AFN 221 Personal Finance Savings PDF

AFN 221 Personal Finance Lecture Topic: Savings Andreas Milidonis Department of Accounting & Finance University of Cyprus Email: Andreas.Mi...

AFN 221 Personal Finance Lecture Topic: Savings Andreas Milidonis Department of Accounting & Finance University of Cyprus Email: [email protected] 1 “Concept Map” for the Course Introduction Interest Rates Inflation & Time Money Management Savings Consumer Borrowing (Credit) Review & Midterm Exam Mortgage Insurance & Risk Investing Management Retirement Risk & Return Biases Review & Final Exam 2 2  Learning Objectives Types and uses of financial services. Factors affecting financial services. Assess the costs and benefits of various savings plans. Identify the factors used to evaluate different savings plans. Evaluate the costs and benefits of different types of payment accounts. Saving for college, house and other financial goals. 3 3 Financial Services for Financial Planning Analyze factors that influence the selection and use of financial services. – In recent years, banking activities have moved: from standing in line for a teller…to using a smartphone app. from writing a check…to transmitting money with a mobile payment system. from sending in a deposit by mail…to clicking a picture for a remote check deposit. from obtaining a loan from a bank…to borrowing from a peer-to- peer lender (not yet in Cyprus). 4 4  Managing Daily Money Needs – Buying groceries, paying the rent, and completing other routine spending activities require a cash management plan – Cash, check, credit card, debit card, and online/mobile transfer are the most common payment choices – When you need more cash than you have available, you either liquidate savings or borrow Using savings or borrowing reduces your net worth 5 5 Mistakes Made Frequently – Mistakes made frequently in managing current cash needs include… Overspending from impulse buying and using credit Not having enough liquid assets to pay current bills Using savings or borrowing to pay for current living expenses Failing to put unneeded funds in an interest-earning savings account or investment program 6 6  Types of Financial Services – Savings Time deposits, savings accounts and certificates of deposit (CD’s) – Cash Availability and Payment Services Demand deposits, checking accounts and other payment methods – Borrowing for the short-term or long-term – Investments and Other Financial Services Insurance, investment, real estate purchases, tax assistance, and financial planning 7 7 Asset Management Account Asset management account ⎼ Also called a cash management account or a wealth management account ⎼ All-purpose account offered by investment brokers and financial institutions 8 8  Financial Service Activities Through a Smartphone – Banking using text messages, mobile web banking, or banking apps 9 9 Online and Mobile Banking – Benefits of convenience and saving time along with instant information access – Concerns of privacy, security of data, ease of overspending, costly fees, and online scams must also be considered – Traditional Electronic Banking Automatic teller machine (ATM; also called a cash machine) offers various transactions Debit card (or cash card) used to make purchases with your own funds 10 10  Opportunity Costs of Financial Services – Higher returns for long-term savings may be obtained at the cost of low liquidity (inability to obtain your money quickly) – Convenience of nearby ATMs come at a price – they typically charge high service fees – The “no-fee” checking account with a $500 non-interest-earning minimum balance means lost interest earnings 11 11 Financial Services and Economic Conditions – Changing interest rates, rising consumer prices, and other economic factors influence financial services – Be aware of current trends and future prospects for interest rates – Read The Financial Times, Wall Street Journal, business periodicals such as Bloomberg Businessweek, Forbes, Fortune, and other online finance sources. => You can get free subscriptions to some of these, if you create an account with your UCY email address. 12 12  Changing Interest Rates Changing interest rates and decisions related to financial services… 13 13 Financial Institutions Compare the types of financial institutions. DEPOSIT INSTITUTIONS – Commercial Banks Offers a full range of services including checking, savings, lending, and other services Organized as corporations – Credit Unions Are user-owned, nonprofit, cooperative financial institutions Annual banking studies report lower fees and lower loan rates with higher satisfaction levels compared to other financial institutions 14 14  Other Financial Institutions (1 of 2) – Life Insurance Companies Provides financial security for dependents Offers insurance plus savings and investment features; recently expanded to offer investment and retirement planning – Investment Companies Are also referred to as Mutual Funds Offer a money market fund, which is a combination savings- investment plan, on which you can write a limited number of checks Accounts are not covered by federal deposit insurance 15 15 Other Financial Institutions (2 of 2) – Mortgage Companies Provide loans to customers to purchase homes – Other Financial Service Providers Includes retailers, Internet banks, and P2P lending networks 16 16  Savings Plans Assess the costs and benefits of various savings plans. REGULAR SAVINGS ACCOUNTS – Usually involve a low or no minimum balance – Credit unions call them share accounts 17 17 Certificates of Deposit ⎼ A CD is a savings plan that requires you to leave your money on deposit for a set time period, otherwise you incur early withdrawal penalties Several types to chose from Consider all the earnings and all the costs before saving with a CD Consider creating a CD portfolio with CDs maturing at different times (3-month, 6-month, 1-year, 2-year) Review current information about CD rates 18 18  Money Market Accounts and Funds ⎼ A money market account is a savings account that requires a minimum balance and has earnings based on market interest rates ⎼ Money market accounts at banks and credit unions are covered by federal deposit insurance This is not true of money market funds, which are a product of investment companies 19 19 Evaluating Savings Plans Identify the factors used to evaluate different savings plans. 20 20  Rate of Return – Percentage or yield is the increase in value of your savings from earned interest – Example: a $100 savings account that earned $3 has a yield of 3 percent ($3/$100) – Compounding refers to interest that is earned on “previously earned interest” More frequent compounding means the higher your rate of return 21 21 Annual Percentage Yield – Annual Percentage Yield (APY) as the percentage rate a saver should expect to earn Formula to calculate the APY = (100) × (Interest/Principal) NOTE: Formula is applicable when the number of days in the term is 365 or when the account does not have a stated maturity  Example: Interest of $66 on principal of $1,200 =(100) × ($66/$1,200) = 5.5% (APY) 22 22  Inflation and Tax Considerations INFLATION – Compare your savings rate with inflation rate – If inflation rate is higher than savings rate, then savers will experience loss in buying power TAX CONSIDERATIONS – Taxes reduce interest earned on savings – Taxes are not withheld from savings and investments; you may owe additional taxes at year-end as a result of earnings on saving 23 23 After-Tax Savings Rate of Return 24 24  Liquidity and Safety LIQUIDITY – Allows you to withdraw your money on short notice without a loss of principal or fees – With certain types of savings accounts, early withdrawal penalty may be loss of interest or lower earnings rate SAFETY – If a financial institution fails, then your savings up to 100,000 euros per person per financial institution are insured by the state (Cyprus). – This is called deposit insurance. 25 25 Restrictions and Fees Evaluate the costs and benefits of different types of payment accounts. ⎼ Banks may charge additional fees such as: a monthly maintenance fee for low-balance accounts an inactivity fee if no deposits or withdrawals occur for 6 to 24 months, depending on the bank a transaction fee for more than six withdrawals during a month a transfer fee by online banks for outgoing payments a wire-transfer fee 26 26  Evaluating Checking Accounts Need to be evaluated based on: – Restrictions – Fees and charges – Interest Interest rate, compounding method, and interest computation Minimum deposit to earn interest or avoid a service charge – Special services such as overdraft protection and online access to view and print checks that have been paid 27 27 Checking account – Writing Checks ⎼ Before writing a check, record in your check register and deduct amount from your balance ⎼ Proper check writing steps: 1. Record the date 2. Write the recipient’s name 3. Record the amount in numbers 4. Write the amount in words 5. Sign the check 6. Note the reason for payment ⎼ A stop-payment order may be necessary if a check is lost or stolen 28 28  Reconciling Your Checking Account – Used to compare the bank’s balance and your checkbook balance – Reasons for differences a. Interest earned b. Checks that have not cleared c. Deposits not yet received by bank 29 29 Payment Methods – Bank check Personal check linked to your current account – Certified check Personal check with guaranteed payment Amount deducted from your balance when bank certifies the check – Cashier’s check Check from a bank you get by paying the amount of the check plus a fee – Money order Purchase at financial institution, post office, store – Money transfer services Fast, convenient, and safe method to send money around the world Examples: MoneyGram, TransferWise, Western Union, and Xoom – Traveler’s check Sign each check twice Electronic traveler’s checks — prepaid travel card used when visiting other nations 30 30  Saving for a college education A child’s college education can be a significant expense. To ensure that you are able to meet the expense, plan ahead.  We already showed the power of interest compounding. To save for your child’s education in the US you will need about $200,000. One way to do it is to set aside about $80,000 when they are born.  But for many, it is hard to come up with $80,000 at any given moment (especially with all the other expenses new children bring!). It is more manageable to save a little bit each year.  If you invest in a combination of stock and bonds that you expect to earn 5% each year, you could save for your child’s education by saving $7,109 at the end of each year.  Or, if you’d prefer to start today, you can save $6,771 at the beginning of each year, starting today. 31 31 Saving for a college education Let’s see how to compute the necessary end-of-year contributions (you will do this in AFN 222) This problem has the following cash flow structure: FV = $200,000 PV = 0 PMT=? PMT=? … PMT=? PMT=? Year 1 Year 2 … Year 17 Year18 Interest Rate = 5%, Frequency = 1 Where the payment can be solved for using a financial calculator: Time Value of Money P/Y 1 PV $0 N 18 FV $200,000 I/Y 5% PMT= -$7,109.24 32 32  Saving for a college education Now let’s see how to calculate the required contributions when they are made at the beginning of the year. If instead of saving money at the end of year you do it at the beginning of the year, then Time Value of Money BGN BGN P/Y 1 PV $0 N 18 FV $200,000 I/Y 5% PMT= -$6,770.71 It only costs $6,771 per year instead of $7,109 if you contribute at the beginning of each year. This is because, when you contribute earlier, each contribution gets an extra year’s interest! 33 33 Saving for a down payment Even with a mortgage, homebuyers may still need to accumulate savings to meet their down payment, and this may require several years worth of savings.  To make a 20% down payment on a $400,000 house, a homebuyer will need 0.20 ∗ $400,000 = $80,000.  If the homebuyer sets aside $1,250 each month in a savings account earning 3%, it will take about five years to accumulate the necessary savings.  Or, if the homebuyer wants to have enough to make the down payment in 3 years, he must set aside $2,126.5 a month for three years. 34 34  Summary What factors affect the selection and use of financial services. Typical mistakes people make The impact of online banking (made stronger through the coronavirus) Different types of financial institutions Different types of saving plans offered The relation between tax and savings Payment methods Example using education financing 35 35