Chapter 1 Overview of a Financial Plan

Chapter Objectives Explain how you benefit from personal finance Identify the key components of a financial plan Outline the steps involved in developing your financial plan

Definitions Personal finance: the process of planning your spending, financing, and investing to optimize your financial situation Personal financial plan: a plan that specifies your financial goals and describes the spending, financing, and investing plans that are intended to achieve those goals Opportunity cost: what you give up as a result of a decision

How You Benefit from an Understanding of Personal Finance Make your own financial decisions Every spending decision has an opportunity cost Judge the advice of financial advisors Make informed decisions Become a financial advisor Many career opportunities available

Components of a Financial Plan Budgeting and tax planning Managing your liquidity Financing your large purchases Protecting your assets and income (insurance) Investing your money Planning your retirement and estate

A Plan for Your Budgeting and Tax Planning Budget planning: The process of forecasting future expenses and savings Evaluate your current financial position Assets: what you own Liabilities: what you owe Net worth: the value of what you own minus the value of what you owe

Budget and Tax Planning

A Plan to Manage Your Liquidity Liquidity: access to funds to cover any short-term cash deficiencies Money management: decisions regarding how much money to retain in a liquid form and how to allocate the funds among short- term investment instruments

A Plan to Manage Your Liquidity (cont’d) Credit management: decisions regarding how much credit to obtain to support your spending and which sources of credit to use

Managing Your Liquidity

A Plan for Your Financing Loans often needed for large expenditures College tuition, car, house Managing loans How much can you afford to borrow? Determining maturity of the loan Selecting a loan with a competitive interest rate

Financing Your Large Purchases

A Plan for Protecting Your Assets and Income Insurance planning: Determining the types and amount of insurance needed to protect your assets Automobile and homeowner’s insurance protect assets Health insurance limits potential medical expenses Disability and life insurance protect your income

A Plan for Your Investing Any funds beyond what you need to maintain liquidity should be invested Primary objective to earn a high return Potential investments include stocks, bonds, mutual funds and real estate Risk: uncertainty surrounding the potential return on an investment Manage investments to keep risk at a tolerable level

A Plan for Your Retirement and Estate This includes insurance planning, retirement planning, and estate planning Retirement planning: determining how much money should be set aside each year for retirement and how you should invest those funds Estate planning: determining how your wealth will be distributed before or upon your death

Building Your Own Financial Plan Enhances your net worth Builds your wealth All components of your financial plan affect your cash inflows and outflows and how much cash you have available

How Financial Plan Decisions Affect Your Cash Flows How the components relate to your cash flows Cash inflows are cash that you receive Cash outflows are cash that you spend Budgeting balances income and spending Liquidity deals with cash excesses or shortages

How Financial Plan Decisions Affect Your Cash Flows (cont’d) Part 1 – Tools for Financial Planning Budgeting allows you to plan how you will use the cash you receive in a given period How much should you work this month (if your employer allows flexibility)? Budget decisions determine how much you spend and the amount of your cash outflows each month What products or services should you purchase this month?

How Financial Plan Decisions Affect Your Cash Flows (cont’d) Part 2 – Managing Your Liquidity If you have excess cash this month, how much cash should you add to your checking or saving account? If you have a cash deficiency this month, how much cash should you withdraw from your checking or savings account? If you have a cash deficiency this month, how much credit should you use from credit cards or other sources?

How Financial Plan Decisions Affect Your Cash Flows (cont’d) Part 3 – Personal Financing Should you lease a car? Should you borrow money to purchase a car? Should you borrow money to purchase a home? How much cash will you need to borrow? How long a period will you need to borrow funds? What is the ideal source from which you will borrow funds?

How Financial Plan Decisions Affect Your Cash Flows (cont’d) Part 4 – Protecting Your Wealth What types of insurance do you need? How much insurance should you purchase to protect your assets? How much insurance should you purchase to protect your income?

How Financial Plan Decisions Affect Your Cash Flows (cont’d) Part 5 – Personal Investing How much cash should be used to make investments? What types of investments should you make? How much risk should you tolerate when making investments?

How Financial Plan Decisions Affect Your Cash Flows (cont’d) Part 6 – Retirement and Estate Planning How much cash should you invest toward your retirement each month? What types of investments should you make for your retirement accounts?

Summary of Financial Plan Components Summary of sources of cash Attempt to work more hours Withdraw cash from savings Obtain a loan Cash in an insurance policy Sell some of your investments Withdraw funds from your retirement account

Summary of Financial Plan Components Summary of uses of cash Purchase products and services Deposit cash in your checking or savings account Pay interest payments on a loan or pay off a loan Make insurance payments Make new investments Contribute toward your retirement account

How Financial Planning Relates to Cash Flow

Integration of the Financial Plan Components Budgeting decisions affect liquidity management decisions Liquidity management decisions can affect your financing decisions Financing decisions can affect your insurance decisions Insurance decisions can affect your investment decisions

Integration of the Financial Plan Components (cont’d) Investment decisions can affect your retirement planning decisions Retirement planning decisions can affect your budgeting decisions

How Psychology Affects Your Financial Plan Major impact on human behavior and decision making Major impact on spending behavior and ability to implement an effective financial plan Consider two different types of spending behavior Focus on immediate satisfaction and peer pressure Focus on the future

How Psychology Affects Your Financial Plan Assess your own spending behavior Do you pay rent for a single apartment rather than share an apartment? Do you have large monthly car payments? Do you have credit card bills that you only make the minimum monthly payment toward each month?

How Psychology Affects Your Financial Plan Do you spend all of your income that is not needed for rent or car loans payments within the first day or two of receiving your paycheck? Do you always find a reason each month to spend all of your income?

Developing the Financial Plan Step 1. Establish Your Financial Goals Types of financial goals Car, home, college, wealth, charity Set realistic goals Stronger likelihood of reaching goals Timing of goals Short term (within one year) Intermediate (between 1–5 years) Long term (beyond five years)

Developing the Financial Plan (cont’d) Step 2. Consider Your Current Financial Position How your future financial position is tied to your education Consider your skills, interests, and career paths How your future financial position is tied to your career choice Choose a career that will be enjoyable and suit your skills

Developing the Financial Plan (cont’d) How your future financial position is tied to the economy Economic conditions affect types of jobs available, salaries offered, price of services, value of assets Financial crisis of 2008-2009 affected financial positions in many ways Reduction in new job opportunities Elimination of some jobs Lower salaries for existing jobs Value of many assets declined

Developing the Financial Plan (cont’d)

Developing the Financial Plan (cont’d)

Developing the Financial Plan (cont’d)

Developing the Financial Plan (cont’d) Step 3. Identify and Evaluate Alternative Plans That Could Achieve Your Goals Plans could be conservative or aggressive Step 4. Select and Implement the Best Plan for Achieving Your Goals The Internet has valuable financial planning information

Using the Internet to Facilitate Financial Planning Provides updated information on all parts of your financial plan Current tax rates and regulations Investment performances New retirement plan rules

Using the Internet to Facilitate Financial Planning Online calculators Estimating taxes Determining how your savings will grow over time Determining whether buying or leasing a car is more appropriate

Developing the Financial Plan (cont’d) Focus on Ethics: Personal Financial Advice Your objective is to get the best advice appropriate to your needs Be wary of unethical behavior Difficult to discern Be wary of incompetent advice Be alert, ask questions, carefully consider advice

Developing the Financial Plan (cont’d) Step 5. Evaluate Your Financial Plan Keep plan in an accessible place and monitor your progress Step 6. Revise Your Financial Plan Change plan as financial condition and financial goals change