CHAPTER 1

Finance for Individuals

Personal finance and financial literacy forms the cornerstone of what you would like to do, how you want to live your life, and the broader business goals you might have. Understanding how finance works, the building blocks and foundational aspects of finance and financial literacy, and how to get a handle on your personal finances is an essential step in this process. The first part of this guide focuses on the different aspects and parts of personal finance, but it is important to understand that personal finance provides a platform for any budding entrepreneur. Whether you are simply trying to improve your personal finances, or looking to shore up your personal finances before launching your newest business idea, getting your personal finances right will only help.

Back to Basics

Before diving into some of the specific life events and concepts related to personal finance and financial health, it is a good idea to review some of the most oft-repeated concepts and terms linked to personal finance. Additionally, this provides us an opportunity to examine some of the tools and information that exist for individuals seeking to learn more about personal finance and improve their financial health and well-being.

Credit Score—Your credit score is arguably one of the most important pieces of financial information about you as an individual, but what exactly is it, and what does it represent?

The most commonly used credit score is known as the FICO score, which is a proprietary tool created by the Fair Isaac Corporation. Due to the proprietary nature of the calculation the exact formula is not revealed, but according to publicly available information, the calculation consists of the five major categories listed below:

As you can see, a credit score is a combination of multiple factors that are used to assess and document both your credit history as well as your potential for paying down amounts borrowed in the future. Knowing is half the battle, as the saying goes, and being aware of the factors taken into account when your credit score is being calculated will help you manage your credit habits to help you get the highest score possible. As noted above, one of the factors weighted into the calculation of your credit score is the amount owed on the credit cards; paying down credit card is one of the healthiest things you can do for yourself with regard to improving your credit profile and score. Like many things, however, there are multiple points of view related to the most effective and efficient way to accomplish this goal. One of the most commonly debated items is whether or not to pay down credit cards bills with the highest outstanding balance or credit card bills with the highest interest rate; both methods have merit depending on the specifics of your situation. There are benefits to both methods, and depending on your personal financial situation you may benefit from one approach over another.

Paying down credit card debt with the highest amount owed will obviously reduce the amounts you owe as well as improving your payment history and track record. Proceeding with this approach will also involve building a budget to pay down the credit card in a timely manner; simply making minimum payments will not get you out from under credit card debt in a timely manner. Conversely, and especially if you have one or two credit cards with interest rates much higher than your other cards, it might be advisable to pay down those individual balances before paying down balances not linked with higher rates.

Every dollar paid in interest represents dollars that are not being applied to pay down the principal owed on your credit cards. Interest payments can be one of the most costly personal finance items to overlook; these dollars do not reduce the amount you have to pay back and deny you the use of those funds for other activities or uses. Funds that are used to make interest payments are funds that are not available for other investments, educational opportunities, or other endeavors you are interested in participating in. Einstein is thought to have said compound interest is the 8^th wonder of the world—don’t let it work against you!

Monthly Payments versus Total Cost—An old piece of financial advice is that commercial lenders and creditors tell people not to worry about the total cost or total price of the product they are buying, and to only worry about the monthly payments they will have to make. Monthly payments can quietly become part of your subconscious routine so that you do not even fully realize the drain that these monthly payments have on your financial health and flexibility. Purchasing big-ticket items, putting these items on credit, and signing up for additional monthly payments can eventually create a wall of payments (and cash outflows) that severely restrict your financial flexibility. One recommended step is to put together a list of all of your non-optional monthly payments (items like utilities are usually not optional in nature) to get a more accurate picture of how much money you are actually spending each month. A key aspect of financial well-being and financial wellness is the flexibility to embrace your life and activities as you would see fit.

Interest—Interest, by default, increases the total amount that must be paid back over the life loan; this is not necessarily always a bad thing. Particularly on loans that are longer in length, such as student, auto, and mortgage loans, the interest rate can have a dramatic effect on the total dollars you actually pay back. In addition to increasing the total amount that you must pay back over time, it is always important to keep in mind that every dollar that is repaid in interest has no impact on the principal amount you must pay back when the loan term ends. Whenever possible, and it usually is open to at least a brief discussion, advocate and push for lower interest rates.

On the other hand, if you are attempting to save funds and increase the total amount of investment through accumulation of interest, and an increase in principal, higher interest rates will be of benefit to you. Anybody who has taken a look at the interest rates on saving accounts or fixed income items in the last decade or so is surely to have noticed the rates paid are extremely low. This once again goes to show that it is important to understand both the terms themselves and the effect such terminology will have on your personal finances, including interest and the flipside of interest—inflation.

Inflation—Inflation is a term that is bantered around incessantly online, on business television networks, as well as in print media, but what exactly is it and what does it mean for you? Cracking open an economics textbook will probably generate a definition that goes something like this

Put another way, inflation is an occurrence that reduces the value of what your dollars can buy in the future versus what your dollars can purchase today, that is, you would have to earn or have more money to buy the same amount of products or services in the future versus the present. While some economic policy makers look to some inflation as healthy, and tout deflation (the opposite of inflation) as a financial enemy, it is important to keep in mind the effect these terms and concepts have on your personal finances. On an individual basis, products and services that cost less year over year enable you to buy more of them (think DVD players or flat-screen TVs), whereas inflation means that certain items and/or services have become more expensive (think cars, rent, and college tuition). When discussing or analyzing personal finance or finance at large (including inflation) it is always important to keep this following concept in mind:

But more on that in the coming pages ... back to the good stuff!

Assets and Liabilities

Assets and liabilities are financial terms that almost everyone has heard of, in one context or another. Businesses have assets and liabilities on what is called the balance sheet, or in the case of operations managed as not for profit entities, the change in net assets. Assets represent future economic benefits, and liabilities represent future economic detriments. Definitions presented in some textbooks, and definitions used by many people (who assume they are correct) might vary from these, but I feel these definitions are most accurate for the following reasons. Businesses and individuals acquire assets for one of several reasons, but the underlying motivation is that having this asset will improve either performance or quality of life down the road = a future economic benefit. Liabilities, conversely, represent funds or items that you have gained the usage of in the present without fully paying for; you will owe this money in the future = an economic detriment in the future.

Stocks (Equities)—Media outlets such as CNBC and Bloomberg dominate the airwaves and online news space with daily coverage of stock markets around the world. Jam-packed with graphs of all shapes and sizes, market commentary, and analyst predictions these media organizations generate their revenues by attracting viewers to watch their coverage of market events. Via analysts in suits, celebrity appearances, and whirlwind of cuts to reporters on the ground and the end result is fast-moving vortex of financial information and data. But, at the end of the day, what exactly is a stock and how should it factor into your personal financial plan? Does this whirlwind and constant activity have anything to do with the core topics and information that truly impact your personal finances?

First and foremost, we are taking the time to cover this topic because everyone who has a retirement plan is a stock market investor. Whether it is a pension, 401(k), 403(b), or some other type of retirement setup, virtually all retirement funds invest heavily in stocks. Second, and arguably more importantly, the price of a stock can have very little to do with the actual performance of the organization. Investopedia represents a great resource for anyone looking to learn more about financial terminology, and what it actually means for them—I can’t tell you how much this site helped me in college! Third, and perhaps most importantly, is what the ownership of a share of stock actually represents. Stock ownership represents fractional ownership of the organization, meaning that shareholders are the actual bosses of the organization:

Hundreds of books have been dedicated to the concepts of stock market investing, and how best to do so, but for the vast majority of people the most appropriate route to take might be to invest in index funds. These financial tools mirror the performance of the market they are designed to emulate, and you are spared the work! Additionally, many index funds charge lower fees than either you yourself would incur from buying and selling individual stocks, or from putting your money to work with an active money manager. Regarding investing in stocks, or bonds (which are up next), you must always keep the following rule in mind:

Dividends—Dividends are, in this author’s humble opinion, one of the best aspects of owning stocks—whether you decide to purchase individual securities or invest in an index or other sort of aggregation of individual equities. There are three dates—date of declaration, date of record, and date of payment—that are always important to remember with dividends, but only one really matters to you as the stock holder is the date of record. This date, the date of record, determines who will actually receive the dividend payment; regardless of who actually owns the shares at the time of payment. Usually paid in the form of cash, dividends are, in essence, cash payments that owners of shares receive simply because they own the shares. If this sounds like a good deal that’s because it is. One caveat to keep in mind, however, is that dividend income is taxed like regular income.

Bonds—If stocks represent ownership of an organization then bonds represent a possible less volatile way to invest some money, as these instruments represent amounts that creditors and other lenders have lent to the organization to fund growth, capital expenditures, and other organizational objectives. Bonds can be issued for terms varying between 5, 10, 20, and even longer durations; this means that owners must be compensated for the lack of availability of their funds. Compensation in terms of bonds typically has two forms; the return of the original principal as well as interest payments received on a periodic basis. Bonds are repaid at the maturity date identified on the instrument when it is first issued, that is, the original face value of the bond is repaid in full. Additionally, and of greater interest to your personal finances, is the interest income that you can generate from owning bonds.

529 plan—A 529 savings plan is a savings plan that takes advantage of specific section of the tax code (hence the 529) to assist people savings funds for college education. The rules and restrictions can vary from state to state regarding contributions, deductions, and whether funds contributed can be used for nonspecific education items. Numerous online resources are available to answer some of the most common questions related to these plans, and links to resources you can use to find out the rules applicable to your state.

401k—The 401k is probably one of the most oft-discussed financial terms and plans, but it is also one of the most commonly misunderstood and misinterpreted financial terms. Mirroring the origin of the 529 college savings plans, the 401k system takes advantage of a section of the tax code that specifically outlines both the benefits and disadvantages of utilizing a 401k savings plan instituted by your organization. In essence, what the 401k plan is a matching plan between you and your employer that contributed a pre-set amount (determined by you), that is deducted out of your paycheck and allocated to funds that you have selected. Usually the amount that is deducted from your paycheck is expressed as a percentage—let’s say 3 percent of your paycheck amount.

The pre-tax deduction of these funds is an important characteristic of this savings plan; 3 percent of your pre-tax earnings is obviously going to be higher than 3 percent of your earnings after taxes have been taken out. Additionally, many employers will match your contributions up to a certain level, that is, your employer will match your contributions, $0.50 on the dollar, up to 6 percent of your pre-tax check amount. To put it another way, you are getting a risk-free return of 50 percent on the money you are putting away into your 401k if you are contributing the full amount; this totals 9 percent of your pre-tax earnings being saved with every paycheck. Throw in the fact that this is automated and you do not have to manually do it every month, and the 401k system is a solid way to start (and continue over time) to save for retirement.

Now, it is important to keep in mind that there are some restrictions when it comes to the amounts that have contributed to this retirement savings plans. Funds normally cannot be withdrawn from the account before the contributor (you) has reached the age of 59.5 years old (don’t ask why it’s 59 and a half years), and the funds are taxed as they are withdrawn. Remember that while the funds were contributed (and grew) over time without any taxes being withdrawn the tax man does eventually collect his share of proceeds. Always consult with your employer regarding the specifics of your organizations 401k plans, investing options, and institutions that your organization has partnered with to manage the fund.

Fees—Fees are an especially important aspect to monitor when examining different fund options. While at first glance, fees of 3 to 4 percent on your investment amounts might not seem like a large amount, the effect of 3 to 4 percent fees compounded year over year can have a severe effect on how much money you are able to save over time. This harsh reality also has had the effect of helping to promote the spread of index funds, which differentiate themselves based on low fees, and other alternative investing strategies. I cannot overstate the importance of paying attention to exactly how much you are paying in fees, as every dollar you pay in fees represents dollars you will never get to save, invest, and use in the future.