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Experiencing

Financial Literacy

An Illustrated Introduction to Personal Finance

Margaret Williams Mathew Georghiou

2 GoVenture Experiencing Financial Literacy

GoVenture Experiencing Financial Literacy

This resource is designed to be a stand-alone learning tool, as well as a supplement for use with GoVenture software simulations.

Authors: Margaret Williams, Mathew Georghiou. Cover Design: Wendy McElmon

ISBN 1-894353-13-7

Copyright ©2005, First Edition by MediaSpark Information Technology Solutions Incorporated (MediaSpark)

All rights reserved. No part of this publication may be reproduced or transmitted in English or in other languages in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher.

GoVenture and MediaSpark are registered trademarks or trademarks of MediaSpark in Canada, the United States, and other countries.

MediaSpark Incorporated, Publisher PO Box 975 Sydney, Nova Scotia Canada B1P 6J4 www.mediaspark.com www.goventure.net

USA and Canada Version – First Printing, 2005

Disclaimer

GoVenture is a learning simulation. As such, it should not be used to make real-life investment decisions. Similarly, all GoVenture information resources have been designed for learning purposes only and should not be used to make business, legal, financial, or other decisions. Consult appropriate professional advisors prior to undertaking any venture.

MediaSpark will not be liable, in any event, for any damages whatsoever (including, without limitation, damages for loss of business profits, loss of business information, interruption, or other pecuniary loss) arising out of use or inability to use the materials, even if MediaSpark has been specifically advised of the possibility of such damages. In no event will MediaSpark’s liability for any damages ever exceed the cost of the license fees (as outlined by MediaSpark) paid by you for your right to use this material. MediaSpark makes no representation that this material is free of defects.

Table of Contents 3

Contents

1. Welcome ................................................................................................... 5

2. GoVenture Financial Literacy..................................................................... 7

What is the GoVenture Financial Literacy Simulation ..............................................................7

What Makes GoVenture Financial Literacy Unique ..................................................................7

GoVenture for You .............................................................................................................8

What You Need to Play GoVenture Financial Literacy ..............................................................9

More Information.............................................................................................................10

Section I: Introduction to Personal Finance ................................................... 11

3. Your Personal Finances ........................................................................... 13

Cash Flow.......................................................................................................................13

Assets, Liabilities, and Net Worth (Equity) ..........................................................................14

4. Your Assets ............................................................................................. 17

Cash ..............................................................................................................................17

Investment Securities ......................................................................................................17

Capital Assets .................................................................................................................17

Investment Property or Personal Use Property ....................................................................18

5. Your Liabilities ........................................................................................ 21

Borrowing, Debt, Loans, and Credit — What Are They?.........................................................21

Why Do People Borrow? ...................................................................................................22

Interest Payments ...........................................................................................................23

Credit Ratings .................................................................................................................24

Revolving Credit and Loans...............................................................................................24

Rents and Leases ............................................................................................................26

Family Loans and Loan Guarantees....................................................................................26

Consumption, Income, and Wealth Taxes ...........................................................................27

6. Managing Your Assets and Liabilities ...................................................... 29

Setting Goals and Planning ...............................................................................................29

Monitoring Your Financial Health........................................................................................31

Insuring Your Life and Assets ............................................................................................35

Living and Retiring Comfortably.........................................................................................38

7. Key Investment Concepts ....................................................................... 39

Time Value of Money........................................................................................................39

Return on Investment (ROI) .............................................................................................40

Rate of Return.................................................................................................................42

Risk and Return...............................................................................................................43


Economic Influences ........................................................................................................46 Economic Indicators .........................................................................................................52

8. Making Your Money Grow........................................................................ 55

Savings and Debt Investments ..........................................................................................57 Equity Investments ..........................................................................................................60 Gambling........................................................................................................................62 Qualified Retirement Plans ................................................................................................63 Summary........................................................................................................................63

9. Next Steps............................................................................................... 65

Section II: Additional Reference Material ....................................................... 67

10. The Investment Timetable ...................................................................... 69

11. Calculating the Return on Investment..................................................... 71

Comparing Investments and Rates of Return.......................................................................71 Simple Rates of Return.....................................................................................................72 Compound Rates of Return ...............................................................................................74

12. Bank Accounts ........................................................................................ 77

Checking Accounts ...........................................................................................................77 Savings Accounts.............................................................................................................78 Term Deposits .................................................................................................................79 Electronic Banking Services...............................................................................................79 Risks and Benefits — Bank Accounts ..................................................................................80

13. Credit and Loans ..................................................................................... 81

Credit Cards — Financial Institution Credit Cards .................................................................81 Credit Cards — Retail Charge Cards ...................................................................................83 Personal Line of Credit......................................................................................................84 Overdraft Protection.........................................................................................................84 Personal/Consumer Loans.................................................................................................85

14. Taxes ...................................................................................................... 87

Direct and Indirect Taxes..................................................................................................87 Sales Tax........................................................................................................................87 Income Tax.....................................................................................................................87 Real Estate Tax (Property Tax) ..........................................................................................90 Estate Tax ......................................................................................................................90 Tax Shelters....................................................................................................................91

Chapter 1 Welcome 5

Experiencing Financial Literacy

An Illustrated Introduction to Personal Finance

1. Welcome This document is an illustrated introduction to the basics of personal finance. It is a companion piece to MediaSpark’s GoVenture Financial Literacy simulation. The purpose of this document is to provide a complete overview of the key elements of personal finance, as well as to explain the basic options and decisions that can be made — all in a condensed, easy-to-read format.

The GoVenture Advisor

The GoVenture Advisor — the animated “GO” character — will alert you to features in the GoVenture software simulation, examples of concepts, and where you will find more information on a topic in the second section of this book.

GO to the GoVenture Financial Literacy simulation software to apply these techniques.

GO here to see an example of a concept discussed in the text. For more information on this topic, GO to the indicated area(s) in Section II: Additional Reference Materials.


Chapter 2 GoVenture Financial Literacy 7

2. GoVenture Financial Literacy

What is the GoVenture Financial Literacy Simulation The fastest and most effective way to learn the basics of money management! GoVenture Financial Literacy is a realistic software simulation designed to help youth and adults learn about personal money management decisions in a fun and educational manner. Like a flight simulator for finance and life, GoVenture Financial Literacy enables you to learn-by-doing. It’s easy to use, visual, interactive, and exciting! Establish your life plan, enter your financial information — job, budget, home, transportation, and living expenses — and then live your financial future for up to 10 years. Watch your savings grow and shrink based upon the economy, your investment decisions, and your personal spending habits. What kind of lifestyle will you be able to afford? Try GoVenture Financial Literacy and find out! Practice your money management skills on your own, or against your friends and classmates. Gain practical experience so you have the knowledge and ability to plan your own financial future. Unlike any book, course, or seminar, GoVenture Financial Literacy enables you to gain years of finance and life experience in minutes! Play again and again — every new simulation you run is different!

What Makes GoVenture Financial Literacy Unique GoVenture simulations enable learning-by-doing, an approach that cognitive scientists have identified as the fastest and most effective way for human beings to learn. GoVenture simulations immerse the learner in a highly visual and interactive environment in such rewarding ways that the learner feels both intellectually and emotionally engaged in the experience - as if he or she were personally living it. GoVenture Financial Literacy is designed to meet three key objectives, which differentiate it from other personal finance products:

1. GoVenture helps you identify personal life goals and set your goals in a visual environment.

It is difficult to identify and set financial goals, and these goals are not intuitive when expressed as purely mathematical concepts. GoVenture uses a visual interface to help identify goals and make it easier to relate to the financial concepts.

2. GoVenture is not a tool to document your financial life; it is a teaching tool which helps you learn about personal finance.


Many products on the market help document your personal finances, but they are designed to record data, or perhaps to calculate mathematical projections — not to teach. GoVenture is designed as a teaching tool.

3. GoVenture lets you “live” your possible financial future for 10 years.

As a simulation, GoVenture allows you to “live” your life in a virtual environment for up to 10 years. You can replay the simulation unlimited times to try different strategies or different personal goals.

GoVenture Financial Literacy is designed to be used as a learning program on its own, or to complement other learning materials, courses, programs, and curricula. It can provide a valuable learning opportunity for an individual or an entire class, within a single hour of use or over an extended period of time. The educational foundation and ease of integration in the classroom and curriculum make GoVenture Financial Literacy the first choice among learners who are in the early stages of learning about personal finance, as well as educators and trainers who are providing basic finance and life skills training.

GoVenture for You

Personal Planning

Planning your future is perhaps the most important strategy you must develop and monitor. GoVenture allows you to experience up to 10 years of virtual results in a few hours – and more importantly, learn from this experience. You can see what happens in different economic environments, and with different investment portfolios. You can even learn how to adjust for unexpected events. GoVenture can make you better prepared to address your actual personal financial future.

Education

GoVenture has been designed to be suitable for a variety of instructional approaches and levels. Whether the need is to create a completely new curriculum or to enhance an existing one, GoVenture offers a successful and valuable experience for instructors and learners, from middle school to adult education.

Investment

GoVenture includes basic investment options that introduce strategies to balance risk, income generation and growth. You are placed in changing economic conditions which will further challenge your investment skills. The ability to play over and over again at no real financial risk helps develop a more intuitive understanding of investing.

Chapter 2 GoVenture Financial Literacy 9

Career and Family

GoVenture provides you with the ability to plan major career and family objectives, and then simulates how they might affect your personal finances and future goals. It helps you develop a greater understanding of the financial and time commitments needed to meet these objectives.

Economics

GoVenture brings the study of economics to life in a controlled environment. Key economic factors are simulated, without the complexity of true worldwide economies. Using the GoVenture experience, you can learn how economic changes influence markets and affect you on a personal level.

Mathematics

GoVenture can be used to enhance mathematical skills. While prices and current totals are calculated by the simulation, you must project your cash requirements, investment returns, and future expenses so that you can manage your cash flow and increase your net worth.

Life Skills Training

GoVenture helps develop a number of necessary skills for success in the fast-paced Knowledge Economy, including: planning, just-in-time learning, problem solving, organization, critical thinking, and risk management. GoVenture addresses life skills training directly by immersing you in a simulated world of experience that transcends the limitations of traditional teaching and learning approaches.

Unlike conventional educational materials, games and Internet portals, GoVenture offers a comprehensive learning experience. Simulations are combined with a wide range of learning resources for quick and easy integration into self-directed or facilitated learning environments.

What You Need to Play GoVenture Financial Literacy GoVenture Financial Literacy is designed using proven technologies that will operate on personal computers, either stand-alone or over the Internet. For specific system requirements, please refer to the software documentation.


More Information For more information on GoVenture Financial Literacy and other simulations, visit the GoVenture.NETwork Internet portal or contact MediaSpark at:

Sales: 1-800-331-2282 USA/Canada Telephone: 902-562-0042 Fax: 902-562-1252 Internet: www.goventure.net

11

Section I: Introduction to Personal Finance


Chapter 3 Your Personal Finances 13

3. Your Personal Finances Whenever you own things of value (called “assets”) and have access to money (also an asset), you are looking after your finances, in one way or another. Personal finance is the term used to describe this management of your assets. The two key elements of personal finance are how you make your money and how you spend your money — your cash flow. How you plan and manage your money is the focus used in this document.

Cash Flow Making money represents all the ways you receive cash. You might make money by working at a job, by buying and selling stocks, or even winning the lottery. These are your sources of incoming cash. Spending money is something that most people find easy to do. Spending represents the uses of your cash. Together, making money and spending it represent the basic concept of cash flow — how money flows in and out of your accounts: Cash in, minus Cash out.

Making Money (Cash In)

There are two primary types of money you can make: earned income and unearned income. These are general categories, but they are good terms to show the basic difference between money you work for and other money you receive.

Earned Income

Most people think of making money by finding a job and getting a salary or an hourly wage. This usually means working for a business, organization, or the government. Or, you might become an author and earn royalties from your books. You could also be self-employed and earn a salary from your business. Earned income is money you get from your employment, that is, what you earn for yourself in your profession, career, or job. But there are other ways to make money.

Unearned Income

If you start a business, your company might generate profits for you. You might receive inheritance money or trust fund income from your relatives. You might receive gifts; or you might get lucky and win money from bingo, or betting, or the lottery.


The most common way to produce more income than you yourself can earn is to put your money to work for you and to let it earn more money for you. This type of income generally comes from interest on savings or from gains on selling things you own. While the tax law calls this “unearned income,” it doesn’t happen by itself. You have to work at managing your money carefully in order to make it grow.

Spending Money (Cash Out)

Spending money is easy! Making sure you spend within your means is not. When deciding how to spend your money, you must plan both for your current expenses and for your future financial goals. Your current expenses cover the essential cost of living — expenses such as housing, transportation, food and clothing. Additional discretionary expenses will be budgeted to cover optional expenses like entertainment, extra clothes, hobbies, education, and charitable donations. Discretionary expenses are those expenses over which you have more control, and which are not mandatory for you to live and earn your wages. But you should also consider the future, and your family’s future. You may have children to put through university. You may need a bigger house for your family. And, you need to plan for your retirement, when you stop earning wages and live off your savings and other benefits eligible to you. Regardless of what your specific goals are, part of how you “spend” your cash is likely to include putting some money aside to meet your future financial requirements. (For more detailed information on Cash Flow, see Chapter 6: Managing Your Assets and Liabilities: Monitoring Your Financial Health.)

Assets, Liabilities, and Net Worth (Equity) When you apply for a loan, the bank will want to know your net worth. Net worth is an indicator of your personal wealth. If you are looking to your future, you can watch the change in your net worth as a mark of progress towards your future goals. But, what is net worth? To answer that question, you have to understand assets and liabilities.

Assets

An asset is an item of economic value, which you own, and which is cash or could be sold for cash. It is important to distinguish between an item of economic value and an item that may only have sentimental value. While something may be emotionally important to you, if no one will buy it, then it is said to have no cash value and is not considered an asset.

In GoVenture Financial Literacy, you set up your income and expenses by choosing a job and lifestyle. You can buy and sell assets, change your expenses, make investments, and more.

Chapter 3 Your Personal Finances 15

Liabilities

A liability is a debt — money or equivalent monetary value of things that you owe someone else. You have liabilities to your telephone company for using their service. You may have credit card bills, a mortgage, a car loan, or other types of borrowings or payments due.

Net Worth (Equity)

Net worth, also called equity, is the total worth of the things you own (your assets) minus all your debts (your liabilities). Or, you can think of it as the amount you would have left over if you sold all your assets and paid off every single one of your debts today. If the number is positive and growing, that is good. If your net worth is negative and shrinking, you may be in financial trouble.

Net Worth = Assets — Liabilities To determine your net worth, make a list of all your assets and liabilities. Then subtract the liabilities from your assets. Keep in mind that the cash value of your assets is what they are worth if you sold them today, and not what you may have paid for them. Your liabilities are what you owe as of today, not the original amount, or last month’s bills. Here is an example of a net worth calculation:

Net Worth Calculation, as of June 30, 2005

Original Cost Current Value Assets Cash on Hand $ 150 $ 150 Cash in Checking Account 1,100 1,100 Cash in Savings Account 2,650 2,650 Personal Use Assets: - Automobile 25,000 13,000

- House 150,000 175,000 Investment Assets:

- Stocks, Bonds, Mutual Funds 50,000 70,000 - Other - Stamp Collection 500 1,500 $229,400 $263,400 Original Amount Liabilities Bills, Unpaid $ 750 $ 750 Credit Cards, Unpaid Balance 2,300 2,350 Automobile Loan 20,000 10,000 Mortgage (loan) for the House 120,000 110,000 Personal Line of Credit Loan 5,000 2,000 Other Loans & Obligations: - Family Loan 10,000 10,000 - Income & Property Taxes Due 0 0 - Personal Guaranty of Son’s Car Loan 15,000 13,000 $173,050 $138,100 Net Worth = Current Value of Assets — Liabilities $125,300

Example


Note that your net worth is just a snapshot of today’s values. It does not include money you might make in the future, such as salary from your job, or an inheritance, or increases in the value of your assets. Nor does it include future loans and expenses due. All these future events are uncertain or unknown today.

In GoVenture Financial Literacy, your net worth is constantly calculated and updated for the current market value of your assets, as well as for the up-to-date balance of your liabilities.

Chapter 4 Your Assets 17

Bank Accounts

4. Your Assets Your assets represent everything you own which has an economic value. Assets can be either cash or something which could be sold for cash. Almost everything you own and use for your own personal purposes now, or which you are saving for the future, is an asset, because most possessions have some economic value. Assets may also be categorized or described as:

• Cash • Investment Securities • Capital (non-cash) Assets • Investment Property or Personal Use Property

Cash Your cash assets include money which you have on hand in your wallet or elsewhere in your possession, money you have deposited in bank accounts, plus any checks or money orders which you have received but not yet cashed.

Investment Securities Investments are assets which you have obtained in order to provide future increases in value. The increases may come from periodic payments you receive of interest income or dividends, or from appreciation. Appreciation means increases in the value of an item, so you can sell it at some future date for more money than it cost you to buy it. Be careful when using the term “investments,” because it can refer to several different things. Some people use the word “investments” to mean things like stocks, bonds, mutual funds, and certificates of deposit. However, it is more correct to call these items investment securities. With an investment security, you are given a piece of paper – a contract – which secures your ownership share of a certain asset. If you look back at the definition of investments in the first paragraph above, you will realize that investments mean much more than investment securities. Investments can also be actual, physical property you own: these are capital assets.

Capital Assets Assets other than cash are often called capital assets (also called capital property and sometimes fixed assets). A capital asset is a physical item you own which usually cannot instantly be converted into cash, and which is usually held for a long period of time. Capital assets can include:


• Real estate • Automobiles • Art and antiques • Jewelry and gems • Gold, silver, and precious metals • Collectibles (stamp collections, coin collections, etc.) • Even animals can be capital property, for instance a racehorse, as long

as there is a resale value.

Note: For tax purposes, capital assets include your stocks, bonds, and mutual funds. What is common among all capital assets is that liquidating your property (converting it into cash) may take time. This is because there you cannot instantly sell a capital asset. For this reason, capital assets are usually considered long term investments.

Investment Property or Personal Use Property Capital assets that are used for investment property are generally those which you do not use on a day-to-day basis. Investment properties are those assets you buy with the hope of selling at a gain. If you buy something for your own use or if you will never sell it, then it is not investment property. Capital assets are classified as either investment property or personal use property (non-investment property) for two reasons:

1. Personal Financial Planning — You do not usually purchase something for your personal use in hopes of reselling it for a gain, an increase in monetary value. Its value to you is in having and using it. On the other hand, investment property is purchased for a future potential gain, and not for personal use.

2. Income Taxes — When you sell any capital assets, capital gain income tax rules apply. If you decide to sell personal use property, there may be special capital gain exemptions for these transactions.

Your car depreciates (loses value) the more you drive it. So, this would not be considered an investment. If, however, you owned an antique classic car which you only drove on special occasions and kept in good running order, this could be considered an investment property. Similarly, a baseball card collection or coin collection that you keep in mint condition would be an investment, as long as you might sell it some day. If you will never sell it, then it is not investment property.

Example

Chapter 4 Your Assets 19

The most common types of capital assets used for investment property are:

• Real estate • Precious metals • Gems

In all these cases, there are normally markets for buying and selling. Many other assets can be investment property, but often things like art and collectibles are kept for personal enjoyment and not for resale.

In GoVenture Financial Literacy, you can buy and sell a wide range of assets for your personal use. You can invest in low, medium, and high risk investments.


Chapter 5 Your Liabilities 21

Credit and Loans

5. Your Liabilities A liability is a debt — money or equivalent monetary value of things that you owe someone else. In your personal finances, your liabilities represent the money you owe on the goods and services which you purchased but have not completely paid for yet. This includes repaying any money borrowed to buy these things. Your liabilities also include any guaranties you may have made for other people’s loans. A loan guaranty makes you responsible for payment of the debt if the other people who borrowed the money do not make their own payments. Your liabilities can be classified in the following categories:

• Unpaid bills • Unpaid credit card balances • Bank loans • Rents and leases • Family loans and loan guarantees • Unpaid taxes

Your bills and taxes are normally paid off in a short period of time. Credit card balances and loans are paid off over a number of installments. Guaranties may never be paid by you, but since you are ultimately responsible for payment, any amounts you guaranty are a liability and reduce your net worth. All of these liabilities represent types of borrowing, debt or credit, because in all cases you (or someone you have guaranteed) have received something of value before it has been paid for fully.

Borrowing, Debt, Loans, and Credit — What Are They? Borrowing, debt, and credit can be three terms for the same thing.

Borrowing is to receive something of value, with a promise of giving something of equal or greater value back at some point in the future. You can borrow your neighbor’s lawn mower, or borrow $100 from your parents, or borrow money from a bank to buy a car. Debt or Loans, in financial terms, normally refer to a formal type of borrowing. It is an obligation (usually money) documented in a contract or legal agreement. You owe someone else and must make payment by a specified date. Borrowing money from a bank to buy a car would be a debt documented in a loan agreement.

Credit has three different common definitions:

1. Sometimes it is used to mean the same thing as debt. For example, at a store’s checkout counter the attendant might ask you, “Are you paying by cash or credit?” Here, credit means you will not pay for the merchandise today, but


Credit Cards, Line of Credit, Overdraft Protection, Personal Loans, Mortgages

agree to pay either your credit card company, or your account at that store when you get their bill.

2. It can also refer to your capacity to borrow, or the maximum amount of financial borrowing you can do. For example, if you are approved for a $20,000 loan to buy a car, then that is the maximum you can borrow from the bank to buy a car. If your credit card company provides you with a credit limit of $5,000, you cannot charge amounts over a total balance of $5,000 at any given time.

3. The third definition of credit is a refund or reduction. This comes from accounting terms (debits and credits). If you return a purchase to a store, you may have heard someone say, “We’ll credit your account for this amount.”

There are many different types of borrowing options. Some are specialized for the type of purchase, for example mortgages are for buying real estate. Others can be general loans for purchasing a variety of goods and services, for example credit cards. When deciding which type of credit to use, understand the advantages and drawbacks of each, so that you select the best option for your situation. For large borrowings, you should get professional financial advice to help you make your selection.

Why Do People Borrow? Being able to borrow money allows you to have things before you can afford to pay for them. You may take a mortgage out on your home. Then you live there while you pay off the debt. You might take a loan out to buy a car, and pay the loan off while you are driving the car. Having the ability to borrow can improve your lifestyle and provide greater comfort than you might be able to otherwise afford. Without the ability to borrow, you would only be able to buy things by paying the full purchase price up front with cash.

Example You want to buy a $15,000 car. But, you only have $5,000 saved today. Would you save up for the car or borrow to have it now? Review your options.

A. Save $200 a month, for 5 years, then buy the car with cash: (The price of cars will go up over 5 years, too.)

5 Years

B. Borrow $10,000 to buy the car, repaying $225 a month, for 5 years:

5 Years


Debt must be managed, to avoid borrowing too much so that the repayment requirements limit your cash available for basic necessities like food and shelter. Some governments which have overspent in the past are now paying millions of dollars a month in interest on the debt from this overspending. Personal debt is a lot less than this, but it can still cause hardship in repaying if you build up too much debt. Only you can decide the importance of your purchases and loans. But debt is not free, so you must manage your debt and current purchases against your ability to repay the debt.

Interest Payments When you borrow money, you usually have to pay back more than the amount you borrow. This additional payment is called interest. Interest is the fee charged by the lender for the use of the borrowed money. The interest due is usually stated as an annual percentage (the interest rate) of the principal (the amount borrowed). Every payment you make on a loan goes first to pay for the current amount of interest due, and the remainder is used to reduce the amount of unpaid principal.

Example Avoid Borrowing Too Much Money!

Make sure you have enough money to live and pay your debts.

What can you afford to borrow money for and buy?

Your Monthly Income $500 Minus Your Monthly Living Expenses —$200 to $250 Left Over to Save or Pay Debt $250 to $300

Sports Car Payment = $500 a month

New Economy Car Payment = $200 a month

Used Car Payment = $100 a month

Widescreen Digital TV Payment = $85 a month

Stereo System Payment = $50 a month

MP3 Player Payment = $15 a month

New Snowboarding Gear Payment = $100 a month

Snowboarding Lessons Payment = $80 a month

Ski Lift Season Pass Payment = $25 a month

Example

Lender Loans $1,000 Interest 5% a year (1,000 x 5%) Loan to be repaid after 5 Years

Borrower Repays Year 1 - $50 Interest Year 2 - $50 Interest Year 3 - $50 Interest Year 4 - $50 Interest Year 5 - $1,000 Loan + $50 Interest Total Interest Paid = $250


Credit and Loans

Credit Ratings If someone asks you if you have good credit, they are using credit to refer to your ability to take on more debt, and if you have a history of paying your debts on time. This is also called a credit rating. A credit rating is based on your history of borrowing and repayments. If you have never borrowed before, then you may find you have “no credit rating.”

It is always good to have a “good credit rating.” This means that you pay your debts and meet your financial obligations on time, and that you may have the ability to borrow more and repay it if needed.

People with bad credit have a history of not repaying their debts on time. If you have a bad credit rating, it will be difficult to borrow money in the future. People with no credit rating have no history of borrowing documented. It may also be difficult to borrow money if you have no credit rating. Credit bureaus are governed by state/provincial laws. They track information on personal uses of credit — how much you borrow, when you pay it off, and how prompt you are in paying your loans and other obligations like phone and electrical bills. Most of this information is kept on file for up to seven years.

Banks, credit card companies, and other lenders will check your credit rating as part of their process in deciding to lend you money or not. You can get a copy of your own credit report by contacting your local credit bureau (check the telephone book’s yellow pages). There may be a small fee for the service, and it may take two or three weeks to obtain a written report. If you are unsure of how to obtain a copy of this report, contact your banker or financial advisor.

Revolving Credit and Loans

Revolving Credit

Some debt arrangements allow you to borrow and repay and then borrow again. These are types of revolving credit, because you can go round and round – borrowing, paying back, and borrowing again – as long as you meet monthly minimum payments and do not exceed the total credit limit assigned to you.

In GoVenture Financial Literacy, your credit rating is tracked, and can impact your ability to take out new loans.


Credit and Loans – Personal Loans

A maximum credit limit is established and there are terms for minimum monthly payments. Then you decide how much you are going to borrow and how much above the minimum you will pay each month. Credit cards, personal lines of credit from your bank, and overdraft protection on checking accounts all operate in this manner.

Loans

Contrary to revolving credit, most loans are one-time borrowings, where all the money is provided when you sign the loan in one lump sum, and a fixed repayment schedule is set up. If you want to borrow more money later, you have to take out a new loan. Car loans, mortgages (loans to buy real estate), home improvement loans, and other personal loans are all set up in this fashion.

Loans can be obtained from banks, credit unions, trust companies, and other financial institutions – including your life insurance company. What is common to them all is that there is a contractual agreement to repay the money loaned, plus a given interest fee over a specified number of payments.

The repayment term, payment amounts and interest rates vary by type of loan, the type of lending institution, the riskiness of the loan for the lender, and the credit worthiness of the borrower.

People who borrow money are called debtors: they owe a debt to repay the lender a certain amount of money. The lender is also sometimes called the creditor: this is the person or organization which has provided credit and loaned the money.

You only paid $50 on last month’s balance. This month you can pay any amount between $25 and $382.48, the current balance. Until you make a payment, you only have $617.52 credit left for new charges. Can you follow the calculations on the monthly statement?

Example Your Credit Card Monthly Statement

GoVenture Bank Credit Card

Statement Date November 30, 2003

Credit Limit $1,000.00

Available Credit $ 617.52 This month’s activity:

Nov 2 GoVenture Hardware $ 35.53 Nov 6 The Ski Place $144.15 Nov 15 GoVenture Pizza $ 12.45 Nov 18 Payment - Thank You —$ 50.00 Nov 23 Cinemaplex 25 $ 25.00 Prior Balance $215.35 Payments Received $ 50.00 New Purchases $217.13 New Balance $382.48 Minimum Payment Due $ 25.00

Payment Due Date – December 30


Secured and Unsecured Loans

All loans are either secured or unsecured. A secured loan means you have pledged another asset against this debt. If you default on the loan, you lose the pledged asset. This is standard for car loans and real estate mortgages. Here the pledged asset is what you are buying. For example, if you don’t make your car loan payments, your car can be repossessed. If you don’t make your mortgage payments, you could lose your house. If this is done, the creditor sells the repossessed asset to pay off the balance of the loan.

Unsecured loans have no pledged assets backing them up. You will have a lower borrowing limit if the loan is unsecured, because the financial institution’s risk of loss is higher if you don’t repay the loan.

Rents and Leases Rents are agreements to pay for the use of an asset, usually to occupy certain space or to use certain goods. You might rent a car by the day. You can rent parking spaces and apartments by the month. You rent videos and DVD movies by the night. These are all types of rentals. You never own the asset; you only pay to use it for a while. A lease is a contractual agreement which allows you to have use of an asset over a long time (an apartment, a car, etc.) while making regular payments over a set time frame.

Some leases, like an apartment lease, are just a long term rent. That is, you have no rights to purchase or own the asset at the end of the lease. So these assets are not part of your net worth. Other leases provide you the option to purchase the asset at the end of the lease. Depending on the lease, this purchase price might be the market value of the asset at that time, or a nominal charge like $1. These are called financing leases, and they are actually types of loans. You have a fixed repayment period, regular payments, and interest (usually a fixed rate). If you have an option to purchase or lease an asset, you should compare the costs, tax impacts, and benefits between taking out a personal loan to purchase and leasing. If you have ownership rights in the asset, then you should list the asset and the liability as part of your net worth calculation.

Family Loans and Loan Guarantees You may also receive loans from friends and family from time to time. Family loans are usually informal lending arrangements. These loans often have no written agreement, and may not require interest payments or set repayment terms. You might also be asked to loan a family member money at some point in time. Or you might be asked to guaranty the loan someone is taking out. A loan guaranty is also

In GoVenture Financial Literacy, you have a credit card account. You can take out a mortgage or get a loan. You may have to pledge an asset in order to qualify for the loan.


Taxes

called co-signing a loan. If you guaranty a loan, it means that if the borrower neglects to make the loan payments, you are then legally required to make the payments. You hopefully will never pay anything on these guarantees, but because you might have to do so, these guarantees are considered liabilities and reduce your net worth.

Consumption, Income, and Wealth Taxes Taxes are funds that must be paid to the government in order to enable the government to pay for its operations; such as public schools, road maintenance, garbage collection, etc. Federal, state/provincial, and county/municipal levels of government each have rights to charge certain types of taxes. One way to look at taxes is to determine if they are charges on your:

• Consumption of goods,

• Income from wages and investments, or

• Wealth from owning investments and capital assets. Consumption tax is levied on goods and services you purchase. Income tax is assessed on your earnings — whether from wages, interest income, dividend income, capital gains income, gambling income, or other types of cash and value you receive. Your wealth is your net worth. So wealth tax is a charge made based upon your net worth. The US and Canada do not have a wealth tax, but many other countries do. For instance you might have to pay a higher income tax rate if your net worth were over a certain amount in countries with a wealth tax. And while the US and Canada do not have a wealth tax, there are taxes on parts of your wealth. What comes closest to a wealth tax is real estate (property) tax. This tax is based on the value of your real estate. You pay it for as long as you own the property. Here are some common types of taxes, and how they would be categorized:

TAX TAX ON

Sales Tax Tobacco, Liquor, Gasoline Taxes

Consumption

Income Tax • Wages • Pension Income • Gambling Income • Interest Income • Dividends • Capital Gains

Income Note that when you receive value from your wealth (interest, dividends, capital gains), it is taxed. But the total value of this investment wealth is not taxed.

Real Estate (Property) Tax Estate Tax

Wealth


Depending on the type of tax, you may pay the tax as part of your purchase (sales tax), receive a periodic bill for your taxes (real estate tax), or be required by law to make withholdings from your wages and fill out forms each year (income tax). Taxes are similar to other liabilities — if you do not pay them on time, you will be charged interest and penalty charges.

In GoVenture Financial Literacy, you pay sales tax on your purchases. Income taxes are due each year in April. You will be prompted to file your income tax return.

Chapter 6 Managing Your Assets and Liabilities 29

6. Managing Your Assets and Liabilities Whenever you choose to spend money, save it, give it away, or invest it, you are making a personal finance decision that will affect you in some way or another – either today or in the future.

Making good personal finance decisions starts with understanding your own personal financial requirements and goals, and then understanding the options that are available to you for reaching your goals. The better you understand your goals and options, the better you will position yourself for the financial future you desire. Money management is a major cause of stress for people all over the world. By planning your financial future early in life and assessing your needs regularly, you can minimize your stress while maximizing your personal wealth.

Setting Goals and Planning Most people have goals and dreams for the future. Realizing them often depends on your financial resources, which means the better you manage your money today and in the future, the greater the chance you will be successful. By setting goals, planning, and investing your money wisely, you are taking the first and most important steps to realizing your goals and dreams.

Setting Goals

To set your personal goals, think about what you want in the future, for yourself and your family. Do you want a large home? a vacation cottage in the country? a sports car? a comfortable retirement income? to have two children and send them both to university? Make a list of your goals. Set reasonable goals, or at least be willing to revise your goals to match the realities that you will face in the future.

In GoVenture Financial Literacy, you set up your life goals, and then manage your finances to try your best to meet these goals.


Some of the most common goals which impact your personal finances are:

• Education and training programs • Career • Marriage and family • Homes • Cars • Vacations • Money • Retirement income

You may have other goals, like learning to play a musical instrument, owning certain assets, and more.

Planning for Your Future

Now that you have goals you wish to reach, you have to plan how you might achieve them. Think of this as a road map. You are at the beginning of a journey, and your goals are the destination. In between these points there are various routes. Several may lead to your goals. Others will take you away from them. The first step is to estimate how much money you think each of your goals will require. Then determine how many years you have until you need this money. You may find that your goals are not all at the end of your journey, but that several are along the way in a time line.

This process may seem a daunting task to start with. But the important thing is to have a plan and to start acting on it.

For instance, you may want to own a country home in five years. If your children are three and five years old now, then you will need their university tuition money in 13 to 15 years. However, your retirement may be 30 years away. How much more money do you need to make? Compare the estimated cost of your goals with what you have today (after you pay your liabilities). The difference is what you still need. Plus you need to have enough money to live as you work towards your goals. Now you have to look at your income and what you spend today, and at the ways you might obtain this additional wealth. Can you earn enough from your employment alone? Probably not. So what might you do?

Example


Investing

Investments are assets which you have obtained in the hope that these assets will increase your wealth. Investing is the process of buying and selling assets to increase your wealth. The gains might come from interest or income generated by the investment. It might come from the increased value from the time of purchase to the time you sell. Or, it might come from a combination of both income and increased value. This is a very broad definition. It covers many types of investments, from savings accounts, to investment securities and capital assets. Like forks in the road, each investment option has different characteristics and risk. These will be discussed in more detail in subsequent chapters.

Start Today!

One of the most important rules of personal finance is to start on a plan today. If your plan shows you can only invest $5 or $50 a month, that is a start toward reaching your goals.

Monitoring Your Financial Health The three most important tools in monitoring progress towards your financial goals are:

• Cash Flow • Budget • Portfolio Management

Cash Flow

Your cash flow consists of money coming in and going out. What comes in are the sources of your cash, or income, and what goes out are called the uses of your cash, or expense.

Income

Income can be categorized as earned or unearned. As discussed in Chapter 3, this is either money from your employment or money from other sources. Income can also be categorized as regular (or recurring) or one-time. Examples of these different types of income are given on the next page.


Type of Income

Income Item Regular One-Time

Salary √ Earned Income Hourly Wages √ Contract Fee √ Bonus √

Trust Income √ Unearned Income Annuity √ Inheritance or Gift √ Lottery Ticket Winnings √

Expense

Expenses are your bills and purchases. Some expenses are required in order for you to live and earn your wages, for instance food and clothing. However, even with these mandatory living expenses you often have choices of how much to spend. For example – should you rent or buy a house? Other expenses are more optional, or discretionary, such as how much to spend on entertainment.

It is also important to differentiate between fixed and variable expenses. Fixed expenses are bills which tend to be the same each month or year, such as rent. Variable expenses are those which change often. Usually you have some control over your variable expenses. Here are some examples:

Type of Expense

Expense Item Fixed Variable

Rent √ Mandatory Expenses Insurance √ Real Estate Tax √ Gas for Car/Transportation √ Food √ Medical Expenses √

Gym Membership Fee √ Discretionary Expenses Education – Tuition Fee √ Vacation Cost √ Hair Cuts/Beauty Treatments √

If you have more income than expense, you are said to have a positive cash flow (“in the black”). If your expense is higher than your income you have a negative cash flow (“in the red”).

Example

Example

The terms “in the black” and “in the red” come from the color of the ink that bookkeepers historically used to record positive and negative values in manual ledgers.


Determining your cash flow helps you to project if you will have a cash shortfall or surplus. If you have a shortfall, you will either have to cut back your spending, earn more money, or borrow money. If you have a surplus, you can decide if you are going to spend it or invest it. To determine cash flow, pick a period of time (such as a month) and record all money coming in and going out, as well as how much money you currently have. Note that not all liabilities are paid in the same periods. For example, real estate taxes are generally paid every six months, and insurance is usually an annual charge. You may find it easier to show a reserve (money you set aside each month) for the monthly portion of these less frequent charges in your cash flow.

Budgets

A budget is an itemized list of estimated expenditures and the expected ways to pay for them, for a given time period. By budgeting you can manage your finances better, and watch to make sure you don’t spend more money than you budgeted.

In addition to income and expense items, budgets often include planned amounts for savings or investment. For instance, you might have money taken out of your paycheck for a retirement plan. Or, you might make monthly payments to a savings

Amount Sources of Cash Regular Income

• Salary, net take-home pay $ 3,000 • Interest on Savings Account 20

One-Time Income • Birthday Money, Gift 100 • Sale of Stock (for car down payment) 5,300

Loans and Debt Funds Received • Car Loan 15,000

Total Cash IN $ 23,420 Uses of Cash Special Purchase

• New Car $ 20,000

Living Expenses • Rent 1,200 • Utilities 200 • Car Loan Payment 200 • Gas/Transportation 100 • Food 250 • Health Care 100 • Insurance Reserve 100 • Real Estate Tax Reserve 150

Discretionary Expenses • Clothing 100 • Entertainment & Recreation 100 • Donations & Charities 100 • Miscellaneous 100

Total Cash OUT $ 22,700 Surplus Cash for Spending or Investment $ 720

Example


account. These are uses of your cash that may remove it from easy access, but the money is still yours. Think of it as paying yourself.

The main difference between a budget and a cash flow is that budget use estimates and cash flows use actual amounts. A budget is an estimate, done before the money is earned and spent. A cash flow shows actual results of earnings and expenses. It is also useful to compare your budget with what actually happened. This helps you to make your future budgets more accurate.

Portfolio Management

A collection of investments is known as a portfolio. Portfolio management means watching all your investments, and balancing your various investment needs. The most common portfolio management issues are:

• Liquidity • Investment Income • Growth/Capital Gain • Risk • Tax Planning

Liquidity

Liquidity means how easily your investment could be cashed and used. If you are saving for your retirement, you won’t need the cash for many, many years. However, if you’re saving for this year’s vacation, you have to be sure you will have the cash available in time for your trip.

Investment Income

Some types of investments make periodic payments of interest or dividends: this is called investment income. If you need investments to generate regular income without selling assets or reducing the principal amount, then you must choose investment options which will do this.

Growth/Capital Gain

The value to some investments is not periodic income, but the increase in the overall value of the asset. When you sell the asset, you receive more money that you paid for it. This is called growth or capital gain. In many cases this growth can exceed the sum of all the interest you might have received from another investment. Unlike interest income and dividends, you must sell this asset to get cash back and any capital gain.

Risk

Risk is uncertainty. Whenever there is an unknown future, there is risk. Many investment decisions you make will carry a risk that the investment will not provide the future value you expect. You might lose some of your money or even all of it. Or, you might gain a little or a lot. Each investment carries a certain risk that it will not perform as anticipated. It is likely that your portfolio will have a blend of different risk levels.

In GoVenture Financial Literacy, you choose your investments and manage your portfolio.


Tax Planning

Another part of your portfolio management is tax planning. You must plan the most advantageous manner for investing with your income taxes in mind. Certain investments provide ways to reduce or defer tax payments. For example, there are many retirement plans which defer all taxes until the time you use the money after you retire. Government bonds are usually tax exempt. If you want to avoid current income tax on your investments, your portfolio may include some tax exempt or tax deferred investments.

Insuring Your Life and Assets There are no guarantees in life, but you can pay a reasonable cost to insure against the unexpected loss of certain assets, and even your life. There are three major categories of insurance products:

• Those used as investments.

• Those used to pay for the costs of loss or damage.

• Medical and health insurance.

Annuities and certain types of life insurance are used as investment instruments. Other insurance guards against your financial loss to property (house, car, possessions, travel, lawsuit claims, slander), or your health and ability to earn a living (medical, loss of use, or disability coverage). Insurance is a contract, called a policy. You, the insured, pay a specific sum or series of payments (called premiums) to the insurer or underwriter. In return for your money, the insurer agrees to guaranty against the loss of certain specified risks, up to specified limits. You can insure many things, but some insurance may be so expensive that you decide to do without it. The most common types of insurance purchased are:

• Life Insurance • Health Insurance • Automobile Insurance • Property Insurance

Life Insurance

Like the name implies, life insurance insures your life. That is, it pays an individual whom you name, your beneficiary, a certain amount of money when you die. There are exclusions: for instance, death by suicide is not covered. Why do you need life insurance? Obviously the benefit does not go to you. But the life insurance payment to your beneficiary can be used to:

• Cover the costs of your funeral and settling your estate, and

• Provide your family members with financial security.


Buying life insurance is important, and it can be confusing. There are a number of policies to choose from, and it is often difficult to compare one to the other when you are shopping for the right policy. Some insurance companies offer policies which include a savings component. In these cases there is monetary value to you in your lifetime, in addition to the death benefit, the amount paid to your beneficiary upon your death. The basic types of life insurance policies can be broken down into two major categories: term life and whole life. Annuities are a third category. Annuities are primarily a savings vehicle, but they pay a death benefit and are considered an insurance product.

Do You Need Life Insurance?

The best way to decide this is to ask yourself, “Would my death create a financial hardship for anyone?” If the answer is “yes,” you need life insurance.

Some people recommend buying life insurance when you’re young so that the premiums will be low. If your death would not create a financial hardship on anyone, then you may wish to invest the money instead of spending the money on insurance premiums. High wealth individuals should also consider the tax impact on your estate. When properly structured the life insurance death benefit may be completely exempt from estate taxation. So your beneficiaries could use it to pay the taxes on your estate.

How Much Do You Need?

This is more difficult to determine. Some people just pick a number out of the air. Some people use a number equal to four or five times their annual income. Others take a more analytical approach:

What would immediately need to be paid?

• Funeral expenses • Estate taxes and probate costs • Mortgage • Debt • Children’s college funds

What would your family need to maintain their standard of living?

What other income would your family have after you are gone?

• Social Security (US) or Social Insurance (Canada) benefits • Retirement benefits • Savings and investments • Their own wages and earnings

What economic factors do you have to consider?

• Inflation • Interest rates


It is complex, especially when you try to estimate how much inflation will erode the future insurance benefit. Insurance agents can help you with these estimates. Ultimately, it will probably come to a compromise between the future benefit you would like to have and what you can afford today.

Health Insurance

Health insurance is recommended in the US and usually is available through your employer’s group plans. In Canada basic health coverage is provided to all residents, but supplemental plans may be desired to cover prescriptions, dental care, and when traveling out of your home province. Other insurance options include coverage for the possible loss of your ability to earn a living: disability coverage, or for specialized professions, loss of use (e.g. a surgeon would insure his hands).

Automobile Insurance

Certain amounts of automobile insurance are mandatory by law. Most drivers carry more than legal requirements to pay for damages and cover lawsuits from others. Insurance coverage usually includes payment for damage to the vehicle, and medical costs from personal injury if you cause an accident.

Property Insurance

Your mortgage lender will require that you purchase certain amounts of insurance against damage to the house you are buying. Homeowner policies usually cover both the structure and a specified amount of personal goods within it. If you do not own your home, you can also purchase insurance for just your personal belongings, and not the building itself. Special high-value items should be identified separately to your insurer, for example — computers, jewelry, boats, antiques, coin or stamp collections, etc.

Other Insurance

Other types of liability insurance and short term coverage for travel and goods are also available. Specialty coverage can range from personal liability insurance to pet insurance. To decide if you should have the coverage, consider the risk that such a loss might occur, and then the cost of the loss versus the cost of insurance.


The Investment Timetable

Living and Retiring Comfortably

By calculating your net worth and keeping an eye on your cash flow, you can begin to determine what your future financial health might look like. If you expect to retire at a young age, then you will need to build up enough net worth to be able to do so, including factors such as inflation. Or you can simply plan to balance your

current life style with enough investment to assure a comfortable retirement at a later time in your life. There are trends for investment portfolios in “an average person’s” lifetime. Many people find they are not “an average person,” and their financial requirements are different, or they don’t have the expected investment portfolio for their age level. So an investment timetable should be used only as a general guideline. It is never too late to start saving and investing. But your age, family responsibilities, and financial commitments may require you to adapt the investment strategy to your specific situation. In your younger years, you will want to look to long-range growth investments. You may be able to afford to take some higher risks, as you will have time to adjust for losses. As you grow older, you will continue to diversify your portfolio of investments. Then, as you approach your retirement, consolidate your holdings and reduce the amount of high risk investments. During retirement years, you will likely wish to have more income generating investments and low risk to give you security.

In GoVenture Financial Literacy, you make all your investment decisions — year-to-year, and week-to-week.

Early Years To Mid 30s Get started! Growth-oriented.

Middle Years Mid 30s – Late 40s Build value and invest! Diversify. Growth-oriented.

Retirement Years 60 and over Security! Income-oriented. More conservative.

Pre-Retirement Years Late 40s – Retirement Consolidate! Diversify but reduce amount of high risk.

Chapter 7 Key Investment Concepts 39

7. Key Investment Concepts

Before you can start to evaluate the benefits of different investment options, you must understand some key investment concepts:

• Time Value of Money • Return on Investment • Risk and Return • Economic Influences

The value of your investment is measured by the amount of value returned to you and the holding period of your investment. Returns vary greatly, as does the potential risk in each investment. So time, risk, the rate of return, and the possible economic influences must be considered when making your investment decisions.

Time Value of Money Lenders and investors want to have the dollars they loan, or invest, today to be worth more when those dollars are returned in the future. There are two components in the future value they are looking to cover:

1. Inflation 2. Opportunity Cost

Inflation

The time value of money means, in part, that the worth of money changes over time. As time passes, each dollar will usually buy less and less value. This is called inflation. As the prices of goods rise over time, a dollar in the future will not buy as many goods as it does today.

In terms of investing money, if you invested a dollar today and only got one dollar back 50 years from now, you are likely to lose value in terms of your buying power. Fifty years from now you might need $5 or $10 to keep the same buying

Have you ever heard one of your older relatives say, “A dollar today just isn’t worth what it used to be! In my day, well, you could buy …”

So if a 25-cent candy bar in the 1950’s now costs $1.00, then the value of today’s dollar is much less, because it takes four times as much money to buy the same item (i.e. in 1950 you could buy four candy bars for $1.00, but now you only get one).

Example


power. This is one reason that banks charge interest when they loan money — to try to make sure the value of the money being repaid in the future is at least the same as the value of the money they are loaning or investing today.

Opportunity Cost

The opportunity cost is an estimate of the value you did not get from other possible uses of your money. If you could invest your money for five years and be guaranteed to get back exactly the amount of original investment plus inflation, would you do it? Probably not. That is because you

would be no better off than you are today with the money. Your buying power would not have grown at all. During those five years, if you had kept the money you might be able to use it to do a lot of other things — build a bigger house, buy a better car, or make another investment — because you have other opportunities for the money. Ideally, you would like to get your money back, with inflation and some additional amount to compensate for the other opportunities you did not take. Perhaps it is easiest to think of this opportunity cost as the charge for using your money over a period of time. It could even be considered as a type of “profit,” so that you wish to get your principal, plus inflation, plus some profit back from your investment.

Return on Investment (ROI) The extra value that you want back from your investment is the called the return on investment (ROI). This is the benefit (the “return”) you expect to receive in the future. There are three ways to receive a return on your investment:

1. Interest Income 2. Dividends 3. Capital Gains

The type of investment determines whether your return is interest, dividend, or capital gain. Here are some common investments:

Possible Types of Return Type of Investment Interest Dividend Capital Gain Savings Account √

Treasury Bill √ Bond √ √ Stock √ √ Diamonds √ Real Estate √

Example


Interest Income

Interest is the fee charged by a lender (investor) when providing money to a borrower. When you borrow money, you repay the amount you borrowed plus interest. When you loan money, you receive the interest income plus repayment of the original amount you loaned. For example

Dividends

A dividend is a distribution of part of a company’s profits, which is paid by the company to its shareholders (another name for investors, because they hold shares of stock in the company). Dividends are authorized by the Board of Directors, and are generally paid quarterly, semi-annually, or annually. Most often, dividends are paid yearly. Not all companies pay dividends – in fact, most companies do not. Generally companies reinvest profits back into the company in order to grow the company, instead of paying dividends.

Capital Gains

With capital gains, an investor expects to make money through an increase in the overall value of an asset (such as property, art, shares in a company, etc.). This increase is called capital gain because investors make a gain on their capital assets: that is, they receive more value than what it cost to purchase the asset. Capital gains offer the potential for very high rates of return on investments – much more than dividends and interest normally provide. Capital gains are what have made some people overnight millionaires. There is always the possibility that you might end up selling an asset for less than you paid for it. This is called a capital loss.

Company-A Issues dividends of $0.50 per Share.

You own 100 Shares. You will receive $50 (100 Shares x $0.50 per Share) in dividends as your share of the profits

Example

Example

Lender/Investor Loans $1,000 Interest 5% a year (1,000 x 5%) Loan to be repaid after 5 Years Return on Investment = $250 (5 years x $1,000 x 5%)

Borrower Repays Year 1 - $50 Interest Year 2 - $50 Interest Year 3 - $50 Interest Year 4 - $50 Interest Year 5 - $1,000 Loan + $50 Interest Total Interest Paid = $250


Rate of Return Investments not only have different types of return, or gain, but also have levels of return and different time periods for the return. When the return on investment is expressed as a percentage of the original investment, it is called the rate of return on investment, usually shortened to just the rate of return. By calculating a rate of return, you can more easily compare the value of different investments. The higher the rate of return, the bigger your monetary gain will be. The total dollars you gain from an investment will vary depending on the amount invested, the length of time you hold the investment, and the rate of return. The rate of return is usually calculated on an annual basis to help you compare investments of different durations. There are several different ways to calculate the rate of return. Simple rates of return are easiest to compute, but the most commonly used rates of return are compound rates. Simple rates of return compute the gain as a percentage of the original amount for the entire period. To get an annual rate, you divide by the number of years. Compound rates are more complicated calculations because they adjust for the time value of money, as if you had re-invested your periodic gain at the same rate — like getting interest on your interest. Compound rates of return are lower than simple rates for the same return on an investment. Therefore, when comparing rates of return, make sure you are comparing the same types of rates.

Company-A Share Price is $1

You buy 100 Shares for $100 (100 x $1)

Example Today Sometime in the Future

Company-A Share Price is $3

You sell 100 Shares for $300 (100 x $3) Your Capital Gain = $200 ($300 - $100)

Calculating the Return on Investment

You invest $10,000, and 3 years later you get $13,000 back.

Simple Rate of Return $13,000 — $10,000 = $3,000 Gain (Return on Investment) $3,000 ÷ $10,000 = 30% Rate of Return over the 3 years.

Simple Annual Rate of Return $3,000 ÷ $10,000 ÷ 3 Years = 10% a Year

Compound Annual Rate of Return = 9.1% a Year, compounded annually (see Calculating Rates of Return)

Example


This may seem easy, but often your investment decisions have many different options. When in doubt, seek professional investment advice.

Risk and Return Risk is uncertainty. With investments, this means the uncertainty of how much of your investment you could lose or gain. There are many types of investments, each of which has varying levels of risk and possible returns. The better you can balance the risks and potential returns of your investments, the better you should be able to meet your investment goals.

Risk versus Return

There are no investments that can be made with 100% guarantees of the future outcome. Even if you decide to stuff money in your mattress, your house might catch fire or mice could chew up your money.

Calculating the Return on Investment

For instance, how would you compare the following investments?

• Mutual Funds, $25,000, expected to grow by $15,300 in 5 years. • Real Estate purchase of $50,000, expected to be worth $150,000 in 6

years. • Stock purchase of $75,000 in a growth company, expected to triple in

value in 4 years. Knowing the rate of return for each investment option makes it much easier to compare them:

Mutual Fund Real Estate Stock Investment $25,000 $50,000 $75,000 Expected Growth

Grow by $15,300 in 5 yrs

triple in 6 years triple in 4 years

Future Value $40,300 $150,000 $225,000 Return (Gain) $15,300 $100,000 $150,000 Compound Annual Rate of Return

10%

20%

32%

You can now see that the stock investment is expected to have the highest rate of return. It is still not an easy decision, but knowing the rate of return makes them easier to compare. You must next balance the amount of money you have to invest, the length of time you can invest it before you need the cash back, and the risk that the expected return might not happen.

Example


The risk of each investment will vary. The risk can range from almost none to extremely high. At the same time, the potential return will run parallel to the perceived risk. That means that the lower the risk, the lower the expected return is. And the higher the risk, the higher the potential return is. Low risk investments are those where it is unlikely you will lose any part of your investment. Low risk investments only return a small amount of income. Examples of low risk options would include:

• Passbook savings account

• Bank term deposits

• Federal government savings bonds

• Guaranteed rate annuities

High risk investments are those where it might be possible to lose your entire investment. These investments often have the potential to give you extremely high returns, in repayment for risking your money. Examples of high risk options would include:

• Stock in high risk companies, e.g. drilling for oil

• Investing in what the future price of certain commodities will be (Futures)

Risk and reward potentials vary from investment to investment. This makes reviewing the risk-reward profile a key feature of each investment decision.

Your Risk Profile

When determining where to invest your money, you must understand the risk involved: Could you lose the potential benefit? Could you lose part of your original investment? Could you lose all of your original investment? How likely is this to happen? Is the risk lower if you hold the investment over a long period of time?

And most importantly, you must understand your own willingness to take this risk. For instance, which of the following statements would you select as best describing your investment risk preferences:

� I like to gamble; I want to try for big gains; and I don’t care if I lose the

whole amount.

� I’m willing to risk a lot, but I don’t want to lose all of my principal.

� I’m willing to invest some in riskier options, but I don’t want to lose more than ______% of the original principal amount.

� I am fairly conservative. I’d like to keep as much of the principal as possible, even if it means lower returns.

� I don’t want to lose any of the original principal amount, even if it means low returns.


In developing your risk profile consider the following issues:

• How much money do you want to make?

• When do you need the money?

• How much loss can you tolerate?

• What is the minimum amount you need?

• What is your knowledge level as an investor?

How much money do you want to make?

The greater the amount of gain needed to meet your financial goals, the more you may need to invest in higher yield opportunities (those with a higher return) — and thus take on moderate to high risk.

When do you need the money?

How soon you need to access the money will also depend on how much risk you might need to accept to reach your financial goals. The less time you have to build your net worth to your target level, then the higher the rate of return you will need to achieve this. And that will mean taking on more risk. If certain levels of risk are unacceptable to you, then you may need to adjust your goals.

How much loss can you tolerate?

Remember there are no guarantees in investing. Therefore, you must identify how much you would be willing to lose, or how much you could lose and still meet your base level goals. If you have already lost near your maximum amount from earlier risky investments, then you will have to revise your risk profile for future investments.

What is the minimum amount you need?

Determine the minimum level of net worth for your financial security. You can use this as a base level, or minimum for your goals. When assessing the rate of return, investment risk, and loss potential compare the possible outcomes to this minimum level. This may help you decide if you are willing to accept certain new risks.

What is your knowledge level as an investor?

Know what you don’t know, and what you do when it comes to investing. The less you know about an investment, the riskier it becomes. For example, if you happen to know a particular company or industry, you are better able to project a company’s chances of success. Your investment then becomes less of a bet the company will make good, and more of an informed estimate that the company will do well. You can increase your own understanding, or hire the services of qualified investment advisors to reduce some risk in your investment choices.


Economic Influences The economy is all around us. If affects everyone in the world in some way or another. Having a basic understanding of the economy is invaluable in making personal investment decisions. There are several national and global factors that affect the economy, which in turn affect your ability to make and spend money. For example, when the economy is weak, companies may lay off employees, stock markets may crash, and interest rates may drop. When the economy is strong, companies may hire more employees, salaries may increase, interest rates rise, and the stock market may boom. Changes in economic conditions affect people in some way or another — sometimes in very complex relationships. By understanding some of the basics about the ups and downs of the economy, you can make better financial decisions. The following are key factors that affect the economy. Each is described in sections that follow.

• Interest Rates • Inflation • Foreign Exchange Rates • Financial Markets • Government Spending and Policy • Global Events

Interest Rate

What is it?

Interest is the cost of a loan. When someone gives you a loan, they expect you to pay back the principal (amount of money you receive) plus interest (their profit). The higher the interest rate, the more the loan costs you. Or, if you loan money to the government or a company by purchasing a bond, you, too, expect to get interest plus your original investment back. Common terms used to describe interest are prime rate for a bank loan, and coupon rate for a bond. Prime rate is the interest rate set by major banks for loans to their best corporate customers. Individuals are usually charged interest rates higher than the prime rate for their loans. The coupon rate is the interest rate paid on a bond to the purchaser of the bond.

In GoVenture Financial Literacy, you can track the economic trends, and use this information to help you with your investment and other decisions.


Example

Cause/Effect

In most loans the interest rate is set by the lender (the person or company providing the loan). In the case of bonds, the interest rate is set by the borrower (the company or organization offering the bond), based on current market conditions. Interest rates vary by type of loan and the credit rating of the borrower. Generally, the higher the risk of default is, the higher the interest rate is. Default means the failure to make the payments or to meet other requirements of a loan or legal agreement. Interest rates also fluctuate with changes in inflation, so that the interest rate covers the rate of inflation (see below) plus a reasonable return on top of inflation.

Inflation

CAUTION: $1 today is not the same $1 in the future — because of inflation.

What is it?

Inflation refers to the increase in the amount of money needed to buy the same goods and services over time.

Interest

Loan of $1,000 at 12% Annual Interest (with monthly payments of $100 plus interest)

Month

Loan Balance

Payment (Interest = 12%/12 months x Loan Balance)

January $1,000 $100 + $10 Interest = $110

February $ 900 $100 + $9 Interest = $109

March $ 800 $100 + $8 Interest = $108

April $ 700 $100 + $7 Interest = $107

May $ 600 $100 + $6 Interest = $106

June $ 500 $100 + $5 Interest = $105

July $ 400 $100 + $4 Interest = $104

August $ 300 $100 + $3 Interest = $103

September $ 200 $100 + $2 Interest = $102

October $ 100 $100 + $1 Interest = $101

November $ 0 Total Repaid = $1,000 + $55 Interest

A car that used to cost $10,000 in the 1970s, may now cost $25,000. A soft drink that used to cost $0.25, may now cost $1.00.

Example


Inflation lowers the value of your money because it costs more to buy things. This is also referred to as the decrease in buying power of money.

As inflation increases, so do interest rates. This happens because money lenders want to make sure they can cover the cost of inflation.

If inflation is at or close to 0%, this is called price stability. Deflation is the opposite of inflation and is used to describe the situation when prices lower over time. Note that people also refer to “drops in the inflation rate,” which is the same thing.

Inflation/deflation is a general indicator of changes in buying power. Costs of individual goods and services increase with inflation. But, their prices may also increase or decrease for reasons that have nothing to do with inflation or deflation.

Cause/Effect

Inflation reflects changes in the currency’s (the money’s) buying power of goods and services. When the costs to make goods increase, prices go up, and there can be an overall domino effect in prices causing inflation. But what causes costs to change?

• Supply and Demand When demand for an item is greater than the supply, the items are hard to come by and prices usually go up. Conversely, when supply is greater than demand, there are too many around and prices generally are lowered.

• Value of National Currency If the value of the national currency changes compared to other world currencies, this changes the buying power of imported goods (which changes the costs), and it changes the value received when selling abroad. These changes can affect inflation, for example: Currency value drops –> Cost of imported goods rises Currency value rises –> Cost of imported goods drops

• Anticipation of Changes to Supply and Demand In some cases, the change in supply and demand does not have to happen: it only has to be believed to be coming. For certain products, like oil, the anticipation of a change in supply can cause stockpiling and price changes.

Generally, inflation is not desired, so governments try to adjust monetary policy to keep inflation under control.


Foreign Exchange Rate

What is it?

The foreign exchange rate is the value of your country’s currency compared to another country’s currency.

For example, if you are an American visiting Canada, your US$1.00 might be worth CA$1.50. But, if you were a Canadian visiting the United States, your CA$1.00 would be worth only US$0.67.

Cause/Effect

The foreign exchange rate affects the cost of travel, imported goods and services, and exported goods and services. If your currency has a high value (is strong), then goods from your country cost more to others in countries whose currency has a lower value (is weak). But goods imported from countries with weak currencies are less expensive for you.

Your Currency is

Higher in Value Your Currency is Lower in Value

Travel

Costs you less to travel abroad. Costs you more to travel abroad.

Tourism Fewer tourists to your country due to higher costs.

More tourists to your country due to lower costs.

Imports More imports because items cost less to buy. Reduced price of imported products.

Fewer imports because items are more expensive to buy. Increased price of imported products.

Exports Fewer exports because items cost more for foreigners to buy.

More exports because items cost less for foreigners to buy.

The value of a currency is not set by the government or any other organization. Instead, it is based upon its market value, just like any other item that is freely traded. If there are more buyers of a currency than sellers, then the price goes up, and vice versa. Governments often try to influence the value of their currency by buying and selling currency and other monetary policies, but they do not control the value.

Government Spending and Policy

The modern capitalism practiced in the United States and Canada holds that the government should play a supportive rather than a direct role in free markets. To this end, the government sets policies and laws to facilitate free enterprise, and also adjusts and influences certain economic factors to help speed up or slow down economic growth, as needed. This includes tax, interest rates, and government spending.

Example


Taxes

Taxes are funds that must be paid to the government in order to enable the government to pay for its operations. When the government increases taxes, citizens have to pay more money to the government, leaving you with less money for your own living expenses and savings. The less money you have to spend and save, the less that flows into the economy. Consequently, economic growth slows.

Interest Rates

When you deposit money in the bank, the bank doesn’t keep your cash in its vault. Instead, the bank invests the money. Banks are constantly borrowing money from the government and each other in order to maintain legal minimum levels of cash on hand for their customers. The government directly affects interest rates by setting the interest rate in which banks borrow money from the government. In the US this is called the Discount Rate (the primary credit rate). It is set by the Federal Reserve Board, and it is available for short term (usually overnight) borrowings by eligible financial institutions in sound condition. In Canada, this is called the Bank Rate, and it is set by the Bank of Canada. The Bank of Canada’s official key rate is now called the Target for the Overnight Rate, which is set midway (+/– 0.25 of a point) between the borrowing rate (the Bank Rate) and the interest rate paid on overnight deposits. The banks’ minimum level of cash is the Reserve Requirement, and it is set by the government in order to protect citizens. For example, if you wanted to withdraw $1,000 from your bank account today, the bank must have this money available to give to you when you ask for it.

Banks also maintain these minimum levels of cash by borrowing from the government and from each other. The interest rate for banks borrowing from banks is called the Federal Funds Rate in the US, and the Overnight Rate in Canada. The banks then set their Prime Rate, which is the interest rate they provide to their best customers, above their costs to borrow money.

USA Canada

Discount Rate

Federal Funds Rate

Prime Rate

Bank Rate

Average Overnight Rate

Prime Rate

December 2000

6.00 6.48 9.50 6.00 5.80 7.50

December 2001

1.25 1.77 4.75 2.50 2.24 4.00

December 2002

0.75 1.23 4.25 3.00 2.74 4.50

Only top-rated corporations usually can borrow at the prime rate. All other borrowing rates are set above the prime — depending on the type of loan, the risk, and the length of time the rate is locked in.


Spending

The government generally is the largest consumer in the country. (The US federal government is the biggest consumer in the world!) The government purchases goods and services and employs people throughout the country, using taxes collected to pay for it all. If the government decides to increase spending on its operations and in programs, then economic activity will increase. Reduced government spending may cause loss of jobs and other decreases in the economy due to the lower demand for goods and services by the government.

Global Events

Increasingly, the economic success of a nation is affected by factors around the globe. Sometimes called globalization, the following information outlines some of the key issues.

Imports and Exports

Being able to sell products and services into other countries enables businesses in your country to expand, employ more people, and bring wealth back to your fellow citizens. Similarly, enabling other countries to sell their products and services in your country provides you with access to new items, which offers you more choice in quality and cost. However, by importing and exporting you must also compete with people around the world. If you cannot compete, you risk losing jobs and wealth.

Investment

When foreign governments, businesses or individuals invest money in your country, local businesses are able to expand, which in turn creates new products and services, and results in more jobs for the citizens.

Access to Funds

Governments often need to borrow money to fund their operations and to improve the welfare of its citizens. Governments of countries which are economically strong tend to be able to negotiate better interest rates, reducing their cost of borrowing.

Changes in the economy can have multiple effects, and multiple things may change at the same time. This makes it very difficult to control or predict the economy in detail, but influences and general trends can be followed.


Economic Indicators An economic indicator is a set of statistical data that shows trends in the economy. A leading indicator helps predict trends of what may happen before the economy has actually changed, while a lagging indicator show trends of change after the change has occurred. The following indicators are often used to track changes in the economy.

• Gross Domestic Product (GDP) • Unemployment Rate • Prime Rate • Consumer Price Index (CPI) • Employment Growth • Housing Starts • Motor Vehicle Sales • Personal Savings Rate • Value of the Dollar

The first four of these indicators are described in more detail below.

Gross Domestic Product – Economic Growth

Gross Domestic Product – or GDP – is the total of all goods and services produced in a nation in a given year. Goods and services are consumed domestically or exported to other countries, and as GDP increases, a nation’s economic growth is also said to increase. This measurement is usually stated as the percentage change from the previous year. Nominal Economic Growth includes inflation, while Real Economic Growth is Nominal Economic Growth minus inflation.

US Gross Domestic Product (GDP) $ Billions

Year Nominal GDP (Current Year $)

Real GDP (1996 $)

1950 $ 294.30 $ 1,686.60 1960 $ 527.40 $ 2,376.70 1970 $ 1,039.70 $ 3,578.00 1980 $ 2,795.60 $ 4,900.90 1990 $ 5,803.20 $ 6,707.90 2000 $ 9,824.60 $ 9,191.40 2002 $10,446.20 $ 9.439.90

Source: US Bureau of Economic Analysis. Note that Real GDP is reported in a fixed year’s dollars in order to eliminate the effect of inflation.

In GoVenture Financial Literacy, the economy of your simulation is reflected in four economic indicators: economic growth, unemployment rate, prime rate, and inflation.


Unemployment Rate

The more people who are employed in a country the better it is for everyone because there is more money flowing through the economy. The Unemployment Rate is the percentage of individuals in a nation who are actively seeking employment but do not currently have a full time or a part time job. Those who are not actively seeking employment are not included in the measurement: this sometimes misrepresents the true unemployment rate.

Unemployment Rates

Year USA 1950 5.3 1960 5.5 1970 4.9 1980 7.1 1990 5.6 2000 4.0 2002 5.8

Source: Annual Unemployment Rate — US Department of Labor

Consumer Price Index – CPI

The more expensive goods and services are, the less people can afford to buy, unless they increase their incomes to match. The Consumer Price Index (sometimes called the Cost-of-Living Index) measures the rate of inflation by monitoring the average change in the price of several hundred goods and services in the country. This basket of goods and services includes categories such as clothing, housing, transportation, food, electricity, and more.

Inflation Calculator $100 in 1950

How Much to Buy the Same Amount Now? Year USA US

CPI Canada CA

CPI 1950 $100.00 24.1 $100.00 15.1 1960 $122.82 29.6 $122.52 18.5 1970 $162.00 38.8 $160.93 24.3 1980 $341.91 82.4 $354.97 53.6 1990 $542.32 130.7 $621.19 93.8 2000 $714.52 172.2 $757.62 114.42002 $746.47 179.9 $795.36 120.1

Source: US Department of Labor & Bank of Canada

Prime Rate

The prime rate is the interest rate set by major banks for loans to their best corporate customers. An increase in banks’ prime rates often signals a slowdown in the economy, because it is more expensive to borrow money. When interest rates are low, more people and companies tend to borrow money to buy goods and services. This is believed to generate an increase in economic activity, so a reduction in interest rates is used to stimulate a slowing economy, by providing lower costs to borrow money.


Chapter 8 Making Your Money Grow 55

8. Making Your Money Grow Once you have money in hand, you have to decide what to do with it. You have four options, but only the last two actually can increase your wealth:

1. Spend it. 2. Store it. 3. Invest it. 4. Gamble it.

What you do with the money is a key determinant to whether or not you will realize your financial objectives. The chart below gives the basic benefits and drawbacks of these options.

Option

Positive Benefits Negative Drawbacks

Spend It

Buy something for yourself or a loved one. Enjoy!

• Pay for living expenses • Purchase items you want

• Once money is spent, it is gone.

Store It

1. Keep it with you (“stuff in a mattress”)

• Fast access to the money.

• No growth opportunity — because of inflation you may actually lose.

• Money could be lost, stolen, or destroyed. No security.

2. Place in a safe location (e.g. safe deposit box)

• No risk of losing the principal amount.

• Fast access to the money. • Secure.

• No growth opportunity — because of inflation you may actually lose value.

Invest It

1. Place it in a Savings Account

• Receive interest income. • Some limits to accessing

the money, but still fairly easy.

• Safe – principal is rarely at risk.

• Fees to access funds early. • Low return on investment –

hopefully enough to cover inflation.

2. Purchase capital assets as an investment

• Opportunity to gain a return on investment that could be significant.

• Could be risky depending on the types of investments you choose.

• May not be able to sell easily or quickly.

3. Invest in stocks, bonds, mutual funds, futures, or commodities

• May be high or very high returns.

• Possible to make very large gains in a short period of time.

• Usually quick and easy to sell and get cash back.

• No guaranty on how much you will get as a return. May be low or moderate returns.

• Possible to lose your entire investment with little notice. You must closely monitor your investments.


Option

Positive Benefits Negative Drawbacks

Gamble It

Try your luck at any one of the many gambling options.

• You might win. Winning a lottery with a large pot could give you instant wealth.

• Usually no minimum funds are required.

• Odds are that you will lose. • Not all forms of gambling are

legal.

If you want to have any chance of making your money grow, you only have two options: invest or gamble. What is the same about these two options is that there are opportunities to put small or large amounts of money into them, depending on the specific instruments* selected. However, there are many differences. The main different characteristics are summarized in the chart below.

* A financial instrument is a legal document or obligation which has monetary value or which records a monetary transaction. Stocks, bonds, and loans are all examples of financial instruments.

Investment instruments fall into two categories: debt and equity. Debt instruments are where you loan your money to another institution or person. Your gain from debt instruments normally comes in the form of interest payments on top of repaying you the amount loaned. Equity investments are when you purchase all or part ownership in an asset or a company. Gains from equity investments are less predictable and come mostly or all from the future value at which you sell your ownership share.

Invest Characteristic Savings &

Debt Investments Equity Investments

Gamble

Basic Type of Instruments

Debt (e.g. Certificates of Deposit, Bonds, certain Mutual Funds)

Equity (e.g. Stocks, real estate,

gems, certain Mutual Funds)

Games of Chance

Risk of Losing Your Return and Principal Amount

Almost None to Low

Moderate to Very High

Extremely High

Primary Type of Return

Interest Dividends, Capital Gains, or Both

Gambling Income

Amount of Return

Very Low or Low

Low to Very High

Moderate to Extremely High

Knowledge Required

Low Moderate to High

Low to None


Definition of Saving, Investing and Gambling

Saving and investing are often used interchangeably in everyday speech. And it can get confusing. Some people also confuse investing and gambling.

• Saving means to prevent the waste or loss of (to conserve), or to set aside for future use (to store).

• Investing means to purchase or obtain something of value for a future financial gain.

• Gambling can be defined as a) to play a game of chance for stakes, or b) to take a risk in the hope of gaining an advantage or a benefit.

When talking about monetary savings, most people mean a type of investment where you do not lose your money.

The term “gambling” is also used in different ways. Technically, by the definition of investing, a lottery ticket might be considered an investment. However, few if any people consider games of chance to be investments. On the other hand, under the second definition of gambling all investments are a form of gambling, because there is always some risk in any investment.

Experiencing Personal Finance uses “savings” to mean savings investments, i.e. very low-risk investments. “Investments” includes investing in both debt and equity instruments. “Gambling” means playing a game of chance.

Savings and Debt Investments

Type of Instruments — Debt

When you put your money in a savings account at the bank, you probably don’t think of yourself as a lender. But, this is exactly what you are doing. You are lending your money to the bank to use. For that use, they pay you interest. There is usually a specified interest rate, duration of the investment and amount of principal. Certain options (like passbook savings) give you total flexibility in the amount you put in the account and when you can deposit and withdraw your money. You will notice that the options that give you the most flexibility tend to pay the lowest amount of interest. Because the bank has to be prepared for anything you might do, they cannot afford pay you as much interest. Lower interest return is the price you usually pay for financial flexibility. Examples of types of savings and debt investments are given on the following page.


Bank Accounts

Type of Debt Instrument Institutions Selling This*

Passbook Savings Account

Term Deposits Accounts - CDs (USA) - GICs (CAN)

Bank, Savings & Loan, or Credit Union

Federal Savings Bonds

Financial Institution – only at specific times

Government Bills, Notes and Bonds - Federal - State/Provincial - Municipal

Financial Institution or Brokerage House

Corporate Bonds - Utility Companies - Corporations, etc.

Debentures

Mortgage-Backed Securities

Annuities Insurance Company

Whole Life Insurance * With growing deregulation in the financial community, more institutions are offering a wider variety of investment instruments.

In all the cases above, you become a lender. You loan your money to others – such as to a government, corporation, or financial institution – for a period of time. In return they pay you the money back plus some form of interest. These are all considered debt instruments or debt securities. Some of them have minimum or fixed amounts of principal required. Most have fixed time periods before you can access your money. Each has a specified interest rate. Some rates are fixed for the term of the debt. Some rates vary with changes in the prime rate, and may be stated, for example, like “prime plus 4%.”

Risk of Losing Return and Principal — Almost None to Low

The risk of losing your original, principal amount in savings is very low. The US and Canada have federal deposit insurance which covers your bank accounts up to a certain amount. With bonds and life insurance products, the only risk is that the organization issuing the instrument goes bankrupt. This is highly unlikely with federal government bonds, which is why they are considered so safe. While bankruptcy is possible, it is usually a low risk.

If you are uncertain of the risk involved, ask the person handling the transaction or your investment advisor.


Type of Return — Interest

The type of return from debt instruments is interest. Sometimes this is paid as an amount on top of your initial principal amount (for example interest on a fixed-term deposit). Other times the interest is “paid” in the form of a purchase discount. When you buy at a discount, you pay the maturity value (also called the face value, that is the amount to be paid when the debt is paid off) minus the value of the interest to be paid later. Your rate of return is the same whether you buy at full face value or at a discount.

Note: Bonds, other than government savings bonds, can be bought and resold before maturity. There may be a capital gain or loss in this transaction, but these gains/losses are usually small, and are not the focus of the investment. The primary gain from a bond is the interest income.

Amount of Return — Very Low or Low

Because the risk is low, the return is also fairly low. The greater the security or guaranty of return, the lower the return will be. The other things which will usually affect your return are a) the amount of flexibility for you to increase/decrease your principal amount or terminate the investment, and b) the minimum principal required. In some instruments you can terminate early and pay the penalty of losing some or all of the interest. In others you cannot access your money until the security has matured. Some bonds are bought and sold on the market, so you don’t have to wait for them to mature. However, the prices will be adjusted for the value of the future interest.

Buying at Face Value (Maturity Value) Buying at a Discount

Face Value: $1,000 $1,000 Interest Rate: 10% 10%

Purchase Price: $1,000 $ 909 Interest Paid: $ 100 $ 91

Amount Paid at Maturity: $1,100 $1,000 Rate of Return 10% 10%

Example

In GoVenture Financial Literacy, you have a standard savings account at the bank. You can invest in low, medium, and high risk investments.


Knowledge Required — Low

Because debt investments are relatively secure, limited knowledge is needed when making decisions about them. You do still need to know what your options are. There may also be transaction fees charged. And while the risk is low, there is still some degree of risk, especially on certain bonds. So, it is best to become an informed investor, or to ask your investment advisor for recommendations.

Equity Investments

Type of Instruments — Equity

Investing in equity instruments means owning all or part of something. Most people think of stocks when they think of equity investments, because this is one of the most common types of ownership. With stocks you purchase a small percentage of ownership in a company. Because of the ease of buying and selling in stock markets, stocks and mutual funds have become the most common forms of equity investments. But there are other equity investment options. The most common are summarized below. More detailed information on each category of instrument can be found in subsequent sections on the specific instruments.

Types of Equity Instruments

Stocks

— Common — Preferred

Mutual Funds — Various

Commodities — Wheat, Corn, etc.

Precious Metals — Gold, Silver, etc.

Derivatives — Various

Capital Assets

— Real Estate — Art & Collectibles — Gems — Other Property, e.g. race horse syndication

Risk of Losing Return and Principal — Moderate, High, Very High

Equity investments carry higher risk. Because you own part or all of something, your gain depends on the future value of this asset. If the value drops, you lose. If the value rises, you gain. There are no guarantees or insurance on what the future value of your investment will be. Each type of equity investment carries its own risks. So you must investigate specific information about each investment you are considering.


An example of a moderate risk investment might be buying gold bullion. While the world price of gold can drop, it generally has been increasing over time. An example of a high risk investment might be buying stock in a gold mine exploration company. The risk of not striking gold is very high. But if they do find gold, the returns might be very high, too.

Type of Return — Dividend or Capital Gain

Most equity investments only provide you with capital gains at the time you sell the asset. Stock and mutual funds may issue periodic dividends in addition to potential capital gains.

Amount of Return — Low to Very High

In the late 1990’s the stock market for technology companies was booming, and many people made a lot of money, or in some cases the market value of their stocks grew dramatically. The crash of technology stocks in 2000 turned many millionaires into paupers. They were millionaires on paper, because the stock they owned was valued very high. After the market crashed (often called the “Dot Com” crash after all the failed Internet companies), their million-dollar stock was worth only pennies. People who had sold their technology stock before the crash made a lot of money. Those who didn’t generally lost a lot of money. Meanwhile, other non-technology sectors of the market did not go through either the very high or very low swings in this period. This is generally true of any equity investment – the amount of return will vary, depending on economic conditions and the timing of selling the asset.

Knowledge Required — Moderate to High

If you purchase equity with no knowledge of what you are buying, you are taking great risk. You may get lucky, but without investment knowledge it is unlikely that you will be able to spot market indicators of change (for the good or bad). The more money you invest in equity and the higher the risk of your investments, the more you need to know about them. Most people seek the services of a qualified investment advisor.

In GoVenture Financial Literacy, you can invest in low, medium, and high risk investments.


Gambling

Type of Instruments — Games of Chance

In North America, gambling is a regulated activity. There are many forms of legalized gambling. The chance at instant financial freedom resulting from a very small expense has been a draw for many, many people. It presents such a temptation that gambling becomes an addiction for some. Others however, find gambling an entertainment activity — instead of going out to dinner and a movie, they go to a casino. And, a few people make gambling a full time profession by studying, analyzing, and trying to beat the odds on a consistent basis. Most people, especially investment advisors, do not recommend or encourage gambling. It is identified here, in order to separate gambling from investment opportunities.

Some of the most popular forms of legalized gambling include:

Types of Gambling Instruments

• Lotteries

• Betting (Racetrack, sports, etc.)

• Casino Gambling

• Other – e.g. Bingo

Risk of Losing Return and Principal — Extremely High

Chances are — you will lose. The odds are always against you. In casinos, they talk about the “House” (the casino, the company) always winning. Gambling is certainly profitable for the organizations that run the games. But only a very, very small percent of gamblers actually win more than they lose. Most financial advisors will recommend that, if you gamble, you should treat your gambling money as part of your entertainment expense, and expect to lose it all. Determine how much you can lose, and then stop at that point.

Type of Return — Gambling Income

Return from gambling is not considered capital gain. Capitals gains come from the sale of an asset, and are usually held a length of time before being sold. Your gambling receipt or ticket is not considered a capital asset, and in many cases you have no ticket or document for what you have spent (e.g. at the casino). The gain from gambling is usually called winnings or gambling income.

In GoVenture Financial Literacy, if you wish to try your luck at gambling, you can buy a lottery ticket.


Taxes — Qualified Retirement Plans

Amount of Return — Moderate to Very High

There are “scratch and win” lottery tickets that may have small returns, and there are also multi-million dollar lottery draws. Gambling income could be any amount. But, the odds of actually winning a large amount are astronomically small.

Knowledge Required — Low or None

Some people call winning at gambling just “sheer dumb luck,” because it rarely takes knowledge to win. It takes luck. No expertise at all is required in lotteries. Some may argue that betting on sports and other types of gambling requires knowledge. And, certainly some knowledge may improve your odds — but the odds are still heavily against you, even with expert knowledge.

Qualified Retirement Plans While you work, you pay monies toward government funded retirement assistance (Social Security in the US, or Social Insurance/Canada Pension in Canada). When you reach retirement age, you then receive monthly payments from the government, based on how much you contributed during your working years. Unfortunately, these benefits are rarely sufficient to cover all your retirement income needs. It is therefore recommended that everyone supplement the government-paid assistance amounts by having other pension or retirement funds. There are many forms of retirement plans which qualify for special treatment under federal tax laws. These are structured programs which allow you to defer certain income taxes until you access the money in your retirement. They are not special investments. They use standard investment options, though certain plans have limits as to what type of investments you can include in that retirement plan. It is advisable to have some retirement savings. Due to the complexity of regulations and tax implications on retirement plans, it is best to seek advice from an investment or tax professional in this matter.

Summary Personal finance is all about your wealth and the different things you may need to consider in planning and managing it. Personal finance includes understanding your cash flows — your income and expenses. It includes being able to budget your cash and invest surplus money in ways which will be likely to grow your wealth. Personal finance includes making decisions on what assets to buy, to sell, or to insure. It includes making decisions on how much money you will spend to maintain your


current lifestyle, compared with how much you will invest for the future. And, it includes making decisions on what type of investments to make. You do not have to be a financial expert to plan and manage your personal finances, but you are likely to need periodic professional advice. In many cases, financial planning and tax experts may be able to help you earn much more money than the cost of their fees, so do not think you always have to do it all by yourself. Consider the costs, risks, tradeoffs, and potential benefits of spending your money in one way over another. Like planting a garden, your personal finances require careful planning, and ongoing work to tend and monitor them so they will grow and be fruitful in the future. Your personal finances require a lifetime of monitoring. You cannot put your personal finances on “autopilot.” You must frequently review your goals, plans, and financial situation, adjusting them for changes in goals and unanticipated events that have happened along the way. Remember to:

• Set, monitor, and revise, as necessary, your personal life goals. • Plan how to meet your goals. Periodically review your plan to make sure you are

still on track. • Budget and manage your cash flow. • Invest for the future, as early as you can, as often as you can, and as much as

you can — in accordance with your financial plan. • Seek professional guidance if you are not certain of how to proceed.

Chapter 9 Next Steps 65

9. Next Steps

If you are looking for even more information on personal finance issues, refer to Section II of Experiencing Financial Literacy. Or, now that you have reviewed the key elements and terminology of personal finance, you can put your knowledge to practice! And a fast, fun, and risk-free way to learn-by-doing is to try the GoVenture Financial Literacy simulation. Good luck, and GoVenture!

.

www.GoVenture.net


67

Section II: Additional Reference Material


Chapter 10 The Investment Timetable 69

10. The Investment Timetable At different times in your life you will need to apply different investment strategies. The younger you are, the more time you have to invest and grow your wealth. This allows you to take some greater risks and target higher growth options, because you will likely be able to recover from some losses over the long run. As you grow older, you may need to diversify your investments

into a range of instruments to reduce risk in any given industry or type of investment. The closer you get to retirement, the greater this need will become. And during your retirement you will need the highest amount of security so that you will not lose the money you rely upon for your day-to-day cost of living. In this last phase, you will apply the most conservative investment strategy. But there are other challenges at each stage of your life. For instance, it is easy to recommend that you start investing when you are young, but when you are young is the time you are least likely to have much money to invest. Even if you did not start investing early, no matter what your age, you should develop an investment plan that is right for you and your specific circumstances. Use this timetable as a general guideline, and seek professional investment advice as necessary. Common Situation Investment

Objective General Advice Financial Challenges

Early Years (up to mid-30s)

• Early earning years. • Heavy financial

expenses (car, house, family).

• Minimal investments.

Get started! Growth-oriented investments

• It’s never too soon to start investing.

• Develop a plan. • Start investing regularly

to save for short-term needs and plan for long range future retirement.

• The more you put towards retirement now, the longer it has to grow and appreciate in value.

• Low income and overall shortage of cash.

• Assets need to be liquid to cover current needs and expenses.

Middle Years (mid-30s to late 40s)

• Usually more income is available for investments and discretionary expenses.

• Growing portfolio of investments.

• Establish good investment strategy and objectives.

Increase your portfolio’s value and invest! Diversify portfolio and target growth investments

• Maximize yearly retirement contributions.

• Diversify investments to help meet your goals.

• Larger proportion of growth/equity investments – you have time to let them grow.

• More family commitments.

• Difficult to save or invest a lot.

• Greater need to manage investment portfolio.

• Greater need to know how to minimize taxes on investment income.


Common Situation Investment Objective

General Advice Financial Challenges

Pre-Retirement Years (late 40s to Retirement)

• Your heavy spending should diminish, and you have fewer family commitments.

• You can maximize your investments.

• Your investment portfolios have significant holdings.

• Financial goals change to medium-term timeframe.

Consolidate! Diversify your holdings, but reduce the amount of high risk investments

• Maximize your retirement contributions.

• Review your investment mix, decreasing the percentage of higher risk investments.

• Begin to make more specific plans for your retirement.

• The unknowns in planning for your retirement.

• Managing your investment portfolio to get adequate returns.

• Adjusting your risk profile, reducing the risk level in the overall portfolio.

• Tax planning to minimize investment income taxes.

Retirement Years (60 and Over)

• Your focus is on your retirement and having enough money for your lifestyle.

• Your financial commitments are generally smaller.

• Use your retirement plans plus investment income to live on.

Security! More income-generating and conservative investments

• Continue investing but shift investment mix towards more conservative and income-generating instruments.

• Focus on estate planning.

• Do you have enough? • How will inflation

affect your retirement income?

• It is hard to know how long your retirement will last — possibly as long as 30 or 40 years.

Based on The Investment Timeline from “Investing Your Dollars, A beginner’s guide to investing.”

Canadian Bankers Association.

Chapter 11 Calculating the Return on Investment 71

11. Calculating the Return on Investment

Comparing Investments and Rates of Return Investments not only have different types of return, or gain, but also have levels of return and different time periods for the return. The rate of return on your investment is calculated in order to evaluate the value of your current or potential investments. Then you can compare parallel numbers to see the relative benefits of each investment option. Here is an example which was used earlier. Even with this

simple investment over a three-year period, the return can be calculated in several different ways. The importance of understanding which type of expected return is being provided for any potential investment is clear in this example. And when comparing investments, it is equally important to evaluate them using the same type of rate of return for each opportunity. Here are three very dissimilar investment opportunities. How would you rate the value of these investments?

• Mutual funds, $25,000, expected to increase by $15,300 in 5 years. • Real estate purchase of $50,000, expected to be worth $150,000 in 6

years. • Stock purchase of $75,000 in growth company, expected to triple in 4

years. You will need to evaluate: 1. The amount of investment money needed, compared with your available capital. 2. The time and liquidity estimated for each investment, compared with how soon you

may need to use the money from the investment. 3. The risk that you may not obtain the expected returns or the risk that you might lose

some or all of your investment, compared with your risk profile and portfolio goals.

You invest $10,000, and 3 years later you get $13,000 back.

Simple Rate of Return $13,000 — $10,000 = $3,000 Gain (Return on Investment) $3,000 ÷ $10,000 = 30% Rate of Return over the 3 years.

Simple Annual Rate of Return $3,000 ÷ $10,000 ÷ 3 Years = 10% a Year

Compound Annual Rate of Return = 9.1% a Year, compounded annually

Example


4. The rate of return which might be expected from each investment, compared to each other.

If the first three issues (amount of capital, liquidity, and risk) are all acceptable, then your decision will rest upon the estimated value of the investments. This is where the rate of return calculations becomes very important.

Simple Rates of Return Simple rates of return are easiest to calculate, but may result in what seems to be a very high return rate. Caution should be used when using simple rates of return for evaluating investment decisions. It is useful to understand these calculations before going on to compound rate calculations.

Percent of Total Return on Investment

The total return on investment is the percent of the total change from your original investment to the value you receive when you sell it. The total return rate is the easiest calculation. But it is seldom used, because this calculation does not account for the differences in investment time. The calculation looks at the percent change (increase or decrease) that occurred in your investment. For example, you invest $1,000. To get a total 10% gain, you would have to receive $1,100 from the investment — regardless of whether you held your investment for one month or 10 years.

Now, using the formulas above, compute the return and simple interest total return on investment for the three sample investment options given on the previous page. See if you can come to the following answers.

Total Return on Investment (Simple Interest)

Return on Investment Using starting value and rate of return, compute the future value: Future Value of Investment = Starting Value x (Rate + 1) where the Rate is expressed as a decimal (i.e. 0.1 and not 10%)

Future Value = $1,000 X (0.1 + 1) = $1,100

Rate of Return Using starting value and future value, compute the rate of return: Rate = (Future Value ÷ Starting Value) — 1

Rate = ($1,300 ÷ $1,000) — 1 = 0.1 [10%]





Future Value $40,300 $150,000 $225,000 Return (Gain) $15,300 $100,000 $150,000 Simple Total Rate of Return

61%

200%

200%

Notice that two of the investments have the same rate of return, even though one takes you six years to obtain, and the other only four years. Because this calculation does not adjust for the time an investment is held, it is rarely used.

Simple Annual Rate of Return on Investment

Most frequently, return rates are stated on an annual basis, to make it easier to compare investments of differing durations. Calculating an annual rate is done by converting the total return calculation into a yearly equivalent rate.

Assume you invest $1,000 for 3 years. To get an annual 10% simple return rate, you would have to receive $1,300 from the investment. That is a growth of 10% of your original investment each year.

Simple Interest (Annual Return on Investment)

Return on Investment Using starting value and rate of return, compute the future value: Future Value of Investment = Starting Value x [(Rate x # Years) + 1] where the Rate is expressed as a decimal (i.e. 0.1 and not 10%)

Future Value = $1,000 X [(0.1 X 3) + 1] = $1,300

Rate of Return Using starting value and future value, compute the rate of return: Rate = [(Future Value ÷ Starting Value) — 1] ÷ # Years

Rate = [($1,300 ÷ $1,000) — 1] ÷ 3 = 0.1 [10%]


Now compute the simple annual rate of return on the earlier examples.





61%

200%

200%

Simple Annual Rate of Return

12%

33%

50%

Notice how the annual rates of return on the investments have dropped significantly now that time is factored into the equation. The real estate and stock investments no longer have the same return. Time is important, because the longer your investment money is tied up, the greater the inflationary impact on your returns could be, and because your risk of loss is extended over a longer period.

Compound Rates of Return

Compound rates are calculated assuming that you can re-invest each period’s gains at the same rate, earning money on the gain as well as on the original investment value. In other words, compounding assumes that you get interest on your interest while you hold the investment. For instance, if you received $100 of interest income each year from your investment, compounding assumes you would keep re-investing that $100 every year for the remainder of the investment and make more money on your ever-increasing investment balance.

Compound rates can be calculated with an annual compounding period, semi-annual compounding, monthly, or even daily compounding. Interest on a savings account is normally compounded daily. Whatever compounding period you use, make sure to use the same period for all calculations so they will be comparable. Note that whenever you use a compound rate, it is always shown as an equivalent annual rate, no matter how frequently it is compounded.

Compound Rate of Return, Compounded Annually

Here is an example of a simple annual rate of return compared with compounding your return annually at a 10% rate. Follow each year’s calculations for each type of return to see why these totals vary.


Simple Annual 10% Return Compound Annual 10% Return (compounded annually)

Year Value Annual Gain (Rate x Starting Value)

Starting Value

Annual Gain (Rate x Starting Value

of that year)

Ending Value

1 $1,000 $100 $1,000 $100 $1,100 2 $100 $1,100 $110 $1,210 3 $100 $1,210 $121 $1,331

Ending Value

$1,300 $1,331

You can see in the example used here, that the amount of gain from a 10% rate of return varies depending on the calculation used. A higher actual gain comes from the compounded rate, because each year you are earning return on the prior years’ gains.

Using a formula to get the compound rate of return is a lot faster than doing each calculation manually (like the example above). You calculate compound rates of return as follows:

An annual compound rate is frequently used, but you can calculate compounded rates on any time period. Monthly and daily compounding would be calculated as follows, but it is much easier to use a financial calculator or program to solve for these rates. However, if you are dealing with estimated returns, annual compounding may be precise enough for your purposes. In the examples on the next page, you can see that the difference in gain between compounding yearly, monthly, and daily is not very large.

Compound Rate of Return – Compounded Annually Return on Investment Using starting value and rate of return, compute the future value: Future Value of your Investment = Starting Value x (Rate + 1)n where the exponent “n” = number of years

and where the Rate is expressed as a decimal (e.g. 0.1 and not 10%) Future Value = $1,000 x (0.1 + 1)3 = $1,331 a 3-year investment compounded annually Rate of Return Using starting value and future value, compute the rate of return: Rate = [(Future Value ÷ Starting Value)1÷ n] — 1 Rate = [($1,331 ÷ $1,000)1÷ 3] — 1 = 0.1 [10%]


Now compute the compound rate of return, compounded annually, on the earlier examples.



triple in 6 years

triple in 4 years


61%

200%

200%

Simple Annual Rate of Return

12%

33%

50%

Compound Annual Rate of Return

10%

20%

32%

Notice how these returns on the investments have dropped once again, when the annual rate of return is compounded.

Remember: 1. The simple total return can give a distorted rate because it does

not factor in the time you hold the investment. 2. The simple annual rate of return will give a rough estimate of

the relative returns between investment options. 3. A compounded rate is the best gauge, because it takes into

account the time value of your money, showing what you could make on your gains if you re-invest the gains elsewhere while you hold the investment.

4. Above all, you can also see how important it is to make sure that you are comparing the same type of return rates when making investment decisions.

Compound Return – Compounded Monthly or Daily

To compound in periods shorter than a year, the formula must be modified to adjust to annual equivalents. Monthly and Daily have been used here, but you can use any timeframe desired. Return on Investment Using starting value and rate of return, compute the future value: Future Value of your Investment = Starting Value x [(Rate ÷ p) + 1]n x p where the exponent “n” = number of years

and the Rate is the annual rate expressed as a decimal (e.g. 0.1 and not 10%) and the variable “p” = number of compounding periods in a year

$1,000 x [(0.1 ÷ 12) + 1]3 x 12 = $1,348, three years, compounded monthly $1,000 x [(0.1 ÷ 365) + 1]3 x 365 = $1,350, three years, compounded daily Annual Rate of Return, Compounded for shorter periods Using starting value and future value, compute the rate of return: Rate = ([(Future Value ÷ Starting Value)1÷( n x p)] — 1) x p ([($1,348 ÷ $1,000)1÷ (3 X 12)] — 1) X 12 = 0.1 [10%] compounded monthly ([($1,350 ÷ $1,000)1÷ (3 X 365)] — 1) X 365 = 0.1 [10%] compounded daily

Chapter 12 Bank Accounts 77

12. Bank Accounts Banks hold your money in trust for you and for millions of other people. The banking system provides people with:

• Secure, and usually insured, accounts for depositing and holding money.

• Interest income on certain types of accounts, usually those where you do not actively use the balance.

• Check writing, debit cards, and credit card services to make it easier for you to make purchases and pay debts without having to carry large amounts of cash with you.

• Loans and borrowing opportunities.

• High security safe deposit boxes. Because of these services and the responsibilities banks have to the public, banking is a highly regulated and controlled industry.

Commercial banks, savings & loan associations, and credit unions provide people with access to safe and convenient banking accounts for one primary reason: they want access to your money. When you deposit your money in a bank account, it isn’t left sitting in their vault. The financial institution puts your money to work by investing it or loaning it to other people. The financial institutions generate profits by charging more interest on loans than they pay on savings, and by investing money wisely. They also derive some revenue from service charges on your bank accounts and other transactions. Many financial institutions have now branched out and also can offer investment services, insurance, savings bonds, and mutual funds. These services and investments will be discussed in subsequent chapters.

Checking Accounts Checking accounts provide you with secure storage and flexible access to your cash. You don’t have to carry a lot of cash with you all the time, and you can easily send money to designated recipients that you cannot easily visit. A checking account allows you to deposit money and withdraw it either by visiting the financial institution, using a banking machine (also called ATMs – Automatic Teller Machines, or ABMs – Automatic Banking Machines), or by writing a check. You can also usually set up direct deposits of your wages, and direct payments of loans and other bills. With the more recent Internet banking options, you can monitor your account and pay bills electronically. Federal laws guaranty bank balances (the amount of money you have in your account at a given time) up to certain limits, so that your money is protected against theft or

In GoVenture Financial Literacy, you have both a checking and a savings account. You can make automatic deposits to and payments from your checking account, and more.


loss from the bank itself. Most checking accounts do not provide interest, though some can earn minimal amounts of interest. Normally there are monthly charges on your transactions, a flat service fee, or minimum balances required. The money in your checking account is considered part of your cash in your net worth calculation. It is not an investment.

Savings Accounts Savings accounts are another type of bank account. They provide the same security as checking accounts. Savings accounts also tend to have lower fees and will pay a specified amount of interest to you on your account balances. Most savings accounts are set up with the assumption that there will be limited transactions in the account — mostly deposits as you build your savings, and a few periodic withdrawals. Therefore, a savings account allows you to deposit money but withdrawing it may carry certain limitations, such as not being able to write checks, a limited number of withdrawals, time restrictions on when you can withdraw, or even a service charge for withdrawals. Your financial institution will provide you with details on the available accounts, restrictions, interest paid, and any fees charged. The most common types of saving accounts are called Passbook Savings. But other varieties of Statement Savings and other accounts may be offered. Different requirements may apply in terms of minimum balance, interest, and reporting provided by the financial institution.

Passbook Savings

Like its name, a passbook savings account provides you with a small passport-like book. Each time you make a deposit or withdrawal, the bank posts the entry into your book. They do not send out monthly statements. Interest posted to your account is recorded the next time you make a transaction. And, all transactions have to be made at the bank. With the growing popularity of banking machines and online banking, passbook savings accounts are becoming less common.

Statement Savings

Statement savings accounts are a simple variation of the passbook accounts. Instead of a passbook, the bank sends out monthly statements on your account.

Combination Checking/Savings Accounts

Some banks offer savings accounts with check writing. These accounts usually require minimum balances be maintained. When interest rates are low, these accounts pay almost no interest, and therefore, they offer very little, or no, advantage over having a regular checking account and a savings account.

Chapter 12 Bank Accounts 79

Term Deposits Term deposits are fixed savings investments — the amount, the duration, and the interest are pre-set. The benefit to term deposits over savings accounts is that they offer higher interest rates than passbook and statement savings accounts. The drawbacks to term deposits are that there are restrictions in the amounts you can deposit, and that your money is not accessible until the end of the term of time of the deposit. Term deposit options usually include amounts of $1,000, $5000, $10,000, or more for time periods of three months, six months, one year, two years, or five years. The interest rates are set at the time you obtain the term deposit. You cannot access your money until the maturity date, though in some cases you can get your deposit back but incur severe penalties (usually losing all your interest). In the US, term deposits are commonly called Certificates of Deposit (CDs). In Canada, they are called Guaranteed Investment Contracts (GICs).

Electronic Banking Services When you open checking accounts, credit card accounts, and certain types of savings accounts with a bank, you are often provided options for electronic banking access to your accounts: debit cards, banking machines, telephone banking and Internet banking.

Debit Cards and Banking Machines

Debit cards and banking machines now expand access to cash and financial transactions to 24 hours a day and 7 days a week in a wide number of locations outside of your bank’s physical premises. A debit card is not a credit card, though it may look like one. The debit card gives you electronic access to your checking and some savings accounts through banking machines (also called ATMs – automatic teller machines, or ABMs – automatic banking machines). You can use your debit card to pay for purchases directly from your account at certain stores. Some banks use your card in lieu of using deposit and withdrawal slips when you transact business with their tellers. And, you can use the debit card at banking machines — both at your bank’s machines and at others connected in an inter-bank electronic network around the country and the world. Once you are assigned a password for your debit card, called a PIN number (personal identification number), you can use banking machines to make deposits and cash withdrawals. There are usually daily maximum cash withdrawal limits for security reasons. Regardless of daily cash withdrawal limits, you cannot withdraw more than the balance of cash in your accounts, because there is no additional credit provided by having a debit card.


Debit cards are accepted for payment of purchases by a growing number of vendors. This reduces the need to carry cash, without requiring a credit card. With inter-bank electronic transactions, most banking machines accept your debit card and credit cards which have been set up with PIN numbers, even though it is not your bank’s machine. However, there is usually a transaction charge posted to your account if you use another financial institution’s banking machine. Most checking accounts come with a debit card at no additional cost to you, since the banks encourage use of electronic banking options.

Telephone Banking and Internet Banking

Telephone banking and Internet banking, like having a debit card, are services linked to your bank accounts and credit cards that you have established with your bank. Telephone banking allows you to connect either over the telephone to a limited number of automated services. The technology is limited because your transactions must all be entered in by means of the telephone’s number keys. Internet banking allows you to connect over the Internet to a secure website where you can access account information and handle certain transactions like paying bills and transferring funds between accounts. Since you have your computer’s full keyboard to enter transactions, Internet banking is quickly replacing most of the services in telephone banking. The bank usually charges a fee for providing you with access to these services, and this fee may be linked to your checking account’s monthly service charges.

Risks and Benefits — Bank Accounts Because financial institutions are entrusted with people’s savings, the government closely regulates them in order to deter poor banking practices and corruption. However, it is still possible for such organizations to go bankrupt. Because of this, governments in countries such as the United States and Canada protect their citizens’ money by insuring a certain amount against loss. These guarantees provide a great degree of security, but they are limited. So while your money is generally safe, it may not be 100% protected. It is best to

check with your financial institution to determine how much of your account balances are insured. Interest rates on your deposits are generally low. Some term deposit and money market accounts can provide a more convenient way to make these types of savings investments.

Chapter 13 Credit and Loans 81

13. Credit and Loans The term credit is often used to mean your capacity to borrow, or in some cases your pre-approved capacity to borrow. The following are the most common types of consumer credit and loans.

Credit Cards — Financial Institution Credit Cards Credit cards are accepted around the world today. The concept is simple: You agree to repay the bank (or the financial institution) which issued the card for any payments it makes on your behalf. You are provided a credit limit, an account with a bank or other financial institution, and a plastic card with the account number embossed, along with your name and the expiration date. You can use your card — in person, over the phone, on the Internet — to “purchase” goods and services. You receive the goods and services, and the bank pays for them. Each month the bank sends you a statement of everything the bank has paid for on your behalf. You are required to pay a minimum amount on the account within 3 to 4 weeks. Interest is charged on any unpaid balances after that time. Credit card interest rates are normally significantly higher than the current loan rates. Most credit cards also let you obtain cash advances from the card, up to your maximum available credit. Cash advances can be obtained from the bank itself, or from many banking machines. Interest is normally due from the first day of a cash advance. Your available credit is your credit limit minus purchases and advances received but not yet paid for, and minus any interest due. When you make reservations with hotels, and use your credit card to guarantee the booking, the hotel may place a reserve against your credit card. A reserve reduces your available credit but is not an actual charge. The hotel, in this case, is reserving credit space on your credit card account today, to make sure you will have enough available credit to pay their charges when you arrive.

Types/Brands of Credit Cards

There are hundreds of different financial institutions in the US, hundreds in Canada, and thousands worldwide which issue credit cards. These cards can be used to purchase a wide range of goods and services, from a variety of different providers around the world. While there may be hundreds of different issuers of these cards, the brand of cards commonly used is much shorter. The most common types include (in alphabetical order):

• American Express • Discover • enRoute/Diners Club • Mastercard • Visa


Uses

Bank credit cards are considered all-purpose because you can decide either to pay your balance in full or to extend your payments over time, and because the cards are accepted by numerous stores and service providers. Vendors may refuse to accept personal checks, so you will need either cash or a credit card to make some purchases. You can use credit cards to avoid carrying cash, or you can use your credit cards to buy things and then pay for them over time. You can also use credit cards to make purchases by telephone, on mail orders, and over the Internet. A credit limit is established on your card and you can charge amounts up to that total balance. Depending on your repayments and use of the credit card, your credit limit may be increased or decreased in the future, depending on your usage and payments on the account.

Credit cards have become so widely accepted that most people have at least one credit card.

Costs and Features

There are credit cards that offer special features, like insurance, discounts, and support of a charity. There are credit cards with and without an annual fee. There are credit cards with low monthly interest, or low introductory interest rates. There are “preferred customer” credit cards, often called Gold or Platinum. And, there are basic, no-frills credit cards. When choosing which credit cards to have, consider the following:

• Annual fees.

• Monthly interest rate on purchases — make sure to read the fine print in case the advertised rate is only good for a limited number of months.

• Monthly interest rate on cash advances.

• Additional benefits and services provided.

Then compare this to how you plan to use the credit card:

• Do the vendors where you usually shop accept this type of credit card?

• Do you plan to pay off your balance each month? In this case a higher monthly interest might be an advantage over a higher annual fee.

• Is it accepted at banking machines you might use for emergency cash on your travels?

• How many credit cards do you need?

• Are the extra features provided meaningful to you, or would a no-frills credit card be just as useful and cost less?


Credit Cards — Retail Charge Cards Similar to financial institution credit cards, some businesses offer charge accounts and credit cards.

Types/Brands of Credit Cards

Many retailers issue their own credit cards. These cards are usually limited to purchases from a given store or franchise. Types of retail charge cards include:

• Gas stations • Department stores • Grocery stores • Mail order companies

More recently, these companies have begun issuing credit cards in conjunction with a financial institution. For instance, you may have an ABC Company Visa or Mastercard. This gives you the flexibility of any Visa or Mastercard, and you may be offered special benefits by the company affiliated with the credit card.

Uses

Retail charge accounts can come in a variety of forms. Some are 30-day accounts which must be paid in full each month. Others allow installment plan payments for a specified number of months. Some others are all-purpose, because you can pay in full or pay over time, as long as you make minimum monthly payments. With all you will have to pay interest charges if you do not repay your monthly purchases in full, like interest on any loan. Similar to credit cards issued by financial institutions, you will have a maximum credit limit assigned to your account.

Costs and Features

Retail charge cards often offer special loyalty programs or points. Costs can vary, and interest will be charged on extended repayments — just like with other credit cards. So, when considering which retail charge cards to get, consider:

• Annual fees.

• Monthly interest rate on purchases — make sure to read the fine print in case the advertised rate is only good for a limited number of months.

• Additional benefits and services provided.

Then compare this to how you plan to use the credit card:

• How frequently do you shop at these businesses?

• Do these vendors accept one of your other credit cards?


• Do you plan to pay off your balance each month? In this case a higher monthly interest rate might be better than an annual fee.

• How many credit cards do you need? Are the extra features provided meaningful to you, or would a no-frills, general purpose credit card be just as useful and cost less?

Personal Line of Credit

A line of credit is an established credit limit that you set up with your bank or financial institution. Once approved, you can spend any amount, up to the credit limit established. Like a credit card, you will receive monthly statements and will be required to pay monthly amounts towards interest and unpaid balances. Sometimes the payments will be fixed, and in other cases you will be required to pay a minimum payment but can pay as much on top of this as you desire.

You usually are given checks on this account. You can write a check to yourself to draw on your line of credit, or write a check to a creditor directly, if your creditor accepts payment by check.

Interest is charged on any unpaid balances. This interest can be significantly lower than interest on credit cards.

You should also inquire if there are any annual fees or application fees.

Overdraft Protection

Overdraft protection is a feature provided by financial institutions on your checking accounts. If you have this service, the institution will honor the checks you write on your account, even if this takes your account into a negative balance — up to the maximum credit limit on the overdraft account.

Some people have used overdraft accounts like a line of credit, carrying a negative balance until they can pay it off over time. The other benefit is that your checks will not “bounce” — be refused for non-sufficient funds (NSF) — by the bank. Bounced checks will lower your credit rating.

There is usually a charge for an overdraft service, plus interest fees on any unpaid balances. Compare the costs with other financing options, like a line of credit, if you frequently dip into negative balances on your account.


Personal/Consumer Loans Personal loans can be obtained from banks, credit unions, trust companies, and other financial institutions – including your life insurance company. What is common to them all is that there is a contractual agreement to repay the money loaned, plus a given interest fee over a series of payments. The repayment term, payment amounts and interest rates vary by type of loan, the type of lending institution, the risk of the loan to the lender, and the credit worthiness of the borrower. A secured loan means you have pledged another asset against this debt. If you default on the loan, you lose the pledged asset. This is very common in car loans and real estate mortgages. Here the pledged asset is what you are borrowing the money for. So, for example, if you default on your car loan, your car is repossessed. If you default on your mortgage payments, you could lose your house.

Unsecured loans have no pledged assets backing them up. You will have a lower borrowing limit if the loan is unsecured, because the financial institution’s risk of loss is higher if you default on the loan.

Term/Installment Loans

This is money advanced for a specific purpose, for example buying a car, or a vacation trip. Regular repayments are scheduled. The loan may be secured or unsecured. Interest rates will vary, depending on market conditions. In some instances there is a fixed rate of interest charged for the entire term of the loan. Other loans have variable rates. Variable rates change in relation to changes in the prime lending rate. How frequently your rate is adjusted depends on the loan: it could be daily, monthly, yearly, or at preset intervals. If you have a fixed rate loan, then your payments stay the same for the entire loan repayment period. If you have a variable rate loan, the loan payment varies depending on the current interest being charged.

There may be prepayment penalties if you pay off your loan early.

Demand Loans

A demand loan is one which the lender may require payment in full at any time. Equally, the borrower can pay off the loan at any time without penalty. Interest rates are usually variable rates, based on the prime rate plus a certain number of percentage points.


Life Insurance Loans

If you have a whole life insurance policy, you can borrow from your insurance company against the cash surrender value of the policy. Repayment terms may be more open in these loans. But the face value of the policy is reduced by the amount of the unpaid loan balance. [For more information on life insurance, see the Insurance section.]

Residential Mortgages

Residential mortgages are long term loans, secured by the property being purchased. In most cases you can only borrow up to 80% of the market value of the property without requiring special insurance or other requirements.

Financial institutions, including insurance companies, offer an often complex array of options:

• Variable interest rates. • Fixed interest rates — different rates for

different lengths of time. In the US mortgages can have fixed rate terms as long as 30 years. In Canada seven or ten years is usually the longest term you can lock in an interest rate, even if the payments are calculated over a 30-year repayment period.

• Cash back incentives. • Some mortgages even offer air miles on

certain airline frequent flyer programs.

Home Equity Mortgages

As you pay down your mortgage, your percent of ownership increases. This is called your equity in the home. You can use this equity as security for other borrowing needs.

Conditional Sales Contracts

These are loan agreements offered through retailers, often those selling high-priced products like computers, furniture, and appliances. When you make the purchase, you sign a conditional sale contract and a promissory note. These may be sold by the retailer to another financial institution, and you will make your repayments to the financial institution.

Chapter 14 Taxes 87

14. Taxes

Direct and Indirect Taxes Taxes are funds that must be paid to the government in order to enable the government to pay for its operations. A tax charged on personal income is called a direct tax. If the tax is charged on, or included in, the price of goods it is called an indirect tax. Direct taxes are structured in an attempt to treat people in the same situation equitably. Since people have different incomes and expenses this is a very complicated matter. But in principle, if two people had the exact same earnings and expenses, and lived in the same state/province, then they would pay the same amount of income taxes. With an indirect tax, the more you consume of the taxed product, the more tax you pay. For example, if you do not drink alcoholic beverages, you pay no liquor tax. The more you drive your car and the bigger your vehicle, the more gas you’ll use and the more gasoline tax you’ll pay. Some people refer to these indirect taxes as consumption taxes, because the more you consume the more tax you pay.

Sales Tax Most goods and several services have taxes added to them. Most sales taxes are charges determined by state/provincial and local governments. However, there are federal sales taxes embedded in goods like gasoline and liquor. In Canada there is also the national Goods and Service Tax (GST). Sales taxes vary from region to region, depending on the tax laws of that particular area. Aboriginal peoples of the US and Canada are exempt from many sales taxes. Foreign visitors may be able to apply for refunds on some of the sales taxes paid during their stay. Other than this, it is almost impossible for other individuals to avoid paying sales taxes. The sales tax then becomes part of your purchase cost.

Income Tax

Taxes on Net Income

Income can be broken down into earned income from your wages and unearned income from investments, savings, inheritances, gambling winnings, and other sources. There are direct taxes on all types of income, but some types of income have greater allowances and deductions to reduce the taxes.


Both federal and state/provincial governments charge income taxes. These taxes are filed annually through the federal agency: Internal Revenue Service (IRS) in the US, and Canada Customs and Revenue Agency (CCRA) in Canada. The federal tax service remits the portion of your state/provincial taxes to the appropriate entity. [Note: A few states have no tax on earned income, but may have taxes on unearned income and higher property taxes to compensate for this.] The tax return forms used to report your income include all types of income – earned and unearned. As you work through the tax return each type of income is identified. After deducting allowed expenses, you come to a Taxable Income amount. The tax rate on your Taxable Income varies – the more Taxable Income, the higher the rate.

Income Tax Withholdings and Estimated Tax Payments

Law requires that you make periodic estimated payments toward your annual income taxes. Your employer must deduct amounts from every paycheck you earn and pay them to the government on your behalf. If you are self-employed you must make your own estimated tax payments. You may be charged a penalty if you have not provided enough estimated payments during the year. This situation usually only affects self-employed people.

Many people receive refunds each year because more was withheld than was due. However, people who have a lot of unearned income may find that they still owe additional taxes. Your withholdings are estimated based only on your wages. If you have additional sources of income, you can have your employer increase the withholdings to avoid owing taxes at the end of the year.

Taxes on Investment Earnings

Earnings from your investments may be:

• Interest Income • Dividend Income • Capital Gains

Each of these types of income is treated differently for tax purposes. Foreign interest income and dividends are also handled separately. Professional tax and investment advisors can help you plan for your taxes as well as your investment decisions.

Interest Income

Interest income is usually treated just like your wage earnings. This is the highest tax rate.

Chapter 14 Taxes 89

Dividend Income

Usually a portion of your dividend income is deductible and only the remainder is included with your wages and interest income. This gives a slightly lower effective tax rate on dividends than on interest income.

Capital Gains

Capital gains have a significantly lower rate, which makes it advantageous for tax purposes to have your earnings in this category. See additional information below in the Capital Gains Tax section, below.

Foreign Income

Interest income and dividends from foreign investments are usually taxed just like your wages.

Capital Gains Tax

For tax purposes, capital gains and losses arise from the sale of capital assets, including stocks and bonds. Or to state it another way, capital gains taxes are applied to realized capital gains. [See the Capital Assets section for more information on what constitutes a capital asset.]

Realized Capital Gains

When you sell or dispose of a capital asset you will either receive more, less, or the same amount of value as when you originally acquired the asset. These are realized capital gains and losses: you no longer have the asset; all you have is what you received for the asset.

Unrealized Capital Gains

While you continue to own a capital asset, its value may rise or fall. This gain or loss is considered a “paper gain/loss” because it is only on paper — you have not actually sold the asset.

Governments have legislated special tax reductions to encourage people to invest more of their money. You pay tax on your capital gains as part of your income tax return. But the tax on these gains is much lower than on your regular income. Tax calculations can be complicated, so it is best to seek professional tax advice. However, as a general statement, you are allowed to deduct your capital losses from your capital gains. In the US, the tax rate on your net capital gains ranges from 20% to 28%. In Canada, you are allowed to deduct 50% of your net capital gains, and the rest is included with your Taxable Income.


Reducing or Deferring Income Taxes

Reducing Taxes

You can reduce the income taxes you owe if you have eligible expenses and deductions. This can be a simple or a very complex matter. It is best to get professional tax advice in this area.

Deferring Taxes

When possible and beneficial, you may find investments which will defer taxes into the future. Retirement plans are set up in this manner. Thus even though you may earn interest income this year, it is not taxed until the future when you start using the retirement monies you have put aside.

The rationale for trying to defer taxes into the future is that you will normally have a lower income when you have retired, so you will pay less tax on the earnings in the future than you would today. In addition, there is the time value of money. With ongoing inflation, there is a chance you will actually pay less taxes in terms of equivalent buying value of those future tax dollars.

[See also, the Tax Shelters section, following.]

Real Estate Tax (Property Tax) Real estate tax is charged annually, and often paid in two semi-annual installments. Properties are assessed for a tax value, and the municipality establishes its tax rate. This tax rate is usually given as a certain number of dollars of tax for every one thousand dollars of assessment. Your taxes can go up a) if the municipality increases the tax rate, or b) if your assessment value goes up. Your assessment value could go up if you make major improvements or expansions to the house, or if there is a regional re-assessment done because of changes in the economy. Your assessed value could also go down, if the new assessment finds that the economy or the value to property in your neighborhood has dropped significantly.

Estate Tax Upon your death, your wealth is subject to taxation before being disbursed to your beneficiaries. This is called the estate tax. In the US there is normally an exclusion for the first $600,000 of net worth. In Canada there are few or no exclusions allowed. Individuals, and especially those of high net worth, generally seek professional estate planning advice to minimize the amount of their wealth paid to the government and to maximize the gifts to their beneficiaries.

Sold

Chapter 14 Taxes 91

Tax Shelters Tax shelters are more correctly called income tax shelters. These are financial planning and investment options which “shelter” your income from taxation — either by eliminating, reducing, or deferring the income taxes you pay. Some bonds reduce your tax liability by offering tax-free interest. However, the interest rates are usually lower because of this. When evaluating any tax shelter technique, you should compare the return on investment and the tax benefits to help you decide if this is a valuable option for you to take.

Qualified Retirement Plans

There are a number of retirement plans which qualify under federal tax law, and which allow you to invest money and defer taxes on the capital gains and earnings until you retire and use the money.

Employer-Sponsored or Individual Plans

These are group pension plans offered by your employer or union. You may be required to work with the organization for a number of years before you qualify for benefits. Some or all of your benefits may be lost if you leave the organization before you retire. Be sure to understand your organization’s pension plan requirements, benefits, and limitations. Individual plans are accounts in your name. These may be available through your employer, as well as totally separate from your work. Since these accounts are in your name, they are part of your net worth, and you can continue building these balances regardless of where you work. There are also ways to move your account from one financial institution to another without any tax penalty. Because more and more people change employers in their careers, individual plans are becoming more popular, since you take these with you wherever you work. They also can be used to supplement the benefits you expect to receive from your employer.

Defined Benefit versus Defined Contribution

Plans are either set up as defined benefit plans or defined contribution plans.

• Defined benefit plans guaranty you a certain retirement income, usually based on your years of service with the company and your average wages.

• Defined contribution plans are structured around how much you can contribute. There are no guarantees as to how much retirement income your contributions will provide. Given uncertainties in the investment market, these plans are becoming more and more common for individuals and corporations.


Defined contribution plans have varying restrictions on: o Maximum annual contributions o Types of investments allowed o Percent of foreign investments

Common US Retirement Plans

401K Plans and other Employer Pension Plans A 401K plan is a defined contribution retirement plan, offered by a corporation to its employees. Income is tax-deferred. In some cases the corporation will match the employees’ contributions. The name comes from the section in the IRS tax code which describes this type of plan. Corporations may offer a range of other qualified pension plans.

IRAs (Individual Retirement Accounts)

Individual Retirement Accounts allow individuals to set aside a few thousand dollars per year in tax-deferred accounts.

Keogh Plans Keogh plans, also called self-employed pensions, are tax-deferred plans for self-employed people and unincorporated businesses.

Common Canadian Retirement Plans

ESPP (Employer Sponsored Pension Plan) Employer Sponsored Pension Plans can be set up as defined benefit plans, defined contribution plans, or group registered retirement savings plans. Plans, contributions, and benefits will vary.

RRSP (Registered Retirement Savings Plan)

Registered Retirement Savings Plans allow individuals to set aside a percentage of their annual wages in tax-deferred accounts. Each year when Canada Customs and Revenue Agency reviews your income tax return, they issue a Notice of Assessment which includes a statement of unused RRSP allocations and next year’s maximum RRSP contributions.

Education Savings Plans

There are similar options for reducing or deferring taxes for educational savings. Options include Coverdell Educational Savings Accounts and certain states’ College Savings Funds (US), and Registered Educational Savings Plans (Canada). Check with your financial advisor or financial institution for more information on these plans.

Chapter 14 Taxes 93

Trusts

A trust is a legal arrangement where an individual, called the trustor, gives control over certain monies to a person or institution, called the trustee. The trustee manages and invests the monies for the benefit of the beneficiaries of the trust. As a separate legal entity, the trust is subject to a different set of tax laws.

There are many types of trusts, and some may provide you with the ability to defer or reduce your tax liability. Seek professional advice concerning these options.

Trust Funds

Trust funds are the financial assets held in trusts.

High wealth individuals may elect to set up trust funds for their children, as part of their estate planning. This may shelter the money from certain estate taxes, but trust funds are not tax-exempt.

Investment Trusts

Investment trusts are funds set up to produce income through investments. They are regulated entities which have a fixed number of shares that can be traded like stocks. These investment trusts may offer preferential tax treatment.

One of the most commonly known types of investment trust is a Real Estate Investment Trust (REIT). A REIT is set up to invest in income property and/or mortgage loans. These are more liquid than actually owning real estate. They allow you to share ownership and invest less than the purchase price of a given piece of property. Because they are traded like stocks, they are highly liquid – easy to sell. And, like stocks there are no guarantees of return on your investment. People have made and lost money in REITs.

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