and the amount generated through the repossession and sale of the collateral. • Recourse clause establishes what additional actions the lender can take to seek repayment in case of default. Attachment of wages to secure a portion of the debtor’s salary is a common recourse. An insurance agreement clause requires the purchase of credit life insurance to repay the loan in the event of the borrower’s death. This clause adds, sometimes tremendously, to the cost of the loan because credit life insurance is a very expensive type of life insurance that mainly benefits the lender. 6.

Home equity credit loans and credit lines are very popular sources of consumer credit. List the advantages and disadvantages of borrowing against home equity. Home equity credit loans/lines offer two distinct advantages. First, the loans generally carry a lower interest rate than other consumer loans. Second, the interest paid (within limits) is tax deductible. The consumer saves money initially by paying less interest on the loan, when compared to competing consumer loans, and later through tax savings equal to the marginal tax bracket percent multiplied by the amount of interest paid. Because the consumer’s built-up equity in the home is the collateral for a home equity loan, the home is at risk should the consumer default. This is a major disadvantage. Other disadvantages focus on the loss of financial flexibility. Those dollars cannot be used for other purposes—they are committed to repay debt. Future debt repayment of any kind commits future income and reduces flexibility.

7.

Student loan programs are available to students and parents to finance college-related expenses. Compare and contrast the programs available to students and parents. How are the interest rates determined? Students have two options for financing their education: Federal Direct Loans and Stafford Loans. Both of these options have borrowing limits that increase with academic level succession and interest rates that are capped at 6.8 percent. These loans also defer payment during enrollment and for six months after graduation. Parents also have two options for financing the child’s education: PLUS Direct and PLUS Loans. With these loans, the available amount of financing depends on the total budgeted cost of education minus any other financial aid received, so the total amount available may be more than the Federal Direct or Stafford Loans offer. These parental versions are capped at 8.50 percent over the life of the loan, but loan repayment is not deferred.

8.

Home equity, student, and auto loans are special-purpose consumer loans. Which ones offer the unique benefit of tax deductibility for interest paid?



Only home equity and student loans offer tax advantages for the borrower. As noted in Chapter 4, home equity interest (with restrictions) is an itemized deduction. Student loan interest appears on the tax form as an adjustment to income (with income restrictions). Both reduce the annual tax liability of the borrower. The typical auto loan offers no tax advantage, although a knowledgeable consumer could use a home equity loan to purchase a car, thereby making the interest tax deductible. But if the consumer should default, the home, and not the auto, is the security for the loan. 9.

What loan costs are included in the determination of finance charges? What is APR? How is it used? All costs associated with a loan (e.g., interest, loan processing fees, credit check fees, and any required insurance fess) make up the finance charges. APR, or annual percentage rate, is a federally required, standardized calculation of the approximate true cost of borrowing. It compares the cost of all finance charges over the life of the loan to the loan amount. APR represents the annualized true simple percentage cost of the loan.

10.

What are payday loans? Besides the high interest rates, what are some of the dangers associated with this type of loan? Payday loans are typically short-term loans, used by consumers to cover expenses between paychecks. These loans have a fee that can sometimes be equal to paying 800 percent interest on an annualized basis. The high fees are a major disadvantage, offset only by the fact that people with poor credit can typically qualify. Because the loan costs are assessed as “fees” and not interest, and the true interest rate is so high, some states have exempted payday lenders from laws that limit interest rates. Consider Principle 1 from the perspective of the lender. Other states chose to protect consumers by banning payday lenders.

11.

What methods are used to calculate interest on a single-payment loan? Which method is preferable to the consumer? Both the simple interest method and the discount method are used to calculate interest on a single-payment loan. Comparison of the APR for $10,000 borrowed for 6 months at 12 percent (with no additional finance charge fees) using the simple interest method (12.0 percent) and the discount method (13.64 percent) reveals that the simple interest method is preferable. The discount method APR is larger because the interest is deducted before the loan is received. This means the principal amount actually received is smaller than the stated principal of the loan.

12.

Why are loans based on the simple interest method a better option than loans using the add-on method? Is this true even if the consumer decides to repay the loan early? With a simple interest loan, interest is paid only on the unpaid balance. With the add-on method, interest is paid on the original principal over the entire life of the loan, yielding an APR almost twice the stated interest rate. When borrowing $5,000 for one year at 14


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percent (with no additional finance charges), the APR for the simple interest method is 14.0 percent while the APR with the add-on method is 24.91 percent. If the loan is repaid early, the simple interest method offers the debtor greater savings than the add-on method. Fortunately, the simple interest method is most commonly used, and consumers should always shop for credit and compare the APR for each loan. 13.

Loan costs vary significantly with the lender. Identify at least two inexpensive loan sources, two more expensive loan sources, and two most expensive loan sources. The most inexpensive loan sources are usually the family, the cash value of a life insurance policy, a home equity loan, or other secured loan. Credit unions, S&Ls, and commercial banks are a more expensive source of loans, depending on the type of loan, desired maturity, and type of interest (variable- or fixed-rate). Comparison shopping is critical when considering these sources, but credit unions often offer the best deal. Retail stores, finance companies, and small loan companies offer the most expensive loans and accept consumers with greater risk of default.

14.

Based on Principle 8: Risk and Return Go Hand in Hand, name five ways you can reduce the risk for the lender thereby reducing the return for the lender and saving yourself money. Consumers can reduce the risk and return for the lender by doing the following: • Maintaining a strong credit report and high FICO score • Choosing a variable-rate loan • Keeping the term of the loan as short as possible...this means higher payments! • Providing collateral for the loan...this means managing income to acquire savings and assets! • Paying a large down payment to reduce the amount financed...this means managing income to accumulate savings.

15.

Why are mortgage payments not included in the debt limit ratio? Mortgage payments are not included in the debt limit ratio because the ratio measures commitment to more expensive, short-term consumer debt.

16.

According to the debt resolution rule, what is the time frame for repayment of short-term debt? What types of borrowing are not considered in the debt resolution rule? The debt resolution rule asserts that consumers should be capable of paying off all consumer credit within any 4-year cycle, with the exception of financing a home or education.

17.

Remedies for overcoming excessive credit use can affect your present and future financial situation. Name eight remedies to consider when you are having trouble paying your bills. List the advantages and disadvantages of each.



Remedies for excessive credit use vary with the severity of the problem, as well as the impact on the household finances. To overcome payment problems, consider the following: • Develop and implement a budget that brings in more money than is going out. In other words, live on current income, including debt repayment, and pay as much as possible. Pay off the short-term debt with the highest interest rate first. • Develop self-control with credit use. In other words, stop charging and building more debt; live on current income. • Talk to creditors about restructuring the loan, changing the payment amount, etc. • Get help from a credit counselor. • Review borrowing sources and costs to determine if there is a cheaper way to borrow money to repay this debt (i.e., refinance) or as a future loan source. • Use savings to pay off current debt. This is an emergency measure and ignores the original purpose of savings—for future goal achievement. • Get a debt consolidation loan to reduce payments and possibly the interest rate. • Declare bankruptcy. 18.

What is the fundamental difference between Chapter 7 and Chapter 13 bankruptcy? What three major criteria differentiate a filer’s eligibility for each chapter? What debts cannot be discharged in a Chapter 7 bankruptcy? The primary difference between Chapter 7 and Chapter 13 bankruptcy is the repayment of debt. With Chapter 13, assets are maintained, and the majority of debt is repaid with court supervision; with Chapter 7, assets are liquidated (with some restrictions) to repay debts, and the remainder are discharged. Chapter 7 bankruptcy excludes debts for child support, alimony, student loans, and taxes, which must be repaid. Filer eligibility for each Chapter is contingent on the following: • “Means test” based on the filers income versus the median income in the state • Disposable income level ($100 per month);or • Sufficient disposable income to repay at least 25 percent of debt owed over 5 years

PROBLEMS AND ACTIVITIES ANSWERS 1.

The after-tax cost of the 8.75 percent home equity loan would be 6.93 percent based on the following calculation, which considers the tax savings on both federal and state taxes: 6.93% = 8.75% [1 – (0.15 + 0.0575)] The monthly payment for the unsecured loan is $47.07 per $1,000 borrowed versus $45.57 per $1,000 for the home equity loan, according to the Monthly Installment Loan Tables in Appendix E. The corresponding monthly payments would be: $47.07 ×2.5 = $117.68 for the unsecured debt $45.57 × 2.5 = $113.93 for the home equity loan


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The difference in payment would result in a savings of $90.00 over the life of the loan in addition to the applicable tax savings of $48.62 [($113.93 × 24) – $2,500] × 0.2075. Rico should choose the home equity loan, which is $138.62 cheaper. 2. Based on the Monthly Installment Loan Tables in Appendix E, Shirley’s monthly payment for the simple interest loan would be $134.69 ($89.79 × 1.5) for a total loan cost of $1,616.28 ($134.69 × 12). Using the add-on method, Shirley would pay a monthly payment of $140. Interest = principal × interest rate × time Interest = $1,500 × 0.12 × 1 = $180 Payment = (Principal + interest) / number of payments Payment = ($1,500 + $180) / 12 = $140 With the same loan terms, Shirley will save $5.31 a month, or a total of $63.72, if she finds a loan using the simple interest method. The add-on method is more expensive because it assumes that you have the entire loan balance outstanding for the entire period, rather than a decreasing balance, as is taken into account by the simple interest loan. 3.

Following the steps in Table 7.5 would show that paying off the add-on interest loan in 6 months would save Shirley 27 percent of her total interest payments or $48.46. Rebate = (Sum of months left / sum of total months) × total interest payment Rebate = (21 / 78) × $180 Rebate = $48.46

4.

Borrowing $1,000 to be repaid monthly for 12 months is a better deal. As demonstrated by the calculations below, interest on the single-payment loan would equal $120, while interest on the installment loan would equal $66.20. Based on the Monthly Installment Loan Tables in Appendix E, each monthly payment would be $88.85, or a total of monthly payment of $1,066.20. Total Interest for a Single-Payment Loan = principal × interest rate × time $120 = $1,000 × 0.12 × 1 This is a good example of the simple interest concept of paying interest on the money the borrower has available to use. Interest costs are higher when you have the use of the entire $1,000 for the full year. With installments, the principal is being repaid gradually, and interest is paid only on the unpaid balance of the loan.

5.

Typically, stage of the financial life cycle, income, net worth and credit score move in unison. As households progress through the life cycle, income and net worth tend to increase as well, until the retirement years when income and net worth may decline, with no appreciable effect on credit score. In the early years of the accumulation stage of the life



cycle, households often have not purchased life insurance or owned it long enough to accumulate cash value. Similarly, home equity may not be sufficient to qualify for a home equity loan. Consequently, these inexpensive loan sources may not be available although income and credit score are stable or increasing. Building a strong credit score will reduce the risk for the lender and the cost for the consumer, regardless of the other factors. Consumers should shop for credit and choose the most favorable lending terms, recognizing that the type of loan (secured or unsecured), length of the loan, and variable or fixed-rate of interest reflected by the APR are important considerations. 6.

Answers will vary. Advantages of secured loans include lower interest rates, easier approval process, and less emphasis being placed on credit history. Disadvantages of secured loans include the possibility of the collateral being repossessed and the possibility of still owing money even if the collateral is repossessed.

7.

Assuming the prime rate does not change, your new rate is 2 percent and 4 percent for a total rate of 6 percent.

8.

The monthly payment to finance $3,500 would be $177.28 (This can be solved by inputting the following values into a financial calculator: N = 2*12, I/Y = 19.5/12, PV = 3500, FV = 0, CPT PMT). He would save $25.33 per month by increasing his down payment to $1,000. His monthly payment would be $151.95. His net savings is $107.92 (($25.33 × 24) – $500).

9.

Antonio’s after-tax return from cashing in his CD would be 1.38 percent based on the following calculation, which considers both the federal and state taxes: 1.38% = 2% [1 – (0.25 + 0.0575)] Because his CD earnings rate of 1.38 percent, after taxes, is less than the in-store financing rate of 2 percent, he should cash in his CD to purchase the golf clubs.

10. Noel and Herman currently have a debt limit ratio of 14.62 percent ($475/$3,250). Ideally, this ratio should not exceed 15 percent to insure maximum financial flexibility. At 20 percent ($675/$3,250), no additional consumer debt should be taken on. Consequently, Noel and Herman have few choices. If they are willing to exceed the 20 percent recommendation, they can have any size car payment. But meeting that payment, and others, may be impossible. To stay within the 20 percent limit, they can afford a car payment of $175 ($650 – $475), which is not very realistic. Noel and Herman would be well advised to postpone the car purchase until they have significantly reduced their debt limit ratio by paying off some of their current debt obligations. 11. The difference in monthly payments is $41.52. The payment for the 48 month loan is $234.85. (This can be solved by inputting the following values into a financial calculator: N = 48, I/Y = 6/12, PV = 10000, FV = 0, CPT PMT.) The payment for the 60 month loan is


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$193.33. (This can be solved by inputting the following values into a financial calculator: N = 60, I/Y = 6/12, PV = 10000, FV = 0, CPT PMT.) 12. The total amount Bae will have to repay for his student loans is $33,306. His monthly payments are $277.55. (This can be solved by inputting the following values into a financial calculator: N = 10*12, I/Y = 6/12, PV = 25000, FV = 0, CPT PMT.) You must take the monthly payment times 120 payments to calculate the total amount paid. If the $25,000 were grants instead of loans, no money would have to be repaid. Grants are free money. 13. You could claim a maximum of $18,000 in educational credits if you had $18,000 worth of expenses ($2,500 × 4 for the American Opportunity Credit and $2,000 × 4 for the Lifetime Learning Credit). 14. His monthly payments will be $307.59. (This can be solved by inputting the following values into a financial calculator: N = 10*12, I/Y = 5/12, PV = 29000, FV = 0, CPT PMT.) He should not use his emergency fund to pay his student loans unless he has more than six months’ worth of expenses in his fund, even though his student loan rate is higher than his savings rate. 15. Noah will have paid a total of $40,203.15 for his student loans, and Ava will have paid a total of $25,058.74 for her student loans for a difference of $15,144.41. (Noah’s total can be solved by inputting the following values into a financial calculator: N = 10*12, I/Y = 16/12, PV = 20000, FV = 0, CPT PMT and multiplying the result by 120 payments; Ava’s total can be solved by inputting the following values into a financial calculator: N = 10*12, I/Y = 4.66/12, PV = 20000, FV = 0, CPT PMT and multiplying the result by 120 payments.) DISCUSSION CASE 1 ANSWERS 1.

The monthly payment using the 48-month car loan is $287.35. (This can be solved by inputting the following values into a financial calculator: N = 48, I/Y = 7/12, PV = 12000, FV = 0, CPT PMT.) The monthly payment using the home equity line of credit is $295.78. (This can be solved by inputting the following values into a financial calculator: N = 48, I/Y = 8.5/12, PV = 12000, FV = 0, CPT PMT.)



2.

To manually account for tax savings difference: Step 1: Calculate the total interest paid Total interest = (payment amount × number of payments) – principal paid $2,197.42 = [($295.78 × 48) – $12,000] Step 2: Calculate the potential interest savings Interest savings = total interest paid × combined tax rate) $675.71 = $2,197.42 × (0.25 + 0.0575)

3.

The after-tax interest rate of the home equity loan would be 5.89 percent based on the following calculation, which considers the tax savings on both federal and state taxes: 5.89% = 8.5% [1 – (0.25 + 0.0575)] If only the federal tax savings are considered, the after-tax cost of the home equity loan is 6.38 percent. After-tax cost = pretax cost – tax savings $1,795.20 = $1,795.20 – $0 $1,521.17 = $2,197.42 – $675.71 Although the stated interest rate and payments (from question 1) for the home equity loan are higher, Karou should choose the home equity loan, which is $271.09 cheaper (($13,792.80 – $12,000) – $1,521.71), when the total interest costs and tax savings are compared.

4.

Using the add-on method, Karou’s father would have paid a monthly payment of $175. Adding the interest ($100 as calculated below) to the principal amount ($2,000) and dividing by the total number of payments ($2,100/12) yields a payment amount of $175. Interest = principal × interest rate × time Interest = $2,000 × 0.05 × 1 Interest = $100 The final loan repayment of $517.31 would yield a total savings of $7.69 (shown below): Original Loan Principal Plus: Interest Due the Lender (72/78 × $100 = $92.31) Total Amount Due the Lender Less: Payments Made (9 × $175 = $1,575) Equals: Amount Needed to Repay the Loan

5.

$2,000.00 + 92.31 $2,092.31 – 1,575.00 $ 517.31

Based on the Monthly Installment Loan Tables in Appendix E, Karou’s father would have paid a monthly payment of $171.22 ($85.61 × 2) to finance $2,000 using the simple interest method.


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Karou’s father would have paid $509.42 and saved $4.25 ($2.12 + $1.42 + $0.71) in interest payments, as shown from the calculator results shown below. (Note that the payment amounts differ slightly due to rounding error differences when using the factor from Appendix E and a calculator—whether handheld or an Internet application.) Payment schedule: Pay # Payment

Principal

1 2 3 4 5 6 7 8 9 10 11 12

$162.88 $163.56 $164.24 $164.92 $165.61 $166.30 $166.99 $167.69 $168.39 $169.09 $169.79 $170.54

$171.21 $171.21 $171.21 $171.21 $171.21 $171.21 $171.21 $171.21 $171.21 $171.21 $171.21 $171.25

Interest $8.33 $7.65 $6.97 $6.29 $5.60 $4.91 $4.22 $3.52 $2.82 $2.12 $1.42 $0.71

Loan balance $2,000 $1,837.12 $1,673.56 $1,509.32 $1,344.40 $1,178.79 $1,012.49 $845.50 $677.81 $509.42 $340.33 $170.54 $0.00

6.

The difference in interest charges using the two methods of interest calculation, assuming no prepayment, is $45.36 ($2,100 – $2,054.64) based on the factor tables or $45.42 ($2,100 – $2,054.58) if using a financial calculator. The add-on method is more expensive.

7.

Karou can reduce the risk and return for the lender by doing the following: • Maintaining a strong credit report and higher FICO score, which reduces lender risk and allows Karou to borrow at a lower interest rate • Choosing a variable-rate loan to share with the lender the risk of rising interest rates • Keeping the term of the loan as short as possible, which reduces the lender’s risk of Karou defaulting on the loan or making late payments • Paying a large down payment, which reduces the amount financed and also reduces the lender’s risk of full payment should Karou default and the car be repossessed

8.

The bank loan is secured by the car; in other words, the car is the collateral. The collateral for the home equity loan is Karou’s home; therefore, should she default on her auto payments, her home is at risk. If Karou defaulted on the bank auto loan and the bank repossessed her car, any loan balance remaining after the bank sold the car as well as any associated collection costs, selling costs and attorney fees would be Karou’s responsibility. She would have accepted the deficiency payments clause of the loan when she signed the loan agreement.




Mary Lou can apply for either the Federal Direct Loan or the Stafford Loan. She would be in good company, as nearly 20 percent of all college students receive them. However, if she is still dependent on her parents’ income, there is a $5,500 funding limit for her junior and senior years.

2.

Using the calculator, the monthly payment on the student loan is –$60.66, as shown below. PV = $5,000 N = 120 months I/Y = 8.00%/12 = 0.6667% PMT = ? Using the keystrokes as above, except substituting 9.25/12 (or 0.7708) percent for the interest rate, shows a monthly payment on the home equity loan of $64.02.

3.

Mary Lou’s parents qualify for a tax deduction on the home equity loan interest (within limits). Mary Lou qualifies for a tax savings on the student loan interest paid up to a maximum of $2,500 annually, although the eligibility for the adjustment phases out as income increases. Another advantage to the school loan is that Mary Lou would continue to establish her own credit history, and she would have the option to defer the loan repayment until after graduation and again in the future should she decide to return to school full time. Given the differences in the interest rates and the federal marginal tax brackets for Mary Lou and her parents, the student loan is the cheaper alternative based on the following calculations: • •

4.

Home-equity loan tax-adjusted rate 6.66% = 9.25% × (1 – 0.28) Student loan tax-adjusted rate 6.00% = 8.00% × (1 – 0.25)

Mary Lou’s current debt limit ratio is 67 percent [($189 + $64.02) / $375], if she chooses to use her father’s equity line because the payments are not deferred until after graduation. However, her debt limit ratio would be 50 percent ($189 / $375) if she chooses the student loan, because the payments would be deferred until six months after graduation. After graduation, her debt limit ratio would be 9.99 percent [($189 + $60.66) / ($30,000/12)] if she chooses the student loan and 10.12 percent [($189 + $64.02) / ($30,000/12)] if she chooses the home equity loan.

5.

Assuming Mary Lou does not anticipate dramatic increases in her salary to more than $50,000 that would significantly limit the amount of the student loan interest adjustment, the student loan is the cheaper alternative. (Phase in for the partial student loan interest adjustment in 2008 is $50,000, and the income range is adjusted upward annually.) The student loan also will contribute to her FICO score and will offer the deferral options. Another possible financing option is that her parents can apply for either PLUS Direct or PLUS Loans. With these loans, the available amount of financing depends on the total budgeted cost of education minus any other financial aid received, so the total amount ©2016 Pearson Education, Inc.

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available may be more than Mary Lou can receive through the Federal Direct or Stafford Loan programs. DISCUSSION CASE 3 ANSWERS 1.

A major difference between Direct Subsidized and Direct Unsubsidized loans is that subsidized loans do not accrue interest while the student is in school or during the grace period. Unsubsidized loans accrue interest from the day they are awarded, and students can either pay the interest as they go or let it accrue until the end of their grace period. Students must demonstrate financial need for subsidized loans but not for unsubsidized loans.

2.

Carly has a 6-month grace period. She must begin repayment of her loans six months after graduation.

3.

The four basic student loan repayment options include the following: • Standard—this is the default repayment option where you pay an equal amount each month for 10 years. This repayment option results in the least amount of interest paid. • Extended—payments are made over a period of 10 to 30 years, which results in higher interest paid over the life of the loan. • Income-based—payments are based on a percentage of discretionary income. This results in low monthly payments, but more paid in interest over the life of the loan. Any debt not repaid after 25 years of payments is forgiven. • Graduated—payments start low and increase every two years. This results in lower monthly payments in the early years, but more paid in interest over the life of the loan.

4.

Carly’s student loan debt could limit her opportunities for taking on new debt, such as buying a car or home. Too much debt relative to income could result in a lower credit score rating and therefore higher interest rates on new debt and a lower credit rating could impact her ability to rent an apartment or qualify for certain jobs.

5.

Common monthly expenses will include, at a minimum, the following: • Rent or monthly house payment • Utilities (electricity, gas, water, sewer, trash) • Food • Medical insurance premiums • Student loan payment • Fuel for her vehicle • Car insurance premiums • Cell phone payment • Possible car payment • Internet/television service at home (optional, but possibly necessary to prepare for work) • Entertainment (optional, but probably advised as she begins a career in a new area)



Although Carly may consider living with her parents, there are nonfinancial limitations to doing so. Her freedom would be restricted to the rules of her parents’ home, and she may feel uncomfortable in her role as a working adult being forced to live “like a child” in her parents’ home. 6.

Carly could qualify for student loan deferment if she becomes unemployed or meets hardship standards. She could also qualify if she is enrolled at least half time in a college program, although that is unlikely given her demands as a new teacher. Carly could postpone her student loan payments for up to 3 years and the interest on her Direct Subsidized loans would not accrue during this time period. The interest on her Direct Unsubsidized loans would accrue interest during this time period.

7.

As long as Carly were enrolled at least half time in a graduate program, she could qualify for loan deferment. She would not qualify for forbearance just by going back to school. However, if she were to become seriously ill or encounter a financial hardship during that time, she may be able to qualify for loan forbearance.

8.

Advantages: • She will only have one monthly payment to manage. • She may be able to qualify for a lower interest rate. Disadvantages: • The decision must be made within the grace period for Direct loans. • Loan consolidation cannot be reversed. Carly should never consolidate private loans with her Direct loans because she would lose the benefits that Direct loans provide.

9.

Student loan debt is one of the few debts that cannot be forgiven in bankruptcy. This is why it is so important for Carly to make her payments on time and not take on new debt that she cannot support with her current income.

10. To avoid overreliance on student loans, Carly and her future spouse should consider saving for their children’s college education early. Tax-advantaged plans, such as a Coverdell Educational Savings Account or a 529 plan, would be recommended. 11. The monthly payments on Carly’s $27,850 loan would be $290.79. The total amount paid in interest would be $7,044.80 (($290.79*120) – $27,850). PV = $27,850 ?

N = 12*10 = 120 months

I/Y = 4.66%/12 = 0.3883%

FV = 0 PMT =

If the interest rate were 3.86 percent, the monthly payments would be $280.12 and the total amount paid in interest would be $5,764.40 (($280.12 × 120) – $27,850). PV = $27,850 ?

N = 12 × 10 = 120 months

I/Y = 3.86%/12 = 0.3217%


FV = 0 PMT =

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If the interest rate were 6 percent, the monthly payments would be $309.19 and the total amount paid in interest would be $9,252.80 (($309.19 × 120) – $27,850). PV = $27,850

N = 12 × 10 = 120 months

I/Y = 6%/12 = 0.50%

FV = 0 PMT = ?

12. Assuming an interest rate of 4.66 percent and a balance of $27,850, Carly will pay the following amounts in monthly payments and have the resulting total interest payments with the three repayment options listed in the table: Repayment Option Monthly Payment Amount Total Interest Paid Standard $291 $7,109 Graduated $164 – $493 $8,992 Income-based $156 -–$291 $11,544 Source: https://studentloans.gov/myDirectLoan/mobile/repayment/repaymentEstimator.action


CHAPTER 8 THE HOME AND AUTOMOBILE DECISION

CHAPTER CONTEXT: THE BIG PICTURE This chapter is the last in the four-chapter section titled “Part 2: Managing Your Money.” Other chapters in this section considered financial products and strategies for managing cash and credit within the financial plan. This chapter introduces the four-step smart buying process and applies it to the purchase of housing and transportation. The home-buying process, including the associated costs and variety of mortgage loans, is a primary focus of this chapter. Significant student messages include (1) the importance of assessing personal needs and wants when selecting transportation and housing and (2) the need to consider these costs in the context of the financial plan. CHAPTER SUMMARY This chapter uses the four-step smart buying process to illustrate planned purchases of automobiles and housing. Comparison-shopping to make a selection that fits personal and financial needs is stressed. Both leasing and financing of automobiles is considered. Different housing options are considered, as are the advantages and disadvantages of owning and renting housing. Costs of housing ownership are reviewed and categorized as initial or one-time costs, recurring costs, and maintenance and operating costs. The chapter concludes by describing the process of selecting a home, negotiating the price and contract, and securing financing. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Make good buying decisions.

2.

Choose a vehicle that suits your needs and budget. a. Holdback b. Closed-end lease or walk-away lease c. Purchase option d. Open-end lease

3.

Choose housing that meets your needs. a. Cooperative or co-op b. Homeowner’s fee c. Condominium (condo) 141



d. Down payment e. Closing or settlement costs f. Points or discount points g. Loan origination fee h. Loan application fee i. Appraisal fee j. Title search k. PITI l. Escrow account 4.

Decide whether to rent or buy housing.

5.

Calculate the costs of buying a home.

6.

Get the most out of your mortgage. a. Mortgage banker b. Mortgage broker c. Conventional mortgage loan d. Government-backed mortgage loan e. Assumable loan f. Prepayment privilege g. Adjustable-rate mortgage (ARM) h. Initial rate i. Negative amortization j. Balloon payment mortgage loan k. Graduated payment mortgage l. Growing equity mortgage m. Shared appreciation mortgage n. Interest only mortgage o. Private mortgage insurance p. Independent or exclusive buyer broker q. Real estate short sale r. Earnest money s. Closing t. Settlement or closing statement

CHAPTER OUTLINE I.

Smart Buying A. Step 1: Differentiate Want from Need B. Step 2: Do Your Homework C. Step 3: Make Your Purchase D. Step 4: Maintain Your Purchase


Chapter 8: The Home and Automobile Decision

143

II.

Smart Buying in Action: Buying a Vehicle A. Step 1: Differentiate Want from Need B. Step 2: Do Your Homework 1. How much can you afford? 2. Calculator clues 3. Which vehicle is right for you? C. Step 3: Make Your Purchase 1. Financing alternatives D. Step 4: Maintain Your Purchase

III.

Smart Buying in Action: Housing A. Your Housing Options 1. Houses 2. Cooperatives and condominiums 3. Apartments and other rental housing B. Step 1: Differentiate Want from Need C. Step 2: Do Your Homework 1. One-time costs 2. Recurring costs 3. Maintenance and operating costs

IV.

Renting Versus Buying

V.

Determining What You Can Afford 1. Financial history 2. Calculating your mortgage limit: method 1—ability to pay— PITI to monthly gross income 3. Calculating your mortgage limit: method 2— ability to pay— PITI plus other debt payments to monthly gross income 4. Calculating your mortgage limit: method 3— appraised home value 5. Calculating your mortgage limit 6. How much should you borrow? Financing the Purchase—the Mortgage 1. Sources of mortgages A. Conventional and Government-Backed Mortgages B. Fixed-Rate Mortgages C. Adjustable-Rate Mortgages 1. Initial rate 2. Interest rate index 3. Margin 4. Adjustment interval 5. Rate cap 6. Payment cap 7. ARM innovations D. Adjustable-Rate Versus Fixed-Rate Mortgages E. Specialty Mortgage Options

VI.



F. G. H. I. J. K.

1. Balloon payment mortgage 2. Graduated payment mortgages 3. Growing equity mortgages 4. Shared appreciation mortgages 5. Interest only mortgages 6. Option payment ARM mortgages 7. Risks associated with specialty mortgages A Word of Warning: Beware of Subprime Mortgages and Predatory Lending Mortgage Decisions: Length or Term of the Loan Coming Up with the Down Payment Prequalifying Step 3: Make Your Purchase 1. The contract Step 4: Maintain Your Purchase

VII.

Behavioral Insights A. Principle 9: Mind Games, Your Financial Personality, and Your Money

VIII.

Action Plan A. Principle 10: Just Do It!

APPLICABLE PRINCIPLES Principle 1: The Best Protection Is Knowledge It is your responsibility to protect yourself By including contingencies in the sales contract, to seek out home inspections, and to carefully review estimates of closing costs against the final documents. It also is your responsibility to ascertain the best housing alternative, mortgage loan, and interest rate for your particular situation. If you are renting—read the lease and know what the contract says. The same applies to buying or leasing a car. Comparison shop, read the contracts, and understand what this commitment means for your financial future. Protecting yourself depends on what you know and how you use that knowledge. Also, the best way to avoid predatory lending is with knowledge. Principle 9: Mind Games, Your Financial Personality, and Your Money You’ll find that the price you set for your car or house will impact the price a buyer is willing to pay. When you set a high price, buyers use that information when they determine how much they think the car or house is actually worth. However, if you set the price ridiculously high, the impact of the price will be much less than if you set a high, but realistic price. Your choice of price can also give the impression of prestige (use a round number) or a bargain (use a precise number). Principle 10: Just Do It! Vehicles and homes are the two largest decisions you could make in your lifetime. Prepare early so you are certain to account for all of the financial lessons learned in this chapter.



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SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Individually or in small groups, ask the students to implement the four-step smart buying process to buy an automobile—either their dream car or a realistic purchase to be considered in the near future. Encourage students to consult a wide range of product/consumer information sources, including the Internet and personal visits to auto sales lots. Remind them to locate sources that would be helpful in each step of the process. Ask students to share their results through papers, posters, or oral presentations.

2.

List the pros and cons, from both a financial and personal perspective, of leasing and financing a vehicle. Now visit an auto dealership and ask for a copy of their purchase and lease agreements. Evaluate the agreements and associated fees in a one-page report.

3.

Invite a banker or mortgage professional to guest lecture on new mortgage products, such as the interest-only mortgage, or other special homebuyer programs that might be available locally. What are the advantages and disadvantages of using a less traditional mortgage? What factors are contributing to the demand for such products or other special homebuyer programs? Ask the speaker to describe the various price segments of the market and the availability of housing in different price ranges.

4.

Ask a local real estate professional to prepare a sample estimated closing costs sheet for a specific piece of real estate that you can describe to the class. Share the closing cost sheet with the class to illustrate actual costs for points, fees, and other costs. How much down payment would be required? How much would the purchaser need at closing? Who gets paid at closing? Out of closing?

5.

Write a one- or two-page summary of the possible advantages and disadvantages, both financial and personal, of renting and owning a home.

6.

Consult www.realtor.com. Choose two homes that you might consider buying within the next 5 to 10 years. Calculate the down payment and the principal and interest portion of the mortgage payment if you financed 80 percent of the sales price over 30 years at a rate of 5.5 percent. With that limited insight on the one-time and recurring costs, also consider the maintenance and operating costs for each home. Write a report outlining your wants and needs, your calculations, and the reasoning behind your choice.

7.

Too often, consumers only consider if they can meet a monthly payment within the monthly budget. The decision to purchase or lease housing or transportation is much more complex. Use the categories of initial costs, recurring costs, and maintenance and operating costs to explore this decision further. Discuss the implications of these “other” costs as a part of a planned purchase that meets individual needs and fits the household budget.



8.

Have students write a complaint letter to a company in which they recently experienced a problem with a product. Have them report the responses they receive back to the class.

9.

Have students talk to their parents or other close family relative(s) to determine if they have ever encountered an unethical lender. Use Checklist 8.8 as a guide when asking your family questions. If someone has come across an unethical lender, what did the relative do in response?


What issues, or factors, does the “smart buyer” process attempt to control? The end result of the smart buyer process is buying decisions that are well thought out and well researched. As such the process attempts to control: purchasing, or differentiating need from want and limiting purchasing to needs; product selection—a needed product that is the best choice for the price and at a cost that fits your budget; and impulse buying.

2.

Summarize the four-step process for smart buying. How does Principle 9: Mind Games, Your Financial Personality, and Your Money play a role in this process? The four steps of the smart buying process entail: 1. Differentiate want you want from what you need. As Principle 9 dictates the use of mental accounting and the sunk-cost effect can sway your view of a realistic purchase. 2. Pre-shopping homework to explore personal needs and wants, to identify product alternatives, and to consider the relationship between your budget and the product’s cost. 3. Making your selection, after detailed comparison-shopping to consider price, product features, quality, warranty, and after negotiating the price and evaluating alternatives for financing. 4. Maintaining the purchase or resolving any product, service or quality complaints with the seller, manufacturer, or government, after the purchase.

3.

Effective complaints do not reflect anger or include threats. List five key points to remember when making an effective complaint. To make an effective complaint, briefly but clearly include the following five key points: 1. Note the date and place of the purchase or service. 2. Describe the product or service (e.g., serial or product number, warranty information). 3. Describe the specific problem with the product or service (e.g., what is the problem?). 4. Explain your attempts, and with whom, to correct the problem, including specific details. 5. Explain what you want done to correct the problem and identify a reasonable date for action, including your next step if the problem is not resolved.



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Type your letter and include copies, not originals, of any relevant documents describing the product or service and your attempts to resolve the problem. Sending your letter with return receipt requested ensures that your complaint was received and provides the identity of the person who signed for it. If the company does not respond in a reasonable time, take the next step by filing a complaint with the local or state consumer protection office, the Better Business Bureau, or the appropriate state or federal regulatory agency. 4.

What factors should you consider when trying to determine what vehicle to buy? Some factors that help determine personal preferences in vehicles include the following: 1. Amount buyer can afford to spend on the vehicle. 2. What the vehicle will be used for. 3. Lifestyle of the owner. 4. How long the vehicle will be kept. 5. The reliability of the vehicle. 6. How many people the vehicle needs to accommodate. 7. The operating costs of the vehicle. 8. The physical “fit” between car and driver. Is the vehicle comfortable? 9. The climate in which the vehicle will be used.

5.

What three factors determine the monthly payment on an automobile loan? The three factors that determine the monthly auto loan payment are 1. Amount of the loan 2. Length of the loan 3. Interest rate on the loan, which will depend on the source of the loan

6.

What is the holdback on a new car? Why are the holdback, rebates, dealer incentive, and markup important when negotiating a new car price? A holdback is a payment from the manufacturer, typically 2 to 3 percent of the new car retail price, paid to the dealer after the car is sold. Holdbacks increase the dealer’s profit, as do markups. Rebates are typically paid to the customer, whereas dealer incentives may or may not be shared with the customer. In sum, these issues complicate the auto purchase and pricing. The best defense is knowledge—of the dealer cost or invoice price on the vehicle as well as the related holdback and any available rebate or incentive. In negotiating the price, use the guideline of paying no more than $100 to $500 over invoice price for a new American-made auto or slightly more for a foreign-made vehicle, after any available rebate. Remember that this guideline is contingent on the demand for the vehicle and the amount of the holdback.

7.

What is the purpose of an auto lease? What are the two types of leases? What is the major difference between the two? The purpose of an auto lease is to allow the lessee to have a new car every few years without the up-front costs of purchasing. The two types of leases are closed-end and open-end. With



a closed-end lease, the lessee is required to return the vehicle in good condition with only normal wear and tear. Under these conditions, no further payment is required, and the lessor carries all responsibilities for the vehicle at lease end. In contrast, with an open-end lease, the consumer assumes all responsibility for the vehicle at the end of the lease. At the end of an open-end lease, the value of the vehicle is compared with the estimated end-of-lease value of the auto. If the vehicle is worth less at turn-in than the lease had specified, the lessee must pay the difference. For this reason, open-end leases are not recommended. 8.

Identify the characteristics of a consumer who should seriously consider auto leasing. What are the six factors that determine the monthly lease payment? A financially stable person who has good credit but lacks the funds for a down payment, drives less than 15,000 miles annually, takes good care of the vehicle but wants to avoid maintenance and trade-in, and does not mind the idea of never ending vehicle payments is a good candidate for a lease. The six factors that determine monthly lease payment are 1. Price of vehicle 2. Up-front fees such as taxes, insurance, or service contracts 3. Amount of the down payment or trade-in 4. Vehicle value at the end of the lease 5. Rent or finance charges 6. Length of lease

9.

Whether it is for a new or used vehicle, why is auto maintenance so important? List five maintenance tips to remember. Maintaining your purchase is always important (step 4 of smart buying) but especially so with the investment involved in an auto—new or used. Consider the following maintenance tips (the five tips listed by the student may vary): 1. Read the owner’s manual. 2. Follow the suggested maintenance instructions. 3. Be alert to warning signs—anything that looks (e.g., drips, leaks, smoke), feels (e.g., performance, gas mileage), or sounds different (e.g., engine sounds, squeaks). 4. Be prepared to accurately and completely describe the symptoms. 5. Identify a repair facility before you need one by seeking recommendations. 6. Check the qualifications and training of the technicians. 7. Talk with the repair shop owner or manager if not satisfied with the service to resolve the problem and avoid jumping from shop to shop.

10. What is the difference between a condo and a co-op? What are the advantages and disadvantages of each compared to living in a single-family house? In a co-op, the residents own shares in the corporation that gives them rights to their living space and reflects the dollar value of their “space.” In contrast, condominium residents actually own their living space and jointly own the land, common areas, and facilities. Both require a monthly maintenance fee. Advantages and disadvantages of both forms of ownership, as listed, are common with two major exceptions. Co-ops (1) offer less



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opportunity for capital appreciation than a home or condominium where the owner can improve the unit and (2) co-op shares can be more difficult to sell. Advantages include • Affordability and amenities such as pools, tennis courts, and health centers • Low maintenance Disadvantages include • Lack of privacy • Lack of choice about style and decoration 11. What three major categories of expenses make up the costs of homeownership? Give two examples of each. The major expense categories of home ownership include the following: 1. Initial (one-time) costs (e.g., discount points, origination fees, application fees, appraisal fees, title search fees, attorney fees, title insurance, and down payment) 2. Recurring costs (e.g., mortgage payments for principal, interest, property taxes, and homeowner’s insurance) 3. Maintenance and operating costs (e.g., painting, roof repairs, appliance replacement, and landscaping) 12. What four separate expenses make up the mortgage payment? What acronym is used to describe a mortgage payment? The mortgage payment consists of principal (P), interest (I), taxes (T), and insurance (I). Therefore, the payment is given the acronym PITI. 13. What two primary lifestyle and financial factors should you consider in the buy or rent decision? Two primary factors to consider when deciding to buy or rent are timing and taxes. First, you must plan to stay in the home for a minimum of several years to recover initial purchase costs, to benefit from price appreciation, and to repay a significant portion of the mortgage to increase equity. Second, buying offers substantial benefits to those who itemize their taxes, as owners get to take advantage of the points, mortgage interest and real estate tax deductions. Since these costs may exceed the standard deduction for many households, all other itemized deductions are “icing on the cake.” 14. From a financial point of view, over a 7-year period, why is it better to own than to rent? Consider costs, return, and taxes in your answer. (Hint: Use Figure 8.6.) Owning is better than renting over a 7-year period. This is true because over 7 years, the upfront costs of the purchase are offset by the price appreciation and the tax advantage of being able to itemize housing-related expenses, such as mortgage interest and real estate taxes.



15. What three factors determine the maximum amount a bank will finance for a home mortgage? The lending institution specifically looks at three factors when qualifying a prospective homebuyer for a mortgage. 1. Financial history to determine the steadiness of income and credit rating. 2. Ability to pay to determine qualification ratios comparing (1) PITI to monthly gross income and (2) PITI plus other debt payments to monthly gross income. 3. Appraised value of the home to determine 80 percent of the value, the mortgage loan limit for most lenders. 16. What are the advantages and disadvantages of using IRA savings as a down payment? Using IRA accumulations for up to $10,000 of a down payment offers the benefit of no penalties on the withdrawal. Also, the funds had been growing tax-deferred, which allows for a little faster accumulation than in a taxable account. However, if the down payment is withdrawn from a Traditional IRA, income taxes will likely be due on the contribution (depending on whether the contribution was originally fully or partially tax deductible) and taxes will be due on the earnings. With a Roth account, the withdrawal is tax-free if the 5year period has been satisfied. Other disadvantages include the trade-off of one goal for another, and once withdrawn from the IRA account, the funds cannot be later replaced and allowed to grow tax-free for retirement. 17. What is the difference between a traditional real estate agent and an independent buyerbroker? Is there an advantage to either for someone buying a home? A real estate agent traditionally represents the seller, and it is the seller who pays the agent’s commission. Because of this potential conflict of interest, the buyer needs to know the difference between advice and sales pitch. An independent buyer/broker, on the other hand, exclusively represents the prospective buyer. These independents are obligated to get the buyer the best possible deal. Buyer/brokers show buyers potential houses that are listed with a firm or that are being sold by the owner. This exclusive relationship tends to promote more objective and critical home buying. All of these factors are advantages for the prospective homebuyer. 18. What factors should be considered before signing a lease or rental agreement? Before signing a lease or rental agreement, be sure to do the following: • Determine if the unit is affordable. What percentage of take-home pay will be needed for housing costs? • Review the location for safety and convenience features. • Understand the lease and all restrictions (e.g., who is responsible for the utilities?). • Get any changes in the lease in writing. Do not accept a verbal agreement. • Determine the reliability of the landlord for handling complaints and repairs. • Purchase renter’s insurance for personal property and liability protection.



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19. What provisions should be outlined in a real estate contract? Provisions to be outlined in a real estate contract include the following: 1. The buyer, seller, selling price, and method of payment 2. The legal description of the property 3. The date of possession 4. The provisions for the title search payment 5. Listing of necessary inspections (e.g., termites, radon) and actions to be taken 6. Purchase contingencies, such as suitable funding of specific amount, interest rate, and term 7. Provisions for the partial year payment for utilities, taxes, insurance 8. Condition of house at closing, with provisions for a final inspection to insure compliance 9. Any other agreed-upon contingencies 20. What is the difference between mortgage bankers and mortgage brokers? Does either offer prospective homeowners an advantage? If so, what? Mortgage bankers originate mortgage loans and sell them to investors for a fee. Mortgage brokers work as middlemen who place mortgages with investors but do not originate the mortgages. The advantage mortgage brokers offer to prospective homebuyers is that they comparison shop to find the best terms and rate available. 21. What are the advantages and disadvantages of government-backed loans, such as VA or FHA loans? Advantages of FHA and VA financing include the following: • Lower down payment • Lower interest rates • More lenient lending requirements Disadvantages of FHA and VA financing include the following: • Increased paperwork for loan qualification • Higher closing costs (with the exception of the down payment) • Limits on the maximum mortgage funding available 22. How do the time value of money and taxes complicate the decision on the term of a mortgage? The choice of mortgage term is influenced by a number of factors, including interest rates, financial discipline, competing financial goals, financial flexibility, the time value of money, and taxes. The time value of money suggests that the 30-year mortgage is the better option, as the latter payments are made with dollars that are worth less due to inflation. The lower payment also means more dollars may be available for alternative investments as opposed to making the larger payment required for the 15-year term. Conversely, all of the payment at the end of the 15-year period would be available for investment. Earnings on both scenarios would vary with the assumptions made. Finally, the longer the term, the longer the



homeowner can benefit from the tax advantage of itemized deductions. In sum, the lower interest rate associated with the shorter-term mortgage should not be the only deciding factor when considering mortgage term. 23. What are some factors that determine whether a homeowner should refinance? Two rules guide the decision to refinance. First, are rates at least two percentage points lower than the existing mortgage? Second, does the homeowner expect to live in the house more than two years? If the answers are “yes,” then it is probably cost effective to pay the closing costs necessary to refinance. Regardless of the rules of thumb, the homeowner must determine if the costs of refinancing can be paid back in a reasonable amount of time. PROBLEM AND ACTIVITY ANSWERS 1.

First, determine the monthly payment of $356.76. Calculator solution PV $15,000 PMT ? I/Y 6.65/12 N 48 FV $0 CPT PMT -$356.76 or $4,281.16 yearly Second, calculate the first year total cost, which equals $8,571.16, as itemized below: Loan payments for one year $4,281.16 Property taxes $ 300.00 Sales tax assessed at purchase $ 450.00 Title and tags $ 40.00 Use and maintenance $1,500.00 Insurance $2,000.00

2.

Using the calculator, the monthly payment on the 5-year auto loan is $386.66. Calculator solution PV $20,000 PMT ? I/Y 6/12 N 5*12 FV $0 CPT PMT -$386.66



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Using the calculator, the monthly payment on the 4-year auto loan is $469.70. Calculator solution PV $20,000 PMT ? I/Y 6/12 N 4*12 FV $0 CPT PMT -$469.70 Using the calculator, the monthly payment on the 3-year auto loan is $608.44. Calculator solution PV $20,000 PMT ? I/Y 6/12 N 3*12 FV $0 CPT PMT -$608.44 As the time period gets shorter, the payment increases. 3.

The total spent on the vehicle increases by $660 if financed at 7 percent rather than at 5 percent. Shopping for the lowest-cost financing available can significantly reduce interest costs as reflected in the monthly payments and total cost for the vehicle. The monthly payment on the 4-year auto loan financed at 6 percent is $352.28. The total amount spent over the course of the loan is $16,909. Calculator solution PV $15,000 PMT ? I/Y 6/12 N 4*12 FV $0 CPT PMT -$352.28 The monthly payment on the 4-year auto loan financed at 5 percent is $345.44. The total amount spent over the course of the loan is $16,581. Calculator solution PV $15,000 PMT ? I/Y 5/12 N 4*12 FV $0 CPT PMT -$345.44 The monthly payment on the 4-year auto loan financed at 7 percent is $359.19. The total amount spent over the course of the loan is $17,241.



Calculator solution PV $15,000 PMT ? I/Y 7/12 N 4*12 FV $0 CPT PMT -$359.19 4.

An escrow account is a special reserve account used to accumulate the annual property (real estate) tax payments and homeowner’s insurance premiums for the homeowner. Assuming no quarterly or semi-annual tax withdrawals from the account, the account should total $850.68 = [($94.52 × 3) + ($94.52 × 6)] and include the 6 months of escrow payments plus the 3 months collected in advance.

5.

Using the calculator, the monthly payment on the 30-year mortgage is $536.82. Calculator solution PV $100,000 PMT ? I/Y 5/12 N 30*12 FV $0 CPT PMT -$536.82 The total amount of interest paid is the total of the loan payments minus the original amount of the loan. Total of payments = Payment amount × total number = $193,255.78 ($536.82 × 360) Total interest = total of payments – loan amount $93,255.78 = $193,255.78 – $100,000

6.

The total closing costs of $23,800 are itemized below: $20,000 = Down payment (20 percent of the selling price) $1,600 = Discount points (2 percent of the $80,000 loan amount) $800 = Origination fee (1 percent of the $80,000 loan amount) $1,400 = Other fees $23,800 = Total

7.

Using the calculator, the monthly payment on the 30-year, 5.0% mortgage is $536.82. Calculator solution PV $100,000 PMT ? I/Y 5/12 N 30*12 FV $0 CPT PMT -$536.82



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Using the calculator, the monthly payment on the 15-year, 4% mortgage is $739.69. Calculator solution PV $100,000 PMT ? I/Y 4/12 N 15*12 FV $0 CPT PMT -$736.69 Using the calculator, the monthly payment on the 20-year, 4.5% mortgage is $632.65. Calculator solution PV $100,000 PMT ? I/Y 4.5/12 N 20*12 FV $0 CPT PMT -$632.65 Mortgage 30 year, 5.0% 15 year, 4.0% 20 year, 4.5%

Monthly Payment $536.82 $739.69 $632.65

Total of Payments $193,255.20 $133,144.20 $151,836.00

The safest financial option would be the 20-year fixed rate mortgage at 4.5 percent. It allows the prospective homebuyer to pay off the home in 10 less years than the 30-year mortgage and to save $41,419 in interest payments. The only question is the possible opportunity costs. Ultimately, the best option is a function of the homeowner’s risk tolerance. The 20year mortgage allows for quicker growth of equity in the home, which might offer a nice return in the future. However, the 30-year mortgage allows for the difference to be invested, which might offer a better return on investment. 8.

9.

Using a financial calculator yields the following answers: Payment after 1st Loan Initial Payment Total Interest Adjustment a. $899.33 $334,788.35 $995.81 b. $899.33 $326,431.53 $1,087.11 c. $899.33 $334,034.59 $1,077.31 d. $899.33 $328,764.06 $1,171.36

Maximum Payment $1,396.84 $1,395.31 $1,456.44 $1,449.37

Assuming maximum annual decreases in Kalid’s mortgage rate, his first year rate was 8.375 percent, his second year rate fell to 6.375, and his third year rate hit the floor rate of 5.5 percent. This would give him an average annual interest rate of 6.75 percent (8.375 + 6.375 + 5.5) / 3.

10. According to Method 1, the maximum 30-year, 4.5 percent, fixed-rate mortgage for which the homebuyers could qualify is $184,861.62; however, using Method 2 results in a



mortgage of $146,047. The qualification process that most lenders use would be the one that yielded the lower amount. Therefore, the couple would be limited to approximately a $146,047 mortgage. Method 1: PITI/Gross Income < 0.28 PITI/(45,500/12) = 0.28 PITI = 1061.67 PI = 1061.67 – 125 = 936.67 Calculator solution PV ? PMT -$936.67 I/Y 4.5/12 N 30*12 FV $0 CPT PV $184,861.62 Method 2: PITI + Other Debt/Gross Income < 0.36 PITI + Other Debt/(45,500/12) = 0.36 PITI + 500 = 1,365 PITI = 865 PI = 865 – 125 = 740 Calculator solution PV ? PMT -$740.00 I/Y 4.5/12 N 30*12 FV $0 CPT PV $146,047.26 DISCUSSION CASE 1 ANSWERS 1.

Answers may vary, but sources of vehicle buying information include the following: • Consumer’s Resource Handbook—Listing of organizations to help with a complaint and other buying tips • Consumer Reports—Comparisons of product quality, features, price • Edmund’s Car Buying Guide, Edmund’s Used Car Prices, or the Edmund’s Internet Site—Price information • Internet sites such as AutoSite—Product, price, insurance, and resale information • Center for the Study of Services’ Cars Bargains Service—Competitive bids from auto dealers in your local area • National Automobile Dealers Association (NADA) Official Used Car Guide—Price information • Kelley Blue Book or the Kelley Blue Book Internet Site—Price information



2.

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Answers will vary; however, the following is representative: For the vehicle to meet Samuel’s business needs, it should be either a truck or a van. Factors important to them are low ownership costs for insurance, gas, and maintenance. When comparison-shopping, the Paganellis should look for information on insurance costs, gas mileage, and body and mechanical reliability. Considering these factors in their vehicle choice will help to ensure lower operating costs for their new vehicle.

3.

The highest priced vehicle they can afford is $27,649 ($23,649.33 + $4,000 down payment). Calculator solution PV ? PMT -$550 I/Y 5.5/12 N 4*12 FV $0 CPT PV $23,649.33

4.

The Paganellis are better off selling their car because they will get more money than they would by trading it. However, trading in the vehicle offers the convenience of not having to list, show, or sell the vehicle on their own.

5.

Answers will vary; however, key factors important to a good lease include the following: • Negotiate a fair agreed-upon value of the car. Often best to do before disclosing an interest in leasing instead of buying. • Keep the down payment low. • Negotiate a warranty that covers the lease period so that you avoid major repair costs. • Define and understand “normal wear and tear” within the lease contract. • Define and understand the termination fee, or fee for ending the lease early. • Include insurance for early lease termination as a result of the vehicle being totaled in an accident. • Lease a vehicle that does not rapidly depreciate. • Secure a low rent, or finance charge, within the lease.

6.

Financing is most likely the better alternative to leasing for the following reasons: • No restrictions or end of lease fees for “wear and tear”: Working as a plumber, Samuel would probably put everything, including the kitchen sink, in the vehicle, causing at least some dents and dings. • No mileage restrictions: Driving for work normally puts excess miles on the vehicle, especially for an independent businessman like Samuel. For a cost-effective lease, the consumer should drive less than 15,000 miles annually. • No modification restrictions: Again as a plumber Samuel is likely to want to modify the truck to suit is business needs.

7.

Lemon laws vary from state to state, but most states allow for a refund on your purchase. However, the following conditions normally apply: (1) you made four attempts to fix the ©2016 Pearson Education, Inc.


problem, and (2) the car must have been out of service for at least 30 days within the first year or within the first 12,000 miles. DISCUSSION CASE 2 ANSWERS 1.

The four types of housing available to Seyed to own are as follows: • House: Single-family dwelling that is purchased. Allows for more space, privacy, control over living space, and equity accumulation. • Cooperative: Apartment building owned by a corporation in which the tenants are the stockholders. Instead of owning an apartment, a resident owns shares, which reflect the value of their portion of the building. These residents normally pay a fee to the co-op for upkeep and taxes. • Condominium: A variety of housing forms including apartments, townhouses, and highrise buildings where the residents own their individual dwelling units but jointly own the land and common areas. Residents normally pay a maintenance fee. • Planned Unit Development (PUD): Similar to cooperatives and condominiums except the home and land on which it sits are individually owned, in addition to a share of all common features of the development. Residents normally pay a homeowner’s fee for any commonly shared expenses and maintenance.

2.

Several sources of real estate purchase information include the following: • Internet sites like HUD’s Buying a Home, Neighborhood Search at Homes.Com or Homefair.com • Real estate agent or independent buyer/broker (for the latter check for referrals from Buyers’ Resources, Buyers’ Agents, or the National Association of Exclusive Buyer Agents at www.naeba.org) • Professional building inspectors for the structure, systems, radon, termites, etc. • Attorney • Traditional lenders (e.g., banks, S&Ls, credit union) • Specialized lenders (e.g., mortgage bankers or mortgage brokers) Prequalification with a lender confirms the maximum mortgage amount for which Seyed would be eligible and may reduce his anxiety about financial risk. The prequalification letter provided by the lender reduces uncertainty for the buyer and the seller. It establishes Seyed as a legitimate purchaser and averts any concerns from the seller about Seyed’s ability to qualify for financing, should the seller accept his contract. For these reasons, prequalifying could be a good idea.

3.

According to the 28 percent guideline, Seyed could qualify for a maximum monthly mortgage payment, including taxes and insurance, of $1,470.00. However, the 36 percent guideline that includes existing consumer debt payments, further limits him to $1,290. Method 1 = gross monthly income × 28% $1,470 = ($63,000/12) × 0.28



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Method 2 = (gross monthly income × 36%) – current credit repayments $1,290 = (($63,000/12) × 0.36) – $600 4.

Seyed’s projected PITI payment would be $704.24 ($584.25 + $97.07 + $22.92) Step 1: Determine the principal and interest payment per month. Calculator solution PV $112,000 PMT ? I/Y 4.75/12 N 30*12 FV $0 CPT PMT -$584.25 (principal and interest) Step 2: Determine the tax payment per month Tax Payment = $97.07 {[($128,000/100) × 0.91]/12} Step 3: Determine homeowners’ insurance payment per month Insurance Payment = $22.92 ($275/12)

5.

Seyed would not realize gains after the first year, as is typically true, but would be better off to buy when the longer time frame is considered. This is true regardless of whether he chooses to itemize or take the standard deduction. The latter approach results in smaller gains.

6.

Seyed should be prepared to pay $45,000 on the day of closing. Down payment = [$180,000 (purchase price) × 0.20 (percentage down)] = $36,000 Closing Costs = [$180,000 (purchase price) × 0.05 (percentage closing cost)] = $9,000

7.

Because the maximum monthly payment for which Seyed can qualify is $1,290 (from question 3), he can afford this home by financing it over 20 or 30 years. Financing it at 15 years results in a monthly PITI payment of $1,317 ($136.50 + $22.92 + $1,157.58), which is just over his affordability limit. Step 1: Determine the tax payment per month Tax Payment = $136.50 {[($180,000/100) × 0.91]/12} Step 2: Determine homeowners’ insurance payment per month Insurance Payment = $22.92 ($275/12) Step 3: Determine the principal and interest payment per month based on a loan amount of $144,000 ($180,000 – $36,000) from question 6.



The monthly payment on the 15-year, 5.25% mortgage is $1,157.58. Calculator solution PV $144,000 PMT ? I/Y 5.25/12 N 15*12 FV $0 CPT PMT -$1,157.58 The monthly payment on the 20-year, 5.25% mortgage is $970.34. Calculator solution PV $144,000 PMT ? I/Y 5.25/12 N 20*12 FV $0 CPT PMT -$970.34 The monthly payment on the 30-year, 5.25% mortgage is $795.17. Calculator solution PV $144,000 PMT ? I/Y 5.25/12 N 30*12 FV $0 CPT PMT -$795.17 8.

Assuming Seyed pays a 20 percent down payment, private mortgage insurance will not be required. A gift letter will not be needed, as he has personally saved all of his funds without benefit of any gifts.

9.

Due to his risk tolerance, a fixed-rate mortgage is recommended. Other mortgage variations do not offer the same control for his financial future because of the uncertainties associated with the payment amount and the equity build up. Given Seyed’s situation, he should probably not consider an interest-only mortgage. The advantage of an interest-only mortgage is significantly lower payments for the initial interest only period. However, once the mortgage is fully amortized over the remaining period of the mortgage, the payments increase to cover principal and interest—and in the case of an adjustable rate mortgage, the payment may need to reflect a higher interest rate than during the initial period. Fixed rate interest only mortgages are available but have the same problem of significantly higher principal and interest payments once the loan is fully amortized, albeit based on a constant interest rate. Optional principal payments may be made to reduce the balance and build equity with interest only mortgages; however, interest-only mortgages are based on two premises: significant home value appreciation to build equity and the ability of the consumer to pay the future higher payments. Seyed is attempting to control his



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financial situation, given his concerns over investment returns and financial risk, and he can find a house with a payment that fits his current budget. Furthermore, he has no indication of significant future salary increases to accommodate the higher payments required. Seyed’s best option is a fixed rate mortgage with a known payment structure (except for annual tax and insurance increases) and equity accumulation.


CONTINUING CASE: CORY AND TISHA DUMONT PART II: MANAGING YOUR MONEY 1.

Joining a credit union might offer the following advantages to Tisha: efficient operation that supports lower fees, favorable rates for loans, and higher interest rates paid on deposits. Convenience is another benefit, as the credit union may have a branch or ATM located at her place of employment. Otherwise, credit unions are similar to commercial banks and S&Ls.

2.

First, the Dumonts should differentiate between "online banks" and "online banking." Online banks exist only electronically and because of the lack of "brick and mortar" expenses, generally pay more on deposits and may charge lower fees. Online banking is simply account access via the Internet, mobile phone, or other online device to an account with a traditional financial institution. Second, the Dumonts need to consider the advantages and disadvantages of online access. Online banking offers convenience and efficiency. Available services include fund transfers between your accounts or to another bank customer, bill payment, account monitoring (ATM transactions; account balances for bank accounts, IRAs, CDs, and securities; check activity), check ordering, loan or mortgage applications, and investment purchases. Account information can be downloaded directly into personal finance software (e.g., Quicken, Microsoft Money, TurboTax) to facilitate recordkeeping. Many offer other personal financial management support such as stock quotes or rate alerts. A primary disadvantage is personal acceptance, or comfort, with online banking. Start-up to register, get required documents in place (such as a durable power of attorney for couples who wish to have access to all account information for each other), learn how to use the system, and then adapt to future site changes or data re-entry needs are other disadvantages. Customer service may also be poor to support these services. To protect themselves customers should make it a practice to print and maintain all records to verify the bank statement. For many the biggest disadvantage of an online bank is the lack of a “brick and mortar” institution to visit.

3.

The Dumonts should consider the following when shopping for a new bank: • Services: available range of products (e.g., deposit, loan, or investment) and fees, as well as services such as personal attention or financial advice from staff or management. • Safety: federal deposit insurance and a sound financial institution • Cost: the minimum balances required and fees charged to maintain accounts • Convenience: proximity of the bank and ATMs to home or work and hours of operation. Other convenience services include safety deposit boxes, direct deposit and overdraft protection. • Consideration: the reputation that a bank enjoys for personal attention to and services for customers. 163



4.

Of the three options identified for their emergency fund, the money market mutual fund (MMMF) offers the advantages of competitive interest rates, check writing privileges (limits on amounts and number of checks may apply), and relative safety although not federally insured. The Dumonts could accumulate the required minimum initial investment ($500 to $2,000) in a savings account, and then transfer the funds to the MMMF. In fact, a federally insured savings account could be used for their emergency fund, but likely would earn less than the MMMF. CDs offer the advantage of federal insurance, but access is limited until the maturity date, which may not match the timing of the emergency. Although considered liquid, longer maturities are required for higher interest rates, but early withdrawal penalties could significantly reduce the earnings should the funds be needed. Also, because rates are locked in, this feature can be a real disadvantage when rates are rising. MMMFs would automatically benefit from rising rates. Asset management accounts combine banking and brokerage products and services, but unless this “package” is needed, the service fees, minimum initial investment requirements, and lack of federal insurance make this option inappropriate for the Dumonts. However, the MMMF account within an asset management account could serve as an emergency fund for a customer who required the combination of products and services offered by an asset management account. Liquidity is essential for emergency funds, but having living expenses for 3 to 6 months sitting idly earning little or no return is unwise. The balance is to sacrifice return by having some emergency funds readily available, but to have the remaining emergency funds earning more. Higher yielding, less liquid investments may be the best alternative. Available credit, such as a home equity line or credit cards, could be a substitute for emergency funds, until less liquid, higher earning accounts could be accessed. However, the cost of using credit must be considered relative to the higher earnings. The unique household situation, for example both Cory and Tisha are employed, must also be considered when determining the amount and savings, investment, or credit alternatives

5.

Because the Dumonts are in the 15 percent marginal tax bracket, the after-tax return on their 1 percent bank account equals 0.85 percent, or [1 × (1 – 0.15)]. Thus, the 0.25 percent federal and state tax-free money market fund provides a slightly lower after-tax return than their taxable 1 percent savings account, ignoring the effect of state taxes.

6.

Automatically having a portion of Tisha’s or Cory’s paycheck routed into savings offers several advantages. First, disciplined savings means they automatically will be working toward their goals and, second, learning to live on their adjusted take-home salary. Third, because of the time value of money, the earlier they get funds into savings, the more those funds have the opportunity to earn. Automatic employer savings plan deductions are typically available for several cash management alternatives, including transferring funds into CDs, money market mutual funds, asset management accounts, or U.S. Savings bonds. Another option is to authorize transfers into a savings, or other type, account directly from



their bank account, following the direct deposit of their paychecks. In summary, most employers and financial institutions—banks, S&Ls, and credit unions—are willing to help customers, like Tisha, pay herself first. 7.

Identity theft occurs when fraud or other crimes are committed by using someone’s name, address, Social Security number, bank or credit card account number, or any other personal information. It occurs from lost/stolen wallets, information retrieved from household trash, from a change of address form used by thieves to divert household mail, or by “pretexting.” Cory and Tisha should make it a practice to always: • Check their free credit reports offered through the FACT Act to monitor all account activity. • Call one of the credit bureaus to place a fraud alert on their credit records, ensuring that any creditor must confirm their identity before opening an account. • Shred all receipts, statements, and credit card offers that are discarded to safeguard their personal information (e.g., credit cards, other loans, and bank or investment statements). • Only give their credit card number over the phone if they initiated the sale. They should never use a public or pay phone for such transactions—a thief could be listening. • Ignore all phone or Internet “pretexting” inquiries. They should never provide personal or account information, unless fully assured that the inquiry is legitimate and the transfer of information is safe. • Never leave their credit cards behind at a business. • Monitor the arrival of their account statements to ensure they are not lost, stolen, or misdirected by thieves through a change of address scheme. • Be suspicious if they receive a credit card they did not apply for, have problems accessing new credit at favorable rates, or receive inquiries about merchandise or services they did not purchase. • Always maintain a current list of credit cards, debit cards, and other accounts with the 24-hour customer service phone number for each, in case they need to cancel an account. • Never include Social Security numbers, PIN numbers, or other passwords or access codes in any information carried in their purse, wallet, or briefcase. • Invest in a fireproof box or bank safety deposit box to store birth certificates, passports, or Social Security cards to protect them in case of theft, household disaster, or loss of other official identification.

8.

As shown below, the Dumonts’ debt limit ratio equals 15 percent. A debt limit ratio between 15 and 20 percent is considered a danger zone, with problems possible with every increase. To maintain a reasonable degree of financial flexibility, a ratio of less than 15 is recommended. At this level, the Dumonts could still borrow and comfortably meet the payments for an emergency or other unexpected expense. An additional $300 car payment would increase the ratio to 20 percent, which reaches the recommended level for maintaining financial flexibility. The Dumonts may wish to postpone the auto purchase until other nonmortgage debt is repaid and they can maintain a debt limit ratio closer to 15 percent. debt limit ratio =

total monthly nonmortgage debt payments total monthly take − home pay



$911 = 0.1507 or 15% $6,045 $911 + $300 debt limit ratio = = 0.2003 or 20% $6,045 signs should help Cory and Tisha evaluate their credit usage: The following list of warnings debt limit ratio =

9.

• • • • • • • • •

Paying only the minimum monthly payment each month Reaching, or exceeding, the maximum spending limit on one or more cards Charging group expenses, such as dinner out with friends, on your card in exchange for pocketing the cash contributions from your friends Failing to keep an accurate record during the month of current credit card charges Getting cash advances from your credit card(s) to cover expenses when your checking account runs low Being turned down for a new credit card or having an old card canceled Using savings to pay off credit card bills Failing to know how much of your credit card bill is from interest charges or how the interest charges affect your monthly bill Worrying about your credit card bill or getting worried or upset when the bill arrives

The Dumonts have a number of options to consider if they occasionally cannot pay their bills on time. The remedies vary with the severity of the problem, but include the following: • Develop and follow a budget that brings in more than goes out. • Use self-control with credit—stop charging! • Make paying off debt a priority and adjust the budget and spending to accommodate this goal. • Contact the lender about restructuring the loan or reducing the payments. • Seek help from a credit counselor and follow the plan you develop to pay off the debt. • Make sure you are using the cheapest sources of lending, including credit cards matched to usage, and if not, seek other alternatives (e.g., a new card, a home equity credit line loan, or other secured loan). • Use savings, a secured loan, or home equity loan to pay off higher cost credit card debt—but do so with caution. • Use a debt consolidation loan to pay off current debts. Don't be fooled by the lower monthly payment to start charging more. • Consider filing personal bankruptcy—a final alternative for extreme debt problems. 10. Because the Dumont’s opened their credit card more than a year ago, they will not be subject to interest rate increases due to expiration of an introductory rate. They also do not have a variable rate tied to an index. Therefore, the credit card company must send the Dumont’s a notice of rate increase at least 45 days before they can raise the interest rate. In that time, the Dumont’s can shop around for a new credit card. 11. The credit bureau collects, maintains, and provides credit reports to lenders to use in their evaluation of potential borrowers. The credit bureau does not determine creditworthiness. The credit bureau report can be used to confirm information provided on the credit application. It also supplies additional data from other creditors or public court records. The credit bureaus and individual lenders use credit scoring to calculate a numerical FICO score, so named because of the credit scoring models developed by Fair Isaac Corporation. The



FICO score is based on data from the credit application and the credit report. Applicants whose scores meet a predetermined level (711 is the national average, but the best rates require a score of 760 or more) are offered credit; those without a sufficient score, say less than 620, are rejected. In addition to controlling access to credit, the lenders also use the FICO score to determine the interest rate charged. It is a good idea to check your credit report before applying for credit, after being denied credit, and before applying for a job. Inaccurate information could prevent Cory and Tisha from getting their mortgage or, perhaps worse, getting one at a significantly higher interest rate. For this reason, it was recommended that they check their report prior to the mortgage application. These same issues lead to the 2003 FACT Act that provides one free copy of the credit report from each of the three national providers, Equifax, Experian, or Trans Union each year. The Dumonts should take care to avoid the imposter Web sites when requesting a copy of their report. Should they need additional copies, there will be a minimal charge; free reports also are available with verification of a recent credit denial. Periodically checking the report will enable the Dumonts to identify and correct faulty information, which may take a while. Inaccurate or questionable information should be immediately reported to the credit bureau that will then investigate the claim and correct the report, if necessary. Cory and Tisha have the right to add a statement to the report to explain nonpayment or late payments for a disputed account (e.g., faulty or unsatisfactory good or service), but not to provide excuses for credit mismanagement. 12. The “five Cs” of credit, as exemplified by the Dumonts, include the following: • Character: Responsibility in handling debt, such as repayment history and level of credit assumed. Stability, as measured by time on the job and at one address, is also considered. Cory and Tisha have faithfully repaid debt, although they admit they have been late a few times. Cory’s job change could be a factor, depending on the lender, and his other employment history. • Capacity: Measured by income level and current level of borrowing—particularly the level of nonobligated income. The Dumonts' income is reasonably high for a young couple. Their debt limit ratio of 15 percent suggests they have taken on a fair amount of debt, although they are not overextended. • Capital: Measured by assets—financial holdings or investments. The more capital you have, the more creditworthy you are. Aside from meager savings and their 401(k) accounts, the Dumonts have not accumulated a lot of capital. • Collateral: Measured by assets or property offered as security in the event of loan default. Like capital, the more collateral owned, the more creditworthy you are. Cory and Tisha own two cars that could be used as collateral. • Conditions: Impact of the current economic environment on the debtor's ability to repay. This factor will vary with the economic conditions when the Dumonts apply for credit. 13. The most inexpensive loan sources are usually the family, the cash value of a life insurance policy, a home equity loan, or other secured loan. The Dumonts may be uncomfortable borrowing from family. As renters, they don’t qualify for a home equity loan, but Tisha does have cash value life insurance policy. Credit unions, S&Ls, and commercial banks are a



more expensive source of loans depending on the type of loan, desired maturity, and type of interest (variable or fixed rate). Comparison-shopping is critical when considering these sources, but credit unions often offer the best deal. Retail stores, finance companies, and small loan companies offer the most expensive loans and accept consumers with greater risk of default. Payday loans fit the category of most expensive loans—fees can sometimes be equal to paying 800 percent interest on an annualized basis. The high fee is a major disadvantage, offset only by the fact that people with poor credit can typically qualify for this type of loan to cover expenses between paychecks. Given the Dumonts’ financial situation, they should be able to avoid these excessively costly lenders. 14. Credit counselors and debt consolidation loans are strategies for dealing with the high costs and personal anxiety associated with credit overuse. Credit counselors specialize in helping clients develop a workable budget and debt repayment program. As is true when working with any service provider, check the credentials and reputation of the individual. The nonprofit National Foundation for Consumer Credit Counseling is a good place to start. Debt consolidation loans reduce the monthly payment by extending the payment period over a longer time than for the original debts. A debt consolidation loan could simplify life with one lower payment in place of paying multiple creditors. However, the lower payment can give a false sense of financial security and lead to new spending. It is important to comparison shop for the lowest interest rate available and to check out the company with the Better Business Bureau and the consumer protection office. Finally, Tisha’s coworkers should realize that any debt reduction strategy is only a temporary fix if the underlying problems are not addressed. Two strategies are recommended: • Plan and implement a budget that brings in more money than goes out. • Use self-control with credit—stop charging. 15. Preshopping to Differentiate Want from Need is Step 1 of the smart buying process. For Cory and Tisha, this step focuses on how a replacement for their vehicle will fit their needs and lifestyle. Specifically, they need to consider what automotive styles, features, and qualities will best fit their current lifestyle. What functions does this auto need to fulfill? What features are particularly important to them? At the conclusion of this step, the Dumonts should decide if they are keeping the old car or replacing it, and if replacement is the decision, what features and functions are important for the new auto. In Step 2, Do Your Homework, Cory and Tisha will need to comparison shop for different vehicles by comparing price, features, and quality. They will need to read consumer magazines, use the Internet, and visit auto dealers. An initial question is how will this purchase fit their budget? Are there available savings for a down payment? What size monthly payment can they handle within their budget? What are available financing rates? How long will they need financing? How much will the payments be to finance the vehicle? Answering these questions will help them decide if they are shopping for a new or used



vehicle. Next comes visits to dealerships and test drives that are critical to this phase. They should research operating and insurance costs for different vehicles, including any available vehicle warranty. They should also research repair recalls, safety standards, and safety recalls. At the conclusion of this step, the Dumonts should have chosen the vehicle to purchase and decided to sell or trade their used car. In Step 3, Make Your Purchase, the Dumonts need to negotiate the auto price, compare different financing alternatives, and complete the purchase. Critical to negotiating the price on a new car is learning about dealer invoice cost, holdbacks, rebates, and incentives. Edmund's Car Buying Guide,and Internet sites, such as the Edmund’s site or www.kbb.com, are good sources of information. If Cory and Tisha are considering leasing, they should not discuss this until a firm price is established. For a used car purchase, they should check the National Automobile Dealers Association (NADA) Official Used Car Guide or Edmund’s Used Car Prices to determine a fair price. On the Web, check the sites for Edmund’s or the Kelley Blue Book. The Dumonts also should comparison shop for auto loan terms to ensure they get the best deal available. With the conclusion of this step, Cory and Tisha should be driving away in a new car—or at least one new to them! Step 4, Maintain Your Purchase, reminds Cory and Tisha that the best way to protect their vehicle is with regular maintenance from a repair facility, with evidence of qualified technicians that they know and trust. They should pay attention to warranty coverage, maintenance schedules, and any signs of trouble with the vehicle. If necessary, resolving complaints should start with the service provider, or if the problems are more serious should start with the seller and proceed to the company headquarters. Lemon laws provide for a refund if the vehicle is out of service for 30 days during the first year after purchase or the first 12,000 miles and there have been at least four attempts to fix the problem. 16. Several factors characterize consumers who lease autos. Generally, they are financially stable, have good credit but lack the funds to purchase a new car, want a new car every few years, drive less than 15,000 miles annually, and want to avoid vehicle maintenance and trade-in. They take care of their car, don’t make modifications to the car, and often use it for business travel. Cory and Tisha need to compare themselves to this profile. In short, leasing a car is similar to renting a car with the lease price determined by the expected depreciation in the value of the car over the term of the lease. In addition, a rent or finance charge is added to determine the total price. Getting a good deal on a lease requires you to (1) negotiate the lowest possible fair value for the vehicle, (2) choose a vehicle that does not depreciate quickly, and (3) find a lease with a low rent or finance charge. Check the Internet for any manufacturer offered special, subsidized lease packages on selected models. Open-ended leases require the consumer to pay the difference between the car value at the end of the lease and the estimated end of lease value in the original agreement. For this reason, the Dumonts should avoid open-ended leases. Closed-end, or walk-away, leases require no further payment when the lease ends, assuming the vehicle is returned in good condition with normal wear and tear. It is important to get a clear definition of normal wear and tear before the lease is signed. A purchase option may be available, should they wish to purchase the auto.



17. Buying a new car offers Cory and Tisha the thrill of driving a brand new car with all the latest features that they can afford (not to mention the “new car smell”). However, a new car declines in value much more quickly than a used car. Insurance costs may also be higher. Used cars cost less and require a lower down payment than for a comparable new car. However, a used car may have mechanical problems and may have little or no warranty coverage. Trading in a car toward the next purchase is more convenient but may not yield the maximum price. If the Dumonts decide to advertise and sell the car themselves, they may receive more money, but it may take more time and hassle. The Dumonts determine a realistic, not exaggerated, price relative to the book value, keeping in mind that the first digit in the price makes a big difference. All of these factors will influence the potential buyer’s impression of the car’s worth. 18. Financing a used car loan of $12,000 for 48 months at 5.75 percent requires a monthly payment of $280.45. New car financing at 4.35 percent for 48 months would reduce the payment to $272.83. The monthly payment difference between financing a used car at 5.75 percent and a new car at 4.35 percent would equal $7.62, or a savings of $365.76 over the life of the loan. 19. Financing the used car for 36 months instead of 48 at 5.75 percent would increase the payment to $363.71, but yield a savings of $368.04 over the life of the loan, as compared to the longer 48-month term. [($363.71 × 36 = $13,093.56) – ($280.45 × 48 = $13,461.60) = $368.04] 20. A specific asset, such as an auto, guarantees a “secured loan.” The asset can be seized and sold to cover the loan repayment if the consumer defaults. To default means that the consumer missed interest and/or principal payments as agreed in the loan. Typically, the asset, or consumer item, purchased with the loan is used for security. In the sample auto loan contract reviewed by Cory and Tisha, the auto purchased would serve as “security” or collateral for the loan. The term “repossession” refers to the process of the lender seizing and selling the asset used as security for the loan. Should the sale of the asset not generate sufficient funds to cover what is owed on the loan, as well as additional charges for legal fees and seizure and sale of the property, the consumer is responsible for the difference. The “deficiency payment clause” in the loan contract establishes the right of the lender to bill the consumer for this difference. In other words, should Cory and Tisha fail to make their auto payments, or default on the loan, their car could be repossessed and sold. If the car did not sell for enough to pay off the loan, as well as expenses for legal fees, collection fees, and sales fees, then they would have to pay the “deficiency” or difference. They can avoid repossession by not defaulting, or missing payments, on their loan.



21. A home equity loan, like all credit, carries the disadvantage of committing future income to pay for present spending, thus reducing future disposable income. But the major disadvantage that Cory and Tisha should consider is using their home equity as security for another purchase. Their home, not the item(s) purchased, is at risk should they default. They would also lose some financial flexibility, as well as this source of credit, should a major financial emergency occur. However, home equity loans offer some unique advantages. Most offer a generally lower interest rate than other consumer loans, and the interest paid (within limits) is tax deductible. Thus there are two savings—on the amount of interest paid initially and the subsequent tax savings from including the interest as an itemized deduction. The tax savings would equal the marginal tax rate multiplied by the interest paid. The typical auto loan is secured by the auto but offers no income tax benefits. Rates vary depending on whether a new or used vehicle is financed, the lending source, and of course, the FICO score. With the tax deductibility of student loan interest, Cory and Tisha will need to compare this alternative to a home equity loan. The income level for eligibility for a full or partial deduction of the interest as an adjustment to income increases over time, which also could benefit Chad and Haley as they repay their loans. Depending on the type of student loans used (i.e., parents or child as borrower), the debt could be passed on to Chad and Haley, thus protecting the older Dumonts’ financial freedom to spend for other goals or to save for retirement. Federal Direct or Stafford loans would also offer Chad and Haley the benefits of deferred interest while in school and deferred payments until 6 months after graduation. 22. N I/Y PV PMT FV CPT PMT

30-year fixed, 3.88% 30 x 12 = 360 3.88/12 = 0.3233 120,000 ? 0 -564.63

7-year balloon, 3.45% 30 x 12 = 360 3.45/12 = 0.2875 120,000 ? 0 -535.51

1-year ARM, 3.25% 30 x 12 = 360 3.25/12 = 0.2708 120,000 ? 0 -522.25

Aside from the $30 to $40 difference per month in principal and interest payments, the Dumonts should consider several other factors when comparing different types of mortgages. Cory and Tisha should consider (1) payment changes, (2) future budget impact, and (3) equity build up among these mortgages. Before making a final mortgage selection, the Dumonts also should consider how long they plan to live in their home and projected characteristics of their financial future (e.g., an inheritance, breaks in employment, etc.). The 30-year fixed-rate mortgage offers a constant monthly payment (ignoring any future increases in taxes and insurance) that contributes to future financial management control and planning. Equity build up is continuous. Both the 7-year balloon and the 1-year ARM offer initially lower monthly payments that may allow Cory and Tisha to qualify for a larger mortgage. However, on some balloon Copyright ©2016 Pearson Education, Inc.


mortgages, initial payments cover only the interest on the mortgage, which means no equity build up. Payments on some balloon mortgages cover the loan’s amortized value over 30 years, as in this example, which provides for equity accumulation. Either way, payments remain constant. However, the consumer must plan for the future impact of meeting the balloon payment, or refinancing, at the end of the 7-year term. ARM payments are initially lower because interest rates on ARM mortgages are generally lower than fixed-rate mortgages. Should interest rates increase, however, then increasing mortgage payments could wreck the Dumonts’ budget—a future impact they should consider. Equity build up is continuous. The advantage of an interest only mortgage is significantly lower payments for the initial (e.g., 5 years) interest only period. However, once the mortgage is fully amortized over the remaining period of the mortgage (e.g., 25 years), the payments increase to cover principal and interest. Control of the financial situation is a fundamental principle of financial planning, a caution the Dumonts should consider as they evaluate mortgage options. 23. Based only on the 28 percent qualification rule, the Dumonts could qualify for a maximum mortgage of $374,948. However, given the impact of their monthly debt repayment of $911 on the 36 percent qualification rule, their maximum allowable mortgage would drop to $301,424. See completed Worksheet 11, Worksheet for Calculating the Maximum Monthly Mortgage Payment and Mortgage Size for Which You Can Qualify. 24. Creditworthiness, as measured by the FICO score, determines whether you qualify for credit as well as lending sources and finance costs. A solid history of timely repayment of the student loan has benefited Cory’s credit report. Because 10 percent of the FICO score is based on the types of accounts held, there is some benefit from adding the student loan to the Dumonts’ mix of credit card, auto, and other loans. However, the additional monthly payment of $196 has a dramatic effect on the maximum mortgage amount for which they can qualify. Subtracting the student loan payment and recalculating Method 2 on Worksheet 11 results in a maximum mortgage of $342,480, or a difference of $40,056. This amount could make a significant difference in the house purchased. As consumer credit repayment increases, the corresponding PITI payment must decrease to balance the ratio of 36 percent of gross income. The Dumonts cannot afford to overlook this inverse relationship—the higher the consumer credit repayment, the lower the mortgage. However, the student loan debt “purchased” Cory’s education and higher salary, something they also can’t overlook. 25. Given the maximum mortgage qualification amount of $216,293, the projected monthly PITI would equal $1,609 (using Worksheet 11). This represents a difference of $492 over their current rent and renters insurance of $1,117. Cory and Tisha would be well advised to consider a less expensive house given the dramatic increase in their mortgage costs over current rental costs. With little flexibility in their present budget, stretching it to include an additional $492 per month would require some significant changes in their spending patterns. Maintenance costs for the home are an additional expense, which have not been considered in their current budget. In other words, taking the maximum mortgage for which they could qualify may not be the best decision.



26. Remember that a 20 percent down payment means that the mortgage amount, in this case $301,424, equals 80 percent of the home sale price, or a total of $241,139. Accordingly, the 20 percent down payment would equal $60,285. In addition, $15,071 would be needed for closing costs. Cory and Tisha would need $75,356 on the day of closing, nearly six times their current savings of $13,000 for purchasing a home. 27. The monthly payment on a $301,424 30-year mortgage with a 4 percent interest rate would be $1,439. Assuming no mortgage prepayment, the Dumonts would pay a total of $518,040 in principal and interest for their home ($1,439 × 360). Interest payments would total $216,616 ($518,040 – $301,424), almost as much as the house cost! 28. In considering a 15-year as compared to a 30-year mortgage, Tisha must consider the following factors, assuming the same mortgage amount: • Monthly payments are considerably higher for a 15-year mortgage, as the principal is repaid more rapidly. The PI payment would increase from approximately $1,439 to $2,230, assuming the same interest rate. (Interest rate on the 15-year mortgage would actually be less, because of the reduction in risk for the lender.) Lower payments associated with a 30-year mortgage allow more financial flexibility. • Total interest paid on a 15-year mortgage is less than for a 30-year mortgage because the principal is financed for a shorter time. In this case, the 15-year and 30-year interest would equal $99,976 and $216,616, respectively, assuming the same interest rate. However, 15-year mortgages are generally offered with a lower interest rate. • The time value of money is also important, depending on the assumptions about potential investment returns over the 30-year period. At the end of the 15-year period, the mortgage payment amount could be invested for the next 15 years. With a 30-year mortgage, the difference between the lower payment and the higher 15-year payment, $791 monthly, could be invested. Payments spread over the 30 years are paid back with future dollars that are worth less because of inflation. Given the effects of inflation and compounding over the longer time-period, the longer-term mortgage is favorable. • Homeowners benefit from reduced taxes associated with the deduction for home mortgage interest. A 30-year mortgage insures this deduction for a longer period. 29. The classification of costs into one-time, recurring, and maintenance and operating provides a very useful framework for home purchasers. (In fact, the framework can be applied to autos or other large purchases.) One-time costs include down payment, closing and settlement costs. Recurring costs include the monthly mortgage payment of principal, interest, real estate taxes, and homeowners insurance. Maintenance and operating costs include expenses for the structure, the grounds, and from the perspective of operating could be extended to heating, cooling, or other associated costs for “operating” the home. Serious consideration of this classification of expenses forces a homebuyer to consider both the immediate and longer term implications of a potential purchase. For example, a house with wood siding may be cheaper to purchase, and therefore have lower one-time and recurring costs, but maintenance and operating expenses may be much higher than a house that does not require periodic painting or staining, which can be costly or time consuming. Recurring costs for a homeowner’s association fee or other fees for care and maintenance of



commonly owned grounds, which are subject to annual increases, may make one house more costly than one in another neighborhood or development. As these examples suggest, focusing on all three categories of expenses provides a much richer context for evaluating the homes considered.



Worksheet for Calculating the Maximum Monthly

W11 WORKSHEET Mortgage Payment and Mortgage Size for Which You Can Qualify Method 1 Determine Your Maximum Monthly Mortgage Payment Using the Ability to Pay, PITI Ratio. a. Monthly income (annual income divided by 12) b. Times 0.28: Percentage of PITI (Principal, interest, taxes, and insurance) to your monthly gross income that lenders will lend in the form of a mortgage loan (multiply line a by 0.28) x 0.28 = c. Less: Estimated monthly real estate tax and insurance payments = d. Equals: Your maximum monthly mortgage payment using the 28% of PITI ratio To Determine the Maximum Mortgage Loan Level Using the Maximum Monthly Mortgage Payments as Determined Using the PITI Ratio (line d): Step 1: Monthly mortgage payment for a $10,000 mortgage with a ____ year = maturity and a ____% interest rate (using Table 8.1) Step 2: Maximum mortgage level = maximum monthly mortgage payment (line d) divided by the monthly mortgage payment on a $10,000, ____%, ____year = mortgage (step 1 above) times $10,000 = (line d/step 1) x $10,000

$7,000

$1,960 $170 $1,790

47.74

$374,948

Method 2 Determine Your Maximum Monthly Mortgage Payment Using the Ability to Pay, PITI Plus oth Fixed Monthly Payments, Ratio. $7,000 e. Monthly income (annual income divided by 12) f. Times 0.36: Percentage of PITI + current monthly fixed payments to your monthly gross income that lenders will lend in the form of a mortgage loan $2,520 (multiply line a by 0.36) x 0.36 = g. Less: Current nonmortgage debt payments on debt that will take over 10 months to pay off and other monhtly legal obligations such as child support $911 and allimony payments $170 h. Less: Estimated monthly real estate tax and insurance payments i. Equals: Your maximum monthly mortgage payment using the 36% of PITI + other fixed $1,439 = Monthly payments ratio (line f - g - h) To Determine the Maximum Mortgage Loan Using the PITI Plus Other Fixed Monthly Payments Ratio (line i): Step 1: Monthly mortgage payment for a $10,000 mortgage with a ____ year 47.74 = maturity and a ____% interest rate (using Table 8.1) Step 2: Maximum mortgage level = maximum monthly mortgage payment (line d) divided by the monthly mortgage payment on a $10,000, ____%, ____year = $301,424 mortgage (step 1 above) times $10,000 = (lined/step 1) x $10,000

Method 3 Determine Your Maximum Mortgage Level Using the "80% of the Appraised Value of the House" Rule. j. k. l. m.

Funds availble for the down payment and closing costs Less: Closing costs Equals: Funds available for the down payment Times 4: Maximum mortgage level using the "80% of the appraised value of the house" rule (the 20% down, line l, times 4 equals the 80% you can borrow) x 4

Conclusion: Maximum Mortgage Level for Which You Will Qualify (the lowest of the amounts using method 1, method 2, or method 3)


=

$0

=

$0

=

$301,424

CHAPTER 9 LIFE AND HEALTH INSURANCE

CHAPTER CONTEXT: THE BIG PICTURE This chapter is the first in a two-chapter section titled “Part 3: Protecting Yourself with Insurance.” An underlying premise of this section is the use of insurance products to provide financial control, a fundamental element of financial planning. An important message to students is the need to plan insurance purchases that will enable them to control their financial situation and to control the cost of insurance. Fundamental to this is the need to protect financial wellbeing throughout the financial life cycle with life, health, disability, and long-term care insurance. A secondary message focuses on controlling policy costs through knowledge of the policy features and an awareness of what provisions are important to the individual. Purchasing the right insurance product(s) at the best price will enable students to fit the cost of insurance, and any losses covered by insurance, into their financial plan. CHAPTER SUMMARY Determining the need for and selecting cost-effective life, health, disability, and long-term care insurance products are the objectives of this chapter. The purpose of life insurance and the underlying principles of risk pooling introduce the chapter. Two methods for determining the need for life insurance and the level of coverage illustrate this step in the purchase process. Major types of life insurance and the different product variations are reviewed, as are strategies for selecting the type of policy that best matches individual needs. Common features of most insurance policies are considered. Choosing a cost-effective health care insurance plan requires an understanding of the major types of health insurance coverage and the typical provisions included. Characteristics of private and public health care providers are considered, as are strategies for controlling health care costs. Fundamental provisions that will adapt the health care policy to individual needs are discussed. Next, the purposes of disability and long-term care insurance, sources of coverage, determination of coverage needs, and policy features are presented. Recommended buying strategies to help students select the company, agent, and policy are considered throughout the chapter. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Understand the importance of life insurance. a. Patient Protection and Affordable Care Act

177


178


2.

Determine your life insurance needs and design a life insurance program. a. Risk pooling b. Premium c. Actuaries d. Face amount or face of policy e. Insured f. Policy owner or policyholder g. Beneficiary h. Rarnings multiple approach i. Needs approach j. Vleanup funds

3.

Describe the major types of coverage available and the typical provisions that are included. a. Term insurance b. Cash-value insurance c. Renewable term insurance d. Decreasing term insurance e. Group term insurance f. Credit or mortgage group life insurance g. Convertible term life insurance h. Whole life insurance i. Cash value j. Nonforfeiture right k. Universal life insurance l. Variable life insurance m. Coverage grace period n. Loan clause o. Policy reinstatement clause p. Change of policy clause q. Rider r. Settlement or payout options s. Traditional net cost (TNC) method t. Interest-adjusted net cost (IANC) method or surrender cost index

4.

Design a health-care insurance program and understand what provisions are important to you. a. Basic health insurance b. Hospital insurance c. Surgical insurance d. Physician expense insurance e. Major medical expense insurance f. Stop-loss provision g. Fee-for-service or traditional indemnity plan h. Managed health care or prepaid care plan i. Co-insurance or percentage participation provision j. Co-payment or deductible


Chapter 9: Life and Health Insurance

k. l. m. n. o. p. q. r. s. t. u. v.

179

Health maintenance organization (HMO) Individual practice association plan (IPA) Group practice plan Point-of-service plan Preferred provider organization (PPO) Group health insurance Individual insurance policy Workers’ Compensation laws Medicare Medigap insurance Medicaid Flexible spending account

5.

Describe disability insurance and the choices available to you. a. Disability insurance b. Short-term disability (STD) c. Long-term disability (LTD) d. Waiting or elimination period e. Waiver of premium provision f. Rehabilitation coverage

6

Explain the purpose of long-term care insurance and the provisions that might be important to you. a.

Long-term care insurance

CHAPTER OUTLINE I.

The Importance of Insurance A. Why Are Health and Life Insurance So Important? B. Why Is It So Costly? C. What Do These High Costs Mean for You? D. What About Those Who Have No Health Insurance?

II.

Determining Your Life Insurance Needs A. Do You Need Life Insurance? B. How Much Life Insurance Do You Need? 1. Earnings multiple approach 2. Needs approach

III.

Major Types of Life Insurance A. Term Insurance and Its Features 1. Renewable term insurance 2. Decreasing term insurance 3. Group term insurance


180


B.

C. D. E.

F.

G.

H. I. J. K. IV.

4. Credit or mortgage group life insurance 5. Convertible term life insurance Cash-Value Insurance and Its Features 1. Whole life insurance and its features 2. Universal life insurance and its features 3. Variable life insurance and its features Term Versus Cash-Value Life Insurance Fine-Tuning Your Policy: Contract Clauses, Riders, and Settlement Options Contract Clauses 1. Beneficiary provision 2. Coverage grace period 3. Loan clause 4. Nonforfeiture clause 5. Policy reinstatement clause 6. Change of policy clause 7. Suicide clause 8. Payment premium clause 9. Incontestability clause Riders 1. Waiver of premium for disability rider 2. Accidental death benefit rider or multiple indemnity 3. Guaranteed insurability rider 4. Cost-of-living adjustment (COLA) rider 5. Living benefits rider Settlement or Payout Options 1. Lump-sum settlement 2. Interest-only settlement 3. Installment-payments settlement 4. Life annuity settlement Buying Life Insurance Selecting an Agent Comparing Costs Making a Purchase

Health Insurance A. 2010 Health-Care Reform—Patient Protection and Affordable Care Act B. Basic Health Insurance 1. Hospital insurance 2. Surgical insurance 3. Physician expense insurance 4. Major medical expense insurance C. Dental and Eye Insurance D. Basic Health-Care Choices E. Private Health-Care Plans 1. Fee-for-service or traditional indemnity plans 2. Managed health-care plans



F.

G. H. I. J. K. L.

M.

3. Managed health care: HMOs 4. Managed health care: PPOs 5. Group versus individual health insurance Government-Sponsored Health-Care Plans 1. Workers’ Compensation 2. Medicare 3. Medigap plans 4. Medicaid Controlling Health-Care Costs Flexible Spending Accounts Health Savings Accounts COBRA and Changing Jobs What About Choosing Not to Be Insured? What to Look for in a Health Insurance Plan 1. Who’s covered? 2. Terms of payment 3. Exclusions Choosing an Insurance Plan

V.

Disability Insurance A. Sources of Disability Insurance B. How Much Disability Coverage Should You Have? C. Disability Features That Make Sense 1. Definition of disability 2. Residual or partial payments when returning to work part-time 3. Benefit duration 4. Waiting (or elimination) period 5. Waiver of premium 6. Noncancellable 7. Rehabilitation coverage

VI.

Long-Term Care Insurance 1. Type of care 2. Benefit period 3. Waiting period 4. Inflation adjustment 5. Waiver of premium

VII. Behavioral Insights A. Principle 9: Mind Games, Your Financial Personality, and Your Money VIII.



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APPLICABLE PRINCIPLES Principle 1: The Best Protection Is Knowledge Insurance agents are paid to sell. Understand what you do and don’t need and be an informed consumer. Don’t be afraid to shop around for agents. Principle 5: Stuff Happens, or the Importance of Liquidity Having an emergency funds helps with the costs of deductibles and co-insurance you may have to pay in a medical emergency. Choose the right plan to keep your out-of-pocket costs to a minimum. Principle 7: Protect Yourself Against Major Catastrophes Life insurance protects loved ones when income and household services are unexpectedly lost. Without adequate funds to replace lost income or pay for household services, dreams and goals that were once realistic may now be impossible. Likewise, the continually rising costs of health care, the astronomical charges for some medical procedures (e.g., open heart surgery), and the expense associated with ongoing health care (e.g., AIDS) require you to protect yourself from a major budget catastrophe. Health insurance, disability insurance, and long-term care insurance are tools for protecting your financial future. Principle 9: Mind Games, Your Financial Personality, and Your Money Watch out for anchoring in buying life insurance. Just because a policy only costs a few extra hundred dollars a year, does not necessarily mean that you need to increase your coverage by millions of dollars. Calculate your need for life insurance and be a smart consumer. Principle 10: Just Do It! Buying insurance is not a one and done situation. You must continually evaluate your needs with changing life situations. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Ask students to share scenarios from friends or relatives describing the financial impact of death when the household had either adequate or inadequate life insurance coverage. What were the implications for the financial situation or lifestyle?

2.

How have the needs for life insurance changed with the increasing number of two-income households? Remarried households? What are the implications for these changes when considering the need for income replacement and funds to replace household services? Explore with students their attitudes about the responsibility of providing for others after their death. Consider these questions with the class or in small groups.



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Ask a recent graduate, or a senior who has accepted a job offer and completed the benefit selection, to share with the class his or her experiences to learn about, compare, select, and pay for company-provided benefits.

4. Have students interview at least three people from different stages of the life cycle to determine if they own one or more of the following: life insurance, health insurance, dental or eye care insurance, disability insurance, or long-term care insurance. What factors influenced their decision to buy or not buy the insurance coverage? Also inquire about the amount of coverage, type of policy, and premium cost. 5. Use an Internet quote service and obtain life insurance premium quotes for $100,000 of term, whole life, and universal life insurance. Base your request on your own age, gender, and health characteristics (e.g., nonsmoker). How would the costs change if your health characteristics changed (e.g., smoker or nonsmoker)? What if you waited 10 years? How do your characteristics or the projected changes relate to the concept of risk pooling? 6.Interview a friend employed in your career field or interview a benefits representative from a company/agency in your career field. Discuss the benefits that you might expect to receive as an employee (e.g., life, health, dental, eye care, accident, or disability insurance) and the outof-pocket premium costs. Share your findings within the group; summarize the differences in the benefit packages identified in different industries or sectors of the economy. 7. Have students read a life insurance policy from cover to cover and prepare a report of key policy features, including beneficiary designation, policy clauses, settlement options, nonforfeiture options, and riders. Interpret the nonforfeiture options if the policy owner ceased premium payments. 8. Encourage students to begin or increase an activity associated with maintaining a healthy lifestyle (e.g., diet, exercise, and not smoking). Change your habit and maintain this activity for at least a month. Did the lifestyle change increase or decrease spending in the short term? What insurance costs might be affected in the long term? 9.

As a group project, have students visit a nursing home, assisted living facility, or extended care facility and interview a patient care representative or other administrator. Discuss the range of services and costs for care in the facility. What are the options for using long-term care insurance, government benefits, and personal assets to meet the costs? What payment sources does the typical client use?

10. Have students talk to one or more senior citizens about their experiences with Medicare and/or supplemental Medigap health insurance. How does this coverage and the processing of claims compare with the coverage available prior to retirement? Did the people interviewed have the option to continue their company-provided benefits in retirement?


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REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1. How are the concepts of the risk–return trade-off, risk pooling, and the work of actuaries a foundation for the logic of insurance as well as the premium you will ultimately pay? Insurance is based on the concept of pooled risk, or the idea that diversifying the cost of a loss over large numbers of individuals reduces the risk associated with the loss for any one individual. The individual is willing to risk the premium payment for the potential return of much greater amounts of insurance protection, when needed. Clearly, this does not reduce the risk of dying or having an auto accident, but by large numbers of individuals pooling their funds, over time, the accumulated “pot” of money can be paid out to individuals suffering a loss. Actuaries, using statistics and loss characteristics of any group, determine the likelihood of loss for the individual and the corresponding amount, or premium, needed to provide protection. For example, smokers pay more than nonsmokers for life insurance because of greater likelihood of an early death, while young drivers, who are involved in more accidents, pay more than other drivers. With increased risk of loss, there is lower likelihood of return for the insurance company, so the insured must pay more but has the potential to receive a greater return (e.g., the young driver will be covered for losses from potentially multiple accidents). 2. Define the following life insurance terms: beneficiary, face amount, insured, policyholder, and policy owner. How are these terms related? • • • • •

Beneficiary: person designated by the owner of a life insurance policy to receive the policy proceeds upon the death of the insured Face amount: the amount of insurance provided by a life insurance policy upon the death of the insured Insured: person whose life is insured by a life insurance policy (i.e., if they die, policy proceeds are paid) Policyholder: the owner of a life insurance policy; policyholders can include individuals (including the insured) or businesses Policy owner: synonymous with policyholder

A policyholder or policy owner purchases and maintains a life insurance policy on the life of the insured. Upon the insured’s death, the beneficiary receives the face amount of the life insurance policy. 3. What is the main purpose of life insurance? Describe the types of households that need life insurance and those that do not. Summarize the underlying factors that determine the need for life insurance. The main purpose of life insurance is to protect an insured’s dependents in the event of death. Life insurance provides needed funds for survivors to repay a deceased person’s debts (e.g., ©2016 Pearson Education, Inc.


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home mortgage). It can also provide a stream of income to help replace a deceased breadwinner’s salary. Life insurance proceeds can also be used to fund specific financial goals (e.g., a child’s college education) if a family earner dies, and it helps to maintain a family’s standard of living. In summary, life insurance provides peace of mind by reducing the financial consequences experienced when a family member dies. It is not meant to benefit the insured but, rather, those left behind. Life insurance can also provide tax and estate planning advantages, but these are secondary to its major purpose. Types of households that need life insurance might be characterized as follows: • Persons with children who are financial dependents • Single-earner married couples who need insurance for either or both of two purposes: (1) to allow the nonemployed spouse to maintain his/her lifestyle until he/she can become self-sufficient and (2) to allow the employed spouse to pay for child care and housekeeping services formerly provided by a homemaker • Business owners with outstanding business-related debts • Households with large taxable estates (to provide funds to pay estate taxes) Types of households that do not need life insurance might be characterized as follows: • Single persons without a spouse or financial dependents or a married person who is at high risk of contracting a terminal disease (i.e., AIDS, cancer) or health conditions (i.e., diabetes, heart disease) that could make the purchase of life insurance impossible or very costly • Dual-income couples without children in cases where a survivor’s lifestyle would not suffer upon the spouse’s death • The stay-at-home spouse, if the surviving spouse would not need assistance for childcare or housekeeping • Retired couples with adequate savings, Social Security, and/or pension income to provide for a surviving spouse Factors that determine a person’s need for life insurance include the following: • Amount of accumulated financial assets that can be used to support dependents • Number of dependents/stage in family life cycle • Level of financial support provided to others (e.g., total or partial) • Risk of contracting a terminal illness or uninsurable condition 4. Compare and contrast the two basic approaches used to determine the amount of life insurance needed. What are the primary factors considered? The two approaches to life insurance planning are the earnings multiple approach and the needs approach. The earnings multiple approach is a “rougher” estimate than the needs approach. The earnings multiple approach does not take into account the surviving spouse’s income or other accumulated household assets; it only considers income replacement. No allowance is made for funding specific financial goals (e.g., college). The needs approach is more precise because it includes specific expense categories and financial goals and makes allowances for the surviving spouse’s income, existing assets, and other insurance.


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The earnings multiple approach calculates the need for life insurance based on some multiple (e.g., from 5 to 15 times) of annual gross income to be replaced. Using present value of annuity factors, this method is used to determine the lump sum needed to replace the lost stream of annual income. Key variables in an earnings multiple calculation are the number of years that income replacement is needed and the assumed after-tax and afterinflation rate of return from investing insurance policy proceeds. An adjustment is also made for reduced household living expenses accompanying a breadwinner’s death. The needs approach calculates specific categories of expenses anticipated by a deceased’s survivors. Various anticipated expenses are totaled, including burial costs, medical expenses, outstanding debts, job training for the surviving spouse, and educational expenses for children. Once needs are estimated, survivors’ anticipated resources are totaled to determine the income shortfall that needs to be covered by insurance. For example, a surviving spouse may receive income from employment and/or Social Security survivor’s benefits, proceeds from other life insurance, or have other assets that can be used to provide income. The amount of life insurance needed is determined by subtracting current assets and insurance from the present value of a family’s insurance need. 5. Briefly describe five common types of term life insurance. • •

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Renewable term: Term insurance that can be continually renewed, regardless of changes in health status. Each time a policy is renewed, however, premiums increase to reflect the increased risk of mortality with increased age. Decreasing term: Term policy where premiums remain constant, instead of increasing with age, but the face amount of the policy gradually or rapidly declines. Important to choose a policy with a declining value matched to the projected declining need for insurance. Group term: Term insurance provided to an association or group of individuals who are affiliated for a purpose other than buying insurance (e.g., co-workers). Typically, no medical exam is required, particularly with employer groups, which may be an important feature. Credit or mortgage term: This insurance is sold by lenders to provide enough coverage to repay debts if the debtor dies while the loan is still in effect. Convertible term: Term insurance that can be converted into a cash-value policy regardless of medical condition. Premiums are often increased accordingly.

6. Briefly describe the three major categories of cash-value life insurance. •

Whole life: Type of cash-value insurance that provides a death benefit when an insured dies or reaches the maximum stated age (e.g., 100). Policy premiums are constant throughout a policyholder’s lifetime, although it is possible to make payments for a limited period or with gradually increasing premiums. In the early years, cash value begins to accumulate because the premium charged exceeds the cost of insurance for a younger person. In later years, the accumulated cash value is used to supplement the level premiums that are now insufficient to purchase the death coverage. Policyholders can borrow against their cash value, if desired. ©2016 Pearson Education, Inc.


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Universal life: Type of cash-value insurance that separates premium payments into three categories: mortality charge (term insurance), cash value, and administrative expenses. This “unbundling” of the three insurance components gives policyholders flexibility to vary their premium amount to fund what are essentially term insurance and a taxdeferred savings feature. For example, payments can be skipped as long as there is sufficient cash value to pay the mortality charge and administrative expenses. Otherwise, a policy would lapse. Variable life: Type of cash-value insurance that provides a menu of investments that are chosen by a policyholder (e.g., stock fund, bond fund) in combination with term insurance. The policyholder selects the investments for the policy’s cash-value portion and assumes all of the investment risk. This type of policy is suitable for people who are willing to take risks and manage their own investments. High administrative expenses are common for both variable life and universal variable life policies. The latter allows flexible premiums. More attractive investment options exist, and there is no guarantee of any cash value

7. Describe the major differences between term and cash-value life insurance. What are the primary advantages and disadvantages of each? The differences between term life and cash-value life are as follows: • Term life insurance provides coverage for a specific time or “term.” It is pure life insurance and has no savings component. If an insured dies during the coverage period, his/her beneficiary receives the face value of the policy. • Cash-value life insurance has two components: life insurance and a savings plan. Part of a cash-value policy premium is used for each purpose. Cash-value policies are, thus, a form of forced savings. Accumulated savings grow on a tax-deferred basis. Policies can remain in effect for decades as long as premiums are paid. Consideration of advantages and disadvantages often focus on cost. Term insurance provides the most coverage per premium dollar. Because the sole purpose of term insurance is to provide death benefits to a policyholder’s beneficiary, it is less expensive than cashvalue insurance, which also includes a savings component. This affordability is especially important for breadwinners with young children—they need life insurance the most. Cashvalue policies offer the convenience of level premiums, while term insurance premiums increase over the life cycle (unless level-term is chosen) and can become prohibitively expensive with age. Another advantage cited for cash-value insurance is the tax-deferred growth of the cash value. 8. Define the following life insurance policy features: coverage grace period, loan clause, nonforfeiture clause, policy reinstatement clause, suicide clause, and incontestability clause. •

Coverage grace period: An automatic extension for premium payments, generally 30 days after the due date. During this period, a policy remains in force and payments can be made without penalty.


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• •

• • •

Loan clause: Clause in cash-value policies that allows a policyholder to borrow against their cash value, often at a low rate without other fees or forced repayment. The loan balance is subtracted from the policy proceeds, if death occurs before loan repayment. Nonforfeiture clause: Clause that establishes options for a policyholder who chooses to cease premium payments. The three major nonforfeiture options are (1) receiving a policy’s cash value, (2) exchanging the cash value for a paid-up whole life policy with a reduced face value, or (3) exchanging the cash value for a paid-up term policy. Policy reinstatement clause: Clause that allows a policyholder to restore a policy within 3 to 5 years after expiration. Most companies require a physical exam and payment of all past-due premiums, interest, and policy loans. Suicide clause: Clause stating that the face amount of the policy will not be paid for suicide deaths that occur within two years of the purchase of the contract. Incontestability clause: Clause that states that an insurance company cannot dispute the validity of an insurance contract after it has been in place for a specified number of years (usually two). Protects the beneficiary from error, concealment, or misstatement by the insured on the application.

9. Explain the four primary life insurance policy settlement options available to the beneficiary. • •

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Lump-sum settlement option: Beneficiary receives policy proceeds in a single lump sum. It allows the beneficiary the freedom to select investment alternatives and to make withdrawals as desired. Generally, no income taxes would be due. Interest-only settlement option: Beneficiary leaves the policy proceeds invested with the insurance company for a specified period and receives interest payments. Generally, the interest rate paid is tied to market rates with a guaranteed minimum rate. Income taxes are due on the interest earnings. Installment-payments settlement option: The face value of a policy, including principal and interest earned, is distributed to the beneficiary over either a fixed period of time or in a fixed amount. Income taxes are due on the interest earnings. Life annuity settlement option: Beneficiary receives income for life. With a straight life annuity, a beneficiary receives monthly payments for as long as he/she lives. With a life income with period-certain annuity, payments are guaranteed for a stated period (e.g., 10 years) and go to a secondary beneficiary if the primary beneficiary dies within this time period. With a refund annuity, a beneficiary receives income for life and any remaining death benefit is returned to a secondary beneficiary if the primary beneficiary dies. With a joint and survivor annuity, monthly payments continue as long as the two named beneficiaries—generally a husband and wife—remain alive. The method of annuity payment affects the amount received by beneficiaries. For example, because two life expectancies are involved with a joint and survivor annuity, payments are less than they would be under a straight life annuity.



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10. When shopping for life insurance, what key factors should you consider when comparing companies, agents, and cash-value and term policies? How could the Internet assist you? To systematically shop for life insurance, consider the company, the agent, and the policy. To evaluate the companies, consider the following: • Ratings given to the insurance company by the four major ratings services (e.g., A. M. Best; Duff & Phelps; Moody’s Investors Service; Standard & Poor’s) to evaluate if the company is financially sound and able to pay off future claims. • Check the reports at the library to avoid fees from the ratings services. • Know how to interpret the scales used by the different services. To evaluate the agents, consider the following: • Educational credentials and training of the insurance agent (e.g., CLU designation) • Affiliation with good companies and years of experience • Recommendations from others—both friends and professionals • Personal interviews to identify the agent with whom you feel most comfortable To compare the costs and features of similar policies, use the following cost comparisons: • Traditional net cost method (TNC)—calculated by summing premiums over a stated period (e.g., 10 or 20 years) and subtracting dividends paid during this same period and the policy’s cash value at the end of this period. The final result is divided by the number of years in the stated period. In other words, (Summed premiums – Summed dividends) – cash value) / number of years = TNC The formula, while used often, is virtually meaningless because it does not consider the time value of money. • Interest-adjusted net cost method (IANC)—also known as the “surrender cost index,” this method incorporates time value of money concepts. It is, therefore, considered an improvement over the TNC method. Its accuracy, however, depends on the selection of an appropriate discount rate and accurate estimates of policy dividends and cash value. Finally, when comparing term and cash-value policies, for most consumers term insurance offers the best protection for the cost. The higher cost of cash-value polices may prohibitively limit the amount of insurance purchased. The tax-deferred growth of the cashvalue is a benefit, as is the exclusion of the policy proceeds from the calculation of the taxable estate upon death, assuming the policy was not owned by the decedent. However, other tax-deferred investments and estate planning options are available. The Web is less helpful when purchasing whole life insurance, although quotes on different policies are available. But instant quote comparisons, from in some cases several hundred companies, are readily available when shopping for term insurance. Consider at least two of the following as well as an inquiry to an independent insurance agent: • Insure.com www.insure.com • QuickQuote www.quickquote.com • Life Quote www.lifequote.com


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11. Explain the new health insurance exchange system as outlined in the Affordable Care Act. How does this benefit self-employed individuals? The health insurance exchanges allow a consumer to choose from a wide variety of private insurance plans. The exchanges, modeled after the federal employee health program, allows for a diverse option of health insurance plans. The exchanges provide affordable options for self-employed individuals. 12. Define coinsurance and deductible. Coinsurance is the percentage of an insurance claim shared with an insurance company. Generally, the insured pays 20 percent, and the insurance company 80 percent, up to the stop-loss provision limit. A deductible is the amount that an insured must pay before an insurance company will pay for a claim. Generally, the higher the deductible, the lower the premium for a given amount of insurance coverage. 13. Why are dental and eye insurance typically not recommended? What’s the best alternative for meeting these expenses? Dental and eye care insurance pay for expenses that are relatively minor and can be planned for in advance without insurance. Accident insurance only pays if medical expenses are incurred as a result of an accident and is usually limited to a specific benefit for days hospitalized or loss of a body part or limb. Instead of spending money on insurance coverage with limitations, consumers should buy comprehensive health coverage. It should provide protection not only against major catastrophes but also be comprehensive enough to cover all medical claims. 14. What are the fundamental differences between a fee-for-service health care plan and a managed health care plan? Beyond the method of paying for services, what is the other fundamental difference? •

•

Under a fee-for-service health care plan (a.k.a., traditional indemnity), policyholders are billed directly for the cost of medical services and are later reimbursed for all or part of their medical expenses. Another distinguishing feature is greater freedom to choose medical care providers (e.g., doctors, hospitals). Disadvantages include typically higher costs and more paperwork. Under managed health care, most expenses are already covered (by virtue of being a plan participant), but consumers are limited to receiving health care provided by specific doctors, hospitals, and clinics. Managed health care plans both pay for and provide health care services. Most managed care plans (e.g., HMOs, PPOs) provide participants with a primary care physician, who may or may not be the participant’s choice or seen on every visit for medical care. Typically, costs and paperwork are reduced.



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15. Both an HMO and a PPO health plan are examples of managed health care. Describe the similarities and differences between these two plans. • • • •

• • •

Both pay for and provide health care at a discount. Both offer comprehensive medical care services, including prescription drug coverage. Both employ a system of co-payments for services beyond the premium paid by the individual, employer, or both. Both limit access to a specific group of health care providers. Getting a referral to a nonHMO doctor, especially one outside of the HMO’s geographic region, can be extremely difficult. With an HMO point-of-service plan, co-payments are higher for non-affiliated doctors. Similarly, choosing the services of a non-PPO provider carries an additional, or penalty, co-payment. In other words, a PPO is a cross between an HMO (member doctors) and a traditional fee-for-service plan (consumer choice). HMO doctors may work in individual offices or in a central facility, whereas PPO doctors are free-standing practices that have negotiated with the employer or insurer to provide health care to members at a reduced rate. HMOs focus on preventive care and attribute reduced overall costs to this feature. PPOs typically do not. Drawbacks specific to HMOs include quick, cursory service associated with an incentive to see greater numbers of patients and the lack of relationship developed with one specific physician.

16. Describe the major differences between group health insurance and individual health insurance. Which is likely to be cheaper? •

•

Group health insurance is provided to a specific group of people who are associated for a common purpose other than the purchase of insurance (e.g., association members, coworkers). Most employer group policies do not require policyholders to pass a medical exam. Those offered through professional or trade groups often do. Costs of group health insurance are 15 percent to 40 percent less than individual policies. Individual policy insurance is written for a specific person or family, usually requires a medical exam prior to issuance and is generally more expensive than group insurance. Important considerations are age, health, geographic location, and deductible amounts. The benefit is a policy specifically designed to your needs; cost is a major disadvantage.

17. What steps should you take if your health insurance claim is denied? Step 1: Review your policy and explanation of benefits. Step 2: Contact your insurer and keep detailed records of your contacts. Step 3: Request documentation from your doctor or employer to support your care. Step 4: Write a formal complaint letter explaining what care was denied and why you are appealing via the company’s internal review process. Step 5: If the internal appeal is not granted through step 4, file a claim with your state’s insurance department.


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18. Briefly describe the target recipients and the benefits provided by the government-sponsored health care plans of workers’ compensation, Medicare, and Medicaid. Who is eligible for coverage under each plan? Government-sponsored health care plans include the following: • Workers’ compensation is a state government program that provides coverage for workrelated accidents and illnesses. State laws determine benefit levels and requirements for coverage; exclusions do exist, such as for small business employees. • Medicare is a federal government plan that provides limited medical benefits to persons who are disabled or aged 65 and older. Part A of Medicare pays for hospital costs, while part B covers doctor bills and a broader range of services. Deductibles and co-pays apply. Part A is financed by workers’ Social Security taxes and part B charges participants a monthly premium. Prescriptions are not covered and coverage for skilled nursing home care is limited. Part C offers more comprehensive care, including a drug benefit and in some cases vision, dental or preventive care—all offered through private plans. Part D, also offered through a network of approved private companies, provides prescription drug coverage. Part D requires an additional premium. • Medicaid is a joint federal and state medical assistance program that provides benefits for persons with low incomes and limited assets, specifically the aged, blind, and disabled, as well as needy families with dependent children. Note: Eligible individuals may receive benefits from both Medicare and Medicaid programs, with Medicare premiums, deductibles, and co-payments covered by Medicaid payments. 19. How do Medicare Parts B, C, and D, and Medigap policies expand the health care coverage available to persons 65 and older who qualify for Social Security? Medicare Part B, Supplemental Medical Insurance, which requires a monthly premium, covers expenses for doctor’s visits, regardless of where received, and other medical services and supplies. Part C, Medicare Advantage Plans provide comprehensive care, including prescription benefits, and in some cases vision, dental, and preventive services. Medicare Part D, Medicare Prescription Drug Coverage provides prescription drug coverage, with applicable premiums and co-pays, for seniors. Part C and D services are provided through contracts with private companies. The standardized Medigap private health insurance plans provide a range of benefits to supplement or fill the coverage gaps in Medicare Part A and B. In summary, Medicare Parts B, C, and D and Medigap policies expand the network of health benefits and eligible providers for seniors on Social Security. 20. Summarize the advantages and disadvantages of using a flexible spending account to help control health care costs. What is the cap on how much you can contribute to a flexible spending account? Designed as a savings plan of pre-tax dollars, medical reimbursement or flexible spending accounts offer the advantage of paying for uncovered (e.g., deductibles) or otherwise unreimbursed (e.g., eyeglasses or dental charges) health care expenses with pre-tax dollars. Disadvantages include the annual “use it or lose it” feature of the plan and the annual cap on ©2016 Pearson Education, Inc.


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the maximum deposit allowed. To avoid forfeiting funds, a conservative estimate of 80 percent of anticipated health care expenses is recommended to fund the account. The maximum you can contribute to a flexible spending account is $2,500. 21. How does the combination of a qualified high-deductible health insurance plan and a Health Savings Account offer a cost-effective approach to paying for health care? Who might find this option beneficial? The combination of a qualified, high-deductible health plan and a Health Savings Account (HSA) offer consumers the benefit of tax free savings. The funds accumulate for paying health care costs incurred prior to meeting the annual deductible or for health care expenses not covered by the high-deductible health plan. Funds not spent remain in the account for future long-term expenses, such as health or long-term care expenses after retirement. The combination is cost effective because high-deductible plans have lower premiums and annual HSA contributions (limits apply) are an adjustment to income, so the funds are not taxed and they grow tax-deferred, and tax free, if spent according to the HSA rules. The HSA and qualified, high-deductible health plan combination is available to the self-employed, small business owners, employers that offer only limited health benefits, and those under 65 who pay for their own health care. 22. Summarize the advantages and disadvantages of “opting out” of employer-sponsored health insurance. If you opt out of coverage, what exceptions will allow you to enroll in your employer-sponsored health care plan without having to wait until the next open enrollment period? Opting out offers the advantage of a cash payment or credits for purchasing other benefits, assuming you have adequate health insurance coverage through a spouse or other source. An obvious disadvantage would be no health insurance coverage or the inability to enroll. However, the Health Insurance Portability and Accountability Act of 1996 made enrollment access available to those who, for whatever reason, lost coverage through another plan and wish to have coverage without waiting until the next enrollment period. These special rights are available to those who initially declined coverage because of coverage under another plan or for those whose situation has changed due to marriage, birth, adoption, or placement for adoption of a new dependent. Consideration should be given to the dollar amount of cash incentives available to opt out of the plan (i.e., are you giving up a lot for a little?). 23. What protection does disability insurance provide? Who provides disability insurance coverage, and why is it important? How much coverage should consumers purchase? Disability insurance is important because it is earning power insurance. It provides income for household expenses if a worker is unable to work due to accident or illness. Anyone who relies on earnings from a job or self-employment for financial support should purchase a disability insurance policy to protect against the risk of income loss. This includes single individuals as well as those with dependents.


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Employers may provide disability insurance as part of the benefits package or may make it available at a reduced cost. Private policies are also available but are expensive. Limited coverage may be available through workers’ compensation or Social Security plans, but eligibility requirements must be met to receive any benefits. The recommended amount of disability insurance to purchase is the portion of a worker’s income used to maintain his/her standard of living. Insurance company rules also apply. Most insurance companies don’t write policies that pay more than 60 percent to 80 percent of a worker’s after-tax salary. Otherwise, there is a reduced incentive to return to work. 24. Define the following disability insurance terms: definition of disability, residual (partial) payments, and benefit duration. Why is the definition of disability so critical to the availability of benefits? Disability insurance terms include the following: • Definition of disability: Explanation of when an insured is considered “disabled.” Some policies define disability as the inability to perform the duties of your “own occupation,” while others define disability as the inability to perform the duties of “any occupation for which you are reasonably suited.” “Own occupation” policies provide the broadest coverage but are more expensive because there is a greater likelihood of claim payments. Combination definition policies offer significant cost savings and provide benefits if you cannot perform “your occupation” during the first 2 years, when retraining could occur, and revert to a definition of unable to perform “any occupation for which you are reasonably suited” thereafter. • Residual (partial) payments: Disability insurance policy payments made to individuals who return to work on a part-time basis. Residual benefits help make up the difference between full-time and part-time earnings. • Benefit duration: The length of time that policy benefits are paid. Short-term disability (STD) policies generally provide benefits for 6 months to 2 years. Long-term disability (LTD) policies provide benefits until a specified age, generally 65 or 70, or for the person’s lifetime. Only LTD policies truly protect against financial catastrophe. The definition of disability, as set forth by Social Security and private policies, determines the eligibility for benefits. Consequently, understanding the policy definition is very important, as having a policy does not mean that benefits will necessarily be available. The determination of “any occupation for which you are reasonably suited” may be difficult, or the policy interpretation may assume you are eligible to work in a job with earnings significantly lower than your normal job. 25. Describe long-term care insurance. What policy features should a person look for when shopping for a long-term care policy? Long-term care insurance pays for nursing home expenses and/or home health care expenses for persons unable to live on their own due to a stroke, chronic disease, or other physical or mental impairment. Long-term care coverage is generally purchased by those aged 40 or older. The younger the age of the purchaser, the lower the premium charged. ©2016 Pearson Education, Inc.


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Features that a policyholder should look for in a long-term care policy include the following: • Coverage for cognitive impairments such as Alzheimer’s and Parkinson’s disease • Type of care coverage that offers flexible benefits for nursing home care, adult day care, hospice care, or home care by licensed or non-licensed caregivers • A benefit period of at least 3 to 6 years, as the average length of nursing home stay is under 2 years. Women tend to have longer stays and should consider a longer benefit period for this reason. • Waiting period that matches an insured’s ability to cover costs out-of-pocket before insurance payments begin. A 20-day waiting period is recommended. • Inflation adjustment provision that increases benefits relative to the escalating cost of care • Waiver of premium clause that keeps the policy in force while benefits are received. A dual waiver of premium clause waives the premiums for both spouses, when one spouse receives benefits and is eligible for waiver of premium. Comparison shopping is important for this feature as company costs vary significantly. 26. Why are the waiting (elimination) period and the waiver of premium important provisions when purchasing disability and long-term care insurance? The waiting (elimination) period for both disability and long-term care insurance represents a deductible, or period of time when benefits are not received and the insured meets the costs. For both types of insurance, the longer the waiting period, the lower the premium cost. However, recommended waiting periods for the policies are different. For example, a minimum of a 3-month waiting period is recommended for workers to absorb their lost income (e.g., sick days, emergency savings), although a range of 1 to 6 months is typically available. During the long-term care waiting period, the insured must absorb the cost of nursing home or other care. The waiting period is typically 0 to 365 days, but the most common is 20 to 100 days. It is important to match the waiting period to the situation of the individual, so that the policyholder may (1) take advantage of the lowest possible premium and (2) not choose an extended period that initially creates financial hardship. For both types of insurance, a waiver of premium provision waives premium payments once benefits are received. Although the provision or clause can be expensive, it offers valuable protection that benefits will continue. Long-term care policies may offer waiver of both spouses’ premiums (dual waiver of premium) when one spouse becomes eligible; however, comparison shopping is very important if this rider is desired, due to the variation in price.


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PROBLEMs AND ACTIVITIES ANSWERS 1.

The four major provisions of the Affordable Care Act include the following: • Providing new consumer protections • Improving quality and lowering costs • Increasing access to affordable care • Holding insurance companies accountable

2.

Insurance companies cannot legally deny Abilyn coverage. Under the first provision of the Affordable Care Act, insurance companies are prohibited from denying coverage to children under the age of 19 due to a pre-existing condition. The third provision of the Affordable Care Act states that children are allowed to stay on their parents’ plan until they turn 26 years of age. Assuming Micah’s parents are adequately covered, he cannot legally be required to purchase an individual policy through the exchange. The first provision of the Affordable Care Act eliminates lifetime dollar limits on essential benefits. Assuming her health insurance needs are essential, her company is not allowed to cancel her policy or stop paying claims.

3.

The earnings multiple approach method yields the following results: $45,000 × (1 – 0.26) $33,300 × 11.938 $397,535

current annual income to account for the reduction in expenses for two survivors needed annual income PVIFA: 15 years, 3% (from Appendix D) life insurance needed to replace an income stream for 15 years

$397,535 – $112,500 $285,035

total needed to replace income stream existing group insurance additional insurance needed

The earnings multiple approach method considers only the amount needed to replace Joetta’s income for the projected 15-year period. The calculation does not include funds needed to repay debt or save for a specific goal, like college for the children, nor does it consider the availability of other assets to reduce the need. It does not consider the effects of taxes and inflation over the projected period. The life insurance figure will need to be updated periodically as Joetta’s salary or other financial or household data changes. Because Joetta is a single parent, some needs included in the needs approach method are not relevant, such as spousal transitional funds, spousal life income, or spousal retirement income. To use this method, Joetta would need specific information on projected amounts for cleanup funds, debt elimination funds excluding the mortgage, educational expenses for the children, and the availability of Social Security to assist with dependency expenses.



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Existing assets, currently $68,000, to reduce the amount of insurance needed also would be considered. 4.

Virgil Cronk should consider the following riders to ensure that he can increase his benefits without a new medical exam: • Guaranteed insurability rider: Rider that gives the insured the right to increase coverage at specific future intervals without a medical exam. • COLA rider: Rider that increases death benefits by the annual rate of inflation without a medical exam.

5.

The Bauldings’ health care costs: Item Deductible Family member #1 $250.00 Family member #2 $250.00 Family member #3 $220.00 Total $720.00

Bauldings Pay Insurance Pays Total Cost $146.00 $584.00 $980.00 $318.00 $1272.00 $1,840.00 $0.00 $0.00 $220.00 $464.00 $1,856.00 $3,040.00

Of the $3,040 in total expenses, the Bauldings will pay $720 in deductibles and $464 in 20 percent co-payments. The insurance company will pay the remaining $1,856. So, the Bauldings actually paid a little less than 40 percent of the total bills. A flexible spending account offers the Bauldings the advantage of paying for health care expenses not covered by insurance (e.g., deductibles and co-payments) with pre-tax dollars. Disadvantages include the “use it or lose it” feature of the plan and the annual cap on the maximum deposit allowed. 6.

The costs for each plan are calculated as follows: Traditional plan: 15 Office Visits @ $50 Each = $750.00 Minus Deductible = $250.00 Minus 20% Coinsurance = $100.00 Amount Paid by Insurance = $400.00 Amount Paid by Latesha = $350.00 HMO plan: 15 Office Visits @ $10 Each = $150.00 12 Paycheck Deductions @ $20 Each = $240.00 Amount PaidbBy Latesha = $390.00 Typically, more expensive coverage costs and additional paperwork to process claims are disadvantages of the traditional plans. But in this example, Latesha would pay $40 less outof-pocket with the traditional plan, which is an advantage. Another advantage is greater choice in medical care providers, as opposed to the HMO that limits choices through higher charges for non-affiliated doctors. Another disadvantage of the HMO would be possible restrictions on her choice of doctors and hospitals. This could be an issue because she has an identified medical problem and may need specialist care. Getting a referral could be more ©2016 Pearson Education, Inc.

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difficult with the HMO. Advantages of the HMO include less expensive cost of coverage, reduced paperwork, and a focus on preventive care. Either way, she will pay some of her health care costs out-of-pocket. 7.

$3,200/month × 4 months = $12,800 amount of lost earnings $3,200 × 60% = $1,920 amount replaced by insurance (60% of one month’s pay) Julie would lose $12,800 of after-tax earnings ($3,200 × 4 months) with a 3-month elimination period; she would need to “absorb” $9,600 (3 months × $3,200) of income lost during that time. Disability insurance payments would start at the beginning of month four, and she would receive $1,920 ($3,200 × 0.60). Thus, during the entire period of Julie’s disability, she would need to replace $10,880 of income, and the insurance company would replace $1,920. Some ways that she could replace her lost income include the following: • Paid “sick days,” especially if her employer allows her to accumulate them over time for use in a major medical emergency • Short-term disability policy benefits, if available • An emergency fund of 3 to 6 months of expenses • Workers’ compensation, if she was injured on the job A residual benefits clause would allow Julie to return to work part-time but still receive disability insurance benefits. Julie would receive the difference in the part-time and full-time earnings to the limits specified in her policy.

8.

Without long-term care (LTC) insurance, Bobbi could pay as much as $300,000 for nursing home care over a 5-year period. And this does not even include inflation, which would further increase the cost. To lower the cost of LTC insurance, Bobbi can • Buy a LTC policy as soon as possible before costs increase due to advancing age. • Select a longer waiting period (time between nursing home admission and payment of benefits by the insurance company). • Cover the costs of nursing home care through a combination of self-insurance (if she can afford it with available assets) and LTC insurance.


Although situational factors unique to the Porterfields could impact the answer, Cassie and Adam might rank his insurance needs in the following priority: • Health insurance to protect against an increasingly sophisticated and costly system of care. Whether provided through his employer or Cassie’s, Adam needs health insurance to protect their financial future from catastrophic expenses associated with illness or accident. The dental and vision coverage is likely a low priority, unless Adam’s health situation suggests significant expense for dental or eye care. For the average individual, these expenses can be controlled and planned for. • Disability insurance to protect Adam’s earning power for today and tomorrow. This is coverage for their long-term financial plan that the Porterfields should not ignore. The



•

•

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short-term benefit is a nice protection, but depending on sick leave and emergency funds, they could forego this coverage if absolutely necessary. Life insurance provides income replacement protection. Although important, additional protection beyond the 1.5 times salary offered at no premium charge may be sufficient until, and if, the Porterfields have children. Income replacement to help provide for Cassie and the family would gain more significance as the household takes on more dependents and debt—both of which would be dramatically affected by the loss of Adam’s income. Long-term care insurance is not a consideration for Adam given his age, and he may not be eligible until he is age 40 or older. However, this employer-provided benefit should be seriously compared to private polices in the future.

In summary, priorities are health insurance, long-term disability, and the free life insurance. Any excess employer-provided premium dollars could then be applied to the benefits Adam and Cassie judge to be most beneficial to their situation—perhaps short-term disability followed by dental or vision care. A cost analysis could be done for the latter expenses, and indirectly for the short-term disability coverage. 2.

At this time, the Porterfields fit the profile of “married, double-income couple, with no children” for which life insurance is not a necessity, unless there is concern that the surviving spouse’s lifestyle would suffer. Thus, unless there are other dependents or extenuating family circumstances (e.g., high probability of cancer, diabetes, or heart disease that could make it impossible or costly to purchase an individual policy), none would be recommended beyond the company-provided free benefit. However, there is risk in this approach as they would lose their coverage with unemployment, so a small guaranteed renewable or convertible term policy may be recommended, contingent on family health history or lifestyle issues. The earnings multiple approach or the needs approach could be used to assess Adam’s total need for life insurance coverage. The latter approach would provide a more accurate, and comprehensive, assessment.

3.

Because short-term disability offers limited protection (e.g., maximum of 2 years) from financial disaster, long-term disability is typically recommended. This offers protection to a specified age (e.g., 65 or 70) or for a lifetime. Important factors when purchasing disability insurance include: • Definition of disability: Pick a policy that defines disability as unable to perform your “own occupation” or “normal job” not a policy based on performance of “any occupation” as required by Social Security. • Waiting or elimination period: The longer the waiting period, the lower the premium. A minimum of a 3-month waiting period is recommended due to the significant savings. • Noncancellable clause: Keeps the policy in force, or renewable, without rate increases.

4.

Contingent on the answers to the following questions, the Porterfields might consider changing their company-provided health care benefits. This might mean changing to another plan offered by the same employer or changing the family coverage from one parent to the other. However, it will be important to make these changes prior to the pregnancy during the


200


open enrollment period. Some health care policy questions for parents to consider include th following: • Are maternity benefits provided, or are these expenses excluded? • When does the insurance plan begin covering a newborn child? (e.g., from moment of birth or after 14 days of life?) Some state laws require immediate coverage for a newborn. • To what age are children covered and what happens if they are still dependents beyond the specified policy age (e.g., age 23 if in college)? • Given the increases in diagnosis and treatment for emotional and mental disorders, what coverage is provided? • Will increasing expenses for eye and dental care for the growing family, make adding this coverage cost effective or should they open, or add more to, a flexible spending account? In addition, the Porterfields should increase their life insurance protection, and if they have not purchased adequate disability insurance, this coverage should be evaluated. The addition of dependents makes income protection even more important. A thorough review of how to cost effectively maximize employer-provided benefits is warranted. Options to purchase additional coverage, where needed, should be considered. DISCUSSION CASE 2 ANSWERS 1.

Based on the completed Worksheet 12, Worksheet for Estimating Life Insurance Needs, Frank needs approximately $286,000 more life insurance coverage. Most of the information needed for the worksheet is given within the question; however, the reduction in household expenses (line s) and the two desired spousal income amounts, lines y and bb, need to be calculated. The desired spousal income is the difference between Wendy’s projected expenses of $60,000 and her projected income ($40,000) plus Frank’s pension benefits ($5,000). Therefore, her desired spousal income would be $15,000 for line y. For line bb, Wendy’s projected income needs in retirement of $30,000 is reduced by Frank’s pension benefits, yielding $25,000. Also, Wendy’s IRA balance is included in the total available assets (line ff). This is an assumption that would not be right for every situation given that access to the money would be limited by IRS withdrawal penalties.

2.

Yes, Wendy should purchase life insurance for two reasons: • Wendy is a household breadwinner. Although she currently earns less than what Frank does, she is still contributing to household income and her salary would be missed if she were to die. • Wendy undoubtedly provides numerous household services and child care that would likely have to be replaced with paid help if she were to die. Funds need to be available to help Frank cover this potential expense. Term insurance would provide pure insurance protection for Wendy at a relatively low cost.



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NOTE: Although beyond the scope of this text, cross ownership of the policies could be a consideration in life insurance planning. Depending on the size, or potential for growth, of the Kampes’ estate and whether or not they own cash value policies, cross ownership could eliminate some estate tax consequences. Such a strategy removes the cash value of the policy, if any, from the deceased’s estate. However, in this case, term policies were recommended for the Kampes. Having the deceased’s estate as beneficiary of the policy subjects the policy proceeds to estate taxes (assuming the estate is large enough) and probate, as discussed in Chapter 17. 3.

Frank should purchase a term insurance policy. It will provide the most protection for the least amount of premium cost. Because Frank needs to purchase nearly $300,000 of additional insurance, he needs to find an affordable policy.

4.

If Frank left his present job, his employer-provided life insurance would end. This risk is a reason to have a renewable or convertible term policy to avoid the greater risk of death occurring with no life insurance protection.

5.

Although we know nothing about the Kampes’ plans, if any, for a guardian(s) for the children in the event of simultaneous death, without adequate life insurance coverage there would be limited funds provided for the children’s living expenses, or for the achievement of specific financial goals (e.g., a college education). This could cause a drop in the children’s standard of living. Even if only one spouse died prematurely, the surviving spouse would face a similar situation without adequate insurance proceeds to provide for the family.

6.

No. Minor children generally cannot be paid life insurance proceeds directly. The policy should be set up to provide income to whoever will raise the children in the event of premature death, either the surviving spouse or guardian(s) for the children.

7.

Although riders will likely add to the policy cost, the following are recommended: • Guaranteed insurability rider: protects against uninsurability, and would assure the Kampes that they could increase coverage to match future insurance needs. • Cost of living adjustment (COLA) rider: increases policy death benefits at the same rate of inflation without a medical exam. Because the children are young and the Kampes will need the policies for a while, it is a good option to consider. • Living benefits rider, to allow access to funds in case of terminal illness.

8.

The purpose of life insurance is to provide for dependents in the event of death. In other words, it is income-replacement insurance. Given that the children do not provide income, life insurance would not be necessary. The primary needs are adequate protection on Frank and Wendy to replace income in the event of their deaths.

9.

Principle 9: Mind Games, Your Financial Personality, and Your Money could influence the Kampes to assume that the current annual savings of $7,500 is required, and unless they can reduce other living expenses or increase income, then there simply is no money to fund additional life insurance for Wendy or Frank. Despite the acknowledged need, they may ©2016 Pearson Education, Inc.

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agree that the mental account of savings is a more important goal than buying life insurance without conceding that affordable term insurance would provide immediate protection. The savings, albeit important, will not rapidly accumulate a sufficient balance to protect the family in case of premature death.



W 12

WORKSHEET

Worksheet for Estimating Life Insurance Needs Total Needs

Step 1: Immediate Needs Cleanup Funds Final Illness Costs (assumed equal to your health insurance deductible) Estate Administration Costs (assumed equal 4% of your assets) Burial Costs Federal Estate Taxes (if any due) State Estate Taxes Additional Lagal Fees Other Immediate Needs Total Immediate Needs (add lines a through g)

a. to + + + + + +

b. c. d. e. f. g.

$25,000 = h.

$25,000

= m.

$90,000

= q.

$15,000

Step 2: Debt Elimination Funds Credit Card and Consumer/Installment Debt Auto Debt Outstanding Desired Mortgage Reduction Other Debt to be Paid Off at Your Death Total Debt Elimination Funds (add lines I through L)

i. + j. + k. + l.

$90,000

Step 3: Immediate Transitional Funds Schooling Expenses for Surviving Spouse Child Care and Housekeeping Expenses Other Transitional Needs Total Immediate Transitional Funds (add lines n through p)

n. + o. + p.

$15,000

Step 4: Dependency Expenses (family needs while children are in school and dependent on family support) Current Household Expenses (estimated as income less savings) r. Less: Deceased's Expenses (estimated as 30% of line r if surviving family includes only one member, 26% for a surviving family of two, 22% for a surviving family of three, and dropping 2% more for each additional family member) - s. Less: Spousal Income - t. Less: Social Security Survivors' Benefits - u. Less: Pension Benefits and Income - v. Equals: Income to be Replaced Until Children Are Self-Supporting (line r - lines s through v) = w.

$75,500

$16,610 $40,000 $8,000 $5,000 $5,890 (continued)


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W 12

WORKSHEET

Worksheet for Estimating Life Insurance Needs (continued)

Total Dependency Expenses or Money in Today's Dollars Needed for Dependency Expenses (assuming the children have n years until they become selfsupporting and you can earn an i % after-tax and after-inflation return on your investments) (line w x PVIFA i%,n yr ) = (line w x PVIFA __%, __yr ) = (line w x ____)

= x.

$61,138

Step 5: Spousal Life Income (spousal needs after children are selfsupporting) Desired Spousal Income y. $15,000 Total Spousal Life Income or Money in Today's Dollars to Provide for Desired Spousal Income (assuming n years until the children become self-supporting and m years until the spouse qualifies for Social Security or retirement income, and assuming you can earn i% after-tax and after-inflation return on your investments) [line y x (PVIFA i%, m yr - PVIFA i%, n yr )] = [line y x (PVIFA __%, __yr - PVIFA __%, __yr )] = = z. [line y x (_____ - _____)]

$74,895

Step 6: Educational Expenses for Your children Total Educational Expenses (private school needs plus total college needs)

aa.

$205,000

Additional Desired Annual Income at Retirement bb. $25,000 Total Retirement Income or Money in Today's Dollars to Provide for Desired Retirement Income (assuming retirement in m years and desiring the additional income for p additional years, and assuming you can earn i% after-tax and after-inflation return on your investments) [line bb x (PVIFA i%, m yr - PVIFA i%, n yr )] = [line bb x (PVIFA __%, __yr - PVIFA __%, __yr )] = = cc. [line bb x (____ - ____)]

$72,075

Step 7: Retirement Income

Step 8: Total Funds Needed in Today's Dollars to Cover Needs Total

= dd.

(lines h + m + q + x + z + aa + cc)

$481,970

Step 9: Assets and Insurance Available to Cover Needs Cash from Current insurance Policies Retirement Savings and Investments Other Assets Total Assets (add lines ee + ff + gg)

ee. ff. gg.

$150,000 $97,000 $10,000 = hh.

$257,000

Step 10: Additional Insurance Needs Additional insurance Needs (line dd - line hh)


=

$224,970

CHAPTER 10 PROPERTY AND LIABILITY INSURANCE

CHAPTER CONTEXT: THE BIG PICTURE This is the final chapter in this section titled “Part 3: Protecting Yourself with Insurance.” An underlying premise of this section is the use of insurance products to provide financial control, a fundamental element of financial planning. This chapter completes the sequence on protecting life, health, and property. An important message for students is the role of property and liability insurance in planning and controlling their financial future. Paying to repair or replace assets that were not covered by insurance or were underinsured can have a devastating effect on the current year’s budget. Whereas, paying for uninsured liability damages could impact household finances for years. Consistent with the other chapter, this one focuses on strategies to match policy features with individual needs, to control policy costs, and to use the coverage to recover a loss. CHAPTER SUMMARY As the term property and liability insurance implies, these policies provide multiple forms of defense and protection of assets. First, property and liability insurance provides protection from unexpected damage expenses to repair or replace assets such as home, personal property, or auto. Second, the coverage protects from liability losses when the policyholder(s) is (are) judged to be the cause of damages or losses to others. Provisions of homeowner’s policies are introduced; strategies for selecting, buying, and maintaining a cost-effective policy are considered. The role of insurance credit scoring in premium determination is also explored. Strategies for establishing proof of ownership and filing and collecting on a claim are illustrated. Features of an automobile policy are introduced, as well as driver and auto characteristics that determine policy costs and available discounts. The chapter concludes with a discussion of how to file an auto insurance claim. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Understand, buy, and maintain homeowner’s insurance in a cost-effective way. a. Peril b. HOs c. Named perils d. Open perils e. Property insurance f. Personal liability insurance 205


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g. h. i. j. k. l. m. n. o. p. q.

Endorsement Personal articles floater Inflation guard Actual cash value Replacement cost coverage Personal umbrella policy Coinsurance provision 80 percent rule Insurance credit score Deductible Direct writer

2.

Recover on a liability or a loss to your property.

3.

Buy the automobile insurance policy that’s right for you. a. Personal Automobile Policy (PAP) b. Combined single-limit coverage c. Split-limit coverage d. Uninsured motorist’s protection coverage e. Collision loss f. Other than collision loss or comprehensive physical damage coverage g. No-fault insurance h. Lmbrella liability insurance or umbrella policy

4.

File a claim on your automobile insurance.

CHAPTER OUTLINE I.

Protecting Your Home A. Packaged Policies: HOs 1. Section I: Property coverage 2. Section II: Personal liability coverage B. Supplemental Coverage 1. Personal articles floaters 2. Earthquake coverage 3. Flood protection 4. Inflation guard 5. Personal property replacement cost coverage 6. Added liability insurance

II.

Your Insurance Needs A. Coinsurance and the “80 Percent Rule” B. The Bottom Line C. Keeping Your Costs Down—Insurance Credit Scoring D. Keeping Your Costs Down—Discounts and Savings


Chapter 10: Property and Liability Insurance

1. 2. 3. 4. 5. 6. 7. 8.

High deductible discounts Security system/smoke detector discounts Multiple policy discounts Pay your insurance premiums annually Other discounts Consider a direct writer Shop around Double-check your policy

III.

Making Your Coverage Work A. Make an inventory of property owned. B. Know what to do in the event of a loss. 1. Report your loss immediately. 2. Make temporary repairs to protect your property. 3. Make a detailed list of everything lost or damaged. 4. Maintain records of the insurance settlement process. 5. Confirm the adjuster’s estimate.

IV.

Automobile Insurance A. Personal Automobile Policy (PAP) 1. PAP Part A: Liability coverage 2. PAP Part B: Medical expense coverage 3. PAP Part C: Uninsured motorist’s protection coverage 4. PAP Part D: Damage to your automobile coverage 5. Exclusions B. No-Fault Insurance C. Buying Automobile Insurance 1. Determinants of the cost of automobile insurance 2. Keeping your costs down D. Filing a Claim

V.

Behavioral Insights A. Principle 9: Mind Games, Your Financial Personality, and Your Money B. Principle 7: Protect Yourself Against Major Catastrophes C. Principle 1: Knowledge Is the Best Protection

VI.

Action Plan A. Principle 10: Just Do It! B. Renters’s Insurance—Do You Need It? C. Auto Insurance—Required by Law D. Remember Principle 7: Protect Yourself Against Major Catastrophes


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APPLICABLE PRINCIPLES Principle 1: Knowledge Is the Best Protection Pooling the risk and sharing the cost among all covered consumers allows everyone to pay a little, and lose a little, every year. As a result, the insurance company accumulates enough funds to reimburse those who randomly experience a loss. Paying a little every year helps everyone avoid a catastrophic loss. You do not need every insurance coverage that exists, but know what you do need and purchase it. Principle 7: Protect Yourself Against Major Catastrophes Property and liability insurance provides two major protections. First, it provides funds to repair or replace damaged or lost possessions—assets that make up a major part of the net worth for most households. Second, it protects against the financial losses incurred by others when we are judged to be at fault for causing those losses. Most of us could not pay for large property or liability losses without the help of insurance. But it is our responsibility to avoid another catastrophe by buying adequate, cost-effective coverage. The saying “don’t sweat the small stuff” applies—keep insurance costs manageable by protecting from the major losses. Principle 9: Mind Games, Your Financial Personality, and Your Money Do not let your emotions dictate your insurance needs. Understand what you need before shopping and purchase only those needs. Principle 10: Just Do It! You will more than likely require at a minimum health, renter’s, and auto insurance now or in the near future. Look for discounts and purchase what you need to protect yourself from a major financial catastrophe. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Ask a local insurance agent to provide price quotes for a popular sports car or sport utility vehicle using different scenarios (for example, male and female, under and over age 25, with lower and higher deductibles, and with minimal and more adequate liability coverage). Discuss the quotes with the class. Highlight the effect of changes in deductibles and liability coverage on the premium. Consider the cost-effectiveness of increasing annual premiums versus paying for liability losses that exceed the policy limits.

2.

Collect news stories or other media reports about court-ordered liability awards for homeowner or driver negligence. Use the articles to help students understand the potential financial impact of inadequate liability coverage.



3.

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Invite an insurance agent or claims adjuster to discuss issues related to establishing proof of ownership and filing a claim to collect on a loss. How might this process differ in a small town with a relatively stable population versus an urban area with a transient population?

4. Encourage students to prepare a detailed inventory of their personal property. Take photographs or make a videotape to provide additional evidence of property ownership. List the brand, model number, and serial number of valuable items such as appliances, stereo equipment, and computers. 5. Ask students to interview at least three people and ask the following questions: ♦ What are your auto liability insurance limits and deductibles? ♦ If you own your own home, do you have an all-risk or named perils coverage on the structure? ♦ If you own your own home, do you have replacement cost or actual cash-value coverage on the contents? If ♦ you are a renter, do you have a renter’s insurance policy? ♦ Do you have an umbrella policy? Did the students find that the majority of respondents knew a little or a great deal about their current insurance coverages? Did many of the renters have insurance? Why or why not? How many respondents knew what an umbrella policy was? Based on the interviews, what conclusions can the students draw about the public’s level of insurance knowledge? 6. Select three vehicles of similar style, price, and age (e.g., Toyota Camry, Hyundai Sonata, and Ford Fusion) and compare the insurance premiums (by interviewing an agent, visiting a Web site, or calling a toll-free information line) for a given amount of coverage (e.g., 100/300/100) for each vehicle, holding other factors such as driver, location, and annual mileage constant. Write a one-page report of your findings. 7. Compare the rates for a given amount of auto insurance (by interviewing an agent, visiting a Web site, or calling a toll-free information line) for the following: a. An unmarried male and an unmarried female of the same age b. A driver under age 25 and a driver over 25 c. A city dweller and a driver living in a suburban/rural area d. A married driver and an unmarried driver of the same age In all situations assume the drivers have clean driving records and have been continuously insured for the previous 2 years. 8. Obtain two or three quotes on the costs of renter’s insurance in your area. (This can be done in about 10 minutes at www.answerfinancial.com, www.insure.com, or similar Web sites.) Report on the price differences among different insurance carriers and the differences in coverages. If possible, also obtain price quotes for insuring both a car and a rental with the same insurance company. Describe any pricing differences that you might have found.


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REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1. Itemize and describe the differences among the six basic types of standardized homeowner’s policies. Which of the first three policy types is the most comprehensive? • • • • • •

HO-1—Basic Form: provides the narrowest coverage of all HO policies limited to only 11 specifically named perils. Because of its limitations, the policy is not widely available. HO-2—Broad Form: a “named perils” form of insurance that limits coverage to a set of specific perils (e.g., fire, windstorms). Perils not named in the policy are not covered. HO-3—Special Form: an “open perils” form of insurance that covers all perils except those that are specifically excluded (e.g., earthquakes, nuclear accidents). HO-4—Tenant Insurance: policy that provides funds to replace furnishings and personal property in a rented dwelling. These policies also provide liability insurance for renters up to a specified limit. HO-6—Condo Insurance: policy that covers the personal property of condo or co-op owners, plus any structural improvements or alterations made to their unit. HO-8—Modified Coverage: policy designed for an older home that limits coverage to repair costs or actual cash value, rather than replacement cost. The coverage limitation is due to the expense of replacing materials and construction details used in older homes.

An HO-3, Special Form, policy offers more comprehensive coverage than an HO-1 or HO2, Policy. The additional protection explains the 10 to 15 percent increase in cost over an HO-1 policy. An HO-3 covers all direct physical losses to the structure (except the four that are typically excluded), but coverage on the contents is limited to the named perils listed in an HO-2 policy. Both the HO-2 and the HO-3 offer 20 percent of the insurance on the home as loss of use coverage; an HO-1 policy includes only 10 percent coverage. 2. List and describe the four parts of Section I and the two parts of Section II of a homeowner’s insurance policy. Section I has four parts: • Coverage A: Dwelling: protects a house and any attachments (e.g., a garage). • Coverage B: Other Structures: protects other structures on a policyholder’s premises that are not attached to a house (e.g., a detached garage, landscaping). Coverage B is limited to 10 percent of the home’s coverage, or Coverage A. • Coverage C: Personal Property: protects personal property owned or used by a policyholder, regardless of its location. Coverage C is limited to half of the home’s Part A coverage, with limits on losses of specific types of property (e.g., jewelry, coins). • Coverage D: Loss of Use: provides benefits if a home can’t be used as a result of an insured loss. This coverage provides funds to live elsewhere (e.g., a rental property) until the home is repaired. Coverage is limited to 20 percent of the home’s coverage.



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Section II has two parts: • Personal Liability Coverage: protects a policyholder and family members from financial loss if someone is injured on their property or as a result of their actions. Liability insurance is important protection against potentially catastrophic losses resulting from a liability judgment. • Medical Payments to Others: provides payment for a limited amount (e.g., $1,000) of medical expenses incurred by non-family members injured in a policyholder’s home (e.g., if someone falls down the stairs and breaks a leg). 3. What types of personal property have additional, more restrictive limits under Coverage C of Section I? What are they? What can you do to protect yourself from these losses? The following restrictive limits apply under Section I, Coverage C: • $200 limit on money, bank notes, gold and silver • $1,000 limit on securities, valuable papers, manuscripts, tickets and stamps • $2,500 limit on the theft of silverware, goldware, and pewterware • No coverage on animals, birds, or fish Personal articles floaters protect from losses associated with these restrictions. The “all-risk” coverage is typically an extension of the homeowner’s policy, and covers all losses except for those specifically excluded: war, wear and tear, mechanical failure, vermin, and nuclear attack. 4. List and describe at least five examples of supplemental coverage available as an addition to homeowner’s policies. Which two supplemental coverages are the most important? Why? Common examples of supplemental homeowner’s policy coverage include: • Personal Articles Floater: provides extra insurance to increase the limits of coverage on personal property (e.g., silverware, jewelry) beyond those written in a standard HO policy. • Earthquake Coverage: recommended for homeowners in high-risk areas, this policy provides coverage for damage caused by earthquakes, which are otherwise excluded in standard HO policies. • Flood Insurance: recommended for homeowners in flood-prone areas, this policy provides coverage for water damage including floods, mudslides, and water erosion. A policy can be purchased after a community receives approval from HUD. Otherwise, floods are specifically excluded in standard homeowners’ policies. • Inflation Guard: recommended for all policyholders to allow for annual automatic increases in coverage based on a national index of replacement costs. Protects against inflationary losses to the real coverage provided by the policy. • Personal Property Replacement Cost Coverage: policy option that provides for the actual replacement cost of a stolen or destroyed item rather than its actual cash value, which reflects depreciation and can be well below the cost of replacing it. Replacement cost coverage adds about 5 percent to 15 percent to the cost of an HO policy and provides the


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peace of mind that personal property can be replaced, in the event of a loss, without incurring a lot of expense. Added Liability Coverage: option available through most insurance companies to raise a homeowner’s liability limit from $100,000 to $300,000 or $500,000 for a relatively modest additional premium. Umbrella Liability Policy: provides from $1 million to $10 million of protection against large lawsuits and judgments. The policy goes into effect after the insured has exhausted the limits of the liability coverage provided in the homeowner’s or auto policy.

Full protection means full replacement from a total loss. For the average policyholder, supplements for inflation guard and replacement cost coverage on the structure and contents are most likely to provide that protection. 5. Should homeowners consider purchasing an umbrella policy? Why or why not? What exclusions apply? Most homeowners should consider purchasing a personal umbrella policy as their net worth increases; in other words, when their assets exceed the liability limits of their policy. These policies provide liability coverage once the limits of existing homeowner’s and auto policies are exhausted. Umbrella policies, which are relatively inexpensive, provide protection from $1 million to $10 million against lawsuits and judgments. Most losses are covered except for acts committed with intent to cause injury, activities associated with aircraft and some watercraft, and most business and professional activities. 6. What is meant by the 80 percent rule as it applies to the purchase of homeowner’s insurance to protect the dwelling? This is a policy provision that requires homeowners to carry dwelling coverage equal to at least 80 percent of their home’s replacement cost in order to be reimbursed fully for a partial loss to the structure. If the 80 percent figure is not met, then homeowners must pay a prorated percentage of their loss, or the coinsurance. The 80 percent of replacement cost figure is considered the minimum amount of coverage that a homeowner should buy. Many people insure their home for 100 percent of replacement cost in order to receive full reimbursement if their home is totally destroyed. Restrictions still apply in that the maximum amount paid is limited to the policy coverage (regardless of the amount of the loss), the home must be rebuilt on the same location, and if the home is not rebuilt coverage is limited to the actual cash-value loss for the destroyed portion of the home. 7. Develop a list of guidelines that homeowners should consider when purchasing a homeowner’s policy. Guidelines to consider when purchasing a homeowner’s policy include the following: • Amount of replacement cost insurance needed to rebuild the home in the event of a complete loss, with 80 percent of this estimated value as minimum coverage • Need for protection against the effects of inflation on home building costs • Special protection (e.g., flood or earthquake) needed according to home location ©2016 Pearson Education, Inc.


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Value of detached structures, elaborate landscaping, or other personal property that may not be adequately covered Additional business liability coverage needed for a home-based business Replacement cost coverage needed for personal property to be able to replace items at current prices Floater policies needed for personal property valued above stated limits in the policy Additional liability coverage or an umbrella policy to insure that liability coverage exceeds the value of assets Need for coverage on personal property in a rented dwelling

8. Explain why insurance companies use a consumer’s insurance credit score when calculating insurance premiums. What are the five steps you can take to improve your score and keep premiums down? Insurance companies use the insurance credit score to set premiums because of the strong relationship between credit score and insurance loss ratio, or the frequency of claims for both homeowners and auto insurance and the cost of those claims. Claims frequency and cost reflect losses, or costs, to the insurance company that are passed on to policyholders. The higher the insurance credit score, the lower the premium because the statistical relationship would predict fewer claims. The insurance credit score is based on the same factors as a credit score, although weightings for two factors are slightly different. To improve your credit score and control insurance premiums, be sure to do the following: • Pay bills on time. • Pay down your debt—monitor the total amount owed and how close the balance is to your credit card limit(s). • Maintain long-term accounts to increase your FICO credit or insurance score. • Use different types of credit, but be careful when adding new credit cards or other accounts. Monitor borrowing capacity. • Keep your financial life in order—don’t add too much new credit too soon! 9. Describe at least five ways, other than increasing your insurance credit score, to reduce the cost of homeowner’s insurance. Five ways to reduce the cost of homeowner’s insurance include the following, although individual student answers may vary: • Select a financially sound insurer with lower rates compared to other companies. • Increase deductibles. The larger the deductible, the lower the premium. • Obtain a discount for installing equipment, such as smoke detectors and security alarms, designed to reduce the risk of loss. • Obtain a multiple policy discount by purchasing more than one type of insurance from the same company. • Pay premiums annually or semi-annually rather than in frequent installments. • Obtain any other discounts available (e.g., for using fire-resistant building materials, turning age 55, or for having coverage with the same insurer for several years).


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Shop around to compare the cost of homeowner’s insurance offered by a number of insurance companies. Get bids on the total cost, including floaters, so equal comparisons can be made. Consider using a direct writer that sells policies without the use of agents. Because the company does not incur high salary or commission costs, policies often cost less. Check the policy to be sure it matches types and amounts of coverage as well any supplements requested.

10. How do you establish proof of ownership and value of assets? What are the key pieces of information that should be included? Why is this important? Simply owning a homeowner’s policy is not sufficient protection for the assets owned. A homeowner, or renter, must document the assets and their value for adequate reimbursement. Without sufficient records, neither the policyholder nor the insurance company can verify the loss. Steps a homeowner should take to establish proof of property ownership to substantiate a claim include: • Make a detailed list of household items including the brand, model number, serial number, cost, and date of purchase, if known. Pre-printed inventory worksheets are available. • Get an appraisal of valuable personal property (e.g., jewelry) and get close-up pictures. • Videotape the household inventory by walking through each room of the house and describing the contents, including the contents of cabinets, drawers, and closets. Include all home furnishings or other property, both inside and outside of the home, including storage areas. • Store the household inventory and/or video in a safe deposit box or other safe location away from the home. 11. List the duties that a homeowner has after a loss to make an insurance claim. A homeowner should follow these steps to file an insurance claim: • Report the loss immediately to the insurance agent and to the police (in the event of a theft). Should credit cards or ATM cards be involved, cancel the cards immediately. • Make temporary repairs to property to prevent further damage (e.g., putting a tarp on a damaged roof to keep out rain) or burglary. • Make a detailed list of all lost, damaged, or stolen items and their value for use by the insurance agent or the police. • Maintain records of the settlement process, including the expenses involved. • Get a damage estimate from a local contractor to confirm the insurance adjuster’s estimate. Don’t agree until you get fair settlement. 12. Describe the four parts of a standardized personal auto policy (PAP). The four parts of a standardized PAP are the following: • Part A: Liability Coverage: provides protection from losses resulting from lawsuits associated with an auto accident. Drivers should carry at least $100,000 of bodily injury



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liability coverage per person, at least $300,000 for all persons involved in an accident, and at least $50,000 of property damage liability insurance. Part B: Medical Expenses Coverage: pays reasonable medical and funeral expenses incurred within 3 years by a policyholder, family members, and others involved in an accident in an insured vehicle. Typical per person limits are from $1,000 to $10,000. Part C: Uninsured Motorists Coverage: provides coverage for injuries caused by an uninsured motorist, a negligent driver whose insurance company is insolvent, or a hitand-run driver. Part D: Coverage for Damage to Auto: provides for two types of coverage, collision and comprehensive. Collision benefits cover damage resulting from an accident with another vehicle or object. Comprehensive covers physical damage caused in a variety of ways (e.g., falling objects, fire, theft).

13. Explain the difference between split-limit auto liability coverage and combined single limit liability coverage. With split limit coverage (e.g., 100/300/50), there are separate coverage limits for each category of liability: bodily injury per person, bodily injury per accident, and property damage coverage. With a combined single limit (e.g., $500,000), the liability coverage applies to all bodily injury and property damage liabilities without a separate limit for each. 14. What coverage and limitations apply to legal costs resulting from an auto accident? Provided no criminal charges (e.g., drunk driving) are involved, the insurance company will pay all legal costs to defend you in any civil cases brought as the result of an accident. No specific dollar limit of protection applies; legal costs are in addition to the specified policy limits. 15. What is the difference between uninsured motorist’s coverage and underinsured motorist’s coverage? Both forms of insurance are important. Uninsured motorist’s protection covers medical losses caused by a hit-and-run driver, an uninsured motorist, or a negligent driver whose insurance company is insolvent. Underinsured motorist’s coverage provides protection against negligent drivers with inadequate liability coverage. 16. What is the difference between collision loss and comprehensive physical damage coverage? Collision loss covers damages to the policyholder’s auto resulting from a collision, or accident, with another vehicle or object. Payment for collision losses, less the deductible, is paid regardless of fault. However, if the other driver was at fault and has insurance, the losses should be paid by the other driver. Comprehensive physical damage, also known as “other than collision loss,” covers losses that result from fire, theft, larceny, or causes other than a collision. Collision coverage typically does not cover rental cars used for business purposes.


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17. Explain the fundamental concept of no-fault auto insurance. What problems exist with this system? Can you sue for damages? No-fault auto insurance is based on two principles. First, the insurance company of the driver pays for his or her losses, and those of the passengers, without regard to fault. Second, by removing the litigation associated with the determination of fault, insurance should be less costly. The major problem with the no-fault system focuses on the limits on medical expenses and other claims. In some states, the limits are inadequate to cover legitimate medical expenses associated with an accident. Injured parties can collect up to a specified limit, regardless of fault. If the other driver was at fault, an injured party can sue for “pain and suffering.” 18. Name several standard exclusions that would limit the amount of coverage available in a personal automobile policy. • • • • • • •

Cases of intentional injury or damage Using a vehicle without permission of the owner Using a vehicle with fewer than four wheels Driving another person’s car that is provided to you on a regular basis Owning and driving an automobile that is not listed on your policy Carrying passengers for a fee Driving in a race or speed contest

19. Describe the factors that are major determinants of the cost of auto insurance. • • • • • • •

Type of vehicle (sporty cars generally cost more) Use of the vehicle (the less distance people drive, the lower the premium) Personal characteristics such as age, gender, and marital status Policyholder’s driving record (those with accidents and tickets pay more) Area of residence (insurance is generally more expensive in urban areas) Use of available discounts (e.g., for good grades or a good driving record) Policyholder’s insurance credit score

20. List and describe the different types of auto insurance discounts that are commonly available. Which ones provide the greatest saving? Auto insurance discounts are typically based on characteristics of the driver and the vehicle. Premium discounts that are commonly available include the following: • Going 3 years or more without a chargeable accident • More than one vehicle on the same policy • Low annual mileage, or fewer than 7,500 miles per year • Purchasing auto, homeowner’s, or other insurance from the same company • Low damageability auto that is cheap to repair or less appealing to thieves • Being a good student, as measured by high school or college grades • Being a mature driver (e.g., over age 50 or 55) discount ©2016 Pearson Education, Inc.


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Taking a defensive driving course Passive restraints (e.g., airbags and automatic seatbelts) and antilock brakes Driving short distances to work or participating in a carpool Antitheft devices or where you live

A low “damageability” auto designation may earn a 10 percent to 30 percent discount, while a good student discount could carry a discount of up to 25 percent. Up to a 40 percent discount applies to passive restraints. Several discounts save 15 percent, but some save as little as 5 percent. 21. List and briefly describe the ways a consumer can reduce the cost of auto insurance premiums. • • • • • • •

Comparison shop for coverage by obtaining quotes from a minimum of three different insurers and with different deductible amounts. Purchase from only high-quality, efficiently operated insurance companies by checking ratings with A. M. Best Reports (choose companies earning the two highest ratings) and Consumer Reports. Take advantage of available discounts that can lower premiums. Buy a car that is relatively inexpensive to insure. Improve your driving record (e.g., fewer tickets, driving course). Raise insurance deductibles (e.g., $100 to $500 on collision). Maintain adequate liability insurance.

22. If involved in an accident, what should you do at the scene and after the accident? • • • • • • • • • •

If there are injuries, get help by calling the police and the ambulance. Don’t leave the scene; that’s a felony. Prevent other accidents by moving the car(s) or putting out flares. Get the names, addresses, and license plates of all those involved or those who saw the accident. Work with the police; check the report for accuracy and get a copy. If alcohol is suspected, insist that both of you take an alcohol test. Write down all details and take pictures or measurements, if possible. Don’t sign anything, don’t admit guilt, and don’t discuss amount of insurance coverage. Call your insurance agent as soon as possible. Cooperate with the insurance company; if necessary, they will defend you, but if the accident is serious, seek your own legal advice. Record all expenditures associated with the accident.

23. Explain why it is almost always best to choose the highest liability coverage limits and deductible you can afford when purchasing automobile insurance. As discussed in the chapter, liability settlements resulting from accidents have increased dramatically over the past several years. By maximizing liability coverage limits within a ©2016 Pearson Education, Inc.

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policy you insure against claims that may exceed liability policy limits. Generally, as your net worth increases, your liability coverage should also increase. A minimum split-limit coverage of 100/300/50 is a common financial planning recommendation. The downside to carrying additional liability coverage is the increased annual premium cost. The best way to reduce the cost of insurance is to raise your deductible to the maximum that you can afford. The savings in annual premiums often exceeds the benefits of extra coverage. PROBLEMS AND ACTIVITIES ANSWERS 1.

The $140,000 dwelling coverage is the base amount for determining Parts B, C, and D coverage as outlined below: • Coverage B: Other Structures is limited to 10 percent of the dwelling coverage, or $14,000. • Coverage C: Personal Property is limited to half of the home’s coverage, or $70,000 • Coverage D: Loss of Use is limited to 20 percent of the home’s coverage, or $28,000.

2.

Keith and Dena Diem: personal property limits Item Amount Insurance Pays Cash $250.00 Jewelry $1,000.00 Pewterware $1,500.00 Totals $2,750.00

Amount the Diems Pay $250.00 $1,400.00 $0.00 $1,650.00

Total $500.00 $2,400.00 $1,500.00 $4,400.00

Without the additional coverage provided by a personal property floater, the Diem’s coverage is limited by the maximum amounts specified in their policy. Accordingly, $2,750 of their $4,400 loss would be covered by their insurance policy, and $1,650 would need to be absorbed or paid out-of-pocket: $250 over the limit for currency and $1,400 over the limit for jewelry. Based on a $250 deductible, the Diems will receive $2,500 on their claim ($2,750 – $250). 3.

Actual cash value insurance subtracts estimated depreciation from the cost of replacing an asset. In the case of the sofa, if it originally cost $850 and it has been used for half of its expected life (3 years out of 6 years), it would have an actual cash value of $500. With replacement cost coverage, the homeowner would receive the actual cost, or $1,000, to purchase a comparable sofa at the time of the loss.

4.

Carmella can do the following to increase her liability coverage: • Ask her insurance agent to raise the amount of her liability coverage from $100,000 to $300,000 or $500,000. The increase in premium for this additional coverage should be modest. • Purchase an umbrella liability policy to provide protection of $1 million or more. An umbrella policy goes into effect after the liability limits of an underlying homeowner’s policy are exhausted. Umbrella policies are reasonably priced and offer the added benefit of increasing liability coverage on the auto as well as the homeowner’s policy.



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5.

Jerry’s house is insured for less than 80 percent of its replacement value ($235,000 / $315,000 = 74.60%), therefore, Jerry will receive 93.25 percent of his claim because $235,000 is 93.25 percent of the 80 percent requirement ($252,000). So his reimbursement will be $23,779.76 = [($235,000 / ($315,000 × 0.80)] × $25,500), assuming this amount is greater than the actual cash value of the kitchen. If Jerry’s home were totally destroyed, the maximum he could collect is $235,000, or the full amount of his policy. This is $80,000 less than the cost to replace his home. He should maintain at least 80 percent coverage and probably 100 percent coverage to protect against a total loss. Recall that the deductible also must be applied as part of the homeowner’s coinsurance, so he will actually receive something less than $23,780 once the deductible amount is subtracted.

6.

Reimbursement for Carmen’s house equals ($300,000) × [$280,000 / ($300,000 × 0.80)] or $350,000, based on the home value at the time, although the true replacement cost could be much higher and is not known. The equation results in a possible benefit of nearly $350,000 because her coverage exceeds the 80 percent minimum; however, reimbursement will never exceed the amount of the policy. So Carmen will receive a benefit equal to the $280,000 amount of the policy less the $1,000 deductible, or $279,000 for the structure. Coverage for other structures, Part B, in an HO-2 policy is 10 percent of the coverage on the structure, or a total of $28,000, so Carmen would be reimbursed for only $28,000 of the $38,000 loss for the detached garage and pool house. Coverage for the contents, Part C, in an HO-2 policy is 50 percent of the coverage on the structure, or $140,000 (0.50 × $280,000), so Carmen would be reimbursed for the $91,000 actual cash value loss. However, the cost of replacing the contents could potentially be much higher as a replacement cost amount is not known. Coverage for loss of use, Part D, in an HO-2 policy is 10 percent of the coverage on the structure, or a total of $28,000, so Carmen would be fully reimbursed for the $4,500 in loss of use living expenses incurred. Carmen would receive no reimbursement from her HO-2 policy for her medical expenses or the $18,000 value of her three dogs. Medical expenses would have been covered by her health insurance. The dogs are excluded from the homeowner’s policy. Carmen’s situation can be summarized as follows: Structure Other structures Contents Loss of use Medical expenses Value of dogs Total

Losses $300,000 38,000 91,000 4,500 10,000 + 18,000 $461,500

Reimbursement $279,000 28,000 91,000 4,500 0 +0 $402,500


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7.

Larry’s policy will pay $300,000, the maximum liability limit per accident. This amount must cover payments to all persons involved in the accident. Unfortunately, it is not enough because the four liability claims total $400,000. The other $100,000 awarded in the judgment will not be covered by his insurance and would be a personal expense.

8.

The total amount of property damage caused by Bill’s accident is $15,000. The property damage liability limit of his auto policy is $10,000. Therefore, Bill’s insurance will pay $10,000 of the claim. Bill will be responsible for the other $5,000 out-of-pocket.

9.

The discount for having more than one policy with the same insurance company would save Jessica a total of $164, calculated as $44 ($550 × 0.08) on her HO-6 policy and $120 ($1,200 × 0.10) on her auto policy. Another advantage is that if Jessica ever had a claim involving both her home and her car (e.g., a tree falling on a car at home during a wind storm), it would be handled by one company. Also, Jessica only has to build a relationship with one company and insurance agent if she purchases all of her property insurance with one firm.

10. Jana qualifies for the following discounts: • 10 percent no accident discount • 5 percent age 24 – 49 discount • 5 percent defensive driving discount • 15 percent antitheft discount Her total discount is 35 percent of total premiums. Her new premium would be $780 ($1,200 × 0.65), assuming the costs are similar between her current company and the Superior Insurance Company. Insurance premiums vary widely by company, so Jana should carefully compare premium costs, coverage, and discounts available as well as the ratings and reputation of the company. DISCUSSION CASE 1 ANSWERS 1.

The HO-3 (Special Form) of homeowner’s insurance is the best choice for the Leylands. It is the most comprehensive form available because it covers all perils except those that are specifically excluded (e.g., flood, earthquake, war, and nuclear accident). Given the winter weather, “weight of ice, snow, or sleet,” or “freezing of plumbing, heating, air-conditioning, fire sprinkler, or appliance” may be of particular interest to the Leylands. The HO-3 provides protection from all perils on the structure; however, personal property coverage is limited to the 17 named perils.



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The minimum amount of insurance required to receive full payment for partial losses is 80 percent of the home’s replacement cost or $148,000 ($185,000 × 0.80). This is a bare minimum of coverage and is based on the assumption that the cost of the home is equal to the replacement cost. This is typically not true, so the Leylands should seek a reliable replacement cost estimate to serve as the foundation of their insurance decision. Without the inflation guard, or personally remembering to increase their coverage annually, the Leylands run the risk of their coverage falling to less than 80 percent, which means they would have to pay more of the cost for any loss. Because the Leylands indicated a desire to avoid out-of-pocket expenses if their home should be destroyed, they should consider insuring the home for its full replacement value and adding the inflation guard. That way, if a fire or flood, assuming supplemental flood coverage, totally destroyed their home, they would collect the full replacement amount⎯not a reduced amount because of co-insurance, which is a risk they want to avoid. Another option is a coverage amount between 80 percent and 100 percent of replacement cost, say 90 percent or $166,500. Recall that the deductible also must be applied to the homeowner coinsurance payment.

3.

If the Leylands’ personal property is really worth $165,000, the standard 50 percent of the insurance on the house for contents coverage, or $82,500, will be very inadequate. The coin collection, $15,000, and art, $25,000, need endorsements or floater policies to provide coverage up to the market value. The computer and electronics should be covered under the contents coverage, but they should check with the agent. To help themselves and their insurance agent, the Leylands should complete a comprehensive household inventory, with pictures or video, to document their property and the value. The Leylands should purchase replacement cost coverage so that their personal property would be replaced at its actual replacement cost, not actual cash value with depreciation, in the event of a loss. Adding more contents coverage to their basic HO-3 policy, as well as replacement cost coverage and additional riders or endorsements will add to the cost of the Leylands’ insurance. But the costs will be minimal compared to uninsured losses of valuable personal property. Furthermore, they should review the list of ideas for keeping costs down, such as the multiple policy discount, other discounts based on their home or themselves, a higher deductible, and comparison shopping.

4.

Section II Personal Liability Coverage will protect the Leylands if someone is injured on their property due to the Leylands’ actions, or inactions. For example, long winters with snow and ice can be a potential danger for anyone visiting their home, and a potential liability claim if the Leylands could be judged to be at fault for the damages caused. The small medical insurance coverage offers payment of up to $1,000 for medical expenses to non-family members injured at the Leylands’ home. Because of the winter conditions and the potential for small or large claims, the Leylands should carry adequate liability protection and consider increasing the minimum of $100,000 coverage per accident to $300,000 or $500,000. Even if the Leylands enjoy clearing the snow and ice, accidents can happen for which they could be judged to be responsible.

5.

The Leylands should consider flood insurance due to their proximity to the flood-prone river. They should check with the real estate agent selling them their new home or their ©2016 Pearson Education, Inc.

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insurance agent to see if the community has received approval from the Department of Housing and Urban Development (HUD). If necessary, they can purchase up to $250,000 of HUD-subsidized flood insurance on the dwelling and an additional $100,000 on contents. Otherwise, flood and related water damage will not be covered. 6.

Because the Leylands’ net worth exceeds the standard homeowner’s liability protection, the Leylands should consider purchasing a personal umbrella policy. These policies, which provide protection from $1 million to $10 million against lawsuits and judgments, are relatively inexpensive. In today’s litigious society, an umbrella policy simply makes good sense. The greater a household’s assets, the greater the liability insurance need.


Bronwyn is not adequately insured given her potential liability. For example, if she were involved in an accident on her daily commute, and found to be at fault, her potential bodily injury liability and property liability could easily add up to more than $75,000. Split limit coverage of $100,000/$300,000/$50,000 is recommended. She is also underinsured for medical expenses, as a minimum of $50,000 in coverage per person is recommended. Her coverage for Part C: Uninsured Motorists Protection should be increased to the recommended minimums of $250,000 per person and $500,000 per accident. Part D: Coverage for Damage to Your Auto is acceptable, assuming that “full” coverage is based on actual cash value and has a reasonable deductible applied.

2.

No, the policy quoted to Bronwyn does not offer adequate protection. She should consider carrying at least $100,000 of bodily injury liability coverage per person, $300,000 of bodily injury liability coverage for all persons, and at least $50,000 of property damage liability insurance coverage. Her premium will increase; however, she can reduce the impact of the premium increase by increasing her annual deductible.

3.

The standard financial planning rule states that an increase in the deductible will result in a decrease in premiums. Thus, Bronwyn should choose the highest possible deductible in order to reduce her premium, particularly given that she has sufficient savings to cover the higher deductible. In practice, she should choose either the $500 or $1,000 deductible.

4.

Without adequate liability coverage, Bronwyn may be held personally liable for additional expenses and costs. This means that the equity in her home, her savings, and other assets may be subject to creditors and legal judgment should a lawsuit be brought against her. (The insurance company would pay to defend her.) If Bronwyn is not judged to be at fault for the accident, others involved would not be compensated from Bronwyn’s liability coverage. However, even if she is not judged to be at fault, passengers riding with her could be compensated under Part B: Medical Expense Coverage for reasonable medical expenses and funeral expenses incurred within 3 years of the accident. This protection is also available to Bronwyn in addition to her health insurance.

5.

Given Bronwyn’s long daily commute, and the value of her vehicle and other personal assets, she should purchase Part C: Uninsured Motorist’s Protection to protect herself from ©2016 Pearson Education, Inc.


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losses sustained from an uninsured motorist, a negligent driver covered by an insolvent insurance company, or a hit-and-run driver. For Bronwyn to collect, the other driver must be at fault and not have available insurance. Recommended coverage limits are at least $250,000 per person and $500,000 per accident. Because of the number of drivers who do not carry adequate liability insurance, underinsured motorists coverage is another important consideration in Part C. This coverage would pay the difference between the liability limit of coverage available from a negligent driver and the actual loss sustained by Bronwyn, to the limit of the underinsured coverage she carries. If every driver was fully insured, Part C coverage would be unnecessary. To protect her assets and financial future, Bronwyn would be well advised to buy this coverage. Part D coverage protects against collision and physical damage losses. Because her Ford Escape is relatively new, Bronwyn should maintain this coverage to ensure that losses caused by an accident or other physical damage will be repaired. Recommended coverage is the actual cash value of the vehicle, so Bronwyn should not consider reducing or canceling this part of the policy until the vehicle is several years old and the fair market value is negligible. 6.

Bronwyn is potentially eligible for the following common discounts: • Accident free discount • Automobile and homeowner’s multiple policy discount • Passive restraint discount (e.g., air bag, automatic seat belts, antilock brakes) • Antitheft discount • Low “damageability” vehicle

7.

Principle 5: Stuff Happens, or the Importance of Liquidity is a reminder that the unexpected happens⎯but insurance and savings provide a way to manage the unexpected. Adequate insurance protection provides coverage not only for the loss, but also for the income and assets of the insured individual. Unfortunately, that was not the case for the person reported on the radio story. But buying more coverage means higher premiums. By increasing the deductible, the premium can be significantly reduced. This makes adequate coverage more affordable, but it may necessitate a review of liquid assets to insure that (1) the emergency fund is sufficient to cover the deductible and smaller claims that might otherwise have been reported to the insurance company and (2) a reasonable amount is available as liquid assets. Probably Bronwyn, like most people, would rather pay herself in anticipation of a high deductible or the cost of a small claim than paying the insurance company more! If stuff doesn’t happen, the money will stay in the account to grow!

8.

Due to Bronwyn’s promising earnings growth and appreciating assets, she should consider purchasing a personal umbrella policy. This policy provides excess liability insurance with protection against lawsuits and judgments in the amount of $1 million to $10 million. With a multiple policy discount, and maximum PAP and HO insurance liability coverage, her premium for $1 million in coverage should be quite inexpensive.


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9.


While Bronwyn should make every effort to get help for anyone injured in an accident, she should not admit guilt or sign any statements of responsibility until discussing the accident details with her insurance agent or insurance company representative or attorney. Any admission of guilt at the scene of an accident may hinder her efforts to defend her actions later in court. Further, she should not discuss the amount of her liability coverage with those involved in an accident. Although most people are honest, there are those who might try to commit medical or disability fraud if they knew her insurance coverage limits.


CONTINUING CASE: CORY AND TISHA DUMONT PART III: PROTECTING YOURSELF WITH INSURANCE

1.

Using the earnings multiple approach would result in the following life insurance calculations for Cory and Tisha. Cory’s needs = $45,000 × (1 – 0.22) × 12.46 = $437,346 Tisha’s needs = $53,000 × (1 – 0.22) × 12.46 = $515,096 Cory currently has $90,000 (2 × $45,000) of term life insurance through his employer. Consequently, Cory should consider purchasing approximately $347,346 (or $350,000 rounded) of additional life insurance coverage. Tisha has $79,500 of term insurance through her employer, as well as a whole life policy of $50,000. She should consider purchasing an additional $385,596 (or $400,000 rounded) of life insurance coverage ($515,096 – $129,500). Although Tisha or Cory would continue to earn their salaries if widowed and would receive some Social Security benefits, they would experience a significant reduction in their standard of living without adequate life insurance.

2.

The Dumonts, and Cory in particular, take a big risk when their life insurance is entirely in the hands of their employers. If Cory or Tisha leave their jobs, their group term coverage ends. However, they may be able to convert the group coverage to an individual policy. Because the Dumonts need additional life insurance, they should purchase individual policies to supplement the coverage they have. This will reduce the risk of later becoming uninsurable or, if they were to lose their jobs, having no life insurance at all.

3.

At their stage in the life cycle, term insurance is the best option for the Dumonts. It provides the greatest amount of insurance per premium dollar. Universal and variable life policies both include cash value components, through earnings from interest or mutual funds, respectively, which increase the cost of insurance coverage. These policies also tend to have high insurance, investment, and administrative expenses, which add to their cost. The option to skip the premium payment on universal life or a variable universal life may prove too tempting, as it does for many policyholders, who subsequently let the policy lapse. The Dumonts would be well advised to purchase affordable term insurance and do their saving/investing outside of their insurance policies.

4.

The life insurance policy features that should be explained to the Dumonts include the following: • Type of policy: term or cash value. The Dumonts’ policies provided at work are group term insurance policies available for the duration of their employment. Tisha also has a whole life policy (cash value insurance) with $1,800 of accumulated cash value. • Nonforfeiture clause (on Tisha’s whole life policy): options for receiving a policy’s cash value, a paid-up whole life policy with a reduced face value, or a paid-up term policy with the original policy face amount in exchange for ending the policy. The Dumonts 225



• • • • • • •

5.

could exercise this right if they are unable to pay the annual premiums to continue the coverage for an extended period of time. Beneficiary designation: persons named as primary and contingent beneficiaries to receive the death benefits from the policy. Coverage grace period: automatic extension, usually 30 to 31 days after a premium payment is due, before a policy lapses. The premium may be paid without penalty. Loan clause: (on Tisha’s whole life policy) describes procedures and the interest rate charged for borrowing against the policy’s cash value. Suicide clause: clause stating that the face amount of the policy will not be paid for a suicide death within 2 years of the purchase of a policy. Incontestability clause: clause stating that the insurance company cannot dispute the validity of a contract after it has been in force for a specific period, usually 2 years. Settlement options: section that describes alternative ways that the beneficiaries of a life insurance policy can choose to receive death benefits. Riders: special provisions added to a policy that either provide extra benefits or limit the insurance company’s liability. Riders attached to one or more of the Dumonts’ policies could include guaranteed insurability, multiple indemnity, COLA, waiver of premium for disability, or living benefits.

Life insurance is meant to provide funds to replace a breadwinner's wages to protect and support dependents. Chad and Haley are dependents, not income providers. Therefore, the purchase of life insurance is unnecessary and not recommended. The Dumonts should use the money they would spend on policies for the children to increase their own coverage. The claim that Chad and Haley would always be insured is only relevant if (1) the Dumonts continue the premium payments and (2) there is a high probability, based on family health history, that Chad or Haley will contract cancer, diabetes, or heart disease. Otherwise, they will be eligible for insurance in the future, and there is no need for “permanent” coverage starting at this young age.

6.

As a “comprehensive major medical insurance policy,” the Dumonts’ coverage includes basic health insurance for hospital, surgical, and physician expense needs, as well as major medical expense coverage. The latter is very important to extend the basic coverage to protect the Dumonts from the financial effects of a catastrophic illness or accident. The Dumonts should continually analyze the health plans from both employers to determine which offers the best overall plan. The annual coinsurance and family deductible are all standard policy features with reasonable amounts. They are currently paying annual premiums of $3,204 for the coverage, but the monthly opt out fee, from Cory’s employer, effectively reduces this by $1,200 (less the taxes paid on the increased income). Overall, their health care coverage is very cost effective, so no changes are recommended.

7.

The Dumonts have four options for paying a $5,000 medical bill incurred through an auto accident, including payment by • Health insurance • Medical expense coverage with their auto insurance



• •

Bodily injury liability coverage on an auto policy, assuming someone else was at fault for the accident Personal funds, or out-of-pocket. These funds would supplement the health insurance coverage, or be the only source of payment, should the Dumonts not have health insurance. Luckily, they do.

Expenses for an emergency appendectomy would be covered through health insurance and personal funds. Assuming no one else has made a claim this year, Tisha’s health insurance would pay $3,600: the $5,000 medical bill minus the $500 deductible and the $900 of coinsurance (0.20 × $4,500). Tisha would be responsible for the $1,400 of deductible and copay expenses. 8.

Advantages for the Dumonts of switching to an HMO include regular physical examinations and preventive care, minimized paperwork, and lower costs. Tisha may be able to reduce the monthly premium charged for her current coverage. Disadvantages associated with an HMO focus on concerns about quality of care stemming from the incentive system—quick, cursory services and the difficulty in receiving a referral, particularly outside the geographic region. Some fear the system does not allow for building a trusting relationship with a wellqualified physician. Restrictions on physician choices and the associated level of reimbursement vary with the HMO system: individual practice association, group practice plan, or a point-of-service plan. The Dumonts need to thoroughly comparison shop the plans. If Tisha switches to a PPO, costs and paperwork may also be reduced. Members, typically representing an employer group, receive health care at a reduced cost—with the negotiating power of the group determining the level of discount. The disadvantage of a PPO is that participants must seek medical services from participating doctors and hospitals, thereby limiting their choice of care. With a PPO, a participant can go to a nonmember doctor but must pay an additional, or penalty, co-payment to do so.

9.

Assuming Tisha works for an employer with 20 or more employees, she is eligible—under the federal COBRA law—to continue health insurance coverage for 18 to 36 months, depending on the reason for leaving the company. Tisha would be responsible for the full cost of coverage, so it may be less expensive to switch to an individual policy through a health insurance exchange. The Dumonts also have the option of enrolling for Cory’s health coverage. According to the Health Insurance Portability and Accountability Act of 1996, employees and their dependents must be allowed special enrollment rights, beyond the open-enrollment period, (1) if they declined coverage because of coverage through another plan or (2) if their family situation changes (e.g., marriage, birth, adoption). The former situation applies to the Dumonts, so if Tisha loses her family medical coverage, the Dumonts could enroll on Cory’s plan. Should Tisha decide to become a self-employed accountant, the Dumonts could purchase insurance through the health insurance exchange. Tax credits are available if their income is



below a certain limit. The Dumonts would also be eligible for a high deductible health plan and a Health Savings Account (HSA).The combination is cost effective because highdeductible plans have lower premiums and annual HSA contributions (limits apply) are an adjustment to income, so the funds are not taxed, and they grow tax-deferred and tax free, if spent according to the HSA rules. The HSA funds accumulate for paying health care costs incurred prior to meeting the annual deductible or for health care expenses not covered by the high-deductible health plan. Funds not spent remain in the account for future expenses, such as for health expenses after retirement or long-term care expenses. 10. Disability insurance policy features that Cory and Tisha should purchase include the following: • Definition of disability: Tisha and Cory should look for a policy that provides coverage if they cannot perform the duties of their current occupations (i.e., accounting and retail management). • Residual or partial payments benefits: this policy feature provides partial payments if they were disabled and unable to return to work full-time but could return part-time. • Benefit duration: the Dumonts should select policies that provide benefits until retirement age (e.g., 65) or for their lifetime. • Waiting or elimination period: the Dumonts should select a realistic waiting period (i.e. 1 to 6 months) during which they would have to “absorb” the income lost. They should consider their employer’s sick day policy (e.g., whether or not sick days can be accumulated) and emergency fund when selecting an elimination period. The longer the delay, the lower the premium. • Waiver of premium: this important provision waives premium payments if a policyholder becomes disabled. • Noncancellable: this provision protects against both policy cancellation and future rate increases and guarantees that the policy is renewable. • Rehabilitation coverage: this provision provides for employment-related educational or job-training programs. 11. The Dumont’s $25,000 HO-4 renter’s policy amount is probably sufficient given their estimated personal property value of $12,000. However, their property insurance coverage is inadequate for two major reasons: • It lacks replacement cost coverage on personal property, which provides for the actual replacement cost of a stolen or destroyed item (e.g., stereo equipment). Currently, the $25,000 coverage is actual cash value, or coverage for the depreciated cost of property. • It lacks a personal articles floater to increase the limit of coverage on Tisha’s $19,700 antique jewelry collection. To improve their coverage, Cory and Tisha should add a replacement cost rider and a personal articles floater to the existing HO-4 policy. Increasing the deductible could offset a premium increase. See the response to question 14 below for other cost saving ideas. 12. The Dumont’s auto insurance is inadequate because of its low liability limits. The 25/50/25 split liability and property damage limit is extremely low in relation to current medical, repair, and liability costs. The Dumonts should increase their liability limits to at least



100/300/50. Otherwise, they could be liable for judgments in excess of their current liability limits. Higher limits, such as 200/600/100, are also available. The Dumonts also have low uninsured motorist coverage limits. These, too, should be increased to a minimum of 100/300/50 to provide adequate protection against negligent drivers who carry no or inadequate liability coverage. The $20,000 of medical expense coverage is far lower than the recommended $50,000 of coverage per person. Assuming the Dumonts increase their emergency fund or other savings, they should increase the $200 deductible amounts. 13. Cory and Tisha’s current auto insurance policy would pay $25,000 for bodily injury losses incurred by any one person hurt in the accident, a total of $50,000 for bodily injury losses incurred by all persons hurt in the accident, and $25,000 for property damage if they were judged to be at fault. In other words, these are maximum liability coverage limits. If the accident resulted in a total of $65,000 of bodily injury losses to more than one person, the Dumonts would be personally responsible for arranging payment for the remaining $15,000. However, if the $65,000 in bodily injury losses were incurred by only one individual, the Dumonts would be personally liable for $40,000. This coverage is not adequate; the Dumonts are risking their financial future in lieu of paying a slightly higher annual premium. 14. To reduce the cost of property and liability insurance, the Dumonts could do the following: • Make every effort to keep their insurance credit score high, to qualify for lower premium rates. • Increase insurance deductibles (e.g., $200 to $500 or higher). • Take advantage of multiple policy discounts (e.g., HO-4 and auto insurance with the same company). • Pay insurance premiums less frequently (e.g., annually or semi-annually instead of monthly). • Shop around and compare the costs of at least three insurance providers. • Consider only high-quality insurers and possibly a direct writer. • Install security systems or smoke detectors. • Inquire about ANY other available discounts; these can vary significantly by company and may relate to the property (home or auto, such as fire-resistant building materials, auto passive restraints or antitheft devices) or the characteristics of the policyholder (e.g., over age 50 or 55, noncommuter, or good student). • Buy a car that is cheaper to insure and considered a low “damageability” model; be sure to check insurance rates when auto shopping. • Drive less (e.g., fewer miles, join a carpool) and improve driving records. • Double check your policy to ensure that all features and endorsements are included as planned; a claim could be costly that you thought was covered but was not because of an oversight in the policy. • Include adequate liability insurance to avoid paying damage awards from personal assets or income. 15. When the Dumonts become homeowners, they should purchase an HO-3 policy. An HO-3 policy is the most comprehensive of available policies for homeowners because it covers losses to the structure from all perils except those that are specifically excluded. Typical



excluded perils include flood, earthquake (supplemental coverage is available for both, if needed), war, and nuclear accident. Coverage on an HO-3 policy on the contents is limited to the named perils coverage provided in a broad, or HO-2, policy. The Dumonts should strongly consider adding personal property replacement cost coverage for their contents. The additional premium cost of 5 percent to 15 percent over the cost of a policy without this coverage is meager when compared to the increased level of reimbursement. Inflation guard and personal articles floaters—particularly for Tisha’s antique jewelry or any other items that exceed the value of the policy limits—should also be added. The minimum level of $100,000 of personal liability coverage is likely inadequate and should be increased to $300,000 to $500,000. However, the Dumonts should review this relative to their individual situation (i.e., pets owned or other unique situations). Cory and Tisha should consult Checklist 10.2, A Checklist for Homeowner’s Insurance, when shopping. An umbrella policy extends the liability coverage of the auto and homeowner’s policies owned by the insured. An umbrella policy protects against large lawsuits and judgments associated with your home or auto. Umbrella policies do not cover activities with the intent to cause harm, activities with aircraft and some watercraft, and most business and professional activities. The latter require a separate policy. Typical limits range from $1 million to $10 million; the policy does not become effective until the limits of the underlying policies have been exhausted. As the Dumonts proceed through the life cycle and attain more wealth, they may want to consider a policy of this type. However, in the interim, a more cost effective alternative may be increasing their existing liability limits to $300,000 or $500,000.


CHAPTER 11 INVESTMENT BASICS CHAPTER CONTEXT: THE BIG PICTURE This chapter, the first in “Part 4: Managing Your Investments,” explains the importance of setting investment goals, calculating the investment impact of taxes, and understanding risks, diversification, asset allocation, and market efficiency. Other chapters in this section will consider specific investment strategies and investment products, such as stocks, bonds, real estate, and mutual funds. This chapter establishes a foundation for the section by providing an argument for the need to plan carefully before making an investment decision. An important message to students is the need to differentiate between investing and speculating. CHAPTER SUMMARY This chapter introduces the process of investing to accomplish goals in the financial plan. The importance of establishing investment goals is stressed, as well as strategies for creating an investment plan to reach those goals. The difference between investing and speculating is considered. Two basic investment categories are discussed: lending and ownership investments. The importance of understanding the roles of interest rates and risk is presented. Six concepts to keep in mind when creating and managing an investment plan are provided, followed by the definition of diversification and diversification strategies. Sections on risk tolerance and asset allocation are next. This chapter concludes with an introduction to securities markets. Emphasis is given to distinguishing between the primary securities market, where initial public offerings and seasoned new issues are traded, and the secondary market. A discussion concerning the definition and roles of organized and over-the-counter (OTC) exchanges is presented. The goals of the Securities and Exchange Commission (SEC) and self-regulatory organizations, as they relate to securities regulation, are discussed. The process and terms of trading actual securities such as stocks and bonds is also presented. The roles of full service, discount service, and deep discount service brokers are discussed in terms of costs, commissions, and service. A review of behavioral biases ends the chapter. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Set your goals and be ready to invest. a. Investment b. Income return c. Speculation d. Derivative securities 231


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e. f. g. h. i. j. k.

Option Maturity date Par value or principle Coupon interest rate Stock Dividend Capital gain or loss

2.

Manage risk in your investments. a. Nominal (or quoted) rate of return b. Real rate of return c. Interest rate risk d. Inflation risk e. Business risk f. Financial risk g. Liquidity risk h. Market risk i. Political and regulatory risk j. Exchange rate risk k. Call risk l. Calling a bond m. Diversification n. Portfolio o. Systematic or market-related or nondiversifiable risk p. Unsystematic or firm-specific or company-unique risk or diversifiable risk

3.

Allocate your assets in the manner that is best for you. a. Asset allocation

4.

Understand how difficult it is to beat the market. a. Efficient market

5.

Identify and describe the primary and secondary securities markets. a. Securities markets b. Primary market c. Initial public offering (IPO) d. Seasoned new issue e. Investment banker f. Underwriter h. Prospectus i. Secondary markets j. Organized exchange k. Over-the-counter market l. Bid price m. Ask or offer price


Chapter 11: Investment Basics

n. o.

American Depository Receipt (ADR) Churning

6.

Trade securities using a broker. a. Round lot b. Odd lot c. Day order d. Open or good-till-canceled (GTC) orders e. Fill or kill order f. Discretionary account g. Market order h. Limit order i. Stop or stop-loss order j. Short selling k. Margin requirement l. Asset management account m. Cash accounts n. Margin accounts o. Margin or initial margin p. Maintenance margin q. Margin call r. Joint tenancy with the right of survivorship s. Tenancy-in-common account t. Discount or online broker u. Full-service broker or account executive v. Online trading w. Day traders

7.

Locate and use several different sources of investment information to trade securities.

CHAPTER OUTLINE I.

Before You Invest A. Investing Versus Speculating B. Setting Investment Goals C. Financial Reality Check D. Starting Your Investment Program 1. Pay yourself first 2. Make investing automatic 3. Take advantage of Uncle Sam and your employer 4. Windfalls 5. Make 2 months each year investment months E. Fitting Taxes into Investing


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F. Investment choices 1. Lending investments 2. Ownership investments G. The Returns from Investing II.

A Look at Risk–Return Trade-Offs A. Nominal and Real Rates of Return B. Historical Levels of Risk and Return C. Sources of Risk in the Risk–Return Trade-Off 1. Interest rate risk 2. Inflation risk 3. Business risk 4. Financial risk 5. Liquidity risk 6. Market risk 7. Political and regulatory risk 8. Exchange rate risk 9. Call risk D. Diversification 1. Diversifying away risk E. Understanding Your Tolerance and Capacity for Risk

III.

The Time Dimension of Investing and Asset Allocation A. Meeting Your Investment Goals and the Time Dimension of Risk B. Asset Allocation

IV.

What You Should Know About Efficient Markets

V.

Security Markets A. The Primary Markets B. Secondary Markets—Stocks 1. The New York Stock Exchange (NYSE) 2. Over-the-counter (OTC) market 3. The rise of electronic trading C. International Markets D. Regulation of the Securities Markets 1. SEC regulation 2. Self-regulation 3. Insider trading and market abuses

VI.

How Securities Are Traded A. Placing an Order 1. Order size 2. Time period for which the order will remain outstanding



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B. Types of Orders 1. Market orders 2. Limit orders 3. Stop orders C. Short Selling D. Dealing with Brokers E. Brokerage Accounts F. Cash Versus Margin Accounts G. Joint Accounts H. Choosing a Broker 1. Using a full-service broker 2. Using a discount/online broker 3. Making the decision I. Online Trading VII.

Sources of Investment Information A. Corporate Sources B. Brokerage Firm Reports C. The Press D. Investment Advisory Sources E. Internet Sources

VIII.

Behavioral Insights A. Principle 9: Mind games, your financial personality, and your money B. Overconfidence C. Disposition effect D. House money effect E. Loss then risk aversion effect F. Herd behavior

IX.


APPLICABLE PRINCIPLES Principle 1: The Best Protection Is Knowledge To be a successful investor, you must understand the basics and logic of investing. Principle 2: Nothing Happens Without a Plan In order to meet investment goals, you must have a plan. Sometimes the best investment plan is a simple plan that is easy to implement and manage. Principle 3: The Time Value of Money An investor’s best ally is time. The earlier an investment plan is developed and put into place, the easier it is to achieve goals and objectives.


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Principle 4: Taxes Affect Personal Finance Decisions The marginal tax rate—the tax rate paid on your next dollar of earnings—plays an important role when selecting investments. It is also important to evaluate investments on an after-tax basis or looking for ways to make investments grow on a tax-deferred basis, keeping in mind that capital gains are taxed at a lower rate than income returns. In the final evaluation, taxes make some investments better and some worse than they would otherwise be. Principle 6: Waste Not, Want Not—Smart Spending Matters Keeping costs to a minimum helps you take advantage of the time value of money to an even greater extent. Using a discount broker can help you achieve this goal. Principle 8: The Risk–Return Trade-Off Inflation is a form of risk for investors because it erodes the purchasing power of savings. In order to be compensated for inflation risk, you, as an investor, should demand a greater return from your investments. In addition, the more risk (inflation or otherwise) you are willing to assume, the greater the potential reward for that investment. Most investors understand diversification as not putting all their eggs in one basket. However, to mitigate some of the potential negative effects of taking on more risk, you should diversify. Diversification works by having positive returns of one investment offset negative returns of another investment. Principle 9: Mind Games and Your Money Investors can make bad decisions through common behavioral biases. The most common biases include overconfidence, disposition effect, house money effect, loss then risk aversion effect, and the herding behavior. Each of these biases can lead an investor to make irrational decisions such as treating “won” money differently than “made” money or doubling-down on a losing investment thereby cutting there perceived loss in half because they only have to make it “half-way back” to break even. This may just be throwing good money after bad. Principle 10: Just Do It! Regardless of how much money you make or how old you are, it is important to begin saving and investing as soon as possible. Each day reduces the compounding advantages of time. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1. Asset allocation is an important concept to understand when investing. Ask each student to develop a personal asset allocation plan using the allocation examples presented in the text. Ask students what factors should be considered when determining their personal asset allocations, and whether these factors will cause allocations to differ between students. Also ask which specific investments they would include in their asset allocation plans.



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2. Before you can develop an investment plan, you must identify your investment goals. Have students list five short-term and five long-term investment goals for themselves. Have them ask their significant other or other friends or family if they have identified investment goals. If so, how are their goals similar? Do the goals reflect different stages of the financial life cycle? 3. It is commonly assumed that the older a person gets, the less risk tolerant he or she becomes. Why might this be a standard assumption, and do you believe this assumption? Interview several retired persons about their risk tolerance, and how it has affected their asset allocation. Did their allocation changes, if any, follow the recommendations found in this chapter? What do your results tell you? Were they taking more or less risk with their portfolios than recommended? Why might this be the case? Explain your answers in a one- to two-page report. 4. Most mutual fund and brokerage house Internet sites offer free asset allocation and risktolerance assessment services. Visit three or four Internet sites and respond to the questions for the asset allocation programs. Print out the results and write a brief summary of your findings, paying close attention to how accurately the programs assessed your risk tolerance. Were the asset allocation recommendations consistent across the programs? 5. Search the Internet for investment sites that discuss common behavioral biases and heuristics that people use when selecting what investments to buy and when to buy them. How might each of the topics you find relate to a perceived reduction in risk by the investor? For example, answer the question “do people feel safer or more confident as part of a group?” Write a brief report on your findings. 6. Make a list of ten products and services that you use on a daily basis. Examples might include soft drinks, detergents, utilities, and textbooks. Next to each item on the list, make a note of which company produces the good or service. Check online at finance.yahoo.com to determine the stock exchange on which the companies are traded and a recent closing stock price for them. Further review at least a 2-year price history. Did you notice any relevant trends that might lead to the recommended purchase or sale of stock? Explain your recommendations in a brief written or oral report. 7. Did you know that every publicly owned and traded company in the United States is required by law to provide both a quarterly and an annual report to anyone who asks for one? Contact a publicly owned company for its annual report or find the annual report on Edgar-online. In looking at the report, do you see any noticeable trends in sales, profits, and dividends? What other useful information is contained in the report? Given your newfound knowledge, would you purchase shares in the company? Why? 8. Ask students if they would prefer to work with a financial planner who earns 100 percent of income from commissions, 100 percent from fees, or some combination of the two. Why? Then ask the same students how they would like to be compensated if they were financial planners. Why? What insights do the answers provide into understanding Principle 1?


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9. Have students identify, explain, and give examples of the various sources of investment risk defined in the chapter. Of the risks identified, ask students which is the most important risk that they currently face. Why? REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1.

Explain the difference between investing and speculating. Give an example of each. Investing and speculating are defined as follows: • Investing entails putting your money in an asset that generates a return. Examples include real estate, stocks, and bonds. • Speculating generates returns entirely from supply and demand. Examples include comic books, coins, art, futures, options, and gems.

2.

Why is it important to maintain an adequate emergency fund before creating and implementing an investment program? As Principle 5 highlights, unexpected events that require immediate use of cash happen occasionally. By having an emergency fund separate from investment monies, you will have liquid funds to cover unexpected expenses without having to interfere with your investment goals. Financial planners typically recommend that 3 to 6 months’ expenses should be set aside into an emergency fund.

3.

What are five ways to find money to invest? There are several ways almost anyone can find money from daily living expenses to start an investment program. Examples include paying yourself first, using automatic withholding for investments, taking advantage of matching contributions offered by employers or government tax-favored investments (e.g., IRAs and other retirement plans), investing any windfalls received, and picking two months per year to cut spending and increase investing.

4.

Why should you look for tax-favored investment strategies? How can these strategies help you attain your goals? Tax-favored investments consist of two different types of investment vehicles—tax deferred and tax free. Tax-deferred investment accounts, which may also be tax deductible, allow income to be generated without creating a tax consequence until the investment is withdrawn. Tax-free investments, which are not typically tax deductible, grow without tax consequences (tax deferred) and can also be withdrawn tax free. Either of these types of investment accounts effectively increases the rate of return because the returns are not reduced by taxation.



5.

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Name and briefly describe the two basic categories of investments. Provide two examples of each. Lending investments: debt instruments indicate that you’ve loaned money to an individual or firm. Examples include savings accounts and U.S. Treasury bills. Ownership investments: these investments represent ownership in an asset or enterprise. Examples include real estate and stocks.

6. What are the three primary points of information needed to evaluate the potential total and annual return of a lending investment? An investor should know the current “market” price, the par value, and the coupon rate. The current price tells the investor how much they will have to pay for the bond. The par value tells the investor how much they will receive if they hold the bond until maturity. Most bonds have a par value of $1,000. The coupon rate tells the investor how much income they will receive on a periodic basis between the time of purchase and the maturity date. The difference between the purchase price and the par value is the potential capital gain (or loss) the investor could expect. This difference is then added to (or subtracted from) the current income stream to determine the total return. If the total return is divided by the investor’s initial investment, it is then stated as a percentage return. To calculate annualized return, the percentage return is then divided by the holding period, stated in a number of years and fractions thereof, in decimal form. 7. Remembering the information from the tax chapter, when it comes to income taxes, why is capital gain income better than dividends or interest income? Under current tax law, capital gains are better than income returns because taxes are only paid when the investment is sold and the profits are realized, and for those in the highest tax brackets (e.g., 35 percent) capital gains are taxed at a lower rate. This difference is enhanced whenever an investment is held longer than 12 months because long-term capital gains are taxed at either 15 percent or 5 percent, depending on one’s marginal tax bracket. 8.

What is the basic difference between the nominal rate of return and the real rate of return? Which of them might be a better measure of how well an investment has performed? Why? The nominal rate of return, sometimes referred to as the quoted rate, is the return earned on an investment unadjusted for inflation. The real rate of return is the nominal rate minus the inflation rate. The real rate of return is a better measure of how well an investment has performed because it takes into account changes in purchasing power.

9.

Investors need to be aware of nine sources of risk when calculating the risk–return trade-off. List and briefly describe these nine sources of risk.


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• • • • • • • •

•

Interest rate risk: Fluctuations in security prices due to changes in the market interest rate. Inflation risk: The likelihood that rising prices will deteriorate the purchasing power of an investor’s money, and that changes in the anticipated level of inflation will result in interest rate changes, which, in turn, will cause security price fluctuations. Business risk: The risk that fluctuations in investment value may be caused by good or bad management decisions, or how well or poorly a firm’s products or services are doing in the marketplace. Financial risk: Risk associated with the use of debt by a firm. The more debt a firm takes on, the more interest and principal a firm must pay. If a firm can’t make these payments, for whatever reason, bankruptcy will result. Liquidity risk: This risk deals with the inability of investors to sell a security quickly and at a fair market price. Market risk: The risk associated with overall market fluctuations. Political and regulatory risk: These risks result from unanticipated changes–in the tax code or legal environment–that have been imposed by the government. Exchange rate risk: If an investor owns non-U.S. securities, this risk refers to the variability in earnings that result from changing exchange rates. An increase in exchange rates (i.e., the U.S. dollar increases in value) decreases the total return of a foreign investment for U.S. investors. Call risk: The risk to bondholders than their bond may be redeemed prior to maturity.

10. Differentiate between systematic and unsystematic risk. Which of these is more important to the average investor? Why? Systematic risk is that portion of a stock’s risk or variability that cannot be eliminated through diversification. Unsystematic risk is an investment’s risk or variability that can be eliminated through diversification. Unsystematic risk is important for investors because this risk can be reduced through diversification. 11. Why might investors not be willing to take risks with their investment portfolios even though they take risks elsewhere? What investment concepts might help them be more willing to take an appropriate amount of risk? Typically, people are more conservative with their investments because of a lack of knowledge about their risk tolerance or investment products. Principle 8: Risk and Return Go Hand in Hand addresses several concepts that can increase investors’ comfort level. 1. The risk–return trade-off tells investors that as their level of acceptable risk increases, their level of expected return should also increases. 2. The time dimension of investing dictates that higher levels of risk should only be assumed as the time horizon lengthens. 3. Diversification reduces the effects of unsystematic risk on the value of a portfolio 12. What is the long-term relationship between risk and time? Why is this relationship such an important concept to remember when developing and implementing an investment program?



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Principle 8 indicates that some of the risk of any investment seems to disappear as the length of the investment horizon increases. In other words, the longer an investment is held, the less risky it becomes. Although the actual risk of the investment doesn’t actually “disappear,” longer time horizons allow investors to adjust expenditures and increase income over time, which tends to reduce the risk of holding certain investments by smoothing the effects of the potential ups and downs of the market. 13. What is meant by the term “asset allocation”? What makes asset allocation such a simple and powerful concept? Asset allocation is a method for dividing investment money among asset classes, such as stocks, bonds, cash, and real estate. An asset allocation strategy will be influenced by an investor’s time horizon and financial stability (e.g., emergency savings fund). This simple concept is a powerful one because it is an effective method for reducing unsystematic risk through diversification of asset holdings. 14. What is the purpose for adjusting your asset allocation as you age? Why wouldn’t “the best” or highest returning portfolio always be prudent? As you age, your asset allocation should change to accommodate your shorter time horizon. Remaining overly exposed to risky or volatile investments could have a detrimental effect on your portfolio value. By reducing the volatility in your portfolio, you limit your chance of suffering an unrecoverable loss. 15. What is the relationship between market efficiency and the success of market timing? Does market timing work consistently? What six efficient market concepts should be considered when investing? A perfectly efficient market is one where security prices always equal their true value at all times. In effect, efficient market theory states that individuals cannot systematically “beat the market” and that investors should try to stick with their investment plans. Timing the market involves buying stocks before the market rises and selling stocks before the market falls. Systems to “beat the market” do not work consistently and, in fact, seem to provide little help in picking winning investments. Rather than trying to employ some system to beat the market, to maximize returns investors should (1) beware of “hot tips,” (2) keep to their plan and invest for the long term, (3) focus on the asset allocation process, (4) keep commissions down, (5) diversify their portfolio, and (6) seek professional advice if needed. PROBLEMs AND ACTIVITIES ANSWERS 1.

The appropriateness of each investment follows: • Certificate of Deposit (CD): This insured bank deposit offers safety and a guaranteed rate of return; however, certificates of deposit typically require a minimum holding


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•

• • •

period ranging between 3 months and 5 years, with penalties for early withdrawal. This is not the best investment for an emergency fund. Three-month Treasury bills (T-bill): These investments offer the ultimate in safety, but if they are sold before maturity, an investor may lose (or make) money. This is an appropriate investment for an emergency fund, assuming that an investor is willing to lose money if sold early. Gold and Silver Coins: These assets are more accurately classified as speculation and are inappropriate for an emergency fund because of their relative illiquidity and price instability. Portfolio of Energy Stocks: Due to the relative volatility in price shares and potential problems in selling such stocks in a declining market, these investments are inappropriate for an emergency fund. Money Market Mutual Fund (MMMF): This is the most appropriate investment for an emergency fund. Although not federally insured like a certificate of deposit, money market funds offer high liquidity, marketability, and a competitive rate of return, making them ideally suited for emergency fund savings.

2.

Due to the reduced tax rate on long-term capital gains, Jana would save approximately $8,000 in taxes. Because short-term capital gains are taxed as ordinary income, she will not receive any tax benefit if she receives the bonus as a short-term capital gain. $40,000 × 0.35 = $14,000 tax on bonus $40,000 × 0.15 = $6,000 tax on long-term capital gain $40,000 × 0.35 = $14,000 tax on short-term capital gain

3.

Total return = [(Sales Price – Purchase Price) + Dividends] / Purchase Price

($45 − $37 ) + $0.50 = $8.50 = 22.97% $37

$37

After-tax return = {[(Sales Price – Purchase Price) + Dividends] – Taxes} / Purchase Price First calculate the income tax liability on the dividend. Assuming the dividend is “qualified,” then the dividend income would be taxed at the capital gains tax rates. Capital gains tax = Capital gain + Qualified dividend × Capital gain tax rate = $8.50 × 0.15 = $1.275 Now subtract the tax from the gross return and recalculate the percentage return.

($45 − $37 ) + $0.50 − ($1.275) = $7.225 = 19.53% $37

4.

• • •

$37

Interest rate risk: Both Inflation risk: Both Business risk: Both



• • • • • • 5.

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Financial risk: Both Liquidity risk: Both Market risk: Both Political and regulatory risk: Both Exchange rate risk: Both Call risk: Bonds

Real rate of return = Actual “nominal” rate of return – inflation rate (8.50% – 4.00%) = 4.50% Yes, an investor would purchase the bond if primarily worried only about inflation risk as the bond offers a positive real rate of return. The inflation rate would need to increase quite a bit in order to negate the potential “real return.”

6.

a. b. c. d.

The Securities Act of 1933 The Securities Exchange Act of 1934 The Investment Advisors Act of 1940 Securities Investor Protection Corporation (SIPC) established through the Investor Protection Act of 1970 e. Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988

7.

Because the stop-loss order price of $56.00 is set so close to the recent close of $56.50, it is likely that the position will be sold as the stock fluctuates around its closing price. Arianna should set your stop-loss order to safeguard against a major, not minor, fluctuation. A stoploss price of $51 or $52 could be more appropriate as a selling technique.

8.

If the shares are owned “jointly,” Harriett would receive Harry’s shares without the shares passing through probate. However, because the asset was owned “commonly,” Harry’s survivors would receive his shares, which in this case would more than likely still be Harriett. The greatest difference occurs if they die simultaneously. When this happens and the shares were owned “commonly,” then Harry’s heirs would receive the benefit. This can create problems should Harry have had a previous marriage.

9.

Total Purchase Cost Amount Margined Your Contribution

$10,000 (250 shares @ $40.00 per share) – $5,000 (50% – maximum initial margin allowed by the SEC) $5,000

Total Value Loan Remainder Original Contribution Profit

$12,500 (250 shares @ $50.00 per share) – $5,000 (original amount, ignoring any interest) $7,500 – $5,000 $2,500 (This is a 50% gain on contribution)


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Total Value Loan Remainder Original Contribution Loss

$7,500 (250 shares @ $30.00 per share) – $5,000 (original amount, ignoring any interest) $2,500 – $5,000 – $2,500 (This is a 50% loss on contribution)

10. Profits can be made as the market goes down, as shown below: $36,000.00 credit ($90 per share × 400 shares) – $18,000.00 purchase ($45 per share × 400 shares) $18,000.00 gross profit – $1,200.00 dividends (2 × $1.50 per share × 400 shares) – $125.00 commissions $16,675.00 net profit 11. a. Disposition Effect b. Overconfidence c. Herd Behavior DISCUSSION CASE 1 ANSWERS 1.

Given that credit cards are often the most expensive form of credit and the interest rate is much higher than what they could expect in the investment market, John and Emily should pay-off their outstanding credit card debt. Then they should educate themselves about the investment markets, establish some realistic investment goals, and establish a plan of action.

2.

Investment objectives include (ranked by importance and immediacy): • Pay off credit card bills (short term). • Establish emergency fund (short term). • Start saving for a down payment on a house (intermediate term). • Start saving for Lindsey’s college expenses (long term). • Start a retirement savings account (long term). Investment alternatives matched to their goals include: • Use a bank or checking account to pay off credit card bills. • Use a bank account or money market mutual fund for emergency fund savings. • Use a money market mutual fund, bank CD, or U.S. Treasury bills for house savings. • Use common stocks, bonds, and Treasury bills for meeting college savings goals. • Use common stocks almost exclusively for retirement savings.



3.

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Using your financial calculator, input the following values for the different investments: Common stock: PV PMT I/Y N CPT FV

$0 -$2,000 11.3% 40 $1,263,917

Government bonds: PV $0 PMT -$2,000 I/Y 6.4% N 40 CPT FV $342,443 Treasury bills: PV PMT I/Y N CPT FV

$0 -$2,000 4.4% 40 $208,992

4.

Over time, stocks tend to provide investors with the greatest total returns. Also, over time, the risks associated with owning common stocks are greatly reduced. Given John and Emily’s investment goals, stocks appear to offer the best investment opportunities. Stocks combined into a diversified portfolio should, over time, outperform all other investments.

5.

With the addition of government and/or corporate bonds to the asset allocation mix, the “worst case” scenario improves. That is, adding bonds to your portfolio reduces your portfolio standard deviation. So for investors who want to limit their downside risk both in absolute terms and frequency and don’t mind giving up some of the up-side potential, this addition is very beneficial.


Before investing, it is important that Marcelino have his financial affairs in order. Specifically, he needs to establish and stick to a budget. He also should make sure that he has adequate levels of homeowner’s/renter’s, auto, and health insurance to help cover unexpected property and liability, and medical expenses. He should also establish and maintain an emergency savings fund equal to 3 to 6 months of his take home pay.

2.

Marcelino’s plan to make a quick profit in an Internet stock is most closely aligned with the definition of speculation. Short-term strategies that depend almost solely on supply and demand to determine prices are representative of speculation, not investment. ©2016 Pearson Education, Inc.

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3.

The efficient market hypothesis states that all relevant information about a stock is reflected in the stock’s current price. As such, it is extremely difficult to “beat the market” by picking one stock. It is equally difficult to time the market, meaning that buying a stock at a low price and selling it at or near its high price is nearly impossible. Individuals who say that they can beat the market or time the market accurately tend to either overestimate their abilities or underestimate the probability of losing money in the stock market.

4.

Annualized rate of return = [(End – Beginning) / Beginning] × (1 / holding period (in years)) AR (ignore tax) = [($65 – $25) / $25] × 1/3 = 0.5333 or 53.33% After-tax return = [(End – Beginning) – Taxes] / Beginning) × (1 / holding period (in years)) Tax = (End – Beginning) × Capital gains tax rate = $40 × 0.15 = $6 AR (after tax) = ($40 – $6) / $25) × 1/3 = 0.4533 or 45.33%

5.

Unlike a long-term capital gain that could be taxed at a rate as low as 5 percent (2007) or 0 percent (2008), short-term capital gains are subject to the full marginal tax rate. Although this may not be a significant factor for Marcelino as a college student, the difference in capital gains tax rates can be dramatic for individuals in high marginal tax brackets.

6.

In addition to interest rate risk, Marcelino should ideally keep a watchful eye on all of the other risks. However, given the uniqueness of an exploration stock, the most important of the risks would be business risk, political and regulatory risk, and exchange rate risk if the firm deals substantially in overseas markets.

7.

Systematic risk cannot be eliminated through diversification. Holding one stock does not increase systematic risk; however, owning only one stock does increase unsystematic risk. In other words, if a company-unique problem occurs, there is insufficient diversification to reduce the risk of loss. By investing in two unrelated stocks, Marcelino should reduce the volatility of his portfolio due to unsystematic “business specific” risk.

8.

Luc is correct. Marcelino should avoid investing in only one stock. He should focus on accumulating a portfolio of stocks in different industries. In this way, he will reduce unsystematic risk by allowing bad returns from a few stocks to be countered by high returns in other stocks. Ultimately, this approach will reduce total portfolio variation (risk) without negatively affecting expected returns.


Hasit doesn’t need to be overly worried. The Investor Protection Act of 1970 created the Securities Investor Protection Corporation (SIPC), which provides up to $500,000 of insurance to cover investors’ account balances in the event that their brokerage firm goes bankrupt. Cash balances are insured up to $100,000. Note that the insurance is if the holding (brokerage) firm goes under; it does not insure against investment losses.



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2.

Insider trading can be a problem in the securities markets because it causes general distrust of the market’s ability to establish fair prices. The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 were enacted to make it illegal to trade while in the possession of inside information. Although insider trading probably does take place, Chandni need not worry about such trading. The combined effects of insider-trading rules and regulatory oversight by the Securities and Exchange Commission make insider trading a very rare event.

3.

Questions Hasit and Chandni should ask prospective brokers include the following: • What type of investment advice do you offer, and what is the source of that advice? • Does the brokerage firm provide safekeeping and record keeping services? • Are all accounts SIPC insured? • Does the brokerage firm provide supplemental account insurance? • Does the brokerage firm provide an 800 number for transactions and quotes? • Does the brokerage firm pay interest on idle cash in the account? • Does the brokerage firm charge an account maintenance fee in addition to commissions? Hasit and Chandni should look for a broker with a reputation for integrity, intelligence, and efficiency. They should find someone with a relatively long investing history in order to be assured that the broker has seen both good and bad markets. The broker should also take time to learn about Hasit and Chandni’s investment philosophy. Finally, the best broker is one that uses a consultative approach and is upfront about all costs and commissions.

4.

Online trading basically has two advantages, cost and accessibility. But online brokers also have some disadvantages. One of the biggest disadvantages, to a novice investor, is the easy access mentioned as an advantage. Without the basic knowledge of the investment markets, novice investors could make tremendous mistakes. If they need investment advice, online brokers normally have telephone consultations available. However, if Chandni and Hasit need more than basic advice, or they will be investing in bonds, they would be advised to use a traditional broker.

5.

Given that there is no information available about additional family members, nor is there any information about how they want their assets handled in the event of either death, recommending a particular ownership type is difficult. However, the deciding factor could be that assets held with rights of survivorship bypass the probate process, so the transfer of the assets is both quicker and more private. The ownership type they choose should depend on how they want their assets distributed upon death. With tenancy-in-common ownership, when one party dies, his/her share of the asset is passed on to his/her heirs. However, with joint tenancy with right of survivorship, the decedent’s portion of the assets is transferred to the surviving owner. This decision should not be made hastily, and consulting a lawyer is advisable.


CHAPTER 12 INVESTING IN STOCKS CHAPTER CONTEXT: THE BIG PICTURE This chapter on common stock investing is the second in the section titled “Part 4: Managing Your Investments.” An underlying theme of this section is an understanding of the investment process and the need to plan any investment choice carefully. Students will find the information in this chapter to be highly relevant as it focuses on helping students understand and apply the risk–return trade-off rule. Two important messages fundamental to this chapter are (1) successful common stock investing is a direct result of understanding and reducing the risks associated with stocks, and (2) common stock investing should be a part of every financial plan. CHAPTER SUMMARY This chapter considers common stock investing as a component of the investment planning process. The chapter explains why common stocks are a solid investment and, over time, why stocks outperform all other investments. This chapter also details how stocks can be used to reduce risk through diversification and how stocks offer a high degree of marketability and liquidity without relying wholly on interest rates as a determinant of value. Market indexes and measures, such as the Dow Jones Industrial Average and the S&P 500, are discussed. Common stock classifications are defined, and a discussion of stock valuation methods is presented, including examples of the price-to-earnings approach, the discounted dividend model, dollar cost averaging, buy-and-hold strategies, and dividend reinvestment plans. The concept of international common stock investing is also presented. The chapter ends with a review of common stock investment risks and potential mitigating factors. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1. Invest in stocks. a. Declaration date b. Ex-dividend date c. Proxy d. Stock split e. Stock repurchase f. Dividend yield 2. Read stock quotes online or in the newspaper. a. Stock market index 249


250


b. c. d. e.

Dow Jones Industrial Average (DJIA), or DOW Standard & Poor’s 500 Stock Index or S&P 500 Bear market Bull market

3. Understand how stocks are valued and what causes them to go up and down in price. a. Fundamental analysis b. Technical analysis b. Price/earnings (P/E) ratio c. SWOT analysis 4. Employ different investment strategies. a. Dollar cost averaging b. Buy-and-hold c. Dividend reinvestment plan (DRIP) 5. Understand the risks associated with investing in common stock. a. Beta CHAPTER OUTLINE I.

Why Consider Stocks? A. The Language of Common Stocks B. Limited Liability C. Claims on Income D. Claims on Assets E. Voting Rights F. Stock Splits G. Stock Repurchases H. Book Value I. Earnings per Share J. Dividend Yield K. Market-to-Book or Price-to-Book Ratio L. Classification of Stocks

II.

Stock Indexes and Quotes A. The Dow B. The S&P 500 and Other Indexes C. Market Movements D. Reading Stock Quotes Online and in the Newspaper

III.

Valuation of Common Stock A. Fundamental and Technical Analysis Approaches B. The Price/Earnings Ratio Approach C. SWOT Analysis


Chapter 12: Investing in Stocks

IV.

Stock Investment Strategies A. Dollar Cost Averaging B. Buy-and-Hold Strategy C. Dividend Reinvestment Plans (DRIPs) D. As an Investor, What Should You Know?

V.

Risks Associated with Common Stocks A. Another Look at Principle 8: Risk and Return Go Hand in Hand

VI.

Behavioral Insights A. Principle 9: Mind games, your financial personality, and your money B. The status quo bias C. Herd behavior D. Loss aversion

VII.

Action Plan A. Principle 10: Just do it! B. Set your goals C. Fill up your Roth IRB and any employer-sponsored 401(k) plan first D. Don’t invest too heavily in your employer E. Avoid excessive trading costs and taxes F. Beware of “systems” and “hot tips” G. Asset allocation and buy-and-hold work

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APPLICABLE PRINCIPLES Principle 8: Risk and Return Go Hand in Hand The return a stock investor receives is made up of compensation for future anticipated inflation and a real return. As the anticipated inflation rate increases, so does the return demanded by investors. Also, as the required rate of return increases, stock values decrease. Common stock investors also face another potential risk, poor firm performance. As the owners, if the firm does poorly, so will the investors. However, owning several different securities representing different industries can reduce much of the risk (firm-specific) associated with common stock investing. In this way, when one stock does poorly, another may do well, making up for the loss. More diversified portfolios tend to move more closely to the overall market, but common stock investors are still faced with market-specific risk (systematic) that cannot be reduced through diversification. Beta is a measure of systematic risk. Principle 9: Mind Games, Your Financial Personality, and Your Money We all know we shouldn’t buy high and sell low, but the reality is behavioral biases get in the way and lead us to make poor decisions with our money. Awareness of investment biases, such as the status quo bias, herd behavior, and loss aversion can help you be a more informed investor.


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Principle 10: Just Do It! With a time horizon of 10 years or more, it makes sense to invest in common stocks. Consider your goals and stick to them. Take advantage of tax-advantaged accounts to make your money work for you. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Bring several copies of recent newspapers that report composite transactions of stock trades to class. Have students identify two or three familiar companies. Ask the students to list the following data for each company and explain the company’s stock price trend: • Company’s ticker symbol • Week’s high and low price • Volume of shares traded • Dividend • P/E ratio • Dividend yield • High, low, and close price • Stock price net change

2.

Visit http://finance.yahoo.com, www.morningstar.com, or a similar Web site. Use these sources to obtain the book value, earnings per share, dividend yield, price-to-book ratio, and P/E ratio on six to eight companies of your choice. Based on knowledge of these companies and the information obtained, categorize each stock using the six general common stock classifications.

3.

Ask students why stock indexes like the Dow Jones Industrial Average (DJIA) and the S&P 500 are reported so widely, and why other indexes such as the Russell 2000 and the Wilshire 5000 are not as widely reported. In terms of being a better measure of the market as a whole, ask students which index they should follow and why?

4.

Ask each student to choose one stock that is traded actively on one of the major exchanges and reported in the newspaper. Request that each student track the closing price of his or her chosen stock for each day over a 2-week period. Also, have each student track the closing price of either the DJIA or the S&P 500 for the same 2-week period. At the end of the 2 weeks, ask the students to report if their stock increased, decreased, or stayed the same in value over the time period, and whether the market performed better, worse, or about the same. Advanced students should be requested to plot the daily price changes in their stock price and the index, compute rates of return, and compare the stock’s return to the index.

5.

Using the Web site www.dogsofthedow.com/thedow.htm, have students look at the list of companies that have been added to and subtracted from the DJIA since 1929 using the



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“Dow Deletion Table.” Students should use this and the list of the firms that currently make up the DJIA to answer the following questions: a. Identify the companies by name that have been added or subtracted more than once. Why might this have happened? b. Identify the types of companies (by sector or industry) that have been added since 1991. What sectors seems to have been the most popular to add and to delete? c. Identify the highest three and lowest three dividend yielding companies. If these are all supposed to be blue-chip stocks, what might be the explanation for why the dividend yields are so different? 6.

Have students review the Web sites of the major stock markets in the United States and abroad (e.g., www.nyse.com, www.nasdaq.com, www.cboe.com, www.londonstock exchange.com). Request that each site be reviewed in terms of how easily information can be obtained, how quickly market and individual stock returns are posted, and how beneficial the site is for individual investors in general. Ask students to briefly describe their favorite site to the class. If time and resources allow, show some of the recommended sites in class.

7.

Ask students to search the Internet to find the latest estimate of inflation and the approximate interest rate offered by savings institutions in your area. Then ask these students to make a hypothetical common stock investment to be held for at least three years with the assumption that students need to use all of their current savings to make the stock purchase. Ask the students to determine the minimum rate of return they would require to make such an investment, given the current inflation rate, estimates of future inflation, and current savings interest rates. Does a general rate-of-return consensus emerge? What does this tell students about the impact of expectations and compensation for delaying current consumption on required rates of return?

8.

In groups, review the general classifications of common stock. Based on your personal comfort level (risk tolerance), which type of stock would most interest you? Why? Be sure to consider current economic conditions, current media coverage, and the current financial market outlook in your response.


Explain how stocks generate returns. Is one form of return preferable over the other? Be sure to consider both liquidity and taxation in your answer. Returns from common stocks are generated by the receipt of dividends and the realization of capital gains from price appreciation. Currently, income from capital appreciation is preferred for two reasons. First, the investor can choose the timing of the tax consequences by timing the realization of the gain. This is possible because capital gains are only taxed


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when realized. Second, realized capital gains are taxed at a lower rate—currently 5 percent or 15 percent. Dividend income, on the other hand, is taxed at normal income tax rates. The exception to this is that some dividends, termed “qualified,” are also taxed at the capital gains rates. The primary benefit of dividends is that they provide a nearly continuous stream of income. Although some investors choose to reinvest their dividends in more shares of stock, many other choose to receive their dividends as cash, making the income stream very liquid. The bottom-line is that an investor’s preference of one form of return over the other is dependent on their reason for ownership. 2.

List and describe four reasons why someone should consider investing in stocks. • • • •

3.

List the six questions an investor should ask periodically to check the progress of stock investments. 1. 2. 3. 4. 5. 6.

4.

Over time, common stocks outperform all other investments. Stocks reduce risk through diversification. Holding several types of stocks from different industries can greatly reduce risk. Stocks are liquid. Because the secondary markets for common stock are extremely well developed, when you want to sell your stock, you will be able to sell with minimum transaction costs. The growth in stock values is determined by more than just interest rates. The greatest impact on the value of common stocks does not come from changes in interest rates, but from changes in the earning prospects and performance of the firm.

Does the return on the investment meet my expectations and goals? How is the company doing in comparison to others in the same industry? How much money will I get back if I sell my investment today? How much am I paying in commissions or fees? Have my goals changed, and are my goals suitable for today? What criteria will I use to decide when to sell?

What is meant by the term “limited liability,” and why is this concept important to common stock investors? Limited liability refers to the fact that as a common shareholder, you are considered an actual owner of a corporation, but your liability in the case of bankruptcy is limited to the amount of your investment. This is important because it means that the most you can lose, if the company goes bankrupt, is what you have invested.

5.

In terms of a common shareholder’s claim on assets, when should a stockholder receive payment if a company declares bankruptcy? In case of bankruptcy, creditors (i.e., bondholders) have the right to sell off the remaining company assets to regain their money. Only after all claims of the creditors have been paid



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do stockholders get any sort of payout. Usually, when a company declares bankruptcy, common shareholders receive nothing. 6.

Besides having a claim on income, what is the most important right of common stockholders? Why is this right important? The most important right of common stockholders is voting right. It is important because this gives the right to vote on vital matters of the company, including voting for the Board of Directors.

7.

What is a stock split? Why might a stock split occur? A stock split involves substituting more shares for existing shares of stock. The number of shares of stock outstanding increases, but the value of each share drops proportionately. Firms split stock when they feel that their firm’s stock price is getting too high for smaller investors to purchase. Splitting a stock makes shares in the firm more accessible to average investors.

8.

What is the book value of a stock? How is it calculated? What is its relationship to the concept of personal net worth? In accounting, everybody learns that assets minus liabilities equals owner’s (shareholder’s) equity. The book value of a company is the exact same relationship—the value of the company’s assets less the value of the liabilities. In essence, shareholders own what is “left over” after the liabilities have been paid-off by the assets. In personal finance terms, this concept is know as net worth.

9.

Two of the most commonly cited stock market indexes are the Dow and the S&P 500. Which of these two indexes better represents movements in the overall market? Why? Because of its broad nature, the S&P 500 better represents movements in the overall market. It is comprised of the 500 largest (by market capitalization) publicly traded companies where the DJIA 30 is made up of only 30 companies.

10. What is the difference between a bear market and a bull market? How can you easily remember the relevant stock price trends when you hear these terms? A bear market is one characterized by falling prices. A bull market is one characterized by rising prices. You can remember these symbols by visualizing a bear swiping downward when attacking and a bull flinging its horns upwards when attacking. 11. Describe the following stock classifications: (a) blue-chip stock, (b) growth stock, (c) income stock, (d) speculative stock, (e) cyclical stock, and (f) defensive stock. Identify one publicly traded company as an example of each.


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• Blue-chip stocks: issued by large, nationally known companies with sound financial histories of solid dividend and growth records. A blue-chip stock example is Proctor and Gamble (PG). • Growth stocks: issued by companies that have exhibited sales and earnings growth well above their industry average. In general, these companies pay very low or no dividends, instead retaining earnings and plowing those funds back into the company. Microsoft (MSFT) is an example. • Income stocks: associated with more mature firms paying relatively high dividends with little potential for increasing earnings. Most utilities, like Duke Energy (DUK), are considered income stocks. • Speculative stocks: carry high risks and potentially very high returns. Because of their speculative nature, it is difficult to forecast earnings with precision. First Solar (FSLR) is considered a speculative stock. • Cyclical stocks: issued by firms whose earnings tend to move directly with the economy. Union Pacific (UNP) and Nucor (NUE) are examples of a railroad and a steel manufacturer whose earnings are tied most directly to the health of the general economy. • Defensive stocks: stocks whose earnings tend not to be affected by changes in the economy and in some cases actually do better during economic downturns. Examples of defensive stocks include Kellogg’s (K) and Colgate-Palmolive (CL). 12. How are large-cap, mid-cap, and small-cap companies defined? Which of these types tend to produce the highest average return? Large-cap, mid-cap, and small-cap refer to the size of the firm issuing the stock. A large-cap firm is defined as one with a stock market value of more than $5 billion. Small-cap firms are ones with stocks valued at less than $1 billion. Mid-cap firms are those in between. Smallcaps tend to outperform the other categories of firms. 13. Describe the basic differences between technical analysis and fundamental analysis. List examples of different tools a technical analyst and a fundamental analyst might use when valuing an investment. Technical analysis is a method of valuing stocks using charts and computer programs that attempt to predict future supply and demand of a stock or the market as a whole. Technicians typically rely on charts, graphs, mathematical calculations, and trading patterns to predict stock prices. Fundamental analysis relies on the determination of a company’s future sales, earnings, dividends, and market expectations for interest rates and other economic events as a method of valuing stocks. Fundamental analysts typically rely on tools such as the P/E ratio and P/B ratio. 14. What three factors influence the value of common stock? Briefly describe each.



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1. Interest rates—stock values move inversely to interest rates because as required return increases, then the present values (prices) of stocks fall. 2. Risk—as the perceived risk of an investment in stocks increases, then investors are less willing to purchase stocks, thus pushing down prices. 3. Earnings—as earnings increase, then investors are more willing to purchase the stock because a stock represents a claim on income; therefore, as earnings increase, then so should the stock price. 15. In terms of the risk–return trade-off (Principle 8), why is there an inverse relationship between interest rates and the value of a share of common stock? As investors’ required rate of return increases, the present value of future dividends decreases. On the other hand, when interest rates fall, investors will demand a lower rate of return on their common stock holdings, thus pushing common stock prices higher. 16. What are seven investment strategies of which to be wary? 1. 2. 3. 4. 5. 6. 7.

Recommendations based on “insider information” Telephone sales pitches Promises that seem too good to be true Guarantees of zero loss Excessive transactions Recommendations to make drastic changes to your investment strategy Pressure to trade in ways that are inconsistent with your goals and risk tolerance

17. What four advantages does dollar cost averaging offer over a buy-and-hold strategy? When is a buy-and-hold approach a better investment strategy? Dollar cost averaging involves purchasing a fixed dollar amount of stock at specified intervals (e.g., quarterly, monthly, or weekly). In effect, dollar cost averaging allows an investor to buy more shares when prices drop and fewer shares when prices increase, thus creating a lower overall average price. The three other merits of DCA include (1) a reduced likelihood of purchases all shares right before a crash, (2) a reduced investor desire to time the market, and (3) it encourages good investing discipline. A buy-and-hold strategy involves buying stock and holding it for years, thus it is very easy to implement. A buy-and-hold strategy may work better than dollar cost averaging when an investor has a strategy of reducing brokerage fees and transaction costs while postponing capital gains taxes. 18. Summarize the advantages and disadvantages of DRIPs. A dividend reinvestment plan (DRIP) allows an investor to automatically reinvest a dividend distribution into additional shares of a company's stock. This is an outstanding way to accumulate wealth because such a plan allows the power of compounding to take effect as a method of accumulating wealth. Further, DRIPs are really a disguised method of dollar


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cost averaging that allow more shares to be purchased when prices are low and fewer shares purchased when prices are high. Disadvantages of DRIPs include paying taxes on dividends that are not received in cash and not having direct control over the timing of the investment. 19. Explain two ways an investor can reduce risk when purchasing stocks. Diversifying a portfolio and having a long time horizon are the two best methods for reducing risk when purchasing stock. First, diversification reduces unsystematic (firmspecific) risk. As a stock portfolio increases in size to 10 or 20 stocks in different industries, approximately 60 percent of the total risk is eliminated (see Chapter 11, Figure 11.2). Second, longer investment periods reduce systematic risk. As investment horizons increase to 10 or 20 years or longer, the variability of average annual returns is reduced (see Figure 12.6). 20. What does beta measure? How can this measurement help you assemble an appropriate portfolio? Beta is a comparative measure of volatility. Beta is a ratio that compares the price fluctuation of a single security versus the value fluctuation of a market index (e.g., Altria Group, Inc. (MO) versus the S&P 500). Ratios of less than or more than 1.0 show volatility less than or greater than the market, respectively, whereas a ratio of 1.0 means that the price of the security should not fluctuate more or less than the overall market. When constructing a portfolio, it is important to understand the amount of anticipated volatility. By selecting securities with betas less than 1.0, you should understand that the value of the portfolio would appreciate and depreciate slower than the market; and by selecting securities with betas more than 1.0, you should understand that the value of the portfolio would appreciate and depreciate quicker than the market. If you wish to select a portfolio with average volatility, it is important to select securities with betas near 1.0. PROBLEMs AND ACTIVITIES ANSWERS 1.

a. b. c. d.

Prior to the split, your shares of GD were worth $180,000 ($90.00 × 200). After a three-for-one stock split, you will own 600 shares (200 × 3). The price per share after the split would be $30.00 ($90.00 / 3). Because you own three times as many shares, but at one-third value, your total value would not change, or $180,000 = ($30.00 × 600).

2.

a.

Book value of $6.00 per share Book Value =

( Assets − Liabilities ) Common Shares Outstanding

=

( $12,500, 000 − $6,500, 000 ) = $6.00


1, 000, 000


b.

Earnings per share (EPS) of $1.20 EPS =

c.

( Net Income − Preferred Stock Dividends ) = ( $1, 600, 000 − $400, 000 ) = $1.20 Common Shares Outstanding

AnnualDividends per Share ( $250, 000 1, 000, 000 ) $0.25 = = = 0.56% Market Price per Share $45.00 $45.00

Haley is trading at 7.5 times book value, which is very high.

P/B Ratio = 3.

1, 000, 000

Dividend yield 0.56 percent (a small dividend yield) Div.Yld =

d.

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( $45 ×1, 000, 000 ) Market Value $45, 000, 000 = = = 7.5 Book Value ( $12,500, 000 − $6,500, 000 ) $6, 000, 000

The Smell Fresh Kitty Litter Company has a book value of $6 million. Therefore, that is the maximum amount that shareholders could receive. This would result in each shareholder collecting $3.00 per share of stock owned.

Book Value = Total assets − Total liabilities = $10, 000, 000 − $4, 000, 000 = $6, 000, 000 Book Value per Share = 4.

Book Value $6, 000, 000 = = $3.00 per share TotalShares Outstanding 2, 000, 000

The following formulas were employed to answer the question. Book value / share = (Assets – Liabilities) / Shares outstanding P/B ratio = Stock price / Book value per share Earnings / share (EPS) = Earnings / Shares outstanding P/E ratio = Stock price / Earnings per share Note: answers that change from one scenario to the next are in bold type.

a.

Book value / share = $5.5m / 500,000 = $11.00 P/B ratio = $33.00 / $11.0 = 3.0 EPS = $1.5m / 500,000 = $3.00 P/E ratio = $33.00 / $3.00 = 11.0

b.

Book value / share = $5.50m / 500,000 = $11.00 P/B ratio = $33.00 / $11.0 = 3.0 EPS = $1.0m / 500,000 = $2.00 (decrease from original value) P/E ratio = $33.00 / $2.00 = 16.5 (increase from original value)


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5.

6.


c.

Book value / share = $4.50m / 500,000 = $9.00 (decrease from original value) P/B ratio = $33.00 / $9.0 = 3.67 (increase from original value) EPS = $1.5m / 500,000 = $3.00 P/E ratio = $33.00 / $3.00 = 11.0

d.

Book value / share = $5.50m / 1,500,000 = $3.67 (decrease from original value) P/B ratio = $11.00 / $3.67 = 3.0 EPS = $1.5m / 1,500,000 = $1.00 (decrease from original value) P/E ratio = $11.00 / $1.00 = 11.0

e.

Additional liability = (500,000 x 0.20) × 33.00 = $3,300,000 Book value / share = $2.2m / 400,000 = $5.50 (decrease from original value) P/B ratio = $33.00 / $5.5 = 6.0 (increase from original value) EPS = $1.5m / 400,000 = $3.75 (increase from original value) P/E ratio = $33.00 / $3.75 = 8.8 (decrease from original value)

a.

Stock X is a mid-cap stock because its market capitalization is $7 billion. Stock Y is a large-cap stock because its market capitalization is $62 billion. Stock Z is a small-cap stock because its market capitalization is $800 million.

b.

Stock Y is the best candidate to be classified as a growth stock based on its relatively high P/E ratio and because it currently does not pay a dividend, which implies that earnings are reinvested in the firm.

c.

An aggressive investor would find Stock Y appealing because of the growth potential.

d.

Stock X is appropriate for someone looking for safety and earnings. This stock pays a dividend and sells at a modest price-to-earnings ratio. The modest P/E ratio suggests that the stock price should not fall due to excessive valuation. Stock Z is typical of a cyclical stock, and in the right economic environment may also be appropriate.

Given that beta is a measure of stock price volatility, the formula to measure this fluctuation using beta is Stock price change = Market change × Stock beta. a.

Savoy Corp. Hokie Industry Graham Records Expo Enterprises

= 15% × 0.70 = 10.50% = 15% × 1.35 = 20.25% = 15% × 2.05 = 30.75% = 15% × 0.45 = 6.75%

b.

Expo Enterprises should decrease by only 4.50 percent, given a 10 percent market decline, because it has a lower beta than the other stocks. The low beta means that the price swings (both up and down) of the stock should be less than the market.



7.

a.

The current dividend yield of Boeing is 2.20 percent. Dividend Yld =

b.

8.

Annual Dividend $1.68 = = 2.20% Current Price per Share $76.28

The estimated earnings per share (EPS) for Boeing is $4.54. EPS =

c.

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Price = 76.28 = $4.54 P/E Ratio 16.82

Previous closing price equals current closing price minus net daily change $76.28 – (–$0.11) = $76.28 + $0.11 = $76.39

Responses may vary. Sample items include the following: Strengths (internal to company): Leona has lots of experience in tailoring. She has an established clientele list already. Weaknesses (internal to company): Collecting money for Leona’s services will result in self-employment taxes. Opportunities (external to company): In weak economic times, individuals may choose to tailor existing clothes versus purchasing a new wardrobe. Being in a college town provides a continuous turnover of potential clients in an ideal age demographic. Threats (external to company): There may be other tailoring businesses in the area, which will limit Leona’s potential clientele

9.

Based off of this SWOT analysis, it appears that Leona would benefit business. Money Shares Total Shares Quarter Price Invested Purchased Owned 1 $30.00 $200 6.67 6.67 2 $50.00 $200 4.00 10.67 3 $60.00 $200 3.33 14.00 4 $35.00 + $200 + 5.71 19.71 FINAL $43.75 (AVG.) $800 19.71 19.71


from opening her Market Value $200.00 $533.50 $840.00 $689.85 $689.85

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10. Using the information obtained in question 9 shows that the investor would have earned an additional $243.60 ($933.45 – $689.85) by investing $800 at the beginning of the year. This purchase would have resulted in the purchase of 26.67 ($800 / $30) shares with a final market value of $933.45 (26.67 × $35.00), rather than only 19.71 shares with a value of $689.85. DISCUSSION CASE 1 ANSWERS 1.

Given Shannel’s goal to open an antique shop and the potentially long time horizon, she could invest in common stocks. However, because Shannel is very risk cautious, she should stick to high-quality, blue-chip stocks that provide solid dividend and growth records. In certain economic times, defensive stocks may also be appropriate.

2.

She should avoid cyclical stocks because these stocks tend to move with the economy. If the economy were to slump, these stocks could lose substantial value. Shannel should consider investing in defensive stocks. This category of stocks tends not to be hurt as badly as other during downturns in the economy.

3.

Over the period from 1926 through 2004, small capitalization stocks outperformed large cap stocks. Although small companies have historically done well, they also have higher volatility than larger cap stocks. Shannel should only consider investing in small capitalization stocks if she is comfortable with the increased possibility of incurring losses.

4.

Dollar cost averaging would be an ideal investment strategy for Shannel. This is a disciplined method for moving money into stocks. Dollar cost averaging reduces the risks of losing money because, if stock prices fall, each periodic investment allows more shares to be purchased. Further, because stocks tend to increase over time, Shannel can use this strategy to accumulate assets for the purchase of her own antique shop.

5.

An automatic investment plan would allow Shannel to put her investment plan on autopilot. With these plans, money is automatically transferred from her bank account into purchasing common stocks. These plans have two advantages. First, they would force Shannel to maintain a disciplined investment strategy, and second, she would be sure to invest in a falling market when bargains are available.

6.

Four reasons Shannel should consider using a buy-and-hold strategy include the following: • She will not have to worry about trying to “time” the market. • This strategy minimizes brokerage fees and other transaction costs. • She can postpone tax liabilities on unrealized capital gains with this strategy. • This strategy is simple to use.

7.

A dividend reinvestment plan allows dividends received to be invested in additional shares of a firm’s stock. In effect, a DRIP is a form of dollar cost averaging. Without reinvestment of dividends, Shannel’s accumulation of long-term wealth for retirement would be limited to her stock's capital gains. Therefore, she should participate in DRIPs.



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After the two-for-one split, they will own 1,000 (500 × 2) shares. But the shares will still be valued at $40,000 because the price per share should drop by roughly one half (50 percent). The market value will also remain the same before and after the stock split. In fact, their neighbor was incorrect in thinking that a stock split will automatically increase the value of the stock.

2.

The stock’s P/E ratio is 80 ($80.00 / $1.00). By all measures (both dividend payout and P/E ratio), this is a growth stock.

3.

The long-term value of any stock is most closely aligned with a firm’s earnings. The faster a firm can compound earnings, the greater the long-term value of the firm’s stock. This is partially true because analysts use earnings as proxy for a company’s ability to pay dividends in the future. Thus, Pete should pay close attention to the earnings outlook for the stock.

4.

The S&P 500 index is not an inappropriate benchmark for Pete and Jessica because the make-up of the index does not represent the type of company they own. They should consider tracking the performance of their stock to an index comprised of other Internet companies (e.g., NASDAQ index).

5.

They should definitely not invest with this or any other broker who makes cold calls promising unlimited returns or guarantees against losses for an investment.

6.

Student answers may vary but may include information available from Chapters 11 and 12. Before making any stock investment, Pete and Jessica need to look out for the following: • They need to understand the types and potential impacts of the various risks to which they would be exposed. • They should employ an appropriate investment strategy and asset allocation model that meets their rick tolerance. • They should be aware of the psychological impacts on investment decisions. • They need to be aware of misrepresentation, telephone sales pitches, or recommendations based on “inside information” or other tips. • If they use a broker to facilitate the transaction, they should be aware of excessive transactions undertaken by a broker “churning.” • If they use an online account, they need to be prepared for losses and be wary of claims of easy profit or “hot tips.” • They should understand the concept of beta and how the beta of a stock tells how much and in what direction an individual stock price has moved relative to the market. High beta stocks have much more volatile prices swings than low beta stocks. • They should be aware of the advantages of diversification. As the old adage goes, “don’t put all your eggs in one basket.”


CHAPTER 13 INVESTING IN BONDS AND OTHER ALTERNATIVES CHAPTER CONTEXT: THE BIG PICTURE This chapter, the third in the section titled “Part 4: Managing Your Investments,” extends the concept that knowledge of financial products is a key element in becoming a successful investor. This chapter introduces the basic concepts and logic of bond, preferred stock, real estate, and speculative investments. The chapter revisits concepts introduced earlier, such as the time value of money, and discusses the role of taxes, such as the calculation of tax equivalent yields for municipal bonds. Important student messages fundamental to this chapter include (1) the importance of understanding how fixed-income investments, including preferred stocks and different forms of real estate investments, fit into a financial plan, and (2) why students should typically avoid investments in gold, silver, gems, and other collectibles. CHAPTER SUMMARY This chapter considers the value of fixed-income securities within an investment plan. The chapter explains that investors should consider investing in bonds for the following reasons: (1) bonds reduce risk through diversification, (2) bonds produce current income, and (3) if held until maturity, bonds can be a relatively safe investment. Corporate, U.S. government, agency, municipal, zero-coupon, and junk bond characteristics and features are reviewed. The risk–return trade-off of fixed income investing is considered. The tax advantages of municipal bonds are described, and the inverse relationship between interest rates and bond values is presented. Preferred stock and real estate investments, both direct and indirect, are introduced as alternatives to bond investing. The chapter concludes with a discussion of the risks involved in speculating in collectibles (e.g., gold, silver, baseball cards, and comic books). LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated terms: 1.

Invest in the bond market.

2.

Understand basic bond terminology and compare the various types of bonds. a. Par value b. Maturity c. Coupon interest rate d. Indenture e. Call provision f. Deferred call g. Sinking fund 265


266


h. i. j. k. l. m. n. o. p. q. r. s. t.

Corporate bonds Secured bonds Mortgage bonds Debenture Agency bonds Pass-through certificates Treasury inflation protected securities (TIPS) Municipal bonds or “munis” General obligation bonds Revenue bonds Serial maturities Zero-coupon bonds Junk bonds

3.

Calculate the value of a bond and understand the factors that cause bond values to change. a. Current yield b. Yield to maturity c. Accrued interest d. Invoice price

4.

Compare preferred stock to bonds as an investment option. a. Preferred stock b. Cumulative feature c. Adjustable-rate preferred stock d. Convertible preferred stock

5.

Understand the risks associated with investing in real estate.

6.

Know why you shouldn’t invest in gold, silver, gems, or collectibles.

CHAPTER OUTLINE I.

Why Consider Bonds?

II.

Basic Bond Terminology and Features A. Par Value B. Coupon Interest Rate C. Indenture D. Call Provision E. Sinking Fund F. Types of Bonds G. Corporate Bonds 1. Secured corporate debt 2. Unsecured corporate debt H. Treasury and Agency Bonds


Chapter 13: Investing in Bonds and Other Alternatives

I. J.

1. Pass-through certificates 2. Treasury inflation-indexed bonds (TIPS) 3. U.S. Series EE bonds 4. I bonds Municipal Bonds Special Situation Bonds 1. Zero coupon bonds 2. Junk bonds

III.

Evaluating Bonds A. Bond Ratings—A Measure of Riskiness B. Bond Yield 1. Current yield 2. Yield to maturity 3. Equivalent taxable yield on municipal bonds C. Valuation Principles D. Bond Valuation E. Why Bonds Fluctuate in Value F. What Bond Valuation Relationships Mean to the Investor G. Reading Online Corporate Bond Quotes

IV.

Preferred Stock—An Alternative to Bonds A. Features and Characteristics of Preferred Stock 1. Multiple issues 2. Cumulative feature 3. Adjustable rate 4. Convertibility 5. Callability B. Valuation of Preferred Stock C. Risks Associated with Preferred Stock

V.

Investing in Real Estate A. Direct Investments in Real Estate B. Indirect Investments in Real Estate C. Investing in Real Estate: The Bottom Line

VI.

Investing—Speculating—in Gold, Silver, Gems, and Collectibles

VII.

Behavioral insights A. Principle 9: Mind Games, Your Financial Personality, and Your Money

VIII.



267

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APPLICABLE PRINCIPLES Principle 8: Risk and Return Go Hand in Hand Bond rating agencies like Moody’s and Standard and Poor’s provide ratings on thousands of corporate, city, and state bonds. Investors rely on these ratings as a measure of default risk. The lower the bond rating, the higher the rate of return demanded by investors. Principle 3: The Time Value of Money The value of a bond is simply the present value of all the returns that investors receive from a bond. In effect, future interest and principal payments are valued in current dollars and then added together to arrive at the value of a bond. Investors use a discount rate, determined through the use of Principle 1, to convert returns back to the present. Principle 9: Mind Games, Your Financial Personality, and Your Money Diversification in stocks and bonds is needed to achieve an optimal portfolio. That does not mean that the money should be treated differently, though. All money is fungible (spends the same), so be cautious not be overinvest in one asset to accomplish certain investment goals. Principle 10: Just Do It! Set your investment goals and decide how bonds fit into a balanced portfolio based on your risk tolerance and capacity. Mutual funds (discussed in the next chapter) are one way to achieve a portfolio of common stock and bonds. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Ask a group of students to contact local banks, savings and loans, or credit unions or to use the Internet (www.publicdebt.treas.gov) to obtain information about purchasing EE savings bonds. Ask other students to contact local brokerage firms to inquire about purchasing requirements for Treasury securities, corporate bonds, and municipal bonds. Finally, ask another group of students to contact the nearest Federal Reserve branch to inquire about purchasing Treasury securities directly. Ask students to share the findings of their inquiries in class. Use the following questions to prompt a class discussion: • Which bond was the least expensive to purchase? • Which was the most expensive to purchase? • How much did prices for similar bonds vary among the brokerage firms? • What do these results tell students about sales commissions associated with the purchase of bonds?

2.

Present the Wall Street Journal’s online bond information found at http://online.wsj.com/mdc/public/page/mdc_bonds.html, Yahoo!’s finance portal at finance.yahoo.com, or a similar cite. Ask students to choose a large issuer of bonds, such as ©2016 Pearson Education, Inc.


269

AT&T, General Motors, or a local utility firm. Using the tables in the Wall Street Journal, request that students identify a bond, its coupon interest rate, its maturity date, its current yield, the volume traded, the bond’s closing price, and the bond’s net change in price. Ask students to explain (a) how these tables provide information about a firm’s implied credit rating (i.e., bonds with the same maturity and interest rate should sell at the same price, unless one firm is perceived as being a better or worse credit risk), (b) the general trend in interest rates, and (c) the relationship between maturity and yield. 3. Connect to the Federal Reserve’s Web site (www.federalreserve.gov) and locate information about the government’s Treasury Direct program. Pay particular attention to the procedures for buying and selling inflation-indexed bonds. Write a brief report explaining how often inflation-indexed bonds are sold and what the minimum investment is for individuals. In your report, discuss the advantages and disadvantages of using Treasury Direct rather than a brokerage firm. 4. Think about the advantages offered by municipal bonds. In terms of marginal tax rates, what type of investor should consider investing in municipal bonds? Is there an advantage to purchasing municipal bonds issued by the state in which you live? If yes, what is that advantage? 5. Have students take a poll of friends, family, and work colleagues by asking them the following three questions: a. Do you think that real estate is a safer investment than bonds? b. Do you think of your house as an investment? c. Do you think of your jewelry as an investment? Students should prepare a brief summary of their findings, paying close attention to gender and age differences in the way people respond. 6.

Ask students to share their personal insights into the workings of the collectibles markets. Solicit information from students about what types of items they currently collect, and if they collect for fun or potential profit. Ask students what items they currently own that might be collectible in the future, and whether, after reading this chapter, they feel that they should “invest” in collectibles.


What are three reasons why investors should consider adding bonds to their portfolios?


270


Investors should consider adding bonds to their portfolios for the following three reasons: • Bonds reduce risk through diversification because bonds do not move together with other investments over time. • Bonds produce steady income, which is an advantage for those needing some income from a portfolio to achieve their financial goals. • Bonds can be a safe investment if held to maturity. Interest on bonds must be paid, or lenders (creditors) can force a firm into bankruptcy. If a bond is held until maturity, the effects of interest rate changes will have no impact on the bond’s final par value. 2. Why are bonds generally considered to be relatively safe investments compared to stocks? Unlike stock dividends, interest on bonds must be paid, or a firm can be forced into bankruptcy. Bonds are also unique because they almost always have a stated maturity date, at which time an investor knows exactly what the return on the bond will be; thus, if held to maturity, bonds can be a safe investment. Combined, these two bond characteristics make bonds relatively safe. 3.

What is an indenture, and why is it an important document for bond investors? An indenture is the legal document that provides the specific terms of the loan agreement, including the following: • A description of the bond • The rights of the bondholders • The rights of the issuing firm • The responsibilities of the bond trustees This is an important document for investors to read and understand because it is primarily devoted to defining protective provisions for the bondholder.

4.

Why do firms issue bonds with call provisions? During what type of interest rate environment would you expect an issuer to exercise a call? How do firms make callable bonds more attractive to investors? Firms issue bonds with call provisions to allow the firm to replace high interest bonds with lower-cost debt in the event that interest rates decrease during the lifespan of the bond. Bonds are normally called during periods of declining or low interest rates. This is why most bond investors would prefer a bond without a call provision because these provisions do not provide a guaranteed level of interest— at least not guaranteed for the entire period. Investors are rewarded for purchasing callable bonds by (1) receiving a slightly higher rate of interest and (2) a final payment, if called, that is at least equal to if not higher than the par value.



271

5. What is a sinking fund, and why is it an advantage to investors? A sinking fund is money that is set aside on a regular basis to pay off bonds. If an issuer wishes to recall a bond, they must pay for the bond that was called either through a subsequent bond issue or from a sinking fund. This fund is an advantage to the investor because the existence of the fund increases the probability that the issuer will be able to successfully repay the bond at call or maturity. 6.

What is meant by the term “subordination” when dealing with corporate debt? Subordination refers to the order by which unsecured bond holders get paid back if the firm goes bankrupt. “Subordinated” debt is repaid only after the claims of secured bondholders and unsubordinated debentures have been satisfied.

7.

Why is U.S. Treasury debt considered risk free? Describe the possibility of default risk associated with Treasury debt. Treasury securities (i.e., government bonds) are considered risk free because of the government's ability to tax and to print money. There is little or no default risk associated with Treasury securities.

8. Compare Treasury bills, notes, and bonds in terms of maturity and yield. Treasury bills have maturity dates of 3, 6, and 12 months. Treasury notes have maturities of 2, 3, 5, and 10 years. Treasury bonds have maturities of more than 10 years. In keeping with the risk–reward trade-off, issues with longer maturities typically have higher yields; therefore, Treasury bills typically offer the lowest yield and bonds the highest yield. Notes typically offer a yield between that of a bill and a bond. 9.

What is a pass-through certificate, and how is a pass-through both similar to and different from a Treasury security? Give an example of an agency that issues pass-throughs. A pass-through certificate is a type of agency bond issued by government agencies other than the Treasury. These securities are similar to Treasury securities because they are considered virtually risk free; however, these securities typically carry a higher interest rate than Treasury securities. Also, a pass-through certificate pays both principal and interest over the life of the security rather than making a principal payment as the last payment. The most well-known issuer of pass-through certificates is the Government National Mortgage Association (GNMA), commonly known as “Ginnie Mae.”

10. Describe a Treasury inflation-indexed bond. Who should consider these bonds for an investment portfolio? A Treasury inflation-indexed bond is a security that pays an interest rate that varies based on the level of inflation in the economy. The interest rate paid is frequently less than 1 percent above the rate of inflation. Risk-averse investors should consider using these securities


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because inflation risk is minimized. As such, Treasury inflation-indexed bonds may provide a unique way to diversify a stock portfolio. 11. What advantages do I bonds offer investors? At purchase, how do I bonds differ from EE bonds? I bonds, which have a 30-year maturity, are sold at face value, are very liquid, and grow with inflation. I bonds are advantageous because inflation risk is minimized and federal taxes on interest can be deferred for up to 30 years. Further, interest is exempt from state and local income taxes. One major difference of I bonds is that they are issued at face value rather than one-half of face value like EE bonds. 12. What types of entities issue municipal bonds? What significant feature of municipal bonds attracts investors? Given this feature, who should consider investing in municipal bonds? Municipal bonds are bonds issued by states, counties, cities, and other nonfederal governmental agencies. Proceeds from bond sales are generally used to fund public projects. The popularity of municipal bonds stems from the fact that interest from these bonds is tax exempt by the federal government and by the state in which one lives (if the state in which one resides issued the bond). Municipal bonds are very attractive to investors in the highest marginal tax brackets. 13. What are the two types of municipal bonds, and which type has the greater default risk? Why? The two types of municipal bonds are revenue bonds and general obligation bonds. Revenue bonds carry the greater risk because they are not backed by the government’s power of taxation; rather, they are only backed by the revenue stream of the project funded by the bond issue. 14. What is a zero coupon bond? Give an example of when the use of zero coupon bonds might be appropriate in an investment portfolio. Do you think these types of bonds should be owned in taxable or tax-deferred accounts? Zero-coupon bonds are bonds that don’t pay interest directly to investors. Instead, these bonds are sold at a discount from their face value, and at maturity, they return the stated par value. These bonds appeal to investors who need a lump sum of money at some future date but don’t want to be concerned about reinvesting interest. Zero-coupon bonds are best suited for tax-deferred retirement accounts because, even though interest is not currently received, it is currently taxable. 15. What potential risks do investors face when they purchase junk bonds? How are investors compensated for these risks? What rating would you expect to see a junk bond carry? A junk bond is a low-rated bond (BB or below are considered to be junk bonds), also called a high-yield bond. Only firms that have yet to establish a record of solid performance or ©2016 Pearson Education, Inc.


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firms that are experiencing credit difficult issue junk bonds. Because of either the lack of track record or credit difficulty, there could be a higher probability of default associated with these bonds. If the company defaults, investors could lose their investment. In order to be adequately compensated for the risks, investors should demand a premium of between 3 percent and 5 percent in interest over the AAA rate. 16. Explain the difference between current yield and yield to maturity. Which is a more accurate measure of the return an investor will receive? Current yield is the ratio of annual interest payments to the current market price of the bond. Yield to maturity (YTM), on the other hand, is the “true” yield that a bondholder receives if a bond is held until maturity. YTM also considers the fact that if a bond is purchased at a discount and held to maturity, the investor will not only receive coupon payments but will also receive a capital gain. Conversely, if a bond is purchased at a premium and held to maturity, the investor will still receive coupon payments but will also realize a capital loss. Investors should focus on the yield to maturity because this yield takes into account an investor’s total rate of return, including interest and allowing for the fact that the bond may have been purchased for more or less than it returns at maturity. 17. What is the difference between the quoted price and the invoice price? When would you expect the two prices to be equal? The quoted price is what the bond is listed for in a newspaper or periodical index, whereas the invoice price is the sum of both the quoted price and the bond’s accrued interest. An investor wishing to purchase a bond in the secondary market must pay the invoice price. The two prices will only be equal immediately following a coupon payment, when the accrued interest on the bond is zero. 18. What is meant by the terms “premium” and “discount” when referring to the price of a bond? When a bond is selling for a premium to its par value, it means that the bond is selling for more than $1,000. This happens when the coupon rate on the bond is higher than the required return in the marketplace investors are willing to pay more. When a bond is selling for a discount to its par value, it means that the bond is selling for less than $1,000. This happens because when the coupon rate on the bond is lower than the required return in the marketplace investors are willing to pay less. 19. Using sound bond valuation principles, explain in terms of present value why zero coupon bonds sell at such a deep discount to the par value. With normal coupon paying fixed-income securities, the current price is equal to the present value of two amounts: (1) the income stream of coupon payments and (2) the par value that is paid at maturity. With zero-coupon bonds and other forms of pure discount issues, the price is the present value of only one amount—the par value. Given the fact that investors


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will not receive any compensation prior to maturity, this causes the yield to maturity to increase for two reasons: (1) higher risk and (2) longer duration. As yield to maturity increases, the price of the bond decreases; therefore, zero coupon issues sell for a larger discount to par value than standard coupon bonds of a given company and maturity. 20. An investor’s required rate of return is important when valuing a bond. What two factors can cause an investor’s required rate of return to change? If a firm that issues a bond loses its credit worthiness because of poor sales or decreased levels of earnings, an investor should demand a higher required rate of return from the firm’s securities. In this case, the value of a bond will decrease. A change in general interest rates will also change investors’ required rate of return. If there is an expected increase in inflation, the bond price will decrease because investors demand a higher rate of return for delaying consumption. 21. Describe the relationship between interest rates and bond values. If investors’ required rate of return decreases, what should happen to the value of bonds? Would this bond be purchased at a premium or discount? How did you make this determination? There is an inverse relationship between interest rates and bond values. When interest rates rise, bond values drop, and when interest rates decline, bond values rise. Thus, if investors’ required rate of return decreases, the value of bonds in the secondary market should increase. If the investors’ required rate of return is higher than the coupon rate of the bond, then the bond would sell at a discount to par value. This relationship is made most apparent with the relationship between current yield and coupon rate. Given that the current yield is simply the return on investment, if investors require a higher return than the coupon rate offers, then they sell the bond, which reduces the market price of the bond. With the bond now selling at a discount, the current yield is higher than the coupon rate and hopefully matches the investors required rate. 22. What features do preferred stock shares offer investors? What feature, similar to a bond, should cause investors to demand a higher dividend yield? Features to look for when examining a preferred stock include the following: • The issue of preferred stock is important to note. Some firms issue multiple preferred stocks, each with different dividends and features. • Cumulative features require that all past unpaid dividends be paid before any common stock dividends are declared. Investors should look for preferred stock with a cumulative feature. • Adjustable rates versus fixed dividend rates are also worth noting. In an economic environment of rising interest rates, an adjustable rate would be beneficial. • Conversion privileges, which allow shares to be converted into a predetermined number of shares of common stock, are important. Preferred stock with this feature tends to provide a lower dividend rate because the convertibility feature allows the preferred stockholder to participate in the company’s capital gains. ©2016 Pearson Education, Inc.


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Callability features allow most preferred stock to be called by the issuing firm and is similar to a bond call provision. This feature, if associated with a preferred stock, should cause investors to demand a higher dividend yield because it is likely such a stock will be called when interest rates fall dramatically.

23. Describe the differences between direct and indirect real estate investments. A direct real estate investment is one in which an investor has actual ownership of a property. Examples include a personal residence and vacation homes. Indirect real estate investments are properties owned by groups of investors that use a professional to manage the property. Examples include real estate syndicates and real estate investment trusts. 24. Provide five examples of speculation. What distinguishes these “investments” from stocks, bonds, and real estate? Examples of speculation include gold, silver, gems, coins, comic books, and baseball cards. The value of a speculative investment is determined by supply and demand, not by the return earned. The bottom line is invest—don’t speculate. PROBLEMs AND ACTIVITIES ANSWERS 1.

You would pay the selling price of $883.75 ($1,000 × 0.88375). At maturity, the bondholder would receive the par value of $1,000.

2.

a. b. c. d.

$1,000 × 4% × 0.5 = $20 (interest for one-half of the year – semiannual payments) $1,000 × (1 + inflation increase) $1,000 × 1.01 = $1,010 (1% increase in par value for every 1% change in inflation) $1,010 × 4% × 0.5 = $20.20 $1,280.09 Factor Table A solution PV $1,000 PMT n/a

3.

(FVIF2.5 %, 10)

1.282

FV

$1,282.00

Calculator solution PV -$1,000 PMT $0 I/Y 2.5% N 10 FV ? CPT FV $1,280.08

Because EE Bonds are issued at one-half face value, a $500 face value EE Savings bond will initially cost $250. Using the financial calculator, it will take 19.6 years to double in value. PV = -$250; FV = $500 PMT = 0; I/Y = 3.6%


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However, if the rule of 72 is used, you find that it will take approximately 20 years (72 / 3.6) to double in value. 4.

5.

a.

The current yield of the bond is 5.93%. Annual Coupon Payment $55.00 Current Yield = = = 0.0593 or 5.93% Current Market Pr ice $927.50

b.

The approximate yield to maturity for the bond is 6.54%. Yield to maturity = annual interest + ([par – current price] / years to maturity) (par + current price) / 2 = $55 + ([$1,000 – $927.50] / 9 yr) ($1,000 + $927.50) / 2 = ($55 + $8.06) / ($1,927.50 /2) = $63.06 / $963.75 = 0.0654 or 6.54%

c.

Using the financial calculator, the YTM is 6.59 percent, a difference of only 0.05 percent from the approximated equation. PV = -$927.50 FV = $1,000 PMT = $55 N = 9 YTM = ?

Jodie’s equivalent taxable yield = 3.75% / (1 – 0.15) = 4.41% Natalie’s equivalent taxable yield = (3.75% / (1 – 0.25)) = 5.00% Neil’s equivalent taxable yield = (3.75% / (1 – 0.35)) = 5.77% Each of your friends should purchase the municipal bond because the taxable equivalent yield is higher than the 4 percent available on the similarly rated corporate bond, although Neil would receive the most benefit of the choice because he is in the highest tax bracket.

6.

Invoice Price = $1,035 + (4/6 × $32.50) or $1,056.67, based on a quoted price of $1,035 and semiannual interest payments of $32.50.

7.

a. b. c. d.

8.

A bond listed with an April 2041 date will mature on that date. Given an ask price of 95.625, you would pay $956.25 ($1,000 × 0.95625), not counting accrued interest. In order to answer this question, the investor would need to know the time since the last coupon payment or invoice price of the bond. Because this information is missing, the question cannot be solved. The current yield of the XYZ bond is 5.76 percent. Current yield = annual interest payments / market price = $55.00 / $955.00 = 0.0576 or 5.76%

For Bond A With seven years remaining: FV = $1,000 PMT = $100; I/Y = 8% N = 7; PV = $1,104.13



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With five years remaining: FV = $1,000 PMT = $100; I/Y = 8% N = 5; PV = $1,079.85 With two years remaining: FV = $1,000 PMT = $100; I/Y = 8% N = 2; PV = $1,035.67 For Bond B With seven years remaining: FV = $1,000 PMT = $60; I/Y = 8% N = 7; PV = $895.87 With five years remaining: FV = $1,000 PMT = $60; I/Y = 8% N = 5; PV = $920.15 With two years remaining: FV = $1,000 PMT = $60; I/Y = 8% N = 2; PV = $964.33 9.

The bond values are shown below. Note that the discount factors are based on the required rate, not the coupon rate. a. Coupon payment Par value PV ? PV ? PMT -$50 PMT $0 I/Y 5% I/Y 5% N 10 N 10 FV $0 FV -$1,000 CPT PV $386.09 CPT PV $613.91 Bond Value = coupon + par = $386.09 + $613.91 = $1,000.00 = exactly par value because the required rate of return matches the coupon rate of the bond. b. Coupon payment PV PMT I/Y N FV CPT PV

? -$50 9% 10 $0 $320.88

PV PMT I/Y N FV CPT PV

Par value ? $0 9% 10 -$1,000 $422.41

Bond Value = coupon + par = $320.88 + $422.41 = $743.29 = selling at a discount because the required rate of return is greater than the coupon rate of the bond.


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c. Coupon payment PV PMT I/Y N FV CPT PV

? -$50 4% 10 $0 $405.54

PV PMT I/Y N FV CPT PV

Par value ? $0 4% 10 -$1,000 $675.56

Bond Value = coupon + par = $405.55 + $675.56 = $1,081.10 = selling at a premium because the required rate of return is less than the coupon rate of the bond. 10. Because preferred stock is issued in perpetuity, the present value “Price” is determined using the formula on page 453: a. value of preferred stock = $41.18 ($3.50 dividend / 8.5% required rate of return) b. value of preferred stock = $58.33 ($3.50 dividend / 6% required rate of return) Notice that the value increases as the required rate decreases. c. value of preferred stock = $30.43 ($3.50 dividend / 11.5% required rate of return) Notice that the value decreases as the required rate increases. DISCUSSION CASE 1 ANSWERS 1.

Advantages associated with bonds include the following: • Making money if interest rates decrease • Reducing risk through diversification • Providing current and steady income • Offering relative safety if held until maturity Disadvantages associated with bond investing include the following: • Losing money if interest rates increase, “interest rate risk” • Losing money if an issuer experiences financial problems, “business risk” • Having a bond called if interest rates fall, “call risk” • Lacking liquidity, “liquidity risk” • Potentially not being able to reinvest dividends at as high a rate as your initial return, “reinvestment risk”

2.

If interest rates were expected to increase, Miguel should purchase short-term, high-quality bonds. Short-term bonds are less affected by changes in interest rates than longer-maturity bonds. Miguel should avoid long-term bonds, especially zero-coupon bonds, because the value of these bonds fluctuates wildly with changes in interest rates and would drop the most if interest rates rise.



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3.

Miguel should consider the following guidelines when investing in bonds: • If Miguel is in a high marginal tax bracket, he should consider a municipal bond. • He should always keep an eye on interest rates. • He should avoid bonds issued by firms that might experience financial problems. • Miguel should consider only high-quality bonds. • He should avoid callable bonds. • He should take steps to match bond maturities to his investment time horizon. • Miguel should purchase large U.S. companies or the federal government bonds. • When in doubt, Miguel should simply buy a Treasury security.

4.

Miguel should choose a maturity that matches his investment horizon. By doing this, Miguel negates interest rate risk because he knows that he will be paid par value at maturity, so changes in prices due to fluctuations in interest rates are meaningless from a financial perspective. The reason why Miguel would not want to purchase bonds shorter than the investment period is that he could suffer reinvestment risk, or the risk associated when a bond matures and available rates are less than what was previously earned.

5.

Preferred stock is a hybrid between common stock and corporate bonds. Unlike a bond, preferred stock does not have a fixed maturity date, and the termination of dividends will not bring on bankruptcy. Preferred stock is similar to bonds in that dividends are fixed and paid before common stock dividends. Preferred stockholders do not have voting rights. Also, because dividends are fixed, preferred shareholders typically don’t share in corporate profits.

6.

Using the formula on page 453 gives a preferred stock value of $56.25: Value of preferred stock = annual dividend / required rate of return $56.25 = $4.50 / 0.08

7.

Direct real estate investments require much time, effort, and expertise in order to make above-average long-term rates of return. If Miguel is, in fact, serious about making a real estate investment, he should consider an indirect one. Indirect real estate investments are appropriate for investors with little expertise in real estate management and those with little time to develop the necessary expertise to be successful. An attractive indirect investment worth exploring is a real estate investment trust. Most direct real estate investments lack liquidity. In other words, if Miguel needed to sell a direct real estate investment in order to generate cash immediately, there is no guarantee that he could find a willing and able buyer and actually get a fair price for his holdings.


There does not seem to be much cause for concern because the yields on the lowest quality bonds are 5 percent to 20 percent higher than the highest quality bonds.


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2.

In terms of maturity dates, investors should expect the longer term bonds to yield more than shorter term bonds. The example seems reasonable as her yield curve is upwardly sloping due to both the increasing maturity lengths and the decreasing quality ratings.

3.

The difference in yields is reasonable, independent of other market conditions, except for the LAM corporation bond. The current yield on this bond seems very high, probably as a result of a very low price. This bond could be on the cusp of a ratings downgrade or at worst a default.

4.

In this case, Jinnie is being adequately compensated for the increased risk because the yields seem to reasonably correspond to the maturity lengths and quality ratings.

5.

Given that the recommended minimum yield differential between the top investment grade bond (AAA) and the top “junk” bond (BB) is 3 percent to 5 percent and that a BBB rated bond is the lowest investment grade, then there should be a little less than a 3 percent to 5 percent gap. Comparing her ABC Corp bond to her MED Corp. bond, this is not the case in her portfolio; however, there is also a maturity length difference to consider.

6.

Holding all other factors constant, the bond with the shortest maturity will be affected least by an increase in interest rates. (Remember Figure 13.2.) Thus, the value of the B-rated SPEC Inc. bond will change less than the other bonds. The bond with the longest maturity, ABC Corp., would be the most affected by a change in interest rate.

7.

Because the additional risk associated with lower-quality bonds is being adequately compensated for, she does not need to sell any bonds based on this criterion. However, in order to lower her risk exposure, she could sell any of her lower quality bonds and purchase more of the ABC Corp. bond. This reallocation could expose her only to the business risk of holding too much of one security.

8.

I bonds may fit well with Jinnie’s investment needs. I bonds allow investors to start with as little as $50 or as much as $10,000 per year. Besides reducing inflation risk, default risk and liquidity risk, these securities offer tax deferral at the federal level and tax exemption at the state and local level.

9.

The dollar amount of interest earned is based on the bond’s original yield. Because bonds are almost always sold with a $1,000 par value, the annual interest payment can be calculated using the current yield formula: [(x * $1,000)/$945] = 3.17%, where x = original yield ($1,000x/$945) = 3.17% 1000x = $29.9565 x = 3.00% The new investor will earn approximately $30 per year in interest.



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10. Two pieces of information are needed to solve this problem. First, the bond’s par value of $1,000 is needed. Second, the annual interest payment from question 9 is required ($30). Use the approximate yield to maturity formula to solve for the yield:

{$30 + [($1,000 – $945)/3]}/[($1,000 + $945)/2] ($30 + $18.33)/$972.50 $48.33/$972.50 = 4.97% The bond’s yield to maturity is approximately 4.97 percent. The yield to maturity is higher than the current yield because interest rates have risen since the bond was first issued. If the investor holds the bond until maturity, she/he will receive more in par value ($1,000) than was originally invested ($945).


CHAPTER 14 MUTUAL FUNDS: AN EASY WAY TO DIVERSIFY CHAPTER CONTEXT: THE BIG PICTURE This chapter on mutual fund investing is the last in the section titled “Part 4: Managing Your Investments.” Other chapters in this section considered the need to understand the investing process and to plan carefully before making an investment. Previous chapters also outlined specific common stock, bond, preferred stock, and real estate investing strategies. This chapter brings together many of the concepts, investing terms, and principles considered in the previous chapters. Special attention is given to understanding and minimizing fees and expenses associated with mutual fund investing. Important student messages fundamental to this chapter are (1) the importance of understanding why investors use mutual funds within an investment plan, and (2) how mutual funds can be used to accomplish financial planning goals. CHAPTER SUMMARY This chapter introduces the concept of mutual fund investing as an easy, affordable, and riskreducing extension of stock, bond, and real estate investing. Advantages and disadvantages of mutual fund investing are presented. Pricing issues, fees, and expenses relating to mutual fund investing are presented in detail. The net asset value formula is presented. To help investors choose among the approximately 8,000 mutual funds, the text provides guidelines for selecting mutual funds, with recommendations on establishing investment goals, identifying funds that meet objectives, and evaluating funds. Sources and examples of mutual fund information are presented and discussed. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Weigh the advantages and disadvantages of investing in mutual funds. a. Mutual fund

2.

Differentiate among types of mutual funds, ETFs, and investment trusts. a. Investment company b. Open-end investment company or mutual fund c. Net asset value (NAV) d. Closed-end investment company or mutual fund e. Unit investment trust f. Real estate investment trust or REIT g. Hedge fund 283


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3.

Calculate mutual fund returns. a. Load b. Load fund c. Back-end load d. No-load fund e. Expense ratio f. Turnover ratio g. 12b-1 fee

4.

Classify mutual funds according to objectives. a. Money market mutual fund b. Tax-exempt money market mutual fund c. Government securities money market mutual fund d. Stock fund e. Balanced mutual fund f. Asset allocation fund g. Life-cycle fund h. Target retirement fund i. Bond fund j. Exchange traded fund or ETF

5.

Select a mutual fund that’s right for you. a. Mutual fund prospectus

CHAPTER OUTLINE I.

Why Invest in Mutual Funds? A. Advantages of Mutual Fund Investing B. Disadvantages of Mutual Fund Investing C. Mutual Fund-Amentals

II.

Investment Companies A. Open-End Investment Companies or Mutual Funds B. Closed-End Investment Companies or Mutual Funds C. Unit Investment Trusts D. Real Estate Investment Trusts (REITs) E. Hedge Funds—Something to Avoid

III.

Calculating Mutual Fund Costs and Returns A. Load Versus No-Load Funds B. Management Fees and Expenses C. 12b-1 Fees D. Calculating Mutual Fund Returns


Chapter 14: Mutual Funds: An Easy Way to Diversify

IV.

Types and Objectives of Mutual Funds A. Money Market Mutual Funds B. Stock Mutual Funds 1. Aggressive growth funds 2. Small company growth funds 3. Growth funds 4. Growth-and-income funds 5. Sector funds 6. Index funds 7. International funds C. Balanced Mutual Funds D. Asset Allocation Funds E. Life Cycle and Target Retirement Funds F. Bond Funds G. U. S. Government Funds or GNMA Bond Funds 1. Municipal bond funds 2. Corporate bond funds 3. Bond funds and their maturities H. Exchange Traded Funds or ETFs I. Mutual Funds Services 1. Automatic investment and withdrawal plans 2. Automatic reinvestment of interest, dividends, and capital gains 3. Wiring and funds express options 4. Online and phone switching 5. Easy establishment of retirement plans 6. Check writing 7. Bookkeeping and help with taxes

V.

Buying a Mutual Fund A. Step 1: Determining Your Goals B. Step 2: Meeting Your Objectives C. Step 3: Selecting a Fund 1. Where to look—Sources of information 2. Internet screening to find the right mutual fund D. Step 4: Making the Purchase 1. Buying direct 2. Buying through a “mutual fund supermarket”

VI.


VII.



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APPLICABLE PRINCIPLES Principle 8: Risk and Return Go Hand in Hand An investment of $1,000 or less in a mutual fund provides instant diversification by providing investors with a proportional ownership in up to 1,000 different stocks. It’s this instant diversification that gives smaller investors the same ability to reduce risk and obtain returns that many big investors with lots of money receive. However, investing in mutual funds does not eliminate all risk. If there’s a market crash, or if the securities a mutual fund owns are not diversified across industries and the stocks drop in tandem, mutual funds will not provide protection. Principle 9: Mind Games, Your Financial Personality, and Your Money Do not let behavioral biases influence your decision to buy certain mutual funds based on past performance. You know the saying, “past performance is not an indicator of future performance.” Evaluating the mutual fund expense ratios is one of the best predictors of future performance. Pick a small expense fund and stick with your investment strategy. Principle 10: Just Do It! Mutual funds allow you the opportunity to invest in the stock market with very little cash. Investing through a tax-advantaged retirement account generally requires no initial deposit, just recurrent deposits. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Actively managed mutual funds tend to underperform in comparison to the S&P 500 Index. Why is this? Have students use the Web or another source (e.g., mutual fund newsletter, magazine, or financial professional) to identify three to five funds that have beat the market for the past year. Using the Web sites www.morningstar.com, www.smartmoney.com, or finance.yahoo.com, research the individual stocks or sectors of the economy that comprise the fund. Can students explain why these funds are beating the market? Is the S&P 500 Index always the appropriate method to measure performance? Why or why not?

2.

In groups, conduct an Internet search on life cycle funds. Read several of the articles and prepare a short report on why life cycle funds have become so popular. Also, do some research on the average expense ratios for these fund types and include an editorial from a financial publication on whether or not the benefits justify any additional costs.

3.

Ask students to use finance.yahoo.com to sort mutual funds according to their expense ratios. Is there a correlation between low expense ratios and better performance? If all other areas of comparison are equal, why are mutual funds with low expense ratios always a good recommendation?



4.

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Share copies of Morningstar or Value Line mutual fund analysis reports with the class. Bring several copies of recent Friday editions of the Wall Street Journal. Ask students to locate the following information: • Current net asset value (NAV) and most recent NAV change • Fund family, fund name, and ticker symbol • Fund investment objective and investment style • Manager’s history • Year-to-date and 4-week returns • 1-, 3-, and 5-year historical performance • Category rating • Morningstar or Value Line rating • Calendar-year return compared to the S&P 500, or other applicable index • Percent of portfolio invested by market capitalization and sector weightings • Fund fees and expenses Ask students to share the results of their search. Ask students why net asset values vary among funds. Do they see any correlation among commissions charged, annual expenses, and year-to-date returns? Why might an individual’s actual returns from a mutual fund be higher or lower than the returns reported in the paper? Would they invest in the mutual fund? Why or why not?

5.

Encourage students to visit the Web sites for any of the major mutual fund investment companies to review the general information about mutual funds and mutual fund investing. Many companies offer an “investment university” or other section that provides fundamental information on mutual fund investing. Ask the students to compare and contrast the information on two separate sites, assessing the content, level of instruction, and ease of use.

6.

According to Checklist 14.1, tax efficiency is a key area to research when choosing a mutual fund. Look up five different large-cap, growth mutual funds at finance.yahoo.com/funds (note: there is no www in front of this Web address) and www.morningstar.com, or the fund’s Web site and make note of the portfolio turnover rate, the performance, and the tax efficiency of each fund. According to your research, does there seem to be any correlation between either the turnover rate or the performance of the fund and its tax efficiency?

7.

Request students to use the three-step process described in the text to select a mutual fund based on their current circumstances. What classification of fund(s) would be appropriate given (a) the amount of money available to open an account, (b) investment time horizon, (c) the goal or investment objective for the money, and (d) the student’s risk tolerance?


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What is a mutual fund? What makes a mutual fund different from owning a stock or bond directly? Mutual funds work by pooling investors’ money and then investing the funds in stocks, bonds, and various short-term securities. Professional managers oversee these investments. Basically, when you purchase shares in a mutual fund, you are buying a fraction of a very large portfolio, and this helps diversify your holdings, thus reducing unsystematic risk. Mutual funds simply offer a way of holding a basket of investments like stocks and bonds. However, a mutual fund, specifically an open-ended mutual fund, is very different from individual stocks and bonds because they are not traded on the secondary market. Shares of an open-ended mutual fund are always bought and sold directly from the investment company. Conversely, closed-ended mutual funds are traded on the secondary market.

2.

If diversification is a primary advantage of mutual funds, why can’t a mutual fund diversify away systematic risk? Systematic risk results from factors that affect all stocks, such as political unrest, economic uncertainty, or war. The term “systematic” refers to something that affects the entire system, in this case, risk.

3.

Mutual fund investors make money in three ways. Name and briefly describe each. How are these reflected in the formula for calculating total return? • • •

As the values of all the securities held by the mutual fund increase, the value of each mutual fund share also goes up. Dividends If the fund sells a security for more than it originally paid for it, the shareholders will receive this appreciation as a periodic capital gain distribution.

All three are included in the total return calculation. Adding the dividends and capital gains to the period price difference solves this formula. This sum is then divided by the original price. 4.

Describe the organization of a mutual fund. What is the role of the investment manager or advisor? How is he or she typically compensated? A mutual fund, or investment company, is generally set up as a corporation or trust and is owned by the fund shareholders, who elect a board of directors. The fund is actually run by a management company. Management companies like Fidelity and Vanguard typically manage many different mutual funds; however, an investment advisor, or team of advisors, ©2016 Pearson Education, Inc.


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oversees the day-to-day operation of each fund. In this position, the advisor chooses investments, directs allocations, and monitors performance. The investment advisor, usually from the management company, receives a percentage of the total value of the fund on an annual basis as compensation. This annual management fee (charged by all mutual funds) is usually included with other operating expenses in the total expense ratio of the mutual fund. These expenses normally run between 1/4 percent and 2 percent, although it can be much more. 5.

Define net asset value. When is the net asset value of a mutual fund calculated? Net asset value is the value of a mutual fund less any debt owed divided by the number of shares outstanding. The net asset value is calculated at the end of each day.

6.

How do closed-end funds differ from open-end funds? What asset class dominates the closed-end mutual fund market? Unlike open-end funds, closed-end funds cannot issue new shares—there is a fixed number of shares available for purchase. The value of closed-end funds is determined by supply and demand for that fund versus the net asset value used for open-end funds. The primary asset class owned by closed-end funds is bonds.

7. What is an REIT, and how are they similar to and different from mutual funds? REITs (real estate investment trusts) are similar to mutual funds in almost every respect except that REITs specialize in real estate rather than securities. A REIT must collect at least 75 percent of its income from real estate and must distribute at least 95 percent of that income in the form of dividends. There are three different types of REITs: equity, mortgage, and a hybrid of the two. REITs are useful as a diversification tool because they do not move closely with the general stock market. 8. What is a hedge fund? Why are they not a recommended investment for most investors? Hedge funds are risky investments because they are not regulated by the Securities and Exchange Commission like other mutual funds. Because of the high risk (and high fees) associated with owning a hedge fund, they are not recommended for investors with a net worth of less than $1 million or annual income of less than $200,000. 9.

What is the primary difference between a load fund and a no-load fund? What is a back-end load? A 12b-1 fee? A load fund charges a sales commission to purchase and sometimes to sell shares. A no-load mutual fund does not charge a commission to purchase or sell shares. Generally, load funds are sold through brokers, financial advisors, and financial planners. Commissions on load funds can be quite large, typically in the 4 percent to 6 percent range. No-load funds are generally sold directly to investors by investment companies or through no-load mutual fund supermarkets.


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A back-end load, or contingent deferred sales charge (CDSC), is a commission charged to the investor when shares are redeemed, typically within a certain period from initial purchase. The charges normally decrease with time but can be as much as 5 percent. Marketing fees or “12b-1” fees are annual fees that range from 1/4 percent to 1 percent or more and cover marketing expenses, such as direct mail or television advertising. These fees do not benefit the investor at all and should be avoided. 10. What is the “typical” range of an expense ratio? What costs are paid out of the expense ratio? What expense is not included in the expense ratio? How can these costs and expenses affect long-term earnings? Expenses ratios, which typically range from 0.25 percent to 2.0 percent of the value of the portfolio, include the following costs: • Salaries for advisors, custodians, transfer agents, and underwriters • Security trading commissions • Legal fees • Operating expenses All of these expenses are paid from the assets of the mutual fund; therefore, the total cost of these expenses increases as the value of the portfolio increases. This then reduces the value of the portfolio and the subsequent NAV of the shares. Because the NAV is being reduced by the cost of the expenses, it counteracts the increases realized with investment gains and negatively impacts the long-term performance of the fund. The primary expense not included in the expense ratio is the 12b-1 fee. The fee does not benefit current shareholders at all because it is used to cover the costs of promotion and marketing—nothing to do with investment management or performance. All expenses hurt the net return to the shareholders. For example if the fund had a gross return of 9 percent but had an expenses ratio of 1.25 percent and charged a 12b-1 fee of 0.50 percent, then the net return to the shareholders is only 7.25 percent. 11. List the six major categories of mutual funds. What is the fundamental difference among these categories? What two categories are most alike? Why? • • • • • •

Money market mutual funds Stock mutual funds Balanced mutual funds Asset allocation funds Life cycle and target retirement funds Bond funds

Balanced funds and asset allocation funds are quite similar in that both invest in a mix of stock, bonds, and money market securities. Asset allocation funds differ from balanced



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funds because they move money between stocks and bonds (change their asset allocation) in an attempt to outperform the market. In effect, asset allocation funds can be viewed as balanced funds that practice market timing. 12. Why are money market mutual funds considered practically risk free? Money market mutual funds invest primarily in Treasury bills and other very short-term notes, unless they are tax-exempt funds or government securities funds, in which case they invest in municipal debt or government securities, respectively; in any case, the investments typically have maturities of less than 30 days. Because these investments are of such short maturity, they are considered practically risk free, especially the government securities money market mutual funds. 13. What is an index fund, and why should most investors consider purchasing shares in an index fund versus another type of stock fund? An index fund is one that tries to track a market index like the S&P 500 or the Dow Jones Industrial Average. This is accomplished by buying the same stocks, in the same proportions that comprise the index. Index funds tend to outperform other mutual funds because of their very low expense ratios, which can be anywhere from 0.25 percent to 1.25 percent lower than those on other funds. Index funds don’t try to beat the market; they just mimic the market and provide diversification. 14. What are the three main categories of bond funds? What is the primary advantage of each category? The three major types of bond funds are government, municipal, and corporate. The primary advantage of owning government bonds is that they are considered default risk free. A secondary advantage of government-issued Treasury bonds is the income tax advantage. The primary advantage of owning municipal bonds is the income tax advantage. Corporate bonds do not have a specific advantage, but they do normally pay a higher coupon rate than either government or municipal bonds. 15. What is an ETF, and how is it similar and dissimilar to a mutual fund? An ETF is a hybrid between a mutual fund and an individually traded security, and most ETFs track a market index, such as the NASDAQ 100, S&P 500, or the Wilshire 5000; a sector of the market; or a particular geographic region. Unlike mutual funds, these investments can be traded throughout the day on the American Stock Exchange. 16. List the seven special services offered to investors by most mutual fund companies. For each, explain its benefit to a specific type of investor. •

Automatic investment and withdrawal plans: By establishing an automatic investment plan, you essentially make your investments an expense, with the added benefit of reducing risk through dollar cost averaging. ©2016 Pearson Education, Inc.

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• •

• • • •

Automatic reinvestment of current income: this plan functions very similarly to compound interest. By having your interest, dividends, and capital gains reinvested, you then begin to earn a return on the shares just purchased. Wiring and funds express options: this allows the fund company to directly deposit funds into your bank account for easy access, or, more importantly, allows you to make same day purchases of your mutual fund from your bank account to make investing easier. Telephone switching: benefits the customer by adding flexibility and ease when changing your portfolio allocation. Retirement plans: some of the easiest retirement plans to establish are with mutual funds. The investment company provides you with all the necessary paperwork and then handles all of the administrative duties, normally for a nominal periodic custodial fee. Check writing: with the check writing privileges, the account functions like an interest bearing checking account, though normally restricted to money market mutual funds. Bookkeeping and tax help: though not all companies offer “tax cost” analysis, most offer clear and concise statements showing account value, average annual return, and total shares owned.

17. How does an automatic investment plan facilitate Principle 10? An automatic investment plan relates to Principle 10: Just Do It! This benefits the investor because these plans automatically deduct a predetermined amount of money on a fixed interval from a checking or savings account and deposits that money into the mutual fund account. This automates the process and forces the investor to continue investing rather than spending the money. 18. Summarize the three steps involved in the mutual fund selection process. The first step in buying a mutual fund involves determining exactly what your investment goals are and the time horizon associated with meeting those goals. Second, you must identify mutual funds that meet your objectives. Information to look for includes the fund’s goals and investment strategy, the fund manager’s past experience, any investment limitations, any tax consequences, redemption rules, services provided, 10-year performance record, fund fees and expenses, and the fund’s annual turnover ratio. Finally, once a fund has been found, you must closely review the fund's past performance and scrutinize the costs associated with the funds. 19. What is a “mutual fund supermarket”? What are the advantages and disadvantages of buying funds this way versus buying them directly? A mutual fund supermarket, such as the one from Schwab, is a service that allows investors to purchase multiple mutual fund families from one source for little or no fee. The company that provides the service receives their income directly from the mutual funds rather than charging a commission to the investor. The greatest advantage of working with a mutual



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fund supermarket is that you receive a consolidated statement of all your holdings rather than one statement from each fund family. PROBLEMs AND ACTIVITIES ANSWERS 1.

Advantages of mutual funds include the following: • Diversification: mutual funds are an inexpensive way to diversify because when someone purchases shares in a mutual fund, they are purchasing a small fraction of the already diversified holdings of the mutual fund. This directly relates to the idea of Principle 8: Risk and Return Go Hand in Hand. • Professional management: because fund managers control millions of dollars, work full time managing assets, and have access to the best research, professional managers are in a good position to evaluate investments. Mutual funds provide an inexpensive way to gain access to professional management. • Minimal transactions costs: because mutual funds trade in such large quantities, they pay far less in terms of commissions than individual investors. • Liquidity: mutual funds are liquid enough to provide easy access to money. • Flexibility: because there are more than 7,000 mutual funds, there should be a fund for every conceivable investment objective. • Service: mutual funds provide services like bookkeeping, checking accounts, automatic systems to add or withdraw from accounts, reinvestment options, and the ability to buy or sell with a single phone call. • Avoidance of bad brokers: mutual fund managers only make money when their investors make money. Brokers make money by trading. Thus, with a mutual fund, investors avoid potential bad advice, high sales commissions, and churning that can come with a bad broker.

2.

The net asset value for the mutual fund in question is $19.38. NAV =

3.

( market value of assets − liabilities ) = ( $1.2 billion − $37 million ) = $19.38 shares outstanding

60 million

The following calculations assume a 10 percent per year price appreciation over the 2-year holding period. •

Beginning value = [initial investment × (1 – applicable up-front commissions)] o Class A = [$2,500.00 × (1 – 0.055)] = $2,362.50 o Class B = [$2,500.00 × (1 – 0.0)] =$2,500.00 o Class C = [$2,500.00 × (1 – 0.0)] =$2,500.00

•

Net percentage return = gross percentage return – expenses o Class A = 10% – 0.90% – 0.25% = 8.85% o Class B = 10% – 0.90% – 0.50% = 8.60% o Class C = 10% – 0.90% – 1.00% = 8.10%


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Commissions = [transaction amount – sales charge] • Initial commission (Class A only) = purchase amount × commission rate o Class A = $2,500.00 × 0.055 = $137.50 • Back-end (CDSC) commission (Class B and C only) = sales amount × commission rate First determine ending “sales” value Sales Price: o Class B FV = $2,948.49 PV = $2,500; N = 2; I/Y = 8.6% “Net return”; PMT =$0; o Class C FV = $2,921,40 PV = $2,500; N = 2; I/Y = 8.1% “Net return”; PMT =$0; Commission: o Class B = $2,948.49 × 0.040 = $117.94 o Class C = $2,921.40 × 0.000 = $0.00

(4% sales charge in second year) (0% sales charge after first year)

Total dollar expenses = [value of gross return – value of net return] •

2-year gross dollar return (All share classes) = [beginning value × (1 + gross return# of years)] – beginning value o Class A = [$2,362.50 × 1.102] – $2,362.50 = $496.13 o Class B = [$2,500.00 × 1.102] – $2,500.00 = $525.00 o Class C = [$2,500.00 × 1.102] – $2,500.00 = $525.00

•

2-year net dollar return = [beginning value × (1 + net return# of years)] – beginning value o Class A = [$2,362.50 × 1.08852] – $2,362.50 = $436.67 o Class B = [$2,500.00 × 1.08602] – $2,500.00 = $448.49 o Class C = [$2,500.00 × 1.08102] – $2,500.00 = $421.40

•

Total (2-year) expenses o Class A = $496.13 – $436.67 = $59.46 o Class B = $525.00 – $448.49 = $76.51 o Class C = $525.00 – $421.40 = $103.60

4.

Growth funds U.S. Government bond funds Growth and Income funds Life cycle funds Sector funds Index funds

5.

Your total return in the Zap fund is 35.32 percent according to the following formula: Total Return =

=I =J =F =G =E =C

Balanced funds International funds Small company funds Asset allocation funds Aggressive growth funds

=B =A =K =D =H

( current income + realized capital change ) = ( $6.70 + $7.11) = 0.3532 Beginning NAV


$39.10


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Current income = dividends + capital gains $6.70 = $2.10 + $4.60 Capital gain or loss = ending NAV – beginning NAV $7.11 = $46.21 – $39.10 6.

Thomas’s total return including reinvestment is 64.10 percent, as shown below:

⎡( end shares × ending NAV ) − ( beg shares × beg NAV ) ⎤⎦ Total Return = ⎣ Original investment amount ⎡( 265 × $32.20 ) − ( 200 × $26.00 ) ⎤⎦ $3,333.00 Total Return = ⎣ = = 0.6140 200 × $26.00 $5, 200.00 This shows that although the NAV increased by only 23.85 percent, his account value increased by more than 64 percent because of the reinvestment of current income. 7.

8.

Class B would be the better investment for someone who knows that the fund will be sold at the end of five years. For this holding period, the negative impact of front-end loads outweighs the negative impact of a higher annual fee. However, with a longer time horizon, the higher annual fee charged by class B and C shares will allow the total returns of the A shares to be surpassed. •

Net percentage return = gross percentage return – expenses o Class A = 12% – 0.55% – 0.25% = 11.20% o Class B = 12% – 0.90% – 0.50% = 10.60% o Class C = 12% – 1.00% – 1.00% = 10.00%

•

Initial commission = purchase amount x commission rate o Class A = $10,000.00 × 0.0575 = $575.00

•

Back-end (CDSC) commission = sales amount x commission rate (First determine ending “sales” value) o Class B = $16,549.15× 0.010 = $165.49 (1% sales charge in fifth year) o Class C = $16,105.10 × 0.000 = $0.00 (0% sales charge after first year)

•

Total ending “sales” value after commissions = net investment less any remaining CDSC o Class A = [$9,425 × 1.11205] = $16,025.27 o Class B = [$10,000.00 × 1.10605] × [1 – 0.010] = $16,383.66 o Class C = [$10,000.00 × 1.10005] = $16,105.10

a. b.

She would pay $12.00/sh for the open-end fund and $21.95/sh for the closed-end fund. Because the closed-end fund is selling for less than its NAV, it is trading for a discount. The amount of the discount is $2.10 ($24.05 – $21.95) per share. No, because the closed-end fund is selling at a discount, it is possible that the fund is not widely traded and therefore lacks liquidity. Remember, closed-end funds are bought and sold in the secondary market similarly to stocks and bonds, so the price is partly dependent on supply and demand.

c.


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9.


a.

Ending investment value, no reinvestment, and assuming dividends are paid at year end (This is simpler to solve using a spreadsheet. Furthermore, the numbers as shown may not add to the actual amounts shown due to rounding error.)

Year 1 2 3 4 5 b.

Beg (No reinvest) $10,000.00 $10,740.00 $11,534.76 $12,388.33 $13,305.07

Cap App (7.4%) $740.00 $794.76 $853.57 $916.74 $984.58

End $10,740.00 $11,534.76 $12,388.33 $13,305.07 $14,289.65 Total Div =

Dividends (2.1%) $225.54 $242.23 $260.15 $279.41 $300.08 $1,307.41

Total Value (End + Div) $10,965.54 $12,002.53 $13,116.25 $14,312.40 $15,597.06

Ending investment value, with reinvestment, and assuming dividends are paid at year end. (Again, this is simpler to solve using a spreadsheet. Furthermore, the numbers as shown may not add to the actual amounts shown due to rounding error.)

Year 1 2 3 4 5

Beg (With reinvest) $10,000.00 $10,965.54 $12,024.31 $13,185.30 $14,458.40

Cap App (7.4%) $740.00 $811.45 $889.80 $975.71 $1,069.92

End $10,740.00 $11,776.99 $12,914.11 $14,161.01 $15,528.32 Total Div =

Dividends (2.1%) $225.54 $247.32 $271.20 $297.38 $326.09 $1,367.53

Total Value (End + Div) $10,965.54 $12,024.31 $13,185.31 $14,458.40 $15,854.41

c.

The difference of $257.35 ($15,854.41 – $15,597.06) is attributable to the compounded return of the reinvested dividends.

10. a.

The lower cost alternative to purchase is the no-load fund because it doesn’t charge a transaction fee.

b.

Without considering the transaction fees, the lower cost to own for 6 months is the ETF. Investing in the mutual fund would result in a net gain of 6.575% [7% – (0.85%/2)], whereas investing in the ETF would result in a net gain of 6.875% [7% – (0.25%/2)]. However if you consider the transaction fee of the ETF, the answer can vary based on the amount purchased. To determine the “breakeven amount,” divide the fee by the difference in return. If the difference in the fee (0.3% semiannually) is considered, then the transaction amount must be above $6,666.66 (20 / 0.3%) for the ETF to be a better deal.



c.

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Without considering the transaction fees, the lower cost to own for 2 years is again the ETF. Investing in the mutual fund would result in a net gain of 19.14% (10% – 0.85%)2, whereas investing in the ETF would result in a net gain of 20.05% (10% – 0.25%)2. However if you consider the transaction fee, then the transaction amount must be above $2,197.80 (20 / 0.91%) for the ETF to be a better deal.

d.

Without considering the transaction fees, the lower cost to own for 2 years is again the ETF. Investing in the mutual fund would result in a net loss of 22.88% (–10% – 0.85%)2, whereas investing in the ETF would result in a net gain of 21.55% (–10% – 0.25%)2. However if you consider the transaction fee, then the transaction amount must be above $1,503.76 (20 / 1.33%) for the ETF to be a better deal.


Telecommunication stocks tend to be quite volatile, and with $15,000 to invest, it would be very difficult for Rick to achieve adequate diversification. A mutual fund will provide Rick with diversification, professional management, minimal transaction costs, liquidity, flexibility, and a number of useful services.

2.

Rick should consider investing in a telecom or aggressive growth fund, although he should not invest entirely in one fund or in one sector. He might also look into an index fund or other diversified growth fund. These types of mutual funds attempt to maximize capital appreciation. While these funds offer almost unlimited future growth, they also are more risky than bond funds or growth and income funds. Rick’s best move would be to thoroughly research several mutual funds of various styles and sectors and to choose two or three funds that best meet his investment objective and time horizon.

3.

Many factors should be considered when investing in the securities markets. Rick should first consider his risk and volatility tolerance. Will he be able to sleep after a gain of 10 percent one day and a loss of 12 percent the next? Second, he should define his investment objective and time horizon; a high-tech mutual fund would not be appropriate if Rick needs the money in two years. After narrowing his choices, Rick should thoroughly evaluate the fund, including everything from manager’s tenure to turnover ratio and from fund fees to investment services. Last, but not least, he would be advised to periodically monitor his investment choices.

4.

Mutual funds provide diversification, but they do not eliminate all risk. By purchasing only one fund, Rick will be subject to business risk: the risk of poor decisions made by the company. Also, no matter how many funds he purchases, he will always be subject to systematic risk: risk that affects the entire market as a whole.


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5.

Closed-end funds don’t sell directly to investors nor will they buy back shares upon demand. The price of the shares in a closed-end fund is determined by supply and demand for those shares, not by their net asset value. Therefore, shares in some closed-end funds sell above, while others sell below, their net asset value. Thus, if Rick is worried about liquidity and marketability, he should invest in open-end mutual funds, which will always repurchase their shares.

6.

The bottom line is that Rick should keep his expenses as low as possible; expenses erode returns. Expenses only benefit the company, not the investor. Rick should avoid funds with sales commissions and instead seek out no-load funds with minimal expenses.

7.

The results of the students will vary but should consider both risk and volatility.


Because of her short, three-year time horizon, she needs very safe and liquid investments. A money market mutual fund or a short-term high-quality bond fund would be appropriate in meeting Mahalia’s objective because one of the objectives of both investment alternatives is preservation of capital.

2.

Sources like Morningstar, the Wall Street Journal, Lipper Analytical Services, Consumer Reports, Business Week, Kiplinger's Personal Finance, Smart Money, Money, Value Line, and Mahalia's local newspaper are all good published sources of mutual fund ratings. However, some of the most comprehensive investment information is found on the Internet.

3.

Mahalia should look for the following information when reviewing a mutual fund prospectus: • The fund's goal and investment strategy • The fund manager’s past experience • Any investment limitations that the fund may have • Tax efficiency and any tax considerations important to investors • The investment and redemption process for buying and selling shares • Services provided to investors • Performance over the past 10 years or since the fund’s inception • Fund fees and expense ratios • The fund's annual turnover ratio

4.

A fund's past volatility and investment approach tend to continue into the future. There is some, albeit weak, evidence of consistency in fund performance. Looking only at short-term performance will not help Mahalia gauge a fund’s future performance, but a review of past performance can give her further insights into the philosophy and style of the fund.

5.

Loads, fees, and expenses are extremely important given Mahalia’s goal. Given her shortterm time horizon and a need to maximize annual returns, she should be very aware of any



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mutual fund expenses and try to avoid them if at all possible. Mahalia should avoid funds with sales commissions and instead seek out no-load funds with minimal expenses. 6.

Six reasons why a bond fund might appeal to Mahalia are as follows: • Immediate diversification • Liquidity (open-ended funds) • Professional management • Regular income • Bonds can be bought directly from a broker • Bond funds don’t mature

7.

For safety, income, and liquidity, Mahalia should consider purchasing a U.S. Government bond fund or a AAA corporate bond fund.

8.

The shorter-term bond funds are generally more stable; however, they also offer lower annual returns. Bond funds do not have a specific maturity but do maintain an average weighted maturity, based on current portfolio holdings. Mahalia should match the average maturity to her investment horizon.


CONTINUING CASE: CORY AND TISHA DUMONT PART IV: MANAGING YOUR INVESTMENTS 1.

To reach their long-term investment goals, Cory and Tisha must understand their individual tolerance for risk. Then, based on their risk tolerance, for individual or joint goals, they must match that tolerance to the risk-return characteristics of securities in an adequately diversified portfolio. For example, because Cory is more risk averse, learning more about the risk–return trade-offs of investments could increase his comfort with adding more investments that are riskier. Investors who take on too much risk often sell at the slightest market downturn, thus selling at a loss rather than recognizing that volatility, or fluctuations in security prices, are associated with risk. But understanding that risk and return go hand in hand, and that there is risk in being too safe—returns that are not adequate to achieve goals after subtracting the effects of inflation and taxes—may encourage him to add riskier investments. Conversely Tisha’s higher tolerance for risk may be equally devastating to long-term returns if the risk is not adequately balanced in a well-diversified portfolio. Finally, the longer the time horizon, the more risk Cory and Tisha may safely take, yet they must realize that all investments have some risk.

2.

Consistent with Principle 9: Mind Games, Your Financial Personality, and Your Money, Cory and Tisha will be best served by developing an investment plan matched to their goals, risk tolerance, time horizon, investment knowledge and experience, and available funds for investing. Being aware of the following mind games may help them stick to the plan: • Overconfidence: Avoid thinking that they know more than they do, and thinking they can beat the market. • Disposition effect: Avoid the natural aversion to acknowledging bad deals and cutting losses. Instead of selling losers, they could be tempted to sell a winner (and perhaps pay taxes) to feel pride and confidence rather than selling the loser and admitting the mistake. • House money effect: Avoid thinking of earnings as different from the initial investment dollars so that more risk is taken with the earnings. At some point it may be wise to sell and take profits from a security rather than continuing to be greedy, as exemplified during the dot.com bubble. • Loss then risk aversion effect: Avoid assuming that a loss means get out and stay out of the market. Nobody likes losing money, but Cory and Tisha will need to remind themselves that risk and return go hand in hand and market fluctuations will occur. • Herd behavior: Avoid the assumption that behavior trends are based on knowledge, rather than others just following the crowd. Self-fulfilling behavior can force prices up or down.

3. Asset allocation strategies serve two fundamental purposes—to ensure that investors are well diversified and that the asset allocation and investments chosen match the investor’s risk tolerance. Because the Dumonts’ investment horizon for retirement savings is quite 301



long, they fall into the “Time of Wealth Accumulation” phase of the life cycle. This implies that they should be placing the majority of their savings into common stocks or other forms of equity ownership because these investments offer the greatest return to risk ratio over long periods of time. A typical financial planning recommendation for people in the “Time of Wealth Accumulation” phase is to maintain a mix of 80 percent common stocks and 20 percent fixed income securities, including bonds and money market mutual funds. Because much of the risk associated with investing in common stocks is diminished over time, the Dumonts should feel comfortable investing in a mix of blue-chip, growth, income, speculative, cyclical, and defensive stocks. They should also consider investing in a combination of large-, mid-, and small-cap stocks. The Dumonts should also include some international common stocks. The primary advantage of doing so is increased diversification. In general, international common stocks are less highly correlated with U.S. stocks; this combination offers the potential of increasing total portfolio returns while simultaneously reducing risk. But having adequate funds to cost effectively diversify across all of these types of equities is beyond the reach of the average investor, particularly for a young couple like the Dumonts. Because they will be saving for retirement through company-sponsored plans as well as individual accounts they establish, their best option for buying equities is through mutual funds or ETFs. Both offer the benefit of diversification with small investment amounts, very low costs or no costs for trading, professional management, and ease of recordkeeping instead of tracking individual securities. As much as 20 percent of the Dumonts’ current asset allocation could be devoted to fixed income securities. Because the Dumonts’ goal is to accumulate savings for retirement in 30 years, a long-term (i.e., 20 to 30 years in maturity) bond, or more likely bond fund would be appropriate. Due to Cory’s conservative investment philosophy, they should only consider the highest rated bonds, rated AA or above by Standard and Poor’s or Aa or higher by Moody’s. They could consider these same standards when selecting bond mutual funds or ETFs. The highest quality issuer of bonds is the federal government; therefore, the Dumonts could also consider investing in U.S. issued government bonds. 4.

An efficient market is one in which all relevant information about prices is reflected in current prices. The efficient market theory states that it is extremely difficult for individual investors to “beat” the market over an extended period of time. Thus, some financial advisors recommend that investors consider investing in an index of stocks like the Dow Jones Industrial Average or the S&P 500. This type of investment (purchased in an ETF or mutual fund) provides the ultimate in diversification. Indexing may be an appropriate alternative for moderately risk-tolerant investors like the Dumonts. The best long-term strategy for the Dumont’s would include the following: • Invest for the long term and avoid hot tips and mind games. • Keep to their investment plan, regardless of short-term market fluctuations, and don’t attempt to time the market. In short, avoid herding! • Focus on the asset allocation process and the investment time horizon rather than on picking individual securities. Copyright ©2016 Pearson Education, Inc.


• • • 5.

Keep investment costs and commissions down. Maintain a diversified portfolio at all times. Seek professional advice when they need it.

Traditional full-service brokerage firms employ brokers who are paid on commission for giving investment advice and executing trades. Discount brokerage firms are brokerages that simply execute trades without providing investment advice. Because fewer services are provided, commissions are significantly less than for full-service brokerages, where commissions may be 10 to 20 times higher. Two types of discount brokerages are available: premium discount and deep discount. Premium discounts charge a little more but offer some account management services in addition to a range of security and investment information, including analyst’s recommendations, reports, and earnings projections. Deep discount brokers offer extremely low cost, no-frills trading execution—some as low as $7 per trade. Online trading options are available with almost all brokers. The Dumonts must keep in mind that full-service brokers only make money when an account is actively traded. This may not match their investment style, investment needs, or available investment funds. Inactive account fees (e.g., $50 per year) may be charged if the Dumonts don’t make trades. If they decide that they do not need the advisory or management services, a discount or deep discount firm will execute trades and may provide sufficient investment information online at a much cheaper cost. But they should comparison shop costs and services before making a final choice. Bottom line: Cory and Tisha will be best served by keeping transaction costs, commissions, and fees to a minimum. If they are trading bonds, the costs don’t vary with type of broker, and Treasury bonds can be purchased directly from the Treasury Department.

6.

Principle 8: Risk and Return Go Hand-in Hand reminds the Dumonts that investors are rewarded for taking on more risk, but that risk can be reduced through diversification. For example, if the Dumonts own 10 to 20 stocks representing different industries, they will significantly reduce the total risk in their portfolio, and most of the remaining risk is systematic risk. This idea illustrates Principle 8 in that only systematic risk remains in a well diversified portfolio; diversification reduces or eliminates unsystematic or diversifiable risk that is characteristic of an individual security. Diversification reduces risk, explained very simply, by allowing extreme good and bad returns provided by different securities to cancel each other out. The result is that variability, or risk, is reduced without affecting expected returns. Beta measures the relative responsiveness of a stock or portfolio to the movements of the market, as measured by the S&P 500 Index or the NYSE Index. The beta for the market is 1.0, the benchmark for measurement. A stock or portfolio with a beta greater than 1 would be expected to move further, up or down, than the market, whereas a beta less than 1 would indicate the stock or portfolio movement would less than the market trend. Knowing and tracking the beta helps investors to better understand price movements, assuming that two criteria are met. First, a diversified portfolio moves in response to factors larger than the movement of any one company—such as expected inflation, interest rates, or the overall economy. Second, the best combination of securities to reduce risk, as measured by beta, is



a group of securities that do not move in similar patterns. This means different types of securities (e.g., stocks and bonds) and securities that represent different industries and even different countries (i.e., international stocks) will be necessary to fully diversify. If the Dumonts decide that researching, purchasing, and monitoring a portfolio of individual securities is beyond their interest or comfort level, they can achieve diversification through the purchase of mutual funds or ETFs. Although both offer immediate diversification within the individual mutual fund or EFT portfolio, care must still be taken that the Dumonts’ portfolio of mutual funds and/or ETFs offers diversification across different types of securities, just as described above. 7.

a. taxable equivalent yield = rate of return / (1 – marginal tax bracket) = 2.40% / (1 – 0.15) = 2.82% Cory and Tisha should not purchase the tax-free money market mutual fund. The fund’s tax equivalent yield of 2.82 percent is lower than the 3 percent interest offered at the bank. b. tax-exempt equivalent yield = rate of return × (1 – marginal tax bracket) = 8% × (1 – 0.15) = 6.8% A municipal bond paying a 6.8 percemt tax-free return would equal the 8 percent taxable earnings on the U.S. Treasury note, ignoring state taxes.

8.

Their current $2,500 balance will grow to $5,234.44 in 25 years at 3 percent interest. At 5 percent interest, their account balance will grow to $8,465.89 in 25 years. Given that both the money market account and the savings account are similar in risk characteristics, although only the savings account is insured, the Dumonts should transfer their savings balance into the money market. Calculator Solution PV -$2,500 PMT NA I/Y 3% N 25 FV ? CPT FV -$5,234.44

Calculator Solution PV -$2,500 PMT NA I/Y 5% N 25 FV ? CPT FV -$8,465.89



9.

a.

Value of Bond (2% increase in rates) = $877.11 CPT PV = -877.11

b.

I = 10

N = 10

FV = 1,000

N = 10

FV = 1,000

Value of Bond (1% decrease in rates) = $1,070.24 CPT PV = -1,070.24

c.

PMT = 80

PMT = 80

I=7

There is an inverse relationship between interest rates and bond values in the secondary market. When interest rates rise, bond values drop, and when interest rates drop, bond values rise.

10. The preferred stock should sell for $50 ($5.00 / 0.10). The preferred stock is currently overvalued, based on the Dumonts’ required rate of return, using the preferred stock valuation model. 11. The bond and preferred stock recommendations are not appropriate for Chad and Haley at this time. Consider the time frame for the children. Chad and Haley will begin college in 14 years and 16 years, respectively. With relatively long time horizons, the Dumonts can afford to take greater risks with the children’s educational savings in hope of earning greater returns than can be provided by bonds or preferred stock. The Dumonts should consider investing 90 to 100 percent of the children’s college savings into common stock mutual funds or ETFs. They should focus on using aggressive growth funds, small company funds, and growth funds, and perhaps include a small percentage in international funds. As the time horizon of college grows shorter, the Dumonts will need to shift the asset allocation to safer investments to lock in and preserve the gains from the mutual funds or ETFs. 12. Mutual funds may be a good alternative for meeting the Dumonts’ investment objectives because of the following advantages: • Diversification • Professional management • Minimal transaction costs • Liquidity • Flexibility • Service • Avoidance of unprofessional or unethical brokers Given the Dumonts’ time horizon and risk tolerance, the mutual funds listed in a–f might be appropriate for meeting their investment objectives. However, the Dumonts should not ignore the need to periodically rebalance their accounts, and to make planned changes in the asset allocation as the window for funding the goal gets closer. For example, to fund college the Dumonts will need to sell the mutual funds and reallocate the money to a less risky account, such as a money market mutual fund, that will secure the mutual fund earnings. a. Money market mutual funds are an appropriate choice for the Dumonts’ emergency fund.



b. Because the Dumonts would like to purchase a home within the next 2 to 3 years, they need their savings to be very liquid. Thus, 80 to 90 percent of their house down payment savings should be invested in money market mutual funds. The remaining portion could be invested in a balanced fund or high quality short-term bond fund. But given the short time horizon until the money is needed, extreme care must be taken not to risk the principal in exchange for potentially higher returns. c. Chad will begin college in 14 years. Based on this time horizon, the Dumonts should consider investing most, but not all, of Chad's college savings into common stock mutual funds. They should consider aggressive growth funds, small company funds, and growth funds for perhaps 75 to 80 percent of the funds. The remainder could be split between bonds funds and, for a more conservative approach, a money market mutual fund. d. Haley’s college savings should also be invested in a diversified portfolio of equities, bonds, and cash achievable with mutual funds. The same, or similar, mutual funds could be used as those chosen for Chad, but because Haley has a slighter longer time horizon (16 years), the percentage allocated to aggressive growth funds, small company funds, and growth funds could reasonably increase to perhaps 80 to 90 percent of the funds, and for the next few years have little or none of her accounts in cash. e. At 31, Cory’s retirement is more than 30 years away. They can afford to take aboveaverage short-term risk with their retirement savings in hopes of receiving aboveaverage returns. Cory should consider investing in a combination of funds—aggressive growth, small company growth, international common stock, and growth. (Recall that over this long time horizon, the risk associated with equities significantly diminishes.) Given his relative inexperience with investing, he should also consider investing in more conservative funds, such as growth-and-income, balanced, and asset allocation funds, because of less volatility. In order to make the mutual fund selection process easier, Cory may want to consider investing in index funds, life cycle funds, and Target Retirement Funds. The latter might be the best choice by increasing Cory’s confidence that professionals are managing the asset allocation relative to the time horizon for his retirement goal. f. Because Tisha has a higher risk tolerance than Cory does, she may want to be more aggressive with her retirement savings allocation. A combination of growth stocks, growth mutual funds, and aggressive growth mutual funds are appropriate alternatives for her. She should also consider international equity funds as a way to further diversify her portfolio. 13. A balanced fund attempts to “balance” long-term growth objectives with a combination of current income and price stability. To do this, balanced funds invest in a combination of stocks, bonds, or preferred stocks. In general, balanced funds tend to be less volatile than other stock funds. Given this description and Tisha’s (a) long-term retirement horizon and (b) relatively high risk tolerance, an argument can be made to replace this fund with a more



aggressive fund or combination of funds, such as index funds, growth funds, small company growth funds, or aggressive growth funds. When thinking about intermediate- and long-term goals like college and retirement funding, the detrimental effects of both systematic risk and inflation must be considered. Both can be reduced by a broadly diversified portfolio. Although the balanced fund is diversified, its moderate risk approach may not be the best choice for beating the effects of inflation, especially when considering the time horizon for Tisha’s retirement. The Great Basin Balanced Mutual Fund may be more appropriate for college savings because the investment objective of moderate growth coupled with some price stability matches more closely with accumulating assets for college expenses. This will be particularly true as the children age and the objective becomes more stability of value and less price volatility. The fund also matches Cory’s tolerance for less risk, especially for a goal as important as saving for the children’s education. 14. Stock market index funds are an ideal way to invest for intermediate- and long-term goals and objectives. Market index funds are less appropriate for accumulating savings needed in shorter periods of time. Based on the fact that they would like to purchase a house in 3 to 5 years, they should holdings in the index fund and increase house savings allocation to shortterm bond funds or money market accounts that offer more stability of capital. 15. Mutual fund companies offer a number of services that can help the Dumonts systematically save for their goals. These typically include the following: • Automatic investment and withdrawal plans: A way to automatically dollar cost average into a mutual fund. This is a good way of moving excess funds from a money market account or checking account into the stock market. A withdrawal plan would allow the Dumonts to supplement their retirement income by having a certain dollar or percentage amount distributed to them each month. • Automatic reinvestment of interest, dividends, and capital gains: Reinvestment in the securities markets produces the same growth effect as compound interest. If the Dumonts don’t automatically reinvest, they will not accumulate wealth very fast. • Wiring and funds express: Allows for quick access to money in a mutual fund by having distributions wired directly to the Dumonts’ bank account. It also works the other way by allowing them to invest money in a fund immediately. • Phone and Internet switching: Allows the Dumonts to easily move money from one mutual fund to another. This is advantageous during sharp market rises or drops or when the Dumonts wish to make changes to their asset allocation. • Easy establishment of retirement plans: Most mutual fund companies provide investors with everything they need to establish, maintain, and manage a retirement plan like an IRA. Some fund companies will establish an account over the phone, making savings much easier for investors like the Dumonts. • Check writing: Money market mutual fund privilege that is very handy when the Dumonts need their money (e.g., for the home down payment), but check minimums may apply.



•

Bookkeeping and help with taxes: Some mutual fund companies calculate taxable gains and losses whenever fund shares are sold. This service makes tax time much easier.

Although all of these services can benefit the Dumonts, automatic investment plans and dividend reinvestment services can help them accumulate wealth over time. These two methods effectively create a dollar cost averaging strategy that can be used to maintain a disciplined buy and hold approach to managing their assets. Phone or Internet switching can make portfolio rebalancing or planned changes to the asset allocation strategy easy to accomplish. 16. Load mutual funds are generally sold through brokers, financial advisors, or financial planners for a commission The amount and type of commission is determined by the load fund share class: A, B, or C. No-load mutual funds are sold directly by investment companies. If the Dumonts wish to keep their expenses as low as possible, they should invest in no-load mutual funds directly or through a mutual fund supermarket. Although commissions, or loads, are an important factor when choosing a fund, the Dumonts should also make sure that the funds they choose for their portfolio provide the following: • Match their investment objectives. • Have a qualified fund manager who has been with the fund for some time. • Are free of unnecessary investment restrictions. • Provide some tax advantages. • Have low or no redemption costs, and the investment process matches their needs (e.g., minimum required). • Provide services that match their needs. • Performance that equals or exceeds other funds of the same type or of an index over the past 1, 3, 5 or 10 years. • Have modest annual expenses and fees, and no 12b-1 fees. • Have low portfolio turnover rates. The above information is available in the fund prospectus or by researching funds on the Internet. Like all investments, fund performance may change over time, but the Dumonts will be well served to do their “homework” before investing. 17. As the name implies, a mutual fund supermarket brings together the “products” or inventory of many different companies to facilitate shopping, and in this case, more importantly, recordkeeping. In these “supermarkets,” mutual funds from many fund families, including both load and no-load funds, are sold directly to investors. When choosing a supermarket, the Dumonts should evaluate the fund families that are available on a no-transaction fee or small transaction fee basis. Or, the Dumonts could avoid the transaction fee by buying directly from the mutual fund family. The key is to shop around and compare fees and services from the major supermarkets before establishing an account. Using a supermarket will allow the Dumonts to develop a diversified portfolio of mutual funds, to bypass traditional commissions, and to benefit from combined recordkeeping and easy account access. A bank does not offer a better option than the mutual fund supermarket. The “inventory” of mutual funds offered by a bank will be much more limited, typically bank offered funds are Copyright ©2016 Pearson Education, Inc.


load-funds, and there is no federal insurance protection as associated with other “bank” accounts. The convenience of buying mutual funds at the bank and receiving advice from the account representative will likely come at a high price. Instead, the Dumonts’ could purchase no-load index, life cycle, or target retirement funds while they continue to build their investment knowledge and experience. 18. ETFs, or exchange traded funds, are simply index mutual funds that trade on the stock exchange like other securities. ETFs offer the Dumonts the following advantages over mutual funds: • Increased trading flexibility (e.g., selling short, buying on the margin, trading throughout the day) • Ease of establishing an investment position in a sector or country, not otherwise available • Lower annual fees than comparable index mutual funds • More tax efficient than most mutual funds because of the lack of taxable capital gains distributions from mutual fund sales to meet redemption needs For buy and hold investors who trade infrequently, ETFs may be a better option than mutual funds. However, for frequent traders commissions associated with the trades can quickly reduce the savings from lower annual fees and tax efficiency. Investors must deal with the bid-ask spread, and ETFs don’t always sell at their NAV, factors that further complicate the use of ETFs. ETFs also do not offer the shareholder services offered by most mutual fund companies. Assuming that index funds meet the Dumonts’ investment objectives, ETFs could be an alternative to consider for their investment portfolios. But given their financial situation and the need to make frequent small purchases to fund their investment goals, commissions on the ETFs are an added expense. With their limited investment knowledge and experience, Cory and Tisha may be more comfortable with mutual funds and the services provided by the fund companies or supermarkets. 19. The purchase of a primary residence is one of the largest expenses an average American will make in his/her lifetime. Although the purchase of a home will constitute a large expense, and a major asset with appreciation, the Dumonts should be cautioned not to think of their house as an investment. They should, first and foremost, think of their residence as their home. Personal residences lack a high level of liquidity in most localities. If the Dumonts needed to sell their home quickly for a fair market price, there is no guarantee that they could do so. Further, home prices are dependent primarily upon supply and demand in a particular location, and prices can go down as well as up. Nevertheless, many households sell their primary residence to supplement retirement income; however, this choice may not meet the Dumonts’ needs, and they would still need a place to live. 20. There is a wealth of investment information available to the Dumonts. A great deal of research is at their fingertips and available directly from individual companies, brokerage firms, the press, Internet advisory services (reports available at most libraries) and the Internet. Some of these sources include the following:



•

Annual reports on all publicly traded firms. Most are available for free directly from the company or online. • Brokerage firm reports detailing specific companies and the economy • Magazines and Web sites like Money, Smart Money, Kiplinger's Personal Finance, Forbes, Fortune, and Barron's • A variety of information can be found in the Wall Street Journal—recommended reading for every investor. • Rating, or advisory, service publications like Moody’s Bond Survey, Moody’s Handbook of Common Stocks, Moody’s Manuals, Standard & Poor’s Corporate Records, Standard & Poor’s Corporation Reports, and Value Line Investment Survey provide information on companies, stocks and bonds, and industries. • Internet sources must be evaluated for accuracy and bias, but a wealth of information is available. In addition to the Internet sites for the sources listed above, other useful sites include the following, although a search can yield additional links: • www.edgar-online.com sponsored by the Securities and Exchange Commission (SEC) • www.morningstar.com • www.moneycentral.msn.com • http://finance.yahoo.com/ • Mutual fund screeners available from Morningstar, Yahoo! Finance, MoneyCentral, or their brokerage or mutual fund supermarket Web sites should also be tools that the Dumonts routinely use to research mutual funds.


CHAPTER 15 RETIREMENT PLANNING

CHAPTER CONTEXT: THE BIG PICTURE As the first chapter in “Part 5: Life Cycle Issues,” this chapter stresses the importance of establishing a sound, simple, retirement plan at the earliest stages in the financial life cycle. Within the broader context of financial planning, this section explains how concepts such as tax planning, insurance planning, and investment planning affect retirement and estate plans. Important student messages fundamental to this chapter are (1) begin saving for retirement now, no matter what your current age or income may be, and (2) take full advantage of tax-favored retirement plans to fund retirement. CHAPTER SUMMARY This chapter stresses the importance of starting early to plan for and fund retirement. A discussion of the Social Security system, including financing, eligibility, retirement benefits, and disability and survivor benefits is provided. Definitions and examples of employer-sponsored retirement plans, with comparisons of defined benefit, including cash balance plans, and defined contribution plans, are presented. The seven-step retirement planning process is explained and illustrated. Optional Individual Retirement Arrangements (IRAs) are considered, as are plans for the self-employed or small business employees. Distribution and payout options are explained. The chapter concludes with tips on putting together and monitoring a plan. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated terms: 1.

Understand the changing nature of retirement planning. a. Defined-benefit plan b. Noncontributory retirement plan c. Contributory retirement plan d. Portability e. Vested f. Funded pension plan g. Unfunded pension plan h. Cash-balance plan

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2.

Set up a retirement plan.

3.

Understand how different retirement plans work. a. Defined-contribution plan b. Profit-sharing plan c. Money purchase plan d. Thrift and savings plan e. Employee stock ownership plan or ESOP f. 401(k) plan g. Keogh plan h. Simplified pension plan or SEP-IRA i. Savings incentive match plan for employees (SIMPLE) j. Individual retirement arrangement or IRA k. Roth IRA l. Coverdell Education Savings Account or Education IRA m. 529 plans

4.

Choose how your retirement benefits are paid out to you. a. Single life annuity b. Annuity for life or a “certain period” c. Joint and survivor annuity d. Lump-sum option

5.

Put together a retirement plan and effectively monitor it.

CHAPTER OUTLINE I.

Social Security and Employer-Funded Pensions A. Financing Social Security B. Eligibility C. Retirement Benefits D. Disability and Survivor Benefits E. Employer-Funded Pensions F. Defined-Benefit Plans G. Cash-Balance Plans: The Latest Twist in Defined-Benefit Plans

II.

Plan Now, Retire Later A. Step 1: Set Goals B. Step 2: Estimate How Much You Will Need C. Step 3: Estimate Income at Retirement D. Step 4: Calculate the Inflation-Adjusted Shortfall E. Step 5: Calculate How Much You Will Need to Cover This Shortfall F. Step 6: Determine How Much You Must Save Annually Between Now and Retirement


Chapter 15: Retirement Planning

G. Step 7: Put the Plan in Play and Save H. What Plan Is Best for You? III.

Retirement Plans A. Employer-Sponsored Retirement Plans B. Defined-Contribution Plans 1. Profit-sharing plans 2. Money purchase plans 3. Thrift and savings plans 4. Employee stock ownership plans 5. 401(k) plans 6. How much can you contribute? C. Retirement Plans for the Self-Employed and Small-Business Employees D. Keogh Plan or Self-Employed Retirement Plan E. Simplified Employee Pension Plan F. Savings Incentive Match Plan for Employees G. Individual Retirement Arrangements H. The Traditional IRA 1. Saver’s tax credit I. The Roth IRA J. Traditional Versus Roth IRA: Which Is Best for You? K. Saving for College: The Coverdell Education Savings Account

IV. Facing Retirement—The Payout A. An Annuity, or Lifetime Payments 1. A single life annuity 2. An annuity for life or a “certain period” 3. A joint and survivor annuity B. A Lump-Sum Payment C. Tax Treatment of Distributions V. Putting a Plan Together and Monitoring It A. Saving for Retirement—Let’s Postpone Starting for 1 Year VI.

Behavioral Insights A. Principle 9: Mind games, your financial personality, and your money B. Procrastination and lack of self-control C. Choice overload and the complexity of the decision D. Inertia in contributions and investment choices or decision paralysis

VII.



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APPLICABLE PRINCIPLES Principle 2: Nothing Happens Without a Plan Saving money is hard to do even in the best of circumstances. But when it comes to saving for retirement, an event that seems so far away, saving money is even harder. Although an elaborate, complicated plan might be an ideal way to force you to save, these types of plans seldom come to fruition. It is probably better to start off with a modest, uncomplicated retirement plan. Once the plan becomes part of your financial routine and your earnings increase, then you can modify and expand the plan. Principle 4: Taxes Affect Personal Finance Decisions Tax-deferred retirement plans allow investment earnings to grow untaxed until you withdraw these earnings at retirement. The bottom line is that these plans allow you to put off paying taxes so that money that would have gone to the IRS can be invested now and continue growing for your future. In addition, some plans allow for initial contributions to be made on either a full or partial tax-deductible basis, making these plans even more attractive. Principle 9: Mind Games, Your Financial Personality, and Your Money Employers are now able to automatically enroll you in their tax-advantaged retirement plan. This helps eliminate some behavioral biases associated with implementing a savings plan. However, the amount they allocate and the asset allocation they choose on your behalf may not match your goals and risk tolerance. Take the time to learn about your options and make the best choice for your unique situation. Principle 10: Just Do It! Take advantage of the time value of money. This chapter illustrated many ways in which starting early is the best strategy to being prepared for retirement. Even a little bit goes a long way with a time horizon of 40 years or more. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

To encourage students to think about their future retirement needs, ask them to project their current, entry-level salary 40 years into the future, assuming a 3 percent rate of inflation and no other raises. Then, basing their post-retirement income needs on 80 percent of their preretirement income, have them calculate their total savings requirement to fund their retirement. They should assume a 30-year retirement period and a 3 percent inflation rate. Remind the students to calculate a 30-year annuity (PVIFA), not just the need for the first year (PVIF). How much would they need to fund their retirement, assuming that same first year out of college lifestyle? Use this example to illustrate the need to start saving early.



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2.

Have students discuss the types of retirement plans they have been offered in previous or current jobs. Identify the positive and negative aspects of these plans. Evaluate the different plans based on the strategies for promoting increased employee participation and responsibility, for helping employees save for retirement, for reducing employer plan maintenance costs, and other factors.

3.

Make a list of factors that you would want to consider before establishing your own retirement goals. How would these factors change if you were assisting a close, older relative to set retirement goals?

4.

“Pay yourself first” and start early are fundamental strategies when planning for retirement. Interview a group of young professionals to determine if they are implementing these strategies. Are they eligible to participate in their companies’ retirement plan(s)? If not, when will they be eligible? How did they decide the amount to save for retirement? Are they taking advantage of the companies’ match, if applicable? Prepare a report of your findings.

5.

Talk with someone who is currently retired about his or her sources of retirement income. Is current income sufficient to meet needs? What unexpected expenses (e.g., appliance replacements, home maintenance, recreation, or medical care) have had a major impact on his or her retirement level of living? Do you think he or she is putting enough effort into monitoring the plan? Together, develop a list of recommendations to keep in mind for monitoring a retirement plan.

6.

Invite an employee assistance professional or benefits administrator about common mistakes employees make when planning for retirement. Organize your questions around the time frames of (a) the early to middle years of employment, (b) the latter years of employment, (c) the retirement decision and distribution options, and (d) the early and later years of retirement. Report your findings.


What are you purchasing with your payroll tax paid to Social Security? How will your benefits be paid for in 40 years? Payroll deductions for Social Security go into the Social Security Trust Fund to purchase mandatory insurance that provides for you and your family in the event of death, disability, health problems, or retirement. In 40 years, the system may or may not function similarly to the one today. The greatest problem facing the system under the current “pay-as-you-go basis” is that 40 years ago 16


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workers were paying for each retiree. Today that ratio has dwindled to 3-to-1, and in 40 years is projected to be 2-to-1. 2.

How many credits do you need to qualify for Social Security benefits? How is a credit earned? How many can you earn each year? To qualify for benefits, someone needs 40 credits. One credit is earned for each $1,200 in earnings in 2014, up to a maximum of four credits per year. Thus, it takes a minimum of 10 years to qualify for retirement, disability, and survivor benefits.

3.

How is the amount of someone’s Social Security benefit determined? What percentage of income does Social Security typically replace? What percentage of full benefits do those retiring at age 62 receive? The amount of Social Security benefit received is determined by the following: • Number of years of earnings • Average level of earnings • Adjustments for inflation Social Security attempts to provide benefits that replace 42 percent of one’s average earnings, with an adjustment upwards for those in lower income brackets and downwards for those in higher income brackets. For those born in 1960 or later, full retirement benefits will not be available until age 67. Retiring at age 62 will result in a permanent reduction to 70 percent of the full benefit amount.

4.

Why is the amount available from personal savings and Social Security retirement benefits even more important for women than for men? Women live longer than men, so they must have a larger retirement account to support their increased living expense needs. Without Social Security benefits, about half of all retired women would be living in poverty. Social Security benefits are the only source of income for about one fourth of retired women.

5.

What is meant by the term “disability and survivor benefits”? How does the Social Security Administration define “substantial work”? Disability benefits provide protection for those who experience a physical or mental impairment that is expected to result in death or substantial work lost for at least one year. Survivor benefits are paid to families when the breadwinner dies. Payments include automatic one-time payments at the time of death to help pay for funeral costs, as well as monthly payments to the surviving spouse if he/she is over 60, over 50 if disabled, or any age if caring for a child either under 16 or disabled and receiving Social Security benefits. Children may also receive survivor benefits if they are under 18, or under 19 but still in elementary or secondary school, or if they are disabled. Parents may also qualify for survivor benefits from a deceased child if the parents were dependent on the child for at least half of their support. ©2016 Pearson Education, Inc.


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For the purposes of collecting disability benefits, the Social Security Administration’s definition of substantial work is anything that generates monthly earnings of $500 or more. 6.

Describe a pension plan, the most common example of a defined-benefit retirement plan. What are the advantages and disadvantages of this type of plan? Why are defined-benefit plans declining? A pension plan is a defined benefit plan and may be contributory or noncontributory. The contributory modifier describes whether an employee pays into the plan. A noncontributory plan is one where employees are not required to pay into the plan in order to receive future benefits. The retirement benefit, or payout, is based on a formula based on age at retirement, salary level, and years of service. Pension Plan Advantages • Employer bears investment risk. • Employees might not be required to contribute. Pension Plan Disadvantages • May change with little or no notice • May pay only a small percentage of salary • Lack of portability • Lack of inflation-adjusted benefits (fixed benefit amount) • May not be funded, increasing the risk of possible nonpayment of benefits in the future A number of reasons explain why companies have dropped defined benefit plans, but most relate to cost. Low interest rates, poor stock market returns, sky-rocketing health-care costs, and longevity of retirees have forced many companies to abandon pensions in favor of less costly 401(k) and other defined contribution plans. In addition, younger companies never offered pension plans, so competition also has forced older companies to switch to defined contribution plans.

7.

What is vesting? What does it mean for an employee? An employer? Why is it important when initially considering a job offer? When thinking about changing jobs? To be “vested” means that someone has worked for a company long enough to have the right to receive pension benefits in the future. Some pension plans offer immediate vesting, while others require as many as 7 years of employment before becoming 100 percent vested. Should an employee leave the company prior to being fully vested, he/she will forfeit the pension benefit. This eliminates the responsibility of the employer to invest and hold pension funds until some date in the future; however, an employee who often switches jobs among companies that do not have portable plans will not be accumulating retirement funds. The method of vesting used and the likelihood of remaining with the company past the vesting period is an important consideration when comparing employment offers. Similarly,


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the “dollar cost” of losing pension benefits due to a job change should be considered, particularly if the option to become fully vested is soon. 8.

List and briefly explain each of the seven steps and the calculations involved in retirement planning. 1. Setting goals: This first step requires figuring out just what you want to do when you retire. 2. Estimate how much you will need to meet goals: This step helps you turn goals into estimated dollar figures. A key step is to determine basic retirement living expenses. 3. Estimate income available at retirement: This step includes estimating Social Security benefits and pension estimates from your employer. 4. Calculate the annual inflation-adjusted shortfall: At this step, you compare your retirement income with estimated living expenses. A deficit would indicate the need for additional savings. 5. Calculate the funds needed at retirement to cover any shortfall: This step helps you determine how much money you will need to come up with each year to support yourself in retirement. 6. Determine how much you must save annually between now and retirement: In step 5, you determine how much you need to support yourself in retirement. In this step, you determine how much money you need to save each year to meet your objective. 7. Put the plan in play and save: This is the hardest step of all. Once a need has been determined, it is essential that the developed plan be put into effect.

9.

Compare and contrast a defined-contribution plan and a defined-benefit plan. Who is responsible for the investment of funds for each plan? How are benefits determined? How are these plans advantageous to an employer? A defined contribution plan can be thought of as a personal savings account for retirement offered by an employer. Typically, employees and employers make contributions to these plans. In contrast, only the employer funds a defined benefit plan. Although future earnings and payments from the plan are not guaranteed, most defined contribution plans allow employees to choose how assets in the account are invested. Future payments depend upon how well the retirement account performs. In contrast, employees are not given investment choices with a defined benefit plan; the employer agrees to pay a benefit based on a designated formula and is responsible for managing the funds to meet this obligation. Employers like defined contribution plans because their responsibility ends with their contribution to the plan and necessary subsequent bookkeeping functions. In effect, defined contribution plans pass the responsibility for retirement from the employer to the employee. Such plans also pass the risks of investing from employers to employees because the accounts are not insured and payments are not guaranteed.



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The opportunity to choose investment options for retirement funds is an acknowledged advantage of defined contribution plans but can be a disadvantage if the employee lacks the knowledge to make wise investment selections. The lack of employee funding and the employer’s sole responsibility for meeting the designated formula payout are advantages of a defined benefit plan. 10. What is a 401(k) plan and how does it differ from a 403(b) plan? Describe two advantages associated with contributing to such plans. A 401(k) plan is a tax-deferred retirement plan in which contributions from the employee and employer, if applicable, as well as the earnings on those contributions are not taxed until retirement when withdrawals are made. A 403(b) plan is essentially the same as a 401(k) plan except that it is available only for employees of schools and charitable organizations. Both plans offer a tax-deductible employee contribution and tax deferral until funds are withdrawn. 11. What is a “catch-up” provision? Who can use it? Why? A “catch up” provision allows taxpayers over the age of 50 to make additional tax-deferred contributions to a retirement account or IRA to “catch up” their savings to a more appropriate level. The annual “catch up” amount is $5,500, indexed to inflation. 12. Who is eligible to participate in a self-employed or small business retirement plan? Would a public school teacher who moonlights as a photographer qualify for a SEP-IRA? Anyone who owns/operates a small business with full- or part-time employment, works for a small business, or does freelance work on a part-time basis is eligible to participate in a taxfavored retirement plan such as a Keogh, SEP-IRA, or SIMPLE plan. Generally, the plans are self-directed by the employee. The specific eligibility requirements vary for each plan depending on the employment situation. All offer tax-sheltered growth and different options for employer or employee contributions. A teacher who operates a photography business part-time would be eligible to fund a SEP-IRA. 13. How does the traditional IRA differ from the Roth IRA? What characteristics are common to both? Roth IRA contributions are not tax deductible. The account grows tax-free and all withdrawals of principal are tax-free if the funds have been deposited for 5 years. With a traditional IRA, the annual contribution may be fully tax-deductible, partially taxdeductible, or not tax-deductible, but the earnings grow tax-deferred. Withdrawals are taxed when the money is withdrawn, but the taxation on the contribution varies with the original tax status. For example, tax-deductible contributions and the earnings will be taxed when withdrawn. Contributions that were not tax-deductible will not be taxed a second time when withdrawn, but the earnings will be taxed.


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Annual contribution limits of $5,500 in 2014 apply to both the Roth and traditional IRA. Annual contribution limits apply to one or both accounts in combination. Both accounts are self-directed, with few restrictions on the investment chosen. No taxes are paid on the growth of a traditional or Roth IRA while the funds are in the account. Both have options for penalty-free withdrawals prior to retirement, although different criteria apply. 14. Can a nonworking spouse have a traditional IRA? If so, what restrictions apply? Yes, there is a provision to allow a nonworking spouse to make a deductible contribution to a traditional IRA even if the working spouse is covered by a qualified retirement plan or earns a high income. If the modified adjusted gross income (MAGI) on the tax return is below $178,000 the contribution is fully deductible, and if MAGI is below $188,000 the contribution is partially deductible. Above that limit, no deduction applies, but the couple may still fund the IRA and benefit from the tax-deferred growth and other IRA features. MAGI is defined as adjusted gross income before any traditional IRA contributions are subtracted. 15. What penalty-free withdrawals are allowed from a traditional IRA? Withdrawals from a traditional IRA may avoid the 10 percent penalty if the account owner is (a) over 59½, (b) disabled, (c) using the money for the purchase of a first home ($10,000 maximum), (d) covering medical expenses that exceed 7.5 percent of AGI, (e) unemployed and paying for medical insurance premiums, or (f) paying qualified education expenses. 16. What is meant by the term “rollover?” Why is this important? Distributions from pension plans or other company retirement plans are often “rolled over.” This means that, instead of paying taxes on a lump-sum distribution, the distribution can be placed into an IRA or other qualified retirement plan. Rolling over distributions is a way to avoid paying taxes on the distribution while the funds continue to grow tax-deferred. It is important to complete a “trustee-to-trustee transfer” to avoid 20 percent tax withholding on the account. The check should never be made payable to the individual; if the check is sent to you, be sure it is made payable to the IRA. 17. Explain the benefit of the Saver’s Tax Credit. What restrictions apply? The Saver’s Tax Credit is an income tax credit, with a maximum benefit of $2,000 for couples ($1,000 for individuals), to offset part of the first $2,000 a worker contributes to an IRA, 401(k), or other workplace retirement plan. This credit is available for certain low to moderate income filers based on filing status, adjusted gross income, tax liability, and the amount contributed to qualifying retirement programs. This is very beneficial to those who qualify, because this, like all tax credits, off-sets tax liability on a dollar-for-dollar basis. 18. What advantages does a 529 plan offer over a Coverdell Education Savings Account? May a household fund both plans?



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The main advantage of the 529 over the College Education Savings Account is the contribution limit is so much higher. The 529 plans allow as much as $330,000 as compared to the $2,000 annual contribution limit per child under 18 with the College Education Saving Account. A household may fund both plans in the same year; however, for withdrawal purposes, the same expenses cannot be claimed for distributions from both the 529 and the College Education Saving Account. Nor can the same expenses be claimed for the Hope or Lifetime learning tax credits. 19. What is an annuity? Describe the different annuity variations for retirement distributions. An annuity provides a recipient with an annual payout. • Single Life Annuity: Receive a set monthly payment for your entire life. • Annuity for Life or a Certain Period: Payments are made for your entire life; however, if you die before the end of a certain period (e.g., 10 years), payments will continue to be paid to your beneficiary. At the end of the certain period, all payments to your beneficiary will stop. • Joint and Survivor Annuity: This type of annuity provides payments over the life of both you and your spouse. You may typically choose from a 50 percent or 100 percent survivor benefit. In the case of the 50 percent survivor benefit, your spouse would receive one-half of the monthly payment if you died. A 100 percent annuity would continue to pay the full benefit to your spouse. The higher the survivor benefit, the lower the size of the initial annuity. If you are married and choose no survivor benefit, your spouse must sign a waiver giving you permission to accept the alternative. 20. Explain why Social Security benefits are more important for lower income households than for higher income households. Social Security benefits make up 83 percent of retirement income for the lowest income households, whereas higher income households rely on Social Security benefits for only 16 percent of their retirement income. 21. Timing is essential to retirement planning. Why? Timing is critical for successful retirement planning because the earlier an investor starts (a) the longer the time horizon maximizing the benefit of compound interest, (b) the more risk the investor should be willing to accept, (c) the greater the benefit of tax-deferred investing, and (d) the better the chance the investor has at achieving the goal with lower annual investment amounts.


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PROBLEMS AND ACTIVITIES ANSWERS 1.

Jazmin will pay 6.2 percent of her salary to Social Security and 1.45 percent of her salary to Medicare. Therefore, she will pay a total of $3,920.63 [$51,250 x (0.0620 + 0.0145)]. Kristen’s employer will pay a matching amount.

2.

a. b. c.

His annual need is $50,000 × .90 = $45,000. If Grady needs $45,000 of after-tax income and his tax rate is 15 percent, he will really need $45,000/(1 – .15) = $52,941. To calculate the inflation-adjusted annual need, input the following numbers into your financial calculator: N = 40 I = 3.5 PV = 52,941 PMT = 0 CPT FV = 209,608

d.

To calculate the total retirement need, input the following numbers into your financial calculator: N = 20 I = 5 – 3.5 = 1.5 PMT = 209,608 FV = 0 CPT PV = 3,598,684

e.

To calculate the monthly savings need, input the following numbers into your financial calculator: N = 40 × 12 = 480 I = 8 / 12 = .6667 PV = 0 FV = 3,598,667 CPT PMT = 1,031

3.

For income of $119,750 the following 2014 tax liabilities would be incurred: • Social Security = $117,000 × 0.062 = $7,254.00 (2014 income cap is $117,000) • Medicare = $119,750 × 0.0145 = $1,736.38 • Total = Social Security + Medicare = $8,990.38



4.

Answers for Anne-Marie and Yancey are as follows: a. They have a projected need of $58,977.27. Net need = (current living expenses × replacement ratio) + additional annual needs = ($67,000 × 0.70) + $5,000 = $46,900 + $5,000 = $51,900.00 Gross need = net need / (1 – average tax rate) = $51,900.00 / (1 – 0.12) = $51,900.00 / 0.88 = $58,977.27 b.

They have a present value annual shortfall of $1,977.27. Present value shortfall = projected income need – projected income available = $58,977.27 – ($22,000 + $35,000) = $1,977.27

c.

They have a future value annual shortfall of $8,545.76. Future value shortfall = present value shortfall x (FVIF 5%, 30 years) Factor Table A solution PV $1,977.27 PMT n/a

d.

(FVIF5 %, 30)

4.322

FV

$8,545.76

Calculator solution PV -$1,977.27 PMT $0 I/Y 5% N 30 FV ? CPT FV $8,545.65

Step 1: Determine the total shortfall at retirement Using Appendix D, they have a future value shortfall of $91,224.17 at retirement Factor Table D solution FV n/a PMT $8,545.76 (PVIFA8%, 25)

10.675

PV

$91,224.17

Calculator solution PV ? PMT -$8,545.65 I/Y 8% N 25 FV $0 CPT PV $91,222.90


323

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Step 2: Determine the annual payment needed to cover the shortfall at retirement Using Appendix C determines the current fixed annual payment to be $1,247.86 Factor Table C solution PV n/a PMT $1,247.86 (FVIFA8%, 25)

73.106

FV

$91,225.98

Calculator solution PV $0 PMT ? I/Y 8% N 25 FV $91,222.90 CPT PMT $1,247.82

Alternative d. Determine the annual shortfall for retirement In this alternative, the annual value of their withdrawal is assumed to increase. Hence, the rate of return for this calculation must be the inflation adjusted rate of 3% (8% – 5%). Step 1: Determine the total shortfall at retirement Using Appendix D, they have a future value shortfall of $148,804.36 at retirement (Because the annual value of their withdrawal is assumed to increase, the rate of return for this calculation must be the inflation adjusted rate of 3% (8% – 5%).) Factor Table D solution FV n/a PMT $8,545.59 (PVIFA3%, 25)

17.413

PV

$148,804.36


Step 2: Determine the annual payment needed to cover the shortfall at retirement Using Appendix C determines the current fixed annual payment to be $1,313.57. (Because the annual value of their payment is assumed to remain fixed, the rate of return for this calculation must be the nominal rate of 8 percent, because inflation was already considered in Step C.) Factor Table C solution PV n/a PMT $1,313.57 (FVIFA8%, 30)

113.282

FV

$148,804.36




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5.

Russell and Charmin need $77,000 income in retirement. Net need = (current living expenses x replacement ratio) + additional annual needs = $97,000 × 0.80 = $77,600 Gross need = net need / (1 – average tax rate) = $77,600 / 0.80 = $97,000

6.

These calculations are based on the commonly used formula for defined-benefit plans, as found on page 506; variations in the formula used by Anita’s company would determine the actual amounts. Annual benefit = Average salary × years of service × 0.015 = $37,000 × 25 × 0.015 = $13,875 (if Anita retires now.) Annual benefit = Average salary × years of service × 0.015 = $47,000 × 30 × 0.015 = $21,150 (if Anita accepts the promotion and retires later.) Unfortunately, most pensions do not adjust retirement benefits for inflation. In other words, the benefit level remains constant; therefore, the spending power of the pension benefit gets reduced over time by the erosive effects of inflation.

7.

At ABC, Inc. the first year contribution invested for 30 years at 9 percent would be worth $88,225.55. • Reece’s Contribution = $38,000 × 0.10 = $3,800 • Company Match = $38,000 × 0.10 × 0.75 = $2,850 • Total Contribution = $6,650 Factor Table A solution PV $6,650 PMT n/a (FVIF9 %, 30)

13.267

FV

$88,225.55


At XYZ, Inc. the first-year contribution invested for 30 years at 9 percent would be worth $97,512.45. • Reece’s Contribution = $35,000 × 0.15 = $5,250 • Company Match = $35,000 × 0.06 × 1.00 = $2,100 • Total Contribution = $7,350


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Factor Table A solution PV $7,350 PMT n/a (FVIF9 %, 30)

13.267

FV

$97,512.45


The two retirement plans offered by the company would result in a future value difference for the first year of employment of $9,286.90. However, Reece must consider that it is his contribution that is making the difference. Although he would come out ahead at retirement, the ABC offer is more lucrative today. Not only are they offering a salary that is $3,000 more, but they potential could contribute $750 per year more to his retirement plan. 8.

Peter and Blair have a $25,000 ($86,000 – $61,000) per year present value shortfall. They need to save $756,131.85 ($6,674.77per year) to meet their income needs projection. Step 1: Calculate the annual future value shortfall at retirement Factor Table A solution PV $25,000.00 PMT n/a (FVIF3%, ,30)

2.427

FV

$65,675.00


Step 2: Calculate the total shortfall needed to be funded by retirement assuming that the desired annual retirement benefit continues to grow at the inflation rate. Because the annual value of their withdrawal is assumed to increase, the rate of return for this calculation must be the inflation-adjusted rate of 5% (8% – 3%). Factor Table D solution FV n/a PMT $65,675.00 (PVIFA5%, 20)

12.462

PV

$756,131.85




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Step 3: Calculate the annual funding requirement to achieve the savings goal by the time of retirement. Factor Table C solution PV n/a PMT $6,674.77

9.

(FVIFA8%, 30)

113.282

FV

$756,131.85


Funding a 529 plan with $120,000 with earnings of 7 percent until the child reaches age 18 would yield approximately $405,600 for college expenses. Factor Table A solution PV $120,000 PMT n/a (FVIF7%, ,18)

3.380

FV

$405,600


10. Annual contributions of $2,000 to a Coverdell Education Savings Account earning 7 percent would yield approximately $67,998 when the child is 18 and ready to enter college. Factor Table C solution PV n/a PMT $2,000 (FVIFA7%, 18)

33.999

FV

$67,998.00

Calculator solution PV $0 PMT $2,000 I/Y 7% N 18 FV ? CPT FV $67,998.07


Yes, they both qualify for a Roth or traditional IRA, although the Roth offers the greatest benefits. They can contribute $5,500 each in 2014 into their Roth IRA accounts and should seriously consider increasing their contributions as the limits continue to increase. Molly can also take advantage of a SEP-IRA or Keogh plan to defer some of her self-employment income. The SEP-IRA allows her to defer up to 25 percent of her income or $52,000, whichever is less, in 2014.

2.

Although Bill should be funding both the Roth and his 403(b) to the greatest extent possible, fully funding the Roth typically offers the greatest advantage, assuming the same rate of return on the two accounts. Whereas both accounts grow tax-deferred, the Roth account will


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be withdrawn tax-free, but Bill will pay taxes on the contributions and the earnings in the 403(b) account. However, the tax consequences in the current year may also be considered. For every $1,000 Bill deposits in his 403(b), he saves $250 in tax liability for the current year. Without the 403(b) contribution, the $250 would have been paid to the federal government. Conversely, Bill must earn $1,333 [($1,000 / (1 – 0.25) (ignoring Social Security and state taxes)] to have $1,000 after taxes to fund the Roth. In summary, the simple answer is fund the tax-free account in the absence of a match for a tax-deferred account. 3.

“Catch-up” contributions will apply to Bill and Molly when they are 50 years old or older, and will allow them to make additional $1,000 per person retirement contributions beyond the maximum annual limit. The provisions also apply to the 403(b) account, the Roth IRA, and the SEP-IRA or Keogh account for Molly’s self-employment income, although the “catch-up” amounts vary by retirement plan.

4.

They need approximately $117,600.00 at their anticipated retirement date. Replacement need = $70,000 × 0.80 = $56,000 (using the 80 percent replacement rule) According to Table 15.2 in the text, pretax income = replacement income / (1 – average tax rate) = $56,000 / (1 – 0.14) = $65,116.28 pre-tax income Now calculate the future value “inflation-adjusted” income need using Appendix A Factor Table A solution PV $65,116.28 PMT n/a

5.

(FVIF3%, ,20)

1.806

FV

$117,600.00


Step 1: The value of the portfolio at retirement is approximately $316,015.80. Total portfolio value today = IRA + 403(b) = $20,000 + $47,800 = $67,800 Factor Table A solution PV $67,800 PMT n/a (FVIF8%, ,20)

4.661

FV

$316,015.80




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Step 2: Their after-retirement annual income would be approximately $32,187.39; assuming no further contribution into either retirement account, and a fixed withdrawal rate. Factor Table D solution FV n/a PMT $32,187.39 (PVIFA8%, 20)

9.818

PV

$316,015.80

Calculator solution PV -$316,012.89 PMT ? I/Y 8% N 20 FV $0 CPT PMT $32,186.61

Alternative Step 2: Their after-retirement first year income would be $25,358.12; assuming no further contribution into either retirement account, and a continued 3 percent rate of increase on withdrawals. (Remember to use the inflation adjusted return to approximate for a continued increase in their retirement withdrawal rate.) Factor Table D solution FV n/a PMT $25,358.35

6.

(PVIFA5%, 20)

12.462

PV

$316,015.80

Calculator solution PV $316,012.89 PMT ? I/Y 5% N 20 FV $0 CPT PMT $25,357.69

If the Hickoks want their retirement income to remain fixed over their retirement period then they need to invest $11,621.30 annual to cover their projected shortfall. Step 1: Calculate the annual shortfall assuming a fixed withdrawal rate as: Annual shortfall = Projected annual income need – projected annual income available $54,213.00 = $117,600.00 – ($32,187.39 + ($2,600 × 12) Step 2: Solve for the total additional funding requirement needed as of retirement. Factor Table D solution FV n/a PMT $54,213.00 (PVIFA8%, 20)

9.818

PV

$532,263.23



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Step 3: Solve for the annual additional funding requirement to reach their income goal. Factor Table C solution PV n/a PMT $11,631.12 (FVIFA8%, 20)

45.762

FV

$532,263.23


If the Hickoks want their retirement income to increase annually by 3 percent, then they need to invest $16,622.99 annually to cover their projected shortfall. Alternative Step 1: Calculate the annual shortfall assuming a growing withdrawal rate as Annual shortfall = Projected annual income need – projected annual income available $61,041.65 = $117,600.00 – ($25,358.35 + $31,200.00) Alternative Step 2: Solve for the total additional funding requirement needed as of retirement. (Remember to use the inflation adjusted return to approximate for a continued increase in their retirement withdrawal rate.) Factor Table D solution FV n/a PMT $61,041.65

Calculator solution PV ? PMT -$61,041.65 I/Y 5% (PVIFA5%, 20) 12.462 N 20 PV $760,701.04 FV $0 CPT PV $760,713.88 Alternative Step 3: Solve for the annual additional funding requirement to reach their income goal. Factor Table C solution PV n/a PMT $16,622.99 (FVIFA8%, 20)

45.762

FV

$760,701.04


Investments for retirement should always be made in a tax-deferred account if at all possible. The Hickoks should consider increasing their investment into his 403(b) and IRA accounts, as well as starting tax-advantaged accounts for Molly’s self-employment income.



7.

Student answers may vary, however the following could be included: • Allocate any future increases in income to savings before getting used to spending. • Have a plan for saving “extra” money in place, so when it happens you don’t have to think about it. • Keep financial goals readily visible, so planning for retirement seems more real.

8.

Student answers may vary; however, the following could be included: • Molly should open one of the self-employed retirement plans (e.g., SEP-IRA). • Molly should start an IRA. • Bill should increase his retirement plan contributions.

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The advantages of taking pension payouts in the form of an annuity include the following: • Payments continue as long as you are living. • You may be able to continue receiving employer health care benefits. Disadvantages include the following: • Annuities generally do not provide inflation protection. • There is limited flexibility in accessing additional funds in the event of an emergency. • Payments stop when you die—there is no opportunity for gifting the remaining balance.

2.

A 100 percent joint and survivor annuity would be the most appropriate in their case. Their pension income accounts for 35 percent of their retirement income. If Timur were to die before Maurguerite, she would need the greatest possible income in order to maintain her level of living.

3.

Timur and Maurguerite could be better off taking a lump-sum distribution and purchasing an insurance company annuity on their own, or investing the proceeds themselves. Given historical rates of return, they could expect to earn substantially more than 4 percent, even in a conservatively managed mutual fund. A disadvantage of lump-sum distribution is possible tax consequences. One way to reduce the impact of taxes is to have the distribution “rolled over” into an IRA. In this way, they would avoid paying taxes on the distribution while the funds continue to grow on a taxdeferred basis. A possible disadvantage of purchasing an annuity on their own is the chance that they might choose an annuity from a poorly rated insurance company that could jeopardize the safety of the distribution. If they invest the distribution themselves in stocks, bonds, or mutual funds, they run the risk of making a bad investment and losing the money they’ve saved. However, these disadvantages may be offset by the flexibility that a lump-sum distribution offers.

4.

Timur and Marguerite should consider the following strategies to help them monitor expenses and safeguard their retirement lifestyle:


332


•

•

• •

5.

Adjust their investments, particularly in the 401(k) plan, to cover inflation and allow their money to grow conservatively. Fixed income investments, like CDs and bonds, may be safe, but with a long time horizon during retirement, they must still beat inflation and have moderate growth to insure adequate funds for the future. Monitor their investments and the overall health of their former employer. Insurance or other benefits, as well as the price of any company stock they own, could be affected by changes in the company. Changes in company benefits or their investment values could impact their retirement goals and require them to make adjustments. Keep their insurance coverage up to date and the premiums paid. Don’t risk an uninsured loss. Use computer programs or Internet sites to monitor their investment plan and see into the future. By carefully tracking their funds, they can meet their goals without fear of “outliving their money.”

If all of the relatives contribute as planned, then the grandson would have just over $231,900. At that rate, he might be able to afford George Washington University, just barely. Factor Table C solution PV n/a PMT $6,500 (FVIFA7.5%, 18)

35.677

FV

$231,900.50

Calculator solution PV $0 PMT $6,500 I/Y 7.5% N 18 FV ? CPT FV $231,903.02


CHAPTER 16 ESTATE PLANNING: SAVING YOUR HEIRS MONEY AND HEADACHES CHAPTER CONTEXT: THE BIG PICTURE This chapter is the second in “Part 5: Life Cycle Issues.” It focuses on the broader issues of estate planning, such as understanding and avoiding probate, determining the value of an estate, calculating estate taxes, and evaluating wills, trusts, and related planning documents. This chapter is an important one for students to understand both conceptually and practically because, as is highlighted throughout the chapter, estate planning does not, and cannot, exist in a vacuum. To understand the importance of estate planning, students must integrate their knowledge of cash flow management, taxes, insurance, investing, and retirement planning into a comprehensive model of personal financial management. CHAPTER SUMMARY This chapter establishes the importance of estate planning throughout the financial life cycle and explains various estate planning tools that relay the desires of the decedent. The objectives of estate planning, and the four-step process of estate planning, are discussed. Strategies to reduce estate taxes are considered. The basic organization and writing of a will is explained, as well as the use of other documents, such as a letter of last instruction, a living will, and a durable power of attorney. This chapter concludes with a discussion of probate and strategies for avoiding probate. LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms: 1.

Understand the importance and the process of estate planning. a. Estate planning b. Unified tax credit c. Generation-skipping tax

2.

Draft a will and understand its purpose in estate planning. a. Will b. Beneficiary c. Executor or personal representative d. Guardian e. Probate f. Codicil 333


334


g. h. i. j. 3.

Letter of last instructions Durable power of attorney Living will Durable health-care power of attorney

Avoid probate. a. Tenancy by the entirety b. Joint tenancy with the right of survivorship c. Tenancy in common d. Community property e. Trust f. Living trust g. Revocable living trust h. Irrevocable living trust i. Testamentary trust j. Family trust k. Portable estate exemption l. Qualified terminable interest property (Q-TIP) trust m. Sprinkling trusts

CHAPTER OUTLINE I.

The Estate Planning Process A Step 1: Determine the Value of Your Estate. B. Step 2: Choose Your Heirs and Decide What They Receive. C. Step 3: Determine the Cash Needs of the Estate. D. Step 4: Select and Implement Your Estate Planning Techniques. E. Understanding and Avoiding Estate Taxes F. Gift Taxes G. Unlimited Marital Deduction H. The Generation-Skipping Transfer Tax I. Calculating Estate Taxes

II.

Wills A. Wills and Probate B. Wills and Estate Planning C. Writing a Will D. Updating or Changing a Will—The Codicil E. Letter of Last Instructions F. Selecting an Executor G. Other Estate Planning Documents


Chapter 16: Estate Planning: Saving Your Heirs Money and Headaches

335

III.

Avoiding Probate A. Joint Ownership B. Gifts C. Naming Beneficiaries in Contracts—Life Insurance and Retirement Plans D. Trusts E. Living Trusts 1. Revocable living trusts 2. Irrevocable living trusts F. Testamentary Trusts 1. Standard family trusts (also known as A-B trusts, credit-shelter trusts, and unified credit trusts) 2. Qualified terminable interest property (Q-TIP) rust 3. Sprinkling trusts G. A Last Word on Estate Planning

IV.

Behavioral Insights A. Principle 9: Mind Games, Your Financial Personality, and Your Money B. Optimism or superman bias C. Inertia and procrastination

V.


APPLICABLE PRINCIPLES Principle 7: Protect Yourself Against Major Catastrophes One of the best ways to protect your loved ones from the burdens of administering your estate is to have your affairs in order long before your death. This means taking steps today to inventory your property, to prepare a will or a living trust, and to assure that sufficient insurance or liquid assets are available to pay for your final expenses. Principle 4: Taxes Affect Personal Finance Decisions The current federal estate tax rate can go as high as 55 percent of taxable assets. When combined with federal income taxes, more than one half of a person’s entire estate could be lost to taxation. This is unfortunate because, as is pointed out in this chapter, most people can take steps prior to death to avoid most or all estate taxes. This implies that those who pay such taxes may be doing so out of ignorance or fear. Although estate planning can be a complicated process, efforts taken to plan today can reap great gains in the future. Principle 1: The Best Protection Is Knowledge Improper estate planning could result in huge losses of assets intended for your beneficiaries due to estate taxes. Your wishes are not fulfilled, and your beneficiaries miss out on what you intended for them to receive. The use of trusts and lifetime giving can help you accomplish your goals while you are alive and save on taxes.


336


Principle 9: Mind Games, Your Financial Personality, and Your Money Nobody likes talking about their own death. However, failure to plan for death could mean that the people you care for are not cared for in the way you would have liked. Protect your heirs and do some planning now. Principle 10: Just Do It! Everyone needs some form of estate planning. Even if your net worth falls below the lifetime exemption amount, the need for a will, living will, and letter of last instruction applies to almost everyone. Most of the documents can be completed for low or no cost with the help of online tools. Complicated situations should always utilize a licensed professional’s advice. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1.

Have your class discuss the major objectives of estate planning. Ask students to explain why each objective does or does not pertain to them at their current stage in the life cycle. Ask students specifically about durable power of attorney issues, and inquire if most or all of the students agree that anyone of legal age could benefit from having a durable power of attorney.

2. Locate three to five articles about problems experienced by individuals or families who failed to develop estate plans or to identify responsible parties in the event of physical or mental impairment in your state. Have the class summarize the outcomes of “failing to plan.” 3.

Ask students to list and estimate the value of their assets. Once they have inventoried their assets, ask them to think about how they would like to have their property distributed in a will. If the class is very motivated, have them prepare a will with all the major clauses included.

4.

Discuss probate avoidance methods with the class. Ask the students to list and describe a practical example of each avoidance method and how the method of their choice might apply to a specific family situation.

5.

Invite an attorney to class to discuss your state’s probate system. Have the attorney illustrate what can happen to someone’s estate if they die without a will. Ask the attorney to explain why people in all stages of the life cycle should have a will. Also, ask the attorney to discuss the responsibilities of an executor and the qualities people should look for when appointing an executor.

6. Have students make a list of criteria that they would use in selecting the executor of their estate and the heirs named to inherit assets. How would these criteria change if the students were selecting a guardian for their children? ©2016 Pearson Education, Inc.


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7. Have students prepare a letter of last instructions and discuss it with one or more family members. Have family members prepared a letter of last instruction or implemented other estate planning strategies? 8. Ask students to discuss with a close adult friend or relative his or her estate plans including the use of a will, trusts, lifetime gifting, a living will, and/or a durable power of attorney. Request a one-page report of their findings. 9. Request that students visit the Internet sites of at least three charitable organizations. Students can facilitate their search by using one of the following Internet portals: www.giveforchange.com, www.bbb.org, or www.greatergood.com. Ask students to write a one-page summary of the charitable giving alternatives explained and to present their favorite charitable giving sites in class, including a review of the income and estate tax advantages of gifting. REVIEW QUESTIONS AND ANSWERS Review questions can be asked throughout the chapter as a way to gauge student interest and understanding. Answers follow each question. 1. Define estate planning. List the objectives to accomplish through estate planning. Estate planning is the process of planning for an orderly disposition of accumulated wealth before and after death. Estate planning objectives include the following: • Assuring that property is distributed according to your wishes. • Select a guardian to provide for dependents. • Minimizing estate and inheritance taxes and leaving more property for heirs. • Keeping estate settlement costs (e.g., legal fees) to a minimum. • Providing for decision-making authority in the event of physical or mental impairment. 2.

Describe the four steps in the estate planning process. 1. Determine what an estate is worth. Start with a net worth calculation (assets minus debts) and add the face value of life insurance and death benefits provided by employer retirement plans. 2. Choose heirs and deciding how much each will receive. It is important to consider the financial and special (e.g., handicapped child) needs of potential heirs. 3. Determine the cash needs of the estate. Estimate expenses for debts, legal fees, taxes, etc., and earmark liquid assets or life insurance policy proceeds to cover them. 4. Select and implement various estate planning techniques. Examples include writing a will, using a durable power of attorney, lifetime gifting, trusts, and joint ownership of property.


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3. Explain the annual gift tax exclusion. How is it used as an estate planning tool? The annual gift tax exclusion allows an individual to gift up to a certain amount to any number of people without incurring a gift tax. (In 2014, the limit was $14,000 with annual increases likely to occur.) Lifetime gifting can be used to reduce the value of a person’s taxable estate, thus resulting in a lower estate tax. When a married couple uses this technique, they can gift double the individual amount to any one person per year. Up to $51,340,000 of gifts over the annual limit can also be offset by the unified credit, as estate and gift tax rates are linked. Advantages of using, and not exceeding, the annual gift tax exclusion include the following: • Reducing the value of the taxable estate • Avoiding probate, as gifted assets no longer belong to the donor • Benefiting heirs while the donor is still alive • Not taxes for the gift recipient • Avoiding application of the unified credit to offset gifts that exceed the annual exclusion • Avoiding the gift tax by not exceeding the $5.34 million lifetime gift exclusion 4.

Describe the unlimited marital deduction. What exclusions apply? The unlimited marital deduction is an estate tax provision that allows a surviving spouse to receive all of his/her deceased spouse’s assets free of federal estate tax, regardless of the size of the estate. For couples with individual and joint assets valued at under the tax-free threshold amount, the marital deduction is an acceptable way to transfer property to a surviving spouse because there is no estate tax liability. For couples with assets over this amount, leaving assets outright to a surviving spouse can trigger high estate taxes when the surviving spouse dies. This is because the surviving spouse owns all the assets of both spouses and the amount of estate value over the tax-free threshold amount is taxed at rates of 40 percent. A much better option involves taking advantage of the unified credit of the first spouse to die to exempt $5,340,000 of estate value from tax and use this money to establish a family trust. An exception to this is that the unlimited marital deduction does not apply to a surviving spouse who is not a U.S. citizen.

5. What is the generation-skipping transfer tax? The generation-skipping transfer tax (GSTT) is a flat tax in addition to any estate and gift taxes on property transfers that skip a generation (i.e., to a person two or more generations younger than the donor). The purpose of the GSTT is to collect taxes as if an asset had first passed to an intervening generation (i.e., to children and then to grandchildren). 6.

List and briefly describe the four steps involved in the process of calculating estate taxes. 1. Calculate the value of the gross estate by totaling the value of all assets at the time of death, including death benefits from life insurance policies or retirement plans.



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2. Calculate the value of the taxable estate by subtracting, from the gross estate, funeral and estate administration expenses, debts, taxes, and allowable deductions, such as the unlimited marital deduction or charitable deductions. 3. Calculate the gift-adjusted taxable estate by adjusting the taxable estate for any taxable lifetime gifts made in excess of the $14,000 annual gift tax exclusion. 4. Calculate estate tax due by looking up the estate tax due on a specific estate value in an estate tax table and subtracting the unified credit and any applicable state death tax credits. In smaller estates, the unified credit offsets the entire tax due. 7. What is probate, and why is it often prudent to take steps to avoid probate? Probate is the legal process of changing the title of property that is not titled as joint tenants with right of survivorship, tenants by entirety, or by a trust and does not pass by way of a named beneficiary (e.g., life insurance and pension plans). Probate validates a will, provides for an orderly distribution of assets to heirs, and protects creditors. Probate is also public, meaning that anyone can find out about property owned and transferred. This fact, coupled with the relatively high costs involved with probate, makes it prudent to avoid the process. 8. List five reasons why having a will is important. A will allows you to • Appoint a guardian for your children • Stop the state from dictating how your assets will be distributed • Transfer assets according to your wishes • Make special gifts and bequests • Choose an executor/administrator 9.

Describe the basic clauses in a will. What individuals are typically designated in a will? • Introductory statement: identifies the maker of the will and revokes any prior wills • Payment of debts/taxes clause: directs the payment of debts including medical and funeral expenses and taxes • Disposition of property clause: states who is to receive specific items and what happens to the remainder of the estate after all bequests are honored • Appointment clauses: names the executor of the estate and the guardian of minor children • Common disaster clause: identifies which spouse is presumed to have died first in the event that both die simultaneously • Attestation and witness clause: dates and validates the will by having it signed by two or more witnesses A will typically names the executor or executrix, the beneficiaries, the trustee(s) for testamentary trusts, and the guardian(s) for minor children.


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10. What are the roles and duties of an executor? The executor is responsible for making sure that the wishes of the decedent are carried out and for managing the estate property until it is passed to heirs. Specific duties include the following: • Sending copies of the will to all beneficiaries • Publishing death notices • Paying any necessary taxes • Paying the debts of the estate • Managing the financial matters of the estate • Distributing the assets that remain after all bequests have been made • Reporting a final accounting of the estate distribution to the court 11. List four strategies for transferring property that will avoid probate. • Joint ownership, as controlled by state law • Gifts made prior to death but not through the will • Contracts that name beneficiaries, such as beneficiaries identified for life insurance proceeds or pension benefits • Trusts 12. List and briefly describe (a) the three forms of joint ownership and (b) the advantages and disadvantages of these approaches of owning property with others. • Tenancy by the entirety: form of ownership reserved for married couples where property can be transferred only if both parties agree. Upon the death of a spouse, assets held in this form automatically pass to the other. Assets held in this form avoid probate and are eligible for the unlimited marital deduction. • Joint tenancy with right of survivorship: form of ownership where two or more people share ownership of an asset. When one joint owner dies, ownership passes directly to the surviving owner(s). Assets held in this form avoid probate and are eligible for the unlimited marital deduction. • Tenancy in common: form of ownership where two or more people share ownership of an asset. When one owner dies, that owner’s share becomes part of their estate and is distributed according to provisions in their will. Thus, the remaining joint owners do not automatically receive the decedent’s share unless they are named a beneficiary in his/her will. Assets held in this form do not avoid probate. The primary advantage to the first two ownership types is that property owned in one of these two manners avoids probate and therefore passes more quickly to the other owner. 13. What is community property? What restrictions apply to this form of ownership? Community property is a form of ownership in a few primarily western states where husband and wife are assumed to share equally in the ownership of all assets acquired



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during their marriage. Assets held in this form avoid probate and are eligible for the unlimited marital deduction. Furthermore, upon the death of the first spouse, the surviving spouse automatically receives one-half ownership while the other half passes through probate. Restrictions to this ownership type include assets separately owned prior to marriage and gifts or inheritances that have been kept separate after marriage. 14. Briefly explain the gifting exceptions that apply to (a) life insurance, (b) medical and educational expense, and (c) charitable gifts. Three exceptions to the annual tax-free gift exclusion include the following: • Life insurance: The value of a policy, given away within 3 years of the owner’s death, is “brought back” into the estate for the calculation of the estate value and estate tax, if applicable. If the policy is given away more than 3 years prior to the death of the individual, the value of the policy at the time of the gift is subject to applicable gift tax regulations. • Medical and educational expense: An unlimited gift tax exclusion applies for medical and educational expenses paid directly to the school or institution providing the medical service. Can also be applied to the payment of health insurance premiums. The recipient of the gift does not have to be related to the giver. • Charitable gifts: An unlimited gift tax exclusion applies for assets given to a federally recognized charity. Gifts are given tax free. Charitable gifts offer the added benefit of an income tax deduction. 15. What is a trust? Name five possible advantages of using trusts in estate planning. A trust is a legal entity that holds title to property that is managed for an individual (the grantor) or for the benefit of one or more beneficiaries. Advantages of a trust include the following: • Assets placed in a trust bypass the probate process. • Trusts are much more difficult to challenge in court than wills. • Trusts can be used to shelter assets from estate taxes. • A trustee can professionally manage the assets. • Increased confidentiality: Trusts are not a matter of public record. • Trusts can be used to provide funds for a special-needs child. • Trusts can hold assets for minor children until a designated age. • Trusts can provide for transfers by a remarried person to children from a prior marriage. 16. What are the fundamental differences between a living and a testamentary trust? Categorize the following as living or testamentary and briefly describe each: irrevocable trust, qualified terminable interest property trust (Q-TIP), revocable trust, and sprinkling trust. A fundamental difference between a living and testamentary trust is the timing of when the trust becomes effective. A living trust takes effect while the grantor is alive, whereas a testamentary trust is created by a will after completion of probate. Both types of trusts can offer the benefits of reduced estate taxes, professional investment management, and the


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disposition of property according to the grantor’s wishes. The following are descriptions of the primary types of trusts: • Irrevocable living trust: a permanent living trust that cannot be altered once established. The trust, rather than the grantor, becomes the owner of trust assets, which bypass probate and are not subject to federal estate taxes. • Q-TIP trust: a testamentary trust that gives the grantor the ability to provide income to his/her surviving spouse for life and then, at the spouse’s death, to direct where the assets should go (e.g., children from first marriage). Thus, the spouse receives income from a Q-TIP trust, but the assets in the trust are distributed to another party. • Revocable living trust: a living trust where assets can be withdrawn by the grantor. Revocable trusts provide no tax advantages but do avoid probate by having assets go directly to named beneficiaries. • Sprinkling trust: a testamentary trust that distributes income according to need rather than a preset formula. • Standard family (A-B) trust: a testamentary trust that allows a surviving spouse to receive income for life but keeps up to the tax-free threshold amount, or $5.0 million in 2012, of trust assets out of his/her name to avoid triggering the federal estate tax. Upon the death of the surviving spouse, trust assets are distributed tax-free to named beneficiaries (e.g., children). PROBLEMS AND ACTIVITIES ANSWERS 1.

a. b. c.

2.

a. b. c.

Because everything is jointly owned, Kayla does not need a will (and therefore does not need a codicil). She should, however, have a letter of last instructions and a living will to direct her preferences. A codicil will probably suffice for Justin and Edee. If other major changes have occurred in the past 10 years, they may want to write an entirely new will. They also need letters of last instruction and living wills. Mac definitely needs a will to make sure his assets are distributed in the way he wishes. He also needs a letter of last instruction and a living will. There will be no gift tax owed by Lily and Tom on their $20,000 gift to Raoul because a couple can transfer $28,000 per year (2014) to any number of people free of gift tax, a maximum of $14,000 from each spouse. Raoul will not have to pay any income tax because recipients of a gift are not taxed on their gift. Advantages of making a gift to others within the annual gift tax exclusion include the following: • Providing needed income to a friend or loved one while the donor is alive • Reducing the donor’s taxable estate, resulting in lower estate taxes • The recipient of a gift is not taxed on the amount received (although they will be taxed on any subsequent income the gifted amount generates) • Helping avoid probate because gifted assets no longer belong to the donor and are no longer part of their estate



3.

a. b.

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The current estate tax legislation requires that the value of a decedent’s estate by “grossed-up” by the amount of any gifts that exceeded the annual gift tax exclusion. Therefore the value of Zane’s estate is $6,500,000 ($6,300,000 + $200,000). The estate will owe taxes on the amount by which the gift-adjusted taxable estate exceeded the 2014 lifetime exclusion amount of $5,340,000.

4.

Use the following calculations to answer the five questions related to Morgan’s situation. a. Gross Estate: $8,600,000 b. Taxable Estate: $8,600,000 – $18,000 – $52,000 – $1,000,000 = $7,530,000 c. Gift-Adjusted Taxable Estate: Same as Taxable Estate = $7,530,000 d. Amount Subject to Taxation: $7,530,000 – $5,340,000 = $2,190,000 e. Estate Tax Liability: $2,190,000 × 0.40 = $876,000

5.

a. b. c.

6.

Additional information about gifting might be necessary. a. No gift tax because it does not exceed the $14,000 per person limit. b. $21,000 is a taxable gift to the extent that the gift exceeds $14,000. c. No gift tax as long as the tuition was paid directly to Wellesley College. d. No gift tax as long as the money was paid directly to Duke Medical Center. e. No gift tax because gifts to charities are not subject to the annual limit. f. No gift tax, only the cash value is included for the calculation of the gifted amount. Note: For estate taxes, the life insurance policy would be considered part of the estate because it was transferred during the previous three years.

7.

There will be no estate tax due upon KJ’s death, due to the unlimited marital deduction. Although So-hyun’s estate will be valued at $6,000,000 when she dies, she will owe no estate tax either, even though the value of her estate exceeds the $5,340,000 exemption amount. When KJ passed away, the value of his estate was $2,340,000 below the exemption amount. Because of the portable estate exemption, So-hyun is able to add the $2,340,000 unused amount to her own $5,340,000 exemption. Combined, the new exemption amount ($7,680,000) exceeds $5,340,000. Thus, no estate tax liability exits for either So-hyun or KJ.

8.

a.

May Yee’s estate value is $950,000 + $40,000 + $150,000 = $1,140,000. Taxable value of May Yee’s estate is $0. Because Mary Yee used the life insurance policy and the pension benefits contracts to designate the beneficiary, these assets would avoid probate. This would protect her niece’s privacy because she inherited $400,000, a sizable sum. The remainder of her estate would pass through probate. However, probate avoidance does not exempt the asset for estate taxation.

The primary advantage is that joint ownership provides for immediate transfer of assets without using the probate process. However, without some estate tax planning to utilize gifts or trusts, and assuming the estate value is maintained, the estate of the last surviving spouse may incur federal estate taxes. Under these circumstances, using the unlimited marital deduction could prove very costly.


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b.

c.

The Hansens should consider using trusts and gifts to transfer their estate and to reduce estate taxes. They may want to consider a program of planned lifetime gifting, taking advantage of the $14,000 annual gift tax exclusion to reduce the value of their taxable estate. If Elsa and Ludvik coordinate their gifting, they can transfer $28,000 to a single person per year free of gift tax. They should also utilize a trust to either transfer assets out of their estate prior to death or to by-pass the estate of the surviving spouse. The greatest tax benefit would be from using an irrevocable living trust; however, a standard family testamentary trust would also reduce the tax burden for the second-to-die spouse. Elsa’s half-share in the beach house that she co-owns with her sister would go to whomever she has named in her will and would be included in her estate. If Elsa dies intestate (without a will), state law will determine how her share in the beach house is transferred.


Because Lee and Marta do not have a will, probate may not appear to be an issue. However, probate also allows for the orderly distribution of assets of those who die intestate, or without a will. The Howards should be concerned for the following reasons: (a) probate can be costly; (b) probate can create delays in distributing assets to heirs and charities; and (c) the entire probate process is public.

2.

Although a letter of last instructions is not a legally binding document, the Howards should use such a document to provide information and instructions related to their final wishes. Information in this document includes the location of the will, who should and should not be notified of their death(s), location of other documents, Social Security numbers, tax return information, a listing of personal property, and funeral and burial instructions.

3.

A revocable trust allows the Howards to retain control of the assets in the trust and to obtain income from the trust. Revocable trusts provide no tax advantages; however, they do shelter assets from the probate process. With an irrevocable trust, the Howards will relinquish all title and control of assets placed in the trust. Assets removed from their current estate in a timely manner will be excluded from their estate for federal estate tax purposes; however, gifts to an irrevocable trust may be taxable.

4.

The Howards could use either living or testamentary trusts to benefit their heirs. If they choose to place some of their assets in an irrevocable living trust, then the deposited assets would (a) be removed from their taxable estate, (b) avoid the probate process, and (c) income from the trust could be directed toward the grandchildren, also potentially lowering income tax liability. Alternatively if the Howards are less concerned about estate taxes, then they could use any one of several testamentary trusts. Given the income limitations of both grandchildren, a sprinkling trust, where the trustee has some discretion about distributions, could be a beneficial solution. Another option would be a Q-TIP. This trust type would allow either



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Lee or Marta to provide for the surviving spouse but then have the assets pass without additional taxes or probate fees to their child or grandchildren. 5.

Lee could gift his whole life policy to an individual or charity. If the policy is given away within 3 years of his death, the policy will be included in the estate for tax purposes. However, beyond this point, the implications for his estate tax planning are different. If Lee gives the policy to an individual, the amount of the cash value over $14,000, the tax-free gift threshold, will be considered toward his lifetime non-tax-exempt gift amount. This will be offset by part of the unified tax credit, as long as the total non-tax-exempt gifts don’t exceed $5.34 million. The recipient would incur no taxes. No limits on gifts apply to charities.

6.

Although drafting one’s own will is not illegal or necessarily inappropriate, Lee and Marta should hire a competent estate attorney to draft their will. This necessity stems from the fact that the Howards have a relatively large estate and potential health problems.

7.

Lee and Marta should consider keeping the final copy of their will with their attorney. An alternative is a safe at home. If held at home, their executor or personal representative should be notified of the exact location. The original and final copy of the will should not be held in a safe deposit box.

8.

At Lee’s death, no estate tax will be due. Upon Marta’s death, no estate tax will be due. Her estate would be valued at $6.6 million ($6.1 million + $500,000), which is above the $5,340,000 estate exemption. However, the portable estate exemption allows Lee’s unused tax exclusion to be shifted to Marta, resulting in no estate tax being due.

9.

No estate or gift tax is due on Marta’s estate. Marta’s gross estate, after Lee’s death, is valued at $6,600,000. The gift to charity reduces the gross estate to $6,100,000. Because the total value of the other gifts and transfers is less than $5,340,000 ($1,000,000 + $1,000,000 + $14,000), no gift tax is imposed. The taxable estate, after gifts and transfers, is $4,000,000, which is less than the 2014 estate exemption of $5,340,000.

10. Giving their son a power of attorney, as long as the power is limited, is an excellent idea, especially should something happen to both Lee and Marta at the same time. The advantage of this arrangement is that their son could take care of financial matters for them without the need to have the state get involved. The disadvantage could be that if the son was unscrupulous, then he could access the parents’ money for his benefits without their permission or knowledge. DISCUSSION CASE 2 ANSWERS 1.

A qualified terminable interest property (Q-TIP) trust is appropriate for remarried couples like Cindy and Ned to assure that their individual assets are transferred to their children rather than to their new spouse or spouse’s heirs. With a Q-TIP trust, a person’s spouse receives income from trust assets during their lifetime, but the assets are transferred to the grantor’s children (or another designee) upon the death of the surviving spouse. Thus, the original donor has control over the disposition of their property. This seems appropriate for ©2016 Pearson Education, Inc.

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Cindy and Ned, given their wariness about co-mingling assets following their first marriage and divorce. With a Q-TIP trust, the Lipmans can continue to keep their financial assets somewhat separate during their lifetime and following death. If both members can independently provide for themselves after the death of their spouse, they could consider a standard family trust to pass property directly to their heirs. Should there be any question about sufficient resources, a sprinkling trust could be used with the trustee authorized to provide support for the surviving spouse if circumstances warranted. 2.

Neither Cindy’s $3.9 million estate nor Ned’s $3.35 million estate will owe federal estate taxes upon the first spouse’s passing because neither exceeds the tax-free threshold of $5.34 million. Under previous rules, if the marital deduction had not been used, Cindy’s $3.9 million ($3.1 million assets + $800,000 house) estate, when combined with Ned’s $3.35 million estate, would have exceeded the tax-free threshold. However, the portable estate exemption eliminates estate taxes regardless of who passes first.

3.

Cindy and Ned should both prepare a durable power of attorney to provide for someone to act on their behalf in the event they become incompetent. Given their wariness about providing access to each other’s finances, their powers of attorney should be very specific as to which aspects of their affairs it covers and the degree of legal power that is transferred. Another key estate planning document that is recommended is a living will. This document allows an individual to make his/her wishes known regarding medical treatment in the event of a terminal illness, should he/she later be unable to make these decisions for him/herself.

4.

Because Cindy and Ned have opposite views about prolonging life in the event of a terminal illness, they would not make appropriate health care proxies for each other. It might be very difficult for either of them to reconcile their spouse’s wishes with their own beliefs about the use of extraordinary medical care. A much better choice would be someone who shares their beliefs and with whom they could feel confident that their wishes would be carried out.

5.

It is imperative that the Lipmans revise their wills to provide properly for each other. It is foolish to continue to have wills that name former spouses in the trusted position of executor of their estates. This should be changed immediately. The Lipmans should also review (and revise or determine, as necessary) their beneficiary and proxy designations and consider establishing trusts to assure that their assets are passed on to their respective children.


CONTINUING CASE: CORY AND TISHA DUMONT PART V: LIFE CYCLE ISSUES

1.

Because Cory was born after 1960, his Social Security retirement age is 67. Cory can retire at age 62 with reduced benefits, based on how much earlier he retires. Benefits are permanently reduced by 5/9ths of 1 percent for the first 36 months and 5/12ths of 1 percent for subsequent months prior to the “full” retirement age. For someone eligible for full benefits at 67, retiring at 62 would result in a permanent reduction to 70 percent of their full benefits. Conversely, Social Security benefits are increased for those who postpone retirement. Working longer results in a higher average earnings base on which benefits are calculated. A percentage is also added for those who delay retirement. For those born in 1943 or later, Social Security adds 8 percent per year to future benefits for each year that retirement is delayed beyond the full retirement age. In summary, Cory may retire with full benefits at age 67, but delaying retirement will add 8 percent per year to future benefits for each year retirement is delayed. He could receive a permanently reduced 70 percent of his Social Security benefits at age 62.

2.

The surviving spouse would receive a small one-time payment to help defray funeral costs, and a monthly benefit until the youngest child, Haley, turned age 16. Chad and Haley would also receive a monthly benefit if under age 18 or under age 19 and still enrolled in secondary school.

3.

Regarding the Dumonts’ qualified retirement plans, consider the following: a. First, dollars contributed by the Dumonts to a tax-deferred plan are not taxed in the current year. Referred to as “pre-tax” dollars, these contributions are subtracted before the income tax calculation. Because they would have otherwise lost some of the contributed dollars to pay income taxes (estimated as the marginal tax bracket multiplied by the amount contributed), the Dumonts can save more without a direct dollar-for-dollar reduction in money available for living expenses. Second, earnings on the plan contributions are not taxed until withdrawn at the time of retirement. Those earnings remain in the account to generate additional earnings, so dollars that would have gone to pay income taxes remain in the account earning more for the future. b.

The current year tax savings on dollars contributed to a retirement plan, the tax deferred growth of the account, and the time value of money are cornerstones of retirement planning. Time is a critical ally when planning for retirement. Given the benefits of taxdeferred growth, dollars invested early will always be worth more than trying to play catch up later. Recall the example of Selma and Patty (from Chapter 3) who both earned an 8 percent annual return on their retirement savings for the 35 years prior to 347



retirement. Selma invested $2,000 for each of the first 10 years, or $20,000 total; Patty did not start saving until year 11. She saved $2,000 each year for years 11 through 35, or a total of $50,000. Because of the time value of money, Selma started retirement with almost $200,000, while Patty had less than $150,000, yet she saved $30,000 more than Selma—savings that also reduced her standard of living. With the effects of compounding, “time is on your side.” Cory and Tisha cannot wait to save for retirement. c.

If Cory and Tisha are eligible to participate in a defined-contribution plan, such as their 401(k) plans, and either they or their employer contributed to it during the year, they are considered “active participants.” Similarly, if they were covered by a defined-benefit, company-sponsored retirement plan, they would be “active participants.” Eligibility without participation in their 401(k) plans would not qualify for “active participant” status, so they would be eligible to make a fully deductible contribution to a Traditional IRA. However, because they are both active participants, they would be eligible for a full or partial tax deduction for a Traditional IRA contribution (based on the annual modified AGI income guidelines) or they could contribute the maximum of $5,500 to a Roth IRA because they are far below the income limit for couples that triggers the deduction phase-out.

d.

4.

“Catch up” provisions allow taxpayers age 50 or over to make additional tax-deferred contributions to a retirement account to “catch up” their savings to a more appropriate level. For example, additional contributions of $5,500 are allowed for 401(k) and similar accounts, with the limit indexed to inflation. “Catch ups” for the IRAs are $1,000 annually. Once they reach age 50, the Dumonts could use these options to increase their retirement savings, and in some cases, reduce their current year taxable income.

Both Cory and Tisha may each contribute up to $5,500 to an IRA in 2014. Future increases in the contribution amount will be adjusted for inflation. Active participants in qualified retirement plans may not, depending on their income, receive a full or partial tax deduction for contributions to a traditional IRA. However, the Dumonts should be eligible for a tax deduction for a traditional IRA contribution because their AGI is less than the trigger point for full deductibility. Changes in these thresholds, as well as changes in the Dumonts’ income, could affect the status of any future contributions. Or Cory and Tisha could ignore the tax deductibility of the traditional IRA and contribute the annual maximum to a Roth IRA. The income limits for eligibility to contribute to a Roth start at $181,000 for couples in 2014—which Cory and Tisha are well below. Cory and Tisha should consider a Roth IRA, although contributions are not tax deductible. Because the Dumonts’ income may soon exceed the limit for full tax deductibility for the traditional IRA, this is less important. A major benefit of the Roth over the traditional is the fact that none of the withdrawals of contributions or earnings are taxed after retirement—if the funds have been invested for at least 5 years. Another advantage is the option to make a Copyright ©2016 Pearson Education, Inc.


withdrawal, up to the original contribution amount, without a tax penalty, if the funds have been invested for 5 years. There is no requirement that distributions begin by age 70½. Tax-deferred growth is the benefit common to both the traditional and Roth IRA. Remember, no taxes are due annually, so the portion of earnings that would have been paid in income taxes remains in the IRA account generating more earnings for the future. No taxes are due at withdrawal with the Roth; withdrawals from the traditional IRA are subject to taxes on the tax-deductible contributions and all earnings. 5.

With a cash balance plan, employees are credited with a percentage of their income each year (e.g., 4 to 7 percent), in addition to a predetermined rate of earnings or interest. This fixed rate of return is usually tied to a known measure, such as the long-term Treasury bond rate or the return from the S&P 500 index. Advantages include a known retirement plan balance and the account is easier to track. Second, young employees benefit from a build up of retirement benefits early in their work life. Third, employees have the option to take the balance if they leave the company. Two disadvantages focus on investment choice and earnings. Employees do not have the option of choosing how their retirement dollars will be invested because the fixed-rate return precludes these options. Furthermore, employees do not benefit from the true earnings on the retirement investments; the company only contributes the fixed rate of return.

6.

a. To have $64,800 after taxes, or 80 percent of the $81,000 living expenses prior to retirement, to meet their basic retirement living expenses, the Dumonts will need $78,072 before taxes to fund their retirement, in today’s dollars. $64,800/(1– 0.17) = $78,072 present value of pretax income needed to fund retirement. b.

The retirement shortfall of $33,072 in today’s dollars, when carried forward 35 years until the time of retirement, assuming a 4 percent inflation rate, would result in an inflation-adjusted annual need of $130,505. N = 35

I=4

PV = -33,072

PMT = 0

CPT FV = 130,505

$78,072 – $45,000 = $33,072 retirement income shortfall c.

Assuming the Dumonts want to plan on 25 years of retirement with an annual retirement income supplement of $130,505, they would need to accumulate $1,931,297 to fund the annual inflation-adjusted shortfall. NOTE: Answers may vary, as students may assume different retirement periods. This is an opportunity to discuss the effect of longevity on retirement planning and the importance of realistic assumptions matched to the individual. N = 25

I=5

CPT PV = -1,931,297

PMTAD = 130,505


FV = 0


d.

The Dumonts need to save $8,953 at the end of each year for the next 35 years, assuming a 9 percent return, to meet their saving accumulation goal of $1,931,297 to fund their retirement years. N = 35

7.

I=9

PV = 0

CPT PMT = -8,953

FV = 1,931,297

As shown below, the difference in the pretax dollar account and the after-tax dollar account is significant. If the Dumonts invest in a tax-deferred account, they will start off and end up with more money. Without the annual income taxes, they will have the full $2,000 to invest. They will end up with more money because they will be able to compound more of their earnings instead of paying them out as taxes in subsequent years. In reality, the situation for the after-tax account is really worse. The calculation accounts for the income taxes initially due, but ignores the taxes that would have to be paid, and deducted, annually on the growth of the account. This example demonstrates the benefit of not paying taxes on the dollars contributed to a tax-deferred plan. Referred to as “pretax” dollars, these contributions are subtracted before the income tax calculation. Because the Dumonts would have otherwise lost some of the contributed dollars to pay income taxes, they can save more without a direct dollar-fordollar reduction in money available for living expenses. Thus, Cory and Tisha should invest in a 401(k) or other IRS tax-deferred plan. However, they must be cautioned that when the funds are withdrawn, taxes will be due on the contributions and/or earnings, depending on the type of retirement account. Only the Roth IRA incurs no taxes upon withdrawal. Calculator Solution Pretax PV $0 PMT $2,000 I/Y N FV CPT FV

8.

Post-tax $0 $1,700 = $2,000 × (1 – 0.15) 9% 9% 30 30 ? ? $272, 615.08 $231,722.82

Cory’s situation points out two important considerations about any retirement plan. To his benefit, the plan was portable. This means he has the option to retain and move the account to another retirement plan or IRA, if he left the company. The reduction from $4,000 to $2,500 reflects the concept of vesting. Cory had worked for the company long enough to qualify for some part, but not all, of the value of his account. Had he stayed with the company until he was fully vested, the entire account value would have been his to move. Cory has two options: roll the distribution of funds into a traditional IRA or withdraw the funds and end any retirement account benefits. If planned carefully, Cory would incur no



taxes or penalties, and the account would continue to grow tax-deferred until retirement. The second option, of ending the retirement account, would allow Cory to consider other financial goals, but at the cost of paying the taxes on the account, in addition to the 10 percent early distribution penalty. Thus, the $2,500 account would only yield $1,875 calculated as follows [$2,500 × (1 – 0.25)], assuming a 15 percent marginal tax rate and a 10 percent penalty. 9. As explained above, the $2,500 will really be reduced to approximately $1,875 if Cory takes the investment account proceeds now for a surprise vacation or an investment in a taxable mutual fund account. The better option is to rollover the distribution into a mutual fund account, established as a traditional IRA, to avoid the taxes and penalties. With this plan, all $2,500 will go to work earning money for the future. However, in 19 years Cory would still face taxes and penalties if he withdrew money from the IRA for the anniversary trip. In 19 years, Cory will only be 50, not age 59 1/2, thus the withdrawal would be subject to a 10 percent penalty because the funds would not be used for one of the following penalty-free withdrawals: • First home purchase • College expenses • Income needs due to disability • Medical expenses that exceed 7.5 percent of AGI • Medical insurance premiums incurred because of unemployment for at least 12 consecutive weeks In addition to the penalty, Cory would have to pay income taxes on the withdrawal at his marginal tax rate—which in 19 years could be significantly higher than the 15 percent rate due today. Because retirement dollars are targeted for a long-term goal, Cory’s best option is to establish the IRA and protect the tax-deferred status. If he and Tisha make the 25-year anniversary trip a goal, they could start saving for it once they have purchased their home! 10. Tisha would qualify for a tax-favored retirement plan for the self-employed if she manages to make a profit in her tax preparation business. Many small-business owners with no or few employees use a simplified employee pension plan or SEP-IRA. Maximum annual contributions and catch-up provisions apply. Contributions need not be made every year, a benefit to Tisha as she establishes her business and client base. Procedures for establishing the account and reporting it to the IRS are simple. Another option would be the savings incentive match plan for employees, or a SIMPLE plan, that can be used by the selfemployed or small businesses. With either plan, she will be able to make tax-deductible contributions, and the earnings in the retirement plan will grow tax-deferred. 11. Because Cory and Tisha have acknowledged not understanding their 401(k) accounts, the first issue to clarify is that Tisha will not technically receive a “pension” from their current employer. Instead, she will receive the distributions from her retirement account, which is a defined contribution plan. The traditional pension is an example of a defined benefit plan, as is the cash balance plan that Cory’s company is planning to convert to in the future. In that case, Cory would receive a pension.



Tisha cannot automatically choose a single life annuity. Because Tisha and Cory are married, Tisha must obtain a signed waiver from Cory indicating that he waives his right to a survivor benefit from her retirement account. If Cory does not sign a waiver, Tisha should choose a 50 percent joint and survivor retirement benefit. This annuity provides the greatest current benefit, while providing a modest life income for Cory if Tisha dies before him. 12. Cory and Tisha should consider the following to safeguard their future during retirement: • Changes in inflation can have a dramatic effect on their retirement situation—on both the value of securities and the cost of daily living needs. • They may live for a long time and longer than they expected. An asset allocation with sufficient equities to continue conservative growth of their retirement savings during retirement is very important. Such a strategy also will help the Dumonts compensate for the long-term effects of inflation. • They must monitor their retirement planning progress and their employers’ plans or stock values, if applicable. This means adjusting goals (if necessary), carefully tracking retirement investments, and tracking the company’s health to ensure future stock values, especially with an ESOP. If the company health should appear questionable, try to sell stocks and diversify. • Keep insurance coverage up-to-date and maintain adequate amounts of coverage. • They need to check their retirement planning assumptions and calculations occasionally. They might wish to use investment planning software or online programs provided by financial planning firms and publications. Finally, Cory and Tisha would be well advised to understand and follow Principle 2: Nothing Happens Without a Plan and Principle 6: Waste Not, Want Not—Smart Spending Matters. Developing a realistic plan for their retirement, being careful with their lifestyle, and periodically checking the status of their retirement planning assumptions, calculations and asset values will enable them to make adjustments as needed. No one wants to outlive their money, but Cory and Tisha want the financial freedom to enjoy their retirement years and preserve their estate. 13. The five objectives of estate planning include the following: • Plan for the distribution of property and provide for dependents. • Select a guardian for children under 18. • Develop strategies to minimize estate and inheritance taxes. • Develop strategies to keep settlement costs down, including legal and accounting fees. • Determine who has decision-making authority should you become unable to care for yourself as a result of physical or mental impairment. At this stage of the life cycle, minimizing estate and inheritance taxes is not a significant factor. However, the other three issues are important. Writing a will would allow Cory and Tisha to (1) name a legal guardian for Chad and Haley, (2) make arrangements for the distribution of property, and (3) name an executor to administer the distribution of their estates in a cost effective manner. If either Cory or Tisha dies without a will, state law will dictate the distribution of their assets. But more importantly, the future of the children and



the assets is indeterminate now if both Cory and Tisha should die from an accident or other natural disaster. Regardless of the stage of the life cycle, every adult needs a (1) durable power of attorney to provide for someone to act in their place for legal matters and a (2) durable health care power of attorney for someone to make health care decisions in the event of their incompetence. A living will would state their wishes regarding medical treatment in the event of a terminal illness. The latter could include a health care proxy that designates someone to make health care decisions for each of them should they become incapacitated. The Dumonts should not store their will or letter of last instructions in a safe deposit box, as it may be sealed after death until the contents can be inventoried for tax purposes. These documents could be left with their attorney or stored in a safe or fireproof box at home. In some states, a will can be stored with the clerk of the probate court. Foremost storage issues are a safe location and one that is known by family or close friends. The same is true for a durable power of attorney, living will, or health care proxy. The latter documents may be stored with the Dumonts’ doctor(s), although it is important that family or friends are aware of the intent of these documents and their location. 14. There will be no tax implications for the $20,000 gifts to Chad and Haley. The grandparents will not owe any gift tax because the gift is within the annual gift tax exclusion ($14,000 from each of the two donors). There will be no income tax liability because the recipients of the gifts are not taxed on their gift (only the interest it earns later). No generation skipping transfer tax (GSTT) would be due. The senior Dumonts were advised not to give $30,000 to Chad because it would have exceeded the $14,000 per donor per recipient gift limit. Although they could have done this, the gift tax and estate tax work together with a total lifetime tax-exempt limit of $5.34 million on gifts above the annual tax-free gift limit. In other words, the amount of gifts that exceed the annual gift limit, in this case $2,000, effectively reduces the amount of assets that can be transferred at death without incurring estate taxes. 15. A Coverdell Education Savings Account, formerly called the Education IRA, functions similarly to a Roth IRA and has few investment restrictions. Contributions are limited to $2,000 annually for each child younger than age 18, which makes funding the cost of college difficult unless accounts are established very early. Earnings grow tax-free and withdrawals are tax-free if used for qualified education expenses, including certain elementary and secondary school costs. Income restrictions apply with a reduction in the maximum allowable contribution phase out starting at $190,000 for joint filers. Other advantages and disadvantages of the Coverdell Education Savings Account include the following: • Accounts may continue as long as funds are withdrawn before the child is 30 years of age. • Leftover funds may be rolled into accounts for younger siblings. • Funds not used for college incur taxes and perhaps a 10 percent penalty at withdrawal.



•

The Lifetime Learning Credit or the American Opportunity Credit may be claimed for the same year a withdrawal is made from a Coverdell Education Savings Account, provided the same expenses are not declared, or counted, for both purposes.

A 529 plan also offers tax-free growth of education funds limited to qualified college or graduate school expenses. There are two basic plan types: prepaid college tuition plans, which typically cover only in-state institutions, and college savings plans, which offer more flexibility with the use of the funds and the investment choices. Contribution limits are much higher than the Coverdell Education Savings Accounts. Investment alternatives are limited to those in the 529 plan chosen. Individual states sponsor 529 plans, but the plans are open to nonresidents. Features to compare include the available investment options, the flexibility and use of the plan, and any applicable enrollment or annual fees. The Dumonts could establish one or both types of accounts, after carefully studying the restrictions on use, maximum allowable contributions, and how the accounts might apply to the Dumont household. The accounts may be established by the individual or with the help of a financial professional, which will involve a commission or fee. 16. Avoiding probate can be an important estate planning issue as the process takes time and money. Confidentiality cannot be maintained because once the assets are distributed and the taxes paid, a report is filed with the court. Property that does not pass through the will, thereby avoiding probate, is not a part of the public record. To avoid probate, the Dumonts can do the following: • Own property jointly with right of survivorship. • Make gifts of property or assets to others, perhaps at a future date when the Dumonts are more financially secure. Care must be taken when gifting a life insurance policy. • Set up trusts, again in the future when the Dumonts have more assets. • Name beneficiaries in contracts such as insurance policies and employee retirement plan documents. When beneficiaries are named, assets bypass probate and go directly to the named individual(s). 17. As executor of the will, Cory would not be expected to act as guardian for his sister’s child. His sister could surprise him by naming him as guardian; however, they should have discussed this issue previously. Duties of an executor, which Cory would be expected to perform, include the following: • Contacting beneficiaries of the estate • Paying any required taxes or debts of the estate • Managing the deceased’s financial assets until the estate is settled • Distributing remaining assets (after debts and taxes) to beneficiaries of the estate • Making a final accounting of estate distributions to the court In summary, Cory will be expected to (1) carry out Elsa’s wishes for her estate consistent with her will and (2) manage her estate assets until the estate is settled—all assets are distributed and all bills, debts, or taxes paid.



18. Joint ownership with right of survivorship means that two or more individuals share the ownership of an asset. When one joint owner dies, ownership of the asset passes directly to the surviving owner or owners, thereby bypassing the will, probate, and estate taxation. 19. Any asset (i.e., money, securities, life insurance policies, or property) may be placed in a trust so that a third party can hold and manage the asset for the benefit of someone else while they are alive and capable, should they become incompetent, or until after their death. Trusts avoid probate and some trusts shelter assets from estate taxes by essentially removing the assets from the estate—either while the grantor is alive (i.e., irrevocable living trust) or after the grantor’s death (i.e., testamentary trust). Living trusts are established while the grantor is alive, and assets are placed in the trust for management. A revocable living trust gives the grantor the option to withdraw the assets or otherwise control them, their management, or the selection of the trustee at some future date. Because revocable living trusts are controlled by the grantor, they provide no estate tax benefit, but trusts assets do avoid probate. In contrast, an irrevocable living trust does not offer the grantor the option to control the management of the assets—the trust is permanent and cannot be altered. Irrevocable living trusts offer the benefit of avoiding probate and estate taxation upon the death of the grantor. In essence, the trust is not considered part of the grantor’s estate, so any appreciation in the value of the assets is excluded from the estate value and any income generated by the assets can be directed to beneficiaries in lower tax brackets. Testamentary trusts are established by a will and do not exist until after the will is probated. Standard family trusts, one example of a testamentary trust, can be used to reduce estate taxes and to avoid probate. For example, upon the death of the spouse, a family trust would be established to prevent too much property from passing to the surviving spouse. With all the property, upon his/her death, the surviving spouse’s estate could be hit heavily with estate taxes because the total value of the estate would exceed the estate tax-free threshold. Instead, by establishing a family trust, the property is essentially divided to keep the amounts less than the estate-tax-free threshold amount for the surviving spouse, thus avoiding estate taxes on the estate of the surviving spouse and the trust. Ultimately, the heirs would receive the property from the trust and the estate of the surviving spouse. Assets in the trust avoid probate. 20. Relying on the unlimited marital deduction is an ineffective estate planning strategy because it can create significant estate tax consequences for the second-to-die spouse. Assuming the surviving spouse is a U.S. citizen, unlimited assets can be passed without any estate tax consequences. However, the estate of the surviving spouse may later exceed the estate-taxfree threshold amount making it subject to estate taxes. Potential strategies to reduce or avoid estate taxes, thereby leaving more assets for heirs include the following: • Significant planned gifting from the estates of one or both spouses to reduce the estate • Use of a trust to divert assets away from the estate of the surviving spouse


CHAPTER 17 FINANCIAL LIFE EVENTS—FITTING THE PIECES TOGETHER

CHAPTER CONTEXT: THE BIG PICTURE This last chapter in the three-chapter section titled “Part 5: Life Cycle Issues,” culminates, and in some ways summarizes, the entire text. The unique demographic and social trends that make financial security a greater challenge for women are discussed, as are the strategies for preparing for ten significant financial life events. These strategies and the remainder of the chapter summarize and integrate the earlier text content. Students are reminded of the importance of budgeting and recordkeeping, cash management, risk management, investment and retirement planning, and career management within the contexts of financial planning as well as life cycle planning. Because of the importance of debt management to financial success, six keys for handling debt are considered. Seven of the ten principles are reiterated throughout this chapter. CHAPTER SUMMARY This chapter considers demographic and random life events that uniquely affect your financial future. For example, financial security is a greater challenge for women, especially when planning for retirement. But other life events, most of which are anticipated over the life cycle, can have a significant impact on your financial situation and require proactive, planned responses. The chapter considers ten such events. Twelve general strategies for financial success are presented—some deal with life cycle events, while others build on concepts presented earlier in the text. Because debt is a significant financial issue for many households, six keys to successful debt management are presented. The chapter concludes with a challenge to “just do it.” LEARNING OBJECTIVES AND KEY TERMS After reading this chapter, students should be able to accomplish the following: 1.

Understand the importance of beginning your financial planning early.

2.

Recognize the ten financial life events and strategies to deal with them.

3.

Understand and manage the keys to financial success.

4.

Deal with all kinds of debt in the real world.

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CHAPTER OUTLINE I.

The Ingredients of Success A. The Financial Life Cycle B. Women and Personal Finance

II.

Financial Life Events A. Life Event 1: Getting Started 1. Step 1: Manage your life 2. Step 2: Lay the groundwork 3. Step 3: Identify your goals 4. Step 4: Begin saving for your goals 5. Step 5: Manage your portfolio B. Life Event 2: Marriage 1. Step 1: Get organized 2. Step 2: Revisit your financial goals 3. Step 3: Reexamine your insurance and benefits 4. Step 4: Reexamine your taxes 5. Step 5: Make a will 6. Step 6: Make it work C. Life Event 3: Buying a Home 1. Step 1: The purchase fits your financial plan 2. Step 2: Consider tax implications 3. Step 3: Take care of the details D. Life Event 4: Having a Child 1. Step 1: Survey your finances 2. Step 2: Plan for college 3. Step 3: Reconsider your insurance needs 4. Step 4: Update your wills and trusts 5. Step 5: Take advantage of tax savings E. Life Event 5: Inheritances, Bonuses, or Unexpected Money 1. Step 1: Examine the priority of your goals 2. Step 2: Reexamine your goals 3. Step 3: Consider estate planning 4. Step 4: Examine the tax implications F. Life Event 6: A Major Illness 1. Step 1: Reexamine your finances 2. Step 2: Take advantage of tax breaks 3. Step 3: Alternatives to finance your illness G. Life Event 7: Caring for an Elderly Parent 1. Step 1: Health-care and estate planning concerns 2. Step 2: Oversee your parents’ financial affairs 3. Step 3: Discuss long-term health care options 4. Step 4: Estate planning


Chapter 17: Financial Life Events—Fitting the Pieces Together

359

H. Life Event 8: Retiring 1. Step 1: Develop a retirement income plan 2. Step 2: Manage your income in retirement 3. Step 3: Review your insurance coverage and your will 4. Step 4: Keep track of important retirement planning dates I. Life Event 9: Death of a Spouse 1. Step 1: Organize financial material 2. Step 2: Contact sources of survivor benefits 3. Step 3: If you are the executor, carry out your responsibilities 4. Step 4: Change ownership or title to assets 5. Step 5: Review your financial and retirement needs J. Life Event 10: Divorce 1. Step 1: Prepare for divorce 2. Step 2: Avoid credit damage 3. Step 3: Revisit your financial goals 4. Step 4: Reexamine your insurance coverage 5. Step 5: Rework your budget III.

The Keys to Success: A Dozen Decisions A. Number 1: Become knowledgeable B. Number 2: Don’t procrastinate C. Number 3: Live below your means D. Number 4: Realize you aren’t indestructible E. Number 5: Protect your stuff (and look out for lawyers) F. Number 6: Embrace the “B” word (budget) G. Number 7: Reinvent and upgrade your skills H. Number 8: Hide your plastic I. Number 9: Stocks are risky, but not as risky as not investing in them J. Number 10: Exploit tax-favored retirement plans to the fullest K. Number 11: Plan for the number of children you want L. Number 12: Stay married

IV.

Tying Things Together: Debt and the Real World A. The Trap of Too Much Debt B. Successful Debt Management 1. Key 1: The obvious: Spend less than you earn and budget your money 2. Key 2: Know the costs 3. Key 3: Understand the difference between good and bad debt 4. Key 4: Make sure you can repay what your borrow—set your own standards 5. Key 5: Keep Your Credit Score Strong—It Keeps Costs Down and Is a Source of Emergency Money 6. Key 6: Don’t Live with Bad (and Expensive) Debt

V.

Behavioral Insights A. Principle 9: Mind Games, Your Financial Personality, and Your Money B. Changing habits


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VI.



APPLICABLE PRINCIPLES Principle 1: The Best Protection Is Knowledge Financial knowledge is important to everyone, but this is particularly true for women. Due to a number of social and demographic trends, financial success, particularly during the retirement years, is more of a struggle for women. Armed with financial knowledge, anyone, male or female, can learn to manage his or her financial future or recognize good advice from a professional. Financial knowledge is critical to weathering the planned, and unplanned, events that occur over the life cycle. Principle 2: Nothing Happens Without a Plan The first step is financial knowledge, followed by a plan and action. The principles of financial planning apply to everyone, but the foundation is a plan that helps you put the needs of today and tomorrow into context. Plans are grounded in goals, goals that may change over the life cycle or as a result of life events. Armed with a plan, frugality and wealth are amazingly compatible, and in the process you will take the necessary action to accomplish your financial, and life, goals! Principle 3: The Time Value of Money The concept of compound interest is central to understanding the time value of money. For it is the earnings credited to the account that subsequently are a source of more earnings that makes the time value of money such a critical financial planning concept. Almost any goal, regardless of cost, becomes manageable if you start saving early enough and let disciplined savings, prudent investment risk, and your earnings work for you. Principle 5: Stuff Happens, or the Importance of Liquidity Although only mentioned in the discussion of Life Event 1: Getting Started, the importance of liquidity, or always having some savings available when “stuff happens,” could easily apply to all ten of the life events considered. And, more importantly, following this principle might save some folks from the trap of too much debt. Too often, credit and debt are the only available responses when “stuff happens.” Principle 7: Protect Yourself Against Major Catastrophes Major catastrophes can happen at any stage of the life cycle, and in fact catastrophes like a major illness, death of a spouse, or divorce are random life events that can challenge any financial plan or the most stable of financial situations. The purchase of insurance is a primary defense again major catastrophes. But the benefits of having a plan, consulting a base of financial knowledge, and responding with action cannot be ignored.



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Principle 9: Mind Games, Your Financial Personality, and Your Money Financial mind games come in many forms—mental accounts, sunk cost effects, pricing strategies, and procrastination—all of which can be dangerous to your financial health and well-being. Think about it…is $6,999 really that much better of a deal than $7,000? But the most pervasive and dangerous of these biases is procrastination—what may well appear to be logical self-talk that says now is not the time, this can or should be postponed until later. For a few financial decisions that may be true, but most goals, like saving, investing, and reducing debt, require actions that may extend over decades. The only solution is to get started; follow Principle 10: Just Do It! Principle 10: Just Do It! Procrastination is a major pitfall to financial success. No time is better than the present, and starting early capitalizes on your greatest ally—time. Unfortunately, the longer you wait to invest, the harder it becomes to compensate for the effects of time by investing larger amounts. On the other hand, uninsured losses cannot be covered by insurance purchased after the loss. When it comes to financial success, “just do it” is always a good hot tip. SUGGESTED PROJECTS Projects can be assigned as in-class group activities or assigned as homework to increase the applied understanding of key concepts from the chapter. 1. Ask students to research the differences in earnings between men and women. What factors are used to justify these differences? Do these differences vary by career field? In what career fields, if any, do women generally earn more than men do? What strides are women making in rising above the “glass ceiling” into the boardrooms of major corporations? What efforts are the federal or state governments making to ensure earnings equality? Ask students to present their findings as part of a debate on equality of earnings. Have students observed differential earnings in their jobs or internships? 2. Ask students to prepare a one-page personal reflection paper or oral report describing their efforts to learn about their partner’s financial history, habits, or goals. At what point in a relationship should these discussions occur? Ask students to use Checklist 17.1 Marriage, Money, and Financial Personalities as an outline for exploring these topics with their partner. What did they learn? Were they surprised or were their assumptions about their partner’s answers correct? Ask married students to reflect on their experiences both before and after the wedding. 3. The use of debt has individual, household, economic, cultural, and for some, religious implications. As a class project, generate a list of ideas that explore and explain this statement. What were the students’ families practices regarding the use of debt? What are the students’ current practices? What changes do they expect in the use of debt after college? What are the students’ attitudes about debt? Have they considered these broader implications of debt in other classes? If so, in what ways?


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4. Some students may take offense at the idea of attaching a dollar consideration to such personal issues as marriage, divorce, or children. Ask the class to explore this idea. For most people, how much do financial considerations affect these very personal value, and lifestyle, decisions? Are financial implications a secondary consideration? Or, simply not a consideration at all? Help students put this difficult concept in perspective in the broader context of financial success. 5. To learn more about “cheap” living, do an Internet search to generate a list of the “top ten tips” for living frugally or saving money. How do the suggested spending and saving practices vary over the financial life cycle? Which ones might be most acceptable to young professionals getting started? 6. Have students visit the Internet sites www.ed.gov, www.salliemae.com, or www.loanconsolidation.ed.gov to learn more about student loan repayment and consolidation. Review the repayment calculators and determine the monthly repayment for your loans, if applicable, or a hypothetical loan amount. Calculate your debt limit ratio from Chapter 7 based on your projected take-home pay. Assuming you can take on more consumer debt, what is the maximum payment you can add and still have a debt limit ratio below 15 percent? 7. As a group project, ask five friends to estimate how much total debt they will have upon graduation using the categories of (a) student loans, (b) credit cards, and (c) other consumer debt (e.g., auto or electronics loans). Summarize your findings, noting trends and averages. Is most of the debt good or bad debt? Are your classmates in danger of financial troubles after graduation? If so, what intervention strategies would your group recommend? 8. Request that students make a list of typical items paid for through borrowing. Share your list with friends and relatives and ask them to quickly categorize the debts as good or bad. Record their reactions. Then explain the characteristics of good and bad debt and ask them to review the list again. Did their classifications change? How does the average person view debt? Did your respondents consider the characteristics of good and bad debt when making borrowing decisions? Summarize your results. 9. “The more you make, the more necessities there are.” Have students discuss this quote with friends or relatives representing different stages of the life cycle and income levels. Can they recall specific goods or services that became necessities as their income increased? Can they recall specific goods or services that became necessities after specific life events? What do you and your classmates consider as necessities for getting started following college? Prepare a written or oral report of your findings.



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Name ten critical strategies for personal finance success. • • • • • • • • • •

2.

Evaluate your financial health, set your goals, and develop an action plan. Plan and budget. Manage your cash and your credit. Control your debt. Make knowledgeable consumer decisions. Have adequate health, life, property, and liability insurance. Understand investing principles. Make investment decisions that reflect your goals. Plan for retirement. Plan for what happens to your accumulated wealth and your dependents after your death.

Why are the financial decisions during the first 10 years of getting started so important? Name five financial decisions that are typically made during this period. The financial decisions of the first 10 years are so important because bad choices can have long-term detrimental effects. For example, poor credit choices can lower your credit score, which can increase your cost of insurance, or worse yet, lead you to make the decision to reduce costs by reducing coverage. This could result in an uninsured loss. Failing to save or to invest for long-term goals means you miss the beneficial effects of the time value of money and the match for your retirement account. These and other examples suggest that decisions during the first 10 years of getting started can build a solid or very weak foundation for your financial future. Mistakes can be overcome, but at a cost. Individual student answers will vary, but the following are examples of typical financial decisions during this period: • Large purchase decisions, such as buying a home • Life style decisions, such as auto, furnishings • Family decisions, marriage, long-term relationships, children • Continuing education • Purchase of insurance to protect income and assets • Use of debt, for both short- and long-term needs • Decisions about the importance of basic financial planning—goals, financial documents, balancing spending and saving • Decisions about long-term goals, such as investing for children’s education, retirement, • Becoming knowledgeable about financial planning, in general, and more specifically about risk tolerance, asset allocation, and investment strategies • Career advancement • Estate planning strategies matched to individual needs


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3.


List the four steps critical to financial success when planning for the life event “getting started.” Explain how the warning “don’t procrastinate” applies to each step. In your answer, include how often your financial goals should be reviewed. •

• • •

Lay the groundwork by gaining an understanding of personal finance, continuing to update and expand your financial knowledge, and using that knowledge to plan a budget, control debt, establish an emergency fund, purchase insurance, and control your credit score. Identify your goals as the cornerstones of your financial plan. This means specifying and prioritizing each goal, setting a time frame for achievement, and estimating a realistic cost. Begin saving and investing for your goals, including retirement, by controlling lifestyle spending and applying fundamental investment principles. Manage your portfolio by reviewing your investment performance and making necessary changes by rebalancing your investments to maintain your asset allocation, changing your holdings in response to tax law changes, and changing your investment goals to reflect life changes.

Postponing any of these steps can have dire consequences for your first life event, Getting Started, as well as the future stages of the financial life cycle. The Getting Started stage can establish a strong foundation for the future and allow you to capitalize on Principle 3: The Time Value of Money. You may be able to overcome financial mistakes or oversights from this life event, although some could create significant hardship, but it’s much more difficult to compensate for the investments and earnings lost due to procrastination. Financial goals should be reviewed on an annual basis or more often if a major life event occurs. 4.

What factors should a married couple consider when choosing to have one or more checking accounts? Credit card accounts? A single checking account for a couple will facilitate recordkeeping and perhaps get you a better deal on the account because of the balance maintained. In other words, one account is usually easier. However, if a couple has radically different money management styles, separate checking accounts may be a necessity. Having separate credit card accounts assures that both spouses are establishing a credit history that would enable them to get credit in the future—even after a death, divorce, or separation. This is particularly important for women.

5.

Most of the financial life events represent the “typical” progression through the life cycle. Other events, such as receiving unexpected money, or experiencing a major illness or divorce, occur more randomly. For one of these three, review the planning steps for coping with this life event.



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Student answers will vary, but the following is representative. Life Event 5: Inheritances, bonuses, or unexpected money may not allow for advance planning—only a response after the event. Keep in mind that this life event, unlike some others, may precipitate a strong emotional response that may complicate planning for this windfall. However, recommended steps include the following: • Examine the priority of your goals, and the opportunity to reach goals that might have been unrealistic before the windfall. • Reexamine your goals to review the timeline and priorities that will motivate the best use of the money. • Consider estate planning needs that the windfall may create. • Examine the income tax and estate tax planning implications of the windfall. Life Event 6: A major illness can have a tragic impact on the family as well as their finances. Controlling the financial impact, through the following steps, can reduce stress and help the family cope. • Reexamine your finances given the new future situation—medical costs, rehabilitation costs, projected earnings. It may be necessary to use the emergency fund; revise the budget to reflect changes in income, expenses, or goals; or revise your retirement goal or investment strategies to reflect the new time horizon. • Take advantage of tax breaks for an employer-sponsored flexible spending account (pretax dollars available for expenses not covered by insurance) or for itemized deductions for out-of-pocket medical expenses. • Identify alternatives to finance the illness through your home or other insurance. Consider the options of a home equity loan or reverse mortgage. Explore funding from disability insurance, a life insurance cash surrender loan, or life insurance living benefits clause (available only if the condition is terminal). Life Event 10: Divorce is often caused by money problems. But the financial impact of divorce on income, expenses, and net worth can be dramatic, not to mention the legal costs. Planning for finances before and after the divorce can be an important step to the future. • Prepare for the divorce by reducing debt, so there are more assets and less debt to divide; by keeping the divorce civil to reduce legal fees; and by consulting professional financial planning help, if necessary, with expertise in divorce planning. • Avoid credit damage to your score by paying off and closing joint accounts as soon as possible to avoid account problems, by adding explanatory notes (maximum of 100 words) to your credit report, and by asking to have your account “re-aged” by removing any late payment records from your accounts. • Revisit your financial goals and take the opportunity to develop new goals and supporting plans. When planning for retirement, explore all options for Social Security benefits, including from an ex-spouse if you were married for more than 10 years and did not subsequently remarry. • Reexamine your insurance coverage for needed policy changes (e.g., continuation under COBRA or changes in beneficiary) or a new policy on an ex-spouse to replace lost benefit or income. Although not married, you or your children may still be dependent on


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6.

the ex-spouse’s income or insurance coverage. Check your life policy for needed changes. Rework your budget to reflect changes in income, expenses, and income taxes. Don’t delay budget adjustments that allow you to save for retirement or emergencies—savings for both may need to increase. Explore any new tax advantages that may be available.

List five financial planning issues that parents should address when they are expecting a child. Briefly explain why each issue is important. When children are born, several financial planning issues should be considered. • Review your financial situation and budget. Revise your plan and your budget to reflect changes in income, expenses, or new or revised goals, including savings for education. Consider automating your savings. • Start saving for college expenses, based on realistic projections of costs and the use of tax-advantaged plans. • Review life, health, and disability insurance to insure that coverage is adequate; notify your health insurance company when the child is born. • Update your will and name a guardian for the child; review beneficiary designations for retirement or other accounts. • Review the tax implications, including applying for a Social Security number, updating withholding information on your W-4 Form, and exploring flexible spending account needs for pretax dollars to pay medical care costs.

7.

Caring for an elderly parent, retiring, or the death of spouse can have a major impact on an individual’s daily life as well as on his or her finances. For one of these three events, review the planning steps for coping with it. Student answers will vary, but the following is representative. Life Event 7: Caring for an elderly parent involves complicated emotional and financial issues that some have described as a role reversal. The parent becomes the “child” to be cared for, as the child assume the parental role of care giver or decision maker. The following steps can reduce stress and help the family cope. • Start the discussion of health care and estate planning concerns with your parents and other family members. • Accomplish your parents’ financial management desires by organizing paperwork, tracking sources of income and expenses, developing a budget, acquiring necessary estate and end-of-life documents, and cautioning them about using care when divulging financial information. • Discuss long-term care options and explore insurance or self-insurance payment options. • Discuss estate planning issues such as the need to protect the estate and reduce taxes, to plan gifting strategies, and to avert family conflict over the distribution of personal property.



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Life Event 8: Retiring takes many forms depending on the individual, with a variety of income sources available to support this new life chapter. One constant is that planning will likely make the transition occur more smoothly, as considered in the following steps: • Develop a retirement lifestyle and income plan that prepares you for the social, emotional, and mental changes that will occur as well as the financial changes (i.e., income sources, taxes, changes in living expenses, investment asset allocation). • Manage your retirement income to support your desired retirement lifestyle—both in the short term and the long term. Maintain an emergency fund. Monitor investments, investment returns, and withdrawal strategies and adjust as needed. • Protect yourself by reviewing your insurance coverage and your will. Make sure that health care (employer, Medicare and private supplements), long-term care, and homeowner’s policies provide adequate protection. Review or write a will as a foundation of your estate plan. Life Event 9: Death of a spouse involves complicated emotional and financial issues. You’ll need to review the financial plans for yourself and your spouse to monitor asset protection and distribution. Consider the following steps: • Collect and organize the supporting financial papers and the will to carry out your spouse’s wishes. Documents to collect include a minimum of 10 death certificates, life insurance policies, Social Security number and any related records, military discharge papers (if applicable), marriage certificate, birth certificates, and a list of assets. • Contact sources of possible survivor benefits such as insurance companies, Social Security Administration, Department of Veterans’ Affairs (if applicable), and past employers. • If the executor, carry out the responsibilities for paying expenses and taxes, overseeing the sale or distribution of assets, and working with the probate court to settle and finally close the estate. • Make needed changes for ownership and titling of assets and beneficiary designations. Close individual accounts for the deceased spouse and retitle any jointly owned accounts. • As the surviving spouse, review your own financial and retirement needs, such as changes in employer-provided or spousal benefits or changes in the need for health or life insurance. 8.

Financial preparation for at least five of the life events mentions establishing an emergency fund. List the five. In your opinion, an emergency fund would be critical for which of the remaining life events? Why? Although an emergency fund is always important, the critical step of establishing an emergency fund is mentioned when facing the following: • Life Event 1: Getting Started • Life Event 2: Marriage • Life Event 6: A Major Illness • Life Event 8: Retiring • Life Event 10: Divorce


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•

Life Event 4: Having a Child (“make sure you have an adequate emergency fund” is mentioned as part of the strategy, Assess Your Current Financial Situation)

Student answers will vary as to which of the remaining life events would be most critical to have an emergency fund. The Life Events of Buying a Home, Caring for an Elderly Parent, or Death of a Spouse could all require liquid assets to be readily available. Life Event 5: Inheritances, Bonuses, or Unexpected Money could create tax or other unexpected expenses that would require liquid assets. And, given the track record of large lottery winners to mismanage their money and end up in financial difficulty, even those with unexpected wealth should still establish an emergency fund! 9.

List and briefly describe the twelve basic decisions you must make in order to achieve real wealth. • • • • • • • • • • • •

Become knowledgeable. Don’t procrastinate. Live below your means. Realize you aren’t indestructible. Protect your stuff (and look out for lawyers). Embrace the “B” word (budget). Reinvent and upgrade your skills. Hide your plastic. Stocks are risky, but not as risky as not investing in them. Exploit tax-favored retirement plans to the fullest. Plan for the number of children you want. Stay married.

10. Name five strategies to help you compensate for one reality of life—“no one is indestructible.” How does this life reality relate to Principle 7: Protect Yourself Against Major Catastrophes? • •

• • •

Build an emergency fund. Determine if you need life insurance to provide for dependents or to protect your future access to insurance because of your family health history. If so, keep costs down by shopping for term insurance on the Internet, and update whenever your life situation changes. Maintain health insurance coverage with your employer, but if necessary seek an independent policy. Maintain disability insurance coverage to protect your income. If adequate coverage is not available through your employer, seek an independent policy. Lead a healthy lifestyle. It may enable you to avoid some pain and suffering as well as costly bills, time away from work, or in the worst case, an early death.

Principle 7: Protect Yourself Against Major Catastrophes serves as a reminder that insurance is hard to live with and harder to live without! Fully protecting yourself can be expensive, but the greater cost can be with uninsured losses that you face or liability losses



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that you cause for others. To keep costs down, don’t insure for every little possible loss, but definitely spend the money to protect yourself from catastrophic losses. 11. Identify four ways a simple budget, or cash flow plan, can help you achieve wealth. A simple budget or cash flow plan can help you achieve wealth because it forces you • To use self-restraint with your spending. • To think about your spending. • To live below your means. • To be frugal. In short, developing a budget requires you to identify your goals. Following that plan enables you to save enough to reach those goals. 12. Why are equities a prudent investment strategy for accomplishing future goals? Be sure to consider the effects of taxes and inflation. Taxes reduce the return on investments and inflation reduces the purchasing power of dollars that investors have chosen to postpone spending. Because of the effects of taxes and inflation, investors don’t have a chance of meeting their future financial goals unless they invest in equities. Granted, equities are characterized by more risk and price volatility, but in exchange investors are rewarded with a return that historically outperforms all other investments—even after the effects of taxes and inflation. If you don’t take prudent risks with equities, you’ll never reach your goals! 13. What might be described as the “best” investment (aside from education)? Explain why you should take full advantage of any tax-favored investment alternatives available to you. Aside from education, the best investment available is a tax-favored retirement plan with a matching contribution from the employer. The match is obviously free money but a gift that is not available to you unless you invest in your own retirement. In addition, these plans offer two significant advantages. First, your contributions reduce your taxable income, thereby allowing you to contribute dollars to your own retirement account that would have otherwise gone to the government. Second, earnings are not taxed until the time of withdrawal; therefore, money that would have been paid to the IRS as taxes remains in your account to generate future earnings. Finally, start early for the added benefit of the time value of money working to your advantage! 14. Name two social trends that reflect the role of debt in American society. What factors contribute to these trends? Two social trends exemplify the “trap of debt” common to our society. They include (a) hefty borrowing by students and others with little capacity to repay, and (b) excessive borrowing and a cultural acceptance of debt. The following factors, and others, fuel this culture of debt: • “Free goodies” to encourage credit card applications and use by students and others


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• • • •

A consumer attitude that credit enables you to avoid deprivation or the urge to buy because borrowing is so easy A consumer attitude that committing future income to repay debt is not a real concern Credit card offers for increased borrowing limits or more cards Accepted trends of not paying the balance off monthly but incurring interest

15. Why does financial planning require a “call to action”? Whereas financial knowledge can be a priceless asset, it is not enough! You must implement your plans to bring your goals to reality. This means overcoming procrastination, using budgeting and planning to assess and monitor your situation, managing cash and building an emergency fund, eliminating bad debt, building a safety net of insurance, and investing for your goals by using a tax-savvy plan built on fundamental investment principles. All of these steps follow a financial “call to action” to “just do it!” PROBLEMS AND ACTIVITIES ANSWERS 1.

The 40-year annuity would accumulate almost $338,000, while contributing for only 30 years would accumulate almost $323,000, as shown below. In the second scenario, you would have contributed $10,000 less, but at the end of the 40-year period, you would have accumulated only a little more than $15,000 less, or a true difference of about $15,200. The power of compounding over time allowed you to build almost as much wealth as the individual who invested continually over the 40 years. Reversing the scenario and reducing the effects of the power of compounding over time would yield different results. In other words, failing to start investing until later in the time cycle would result in a significantly greater difference at the end of the 40 years. Appendix C Solution 30 years PV n/a PMT $1,000 136.305 (FVIFA9%) FV

40 years n/a $1,000 337.872

$136,305 $337,872

Factor Table A solution PV $136,305 PMT n/a (FVIF9%,10)

2.367

FV

$322,633.94

Calculator Solution 30 years PV $0 PMT $1,000 I/Y 9% N 30 FV ? CPT FV $136,307.54

40 years $0 $1,000 9% 40 ? $337,882.45




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2.

Financial planning is more important for women than men for a variety of reasons, including the following: • Women generally earn less money. • Women are less likely to have pensions. • Women generally qualify for less income from Social Security because they generally earn less over their lifetime. • Women live, on average, 7 years longer than men, increasing their retirement needs.

3.

Of the 10 financial life events, six specifically mention the emergency fund as a financial planning strategy. Only a home purchase, inheritance, care of an elderly parent, and death of a spouse do not specifically mention the emergency fund. Yet, even with these events it is easy to see how an emergency fund would still be part of the financial planning necessary to cope with the event. An emergency fund satisfies the need for every household to have a financial plan built on the fundamentals of liquidity and flexibility. As noted by the financial life events, getting started, getting married, having a child, and retiring are all routine financial life cycle events that may be “eased” by an emergency fund. The more random events, major illness or divorce, certainly can precipitate unplanned for expenses that must be met. In every situation, current income, an emergency fund, or credit are the typical coping responses to avoid more extreme measures like tapping into assets.

4.

Recall the basic principle of insurance—by paying a little annually, in premiums, you protect yourself from larger losses that may occur across the life cycle or unexpectedly. Insurance purchases are critical because they protect your income stream and your assets. The former you protect through disability insurance or life insurance to provide for dependents following your death. Health insurance covers expenses related to maintaining your health and your earnings capacity. Assets are protected with property and liability insurance. Umbrella insurance protects you from liability losses that exceed the limits of your homeowner’s (renter’s) insurance or auto insurance. Of the ten life events considered, only one, Life Event 5: Inheritances, Bonuses, or Unexpected Money, did not prompt an insurance review or consider insurance products within one of the planning steps. Student answers will vary regarding insurance needs after graduation and whether those needs will be met by an employer or through personal policies. However, typical responses would include health, disability, life, and property and liability.

5.

Job insecurity associated with a rapidly changing job market requires that you continually upgrade and reinvent your skills. Doing so helps you maintain current employment and seek advancement within your career field. If you don’t keep up with the innovations in your career field, chances are good you’ll be replaced by someone who does. Student answers will vary regarding methods to stay current in their career field, although all will focus on continuing education and acquisition of new skill sets. Likewise, personal or employer responsibility for paying for investments in advanced skills will vary by the career field. From job interviews, students can learn about the need for additional education,


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certifications, licensure, or other measures of continuing education required for continuation or advancement in a career path. 6.

Although several of the keys to financial success directly mention financial restraint, others allude to this fact. Without financial restraint, you will never have the funds to accumulate an emergency fund, to buy insurance to protect yourself or your stuff, to afford continuing education to reinvent and upgrade your skills, to avoid too much credit, to invest in stocks, to save for retirement, or to pay for a family and children (and maybe even avoid divorce). Recognizing that long-term financial goals can be more satisfying than buying the latest “stuff” empowers you to be frugal today. Spending less than you earn and making wise purchases to get the most for your money gives you the freedom to spend today while managing adequate savings for the future.

7.

a. Mortgage—good debt. Homes tend to increase in value over the long-term allowing you to recoup some of the expenses associated with the debt. b. Home equity line of credit to build a new patio—good debt as long as the patio is not extravagant. Generally, home improvements will add to the value of the house. c. Student loan—good debt. By investing in your human capital, you are increasing your potential for increased earnings down the road. It is important to not overconsume student debt. d. Gap credit card to purchase new wardrobe—bad debt. Clothing is a depreciating asset. e. Car loan for 2015 Dodge Charger with $0 down payment—borderline bad debt. By not making a down payment, you are setting yourself up for potential financial catastrophe. f. Car loan for 2015 Ford Focus with $5,000 down payment—neither good nor bad. Making the down payment helps your asset not depreciate as quickly.


In Step 1, talk, Mindy and Doug should learn about each other’s financial history, habits, and goals related to money as outlined above. Step 2, track, involves tracking their spending habits for a month or so to explore the relationship between money attitudes and money practices. In Step 3, plan and act, Mindy and Doug should develop a budget based on consideration of spending habits, unnecessary expenses, goals, and savings. This will enable them to develop a plan for future financial strategies to accomplish their identified goals. Step 4, review and revise, reminds Mindy and Doug that periodically, and definitely whenever there is a change in family situation, they need to review their budget and financial plan and revise as necessary. This will help them deal with life’s uncertainties while sticking to a plan to achieve their financial goals.

2.

In combining two life events, Getting Started and Getting Married, Doug and Mindy should follow these planning steps as they embark on their new life. • Lay the groundwork by gaining an understanding of personal finance, continuing to update and expand their financial knowledge, and using that knowledge to plan a budget, control debt, establish an emergency fund, purchase insurance, and control their credit scores.



•

•

• •

• •

•

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Get organized through discussions and ground rules for their joint financial situation, including updating and combining records, merging their finances, gaining control of and consolidating debt (while maintaining individual accounts to build strong credit scores), and planning a household center for financial matters and paperwork. Identify individual and couple goals as the cornerstones of their financial plan. This means specifying and prioritizing each goal, setting a time frame for achievement, and estimating a realistic cost. Mindy and Doug should consider short-term goals, like an establishing an emergency fund, as well as long-term goals, like paying for their children’s education and funding retirement. Begin saving and investing for their goals by controlling lifestyle spending, making savings automatic, and applying fundamental investment principles. Manage their portfolios by reviewing their investment performance and making necessary changes by rebalancing their investments to maintain their planned asset allocation, changing their investment holdings in response to tax law changes, and changing their investment goals to reflect life changes. Reexamine their insurance coverage and benefits for comprehensive, coordinated coverage. Designate beneficiaries for all relevant investment, insurance, and retirement accounts. Reexamine taxes, which will change significantly from their college-student status. Make sure W-4 forms reflect correct exemptions and withholding. Identify and take advantage of any tax breaks available through employer benefits offered to Doug or Mindy. Make a will to reflect their new life.

3.

Mindy should not fall victim to the myth that “someone will take care of her”—because Doug earns more and is good at handling money. Because of the unique situation that women find themselves in, generally earning less coupled with less Social Security earnings and less likelihood of receiving a pension, it is extremely important that Mindy stays informed and involved in her financial future. Chances are good she will someday be solely responsible for her finances, as more than 90 percent of women are at some point in their lives. This means she must be able to maintain access to credit and be able to provide for herself—whether before or during retirement. Furthermore, she must know enough to manage her financial affairs or to be able to competently consult a financial advisor for assistance.

4.

As shown below, at the end of the 8 years, Mindy’ Roth IRA would be worth approximately $44,000, based on the following formula: FV = PMT(FVIFA i%, n years) If Mindy leaves the Roth IRA for another 27 years earning 9 percent annually, with no additional contributions, it would be worth $451,950.53—a nice nest egg for retirement and an example of the time value of money at work!


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Factor Table C solution PV n/a PMT $4,000 (FVIFA9%, 8)

11.028

FV

$44,112

Factor Table A solution PV $44,112 PMT n/a (FVIF9%,27)

10.245

FV

$451,927.44

Calculator solution PV $0 PMT -$4,000 I/Y 9% N 8 FV ? CPT FV $44,113.90 Calculator solution PV -$44,113.90 PMT $0 I/Y 9% N 27 FV ? CPT FV $451,950.53

NOTE: The FVIF9%,27 is not shown in the appendices, so students will need to remember from Chapter 3 to calculate (1 + i)n or be given the factor in advance. 5.

To ensure her financial future, Mindy should take the following essential actions: • Develop a financial plan built on the assumptions that she will likely outlive Doug and there’s nearly a 50 percent chance they may divorce. • Stay involved in Doug’s pension plan decisions and make sure she fully funds her own employer-sponsored retirement plans or spousal IRAs. • If necessary, seek the assistance of a financial planner who can guide and motivate her actions. Also, get informed and stay informed on financial matters.

6.

Dealing with issues of credit cards and checking accounts before the marriage provides just one more opportunity for Mindy and Doug to explore their money attitudes and practices. A joint checking account is easier to manage than two separate accounts and may allow them to get a better deal on the account from the bank. But if spending, and recordkeeping styles are dramatically different, two accounts may be the best solution. Separate credit card accounts are a must to ensure that both Mindy and Doug are building strong credit histories and FICO credit scores that will enable them to secure credit in the future, regardless of their marital status.

7.

Several issues require Doug and Mindy’s attention before the birth of a child: • Review their financial situation, and revise their plan to reflect changes in income, expenses, or new or revised goals, including savings for education. • Start saving for college expenses, based on realistic projections of costs and the use of tax-advantaged plans such as a 529 plan or Coverdell Education Savings Account. • Review life, health, and disability insurance to ensure that coverage is adequate; notify their health insurance company when the child is born. • Update or write a will and name a guardian for the child; review beneficiary designations for retirement or other accounts.



• •

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Review the tax implications, including applying for a Social Security number, updating withholding information on their W-4 Form(s), and exploring tax savings from flexible spending accounts. Review and update, or establish, flexible spending accounts to cover medical or dependent care expenses.

8. First, staying married will allow Doug and Mindy to avoid the expense of a divorce. Second, married couples tend to earn more and accumulate more wealth than singles living separately or together. Third, divorce can have devastating financial consequences for women with children, a situation Mindy would surely want to avoid. 9. Using a financial calculator, Doug’s payments will be $256.99 to repay his $12,600 student loan balance over five years at an 8.25 percent interest rate. 10. Assuming no other consumer debt repayment, Doug’s student loan repayment will still leave room to add additional debt for an auto or other lifestyle needs (e.g., furniture, appliances). As shown below, their debt limit ratio is 6 percent, well within the safe range. To remain within the 15 percent safety margin, total payments could increase to $675 (0.15 × $4,500), or additional payments totaling $418. debt limit ratio =

total monthly nonmortgage debt payments total monthly take-home pay

debt limit ratio =

$256.99 / $4,500 = 0.057 or 6%

11. Unless the interest rate paid on his student loans exceeds the return on his retirement account, mathematically the retirement account is the better option. Moreover, it is unlikely the return from paying off his student loans early, in other words the interest expenses saved, would ever exceed the return from equity investments. Also, Doug and Mindy should qualify for several years, barring large salary increases, for a full or partial adjustment to income taxes for the interest paid on the student loans up to a maximum of $2,500. Because of the tax advantages, the effects of compound earnings over a long time horizon, and the availability of an employer match, Doug should definitely capitalize on retirement savings. Do not forget that Doug will be repaying his loans with future dollars that are worth less due to the inflationary decrease in purchasing power. In summary, the psychological benefit of paying off his student loans early is not worth the foregone earnings from his retirement savings. Given the long time horizon and the ability to withstand prudent risk with their retirement investments, Doug and Mindy should choose equity over fixed-income investments. The higher returns will offer greater protection from inflation and the future taxes that will be paid when they make distributions from the account during retirement. 12. Insurance is a critical component of every financial plan. Fundamental to this aspect of financial planning is the accurate assessment of insurance needs and the purchase of cost-


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effective coverage. Life, health, and disability insurance will protect the couple’s income stream. Property and liability insurance will protect their stuff and their assets, both now and in the future, in the event of a large liability claim. As their net worth increases, they should consider an umbrella policy. They should also plan for periodic insurance reviews to evaluate coverage needs. Doug and Mindy can keep insurance costs down by following these strategies: • • • • • •

Live a healthy lifestyle. Take advantage of cheaper insurance through groups, such as their employer(s). Keep deductibles as high as they can afford. Take advantage of all discounts available. Accumulate the necessary emergency fund to cover any coinsurance expenses. Keep their insurance credit score high to keep premiums down.

13. Student answers will vary. Some examples include the following: • Mindy should leave her credit card at home. • Mindy should carry a list of financial goals in her wallet to remind her of her intentions. • Mindy should develop a support system of people she can take shopping with her or call in case she feels the urge to buy a necklace. • Mindy could avoid going to the mall by herself. DISCUSSION CASE 2 ANSWERS 1.

Credit card application tables on campus, offers for free gifts, the cultural lure of easy credit (buy today, pay later), and the future dream of a high salary have made it very easy for college students to get and use credit cards. For this reason, students and others with little capacity to repay have the opportunity to get, use, and abuse credit. Credit bureaus provide your credit history or FICO credit score to creditors, to potential employers, or to other companies doing business with you (like insurance companies that calculate the insurance credit score). Negative information about your debt practices in college sent to any of these sources could have a long-term effect on your financial future. If a potential employer chooses not to interview you because of a bad credit history, you reduce your opportunities to earn income. In addition, spending and credit practices can follow you from college. This only increases the problem and postpones a proactive solution to using and managing debt. Finally, a poor credit history and low credit score can have a direct cost through higher interest rates and insurance premiums; you represent a greater risk to a potential creditor or insurance company.

2.

Three debt and credit trends that suggest few people are practicing frugality include the following: • High levels of borrowing by students and others with little capacity to pay • A cultural acceptance of debt, too often accompanied by excessive borrowing due to increasing credit limits and multiple credit card offers • Too people many continue to acquire and keep bad debt



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3.

Lenders use a variety of ratio calculations to determine borrowing limits. Determining the maximum mortgage or consumer credit payments that you can comfortably afford, in other words determining your own borrowing capacity, allows you to wisely use debt as a part of your financial plan. Good debt is a part of most everyone’s financial situation, but bad debt should be avoided. Setting your borrowing limits in the context of a broader financial plan that helps you save and prepare for the future is a wise strategy for building wealth. This approach allows you to use debt to your benefit, save for future goals, and at the same time save for unforeseen events that might otherwise cause a financial disaster for someone who has committed most of their income to debt repayment. Remember, true wealth is measured by net worth, not simply the purchase of assets financed through borrowing.

4.

Available credit capacity gives you the freedom to use credit in case of an emergency. This offers two advantages. First, you do not have to maintain such a large emergency fund held in a liquid, low-interest account. Second, the funds that would have been held in the emergency fund can be invested in higher yielding accounts where you can earn more. Should an emergency occur and you choose to use credit, you have the option of repaying over time or liquidating other savings or investments accounts to repay the debt. If your credit accounts are charged to the max, you have no recourse in the event of an emergency. That means you must have an emergency fund, or if not, you face an emergency with few or no options.

5.

Three ratios are frequently used to monitor your borrowing capacity. Mortgage lenders assess if your projected PITI payment exceeds 28 percent of gross income or if projected PITI and other credit payments exceed 36 percent of gross income. These are the generally accepted maximums, although some lenders or special mortgage programs relax these standards. The debt limit ratio compares total monthly nonmortgage debt payments to monthly take-home pay. This ratio should not exceed 20 percent, although problems can start as the ratio exceeds 15 percent. You should monitor these ratios before taking on additional debt to insure that they do not exceed the limits, thus putting yourself at risk of credit delinquency or default. Increased amounts of income committed to debt further reduces financial flexibility, a basic principle of financial planning.

6.

Bad debt is defined as debt that results from buying without forethought. Most of the ten “ingredients to success,” if followed, are helpful strategies for avoiding bad debt. By following these strategies, you won’t be tempted, or forced, to buy without forethought. They include the following: • Evaluate your financial health. • Plan and budget. • Manage your cash and credit. • Control your debt. • Make knowledgeable consumer decisions. • Have adequate health, life, property, and liability insurance. • Understand investing principles—following a “hot tip” can cost you money and cause you to turn to credit. • Make investment decisions that reflect your goals—failure to invest and prepare for goals may force you to turn to credit.


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• 7.

Plan for retirement—failure to plan may severely limit retirement income and force you to turn to credit.

Students could eliminate their average balance with 12 monthly payments of $274.33, assuming no additional charges. If the student invested $274.33 monthly in a mutual fund earning 8 percent, he or she would have $1,446,965 saved toward retirement in 45 years.


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