Finance Basics

Finance Basics

Assets – Liabilities = Net Worth

A wealth-creating asset is a possession that generally increases in value or provides a return, such as:

  • A savings account.
  • A retirement plan.
  • Stocks and bonds.
  • A house.

Some possessions (like your car, big-screen TV, boat and clothes) are assets, but they aren’t wealth-creating assets because they don’t earn money or rise in value. A new car drops in value the second it’s driven off the lot. A car is a tool that provides transportation, but it’s not a wealth-creating asset.

liability, also called debt, is money you owe, such as:

  • A home mortgage.
  • Credit card balances.
  • A car loan.
  • Hospital and other medical bills.
  • Student loans.

Net worth is the difference between your assets (what you own) and your liabilities (what you owe). Your net worth is your wealth.

BUDGET TO SAVE
SET FINANCIAL GOALS 

If you make a good income each year and spend it all, you are not getting wealthier. You are just living high.

Thomas J. Stanley and William D. Danko,
The Millionaire Next Door

Most people who have built wealth didn’t do so overnight. They got wealthy by setting goals and striving to reach them.

A personal wealth-creation strategy is based on specific goals. In preparing your goals:

  • Be realistic.
  • Establish time frames.
  • Devise a plan.
  • Be flexible; goals can change.

DEVELOP A BUDGET AND LIVE BY IT

When it comes to finances, people generally fall into the following groups. Where do you fit in? Planners control their financial affairs. They budget to save. Strugglers have trouble keeping their heads above rough financial waters. They find it difficult to budget to save. Deniers refuse to see that they’re in financial trouble. So they don’t see a need to budget to save. Impulsives seek immediate gratification. They spend today and let tomorrow take care of itself. They couldn’t care less about budgeting to save. A budget allows you to:

  • Understand where your money goes.
  • Ensure you don’t spend more than you make.
  • Find uses for your money that will increase your wealth.

To develop a budget, you need to:

  • Calculate your monthly income.
  • Track your daily expenses.
  • Determine how much you spend on monthly bills.

The Value of Assets

Wealth-creating assets are possessions that generally increase in value over time or provide a return. Depreciation is the decrease in an asset’s value over time. Items that wear out or have a falling price depreciate.

THREATS TO WEALTH-BUILDING ASSETS

Risk of default
If the institution or agency fails to repay the original amount of the investment, the entire amount can be lost.

Risk of falling market price
When the asset is bought and sold in an open market, the price can go down or up.

Risk of lost purchasing power
If savings do not grow more quickly than the rate of inflation, the saver is harmed.

Risk of liquidity
Can an investment be quickly or easily converted to cash by selling the asset?
Save and Invest

Take the power of compound interest seriously — and then save.

Dwight R. Lee and Richard B. McKenzie,
Getting Rich in America

You have budgeted and identified an amount to save monthly. Where are you going to put your savings? By investing, you put the money you save to work making more money and increasing your wealth. An investment is anything you acquire for future income or benefit. Investments increase by generating income (interest or dividends) or by growing (appreciating) in value. Income earned from your investments and any appreciation in the value of your investments increase your wealth.

There is an art to choosing ways to invest your savings. Good investments will make money; bad investments will cost money. Do your homework. Gather as much information as you can. Seek advice from personnel at your bank or other trained financial experts. Read newspapers, magazines and other publications. Identify credible information sources on the Internet. Join an investment club.

Compound interest helps you build wealth faster. Interest is paid on previously earned interest as well as on the original deposit or investment. For example, $5,000 deposited in a bank at 6 percent interest for a year earns $308 if the interest is compounded monthly. In just 5 years, the $5,000 will grow to $6,744.

UNDERSTAND THE RISK–EXPECTED RETURN RELATIONSHIP

An investment in knowledge always pays the best interest.
Benjamin Franklin

When you are saving and investing, the amount of expected return is based on the amount of risk you take with your money. Generally, the higher the risk of losing money, the higher the expected return. For less risk, an investor will expect a smaller return. For example, a savings account at a financial institution is fully insured by the Federal Deposit Insurance Corp. up to $250,000. The return—or interest paid on your savings—will generally be less than the expected return on other types of investments. On the other hand, an investment in a stock or bond is not insured. The money you invest may be lost or the value reduced if the investment doesn’t perform as expected.

HOW MUCH RISK DO YOU WANT TO TAKE?

Here are some things to think about when determining the amount of risk that best suits you.

Financial goals. How much money do you want to accumulate over a certain period of time? Your investment decisions should reflect your wealth-creation goals. Time horizon. How long can you leave your money invested? If you will need your money in one year, you may want to take less risk than you would if you won’t need your money for 20 years. Financial risk tolerance. Are you in a financial position to invest in riskier alternatives? You should take less risk if you cannot afford to lose your investment or have its value fall. Inflation risk. This reflects savings’ and investments’ sensitivity to the inflation rate. For example, while some investments such as a savings account have no risk of default, there is the risk that inflation will rise above the interest rate on the account. If the account earns 5 percent interest, inflation must remain lower than 5 percent a year for you to realize a profit.

TOOLS FOR SAVING

The simplest way to begin earning money on your savings is to open a savings account at a financial institution. You can take advantage of compound interest, with no risk. Financial institutions offer a variety of savings accounts, each of which pays a different interest rate.

TYPES OF SAVINGS ACCOUNTS

Savings account (in general)

  • Access your money at any time.
  • Earn interest.
  • Move money easily from one account to another.
  • Savings insured by the FDIC up to $250,000.

Money market account

  • Earn interest.
  • Pay no fees if you maintain a minimum balance.
  • May offer check-writing services.
  • Savings insured by the FDIC up to $250,000.

Certificate of deposit (CD)

  • Earn interest during the term (three months, six months, etc.).
  • Must leave the deposit in the account for the entire term to avoid an early withdrawal penalty.
  • Receive the principal and interest at the end of the term.
  • Savings insured by the FDIC up to $250,000.

Individual Development Accounts
In some communities, people whose income is below a certain level can open an individual development account (IDA) as part of a money-management program organized by a local nonprofit organization. IDAs are generally opened at a local bank. Deposits made by the IDA account holder are often matched by deposits from a foundation, government agency or other organization. IDAs can be used for buying a first home, paying for education or job training, or starting a small business. Training programs on budgeting, saving and managing credit are frequently part of IDA programs.

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