FINA1109- Managing Your Personal Finances PDF

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FINA1109: Managing Your Personal Finances Lecture 1: The Personal Financial Planning Process 3 Key concepts 1. Personal Financial Planning Process of meeting your life goals through the proper management of your finances.

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Life goals: getting a job, buying a home, saving for post-grad (or child's) education, round-the-world holiday, planning for retirement o

Goals can be short or long term

2. Personal Financial Planning Process 1. Analyze your current finances 2. Develop goals 3. Identify and evaluate strategies to achieve your goals 4. Establish and implement your plan 5. Reevaluate and revise your plan as needed

3. Personal Financial Plan 4 components of Personal Financial Plan 1. Establish foundation 2. Secure basic needs 3. Build wealth 4. Protect finances

Key principles of Financial Planning –

Helps to make effective decisions about the future 1. Use reasonable assumptions 2. Apply marginal reasoning

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What changes because of your decision?

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What changes “at the margin”?

3. Consider opportunity costs

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What are you missing out on?

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What else could you have done?

4. Use sensitivity analysis 

Consider other options - If things do not work out, what can we do?

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What if this happens?

Stages of Personal Finance Planning 1. Initial Assessment of Finances 2 indicators when assessing your finance: 

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Personal Balance Sheet

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What do we have/ own

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Assesses financial position/ Net Worth

Personal Cashflow statement

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Measures Financial Performance

Working out your net worth

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Compare assets against liabilities

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Assets: Value of assets, NOT how much they cost you o

Positive: Assets > Liabilities

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Zero: Assets = Liabilities

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Negative: Assets < Liabilities

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Humans are also considered an asset Converting Human to Financial Capital

Time Value for Money

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Lecture 2: Assessing your Financial Position Role of HuCaDs –

Human Capital Derivatives: An investment that derives value from an underlying asset

Why will the buyer buy and why will the buyer sell? o A HuCaD is a way of moving some of the risk you face in your human capital to somebody else. o You accept a lower value for a fraction of your future income for certainty. o So for the seller they are wanting to reduce the risk of uncertain income. o For the buyer, they invest because they speculate that the individual’s earnings are going to be more in the future.

Factors that influence human capital o o o

Positive: Education, Improving your health Negative: Injured, illness What AFFECTS the human capital: Economy, lack of demand for jobs

Evaluate estimates of human capital value o o o

How long you think you will be working for How much will you be making How much you will be making (will it fluctuate)

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However, this estimate is subject to change (new skills, further education) Possible risk: Decline in economy, no demand Hard to predict the future

What are the factors that influences present value?  Size of cash flows –

Larger future cash flows, larger present values

 Timing of cash flows – –

More cash flows, More frequent, larger present values Longer you wait for cash flows, the smaller present values

 Risk of cash flows – –

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Higher Risk, higher discount rate, smaller PVs impatience/inflation of cash flows

Rule of 72 o

Divide 72 by the number of years it takes to double to give the rate you earn,

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Example 72 / 9 = 8% OR Divide 72 by the interest rate to establish how long it will take for your money to double. Example 72 / 6% = 12 years 72 / 8% = 9 years (This is an approximation)

Nominal Interest Rate: – –

Interest rate that does not take inflation into account. The interest rate quoted on bonds and loans

Real Interest Rate: – – –

Interest rate that does take inflation into account Adjusts itself for the inflation and gives the real rate of a bond/ loan To calculate,

o Real Interest Rate = Nominal Interest Rate – Inflation Rate

 It is important because: o

A reflection of the change in purchasing power derived from an investment based on shifts in the rate of inflation  Gives investors an idea at which their purchasing power is increasing or decreasing

For example, suppose a bank loans a person $200,000 to purchase a house at a 3% rate. The 3% rate is the nominal interest rate, not factoring for inflation. Assume the inflation rate is 2%. The real interest rate the borrower is paying is 1%; the real interest rate the bank is receiving is 1%. The purchasing power of the bank only increases by 1%.

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Adjusting between real and nominal rates  Use the base year (the one you are comparing) as the denominator. Example CPI June 1996: 66.7 // CPI June 2018: 113.0 A movie in 1996 costs $7.26. What is the price of the same movie in 2018? 

113/66.7 – 1 = 1.69 – 1 = 69% (Prices will go up by 69%)

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Tickets that costs $7.26 in 1996 costs $12.27 in 2018.

Adjusting 2018 nominal price to real 1996 price: 

Real = 66.7/113 x 14.13 = $8.34 in 1996

Consumer Price Index (CPI) How do prices of 87 groups of goods and services change in price?

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Average these price changes, weighted by size of expenditure

Costs & Benefits of Inflation Costs: o o o o o

Money loses its value and people lose confidence in money as the value of their savings is reduced Inflation can get out of control - price increases lead to higher wage demands as people try to maintain their living standards. This is known as a wage-price spiral. Consumers and businesses on fixed incomes lose out because the their real incomes fall - employees in poor bargaining positions also lose out Inflation can favour borrowers at the expense of savers – because inflation erodes the real value of existing debts Inflation can disrupt business planning and lead to lower capital investment

Benefits:

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Industry-wide price rises enable revenues to grow Growing revenues + a constant gross margin = higher gross profits

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Inflation makes using debt as a source of finance cheaper in real terms

Winners & Losers from Inflation Winners:  Fixed-rate mortgage holders o o

Anyone with large, fixed-rate debts like mortgages benefit from higher inflation They’re going to be paying back with devalued dollars

 Investors in stocks Stockholders get some protection from inflation because the same factors that raise the price of goods also raise the values of companies. o Theoretically, the value of equities varies directly and proportionally with inflation  When you double all prices and wages, you double profits and you double the value of stocks, basically.

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 Investors in commodities o

Buying storable commodities such as gold can be a good hedge against inflation

Losers:  Savers o In an economy where inflation is rising quickly, interest rates rarely keep up, causing savers’ hard-earned dollars to gradually lose buying power.

 Retirees o

A high inflation rate often means wage increases, but that won’t benefit those who are retired, McBride says—their pot of retirement money already is fixed.

 Variable-rate mortgage holders o

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Homeowners with mortgage rates that aren’t fixed see their borrowing costs climb periodically along with the broader inflation in the economy, leading to larger payments and decreased affordability.

Quiz Questions Qn 1. Which of the following would be MOST preferred? A 4% nominal rate of return given a 3% inflation rate

Qn 2. When a bank calculates how much they can lend you they discount all the future repayments to a present value. You have applied for a loan from two banks. You can afford to make monthly payments of $100 per month. Bank A charges 10% interest Bank B charges 5% interest Which of the following is correct? Bank A will be able to provide a smaller loan because the present value of the repayments will be smaller with a higher discount (interest rate)

Qn 3. I am due to be paid $1,000 in two years time (future value). If interest rates (discount rates) decrease this would mean this money would be more valuable to me in todays dollar terms - its present value is larger. True

Qn 4. For which of the following groups would inflation be a positive? Borrowers with loans with a fixed borrowing rate

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Lecture 3: The Role of FinTech and Incentives Step One of PFPP: Analyse your current finances

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Organise financial information to summarise financial performance

[Net worth = Total Assets – Total Liabilities]

2. Using financial ratios as planning tools

Monthly Net Cash Flows: (Cash Inflow – Cash Outflow) / 12 months  Cash Inflow: Income  Cash Outflow: Expenses and loan repayments – –

Loan is what you take, repayments is what you pay (cash outflow) Therefore ‘Personal Loan’ and ‘Credit Card’ is not included in cash outflow.

Useful financial ratios:

 Net Worth Ratio What does it mean? – The Day family own approx. 70% of the assets that they have acquired. Lenders own 30%.

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 Liquidity ratio Compares “liquid”/short-term assets to short-term liabilities What you have in the short term to meet what you have to pay in the short term What does it mean? Shows % of assets available to cover current debt

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Basic Liquidity Ratio  Compares “liquid”/short-term assets to monthly expenses  Compares liquid assets (things close to being cash) to average monthly expenses What does it mean? No. of months you can pay expenses with no income

 Savings ratio  Money that isn’t spent

 Debt Ratio – Sometimes this is measured Total Debt/Total Assets – How much debt we have compared to income Disposable Income: This means how much “after tax” Sometimes we use “gross (before tax) income The size of the ratio is bigger if you use “after tax” So whether a debt ratio is high or low depends on what you are measuring

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Debt Service Ratio – Does not look at how much debt you have, but how much repayment you have – How much of our income goes to repaying the debt – How much debt and debt repayment goes to paying debts

Implementation and Coping Plans in Goal Setting

3 Criteria for operationalising savings goals – – –

What is included? How much are we aiming for? How are you going to save?

SMARTER Goals:       

Specific Measurable. Attainable Realistic (Relevant – What is the use of your goal?) Time-Bound Evaluate Re-evaluate

Planning Fallacy Underestimate time, costs and risks of future actions and Overestimate benefits results in time and cost overruns as well as benefit shortfalls.

Things to help check how real your goal is:    

Approval & support from those important to you - Importance of goal to you/partner/family Confidence in knowledge/understanding Confidence in your budgeting/planning ability Is goal achievable with the available resources? - Is goal achievable within timeframe outlined?

Implementation Plans: what, the why, the when, and the how of the planned action & how to handle identified obstacles Personal Financial Planning Action Plan Template Purpose: What, where, when, how are you going to achieve the goal Will help you in the case of procrastination

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Coping plans: If the progress is slow, then I will focus on the benefits I am gaining Coping Plan Template

Purpose: What am I going to do if I am falling behind? Reevaluate and bring us back to the main point

Quiz Questions Qn1. Which of the following would you be LEAST worried about? A high debt ratio and a high debt repayment ratio

Qn2. Which one of the following would NOT appear on Laura’s personal balance sheet (also called statement of financial position)? Interest received from a term deposit

Qn3. My Cash Flow Statement indicates that over the past year I have spent less than I earned. Which of the following is consistent with this? My assets have increased and my liabilities are the same compared with last year

Qn4. I have a large amount of liquid assets (e.g. cash) and small monthly expenses. Which of the following is correct given this? High Basic Liquidity Ratio

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Week 4: Too Much or Too Little Debt? What is Debt or Credit? Credit: I lend to people Debt: I borrow from people

Definition of Credit National Credit Code:

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Is provided if, under a contract: a) payment of a debt owed by one person (the debtor) to another (the credit provider) is deferred; or b) one person (the debtor) incurs a deferred debt to another (the credit provider).

MoneySmart: o

Borrowing money that is paid back over time with an extra charge (either interest or fees).

Includes credit/store cards, personal/car loans, home loans, overdrafts & borrowing to invest in residential property. It also includes taking out a consumer lease (for example, on a fridge or a computer) or buying things in instalments.

Is HECS/HELP loan a Debt? YES, but it’s different to most debts ... o

Difference: No interest

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Indexed to inflation though  In nominal terms debt increases annually  In real terms constant Key dates – 1 June (11-months old indexed)  Adjusted on this date according to the previous’ quarter’s inflation rate

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What has happened to the value of your HECS/HELP Debt? –

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Nominal balance will grow overtime, but the real value stays the same

Primary purpose of debt o

Smooth consumption   

Debt allows you to shift cash from future to the present Debt is your bargain with yourself that you value what you do with the money now is “worth” more than the value of what you could do with the money (repayment) later Debt illustrates that human capital is a real, valuable asset

Types of loans  Payday loan –

Small amount of money from your pay with very high interest rate over short period of time

 “Interest free” loan –

Allow you to buy gods or services now and pay for them later. You don’t have to pay for interest for a set of period.

 Credit card  Store card –

Credit cards issued by particular retail stores

 Consumer leases –

Allows you to hire an item for a period of time. Make regular rental payments until contract finishes. Not ownership

 Rent to buy –

A purchasing arrangement where you rent an item for a specific time. At the end of the rental period, you can continue to rent or buy it outright.

 Car loan –

Personal loan for the specific purpose of buying a used or new car

 Personal loan  Home loan  Consolidation loan –

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The loan to gather all sundry debts into one loan

But, can’t I change Secured andIsn’t Unsecured my mind? there a Loans cooling off period?

 Secured loans o Generally, o Security offered by borrower  

no Therefore usually lower interest rate  Limited E.g. home mortgage, home is security  circumst If borrower ancesfails to pay, lender can sell the asset owed and return the remaining cash, net of costs, to the borrower when a

cooling period  Unsecured loans will be o No asset pledged provided for small amounts with higher interest rates than for secured loans  Generally to is taking more risk, therefore higher interest cost  The lender consum ers Responsibilities of a Credit Provider  Exc Credit providers: Companies epti that offer a range of financial solutions to consumers. ons Responsibilities of a: Credit Provider Gy By law a credit provider must: m inquiries about your financial situation, requirements and objectives  Make reasonable me steps to verify your financial situation  Take reasonable mb  Decide whether the credit contract you are asking for is 'not unsuitable' for you ers  Do you think they will be optimistic/pessimistic on suitability? hip, doo o Credit Providers must r- have a licence BUT people who provides credit are exempted o “Such as retail to- stores and car yards. doo may be exempt, the actual credit provider must be licensed” o While the store r,the salesperson to identify the name in your credit contract or rental Ask  pho agreement neget a “Credit Guide”  And, etc.  Their licence number  Contact details Sal  Fees and charges esm  Details of your right to complain or a written contact details to access their an, reti External Dispute Resolution Scheme (EDR)

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rem ent villa ge, uns olici ted (10 day s) Not for

Written contract, fees and charges  

Credit contract must be in writing Common fees and charges – Monthly fee for having an account – Late payment fees – Missed payment fees – Fees for going over your credit limit – Establishment fees – Fees for refinancing

Other parties may have liability  Co-Borrowers Both responsible for the joint debt (common with home mortgages where the house is owned jointly)

 Guarantor Must pay if the borrower does not pay as they are guaranteeing the loan (encouraged with a wide variety of loans)

Credit Reports o o o

Somebody (lots of bodies) is (are) watching

 Collate information about YOU Credit reporting agency for credit providers Includes:  Personal info. (name, address, license number, date of birth, where you work)  When you applied for credit  Amount of money you wanted to borrow

A creditor may only report your debt if: – Credit score will be affected as a result.    

Delayed more than 60 days Payment more than $150, Written notification given – Asked in writing to pay the loan Borrower goes missing and uncontactable

 Utilities bill will not impact your credit report & score  

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Defaults 5 years, repayment history 2 years Repayment history (if > 14 days late)

Interest Rates: Price of Money o o o

If you save and receive 1% per month You would nominally receive 12 x 1% = 12% per annum But if you compounded your interest you’d have o o o

(Start with $1): (1 + .01 x 1) = 1.01^1 = $1.01 after 1 month Month 2: ($1.01) x (1.01) = 1.01^2 = $1.0201 Month 3: ($1.0201) x (1.01) = 1.01^3 = $1.030301

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Month 12: 1.01^12 = 1.1268, so interest over year is 12.68%

Nominal = Interest per period x Number of periods in year o Effective (EAR) = (1 + Interest per period) ^ (Number of periods in year) - 1

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(with compounding)

Example:

Calculation of interest on a loan

 Simple/Flat Interest Example Loan of $10,000 with flat interest rate of 12% over 5 years, yearly repaymen...