Basics of Personal Finance

Bill Pottle7/13/2001

Fundamentals of Economics for Households and Individuals

Overview

• Basic Concepts and Definitions

• Assets and Liabilities: Positive Feedback Cycles

• Setting Goals and Planning for the Future

Money

• The oldest historical records we have show that members of early societies traded with each other to get what they needed.

• Money originally consisted of small, valuable items like bits of precious metals and stones. These were easy to carry around and convert to goods and services.

Money• Now, money has lost its intrinsic value. Numbers in a checking account are no more special than numbers in a video game. A $20 bill does not have 20 times as much paper as a $1 bill.

•Why is money important, then?

Money

• Money can be exchanged for GOODS and SERVICES

•Money can be used to provide for NECESSITIES and give you the power to make CHOICES

Necessities

• Things humans need to have in order to survive.

•Food

•Shelter

•Water

•Medical Care

Choices•The choice to send your children to a better but more expensive school

•The ability to travel around the world

•The option to take time off from work to pursue a career in writing, care for elderly parents, or start your own business.

•The freedom to quit a job because of a bad situation without worrying about becoming homeless

The Bottom Line

•Money gives you the power to implement your own CHOICES.

•The more financially independent you are, the more YOU will be able to control your life and the less outside factors will control your life.

Key Concepts and Definitions

•Time Value of Money- Because money gives you the ability to do things (including not touching the money) having a given amount now is ALWAYS preferable to having the same amount at any point in the future.

•Interest- This value is stated as interest, what the borrower pays the lender for the time value

of the lender’s money.


•Compound Interest- The powerful double-edged sword of economics. When the borrower uses the lender’s money for a long period of time, the borrower pays interest on the loan amount or principal, plus he pays interest on the interest he has already paid.

•This leads to an exponential increase in the amount owed.

Example: Compound InterestYear Amount

1 100.00$ 2 107.00$ 3 114.49$ 4 122.50$ 5 131.08$ 6 140.26$ 7 150.07$ 8 160.58$ 9 171.82$

10 183.85$ 11 196.72$ 12 210.49$ 13 225.22$ 14 240.98$ 15 257.85$

0

100

200

300

400

500

600

Amount

$100 invested at 7% interest


•Inflation- Because of natural economic laws, the amount of money increases at about 3% per year. Therefore, money is worth 3% LESS each year that it sits around. Inflation is good for debtors but bad for investors.


•Income- Money that comes into a household.

•Usually as salary and wages from a job

•Proceeds from garage sales

•Gifts, gambling winnings,etc.

•Money from ASSETS.


•Assets- Things that gain value as time goes along (appreciate)

•Stocks

•Real Estate Investments

•Bank Accounts/CDs/Bonds

•etc.


•Expenses- Money that a household pays out

•Rent and Utility Bills

•Payment on Loans

•Payment for food, gas, car, clothing, etc.

•TAXES


•Liabilities- Debt that a household takes on

•Mortgage

•Credit Card debt

•Student Loans

•Items bought on layaway

ExpensesIncome

Assets Liabilities

The Three Types of Households

Type I• Type I households represent a large portion of

the human population

• Income is low and expenses are directly tied to income. Type I households are generally not eligible to receive loans to increase their expenses.

• Type I households frequently have to go without NECESSITIES because they cannot afford them.

• Many Type I households can greatly benefit from assistance.

ExpensesIncome

TYPE I Households

Income=Expenses

$$

Type II• Type II households represent a large portion of

the United States population

• Income is high enough for Type II families to receive credit cards, car financing, etc.

• Type II households have expenses greater than their income. This leads them to take on LIABILITIES.

• Most Type II households cannot benefit from assistance in the long term.

ExpensesIncome

Liabilities

Type II

Expenses > Income

But Liabilities increase

Expenses!

Expenses >Income increases Liabilities

Type III• Type III households represent a minority of

households

• Type III households have income greater than their expenses. This allows them to build ASSETS

• Type III households will often live with much less than Type II households of comparable income.

• Most Type III households can compound any help given to them.

ExpensesIncome

Assets

Type III

Income> Expenses

But Assets increase Income!

Income > Expenses

increases Assets

Type II Vs. Type III

Type II households spiral ever deeper into debt, while Type III households exponentially increase their assets.

•Type II households are always working for money, while Type III households have their money work for

them!

•The two households have the same positive feedback cycles and the same math. Examples can be switched

by exchanging the appropriate terms.

Feedback CyclesTwo basic types of feedback cycles operate in nature

Negative Feedback- Used to keep a certain quantity at a stable level. For example, regulation of blood

p.H.

Positive Feedback- These cycles are more rare in nature. They serve to increase a quantity without

bound. The income-asset and expense-liability cycles are positive feedback cycles.

Example: Positive Feedback Cycles

•Assume Family X has income that exceeds expenses by amount y per year. How much will they be able to save after Z years?

•Year1 = y$•Year Z= [Year (Z-1)*(1+i)+y] $

1 4 7 10 13 16 19

$-

$200,000.00

$400,000.00

$600,000.00

Time [Years]

Amount Gained from 7% interest

$10,000

$5,000

$1,000

Assets Gained after 20 years of investment of specified amount per year

Amount Lost from Debt

Year $2000 Debt per Year $3000 Debt per Year5 14,883.00$ 22,324.00$

10 51,917.00$ 77,876.00$ 15 144,000.00$ 216,000.00$ 20 373,000.00$ 560,000.00$ 50 90 Million 134 Million

100 828 Billion 1.24 Trillion

Notice how quickly debt increases to national debt level proportions (at a credit card rate of 20%) for households who

outspend their income by only a small amount each year

Cycle Differences

• Although the cycles are mathematically the same, the interest rate in the debt cycle is often twice as high as the interest rate in the assets cycle

• The debt cycle is exacerbated by late payment fees, overdrawn account fees, etc.

• Thus, the debt cycle binds its adherents much more strongly than he assets cycle does

What to do?

• How to be a Type III spender?

DISCIPLINE!!!•With very few exceptions:

•If you can’t afford it, you DON’T NEED it.

•Careful Monitoring

Rich Man?

• What makes a person rich?• No mention of any dollar amounts in

previous household profiles.

A rich man:Income from Assets >= Expenses

This person needs no other source of funds to maintain his lifestyle. He works only because he

chooses to

What to Monitor?

• All sources of income and all expenses must be accurately recorded.

• Income from assets as a percentage of total expenses. (ideally >=100%)

• Necessary expenses (for NEEDS) as a function of total expenses. (A higher percentage is generally better)

• Value of Assets as a percentage of Asset goals.

Planning for the Future: Goals

• First, sit down and decide what is important to you, how much it costs in today’s dollars, and how long you expect to have to save before the payment is due

• Convert these amounts into the future value using the inflation worksheet

• Some costs (like college) may increase at a rate different from that of inflation.


• Sample Long Term Goals• Putting the kids through college

• Paying for parents’ care

• Comfortable retirement (annual expense, different math)

• Buying a boat or RV

• Gift to favorite charity

• Trip around the world

• Endow building at University


• Sample Short Term Goals• Having 6 months of expenses saved at all times

• Having the ability to pay for emergency medical procedures

• Owning own home

• Pursuing an advanced degree

• Paying back any debt owed at a higher rate than you can invest money at

• Being able to contribute to Church or other charity

Planning for the Future: Action

• Determine Present Value of Funds needed• Place all funds needed on timeline and bring back to

Present Worth using an appropriate inflation rate.

• This is the amount of money you would need right now to accomplish all of your goals. Chances are you do not have this much money.

• Select one of several investment plans that has an equivalent Present Worth. As long as you stick to this plan, you will have all of the money you need when you need it!

Planning for the Future: Action• A word of caution...

• The analysis is only as accurate as the information you provide. The more research you do, the better your model.

• There are many unknowable elements, especially the return you may expect on your investments. Plot out several scenarios, and expect the true estimate to be somewhere in between.

• Update your full financial plan every six months or 1 year. The more you track it, the more accurate it will be.

Final Words• YOU have the power to invest in your

future. If you do so, you will be rewarded with the power to make choices that control the direction your life takes.

• It takes years of discipline to live while investing money in the future, but it will pay off (With Interest!)

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Basics of Personal Finance