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1 How does the financial-planning process facilitate successful personal financial management?
2 How do cash flow planning and management of liquid assets contribute to your financial goals?
3 What are the advantages and disadvantages of using consumer credit?
4 What types of taxes are individuals responsible for?
5 What factors should you consider in deciding what insurance to purchase?
6 What personal goals are important when making investment decisions?
7 How do investors open a brokerage account and make securities transactions?
8 What emerging trends affect the way you manage your personal finances?
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Web Chapter Managing Your
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Critical Thinking Questions:
following questions as they relate to Carlos and Amy:
Carlos and Amy to save almost three-quarters of a million dollars?
strategies did they follow to help them realize their financial goals?
to provide a secure future for yourself and your family?
An American Success Story
Carlos and Amy Vela found onL o o k i n g A h e a d
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As the youngest son of hard-working immigrant parents, in a family of nine children, Carlos Vela learned from a young age the importance of making a dollar go a long way. Raised with a strong work ethic, he began working a newspaper route in his suburban New York neighborhood at the age of ten, saving his earnings in a metal cash box. His father told him if he worked hard and started saving early in life, by the time he reached his 40s he could amass $1 million. The young Carlos liked the sound of that, and decided to follow his father’s advice.
Now a software designer, Carlos, 36, and his wife, Amy, 34, also an immigrant and a real estate agent, are approaching their first million. How did they do it? Their Certified Financial Planner®, Roy Jarrett, praises the Velas for earmarking 25 percent of their earnings—the highest rate he has seen—for savings. “We’re pleased if our clients save 10 percent of their income,” he says. He credits the couple with working and saving hard and spending little.
The Vela’s disciplined approach to saving has increased their net worth to three-quarters of a million dollars, produced solely from savings and investments from their combined annual income of $155,000. Because Amy has an inside track on real estate in their area, the couple has been able to make savvy real estate investments, retaining both of their former homes as rental properties. The properties have appreciated in value, while the rental income they generate covers their overhead.
Although they enjoy movies and trips to Hawaii, Carlos sees saving as their most important obligation after essential expenses, such as mortgages, utilities, and food, have been paid for. Fortunately Amy agrees with him. The couple does not squander money on clothing, and drives older cars. “I would like a Mercedes,” says Carlos, “and I can afford one now, but it is not part of our plan at the moment.” Instead, by shopping carefully and avoiding impulse buying, the couple is able to put away at least $3,800 per month, ensuring their financial future will be secure.
As you read this chapter, consider the
1. What personal characteristics led
2. What specific financial and investment
3. How would you emulate Carlos and Amy
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76 percent said money is freedom.
SOURCE: Gini Kopecky Wallace, “Can Money Buy Happiness?,” Family Circle (March 15, 2003), pp. 64–68. Reprinted with
permission of Family Circle magazine.
Exhibit 1 Can Money Buy Happiness?
In today’s highly competitive world, young couples like Carlos and Amy are increasingly aware of the need for early financial planning and its importance to their future security and success. Shifts in demographics have skewed the economic picture for many families, making proper financial planning essential. Some of these changes are:
More families (now called sandwich families) find themselves caught in the middle financially, responsible for both their children (couples are having children later in life) and their aging parents (increasing longevity), at a time in their own lives when they’re ready to retire.
Increasing numbers of blended families result from divorce and remarriage.
A significant number of single individuals are solely responsible for their own finances.
Large numbers of people have experienced job losses due to a sluggish post–September 11 economy and corporate downsizing.
The average cost for a middle-income family to raise a child to age 18 is now more than $177,700.
The average total cost of a college education (tuition, fees, room, board, other expenses) is almost $14,000 per year at a public university and close to $30,000 per year at a private one.
More employees are responsible for their own retirement funds.
People have an overwhelming amount of information to consider when choosing suitable financial products.
Changing financial obligations and world economics bring new challenges in preparing for the future. They can also bring confusion, frustration, and
Money. Would life be sweeter if we all had more of it? The answer seems to be yes—and no. a recent poll, 77 percent of adults believe America is the land of financial opportunity, yet 70 percent said the love of money is the root of all evil. And a full 76 percent of Amer cans believe money can’t buy happiness. Here are some other American attitudes toward money:
81 percent said money is power. 79 percent said doing what they love is more important than making money.
75 percent of married adults say they and their mate share their money. 74 percent of adults say they are living paycheck to paycheck. 70 percent said it is just as easy to love a rich person as a poor one. 60 percent of women say they manage money better while 51 percent of men say they do. 54 percent of adults say one of their biggest money pressures is meeting bills. 49 percent prefer to be happy in their personal/family life than rich. 36 percent of women and 28 percent of men report spending conflicts. 30 percent want to be able to buy a house. 29 percent said they would rather be healthy than rich. 19 percent of women and 11 percent of men have a secret stash of cash. 14 percent said they’d rather be rich.
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worry about meeting financial goals. Exhibit 1 reveals how Americans thinkabout money.
This chapter will provide an overview of the information and skills needed tomeet the challenge of managing your own finances. We will demonstrate how thepersonal financial-planning process can help you manage your cash flow and meetyour financial goals. We’ll describe various types of checking and savings instru-ments, and explain how to use consumer credit wisely, manage taxes, and select in-surance. Then we will outline how to set investment goals, develop an investmentstrategy, and make securities transactions. Finally, we will review emerging trendsin personal finance.
FINANC IAL PLANNING: THE F IRST STEPS
In today’s world financial planning is for everyone, not just the wealthy. As Carlosand Amy Vela know, you need personal financial planning whether you have toomuch money or too little. If you have enough money, planning can help you spendand invest it wisely. If your income seems inadequate, taking steps to control yourfinancial situation could lead to an improved lifestyle.
Personal financial planning is the process of managing one’s personal financesto achieve financial goals. Once you have established those goals, you can begingathering information, analyzing the information, and then developing, imple-menting, and monitoring a financial plan designed to meet your goals. Exhibit 2illustrates the personal financial-planning process.
Personal financial planning is a lifelong process. As your personal circum-stances change, so will your needs and goals. By creating flexible plans and revis-ing them on a regular basis, you will build a solid foundation for your financialfuture.
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6. Monitoring your plan. Regularly review and adjust your plan. Track the performanceof the savings/investment components of the plan, and review and adjust the planand your goals as necessary. Keeping up-to-date on the financial environment willhelp you monitor your plan effectively.
5. Implementing the plan. Put your plan into action. Complicated plans may require thehelp of financial-planning experts.
4. Developing a plan. There may be several ways to achieve your goals, so considervarious alternatives before arriving at the plan that works best for you.
3. Analyzing the information. Review the data you have collected and reviseyour goals if necessary.
2. Gathering information. Objective and subjective information are bothimportant components of the decision-making process.
1. Establishing financial goals. Sound financial goals are the basisof your financial plan, a road map that guides spending,saving, and investment decisions.
Exhibit 2 Step Up to Achieve Your Financial Goals
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personal financialplanningThe process of managingone’s personal finances toachieve financial goals.
___________
___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________
___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________
___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________
___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________ ___________________________________________
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Name ______________________________________ Date ________ Date ________
ASSETS Liquid assets Checking accounts
Cash on hand Other ____________________
Mutual funds Stocks Bonds Other ____________________
Automobile
Clothing Other ____________________ Other ____________________
LIABILITIES Bills past due Credit cards Auto loans
Education loans Other ____________________ Other ____________________
Exhibit 3
Jay Martin Change
$ 1,230 $ 895 $ (335) 385 1,546
76 153 77
500 1,000 500
5,346 (1,925) 3,460 8,000 4,540 2,000 4,000 2,000
$ $ $ 8,439
$ 857 $ 472 $ (385) 2,569 (2,569)
9,365 8,593 (772)
$ $ 9,065 $ (3,726) $ 206 $ $ 12,165
planning?
goals?
concept check
Before you set goals and develop financial plans for your future, you should assess your current financial situation. Just as corporations summarize their financial position on their balance sheets, preparing a personal balance sheet will present a summary of your financial position on a given day. Assets, the things you own, are valued at current market value on your balance sheet. Liabilities are what you owe.
They are recorded at the amount you would have to pay if you paid off the entire debt immediately. Net worth, total assets minus total liabilities, measures your wealth at a given point in time.
Completing a personal balance sheet at regular intervals, such as every six months or each year, will help you track your progress toward achieving your goals. You’ll be able to see how your assets are growing and your debt is—hopefully—going down. Exhibit 3 is an example of the personal balance sheets for Jay Martin. As you can see in the “change” column, he has significantly improved his net worth during calendar year 2006 by saving and investing more and paying off his auto loan.
Principles of Personal Finance
Savings/money market accounts Money market mutual funds Certificates of deposit (6 months)
Other investment assets Certificates of deposit (>6 months)
Personal assets
Furniture and appliances
(1) Total assets
Appliance/furniture loans Mortgage loans
(2) Total liabilities NET WORTH (1– 2)
Personal Balance Sheets
12/31/05 12/31/06
1,161
2,421 2,421
3,421
12,997 21,436
12,791 12,371
What are the benefits of personal financial
Describe the six steps in the personal financial-planning process. Develop four personal financial goals for yourself, two short-term (1–2 years) and two long-term (5–10 years). How does a personal balance sheet help you track your progress toward your financial
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Assets listed on the personalbalance sheet may includeearnings from college students’summer jobs that are held inchecking or savings accounts.
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CASH MANAGEMENT: WHERE ’S THE MONEY? Cash management is defined as the day-to-day handling of liquid assets. Liquid assets include cash, checking accounts, various savings instruments, and other assets that can be converted into cash quickly at little or no cost. A cash flow plan (also called a budget) is an important tool for cash management. It helps manage income and expenses, and the savings and investment contributions needed to ac-personal balance sheet complish one’s financial goals. The following steps will help you develop and use a A summary of a person’s fi
nancial position on a given cash flow plan: day; provides information
• Establish your goals and calculate the savings you need to meet them. It is help-about assets, liabilities, andnet worth. ful to prioritize your goals because you may have more goals than money.
Identify each goal, estimate how much money is needed to accomplish that net worth goal, and specify the time frame for achieving the goal. An individual’s wealth at a • Estimate your income and expenses, including contributions to savings. Regiven point in time, calculated view your monthly income and estimate your monthly expenses. The as total assets minus total
monthly budget worksheet in Exhibit 4 illustrates how to monitor your liabilities. income and expenses, or you can create a spreadsheet covering several months.cash management
The day-to-day handling of • Track actual income and expenses for a one-month period. Carry a pad of pa-one’s liquid assets. per with you so you don’t forget small expenditures you make, and record
all income and expenses. At the end of the month, total income and ex-liquid assets penses for each category and enter them on the worksheet in Exhibit 4 in the Cash and other assets that can “actual” column. be converted into cash bothquickly and at little or no cost, • Compare planned and actual income and expenses. Analyze each category that such as checking accounts. was above or below your estimate in the “planned” column and determine
whether this was unusual. For example, if you needed a new suit for an unexpected interview you may have exceeded your clothing allocation for the month. But if you find the situation to be normal, decide whether to cut back your spending or increase your budget for that item. Of course, if you add to that category, you will need to reduce another by the same amount.
• Modify estimates for the next month and repeat the process. Depending on your analysis, you may want to make changes to your original plan. It may take several months before you are able to live within your cash flow plan so it is important to be flexible. But within a short period you will be in control of your spending and saving.
Checking Accounts Checking and savings accounts are the most common liquid assets held by consumers, and a checking account is necessary to manage your income and expenses. A check is a written order, drawn on a depository institution by a depositor, ordering the depository institution to pay on demand a specific amount of money to a person or firm named on the check. Several types of checking accounts are available to meet the diverse needs of consumers. These were briefly noted in Chapter 15.
Electronic Fund Transfers Regardless of the type of checking account you select, you will probably be offered electronic fund transfer (EFT) services. EFT allows you 24-hour access to cash through an automated teller machine (ATM), and point-of-sale (POS) transfers for retail purchases with a debit card. With an ATM card and personal identification
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__________________________________________
__________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________
__________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________
__________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________ __________________________________
__________________________________ __________________________________
__________________________________ __________________________________
P T i Principles of Personal Finance
number (PIN), debit
cash flow plan A cash management tool that includes a plan for managing income and expenses, including contributions to savings and investment needed to ac
often called a budget.
Name:
Planned Actual
Income
Loans
Other ______________ Other ______________
Expenses
Housing
Other ______________
Food Clothing
Medical and dental
Gifts Other ______________ Other ______________
Exhibit 4
you can withdraw cash, make deposits, or transfer funds between accounts. You can pay for goods and services with a POS transfer using your card. It works very much like a credit card with one important exception: The money for the purchase is transferred immediately from your checking account to the vendor’s account.
Using these cards requires good management skills. With both ATM and POS transactions, be sure to enter withdrawals in your check register. Failure to maintain an accurate record of your account balance may result in bounced checks. Guard your cards carefully so they are not stolen or fraudulently used. This is especially important with POS (debit) cards because they can be used without a PIN.
complish one’s financial goals;
Month of ______________________________
Variance
Wages (take-home pay) Support from relatives
Withdrawals from savings
(1) Total Available Income
Fixed Expenses
Automobile payment Insurance Loan repayment Savings for goals Tuition and fees
Subtotal, Fixed Expenses
Flexible Expenses
Personal care Entertainment and recreation Transportation Telephone Utilities (electricity, gas, water) Cable TV
Books, magazines, educational supplies
Subtotal, Flexible Expenses
(2) Total Expenses
Cash Surplus (Deficit) [(1)–(2)]
Monthly Budget Worksheet
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adjusted bank balance.
adjusted checkbook balance.
Exhibit 5
1. If you receive canceled checks place them in numerical order. 2. Compare each check with the check entry on your bank statement and your checkbook
record to make sure the amounts agree. Check off each correct item. Repeat the same process for all other withdrawals such as ATM, debit card, and cash.
3. List and total all outstanding withdrawals (withdrawals deducted in your checkbook but not yet reflected on your bank statement).
4. Repeat Steps 2 and 3 for all your deposits. 5. Subtract the total amount of any outstanding checks from your bank statement, and add any
outstanding deposits to this balance to obtain your 6. Subtract bank service charges and add interest earned to your checkbook balance to find
your 7. Your adjusted bank balance and adjusted checkbook balance should be the same. If not, recheck
your math and the deposits and withdrawals listed in your checkbook. If you cannot find an error, you will need to consult with your bank to see if an error was made in your account.
Seven Easy Steps to Balancing Your Checkbook
If your ATM or debit card is lost or stolen, federal regulations mandate that you may be responsible for up to $50 if the loss is reported within 2 business days, up to $500 if you report it between 3 and 60 days, and for an unlimited amount if the loss is reported after 60 days.
Be aware of ATM fees charged by your bank and the institutions that own the machines you use. Even small fees for withdrawing cash add up quickly if you make several withdrawals. You can usually reduce or eliminate ATM fees by using the ATMs at your own bank.
Overdraft Protection Banks offer checking account holders overdraft protection features to prevent them from bouncing checks because of insufficient funds. A returned check can be embarrassing. However, before you sign up for this service, thoroughly investigate any plan and be sure you know what you are paying. You may be able to link your checking account to a savings account at the same bank for a modest fee per overdraft. Some bounce-protection plans, however, charge the usual bounced-check fee—$25 to $35 per item—plus a per-day fee of $2 to $5 or an interest charge until the account has a positive balance. A $100 advance for 30 days would typically carry a minimum 243 percent annual percentage rate (APR)! Of course, the best way to avoid overdrafts and the extra charges they create is to track your checking account balances regularly, which is easy if you have online banking.
Recently the Federal Reserve Board took action against banks that were earning millions of dollars by offering extremely expensive—as much as $2,000 a year— and deceptively advertised bounce protection plans, targeted almost exclusively to low- and moderate-income consumers. “Overdraft protection products are a deliberate, systematic attempt to hook consumers into overdrafts as a form of high-cost credit,” says Chi Chi Wu, staff attorney for National Consumer Law Center. “There is no question that these products are loans at outrageously high prices.”3
Balancing Your Checkbook This important task reveals possible mistakes you or the bank has made and helps you discover fraudulent debit-card withdrawals. It also helps to avoid bouncing checks, which can be expensive and embarrassing. Exhibit 5 lists the steps to follow in balancing your checkbook.
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Savings Instruments
and
USING CONSUMER CRED I T
The Pros and Cons of Using Credit
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Holding Instrument Balance
Retirement account 45% $6,600 6% $4,000
13% $ 300 Stock 17% $5,700
SOURCE: “Tip Sheet Financial Guide,” Newsweek Magazine (March 24, 2003), p. 63.
Exhibit 6
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Checking accounts are appropriate for money you may need to access on a day-to-day basis, but savings instruments are a more appropriate way to accumulate money for short-term goals (a new television or a vacation) and for unexpected expenses (emergencies and opportunities). Banks, thrift institutions, and credit unions offer a variety of savings instruments, as noted in Chapter 15.
Before selecting your savings vehicle, consider your goals and how you will use it. Compare the interest rate you will receive with those paid by other institutions. Rates are always changing, but financial institutions, the Internet, and magazines such as Kiplinger’s Personal Finance Money are excellent sources of information. Exhibit 6 provides an overview of savings in the average young American’s household by showing the percent in the group holding the given savings instrument and the average balance held.
What if you want (or need) to make a purchase before you have accumulated the money? You might use a credit card or a loan to make the purchase, paying interest to the lender for the privilege of borrowing the money. We have discussed how to set goals and use various types of instruments to save for your future needs, but using credit to make purchases is the opposite of saving money to buy things. In this section, we will investigate the pros and cons of using consumer credit, look at various types of credit, and learn how to build a positive credit rating.
There are a number of very good reasons for using consumer credit:
Convenience.
Immediate use of a good or service.
Bargain prices on sale merchandise.
Opportunity to establish a credit rating.
Convenient record keeping.
Payment for financial emergencies.
Perks such as rebates and frequent-flyer miles.
Although not as numerous, there are also important disadvantages to using consumer credit:
It’s easy to overspend.
Most types of credit cost money in the form of interest charges.
Average Savings Instrument Percent
Certificate of Deposit Savings bond(s)
Savings of Households Headed by an 18- to 34-Year-Old
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Credit Cards
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Any type of credit where the borrower applies for the credit and then, if approved, is allowed to use it over and over again; for example, credit cards.
the Internet, in the mail. They refer to “payday loans,” which come at a very high price, as you find out during your freshman year in college.
borrow $200 from a loan store. loan with money from your student loans and the al
have paid more than $500 and still owe the original $200 loan amount when the owner of the loan store approaches you with a proposition.
Promote his loan store on campus, and for every “referral” you send him, $25 will be deducted from your
that your parents not find out what you have done—you
alize that encouraging fellow students with temporary money problems to use this loan store could place them
in financial jeopardy with potentially damaging consequences, you also see it as the best way to extricate yourself from the financial mess you are in. Although it
perate that you agree to do it.
ETHICAL DILEMMA Do you have a greater obligation to do the right thing for: • • • • All of the above? Is it ever appropriate to ignore your conscience in order to save yourself? In what other way might you have resolved your financial problems without compromising your personal integrity?
Sharking,
Expensive Choice for Borrowers with No Options,” downloaded from
M a k i n g E t h i c a l C h o i c e s
Merchandise may cost more.
The legal commitment to repay debt reduces future discretionary income.
The ability to overspend, especially because credit cards are so convenient to use, can be the most devastating disadvantage. The financial and psychological stress created by this debt forces some students to drop out of college altogether, or work long hours, often causing their grades to suffer. A recent poll showed that the top financial goal of 71 percent of Americans is getting out of debt.
The secret to using credit responsibly is your cash flow plan. Don’t use credit to buy anything that does not fit into your plan. Use your credit card for convenience, using it instead of cash for purchases so that you have to write only one check for all you buy. Then be sure to pay the total bill at the end of the month. Use a credit card for credit (meaning that you will not pay it off monthly) only when really necessary, revising your cash flow plan to repay the debt as quickly as possible.
If you currently have outstanding debt, use a form like Exhibit 7 to inventory your debt and develop a debt repayment strategy. For Becky Sampson, whose debt inventory is presented in this exhibit, an effective strategy might be to borrow from her personal line of credit (at 12 percent) to pay off her high-interest loans— the credit-card balances (18 percent and 21 percent). But she must be careful not to run up her credit-card balances again after paying them off.
Credit cards are the most used type of open-end credit. Open-end credit is any type of credit where once your application for credit is approved you may use it
Managing Your Personal Finances Web Chapter
open-end credit
The ads are everywhere—“GET CASH UNTIL PAYDAY . . . $100 OR MORE . . . FAST!”—on the radio, the television,
Your parents are always after you to be responsible about money and manage the budget you have worked out together. Then your car unexpectedly breaks down and you need to get it repaired. To pay for the repairs you
You plan to pay back the
lowance from your parents. You are proud of yourself for not asking your parents for the extra money, and begin making $50 biweekly payments to roll the loan over. You
loan balance until it is paid off. You are very anxious
do not want to disappoint them . . . again. While you re
goes completely against your character, you are so des
Yourself? Your parents? Your fellow students?
SOURCES: Stephen Rothman, “Officials Call Payday Financing ‘Loan ’” downloaded from Web site http://www.bankrate.com on
April 16, 2003; “Payday Loans = Costly Cash,” downloaded from Web site of the Federal Trade Commission—Consumer Alerts, at http:// www.ftc.gov, on April 15, 2003; Michelle Samaad, “Payday Loans—An
http://www.bankrate.com, on April 16, 2003.
Payday Loans are Costly Cash
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P T i Principles of Personal Finance
Exhibit 7 Debt Inventory
Name Becky Sampson Date 10/15/2006
Type of Debt
Auto Loans
Education Loans
Home Mortgage Loan Home Improvement Loan Other Installment Loans
Single-Payment Loans
Credit Cards
Personal Line of Credit Home Equity Credit Line Overdraft Protection Line Loan on Life Insurance Margin Loan from Broker Other Loans 1
2 3
TOTALS
Creditor
1 2 3
1 2
1 2 1 2 1 2 3 4 5 6 7
University Federal Credit Union
MasterCard 18% $22 Visa 21% $40
First National Bank 12% —
Annual Rate of Interest
8%
Current Monthly Payment
$315
Latest Balance Due
$6,893
$716 $1,608
—
$377 $9,217
Comments
Car will be repossessed if loan is not repaid
$1,000 credit line $2,000 credit line
$3,500 credit line
line of credit For credit cards, the maximum amount a person can have outstanding on a card at any one time.
revolving credit cards Credit cards that do not require full payment upon billing.
grace period The period of time after a purchase is made on a credit card during which interest is not owed if the entire balance is paid on time.
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over and over again. Your line of credit is the maximum amount you can have outstanding at any one time. Some cards require the entire balance to be paid upon billing, but most require a minimum monthly payment. Cards that do not require full payment upon billing are called revolving credit cards. Some credit cards carry an annual fee while others do not.
When you receive your monthly bill and do not pay the entire balance, you are charged interest. Some credit cards offer a grace period, a period of time after making a purchase when interest is not owed if the entire balance is paid on time. Those cards with no grace period will charge interest even if you pay the entire bill monthly.
Depending on how they are used, credit cards can be either one of the most or one of the least expensive ways to make purchases. Those individuals who pay off their entire credit-card balance each month are called convenience users of credit cards. If they select cards with a grace period and no annual fee, they have free use of money for the period of time until the bill must be paid. On the other hand, credit-card users who pay only the minimum monthly payment can incur high
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2% of balance $11,047 4% of balance $ 2,707 8% of balance $ 594
Exhibit 8
interest charges, as Exhibit 8 shows. The average credit-card late fee has more than doubled from $13 in 1995 to nearly $29 today.
Here are some other tips to help you pay off those credit cards:
Don’t wait until the last minute. Many issuers now use a “hair-trigger” for assessing late fees. In some cases you could get hit with a $35 to $40 penalty if the payment is just a few hours late.
Talk back. If you are a customer who carries a balance and pays on time, ask for a lower interest rate and removal of any fees. Tell the issuer you are tempted to switch to another issuer who is offering 0 percent interest. If the bank won’t bargain, shop for a new card.
Check your statement. Credit-card fraud is widespread, so it is important to protect your credit cards and review your monthly statement carefully. Federal legislation limits your responsibility up to a maximum of $50 per card before you report the problem. Even though your direct loss is rather low, the thief may tie up your total line of credit for months until the issue is resolved, and may use one card to get other cards. All credit card users pay indirectly for fraudulent charges with higher interest rates and fees.
Other Card Tricks Minimum monthly payments used to be around 4 percent of the outstanding balance. But today many credit-card issuers set them so low they do not cover the interest or added fees such as late-payment penalties, or fees for exceeding your credit limit. So even though cardholders pay the minimum every month, their balance continues to grow.
Federal bank regulators have issued a new set of guidelines designed to prevent this “negative amortization.” The new rules, which apply to all banks, say that credit-card issuers must set the minimum monthly payment at an amount that will allow the cardholder to pay off the debt within a “reasonable period of time.
So although monthly minimum payments may actually increase, straining the budgets of those cardholders who regularly pay the minimum due, it will free them of debt sooner.
When something calls to you, you can buy it with your credit card. But without first consulting your budget you run the risk of overspending and getting into debt. Learning
venience against the downside of temptation is important when using consumer credit.
Making minimum payments on your credit cards can cost you a bundle over a number of years. Here’s what would happen if you paid the minimum—or more—every month on a $2,705 card balance, with an 18.38 percent interest rate.
Monthly Payment How Long to Pay Off Interest Paid
27 years, 2 months 8 years, 5 months 2 years, 1 month
Minimum Payments Don’t Pay
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Loans
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Finance Cost
36 $627 $2,572 48 488 3,424 60 406 4,360
Exhibit 9
The total amount borrowed under a loan.
Additional fees that may be owed if a loan is repaid
Provisions that allow a lender to take back the collateral if a loan is not repaid according to the terms of the agreement.
Insurance that will repay a loan if the borrower dies while the loan is still outstanding.
Loans differ from credit cards because they are closed-end agreements. You borrow an amount of money called the principal for a specific period of time and agree to pay it back by the end of the term, by paying in installments or as a lump sum. Interest is charged on the amount of principal borrowed, and you may also be required to secure the loan with something of value. An auto loan is a good example of a secured installment loan: Payments on the loan are due in equal monthly installments, and if you default on the debt the lender, who initially files a lien against the auto, has the legal right to repossess the car. Loans are also used to finance a college education, fix up a home, or purchase appliances.
Before you apply for a loan, shop around to get the best deal just as you would for any product you are purchasing. There are numerous sources of consumer loans. Banks and savings and loan associations offer relatively low interest rates to low-risk borrowers. Credit unions generally offer even lower interest rates, but you have to be a member of the credit union to get a loan there. Consumer finance companies specialize in borrowers who are higher risk, and captive finance companies (Ford Credit Corp. and GMAC) offer credit when you are making a specific type of purchase. Online lending is a relatively new way to find a loan; the “Applying Technology” box on page 15 has more information on this growing segment of online banking services.
A family member may charge the lowest interest rate, but if you decide to borrow money from Grandma treat the transaction in a businesslike manner. Draft a loan repayment agreement specifying the amount being borrowed, the interest rate to be paid (if any), and how the debt will be repaid. Both Grandma and you should sign the agreement and keep a copy. This will help to avoid misunderstandings about the terms of the loan.
Three of the most important factors to consider when comparing loans are the dollar cost of credit (finance cost), the annual percentage rate of interest (APR), and the monthly payment. According to the federal Truth-in-Lending Law, lenders must calculate the APR in a standardized way, so, other things being equal, a loan with a lower APR will be less expensive.
But when the term of the loan varies, loans with the same APR will have different monthly payments and finance costs. As you can see from Exhibit 9, the longer the term of the loan, the lower the monthly payment but the higher the finance cost. Selecting a shorter repayment term will save you money in the long run.
In addition to these factors, check a loan for prepayment penalties, tional fees owed if you decide to repay the loan early, and security requirements, which allow the lender to take back the collateral if you do not repay the loan according to the terms of the agreement. Also beware of add-ons a lender may offer. For example, credit life insurance will repay the loan if you die while the loan is still outstanding. Although this sounds like a good idea, consider whether you really need life insurance for this purpose. And if you do, find out what the coverage would cost from an insurance agent rather than the lender. The lender offers convenience, but that convenience generally comes at a cost. It is not
Number of Payments Monthly Payment
Comparisons of a $20,000, 8-Percent Loan
Principles of Personal Finance
principal
prepayment penalties
early.
security requirements
credit life insurance
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Credit History and Credit Ratings
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Banks Branch Out on the Internet
After its first month of operations, the Internet banking site for First National Bank of Amarillo had nearly 1,000 customers. Amarillo is a highly competitive market for online banking with six other banks offering online services. First National chose to differentiate its site so users can obtain real-
than waiting for the end-of-day totals of traditional banking. In addition to banks wanting to take advantage of the
substantial cost savings—estimates place the average teller
for an online transaction—advances in technology and competition for business among financial institutions assure consumers of an ever more stunning array of online banking services 24/7.7
One of the newest of these is Internet consumer lending. According to the U.S. Census Bureau, this service tends to appeal to households with more than $75,000 in annual income. Projections by Meridien Research estimate that traditional lending transactions will stay close to their current number of 75 million through 2005. Internet loan transactions, on the other hand, are expected to increase from a current 26 million to close to 60 million by 2005.
unique online marketplaces where lenders compete for your
by plenty of glowing satisfied customer testimonials.
well, producing more loan originations than a traditional loan-
lending services with enticing marketing slogans touting “instant decisions” and a “quick turnaround.” In the space of two months it was swamped with close to 350 transactions, while its internal systems were only designed to handle 75, stressing their staff and, worst of all, disgruntling their customers.8
What does all this mean for the consumer? As tempting as it may be to test the wonders of Internet lending, be warned that some financial institutions may be setting up unrealistic expectations for their customers. Find out how long a particular lender has been offering Internet lending—
with your loan application and processing, or choose another bank.
CRITICAL THINKING QUESTIONS What are some of the advantages and disadvantages of Internet banking? What should you look for when selecting an Internet source for an important financial transaction like obtaining a loan?
SOURCES: Greg Rohloff, “First National Enters Internet Banking Market,” Amarillo Daily News, Web posted July 21, 2000; John Ginovsky, “Internet Consumer Lending—Do It, But Do It Right,” Bankers News (October 29, 2002).
uncommon to pay 10 times as much for credit life insurance compared to a term life policy purchased through an insurance agent!
Don’t do what Daniel did—finish college with $20,000 in student loans and $9,500 in credit-card debt. Now aged 23 and a recent graduate of the University of California, Riverside, he says, “I know all the temptations and traps that got me where I am now. I wish I’d had this information available to me before.” Daniel has been working with Consumer Credit Counseling Service in California for more than three years and is now their College Outreach Coordinator. As someone who has “been there and done that—over and over again,” he looks forward to sharing his experiences with other students, in the hope it will help them avoid making the same mistakes he did. Go to CollegeDebt.net (http://www.collegedebt.net) to meet Daniel and get out of debt.
One of the reasons for using credit is to build a good credit rating. Three national credit bureaus—Equifax (800-685-1111), Experian (888-397-3742), and TransUnion (800-888-4213)—collect credit information and make it available for a fee to retailers, banks, and other organizations that are subscribers or approved recipients of this highly confidential information. Credit bureaus do not evaluate the data; they report the following types of credit information for each lender: the date the account was opened; the highest amount of credit extended; the current
A p p l y i n g T e c h n o l o g y
time balances on their account as transactions occur, rather
or telephone transaction at $2.36 as compared with 10 cents
Sites such as Compubank.com and LendingTree.com are
business. You can obtain information on a wide range of loans including mortgage, car, and student loans, supported
But if not managed properly, Internet lending can work too
processing system can handle. A West Coast bank, eager to jump on this new business opportunity, advertised their online
longer is better, giving the bank more time to iron out the wrinkles. But if you are at all concerned about a lender’s Internet service ability, either choose to go the traditional route
1.
2.
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How can an inventory of your debt help you make better decisions about debt
concept check What are the pros and cons of usingconsumer credit?
repayment?What is a credit bureau, and what functiondoes it perform in the granting of credit?
outstanding balance; the number of times the account has been 30, 60, and 901 days overdue; and the number of inquiries there have been for this account information. Negative account information can stay in the file for no more than 7 years, 10 years in the case of bankruptcy. Information from the three credit bureaus does not always match, so you should check all three.
Lenders use information from your credit report as well as other information from your credit application to decide whether to grant credit and under what terms. The better “score” you receive, the more likely you are to be approved for a credit card or loan, and be offered lower rates of interest. Because the information in your credit bureau file is so important, you should periodically check your own file for accuracy. If you are applying for a loan, or have been in a dispute with a creditor, request a copy of your credit report from all three major
credit bureaus. If you find inaccurate information in your credit file, report it to
the credit bureau. The credit bureau must investigate your dispute within 30 days or remove the disputed item from your file. If the investigation does not resolve your dispute, you may add a brief statement to your file, which must be included in future reports. In addition, credit bureaus must prevent deleted information from reappearing in a credit report, and creditors are liable if they neglect to correct errors.
MANAGING TAXES
4 Although taxes represent the largest expenditure in the average American fam-ily’s budget, a whopping 91 percent say they have never cheated on their taxes.10
learning goal Because the tax code is very complex, some knowledge on the subject is important. In this section we will briefly discuss the four types of taxes that are paid directly by individuals: income, Social Security and Medicare, sales, and property taxes.
Income Taxes progressive tax The federal income tax is a progressive tax, meaning the higher your taxable in-An income tax that is struc come the higher the percentage of your income paid in taxes. In 2004, taxpayers tured so that the higher a in the lowest tax bracket paid 10 percent on the first $7,000 of taxable income person’s taxable income, the ($14,000 for married taxpayers filing jointly), while higher income taxpayers paid higher the percentage of
at rates of 15, 25, 28, 33, and 35 percent.11 Because of the progressive structure and income paid in taxes. certain tax deductions (the personal exemption and the standard deduction), people with low incomes may pay little or no federal income taxes.
Pay-as-You-Go System The federal government expects us to pay both federal income taxes and Social Security taxes (discussed later) as we earn income. This is accomplished through tax withholding by employers, or by filing quarterly tax estimates on self-employment income, investment income, and other income that is not subject to withholding. When you start a new job, your employer will ask filing status you to fill out a W-4 form on which you report your filing status (similar to your The marital status of a
taxpayer specified on the marital status) and the number of withholding allowances you want to claim. The income tax return. more withholding allowances you claim, the less your employer will withhold from
each paycheck. However, the goal is to have the right amount withheld, so use the withholding W-4 worksheet for guidance. allowances Allowances claimed with an Minimum Filing Requirements The federal government does employer that determine the
not require all income earners to file federal income tax returns. If your income is amounts that are withheldfrom each of the employees’ below the minimum filing requirement in a given year, you do not have to file. If paychecks. you are entitled to a tax refund, however, you must file to receive the refund.
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is another amount that most tax
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Deductions that reduce the amount of income on which income tax is paid. Each taxpayer is entitled to a personal exemption, for himself, his spouse, and each of their dependents; a personal exemption can be used only once.
An amount that most taxpayers can automatically deduct from their gross income in computing their income tax; not permitted if the taxpayer elects to itemize deductions.
Income that is earned from employment such as wages, tips, and self-employment income.
Income that is not earned through employment such as interest, dividends, and other investment income.
Taxpayers can claim personal exemptions that reduce the amount of their taxable income. You can take a personal exemption for yourself, your spouse, and each of your dependents. If you are a taxpayer who is claimed as a dependent by someone else, however, you cannot claim the personal exemption. In 2004 a personal exemption was worth $3,100. The standard deduction payers can automatically deduct from their gross income. In 2004 the standard deduction was $4,850 for single people and $9,700 for married couples filing jointly. If a taxpayer elects to itemize deductions, the standard deduction does not apply.
Filing a Federal Income Tax Return Individuals may use one of three basic forms when filing their income tax returns: the 1040EZ, the 1040A, and the 1040. The 1040EZ and the 1040A are limited to taxpayers with relatively simple finances. Taxpayers can also use the TeleFile system to file their returns by punching in their data on touch-tone phones, or file online at the Internal Revenue Service Web site at http://www.irs.gov/efile/
When completing a tax return, you start by listing your gross income, which inearned income, income earned through employment (wages, tips, self-
employment income), and unearned income (interest, dividends, other investment income). Students must include scholarship and grant proceeds in their gross income if these exceed the direct cost of the education. After totaling your gross income from all sources, subtract any legal deductions you are eligible to take: adjustments to gross income, itemized deductions, personal exemptions, and tax credits. You may claim adjustments for interest paid on student loans, job-related moving expenses, and contributions to Individual Retirement Arrangements (IRAs). In addition, a new tax credit of $2,000 for the Clean-Fuel Vehicle Deduction is available on the purchase of certain hybrid gas/electric motor–powered vehicles.
The tax-filing deadline is April 15. Tax returns filed on April 15, 2005, apply to income earned in the calendar year 2004. If the 15th falls on a weekend, the filing date is the next business day.
Tax Planning As long as your financial life is relatively simple, your biggest tax-planning issues will be having the correct amount of money withheld and keeping the appropriate tax records. However, once you purchase a home,
Managing Your Personal Finances Web Chapter
Don’t let your dependents down—learn to manage your taxes with professional tax software. Proper tax planning will help to minimize your tax burden while maximizing your
personal exemptions
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ind them.
Get Going
Get Help
Get Online
SOURCES: Robert Longley, “U.S. Gov Info/Resources,” downloaded from Web site http://www.usgovinfo.about.com/library/ weekly/bltaxstress.htm, October 21, 2003; Deborah Fowles, “Making Tax Filing Easier,” downloaded from Web site http:// www.financialplan.about.com/library/weekly, October 21, 2003.
IRS Stress Relief Tips
It’s a taxing life. Here’s how to be more organized at tax time.
Get Organized – Keeping your records organized throughout the year takes little time and lots of pressure off at tax time. Use an 8” x 11” envelope for each month to keep receipts and other tax related documents where you can f
– Don’t leave yourself too little time—you’re more likely to overlook something. Besides, the sooner you file, the sooner that refund will find its way back into your pocket.
– Decide whether you’ll be doing the job yourself or using a tax preparer. The IRS sponsors Volunteer Income Tax Assistance (VITA) for taxpayers who need help but are unable to afford a preparation service.
– The IRS Web site http://www.irs.gov has forms and publications for downloading and interactive calculators.
Get Smart – Keep tax returns and supporting documentation for seven years, when supporting documentation can be disposed of and tax returns placed in permanent storage. Shred monthly bank, brokerage, mutual fund, or 401(k) statements when you receive year-end statements, which should be kept for at least three years.
Exhibit 10
begin investing, and earn a larger income, more sophisticated tax planning becomes important. You will probably need a good accountant, perhaps someone who specializes in taxation. You should also learn more about the federal income tax laws and keep up with the frequent changes made to those laws. Exhibit 10 offers some useful advice about organizing your taxes.
Social Security and Medicare Taxes Like income taxes, Social Security and Medicare taxes are payroll taxes—taxes deducted from each employee’s paycheck. Social Security taxes, often seen on a payroll stub as FICA (Federal Insurance Contributions Act), are paid at a uniform rate on a specified amount of earned income (the wage base). Both the percentage and the wage base can change annually.
Your employer matches your Social Security and Medicare paycheck withholding with company funds, and sends the total to the Internal Revenue Service (IRS). Self-employed people are responsible for paying both the employee’s and the employer’s share of this tax by making quarterly estimated payments. They are then allowed to deduct one-half of their Social Security tax as an adjustment to their gross income on their federal income tax returns.
Sales and Property Taxes Two additional taxes are sales tax and property tax. All but five states (Alaska, Delaware, Montana, New Hampshire, and Oregon) currently have sales tax on retail goods and some services. In certain states, items like food consumed in the home, prescription drugs, and services such as doctor’s fees, haircuts, and laundry bills are not taxed. Generally, sales tax rates range from 4 to 7 percent for the state’s share with an additional 1 to 2 percent added by some cities.
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than the income tax.
concept check What is a progressive tax? Explain why thefederal income tax is progressive.What are the personal exemption and thestandard deduction? How do these amountsdiffer for taxpayers who are dependents ascompared with independent taxpayers?Briefly describe three types of taxes other
The biggest single property tax for most individuals is on real estate, including a home. Property tax (real estate tax) is generally divided among the city, the county, the school system (which gets the largest portion), and in some cases the state government. The annual property tax (often paid in two installments) is calculated by multiplying the appraised (or assessed) value of the property by the tax rate. A house appraised at $100,000 could be taxed at 2 percent of its assessed value, resulting in an annual property tax of $2,000. Some state and local governments also impose personal property taxes on items such as automobiles, boats, and even the fixtures, furniture, and fittings belonging to a business.
SELECT ING INSURANCE
5 While financial planning helps us meet our financial goals, we need to make provision for life’s other uncertainties. We could suffer major losses from a serious
learning goal illness, an auto accident, or a fire. Assessing these risks and purchasing the appropriate insurance to protect against them is an important part of a sound financial plan. Insurance planning involves learning about various types of insurance, such as property and liability insurance, health and disability income insurance, and life insurance, and setting priorities for your individual insurance needs.
Setting Insurance Priorities Robert Hartwig, chief economist at the Insurance Information Institute, predicts the cost of insuring cars and homes could continue to rise,13 so before buying an insurance policy, it is important to identify, evaluate, and prioritize your insurance needs. Start by identifying the types of insurable risks you face. For example, if you own a car, you face the risk of being in an accident that is your fault, injuring the other driver and damaging his or her car. Your own car could also be damaged and you could be hurt. Some of the everyday insurable risks people face include:
• Property damage to personal property such as automobiles, homes, and boats.
• Liability losses due to negligent actions.
• Medical expenses due to illness or accidents.
• Loss of income due to disability or premature death.
The key to managing your insurance needs in a cost-effective way is to budget (have funds set aside) to cover minor losses, and to purchase property, health, and life insurance to cover potential major losses.
Property and Liability Insurance Property insurance covers financial losses from damage to or destruction of the in-sured’s property as a result of specified perils, such as fire or theft. Liability insurance covers financial losses from injuries to others and damage to or destruction of others’ property when the insured is considered to be the cause. It also covers the in-sured’s legal-defense fees. The property and liability policies most often purchased by individuals are automobile insurance and homeowners/renters insurance.
automobile liability insurance Automobile Insurance Auto insurance covers financial losses from Insurance that protects the such perils as accident, theft, fire, and liability lawsuits. The two main types of au-insured from financial losses tomobile insurance are liability coverage and physical damage coverage. Automocaused by automobile-
bile liability insurance protects the insured from financial losses caused by related injuries to others and damage to their automobile-related injuries to others and damage to their property. Each policy property. specifies maximum payment limits. For example, a $50,000/$100,000/$25,000
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automobile physical damage insurance Insurance that covers damage to or loss of the policyholder’s vehicle from collision, theft, fire, or other perils; includes collision coverage and comprehensive (other-than-collision) coverage.
comprehensive (other-than-collision) coverage Automobile insurance that covers damage to or loss of the policyholder’s vehicle due to perils such as fire, floods, theft, and vandalism; part of automobile physical damage insurance.
actual cash value The market value, determined by subtracting the amount of depreciation from its replacement cost, of personal property; the amount paid by standard homeowners and renters insurance policies.
replacement cost coverage Homeowners and renters insurance that pays enough to replace lost and damaged personal property.
COBRA A federal regulation that allows most employees and their families to continue group health insurance coverage at their own expense for up to 18 months after leaving an employer.
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policy will pay up to $50,000 for each person injured in an accident but a total of no more than $100,000 per accident for personal injuries, no matter how many people are involved. In addition, it will pay a maximum of $25,000 for damage to other people’s property.
All 50 states have financial responsibility laws that require drivers to show proof of liability insurance, the ability to pay the costs (up to a limit) of any accidents for which they are responsible.
Automobile physical damage insurance covers damage to or loss of the poli-cyholder’s vehicle from collision, theft, fire, or other perils. It includes collision coverage for damage caused by crashing into another vehicle or object, and comprehensive (other-than-collision) coverage for losses due to perils such as fire, floods, theft, and vandalism.
Automobile insurance rates generally depend on the driver’s age, marital status, gender, area of residence, and driving record, as well as the characteristics of the automobile being insured. Young male drivers who live in cities, have more than one traffic ticket, and drive expensive, high-horsepower automobiles are charged the highest rates. Historically this group is involved in the most accidents.
Homeowners/Renters Insurance It is advisable for homeowners and renters to purchase insurance for protection against property damage and liability losses. These policies cover losses due to fire, riots, windstorms, lightning, hurricanes, vandalism, frozen water pipes, and even falling airplanes. Special federally subsidized insurance provides coverage for earthquakes and floods. Homeowners insurance covers both the dwelling and personal property (furniture, clothing, etc.) while renters insurance covers personal property but not the dwelling. A standard policy pays out the actual cash value (similar to market value), determined by subtracting the amount of depreciation for its replacement cost, for personal-property losses. Policies that provide replacement cost coverage, enough money to replace lost or damaged personal property, cost about 10 to 15 percent more.
Homeowners and renters should also carry liability coverage to protect against financial losses arising from their liability for the injury of others. For example, if one of your inebriated guests was injured in a fall after attending a party where you served liquor, you could be legally liable for the subsequent medical expenses. Comprehensive personal-liability coverage purchased as part of a homeowners policy protects against a wide range of occurrences, both on and off your property. But it does not protect you when driving a motor vehicle, for slander or libel, or for professional malpractice.
Health Insurance Elizabeth McKenty wanted a new treatment for her congenital heart defect. Her insurer said no. She appealed, and got another refusal. But McKenty, a 43-year-old librarian in Philadelphia, didn’t give up. With the help of a company that fights denials such as these she appealed again, supporting her request with medical literature showing why the new treatment would give her better odds than open-heart surgery. This time she won.14
Health insurance is a vital component of financial stability. Many families and individuals obtain health insurance coverage through group policies offered as part of employment fringe-benefit plans. Group policies usually include comprehensive coverage at low cost. If you leave your job, your group coverage will terminate, although a federal regulation called COBRA allows most employees and their families to continue group health coverage at their own expense for up to 18 months. You should also be aware that coverage through a parent’s policy usually ends around ages 23 to 25.
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Ti P indemnity (fee-for- There are two basic types of health insurance coverage, available in combinaservice) plans tion and with variations. Traditional health insurance plans, called indemnity (fee-Health insurance plans that for-service) plans, reimburse the insured for medical costs covered by the insurreimburse the insured for ance policy. The policyholder may select the physician, hospital, and other health medical costs covered by the care providers to obtain the required services. The patient pays for the services and insurance policy. The policy-
files for reimbursement from their health insurance company. The primary advanholder selects the health care providers. tage of this type of plan is a greater choice of health care providers for the patient.
The fastest-growing segment of the health insurance market is managed care managed care plans plans. They became popular in the late 1980s as a way to control the spiraling cost Health insurance plans that of health care. Unlike traditional health insurance plans, managed care plans gen-generally pay only for ser erally pay only for services provided by doctors and hospitals that are part of the vices provided by doctors
plan. They may pay a smaller portion of the cost if the insured uses providers that and hospitals that are part of the plan. are not part of the plan.
major medical Major Medical Insurance Major medical insurance can be soldinsurance
as a stand-alone product or combined with a managed care plan. It typically cov-Health insurance that covers
ers a wide range of medical costs with few exclusions and high maximum limits a wide range of medical costs with few exclusions ($250,000 to $1 million). The insured pays a deductible and a percentage of the and high maximum limits. covered expenses. This coinsurance (participation) is typically 15 to 25 percent.
The most common types of managed care plans are health maintenance organizations and preferred provider organi-zations. Managed care health insurance plans help control soaring medical costs by focusing on preventive care.
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The insured pays a deductible Most policies include a limit, or cap, on the total amount the insured must pay. and a coinsurance portion.
Managed Care Plans Unlike traditional health insurance, managed care plans cover preventive care. The insured typically pays a small copayment ($10 to $20) each time he or she needs care. There is generally no cost for hospitalization. The most common types of managed care plans are health maintenance organizations and preferred provider organizations.
Health maintenance organizations (HMOs) provide comprehensive health care services for a fixed periodic payment. Primary-care physicians (PCPs), also
known as “gatekeepers,” are responsible for decisions about their patients’ health care and for referrals to specialists when necessary. Except in the case of an emergency, the HMO will not pay for care that is given by non-HMO providers.
Preferred provider organizations (PPOs) combine major medical insurance with a network of health care providers, contracted to provide services at discounted prices. If you choose to go to a physician who is not a preferred provider, your out-of-pocket costs (deductibles and coinsurance) will be higher than if you receive care from a preferred provider. In some plans you pay only a small copayment (as with an HMO) if you use a preferred provider, thus reducing your paperwork as well as your out-of-pocket cost.
Disability Income Insurance Some insurable risks, such as a long-term illness, can have devastating financial consequences. If you are unable to work due to illness or accident, disability income insurance will replace a portion of your earnings, typically 60 to 70 percent of your monthly income. There is generally a waiting period (elimination period) after the onset of the disability, ranging from 3 to 12 months, before insurance coverage payments begin. The shorter the waiting period,
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Life Insurance
cash value (a dollar amount
(also called or
and individuals have both?
each need?
concept check
SOURCE: Downloaded from the Web site http://www.insurance.com, September 27, 2004.
A percentage of covered expenses that the holder of a major medical insurance
Managed care organizations that provide comprehensive health care services for a fixed periodic payment.
Networks of health care providers who enter into a contract to provide services at discounted prices; combines major medical insurance with a network of health care providers.
Insurance that will replace a portion of your earnings,
your monthly income, if you are unable to work due to illness or accident.
the more expensive the insurance premiums will be. The policy will have a stated duration of benefits, the length of time the insurance coverage payments will continue. Under short-term policies, benefits are paid for periods ranging from 13 weeks to two years; long-term policies provide payments for periods of five years through the insured’s lifetime.
One of the most important considerations in this type of insurance is the pol-icy’s definition of disability. With some policies you are considered disabled if you cannot perform the functions of your own occupation; with others you are disabled only if you cannot work at all. Exhibit 11 lists some of life’s riskier career choices.
Life insurance provides a specific amount of money upon the death of the policyholder, which is paid to a beneficiary of the policy owner’s choice, or to the de-ceased’s estate if there is no named beneficiary. The primary reason to purchase life insurance is to provide income for surviving family members, but life insurance can also be used to save for the future. The most common types of life insurance are term life, whole life, and universal life insurance.
Term life insurance provides the maximum amount of life insurance coverage for the lowest premium. It covers the insured’s life for a fixed amount and a specific time period, typically 5 to 20 years. It has no paid to the policy owner if the policy is canceled before the death of the insured). When the policy term ends, protection stops, unless the policy is renewed or a new policy is purchased.
Whole life insurance straight life, cash value, continuous pay insurance) covers the insured for his or her entire life, as long as the premiums are paid. In addition to death protection, it has a cash value that increases over the life
of the policy. Whole life is much more expensive than term insurance and the interest rate used to determine its cash value is low—usually 4 to 6 percent. But it does provide a way to save for the future.
Developed in the 1980s to help insurance companies compete with other financial institutions for investment funds, universal life insurance combines term life insurance with a tax-deferred savings plan. The portion of the premium not used to pay for the term life coverage, commissions, and other business expenses, is invested in short- and medium-term securities. It earns interest, at current market rates, that contributes to the policy’s cash value.
Distinguish between property and liability insurance coverage. Why should families
What are the primary differences between traditional indemnity health insurance and managed care plans? What are the two main reasons for buying life insurance? Which types of policies meet
According to the Bureau of Labor Statistics, the 10 most dangerous jobs are: 1. Timber cutters 2. Airplane pilots 3. Construction laborers 4. Truck drivers 5. Farm occupations 6. Groundskeepers 7. Laborers 8. Police and detectives 9. Carpenters
10. Sales occupations
Exhibit 11 Top 10 Most Dangerous Jobs
coinsurance (participation)
policy must pay.
health maintenance organizations (HMOs)
preferred provider organizations (PPOs)
disability income insurance
typically 60 to 70 percent of
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Investment Goals
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Why Good Business Owners Make Bad Investors Who brings more baggage to the task of personal investing than a small-business owner? Visions for their companies can interfere with the personal goal setting that is a prerequisite for making sound investment decisions. In other words, personal financial goals may be subordinated to business objectives, reducing choices in investing to either building up their core asset, their business, or committing those dollars to an investment portfolio. The business often wins.
The dilemma facing many small-business owners is how to successfully juggle the financial needs of their business, while adequately meeting their personal investment goals. The temptation to place all their financial eggs in one basket— their business—is huge. It is a quandary many small-business owners face, even those in the financial planning business.
Richard Stanley is a good example. He knows that a well-balanced portfolio is a thing of beauty and a bulwark for the future. As a financial planner he understands that diversification, and keeping a level head, is part of a solid investment
business generates and plow it right back into the business. “I’m betting that by the time I get to retirement age the business will be worth more than I could earn in the market,” he says.
Stanley is like many small-business owners, except for one thing—he earns a living by helping his clients act on the very precepts that he has put on hold for himself. And when it comes to planning for the future, the entrepreneur trumps
business plan, Stanley next plans to fund a move to larger
business premises, with the addition of several more associates to his business.
But for small-business owners they are about so much more
business is investing in yourself, which, in turn, can provide
a monetary value on that. At the same time, small business owners like Richard
Stanley must also protect themselves by applying sound personal financial planning principles, ranging from creating a diversified investment portfolio to maintaining adequate life, health, and property insurance.
CRITICAL THINKING QUESTIONS 1. Why does being a small-business owner present unique
challenges to investing for the future? 2. According to traditional financial planning guidelines,
what should Richard Stanley be doing to prepare for his retirement?
3. How could Richard Stanley contribute to both the continued growth of his business and his personal investment portfolio? Explain.
SOURCES: Adapted from Darren Dahl, “Small Business Owners Expect Fortunes to Grow,” Inc. (August 31, 2004), downloaded from http://www.inc.com/ criticalnews/articles/200408/finances.html; and Kenneth Klee, “Why Good Entrepreneurs Make Bad Investors,” Inc. (November 1, 2002), downloaded from http://www.inc.com.
In disability income insurance, the period between the onset of the disability and the time when insurance payments begin.
In disability income insurance, the length of time the insurance coverage payments will continue.
People invest money for a variety of reasons. Some want to save for a new home, their children’s education, or a vacation. Others invest to build up a nest egg to supplement their retirement income. The “Focusing on Small Business” box above describes the additional financial-planning and goal-setting challenges faced by people who are self-employed. Investing is the process of committing money to various investment instruments in order to obtain future financial returns. It should be considered a long-term strategy. As Chapter 16 describes, the most common investments used by individuals are stocks, bonds, and mutual funds.
Realistic investment goals are based on the investor’s financial resources, age, family situation, and investment motives, so all investors need to first ask themselves: “What do I want to achieve with my investment program?” Setting investment goals is the basis for developing a sound investment strategy. Your investment goals will relate to certain goals in your financial plan, such as saving for a home, your children’s education, and your retirement. Investment goals also play a role in determining how conservative or aggressive you want to be in making investment choices.
Investors can tolerate different levels of risk, and it is important to determine how much risk you can withstand when making investment decisions. The more
F o c u s i n g o n S m a l l B u s i n e s s
strategy. But Stanley, 58, would rather take the money his
the planner. Following the expansion goals outlined in his
Personal financial decisions are complicated for everyone.
than money. As a small-business owner, investing in your
the satisfaction of realizing your dreams. It’s difficult to place
waiting period (elimination period)
duration of benefits
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income stocks).
Increasing risk of loss of principal
Increasing potential gain through appreciation
global mutual funds, emerging market mutual funds, sector mutual funds, direct and indirect investment in real estate
Growth stocks, growth mutual funds, income mutual funds
Balanced mutual funds, blue chip stocks, zero-coupon bonds, high-grade preferred stock, high-grade corporate bonds, variable annuities
High-grade municipal bonds, personal
fixed annuities
FDIC-insured accounts,
bonds, cash value life
bills/notes/bonds
Covered puts/calls, collectibles, speculative common stock, junk bonds
Futures, derivatives, commodities, naked puts/calls
Exhibit 12 Investment Risk Pyramid
Life insurance that covers
amount and a specific period and has no cash value; provides the maximum amount of life insurance coverage for the lowest premium.
The dollar amount paid to the owner of a life insurance policy if the policy is canceled before the death of the insured; term life insurance has no cash value.
risk you are willing to take, the higher the potential return on an investment. The investment risk pyramid shown in Exhibit 12 depicts the relationship between risk and reward.
The most common investment goals are income, growth, and safety. Investors wishing to supplement their income will choose securities that provide a steady, reliable source of income from bond interest, stock dividends, or both. Good choices include low-risk securities such as U.S. Treasury issues, high-quality corporate bonds, preferred stock, and common stock of large, financially sound corporations that regularly pay dividends (called
Another important investment goal is growth, increasing the value of the investment. Many investors look for securities that are expected to increase in price over time. Generally, they choose stocks that expect to continue above-average rates of growth in earnings and price. For instance, the earnings of so-called growth stocks might increase 15 to 20 percent or more at a time when the earnings of most common stocks are increasing only 5 to 6 percent.
Safety is yet another investment goal. Investors who opt for safety do not want to risk losing the money they’ve invested. They generally choose government and
International mutual funds,
residence equity,
MMMF, U.S. EE savings
insurance, Treasury
term life insurance
the insured’s life for a fixed
cash value
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concept check What is investment risk? What is the rela-tionship between risk and return?What steps should be taken before startingan investment program? Why?Discuss three strategies for implementing asuccessful investment program.
whole life (straight high-grade corporate bonds, preferred stocks, and mutual funds. They avoid comlife, cash value, mon stock because of its frequent price fluctuations. continuous pay) insurance Life insurance that covers Developing an Investment Strategythe insured for his or her
Although much is written about various investment strategies, the secret to sucentire life, as long as the premiums are paid; has a cess is to start investing early, as Carlos and Amy Vela discovered. But before cash value that increases putting money into investments it is a good idea to establish an adequate emerover the life of the policy. gency fund (liquid assets that are available to meet emergencies) that covers three
to six month’s expenses, obtain necessary insurance coverage, and reduce debt. universal life
Then diversify your investments and invest regularly. insurance A combination of term life insurance and a tax-deferred Start Early to Enjoy the Benefits of Compounding savings plan. Part of the pre- Financial-planning practitioners and educators believe starting to invest early so mium is invested in securi returns can compound is the most important element in a successful savings/ ties, so the cash value earns investment program. Consider attorney Jeff Stier, who at 27 years old had already interest, at current market
invested $32,000 for his retirement. With no additional contributions to this rates, that contributes to the policy’s cash value. investment and assuming a 10 percent annual return, Jeff ’s $32,000 will grow to
$1,196,939 by the time he is 65 years old! If Jeff had waited until age 45 to start savinvesting ing for his retirement, he would have to invest $20,898 a year for 20 years (a total The process of committing of $417,962) in order to accumulate $1,196,939. money to various investment Start early and let your investments work for you, but remember that you need instruments in order to ob- to protect your assets with the appropriate insurance. And because the interest you tain future financial returns.
pay on debt is usually more than you can earn on your investments, it is important to reduce your debt first. emergency fund
Liquid assets that are available to meet emergencies. Diversify Another important element of a successful investment strategy
is diversification. This means you should invest in different classes of assets—cash diversification equivalents, stocks, bonds, real estate—and purchase securities with different risk An investment strategy that patterns and rates of return. A diverse portfolio, or collection of investments, is involves investing in differ- more likely to meet your investment goals than a single security is. A portfolio that ent classes of assets, such as
includes preferred stocks paying high dividends and growth stocks paying modest cash equivalents, stocks, bonds, and real estate, and dividends increases the potential of achieving both income and growth. Investing purchasing securities with in 5 to 10 different companies in different industries is another way to diversify. different risk patterns and Diversification is an important method of spreading your risk and increasing your rates of return. potential for achieving your investment goals.
portfolio Invest Regularly Make investing for your goals part of your cash flow A collection of investments.
plan. Decide how much to invest, then purchase the investments monthly, quarterly, or annually. Or, better yet, set up automatic transfers from your checking account to a mutual fund or stock dividend reinvestment plan (DRIP) so that a preplanned
amount is regularly invested in the investment vehicles of your choice. Most mutual funds welcome monthly contributions of $50 or
more through their automatic investment plans, and more stock can now be purchased regularly in small increments. Originally, stock DRIPs were set up to automatically reinvest dividend income paid on stocks, but many companies have also made stock purchase plans available to investors who own as little as one share of the company stock.
SECUR I T I ES TRANSACT ION BAS ICS
7 The traditional approach to investing in securities is through a stockbroker at a stock brokerage firm. Investors should seek a broker who understands their invest-
learning goal ment goals and will help them pursue those objectives.
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dividend reinvestment Investors can open two basic types of accounts at a brokerage firm: cash ac-plan (DRIP) counts and margin accounts. With a cash account, purchases of securities are paid A program in which divi for in full by the investor (cost of the securities plus brokerage commissions). In a dends paid by a stock are au- margin account, the investor puts up as little as 50 percent of the cost of the securitomatically reinvested in that ties, borrowing the balance from the broker and paying interest on the loan. The stock along with any addi
broker holds the securities as collateral for the loan. tional stock purchases submitted by the stockholder. Typically when an investor decides to buy or sell securities, they place an or
der with their broker, who handles the transaction on their behalf. The broker transmits a buy or sell order to the appropriate stock exchange, like the New York Stock Exchange (NYSE), where it is sent to the exchange trading floor for execution. To make transactions in the Nasdaq/OTC market, the broker must find out via computer who deals in the security and contact the dealer, offering the best price to make the transaction.
Stocks are usually bought and sold in blocks of 100 shares, called round lots. But if an investor can’t afford 100 shares of a stock, he or she may purchase fewer than 100 shares, called an odd lot. Because only round lots are traded on the exchanges, odd lots are grouped together by brokers to make up a round lot. An extra fee may be charged for odd-lot transactions.
Investors can place three types of orders when buying or selling securities. A market order is an order to buy or sell a security immediately at the best price available. A limit order is an order to buy a security at a specified price (or lower) or to sell at a specified price (or higher). The trade is executed only if the requested limit is reached. With a stop-loss order, the stock is sold if the market price reaches or drops below a specified level. A stop-loss order limits an investor’s losses in the event stock prices rapidly decline.
Brokerage firms are paid commissions for executing clients’ transactions. Although brokers can charge whatever they want, most firms have fixed commission schedules for small transactions. The value of the transaction and the number of shares involved helps to determine the amount of brokerage commission you are charged. Today many investors are using on-line brokerage firms to execute their securities transactions.
8 learning goal
GETT ING DOWNRIGHT PERSONAL
accounts.
concept check
Trends in Personal Finance
identity theft and the increasing “debt load” of the Gen-X generation.
Differentiate between cash and margin
What are the three types of orders investors can place to trade securities?
The protection of your good name and credit rating is critical to sound financial health, so two important trends need to be recognized: the dramatic increase in
Chapter 13 introduced you to the rising problem of identity theft. For the third straight year, the Federal Trade Commission (FTC) confirmed that it topped their list of consumer fraud complaints, accounting for 42 percent (215,000 complaints) of all the complaints it receives. The total number of fraud complaints jumped from 404,000 in 2002 to 517,000 in 2003, costing consumers $437 million, up significantly from 2001’s figure of $160 million. Some other top categories of consumer fraud complaints in 2003 included:
• Internet auctions 15 percent
• Catalog and shop-at-home sales 9 percent
• Internet services and computer complaints 6 percent
• Prizes/sweepstakes and lotteries 5 percent
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15
16
F GEN-X G FUTURE IS NOW
Explain the concept of identity theft and what it means to the victim. How can you avoid falling into the Gen-X
concept check
As you can see from this partial list, Internet-related fraud is one of the fastest-growing segments of consumer fraud, which includes identity theft. Online e-commerce has opened up a whole new world of opportunity for crooks. Eighty-five percent of students now own a PC, and more than half of all students made online purchases last year.
In one notorious case of Internet identity theft, the criminal not only incurred more than $100,000 of credit-card debt, but also obtained a federal home loan and bought homes, motorcycles, and handguns in the victim’s name. To make matters even worse he called the victim to taunt him, as identity theft was not a federal crime at that time. It was this case and others like it that prompted Congress to pass the Identity Theft and Assumption Deterrence Act in the fall of 1998.
Most people do not realize how easily criminals can obtain our personal data, without having to break into our homes or steal our wallets. In public places they may engage in “shoulder surfing,” watching you punch in a telephone calling-card number, or listening in as you give your credit-card number over the phone. Others engage in “dumpster diving,” going through trashcans or communal dumpsters to obtain copies of checks or credit-card and bank statements. Buy a shredder and make sure your personal financial papers are destroyed before you throw them in the trash. As Exhibit 13 (see page 28) shows, there are other precautions you can take to recognize threats and protect your personal information at all times; it’s a valuable commodity.
OR THE ENERAT ION THE
Who doesn’t have piles of credit-card debt when they’re young? It’s practically a rite of passage. But many Gen-X households are also buried under car loans and
student loans; a third carry an installment-loan balance of at least $9,500. Even more worrisome, nearly 25 percent have fallen seriously behind in their payments.
The average annual income (before taxes) for single men ages 25–34 is $36,766, and for single women, $31,640, with average annual expenditures of $28,925 and $28,267, respectively. Although 29 percent of the men and 33 percent of the women have college degrees, 41 percent of them do not know their credit-card interest rate, and 24 percent
Connectivity comes at a cost, with crooks and hackers getting online access to everything. Guard your personal financial information carefully at all times and know to whom and why you are giving it out.
© D
IGIT
AL
VIS
ION
/ G
ET
TY
IMA
GE
S
How do the emerging trends of increased Internet fraud and identity theft place more responsibility on the individual?
“debt trap”?
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17
• • •
• l• • I•
•
http:// .
SOURCE: Robert Longley, “How to Not Get E-Taken,” January 30, 2003, downloaded from Web site http://www.usgovinfo. about.com.
Exhibit 13
Great Ideas to Use Now
do not review their monthly statements. It is easy to see why so many young adults fall into debt that quickly spirals out of control.
Following the suggestions in this chapter with respect to financial goal setting, budgeting, and investing, will help to make sure you can pay your bills and enjoy a financially secure future.
As this chapter clearly demonstrates, you will need to make financial-planning decisions throughout your life. Financial knowledge allows you to manage your financial resources to best meet your goals now and in the future, while lack of knowledge may cost you dearly in money, time, and missed opportunity. You will make your money work for you by spending it in a way that gives you the most satisfaction for the dollar, and investing it so that you get the most return for the amount of risk. The key to making the best use of your money overall is the knowledge to make informed decisions. Let’s look specifically at some areas of financial planning discussed in this chapter.
We are all faced with unexpected expenses from time to time. You cannot know when emergencies may strike or how much they will cost. You may need a new set of tires, or have an opportunity to go skiing over the holiday break. In order to structure your cash flow so that money is put aside for unexpected expenses, you need a spending plan and the discipline to follow it.
The cash management section of this chapter describes liquid assets, such as money market accounts, that could be used for an emergency fund. Financial experts recommend that you keep sufficient financial resources in your emergency fund to cover two to six months of expenditures, including unexpected
With Internet fraud and identity theft dramatically on the rise, how can you protect yourself from this silent scourge that could target you next? Here are some tips from the FTC to protect yourself, your identity, and your money while online:
Never disclose private information unless you are sure who’s collecting it and why. Never give out your passwords. Be wary of any online business that does not give an e-mail address or have a customer service Web page. If it sounds too good to be true, it probab y is. When using a credit card for online purchases, make sure you are using a secure server. nstall an antivirus program and keep it updated. Be wary of downloading “.EXE” program files unless you know their source and what they are going to do. Avoid responding to “spam” mail, which is very often nothing more than an attempt by Internet criminals to obtain large amounts of personal data . . . about you.
If despite your best efforts you still become a target of identity thieves, you can call the Federal Trade Commission toll free at 1-877-FTC-HELP or file a complaint online at www.consumer.gov/idtheft
Keep Your Identity to Yourself
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T r y I t N o w 1. Choose a bank.
2.
It seems wherever you look nowadays, people have been re
more of our everyday needs, we have lost the “human touch,” which is so important, especially in the area of customer service.
made any contact with your friendly local banker a thing of the past. In their never-ending quest for new business, and in an attempt to keep and build loyalty with the customers they have, some banks are rethinking the role of automation, and
to give her paycheck to a real person, which seemed safer than feeding it into a machine. But the young man assured her it was quite safe and helped her make the transaction.
When a competing bank in town solicited her business with offers of free checking and other enticements, she made the switch without a second thought. Her only bond with her bank was with a machine!
So have banks trained their customers too well? Although
transactions cost banks pennies compared with several dollars for an “inside transaction”—the banks are losing something much more valuable in the process, “face time” with their customers. Face time helps build customer loyalty and trust. More important, it allows bank staffers to promote
These might include upgraded checking and savings vehicles, investments, and loans, including home refinancing. Nowa
emergencies and investment opportunities. You will want to choose the best savings vehicle at the best interest rate for your emergency fund. Putting this money into a two-year certificate of deposit would be a mistake if your tires need replacing in 14 months, because there is a penalty for early withdrawal. Putting the money into a money market deposit account at 3 percent, rather than a money market mutual fund paying 5 percent, will cost you $20 a year for each $1,000 in the account. You can probably find something fun to do with $20.
Select three different financial institutions: one that you actually use for checking and/or savings and two others. Determine what checking and savings accounts are available that suit your needs and find out how these accounts are structured (minimum opening deposits, minimum required balances, fees, and other limitations). Look at the institution’s complete list of fees, not just the cost of the checking account. Get a written copy of all account descriptions and fees if possible. Which one would be best for you given your needs? Be sure to discuss your needs as well as the characteristics of the institutions.
Select a credit card. How do you choose the best credit card and use it wisely? Compare three different credit cards. If you already have a credit card(s), use your own in addition to those offered through local banks or flyers you see on campus. Compare annual fees, APRs, methods of calculating finance costs, grace periods, and other terms. Get a written copy of the credit-card terms if possible. Which one would be best for you given your needs and the way you intend to use a credit card? Be sure to discuss your needs as well as the characteristics of the cards.
Customer Satisfaction and Quality
placed by technology. And as technology services more and
Perhaps the most dramatic example of this phenomenon is the banking industry, where ATMs and online banking have
ATMs in particular, with respect to their customer service function. Kate Harris was urged by her bank to try the bank’s newly installed ATM machine to make her deposit, saving herself a 20-minute wait inside. Kate was uncertain. She liked
Kate rarely went inside the bank after that; she preferred the convenience of using the ATM for her regular banking needs.
having customers use ATMs saves the bank money—ATM
other (profitable) products and services the bank has to offer.
days when customers approach Kate’s old bank, they are greeted at the door by a bank staffer, welcoming them inside.
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Where credit is concerned, if it sounds to good to be true it usually is! Advertisements that invite purchases with no money down and no payment for months or even years sound wonderful, but you need to read the fine print and understand exactly what is required. Most require a minimum monthly payment and are only “interest free” as long as you continue to make those payments in a timely manner. Or at the end of the term the entire balance may become due in a lump sum, carrying huge interest penalties if you are not able to pay it all on time. And remember—don’t be afraid to call your credit-card company to negotiate lower rates, more miles, better terms. And calling more than once may trigger greater gains as you may not be advised of all your options on the first call. A brief mention that you are considering switching to a lower-rate card with more benefits will usually produce results.
In the tax area, you can be assessed significant penalties if you don’t pay what you legally owe in taxes, but you need to take legitimate deductions that could save you tax dollars. Not having the proper insurance will cost you if you suffer a loss. No car insurance may mean you take the bus to work. Homeowners and renters insurance is needed to protect against property damage and liability losses. Lack of health insurance can put families on welfare. And buying too much insurance, or insurance from the wrong company, can be expensive.
Once you have met the necessities with regard to financial planning, cash flow, credit, taxes, and insurance, you should develop an investment program that will allow you to achieve your goals. Start early to benefit from compounding, diversify, and invest regularly. Be sure to find a broker who understands your investment goals and will help you achieve them.
Even in areas such as banking and credit, knowledge about how accounts are structured and the fees associated with their use is very important. Take the case of the student who wondered why his checking account cost him so much. With the help of his personal-finance instructor, he discovered that he had made 23 ATM withdrawals from ATMs not owned by his bank—and each one had cost him $1. The monthly checking account fee was only $3, but the total cost for that month was $26! By walking one more block to use his own bank’s ATM, he could have saved the $23 and spent it on something more enjoyable.
P T i
SUMMARY OF LEARN ING GOALS
1 How does the financial-planning process facilitate successful personal financial management? Financial planning is a six-step process that includes establishing financial goals, gathering objective and subjective information, analyzing the information, developing a financial plan, implementing the plan, and monitoring your plan. The process starts with your goals and provides a road map to meet those goals.
2 How do cash flow planning and management of liquid assets contribute to your financial goals? A cash flow plan manages income and expenses. Based on your financial goals, it includes saving for those goals. With money set aside regularly to pay for these goals, you are more likely to achieve them. Liquid assets such as checking and savings accounts are important for day-to-day spending, to meet short-term goals, and for unexpected or emergency expenditures. Liquid assets can be held in safe, accessible accounts so the money is readily available when needed.
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4
5
6
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8
What are the advantages and disadvantages of using consumer credit? The benefits of consumer credit include convenience, the ability to purchase a good or service when you need it and take advantage of bargains, establishing a credit rating, convenient record keeping, meeting financial emergencies, and perks such as rebates and frequent-flyer miles. Using consumer credit has some important disadvantages including the ease of overspending, the cost of credit (interest charges), the possibility that merchandise may cost more, and the reduction in future discretionary income due to the legal commitment to repay debt.
What types of taxes are individuals responsible for? The major taxes paid by individuals are income, Social Security and Medicare, sales, and property taxes. Income and Social Security and Medicare taxes are called payroll taxes because they are based on income and deducted from an employee’s paycheck. Sales tax is assessed on purchases made, and property tax is based on the value of property owned, usually real estate.
What factors should you consider in deciding what insurance to purchase? The key to managing your insurance needs in the most cost-effective way is to budget to cover minor losses and purchase insurance to cover potential major losses. Set aside money in savings so that you can pay for the loss when it happens, and buy good insurance policies to cover major losses.
What personal goals are important when making investment decisions? Investment decisions should be based on your goals and your risk tolerance. Examples of investment goals include the desire for income from interest and dividends, the need for growth (capital gains), and the need for safety.
How do investors open a brokerage account and make securities transactions? Investors must choose a brokerage firm and a stockbroker in that firm. Then they open a cash account or a margin account. In a cash account, all securities transactions are paid in full by the investor. Margin accounts allow investors to put as little as 50 percent of the price of the securities and borrow the rest from the broker. The investor gives an order to buy or sell securities to the broker, who sends it to the stock exchange to be carried out or, in the case of an over-the-counter stock, finds the dealer with the best price. Today many investors are using online brokerage firms to execute their securities transactions.
What emerging trends affect the way you manage your personal finances? The dramatic increase in identity theft means you need to take precautions to protect your good name. Don’t fall victim to the increasing “debt load” of the Gen-X generation—protect your credit rating as well.
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PREPAR ING FOR TOMORROW’S WORKPLACE 1. Use the six-step financial-planning process to develop a financial plan for
yourself for the next year. List your financial goals and gather the appropriate information needed to analyze your situation. Develop your plan and explain how it will be implemented.
2. Use the steps detailed in this chapter to balance your most recent checking account statement. After completing this process, analyze your use of the checking account, EFT services, and so on. Are you satisfied with the way you are handling your account? If not, what changes would you make in how you use it?
3. College junior Andy Jung overused his credit cards last year. He currently has the following outstanding debt on two credit cards plus an auto loan and a student loan:
• MasterCard—$984 outstanding debt, $40 minimum monthly payment, 18 percent interest rate, no annual fee, $25 late-payment fee, 2 percent cash-advance fee ($20 maximum), $1,000 line of credit.
• Visa—$569 outstanding debt, $17 minimum monthly payment, 14 percent interest rate, $20 annual fee, $20 late-payment fee, 1.5 percent cash-advance fee ($20 maximum), $800 line of credit.
• Auto loan—$3,490 outstanding balance, $257 monthly payment, 8 percent interest, 15 more payments.
• Student loan—$15,490 outstanding balance, deferred payments, 7.5 percent interest (unsubsidized).
Andy has $450 a month to use for debt repayment. Divide into small groups and advise Andy on how best to pay off his debt obligations. Start by completing a debt inventory for Andy. Then write a one- to two-page memo explaining how Andy should allocate the $450. Support the rationale for your recommendations.
4. You have just won $100,000 in your state lottery. In light of your personal situation (age, finances, family status, and so on), what types of securities would you choose, and why? Now you also have to find a broker to execute the transactions. Should you use a traditional full-service brokerage, a discount broker, or an online brokerage? Using the Internet and personal-finance publications to gather information, compare the services of these types of firms. Summarize the pros and cons of each and decide which best meets your needs. Justify your choice.
Team!5. Form a team of four or five classmates to evaluate employer fringe-benefit plans. Gather written information on the insurance and retirement benefits offered by at least two employers. This information may be available directly from an employer, from your parents, or from senior classmates who are interviewing with companies. After reviewing the information write a brief summary evaluating the insurance and retirement plans offered, and what investments are available through the retirement plans. Present your findings to the class.
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automobile liability in
automobile physical
coinsurance (participa
comprehensive (other-than-collision) cover
disability income insur
dividend reinvestment
health maintenance or
indemnity (fee-for-
major medical insurance 21
net worth 7
personal balance sheet 7
personal financial plan
preferred provider orga
prepayment penalties 14
replacement cost cover
revolving credit cards 12
security requirements 14
actual cash value 20
surance 19
damage insurance 20 cash flow plan 8 cash management 7 cash value 24 COBRA 20
tion) 22
age 20 credit life insurance 14
ance 22 diversification 25
plan (DRIP) 26 duration of benefits 23 earned income 17 emergency fund 25 filing status 16 grace period 12
ganizations (HMOs) 22
service) plans 21 investing 25 line of credit 12 liquid assets 7
managed care plans 21
open-end credit 11
personal exemptions 17
ning 5 portfolio 25
nizations (PPOs) 22
principal 14 progressive tax 16
age 20
WORKING THE NET 1. Finance Center (http://www.financecenter.com) is a comprehensive, highly
rated financial-planning Web site that includes more than 100 online calculators to help with the number crunching involved in personal finance decisions. Click on Calculators to see how to budget for college living expenses.Input your information and click on Results to tally your monthly livingexpenses. Then click on Graph to view what percentage of funds you have allocated to various types of expenses. Use the site’s calculator to analyzewhether living on campus or at home would save you money. If you decide tolive at home, perhaps a college meal plan would be a good idea to cover yourlunches each day. While at the site check it out, as well as other applicationsthat may interest you.
2. At Bankrate (http://www.bankrate.com) you will find the current averagerates on standard, gold, and platinum credit cards. To find the best rate foryou, fill in the required information based on your wants and needs in a creditcard. Planning to move? Use the site’s calculator to compare the cost of livingbetween two cities. Summarize your findings.
3. Wells Fargo (http://www.wellsfargo.com) offers one-stop shopping for allyour banking needs. Click on Education Center and Paying for College to seetheir full range of college-financing options.
4. Go to Tax Cut (http://www.taxcut.com) for information on taxes and taxpreparation software. Click on Tax Resources for information regarding taxplanning, including information on deductions, how to treat investment anddividend income, and family dependents. Also find and analyze one othertopic that is of interest to you.
5. SmartMoney (http://www.smartmoney.com) provides information to assist you with your personal investing. Go to My Portfolio to create your owninvestment portfolio. Click on Tools to find the information you need totrack your investments. Select a company you would like to know moreabout, perhaps one you might like to work for. Click on Stocks to get thecurrent stock quote for the company and see if there is any breaking newsabout it.
CREAT IVE TH INK ING CASE The Credit-Card Trap In your first week at college a major credit-card company offers you your very first credit card. You are excited about the financial freedom this represents, as your parents were always strict with money. You use the card to buy some new clothes and the state-of-the-art sound system you have been wanting for your dorm room. You also join a group on a visit to a local casino and get swept away in the headiness of the moment. Soon you owe $4,500, and although you struggle to make the minimum monthly payment from the allowance your parents give you, your balance never seems to get any lower. Feeling trapped, you decide to take advantage of an on-campus debt-counseling service where they instruct you to destroy your credit card. They also negotiate with the credit card issuer on your behalf for a reduction in the balance due. They ask you to share your experience with other students to help them avoid falling into the credit-card trap.
CRITICAL THINKING QUESTIONS 1. In speaking with students, what is the first thing you would tell them? 2. What can a student expect to feel when she receives her first credit card? What
types of risks is she exposed to?3. How would you recommend a student control her spending?
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universal life insurance 25
waiting period (elimina
whole life (straight life, cash value, continuous
withholding allowances 16
standard deduction 17 term life insurance 24 unearned income 17
tion period) 23
pay) insurance 25
VIDEO CASE The Edward Jones Approach to Personal Finance Unlike full-service brokerage firms like Morgan Stanley, whose client base includes wealthy individuals and large, institutional investors, and discount broker Ameritrade, whose clients conduct most of their brokerage business online, the Edward Jones Company (http://www.edwardjones.com) focuses on smaller individual investors and business owners who want highly personalized, face-to-face service. The only major financial-services firm that exclusively targets retired investors, working investors, tax professionals and attorneys, and small-business owners, Edward Jones’s approach appeals to investors in smaller communities as well as larger metropolitan areas. In fact, about three-quarters of its offices are in major cities.
Edward Jones provides investment services to its targeted clientele through a branch-office network and a comprehensive IT system. Its more than 8,500 branch offices in all 50 states, plus another 700 in Canada and the United Kingdom, are located in neighborhoods where people live and work rather than in center-city high-rises. Account representatives focus on building long-term relationships with their clients. They also strive to ensure that clients are comfortable with and confident about their investment decisions. As managing partner John Bachman says, “We want our people touching customers.”
The brokerage firm implements its strategy of one-on-one, personalized investment services through three key elements:
• Customizing financial strategies and solutions to each client’s needs and goals. • Providing a Full Service Account (FSA) to simplify customers’ financial man
agement needs. • Focusing on customers who are interested in long-term, relatively high-
quality, low-risk investments.
For instance, the company provides small-business owners with retirement plan choices, cash flow management, and information on legislative issues. For working investors, the company focuses on managing personal finances, saving for retirement, and financing their children’s college education. Its stock reports are written in easy-to-understand language, and its fees are lower than most other full-service brokerage firms.
Edward Jones’s Full Service Account helps clients simplify their financial lives. This cash and investment management account coordinates their savings and investments into an organized portfolio that simplifies record keeping and streamlines transactions. Investors can borrow money through an automatic line of credit and open a money market account.
A third element of the company’s strategy is its focus on clients who are interested in relatively high-quality, low-risk investments that are held for the long term. These investments include certificates of deposit; mutual funds; government, municipal, and corporate bonds; common stocks of companies with histories of sound management and solid growth; retirement plans and individual retirement arrangements (IRAs); and life insurance products, including annuities.
A few years ago, its lack of online trading and other Internet-based services made Edward Jones seem stodgy and out of step with the times. Its recent growth shows that Jones is doing something right. The number of offices has more than doubled in recent years, and it manages more than $250 billion in assets for its 6 million-plus customers.
CRITICAL THINKING QUESTIONS 1. How can Edward Jones’s strategy of one-on-one, personalized investment ser
vices help a customer develop a personal financial plan and an investment strategy?
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2. Suppose that you are looking for investment management services. Would you be inclined to become a client of the Edward Jones Company? Why or why not?
SOURCES: Adapted from the material in the Edward Jones video; the Edward Jones Web site, http://www. edwardjones.com, accessed June 17, 2003; and David Landis, “Street Smart,” Kiplinger’s Personal Finance (May 2003), downloaded from http://www.edwardjones.com.
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Managing Your Personal Finances Web Chapter |35
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Web appendixMANAGING RISK AND INSURANCE
risk management Process of analyzing a firm’s operations, evaluating the potential risk, and figuring out how to minimize losses in a cost-efficient manner.
speculative risk The chance of either loss or gain, without insurance against the possible loss.
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Overview Every day, businesses and individuals are exposed to many different kinds of risk. Investors who buy stocks or speculate in commodities may earn a profit, but they also take the risk of losing all or part of their money. Illness is another type of risk, involving financial loss from not only the cost of medical care but also the loss of income.
Businesses, too, are exposed to many types of risk. Market risks, such as lower demand for a product or worsening economic conditions, can hurt a firm. Other risks involve customers, who could be injured on a company’s premises or by a company’s product. Like homes and cars owned by individuals, business property can be damaged or lost through fire, floods, and theft. Businesses must also protect themselves against losses from theft by dishonest employees. The loss of a key employee is another risk, especially for small firms.
It is impossible to avoid all risks, but individuals and businesses can minimize risks or buy protection—called insurance—against them. Although some risks are uninsurable, many others are insurable. Let’s now look at basic risk concepts and the types of insurance available to cover them.
Risk Management Every business faces risks like the ones listed above. Risk management involves analyzing the firm’s operations, evaluating the potential risks, and figuring out how to minimize losses in a cost-efficient manner. In today’s complex business environment, the concern for public and employee welfare and the potential for lawsuits have both increased. Risk management thus plays a vital role in the overall management of a business.
Types of Risk Individuals and firms need to protect themselves against the economic effects of certain types of risk. In an insurance sense, risk (sometimes called pure risk) is the chance of financial loss due to a peril. Insurable risks include fire, theft, auto accident, injury or illness, a lawsuit, or death. Speculative risk is the chance of either loss or gain. Someone who buys stock in the hope of later selling it at a profit is taking a speculative risk and cannot be insured against it.
Strategies to Manage Risk Risk is part of life. Nevertheless, people have four major ways to deal with it:
• Risk avoidance. Staying away from situations that can lead to loss. A person can avoid the risk of a serious injury by choosing not to go skydiving. Kinder-Care, a nationwide day-care chain, could avoid risk by not transporting children to and from school or taking them on field trips. Manufacturers who wish to avoid risks could produce only goods that have a proven track record. But these risk-avoidance strategies could stifle growth in the long run. Thus risk avoidance is not good for all risks.
• Self-insurance. The willingness to bear a risk without insurance, also called risk assumption. This offers a more practical way to handle many types of risks. Many large firms with warehouses or stores spread out over the United States—Sears or Kmart, for instance—may choose not to insure them. They assume that, even if disaster strikes one location, the others won’t be harmed. The losses will probably be less than the insurance premiums for all the locations.
insurance The promise of compensation for certain financial losses.
insurance policy A written agreement that defines what the insurance covers and the risks that the insurance company will bear for the insured party.
underwriting A review process of all insurance applications and the selection of those who meet the standards.
insurable interest An insurance applicant’s chance of loss if a particular peril occurs.
insurable risk A risk that an insurance company will cover. It must meet certain criteria.
law of large numbers Insurance companies’ predictions of the likelihood that a peril will occur in order to calculate premiums.
Many companies self-insure because it is cheaper to assume some risks than to insure against them. Some choose to pay small claims themselves and insure only for catastrophic losses. Others “go naked,” paying for all claims from company funds. This is clearly the most risky strategy. A big claim could cripple the firm or lead to bankruptcy.
• Risk reduction. Adopting techniques to prevent financial losses. For example,companies adopt safety measures to reduce accidents. Construction workersare required to wear hard hats and safety glasses. Airlines keep their aircraft ingood condition and require thorough training programs for pilots and flightattendants. Hotels install smoke alarms, sprinkler systems, and firewalls toprotect guests and minimize fire damage.
• Risk transference. Paying someone else to bear some or all of the risk of financial loss for certain risks that can’t be avoided, assumed, or reduced to acceptable levels. The way to transfer risk is through insurance. Individuals andorganizations can pay a fee (a premium) and get the promise of compensationfor certain financial losses. The companies that take on the risks are called insurance companies.
Insurance Concepts Companies purchase insurance to cover insurable risks. An insurance policy is the written agreement that defines what the insurance covers and the risks that the insurance company will bear for the insured party. It also outlines the policy’s benefits (the maximum amount that it will pay in the event of a loss) and the premium (the cost to the insured for coverage). Any demand for payment for losses covered by the policy is a claim.
Before issuing a policy, an insurance company reviews the applications of those who want a policy and selects those that meet its standards. This underwriting process also determines the level of coverage and the premiums. Each company sets its own underwriting standards based on its experience. For instance, a life insurance company may decide not to accept an applicant who has had a heart attack within five years (or to charge a 50 to 75 percent higher premium). A property insurer may refuse to issue a policy on homes near brush-filled canyons, which present above-average fire hazards.
To get insurance, the applicant must have an insurable interest: the chance of suffering a loss if a particular peril occurs. In most cases, a person cannot insure the life of a friend, because the friend’s death would not be considered a financial loss. But business partners can get life insurance on each other’s lives because the death of one of them would have a financial impact on their firm.
Insurable Risks Insurance companies are professional risk takers, but they won’t provide coverage against all types of risk. Some risks are insurable; some are not. For instance, changes in political or economic conditions are not insurable. An insurable risk is one that an insurance company will cover. For a risk to be insurable, it must meet these criteria:
• The loss must not be under the control of the insured. The loss must be accidental—that is, unexpected and occurring by chance. Insurance companies do not coverlosses purposely caused by the insured party. No insurance company will pay forthe loss of a clothing store that the insured set on fire. Nor will most companiespay life insurance benefits for a suicide.
• There must be many similar exposures to that peril. Insurance companies studythe rates of deaths, auto accidents, fires, floods, and many other perils. Theyknow about how many of these perils will occur each year. The law of largenumbers lets them predict the likelihood that the peril will occur and then calculate premiums.
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deductibles The amounts that the insured must pay before insurance benefits begin.
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Suppose that an insurance company has 150 policies in Morton, Iowa. The company knows from past experience that these policyholders are likely to have a total of 12 car accidents a year and that the average payment for a claim in Morton has been $1,000. The total claims for one year’s car accidents in Morton would be $12,000 (12 accidents 3 $1,000). Thus the company would charge each policyholder a premium of at least $80 ($12,000 4 150). Profits and administrative expenses would make the premium somewhat higher.
• Losses must be financially measurable. The dollar amount of potential losses must be known so the insurance company can figure the premiums. Life insurance is for a fixed amount specified at the time the policy is bought. Otherwise, the company and the beneficiary (the one who gets the funds) would have to agree on the value of the deceased’s life at the time of death. Premiums have to be calculated before then, however.
• The peril must not be likely to affect all the insured parties at the same time. Insurance companies must spread out their risks by insuring many people and businesses in many locations. This strategy helps minimize the chance that a single calamity will wipe out the insurance company.
• The potential loss must be significant. Insurance companies cannot afford to insure trivial things for small amounts. Many policies have deductibles, amounts that the insured must pay before insurance benefits begin.
• The company must have the right to set standards for insurance coverage. Insurance companies can refuse to cover people with health problems like AIDS, cancer, or heart trouble, a poor driving record, or a dangerous job or hobby. They can also charge higher premiums because of the higher risks they are covering.
Premium Costs Insurance policies must be economical—relatively low in cost compared to the benefits—so people will want to buy them. Yet the premiums must also cover the risks that the insurance company faces. Insurance companies collect statistics on many perils. Then specially trained mathematicians called actuaries use the law of large numbers to develop actuarial tables, which show how likely each peril is. Actuarial tables are the basis for calculating premiums. For example, actuaries use a mortality table showing average life expectancy and the expected number of deaths per 1,000 people at given ages to set life insurance premiums.
Almost every homeowner buys insurance to cover the perils of fire, theft, vandalism, and other home-related risks. With such a large pool of policyholders, homeowners policies are usually inexpensive. Annual premiums are about 0.5 percent (or less) of the value of the home. This low cost encourages people to buy policies and thereby helps spread the insurance companies’ risk over many homes throughout the country.
When setting premiums, insurers also look at the risk characteristics of certain groups, in order to assess the probability of loss for those groups. For instance, smokers tend to die younger than nonsmokers do and thus pay higher life insurance premiums. Female drivers under the age of 25 have a lower rate of accidents than male drivers, so their car insurance premiums are lower.
Insurance Providers Insurers can be either public or private. Public insurance coverage is offered by specialized government agencies. The federal government is in fact the largest single insurer in the United States. Private insurance coverage is provided by privately organized (nongovernment) companies.
Public Insurance Government-sponsored insurance falls into two general categories: social insurance programs and other programs. Social insurance provides protection for problems beyond the scope of private insurers. These programs include:
unemployment insurance Pays laid-off workers weekly benefits while they seek new jobs.
workers’ compensation Covers the expenses of job-related injuries and diseases, including medical costs, rehabilitation, and job retraining if necessary.
Social Security Insurance that provides retirement, disability, death, and health benefits.
Medicare A health insurance program for those over 65.
• Unemployment insurance. Every state has an unemployment insurance program that pays laid-off workers weekly benefits while they seek new jobs. Persons who terminate their employment voluntarily or are fired for cause arenot eligible for unemployment insurance. These programs also provide jobcounseling and placement services. The benefits usually start a week after aperson has lost a job and continue for 26 to 39 weeks, depending on the state.The size of the weekly benefit depends on the workers’ previous income andvaries from state to state. Unemployment insurance is funded by payroll taxeslevied on employers.
• Workers’ compensation. Every state has laws requiring employers to fundworkers’ compensation insurance to cover the expenses of job-related injuries and diseases, including medical costs, rehabilitation, and job retrainingif necessary. It also provides disability income benefits (salary and wage payments) for workers who can’t perform their job. Employers can buy workers’compensation policies or self-insure. A company’s premium is based on theamount of its payroll and the types of risks present in the workplace. For instance, a construction company would pay a higher premium for workers’compensation insurance than would a jewelry store.
• Social Security. Social Security insurance provides retirement, disability,death, and health insurance benefits. Social Security is funded by equal contributions from workers and employers. These benefits go mostly to peopleover 65, although they are available to younger people who are disabled. Morethan 90 percent of all U.S. workers and their families are eligible to qualify forSocial Security benefits.
• Medicare. A health insurance program for those over 65, Medicare was addedto Social Security in 1965 and has two parts: hospital insurance, financedthrough the Social Security tax, and medical insurance, financed through government contributions and monthly premiums paid by those who want thiscoverage. Because Medicare pays only part of the insured’s medical expenses,many people buy supplemental insurance from private insurance companies.
Private Insurance Companies Private insurance companies sell property and liability insurance, health insurance, and life insurance. Life and health insurance companies dominate the industry, accounting for about 70 percent of total assets. Regulation of private insurance companies is under the control of the states and thus varies from state to state.
There are two basic ownership structures for private insurance companies: stockholder and mutual. Just like other publicly owned corporations, stock insurance companies are profit-oriented companies owned by stockholders. The stockholders do not have to be policyholders, and the policyholders do not have to be stockholders. Their profits come from insurance premiums in excess of claim payments and operating expenses and from investments in securities and real estate. Metropolitan Life Corporation is the largest stockholder-owned insurance company in the United States, with assets of about $327 billion. Other major stock insurance companies are Aetna, Allstate Insurance, Continental Insurance, Fireman’s Fund Insurance, John Hancock, and Prudential. Of about 5,000 insurance companies in the United States, most are stock insurance companies.
The rest are mutual insurance companies, which are not-for-profit organizations owned by their policyholders and chartered by each state. Any excess income is returned to the policyholder-owners as dividends, used to reduce premiums, or retained to finance future operations. The policyholders elect the board of directors, who manage the company. Many of the large life insurance companies in the United States are mutuals, including New York Life, Massachusetts Mutual, and Northwestern Mutual Life. State Farm, one of the largest auto insurers, is also a mutual company.
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key-person life insurance A term insurance policy that names the company as beneficiary.
coinsurance Property insurance coverage that is equal to a certain percentage of the property’s value.
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Types of Insurance In the Web Chapter “Managing Your Personal Finances” we introduce several types of personal insurance coverage: property, liability, health, and life. Businesses also purchase insurance for these risks, but with some differences. Most companies offer group health and life insurance plans for their employees as a fringe benefit. Employers typically pay some of the health insurance premiums, and employees pay the rest. The cost is usually considerably less than for individual policies, although it pays to check before signing up. For example, companies may pay for the entire cost of life insurance equal to one or two times the employee’s annual salary, with an option to purchase more under the group plan, but the premiums may be more expensive than buying an individual policy.
Businesses often insure the lives of key employees, such as top executives, salespeople, inventors, and researchers, whose death could seriously limit the income or value of a firm. To protect themselves, businesses buy key-person life insurance, a life insurance policy that names the company as beneficiary. In the case of a partnership, which is dissolved when a partner dies, key-person insurance is often bought for each partner, with the other partner named as the beneficiary, so that the surviving partner can buy the partnership interest from the estate of the deceased and continue operating.
Property and Liability Insurance More than 3,500 companies offer property and liability policies. This type of insurance is important for businesses, which wish to protect against losses of property and lawsuits arising from harm to other people. Property insurance covers financial losses from damage to or destruction of the insured’s assets as a result of specified perils, while liability insurance covers financial losses from injuries to others and damage to or destruction of others’ property when the insured is considered to be the cause. It also covers the insured’s legal defense fees up to the maximum amount stated in the policy. Automobile liability insurance, which we discuss in more detail in the Web Chapter “Managing Your Personal Finances,” is an example. It would pay for a fence damaged when the insured person lost control of his or her car. Commercial and product liability insurance also fall into this category.
Commercial liability insurance covers a variety of damage claims, including harm to the environment from pollution. In the case of product liability, if a defective furnace exploded and damaged a home, the manufacturer would be liable for the damages. If the manufacturer were insured, the insurance company would cover the losses or pay to dispute the claim in court.
Property and liability insurance is a broad category. Businesses buy many types of property and liability insurance. These protect against loss of property due to fire, theft, accidents, or employee dishonesty, and financial losses arising from liability cases. Landlords and owners of business property buy building insurance, a type of property coverage, for protection against both property damage and liability losses. For instance, if a person broke an arm slipping on a wet floor in a hardware store, the business’s insurance policy would cover any claim.
Property insurance policies usually include a coinsurance clause. Coinsurance requires the property owner to buy insurance coverage equal to a certain percentage of the property’s value. To cut premium costs, policyholders often insure buildings for less than their full value, in the hope that a fire or other disaster will damage only part of the property. But insurers limit the payout if the property is underinsured. They use coinsurance clauses as an incentive for businesses to maintain full insurance on their buildings. For instance, some fire insurance policies have an 80 percent coinsurance clause. If the owner of a building valued at $400,000 buys a policy with coverage equal to at least $320,000 (80% 3 $400,000), he or she will collect the full amount of any partial loss. If the owner buys a policy for less coverage, the insurance company will pay for only part of the partial loss.
business interruption insurance Covers such costs as rental of temporary facilities, wage and salary payments to employees, payments for leased equipment, fixed payments, and profits that would have been earned during that period.
theft insurance A broad insurance coverage that protects businesses against losses for an act of stealing.
professional liability insurance Insurance designed to protect top corporate management, who have been the target of malpractice lawsuits
Special Types of Business Liability Insurance Businesses also purchase several other types of insurance policies, depending on their particular needs:
• Business interruption insurance. This optional coverage is often offered withfire insurance. It protects business owners from losses occurring when thebusiness must be closed temporarily after property damage. Business interruption insurance may cover such costs as rental of temporary facilities, wageand salary payments to employees, payments for leased equipment, fixed payments (for instance, rent and loans), and profits that would have been earnedduring the period. Contingent business interruption insurance covers losses tothe insured in the event of property damage to a major supplier or customer.
• Theft insurance. Businesses also want to protect their property against financial losses due to crime. Theft insurance is the broadest coverage and protectsbusinesses against losses from an act of stealing. Businesses can also buy morelimited types of theft insurance.
• Fidelity and surety bonds. What if a firm has a dishonest employee? This situation is covered by a fidelity bond, an agreement that insures a company againsttheft committed by an employee who handles company money. If a restaurantmanager is bonded for $50,000 and steals $60,000, the restaurant will recoverall but $10,000 of the loss. Banks, loan companies, and retail businesses thatemploy cashiers typically buy fidelity bonds.
A surety bond, also called a performance bond, is an agreement to reimburse a firm for nonperformance of acts specified in a contract. This form of insurance is most common in the construction industry. Contractors buy surety bonds to cover themselves in case the project they are working on is not completed by the specified date or does not meet specified standards. In practice, the insurance company often pays another contractor to finish the job or to redo shoddy work when the bonded contractor fails to perform.
• Title insurance. A title policy protects the buyer of real estate against lossescaused by a defect in the title—that is, a claim against the property that prevents the transfer of ownership from seller to purchaser. It eliminates the needto search legal records to be sure that the seller was actually the owner of (hadclear title to) the property.
• Professional liability insurance. This form of insurance covers financial losses(legal fees and court-awarded damages up to specific limits) resulting from alleged malpractice by professionals in fields like medicine, law, architecture,and dentistry. Directors and officers insurance is a type of professional liabilityinsurance designed to protect top corporate management, who have also beenthe target of malpractice lawsuits. It pays for legal fees and court-awardeddamages up to specific limits.
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