Chapter 2 The Financial Plan © 2010 Pearson Education, Inc. All rights reserved

Learning Objectives Describe the purpose of a financial plan Identify the key components of a financial plan © 2010 Pearson Education, Inc. All rights reserved

What is a Financial Plan? A personal financial plan involves specifying financial goals including the spending, financing, and investing plans needed to reach the goal A good financial plan is like a blueprint for a builder. The plan should spell out every aspect of how to accumulate and grow wealth and provide for emergencies Discuss how the financial plan is the “road map” to stability, freedom, and flexibility. © 2010 Pearson Education, Inc. All rights reserved

What is a Financial Plan? A good financial plan includes 7 key components (see figure 2.1): Budget and taxes Managing liquidity, or ready access to cash Financing large purchases Managing your risk Investing your money Planning for retirement and the transfer of your wealth Communication and record keeping Discuss managing your risk. Students might find this terminology difficult. What risk level are you comfortable with? © 2010 Pearson Education, Inc. All rights reserved

Figure 2.1 © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ What is the purpose and function of a financial plan? © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ It is like a blueprint to a builder. It spells out every aspect of your financial life and helps you accumulate wealth and plan for emergencies 0-7 © 2010 Pearson Education, Inc. All rights reserved

The Components of Your Financial Plan The first step in building a financial plan is understanding the different parts of it The following slides explore the seven components and how they can help you achieve financial security © 2010 Pearson Education, Inc. All rights reserved

Component One: A Plan for Your Budgeting and Taxes A budget helps you plan your spending and saving, so you can meet your needs and wants. Creating a budget involves several steps: Establishing your net worth Establishing your income Identifying your expenses Considering the impact of taxes Budgeting is the process of forecasting future expenses and income Discuss how budgeting does not need to be restrictive. It can help you plan for the things you want. © 2010 Pearson Education, Inc. All rights reserved

Step One: Establishing Your Net Worth The first step is to determine where you are financially. Do you have money in the bank? Do you owe people money? Do you have a job? Knowing the answers to these questions will help you determine your current financial positions. This will help you recognize how far you are from your goals and help you set budget priorities Explain to students that your net worth is where you are financially. Increasing your net worth is the point of a financial plan. © 2010 Pearson Education, Inc. All rights reserved

Step 1: Establishing Your Net Worth Assets are anything we own, such as cars or baseball cards. Liabilities are what we owe, or our debt Net Worth = Assets – Liabilities Equity means ownership For example: Asset = Car worth = $5000 Liability = Amount owed on the car = -$2000 Net worth = Car value minus amount owed = $3,000 The equity would also be $3000 Discuss net worth in more detail. Give another example. Student has $500 (assets) Student owes $50 (liabilities) Student’s net worth is $450 (also equity) What is your net worth, discuss? © 2010 Pearson Education, Inc. All rights reserved

Step 1: Establishing Your Net Worth As you save money, you will accumulate more assets (including cash) You will also have the chance to reduce your liabilities Both of these will lead to increasing your net worth Check out Figure 2.2 to see an example of calculating net worth © 2010 Pearson Education, Inc. All rights reserved

Figure 2.2 © 2010 Pearson Education, Inc. All rights reserved

Step 2: Establishing Your Income A key factor in shaping a budget is understanding your income. Having an income is the major means by which a person saves money, builds wealth, acquires assets, and fulfills wants and needs. A person’s income often depends on decisions he or she makes about education and career choices. In general, more education or specialized training translates into more income. Income is the money coming in through wages earned, allowance, or other sources Explain that income is essentially how much money you make. © 2010 Pearson Education, Inc. All rights reserved

Math for Personal Finance Jamaal makes $9 an hour and works about 15 hours a week. He also gets a $25 per week allowance. What is his total annual income? © 2010 Pearson Education, Inc. All rights reserved

Math for Personal Finance Solution: $9 an hour x 15 hours per week = $135 per week x 52 weeks per year = $7,020 per year income from his job. He also gets $25 per week x 52 weeks per year = $1,300 per year income from his allowance. His total annual income is equal to $7,020 + $1,300 = $8,320 © 2010 Pearson Education, Inc. All rights reserved

Step 3: Identifying Your Expenses Expenses are also an important part of a budget When creating a budget, estimate how much money you have going out every month Typical expenses include clothing or entertainment Refer to the chart in Figure 2.3 for typical household expenditures Explain that expenses means what you are spending your money on. Ask students for things they usually spend their money on. © 2010 Pearson Education, Inc. All rights reserved

Figure 2.3 What are your 3 biggest expenses? © 2010 Pearson Education, Inc. All rights reserved

Step 4: Considering the Impact of Taxes Income taxes (money owed to the government on earned income) may also impact your budget The more money you make, the higher the share of your income you will pay in income taxes Include tax planning in your financial plan as your income level increases Discuss how taxes are taken out of every paycheck. Even if you make $10 and work 20 hours, you won’t be taking home $200. © 2010 Pearson Education, Inc. All rights reserved

Component 2: A Plan to Manage Your Liquidity Liquidity assets include cash and assets that can be quickly and easily turned into cash Note that your liquidity is different than your net worth. You may have a number of valuable assets, but if they are not liquid, they will be of little use to you when facing a short-term financial need. Liquidity refers to how much readily available cash you have on hand for meeting immediate wants and needs. Make sure students understand the difference between liquidity and net worth. Net worth can include items such at your car – things that might not be easily turned into cash. Is this money considered a liquid asset? Why/why not? © 2010 Pearson Education, Inc. All rights reserved

Component 2: A Plan to Manage Your Liquidity Money Management and Credit management decisions are both involved in liquidity management. Money management involves making decisions about how much cash or liquid assets to keep in reserve and how much to invest in less liquid assets, such as real estate (buildings and land). Money Management helps determine how much money to keep liquid to avoid cash shortfalls. Discuss how if you don’t have enough money to cover your immediate needs then you need more liquidity. Explain how money management is asking yourself the question: “where should I put my money?” © 2010 Pearson Education, Inc. All rights reserved

Component 2: A Plan to Manage Your Liquidity Credit Management involves making decisions about getting credit and using credit. Credit is commonly used to cover immediate cash shortfalls, so it increases liquidity. Credit can be very costly. When you use credit (borrow money) the lender charges interest on the money you borrow. Interest is like rent on money Explain that credit cards in particular can be costly. Explain how interest rates can be very high and you end up paying more than you originally intended. © 2010 Pearson Education, Inc. All rights reserved

Component 2: A Plan to Manage Your Liquidity Some lenders charge higher interest (rent) on money than others. It is not wise to rely on credit cards if you are not able to pay back the borrowed money quickly. A financial plan should contain a credit management plan. Take a look at figure 2.4 for an illustration of liquidity management. Discuss how a financial plan should have a credit management plan. Explain that a credit management plan might involve details such as limiting the number of credit cards you have and the amount of credit you can use at any one time. © 2010 Pearson Education, Inc. All rights reserved

Figure 2.4 © 2010 Pearson Education, Inc. All rights reserved

Component 3: A Plan for Your Financing Major purchases can require borrowing money for long periods of time. It is common to pay for a portion of the cost of these purchases and to take a loan for – or finance – the remaining amount. Figure 2.5 illustrates this process Discuss what types of major purchases this could include: college, car, house, etc. © 2010 Pearson Education, Inc. All rights reserved

Figure 2.5 © 2010 Pearson Education, Inc. All rights reserved

Component 3: A Plan for Your Financing This type of borrowing (financing) differs from the borrowing credit cards are often used for. Longer-term financing is usually available at a lower cost to the borrower than can be found with credit cards Use of long-term financing requires great caution Discuss the importance of not borrowing too much. You want to make sure you can pay the money back. What do you think the average Credit Card interest rate is? A home mortgage? A car loan? © 2010 Pearson Education, Inc. All rights reserved

Component 3: A Plan for Your Financing A number of factors determine how much you can borrow and the payment terms. Payment terms include information about the interest rate and the time period for paying back the loan You might be lent more money than you should borrow. When you borrow money, you have a payment schedule that requires you to make timely payments. Stress the importance of not borrowing too much. Remind students that lenders make their money by charging rent (interest) on the money they loan. CC=15.9%, Home=4.5%, Car=60 months=4.27, 48 months=4.22 © 2010 Pearson Education, Inc. All rights reserved

Math for Personal Finance Ruston plans on buying a car that is priced at $3,500. He has saved $1,000 for a down payment and his grandparents have agreed to contribute another $500 toward the purchase. How much of the vehicle will Ruston need to finance? © 2010 Pearson Education, Inc. All rights reserved

Math for Personal Finance Solution: Ruston can put a total of $1,500 down on the car and finance the remainder which is $3,50 - $1,500 = $2,000. What is the difference in interest for 48 months (4.27%) vs 60 months (4.22%)? http://www.bankrate.com/ © 2010 Pearson Education, Inc. All rights reserved

Component Four: A Plan to Manage Your Risk Come up with a plan to protect assets as you accumulate them. For example, if you buy a car, what happens if that car is stolen or hit? Unless you have insurance on the car, you will suffer the loss of that asset yourself. If there is a greater chance of you suffering a financial loss, then the risk is higher. Many people purchase insurance Discuss how insurance is risk management. Insurance is protecting your assets. © 2010 Pearson Education, Inc. All rights reserved

Component Four: A Plan to Manage Your Risk Insurance planning is a component of your financial plan It determines the types and amounts of insurance you need. People typically insure houses, boats, cars, and other major assets. You also need insurance to cover you for unexpected events, such as an illness or injury. Many adults have life insurance that will provide a cash amount in the event of their death. Discuss how insurance planning is a component of the financial plan. Discuss the importance of protecting your assets © 2010 Pearson Education, Inc. All rights reserved

Component 5: A Plan for Your Investing Any funds you do not spend should be invested with the expectation of earning even more money. Common types of investments include: Stocks Bonds Mutual Funds Real Estate Discuss investments and how the potential rate of return is important to future planning. © 2010 Pearson Education, Inc. All rights reserved

Component 5: A Plan for Your Investing People invest money so they can make more money Remember that different types of investments have different levels of risk Riskier investments can produce great returns—but also may experience significant losses Explain how you cannot always guarantee more money when you invest more. It is important to plan on this. What level will you invest? Low Moderate or High risk? © 2010 Pearson Education, Inc. All rights reserved

Component 6: A Plan for Your Retirement People who plan for retirement while they are young often retire early Retirement planning involves determining how much to save for retirement and how to invest that money. The government provides several ways to save for retirement that allow you to accumulate wealth without paying taxes until you retire Explain how even though retirement is a long ways away, it is important to start planning for it now. If you start saving now, you may be able to retire early. © 2010 Pearson Education, Inc. All rights reserved

Component 7: A Plan for Communication and Record-Keeping Communicate your financial plan to your family. Keeping good records of your finances is equally important. These records will help you when you file your taxes and calculate your net worth. Your heirs may also need these records at some point as well. Discuss the importance of communicating these plans to family or friends. Your plans and goals can still be attained after you are gone. © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ What are the components of your financial plan? © 2010 Pearson Education, Inc. All rights reserved

Check Your Financial IQ 1. Budgeting and taxes 2. Managing liquidity, or ready access to cash 3. Financing large purchases 4. Managing your risk, Protecting Assets and Income 5. Investing your money 6. Planning for retirement and the transfer of your wealth 7. Communication and record keeping 0-38 © 2010 Pearson Education, Inc. All rights reserved

Summary Financial planning involves specifying financial goals It involves describing the spending, financing, and investing plans needed to reach those goals. Your plan is like a blueprint for your financial future © 2010 Pearson Education, Inc. All rights reserved

Summary A good financial plan contains seven key components: 1. Budgeting and taxes 2. Managing liquidity, or ready access to cash 3. Financing large purchases 4. Managing your risk 5. Investing your money 6. Planning for retirement and the transfer of your wealth 7. Communication and record keeping © 2010 Pearson Education, Inc. All rights reserved

Key Terms and Vocabulary Asset Budgeting Credit management Equity Finance Income Interest Liability Liquidity Money management Net worth Payment terms Personal financial plan Real estate Risk © 2010 Pearson Education, Inc. All rights reserved

Websites www.bls.gov/news.release/cesan.nr0.htm Moneycentral.msn.com/home.asp © 2010 Pearson Education, Inc. All rights reserved