CAULB Purchasing an Insurance Policy Definition Terms

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Chapter 4 Managing Money Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 1 Unit 4A Taking Control of your Finances Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 2 Controlling Your Finances ◼ Know your bank balance. Avoid bouncing a check or have a debit card rejected. ◼ Know what you spend, in particular, keep track of debit and credit card spending. ◼ ◼ Don’t buy on impulse. Think first; buy only if the purchase makes sense. Make a budget, and don’t overspend it. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 3 Example: Credit Card Interest (1 of 2) Cassidy has recently begun keeping her spending under better control, but she still can’t fully pay off her credit card. She maintains an average monthly balance of about $1100, and her card charges a 24% annual interest rate, which it bills at a rate of 2% per month. How much is she spending on credit card interest? Solution Her average monthly interest is 2% of the $1100 average balance. 0.02  $1100 = $22 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 4 Example: Credit Card Spending (2 of 2) Multiply by 12 months in a year gives her annual interest payment. 12  $22 = $264 Interest alone is costing Cassidy more than $260 per year – a significant amount for someone living on a tight budget. Clearly, she’d be a lot better off if she could find a way to pay off that credit card balance quickly and end those interest payments. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 5 A Four-Step Budget-Making Process 1. Determine your average monthly income. Be sure to include an average monthly amount for any income you do not receive monthly (such as once-a-year payments). 2. Determine your average monthly expenses. Be sure to include an average amount for expenses that don’t recur monthly, such as expenses for tuition, books, vacations, insurance, and holiday gifts. 3. Determine your net monthly cash flow by subtracting your total expenses from your total income. 4. Make adjustments as needed. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 6 Example: College Expenses (1 of 2) In addition to your monthly expenses, you have the following college expenses that you pay twice a year: $3500 for tuition each semester, $750 in student fees each semester, and $800 for textbooks each semester. How should you handle these expenses in computing your monthly budget? Solution Amount paid over a whole year: 2  ($3500 + $750 + $800) = $10,100 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 7 Example: College Expenses (2 of 2) 2  ($3500 + $750 + $800) = $10,100 To average this total expense for the year on a monthly basis, we divide by 12. $10,100  12  $842 Your average monthly college expense for tuition, fees, and textbooks comes to a little less than $850, so you should put $850 per month into your expense list. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 8 Example: Cost of a College Class (1 of 2) Across all institutions, the average cost of a three-credit college class is approximately $1500. Suppose that, between class time, commute time, and study time, the average class requires about 10 hours per week of your time. Assuming that you could have had a job paying $10 per hour, what is the net cost of the class compared to working? Is it a worthwhile expense? Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 9 Example: Cost of a College Class (2 of 2) Solution A typical college semester lasts 14 weeks, so your “lost” work wages for the time you spend on the class comes to 10 hr $10 14 wk   = $1400 wk he We find your total net cost of taking the class by adding this to the $1500 that the class itself costs. The result is $2900. Whether this expense is worthwhile is subjective, but remember college graduates earn nearly $1 million more over a career than a high school graduate. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 10 Insurance Costs The premium is the amount you pay to purchase the policy. Premiums are often paid once or twice a year, though sometimes you may pay them more often. A deductible is the amount you are personally responsible for before the insurance company will pay anything. A co-payment usually applies to health insurance and is the amount you pay each time you use a particular service that is covered by the insurance policy. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 11 Example: Emergency Room Visit (1 of 2) Suppose you have an accident and end up in the emergency room, receiving a $7000 bill for your treatment. Fortunately, you have health insurance, but your policy has a $1000 annual deductible, a $250 co-payment for emergency room visits, and pays only 80% of the remaining balance. How much will you pay out of pocket for the emergency room visit? Assume that you haven’t had any other medical expenses in the current year. Solution Your total payment has three parts: Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 12 Example: Emergency Room Visit (2 of 2) • The $1000 deductible, which you will pay in full since you have not already paid any of it earlier in the year • The $250 co-payment for an emergency room visit • Your share of the remaining balance. The total bill is $7000, but you’ve already paid $1250 (the $1000 deductible plus the $250 co-payment). Therefore, the remaining balance is $7000 – $1250 = $5750. The insurance company pays 80% of this, so you owe the other 20%, which is 0.2 × $5750 = $1150. Your total out-of-pocket cost is $1000 + $250 + $1150 = $2400. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 13 Base Financial Goals on Solid Understanding ◼ Find a way to make your budget allow for savings; understand how savings work and how to choose appropriate savings plans. ◼ Understand the basic mathematics of loans. ◼ Understand how taxes are computed and how they can affect your financial decisions. ◼ Understand how the federal budget affects future personal finances. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 14 Chapter 4 Managing Money Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 1 Unit 4B The Power of Compounding Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 2 Definitions ◼ The principal in financial formulas is the balance upon which interest is paid. ◼ Simple interest is interest paid only on the original principal, and not on any interest added at later dates. ◼ Compound interest is interest paid both on the original principal and on all interest that has been added to the original investment. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 3 Example: Savings Bond (1 of 2) While banks almost always pay compound interest, bonds usually pay simple interest. Suppose you invest $1000 in a savings bond that pays simple interest of 10% per year. How much total interest will you receive in 5 years? If the bond paid compound interest, would you receive more or less total interest? Explain. Solution Simple interest: every year you receive the same interest payment. 10%  1000 = $100 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 4 Example: Savings Bond (2 of 2) Therefore, you receive a total of $500 in interest over 5 years. With compound interest, you receive more than $500 in interest because the interest each year is calculated on your growing balance rather than your original investment. Second interest payment: 10%  $1100 = $110 This raises your balance faster than simple interest. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 5 Compound Interest Formula (for Interest Paid Once a Year) A = P  (1 + APR ) Y A = accumulated balance after Y years P = starting principal APR = annual percentage rate (as a decimal) Y = number of years Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 6 Example: Simple and Compound Interest (1 of 3) You invest $100 in two accounts that each pay an interest rate of 10% per year, but one pays simple interest and the others pays compound interest. Make a table to show the growth of each over a 5-year period. Use the compound interest formula to verify the result in the table for the compound interest case. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 7 Example: Simple and Compound Interest (2 of 3) Compare the growth in a $100 investment for 5 years at 10% simple interest per year and at 10% interest compounded annually. The compound interest account earns $11.05 more than the simple interest account. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 8 Example: Simple and Compound Interest (3 of 3) To verify the final entry in the table with the compound interest formula. A = P  (1 + APR ) Y = $100  (1 + 0.1) 5 = $100  1.15 = $100  1.6105 = $161.05 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 9 Compound Interest Show how quarterly compounding affects a $1000 investment at 8% per year. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 10 Compound Interest Formula for Interest Paid n Times per Year  APR  A = P 1 +  n   ( nY ) A = accumulated balance after Y years P = starting principal APR = annual percentage rate (as a decimal) n = number of compounding periods per year Y = number of years Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 11 Example: Monthly Compounding at 3% (1 of 3) You deposit $5000 in a bank account that pays an APR of 3% and compounds interest monthly. How much money will you have after 5 years? Compare this amount to the amount you’d have if interest were paid only once each year. Solution The starting principal is P = $5000 and the interest rate is APR = 0.03. Monthly compounding means that interest is paid n = 12 times a year, and we are considering a period of Y = 5 years. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 12 Example: Monthly Compounding at 3% (2 of 3) APR   A = P  1+  n   nY (12×5 )  0.03  = $5000   1 +  12   60 = $5000  (1.0025 ) = $5808.08 For interest paid only once each year, we find the balance after 5 years by using the formula for compound interest paid once a year. Y 5 A = P  (1 + APR ) = $5000  (1 + 0.03 ) = $5000  (1.03 ) 5 = $5796.37 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 13 Example: Monthly Compounding at 3% (3 of 3) After 5 years, monthly compounding gives you a balance of $5808.08 while annual compounding gives you a balance of $5796.37. That is monthly compounding earns $5808.08 – $5796.37 = $11.71 more, even though the APR is the same in both cases. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 14 Definition ◼ The annual percentage yield (APY) – also called the effective yield or simply the yield – is the actual percentage by which a balance increases in one year. It is equal to the APR if interest is compounded annually. It is greater than the APR if interest is compounded more than once a year. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 15 APR vs. APY APR = annual percentage rate APY = annual percentage yield APY = APR if interest is compounded annually APY > APR if interest is compounded more than once a year Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 16 Continuous Compounding (1 of 2) Show how different compounding periods affect the APY for an APR of 8%. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 17 Continuous Compounding (2 of 2) Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 18 Compound Interest Formula for Continuous Compounding A = Pe ( APRY ) A = accumulated balance after Y years P = starting principal APR = annual percentage rate (as a decimal) Y = number of years e = a special irrational number with a value of e  2.71828 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 19 Example: Continuous Compounding You deposit $100 in an account with an APR of 8% and continuous compounding. How much will you have after 10 years? Solution We have P = $100, APR = 0.08, and Y = 10 years of continuous compounding. The accumulated balance after 10 years is A = P e ( APR x Y ) = $100  e ( 0.0810) = $100  e0.8 = $222.55 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 20 Chapter 4 Managing Money Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 1 Unit 4C Savings Plans and Investments Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 2 Savings Plan Formula (Regular Payments)  APR  ( nY )   − 1 1 + n    A = PMT   APR     n  A = accumulated savings plan balance PMT = regular payment (deposit) amount APR = annual percentage rate (as a decimal) n = number of payment periods per year Y = number of years Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 3 Example: Using the Savings Plan Formula (1 of 2) Use the savings plan formula to calculate the balance after 6 months for an APR of 12% and monthly payments of $100. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 4 Example: Using the Savings Plan Formula (2 of 2) Solution (121/2)    APR (nY )  0.12    1 +  1 + − 1 − 1   n  12        A = PMT  = $100   APR   0.12     12   n     1.01 6 − 1 ) (  = $615.20 = $100  0.01 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 5 Definitions ◼ An annuity is any series of equal, regular payments. ◼ An ordinary annuity is a savings plan in which payments are made at the end of each month. ◼ An annuity due is a plan in which payments are made at the beginning of each period. ◼ The future value of an annuity is the accumulated amount at some future date. ◼ The present value of a savings plan is a lump sum deposit that would give the same end result as regular payments into the plan. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 6 Example: A Comfortable Retirement (1 of 3) You would like to retire 25 years from now and have a retirement fund from which you can draw an income of $50,000 per year – forever! How can you do it? Assume a constant APR of 7%. Solution What balance do you need to earn $50,000 from interest? Since we are assuming an APR of 7%, the $50,000 must be 7% = 0.07 of the total balance. $50, 000 total balance = = $714,286 0.07 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 7 Example: A Comfortable Retirement (2 of 3) In other words, a balance of about $715,000 allows you to withdraw $50,000 per year without ever reducing the principle. Let’s assume you will try to accumulate a balance of A = $715,000 by making regular monthly deposits into a savings plan. We have APR = 0.07, n = 12 (for monthly deposits) and Y = 25 years. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 8 Example: A Comfortable Retirement (3 of 3) APR A+ n PMT =   nY ( ) 1 + APR  − 1 n      $715,000  0.0058333 = (1.0058333)300 − 1   0.07 $715,000 + 12 =   12  15 ( ) 1 + 0.07  − 1 12      = $882.64 If you deposit $883 per month over the next 25 years, you will receive your retirement goal. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 9 Total Return Consider an investment that grows from an original principal P to a later accumulated balance A. The total return is the percentage change in the investment value: A − P) ( total return =  100% P Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 10 Annual Return Consider an investment that grows from an original principal P to a later accumulated balance A in Y years. The annual return is the annual percentage yield (APY) that would give the same overall growth.  A annual return =   P (1 / Y ) −1 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 11 Example: Mutual Fund Gain (1 of 2) You invest $3000 in the Clearwater mutual fund. Over 4 years, your investment grows in value to $8400. What are your total and annual returns for the 4-year period? Solution A − P) ( total return = 100% P $8400 − $3000 ) ( =  100% = 180% $3000 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 12 Example: Mutual Fund Gain (2 of 2) 1/Y A   annual return =   −1 P  1/ 4  $8400  = −1   $3000  = 4 2.8 − 1  0.294 = 29.4% Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 13 Types of Investments (1 of 3) Stock (or equity) gives you a share of ownership in a company. ◼ ◼ ◼ Invest some principal amount to purchase the stock. The only way to get your money out is to sell the stock. Stock prices change with time, so the sale may give you either a gain or a loss on your original investment. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 14 Types of Investments (2 of 3) A bond (or debt) represents a promise of future cash. ◼ ◼ ◼ Buy a bond by paying some principal amount to the issuing government or corporation. The issuer pays you simple interest (as opposed to compound interest). The issuer promises to pay back your initial investment plus interest at some later date. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 15 Types of Investments (3 of 3) Cash investments generally earn interest and include the following: ◼ ◼ ◼ Money you deposit into bank accounts Certificates of deposit (CD) U.S. Treasury bills Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 16 Investment Considerations ◼ Liquidity: How difficult is it to take out your money? ◼ Risk: Is your investment principal at risk? ◼ Return: How much return (total or annual) can you expect on your investment? Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 17 Stock Market Trends The Dow Jones Industrial Average (DJIA) reflects the average prices of the stocks of 30 large companies. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 18 Financial Data—Stocks In general, there are two ways to make money on stocks: 1. Sell a stock for more than you paid for it, in which case you have a capital gain on the sale of the stock. 2. Make money while you own the stock if the corporation distributes part or all of its profits to stockholders as dividends. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 19 Example: Understanding a Stock Quote (1 of 5) Answer the following questions by assuming that the figure shows an actual Microsoft stock quote that you found online today. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 20 Example: Understanding a Stock Quote (2 of 5) a. What is the symbol for Microsoft stock? b. What was the price per share at the start of the day? c. Based on the current price, what is the total value of the shares that have been traded so far today? d. What fraction of all Microsoft shares have been traded so far today? e. Suppose you own 100 shares of Microsoft. Based on the current price and dividend yield, what total dividend should you expect to receive this year? Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 21 Example: Understanding a Stock Quote (3 of 5) Solution a. As shown at the top of the quote, Microsoft’s stock symbol is MSFT. b. The “Open” value is the price at the start of the day, which was $68.14. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 22 Example: Understanding a Stock Quote (4 of 5) c. The volume shows that 25,529,982 shares of Microsoft stock were traded today. At the current price of $68.41 per share, the value of these shares is 25,529,982 shares × $68.41/share ≈ $1,747,000,000 So the total value of shares traded today is about $1.747 million. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 23 Example: Understanding a Stock Quote (5 of 5) d. We divide the 25,529,982 shares traded today by the total number of shares outstanding, which is quoted as 7720 million, or 7,720,000,000, to find that about 0.0033, or 0.33%, of all shares have traded today. e. At the current price, your 100 shares are worth 100 × $68.41 = $6841. The dividend yield is 2.28%, so at that rate you would earn $6841 × 0.0228 = $155.97 in dividend payments this year. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 24 Financial Data—Bonds Bonds are issued with three main characteristics: 1. The face value (or par value) is the price you must pay the issuer to buy the bond. 2. The coupon rate of the bond is the simple interest rate that the issuer promises to pay. 3. The maturity date is the date on which the issuer promises to repay the face value of the bond. annual interest payment current yield = current price of bond Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 25 Example: Bond Interest The closing price of a U.S. Treasury bond with a face value of $1000 is quoted as 105.97 points, for a current yield of 3.7%. If you buy this bond, how much annual interest will you receive? Solution 105.97%  $1000 = $1059.70 annual interest current yield = current price annual interest = current yield  current price annual interest = 0.037  $1059.70 = $39.21 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 26 Financial Data—Mutual Funds When comparing mutual funds, the most important factors are the following: 1. The fees charged for investing (not shown on most mutual fund tables) 2. How well the the funds perform Note: Past performance is no guarantee of future results. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 27 Mutual Fund Quotations Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 28 Example: Understanding a Mutual Fund Quote Based on the Vanguard 500 mutual fund quote shown on the previous slide, how many shares will you be able to buy if you decide to invest $3000 in this fund today? Solution To find the number of shares you can buy, divide your investment of $3000 by the current share price, which is NAV of $222.21: $3000  13.5 $222.21 Your $3000 investment buys 13.5 shares in the fund. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 29 Chapter 4 Managing Money Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 1 Unit 4D Loan Payments, Credit Cards, and Mortgages Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 2 Loan Basics ◼ The principal is the amount of money owed at any particular time. ◼ An installment loan (or amortized loan) is a loan that is paid off with equal regular payments. ◼ The loan term is the time you have to pay back the loan in full. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 3 Loan Payment Formula (Installment Loans)  APR  P  n   PMT =   APR  ( − nY )   1 − 1 +  n     PMT P APR n Y = = = = = regular payment amount starting loan principal (amount borrowed) annual percentage rate number of payment periods per year loan term in years Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 4 Principal and Interest for Installment Loans The portions of installment loan payments going toward principal and toward interest vary as the loan is paid down. ◼ Early in the loan term, the portion going toward interest is relatively high and the portion going toward principal is relatively low. ◼ As the term proceeds, the portion going toward interest gradually decreases and the portion going toward principal gradually increases. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 5 Example: Student Loan (1 of 4) Suppose you have student loans totaling $7500 when you graduate from college. The interest rate is APR = 9%, and the loan term is 10 years. What are your monthly payments? How much will you pay over the lifetime of the loan? What is the total interest you will pay on the loan? Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 6 Example: Student Loan (2 of 4) Solution We use the loan payment formula to find the monthly payments:  APR  P  n   PMT =   APR  ( − nY )   1 − 1 +  n      0.09  $7500    12   = ( −12  10 )    0.09  1 − 1 +   12     Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 7 Example: Student Loan (3 of 4)  0.09  $7500    12   = ( −12  10 )    0.09  1 − 1 +   12     $7500  ( 0.0075) = 1 − (1.0075)( −120 )    $56.25 = 1 − 0.407937305 = $95.01 Your monthly payments are $95.01. Over the 10-year term, your total payments will be mo $95.01 10 yr  12  = $11, 401.20 yr mo Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 8 Example: Student Loan (4 of 4) Of the $11,401.20, $7500 pays off the principal. The rest, or $11,401 – $7500 = $3901, represents the interest payments. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 9 Table of First Three Months For the student loan in the previous example, the table shows the amount of the payment that is applied to the principal. It is easier to use software that find principal and interest payments with built-in functions. Interest and Principle portions of Payments on a $7500 Loan (10-year term, APR = 9%) End of… Interest = 0.0075 × Balance Payment Toward Principal New Principal Month 1 0.0075 × $7500 = $56.25 $95.01 − $56.25 = $38.76 $7500 − $38.76 = $7461.24 Month 2 0.0075 × $7500 = $56.25 $95.01 − $55.96 = $39.05 $7461.24 − $39.05 = $7422.19 Month 3 0.0075 × $7500 = $56.25 $95.01 − $55.67 = $39.34 $7422.19 − $39.34 = $7382.85 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 10 Credit Cards Credit cards differ from installment loans in that you are not required to pay off your balance in any set period of time. ◼ A minimum monthly payment is required. ◼ Monthly payment generally covers all the interest but very little principal. ◼ It takes a very long time to pay off a credit card loan if only the minimum payments are made. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 11 Example: Credit Card Debt Suppose you have a credit card balance of $2300 with an annual interest rate of 21%. You decide to pay off your balance over 1 year. How much will you need to pay each month? Assume you will make no further credit card purchases. Solution  APR   0.21  P $2300   n   12      = $214.16 PMT = = ( − nY )  ( −121)      APR  0.21  1 − 1 +  1 − 1 +    n 12         You must pay $214.16 per month to pay off the balance in 1 year. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 12 Mortgages (1 of 2) ◼ A home mortgage is an installment loan designed specifically to finance a home. ◼ The down payment is the amount of money you must pay up front in order to be given a mortgage or other loan. ◼ Closing costs are fees you must pay in order to be given the loan. These include ◼ Direct fees: appraisal, credit check ◼ Fees charged as points, where each point is 1% of the loan amount: “origination fee”, “discount points” Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 13 Mortgages (2 of 2) ◼ A fixed rate mortgage is one in which the interest rate is guaranteed not to change over the life of the loan. ◼ An adjustable rate mortgage is one where the interest rate changes based on the prevailing rates. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 14 Example: Closing Costs (1 of 3) Great bank offers a $100,000, 30-year, 5% fixed rate loan with closing costs of $500 plus 1 point. Big Bank offers a lower rate of 4.75% on a 30-year loan, but with Great Bank closing costs of $1000 plus 2 points. Evaluate the two options. Solution Great Bank  0.05  $100, 000    12   = $536.82 PMT = ( −1230)    0.5  1 − 1 +   12     Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 15 Example: Closing Costs (2 of 3) Great bank offers a $100,000, 30-year, 5% fixed rate loan with closing costs of $500 plus 1 point. Big Bank offers a lower rate of 4.75% on a 30-year loan, but with closing costs of $1000 plus 2 points. Evaluate the two options. Big Bank:  0.0475  $100, 000    12   = $521.65 PMT = ( −1230)    0.0475  1 − 1 +   12     Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 16 Example: Closing Costs (3 of 3) You will save about $15 per month with Big Bank’s lower interest rate. Now we must consider the difference in closing costs. Big bank charges an extra $500 plus an extra 1 point (1%), which is $1000 on this loan. Big Bank cost an extra $1500 up front. We divide this to find the time it will take to recoup this extra $1500. $1500 1 = 100 mo = 8 yr $15 / mo 3 Unless you are sure you will be staying in the house for much more than 8 years, it is most wise to go with Big Bank. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 17 The Relationship Between Principal and Interest for a Payment Portions of monthly payments going to principal and interest over the life of a 30-year $100,000 loan at 5% Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 18 Example: Rate Approximation for ARMs (1 of 3) You have a choice between a 30-year fixed rate loan at 4% and an ARM with a first-year rate of 3%. Neglecting compounding and changes in principal, estimate your monthly savings with the ARM during the first year on a $100,000 loan. Suppose that the ARM rate rises to 5% by the third year. How will your payments be affected? Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 19 Example: Rate Approximation for ARMs (2 of 3) Solution Since mortgage payments are mostly interest in the early years of a loan, we can make approximations by assuming that the principal remains unchanged. For the 4% fixed rate loan, the interest on the $100,000 loan for the first year will be approximately 4% × $100,000 = $4000. With the 3% ARM, your first-year interest will be approximately 3% × $100,000 = $3000. The ARM will save you about $1000 in interest during the first year, which means a monthly savings of about $1000 ÷ 12 ≈ $83. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 20 Example: Rate Approximation for ARMs (3 of 3) By the third year, when rates reach 5%, the situation is reversed. The rate on the ARM is now 1 percentage point above the rate on the fixed rate loan. Instead of saving $83 per month, you’d be paying $83 per month more on the ARM than on the 4% fixed rate loan. Moreover, if interest rates remain high on the ARM, you will continue to make these high payments for many years to come. Therefore, while ARMs reduce risk for the lender, they add risk for the borrower. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 21 Chapter 4 Managing Money Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 1 Unit 4E Income Taxes Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 2 Income Tax Preparation Flow Chart Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 3 Example: Income on Tax Forms (1 of 3) Karen earned wages of $38,600, received $750 in interest from a savings account, and contributed $1200 to a tax-deferred retirement plan. She was entitled to a personal exemption of $4050 and to deductions totaling $6350. find her gross income, adjusted gross income, and taxable income. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 4 Example: Income on Tax Forms (2 of 3) Solution Karen’s gross income is the sum of all her income, which means the sum of her wages and her interest. Gross income = $38,600 + $750 = $39,350 Her $1200 contribution to a tax-deferred retirement plan counts as an adjustment to her gross income, so her adjusted gross income (AGI) is AGI = gross income – adjustments = $39,350 – $1200 = $387,150. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 5 Example: Income on Tax Forms (3 of 3) To find her taxable income, we subtract her exemptions and deductions. Taxable income = AGI – exemptions – deductions = $38,150 – $4050 – $6350 = $27,750 Her taxable income is $27,750. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 6 Filing Status Tax calculations depend on your filing status, which consist of the following four categories: ◼ ◼ ◼ ◼ Single – unmarried, divorced, or legally separated Married filing jointly – married and you and your spouse file a single tax return Married filing separately – married and you and your spouse file two separate tax returns Head of household – unmarried and paying more than half the cost of supporting a dependent child or parent Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 7 Exemptions and Deductions Both exemptions and deductions are subtracted from your adjusted gross income. ◼ ◼ Exemptions are a fixed amount per person. ◼ Exemptions can be claimed for you and each of your dependents. Deductions vary from one person to another. ◼ A standard deduction depends on your filing status. ◼ An itemized deduction is the sum of all the individual deductions to which you are entitled. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 8 Example: Should You Itemize? Suppose you have the following deductible expenditures: $4500 for interest on a home mortgage, $900 for contributions to charity, and $250 for state income taxes. Your filing status entitles you to a standard deduction of $6350. Should you itemize your deductions? Solution The total if your deductible expenditures is $4500 + $900 + $250 = $5650. The standard deduction of $5650 will put you better off. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 9 Tax Rates ◼ A progressive income tax means that people with higher taxable income pay at a higher tax rate. ◼ Marginal tax rates are assigned to different income ranges (or margins). Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 10 2017 Marginal Tax Rates, Standard Deductions, and Exemptions Tax Rate* Single Married Filing jointly Married Filing Separately Head of Household 10% Up to $9325 Up to $18,650 Up to $9325 Up to $13,350 15% Up to $37,950 Up to $75,900 Up to $37,950 Up to $50,800 25% Up to $91,900 Up to $153,100 Up to $76,550 Up to $131,200 28% Up to $191,650 Up to $223350 Up to $116,675 Up to $212,500 33% Up to $416,700 Up to $416,700 Up to $208,350 Up to $416,700 35% Up to $418,400 Up to $470,700 Up to $235,350 Up to $444,550 39.6% above $418,400 above $470,700 above $235,350 above $444,550 Standard deduction $6100 $12,700 $6350 $9350 Exemption (per person) $4050 $4050 $4050 $4050 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 11 Tax Credits and Deductions As a rule, tax credits are more valuable than tax deductions. ◼ A tax credit reduces your total tax bill by the full amount of the credit. ◼ A tax deduction reduces your taxable income by the amount of the deduction. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 12 Example: Tax Credits vs. Tax Deductions (1 of 2) Suppose you are in the 28% tax bracket. How much does a $1000 tax credit save you? How much does a $1000 charitable contribution (which is tax deductible) save you? Answer these questions both for the case in which you itemize deductions and for the case in which you take the standard deduction. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 13 Example: Tax Credits vs. Tax Deductions (2 of 2) Solution The entire $1000 tax credit is a deducted from your bill and therefore saves you a full $1000 whether you itemize or take the standard deduction. In contrast $1000 deduction reduces your taxable income, not your total tax bill by $1000. For a 28% tax bracket, at best your $1000 deduction will save you $280. However, you will only have this $280 if you itemize deductions. If you itemized deductions are less than standard deductions, your contribution will save you nothing at all. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 14 Example: Varying Value of Deductions (1 of 2) Drew is in the 15% marginal tax bracket. Marian is in the 35% marginal tax bracket. They each itemize their deductions. They each donate $5000 to charity. Compare their true costs for the charitable contributions. Solution The $5000 contribution to charity is tax deductible. His contribution saves him 15% × $5000 = $750 in taxes. The true cost of his contribution is the contributed about minus his tax savings, or $4250. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 15 Example: Varying Value of Deductions (2 of 2) For Marian, who is in the 35% tax bracket, the contribution saves $1750 in taxes. Therefore, the true cost of her contribution is $5000 – $1750 = $3250. The true cost of the donation is considerable lower for Marian because she is in a higher tax bracket. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 16 Social Security and Medicare Taxes Some income is subject to Social Security and Medicare taxes, which are collected under the name FICA (Federal Insurance Contribution Act) taxes. ◼ FICA applies to the following: ◼ Income from wages (including tips) ◼ Self-employment ◼ FICA does not apply to the following: ◼ Income from interest ◼ Income from dividends ◼ Profits from sales of stock Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 17 Example: FICA Taxes (1 of 2) In 2017, Jude earned $26,000 in wages and tips from her job waiting tables. Calculate her FICA taxes and her total tax bill including marginal taxes. What is her overall tax rate on her gross income, including both FICA and income taxes? Assume she is single and takes the standard deduction. Solution FICA tax = 7.65% × $26,000 = $1989 Now we must find her income tax. We get her taxable income by subtracting her exemptions. Taxable income = $26,000 – $4050 – $6350 = $15,600 Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 18 Example: FICA Taxes (2 of 2) From table 4.9, her income tax is 10% on the first $9325 of her taxable income and 15% on the remaining amount of $15,600 – $9325 = $6275. Therefore, her income tax is (10% × $9325) + (15% × $6275) = $1954. total tax = FICA + income tax = $1989 + $1874 = $3863 Her overall tax rate, including both FICA and income tax, is total tax $3863 =  0.149 gross income $26,000 Her overall tax rate is about 15.2%. She pays slightly higher in FICA tax than in income tax. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 19 Dividends and Capital Gains Income with special tax treatment: ◼ ◼ Dividends (on stocks) Capital gains – profits from the sale of stock or other property ◼ Short-term capital gains – profits on items sold within 12 months of their purchase ◼ Long-term capital gains – profits on items held for more than 12 months before being sold Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 20 Tax-Deferred Income Tax-deferred savings plans allow you to defer income taxes on contributions to certain types of savings plans. These include the following: ◼ ◼ ◼ Individual retirement accounts (IRAs) Qualified retirement plans (QRPs) 401(k) plans Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 21 Example: Tax-Deferred Savings Plan Suppose you are single, have a taxable income of $65,000, and make monthly payments of $500 to a tax deferred savings plan. How do the tax-deferred contributions affect your monthly take-home pay? Solution Table 4.9 shows your marginal tax rate is 25%. Each $500 contribution reduces your tax bill by 25% × $500 = $125 While $500 goes into your tax-deferred savings account, your paychecks go down by only $500 – $125 = $375. Copyright © 2019, 2015, and 2011 Pearson Education, Inc. 22
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Explanation & Answer

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Managing money outline







Definition of terms
A summary on Taking control of one’s finances
Critical points on the power of compounding
A summary of the savings plan and investments

A brief discussion on Loan payments, credit cards, and Mortgages
A discussion on Income taxes


Running Head: MANAGING MONEY

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Managing Money
Student’s Name
Institution Affiliation
Date

MANAGING MONEY

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Definition of terms

Premium- refers to the amount paid while purchasing an insurance policy.
Deductible- refers to the amount one is required to pay before the insurance chips in to
pay anything.
Co-payment- in health insurance it describes the amount paid each time by an individual
for a certain service covered in the insurance policy.
The principal- refers to the balance in which interest is paid in financial formulas.
Simple interest- is the interest resulting from the original principal only.
Compound interest- refers to the interest paid resulting from the original principal and
every other interest which is additional to the original investment.
Annual percentage yield (APY) - refers to the actual percentage in which the principal
grows in every year. APY is also called the yield or the effective yield and is said to be more
than APR in instances where interest is compounded beyond once in a year.
Annuity refers to any seq...

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