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Here are some ideas about personal finance for Econ 101 students. All of the items referenced use nontechnical language and are intended for a general audience. Ralph Phillips is a financial planner who offers a similar website. The Wall Street Journal Guide to Understanding Personal Finance by Kenneth M. Morris, Alan M. Siegel (1997, $11.96 at www.amazon.com) is an easy to read book on similar themes.
The Econ 101 Guide to Personal Finance
First, take stock of one's expected monthly income for the period just ahead. Then, design a plan for expenditures that will allow one to live within one's income. Design a budget that will give a good chance of assuring that one can survive the period. In fact, it is best to plan to spend somewhat less than one's income so as to provide a cushion for the unexpected and a start on a savings program.Budget
Making a commitment to live within one's means gives one control. One is more likely to do those things that are most important when one has sacrificed less important things to make it possible. Failure to live within ones' means may reveal itself as an accumulation of unpaid bills, a growing outstanding balance on a credit card, and bounced checks (checks written for amounts of money that are larger than the balance in the account). Each of these problems is costly. Banks charge hefty fees for overdrafts, credit card companies charge significant rates of interest for outstanding debt. Failure to pay creditors on time may make services difficult to get in the future. Banks and other creditors make money on the significant fees they charge for persons whose finances are out of control. Your future options narrow rapidly. Staying in control gives you more options.
A classic way to maintain control is to simply work with cash. Put one's cash in a shoe box in a safe place. Create envelopes for each major expenditure item for the month ahead, and put the necessary amount in each. Spend at most for each item what you have put in the envelope. Even when you use credit cards and checking accounts, thinking of the discipline of a pure cash system as a metaphor for control may help prevent problems.
A pure cash system is cumbersome because many bills are more easily paid through the mail and so checks are useful. Some telephone and Internet transactions are most convenient by credit card. Moreover, keeping cash is often unsafe, cash is more easily lost or stolen than money in banks and credit cards.
Checking Account
So, a second step is to open a checking account at a bank. Typically, one will want to use a bank with convenient local offices and automatic teller machines. By establishing a bank account, one can avoid making large transactions in cash. Checks provide a permanent record, a proof of payment that may be useful in paying taxes, rent, and utilities and in completing transactions by mail. (Never send cash by mail because you have no proof of payment.) Checks from a local bank with printed name, address, and telephone number are more readily accepted at local merchants. Managing a checking account so as to maintain a positive balance is a start on building a record of financial responsibility.
Banks do charge different rates for checking accounts, so shopping for an account may be worthwhile. Typically, banks will offer a budget checking account for a monthly fee of about $10. A deposit of less than $100 may open the account. A charge per check may apply if one writes more than, say, 10 checks per month. If one generally writes more checks than can be written without charge with the budget account, an account that requires a minimum balance may be better. With a minimum balance of $1,000, some banks may pay interest on the balance and allow unlimited check writing. The bank may also offer a no fee credit card.
If one earns income, inquire of one's employer about having the income deposited electronically directly into one's checking account. The automatic deposit will typically appear in the checking account more quickly than one can receive a physical paycheck and deposit it. Automatic deposit is also safer. If one establishes automatic deposit, ask the bank for a lower rate on the checking account.
Credit Card
Third, get a credit card but charge only an amount that you will pay off each month in full. A credit card is often more convenient and safer than using cash or a check. Get a credit card with no annual fee so that it costs nothing. Avoid financial charges by paying off the full amount on the card each month. By using a credit card at a modest rate, you will build a record of paying bills on time that will make it easier to borrow money for a car or house later.
Do not charge more to the credit card than you can pay off immediately because the finance charges are substantial. If you must borrow money, find the least cost way of borrowing money, not a credit card. Do not use the credit card to draw cash against the credit card or write checks against the credit card account. There is a charge of a few dollars for each such cash transaction, making it an expensive way to borrow money.
Occasionally, a Vanderbilt student will accept one of the many offers of a credit card and charge expenditures against the card account to the maximum allowed, say $3,000. The monthly interest payment on this balance might be $45 with ten percent of the outstanding balance due. Getting a bill for $345 with significant financial penalties for non-payment is a significant challenge for a person with no income.
One of the core ideas in Econ 101 is the notion optimizing expenditures within a budget constraint. Given some income and control of spending, you are ready to move to phase two, a concern for the longer run.
To understand one's finances in the longer run, good record keeping is essential. Get control of your current situation by developing a system for keeping good records of your income, expenses, assets, and liabilities.The Quicken software from Intuit allows one to keep track of one's financial position. (See www.quicken.com for financial information as well as information about the software.) It will produce an income statement and a statement of net worth. (We have discussed these in Econ 101.) Produce and consider these financial statements at least annually. One can use Quicken to keep track of checking and investment accounts as well as other assets and liabilities. It supports a budget function and is useful in preparing income taxes. Microsoft's Money is a similar product that also gets good reviews.
The record keeping software requires that you enter each transaction in a form like that used in writing a check. Establish categories of expenditures like food, entertainment, rent, automobile, and the like. The software will then generate reports that summarize expenditures by category. Identify items that may be deductible for income taxes and the software will generate a list of them when you get ready to file you tax return. Record each item of income received and the software will track your income and expenses over time. Enter information about your investments and debt, and the software will generate statements of net worth and help track investment performance over time. BA 200 Accounting discusses issues of record keeping in depth.
In order to achieve one's lifetime goals, financial planning can be extremely important. Planning includes thinking about the following issues:
- consuming now versus saving for the future.
- choosing a portfolio of different assets in which to store one's savings.
- deciding when to purchase a home.
- deciding when to have children.
- deciding how to pay for your children's education.
- deciding when to retire and how much income one wants to have during retirement.
- how much insurance may be appropriate.
- how much one may wish to leave as a bequest .
- anticipating what taxes may be required.
Price Waterhouse publishes a Personal Financial Advisor that gives a more detailed discussion of planning issues.
Quicken offers planning tools that allow one to establish assumptions and make forecasts. One can explore the cost of loans, the amount of saving required to accumulate wealth for education, housing, or retirement. To build wealth, one must consume less than one's income. To build wealth rapidly, consume much less than one's income.
To build wealth, choose less expensive housing and cars, and postpone big ticket purchases. Read The Millionaire Next Door : The Surprising Secrets of America's Wealthy by William D. Danko and Thomas J. Stanley, Ph. D. (1996, $15.40 at Amazon.com) to learn more about the spending behavior of wealthy people. Many have wealth because they avoid conspicuous consumption.
Lifecycle
Think of how your financial position will change over your life. Many occupations involve lower income at the outset with a substantial likelihood of rapid increases to age 50. After age 60, expect earnings to decrease. Major expenses are for education, housing, and retirement. With retirement in one's late 60s or early 70s, one can expect to live another 15 to 25 years. One might anticipate the timing of major expenditures and accumulate wealth accordingly. Many people establish separate accounts for each major purpose and there may be advantages under the income tax in doing so. Each account then represents a commitment to a specific goal and so keeps goals in focus. One can treat all the accounts taken together as a portfolio and adjust the aggregate portfolio mix for risk and return.
Here is an illustration of the importance of planning ahead and sustaining savings over a longer period of time. If one saved $300 per month for 25 years and earned 7.5 percent interest annually, one would accumulate a balance of about $263,000 (ignoring taxes). If one wanted to achieve the same amount of wealth by saving for only 15 years, one would need to save nearly $800 per month. Saving less per period for a longer period of time is more effective than saving at a higher rate for a shorter period of time because the amounts held longer earn more interest. Moreover, the interest earns interest (this is called compounding) and so the balance grows more, the longer it remained invested. The lesson: to accumulate more wealth, start early and save steadily. The tortoise beats the hare. The financial functions in a spreadsheet or the planning tools in Quicken will allow one to make comparisons of this sort for oneself.
Savings
Let's use this idea to consider the rate of saving needed for retirement. Suppose one plans to retire at age 70 and could expect to live to age 95 with income from personal, private savings of $30,000 per year in dollars of current purchasing power. Assume social security benefits are on top of this. Assume that invested funds earn four percent per year after inflation (a conservative assumption). One will need to accumulate $470,000 by age 70 in order to pay out $30,000 per year for 25 years. (One will probably buy an annuity from an insurance company that will guarantee to pay an amount per month for life, regardless of how long one lives.)
If one starts saving at age 23, one need save only $300 per month to reach a balance of $470,000 at age 70 (in dollars of constant purchasing power). Starting at age 33, one need save $480 per month, starting at age 43 one need save $840 per month, starting at age 53, one need save $1,660 per month, and starting at age 63, one need save $5,000 per month in order to accumulate $470,000 in dollars of constant purchasing power at age 70.
So the lessons for financial planning are start early, save steadily, make conservative assumptions, and use readily available software to set your own long term goals and identify the current actions necessary to meet them.
Working for money over a life time accumulates to a career. Choices earlier in time influence results later in time and so one will want to think ahead. For many jobs, committing a longer period of time yields higher incomes through raises and promotions. The employer gains more knowledge of what a worker can do and the worker gains more skills. The accumulation of knowledge and skills continues longer in some occupations than others and so one will want to consider the probable lifetime earnings profile for a person like yourself in a specific occupation. Econ 212 Labor Economics and Econ 251 Wage, Employment, and Labor Markets discuss earnings and jobs extensively.Building Skills
Some skills are general skills and one will generally have to pay for these. Tuition for formal schooling and internships at low rates of pay are examples. Medical residents work for modest incomes for a number of years while they pursue board certification in a specialty. Law clerks with judges may volunteer or work for low pay to gain skill.
Some skills are specific to an industry. A worker may gain experience with one employer that other employers in that industry will be willing to pay for. Workers may move between firms in a given industry. For example, newspaper editors may move from one newspaper to another as they are ready for more responsibility.
Some skills and knowledge are specific to a given employer, for example, knowledge of the firm's product and its customers. Other firms may see no reason to pay for this specific knowledge and so the payoff on investment in firm specific knowledge depends on the firm's own internal compensation policies. Some firms follow a strict seniority rule in awarding raises. Others reward merit. Some offer internal career ladders and promote higher performing employees to more responsible and better paid positions. JobSmart provides summary salary information for specific occupations.
Incentive Compensation
The likely pattern of compensation then varies widely by type of occupation and from employer to employer. Call one extreme the civil service job. The rate of pay is rigidly defined by a formal job description and the number of years one is on the job. Those who are more effective, invest in building more skill, and are more conscientious in the performance of their duties are paid the same as those who are just effective enough to continue to hold the job. Promotion may be unattractive because it means doing a different kind of work, say, supervising others. Public school teaching is a classic example of a civil service pay scheme.
Self employment is a pole apart from the civil service regime. The self employed person reaps all of the rewards of their own effort. The added benefits from investment in job skills, extra attention to a client, and a few more hours of effort accrue exclusively to the self employed. No supervisor makes a judgment about a merit raise or promotion. Of course, the self employed incur substantial risks. They must perform adequately at marketing and finance (or at least effectively contract for these services) in order to sustain their productive activity. Promotional activities that may come naturally at age 28 may be less satisfying at age 48, yet remain as important to the success of the venture.
Between the civil service job and the self employed lie a range of jobs with varying compensation schemes. Close to the self employed is piece rate work. A home knitter is paid by the garments produced, the taxi driver is paid by the amount of fares, a physician or lawyer may be paid, in part, by a fraction of the gross client billings with overhead costs essentially be charged in a direct, visible way. The worker then has a strong, personal incentive to produce.
Where teamwork is important, compensation by the piece fails because a worker will have an incentive to undercut other workers to increase personal pay. So, employers seek to reward the performance of the team. The product management team that successfully increases sales and profits for a specific product may get a significant bonus. Firms may provide shares of company stock to managers so that they have an incentive to seek increases in company profit. In worker managed firms, all of the employees may own shares of the company stock so that every employee has a stake. Of course, when the number of employees in the team is large, the individual action of each employee will have too small an effect on the value of the stock to have much influence on behavior. (Note as well that when employers are owners the return on their wealth may be highly correlated with the return on their labor. If the company fails, they lose both job and wealth. We can think of the choice of employer as part of one's portfolio diversification. As a potential employee/owner one should discount the value of the investment in the company for its increased personal risk.)
Tournaments
There are jobs that provide even more heightened incentives than self employment, call these tournaments. In a golf tournament or horse race, the highest pay goes to the winner, and nearly all of the pay goes to the top few finishers. It is not enough simply to play the game, one must perform ahead of the others. When relative position matters in compensation, there are winners and losers and so the incentive for performance is even more intense than for self-employed or piece rate worker. Tournament jobs are found beyond sports. A number of professions involve an element of the tournament. Law firms may hire many more new JDs than they expect to become partners. Associates must make partner or leave (an up-or-out promotion policy) within a given number of years (typically four to eight years, it varies by city). Although the compensation of partners varies from firm to firm, in some firms partners receive a share of the profits of the firm for life. The consulting and financial services industries also have jobs with significant elements of tournaments. Tenure for university faculty is an up-or-out tournament. Contract production in agriculture sometimes has tournament features as well. Contractors whose livestock show more in weight gain per kilocalorie of feed, relative to other producers, get bonuses.
Career path decisions involve calculations for a life time. One may invest in skills through education or on the job that will provide pay off in various ways in future years. One will think about how one responds to incentives. If heightened pressure improves performance, then jobs with tournament compensation schemes may be preferred. If heightened pressure is debilitating, avoid tournaments.
Intrinsic Rewards
Careers also offer rewards other than monetary. When Picasso hung a bicycle seat point downward on a wall with handlebars above it, U-shaped with handholds outward, he called it "Toro". Did he sell the sculpture, give it to a friend, or keep it for himself? Was he motivated by a fee, friendship, or the notion that "Toro" should hang in a Paris museum (which it does)? Perhaps the answer is equally likely to be: d. none of the above as: e. all of the above, for Picasso would refuse to answer such a silly question. He made art because he loved it. Many people find art in their careers and choose careers because they enjoy the work. Occupations define us perhaps as much as family and schooling, so we look for intrinsic rewards in careers as well as monetary rewards. Often careers with high intrinsic rewards offer lower monetary rewards, but Picasso did quite well financially. Just to give the other extreme, Van Gogh sold only one of his more than 800 paintings during his 37 year lifetime.
Extrinsic Rewards
Careers also offer extrinsic rewards. When we think of the great figures of the 20th century, perhaps Ford, Roosevelt, and Gates come to mind. They made a mark on our civilization that transcends their (ample) financial reward. Careers afford an opportunity to make a difference for our civilization. Soldiers in time of war, physicians in an epidemic, teachers in shaping a future generation, entertainers for the fun and contribution to our vocabulary ("Here's looking at you, kid"), scientists for the new knowledge they reveal, each offers a career with a public dimension. Occupations and employers that fill obviously beneficial roles are more appealing, for example, Johnson & Johnson, the Band-Aid company, and Proctor and Gamble, the soap company. Examples of the opposite make the case: Dow Chemical took several decades to overcome its association with the production of napalm used in the Vietnam War. The tobacco industry will have difficulty hiring workers after 1997 because of the shift from the notion of selling pleasure to selling poison. The extrinsic rewards have dropped sharply. (The obvious deceit of their executives hasn't helped either.)
Location, Teamwork, Risk
Some careers require a commitment to a location. A dentist depends on a given set of patients. If the dentist relocates, several years of lower income will occur while new patients are attracted. Dentists seldom relocate. Other careers demand frequent relocation. Managers of stores in retail chains are apt to move every few years. If they are successful, they will move to more challenging positions. If they are not successful, they will move to less challenging posts or to other employers. Relocation is a burden on families, but may be stimulating for others.
Careers differ in many other ways. Some require the ability to build and work with teams of people, for example, in many kinds of engineering. Some jobs are adversarial, as with many positions for attorneys, bill collectors, and insurance claims people. Some careers require working with people who are in personal crisis, for example, surgeons treating the injured and lawyers mediating divorce. Some careers involve analytic skills, for example, evaluating financial plans or statistics. Many professional careers involve effective written and oral communication. At Vanderbilt, seniors comment that many job interviews focus on analytic and people skills.
To choose a career, then, meet people who hold the careers, find summer jobs close to a target career, read about the earnings levels and changing organization patterns, and learn about the incentive schemes. Many people choose careers because they know and like people who are already in those careers. A few generations ago, most of us pursued our parents' careers and so the problem of career choice was simpler. In the 21st century, relatively few of us will be in careers held by our parents. Indeed, many of our careers didn't exist in our grandparents time. Labor markets are increasingly national and even to a degree international. Many Vanderbilt graduates plan on working abroad for a time. So, the problem of finding a match is becoming more difficult because the choices are so wide. Try the Career Center for literature, help in drafting a resume, and in developing interview skills. Look for a first job that will help you build skills, challenge your abilities, offer suitable financial gain, and the includes appropriate intrinsic and extrinsic rewards. For more information, try The College Board Guide to Jobs and Career Planning Joyce Slayton Mitchell ($11.20, 2nd Edition Paperback, 331 pages, College Board, June 1994 at www.amazon.com).
In investing, seek the maximum total rate of return on the portfolio for a given exposure to risk. The Vanguard Group Homepage (www.vanguard.com) offers a free tutorial on investing. It explains that a portfolio should have a mix of equities (stocks), fixed income securities (bonds), and money (money market funds). When one is investing with a long time horizon, one can take more risk and have a portfolio with a higher proportion of equities. When one has a shorter time horizon, one can afford less risk and should move the portfolio toward a higher proportion of fixed incomes. The mix of equities and fixed income assets in a portfolio is the principle determinant of its rate of return. Keep three to six months of earnings in a money market fund for contingencies.Portfolio
William Spitz is a Vanderbilt alumnus and Treasurer of the University. He has managed a portfolio of over $1 billion for over a decade. He talks about how to invest in his book, Get Rich Slowly (New York: Macmillan, 1996). (Available in paper from www.amazon.com for $10.36.) He says that it is very difficult to get performance in a portfolio of equities that exceeds the performance of the Standard & Poor's Index of the stocks of the five hundred largest firms. So, one might let an S&P 500 index fund be the foundation of an equity portfolio. An index mutual fund with no load (no sales charges) will generally have low service costs. The service cost is the charge to the fund that is used to pay the fees of the firm that manages the fund. Some mutual funds have an annual maintenance fee less than 1 percent of the balance of the fund. To learn more about the stock market, read Burton Malkiel's A Random Walk Down Wall Street (New York: Norton, 1996). (Available in paper at www.amazon.com for $12.76.) BA 240 Business Finance and Econ 259 Financial Instruments and Markets develop ideas about capital markets.
Mutual Funds
Many investors emphasis index funds in their portfolios. For example, an index 500 fund tracks the average price of the 500 stocks in the Standard and Poor's Index (500 of the largest corporations). Other index funds track the average price of other large, well-defined sets of stocks. These funds typically have low management fees because they are not having analysts decide where to invest.
In contrast to index funds are managed funds. Managed funds hire analysts who evaluate individual companies and seek to determine which companies will out perform the market. Managed funds have somewhat higher management costs but afford the prospect of capturing extraordinary gains. Each managed fund has its own objectives, history of performance, and prospects for the future. For example, T Rowe Price offers a wide variety of managed funds with funds that focus on small and mid-capitalization companies, health service companies, technology companies, Asia, Latin America, and Europe. There are many managed funds available with no load (no sales fee). Morningstar provides information about a variety of mutual funds.
The Market Ahead
How to invest is an intensely studied topic. The price of stocks has advanced much more rapidly than the underlying corporate profits for over a decade and the 500 stocks in the S&P 500 have outpaced the rest. Some commentators suggest that the stock market has run up so rapidly because the baby-boom generation is saving for retirement and using equities as the vehicle. Given the success of the 500 index, more investors may have been drawn to invest in these, sending their prices higher than others. When prices track above the underlying corporate profits, investors may be making a run on those assets. At some point, a downward adjustment will occur. Identifying the timing of that adjustment may be impossible.
Some observers suggest diversifying to small or middle size companies and to international equities. When the baby boom generation begins to retire, they are likely to shift their portfolios to bonds. The price of stocks might then fall as the price of bonds rise. Identifying the timing for such a shift may be difficult. Diversifying a portfolio to include small and mid capitalization stocks and international equities may decrease risk and increase return over the long term.
It is common to borrow money to finance expenditures which have a payoff over several years, for example, for schooling, a house, or a car. One should use the lowest cost of funds when borrowing. Subsidized education loans are one source of low-cost borrowing. (The federal government guarantees the loans to the lenders and underwrites some interest costs.) Home equity loans, that is, a mortgage, should also be lower in cost than an automobile or unsecured loans. (Shop for the lowest rate.) One may find current mortgage rates from major lenders on the World Wide Web, for example, from Countrywide. Some new websites purport to list rates from many sources. The interest charges on a mortgage receive favorable treatment under the income tax (see the tax section below). Credit card borrowing and other unsecured loans are typically high in cost and should be a last resort. (Pay off the credit card balance completely every month to avoid charges. Choose a credit card with zero annual fee.) For more information you may wish to read: Credit Card & Debt Management : A Step-By-Step How-To Guide for Organizing Debt & Saving Money on Interest Payments by Scott Bilker (1996, $19.95 at Amazon.com)Credit Worthiness
Three major companies keep track of credit histories. When you apply for a credit card, a loan, or other significant financial transaction, the vendor may check your credit history. If you have never had a credit card or a loan, you will not have a credit history and so you may not be able to get the credit card or the loan. If you have a history of not making payments on your debts, this will show on your credit history and you may not be able to borrow or even make large purchases. If you have been denied credit a report is free, otherwise it may cost about $8 to see a copy of your credit history. Credit histories sometimes contain erroneous information, so it may be useful to see your credit history from time to time, particularly if you contemplate seeking a loan or mortgage. Experian (formerly TRW) 800.682.7654, TRANSUNION 800.916.8800, CBI/EQUIFAX 800.685.1111 are the three major credit information bureaus. Associated Credit Bureaus provides information about the content of credit reports. Keystroke provides an on-line questionnaire to estimate your credit worthiness.
Insure against significant risks but seek the least cost way of insuring each risk.Life & Disability
Term life insurance is typically the least cost form of life insurance. Term insurance does not build a cash value and does not represent an investment. Instead it simply pays a benefit in the event of death during the term of the policy. (Put your investment funds into investments with high return as discussed in investing above.) Term insurance can be purchase that offers a guarantee of renewability for subsequent years.
Life insurance may be available through an employer or a trade association. Life insurance companies sell policies through groups to lower selling costs and to identify less risky prospects. As a consequence, group policies tend to be less expensive than one would buy as an individual from an agent. Shop for a group policy from an established company. Prices for comparable coverage vary widely.
Consider disability insurance. Life insurance only pays if on dies. If one is disabled, disability insurance will pay for rehabilitation and provide income. Some employers offer disability insurance.
Health
Health insurance is an important fringe benefit offered by many employers. Larger employers may offer a choice of health insurance. Traditional health insurance allows one to shop for one's one doctor, hospital, and services. One may pay for the service and file a claim with the insurance company for reimbursement. Many policies include a deductible amount; reimbursement is made only on the amount of claim above the deductible. Some policies include coinsurance, which means that reimbursement is for only a stated fraction of the claim, often 70 or 80%. (You are self-insured for the balance.) A policy may provide a maximum coinsurance, for example, the insurance company may reimburse 100% of the claim when it exceeds $5,000 in a year. There may be a lifetime ceiling on reimbursement of, say, $1,000,000.
Because the cost of traditional health insurance has risen very rapidly over the last 25 years, many employers have sought ways to lower health insurance costs. (One can think of the cost of the health insurance as part of the total compensation package for an employee. If health insurance costs less, wages and salaries can be higher.) Raising deductibles and coinsurance and lowering lifetime ceilings is one method. A more radical method turns to managed care.
HMO
Many large employers provide health insurance through a health maintenance organization (HMO) or a preferred provider network (PPN). The HMO contracts with a limited set of doctors, hospitals, and other services and negotiates for fixed, lower prices for services. The doctors and other services may choose to accept the lower price per service with the promise of a larger flow of patients from the HMO. The contractual relationship between HMO (typically a branch of an insurance company) and the doctors and hospitals varies from one company to another. Some pay the doctor a flat annual fee per patient, giving the doctor a strong incentive to limit services. Other HMOs pay for services as they are used. HMOs may require approval by the insurance company before certain services are provided. Specifically, each patient has a primary care physician who must approve in advance all visits to specialists and other service providers. A PPN is a more loosely organized set of providers with the insurance company exercising little control over the services. In an HMO, a patient will typically make a small co-payment (say $10) each time a service is used. This fee is designed to discourage casual use of the services. When one can choose from among HMOs, one might consider the reputation of the individual doctors and hospitals in the HMO, one might ask for reports on the quality of service provided. HMOs have had difficulty providing adequate levels of mental health services, so questions about coverage for mental health problems may be revealing.
If one is self-employed, employed by an employer that does not offer health insurance, or out of the labor market, access to health insurance will be a significant concern. Buying health insurance personally from an insurance agent will generally be more expensive than comparable insurance would cost an employer because of the problem of adverse selection. That is to say, among people who do not have group health insurance, some of the healthiest will elect not to buy insurance at all. Those who believe that are more likely to require services are more likely to buy insurance. As a result, the fee for insurance to those who do buy must be large enough to cover the claims of those who buy. As the group who buy is riskier, the fee goes higher, encourage still more to opt out, raising the risk and so the price for the remainder. Buying private health insurance is likely to be quite expensive.
Econ 268 Economics of Health discusses issues of health care and the changing market for medical services. It has not been offered for several years, however.
Property & Automobile
Use property insurance to protect against tort liability as well as fire and theft with home, renter, and car insurance. A tort liability is the claim a person might make against you in a law suit should they be injured or die on your property or in an accident involving your car.
Property and car insurance have deductibles. Suppose one suffers a $5,000 lose. The insurance company pays the amount above the deductible. If the deductible is $500, the insurance company pays $4,500. Large deductibles make sense. When you pay a premium for insurance, about half goes to pay the operating costs of the insurance company and about half pays policy holders who suffer losses. Thus, it costs about a dollar for each expected $0.50 of payoff. You are better off to provide for your own small losses than to pay the insurance company $1 for each $0.50 of loss. Moreover, the insurance company incurs disproportionately high costs for settling small claims so the cost of the first $500 of insurance coverage is much higher proportionately than the second $10,000. Consider national flood insurance for a house because ordinary house insurance does not cover damages due to floods.
So, choose large deductibles on home and automobile policies, use your contingency fund for small loses. Consider an umbrella liability policy to increase protection against large lawsuits. An umbrella policy is relatively inexpensive and provides protection against law suits for large damages. For more information, try The Complete Book of Insurance : The Consumer's Guide to Insuring Your Life, Health, Property and Income by Ben G. Baldwin ($19.96 at Amazon.com)
To buy a house requires a down payment of at least 10 percent of the purchase price. Mortgage lenders may lend funds toward purchase as long as the mortgage payment (principle plus interest) is less than 30 percent of gross income. Use Excel's PMT function or Quicken's loan planner to see the relationship between face amount of the loan and the monthly payment at current interest rates. A 30 year fixed rate mortgage at 7.5% annual interest will have a monthly payment of about $700 plus an escrow payment for home insurance and property taxes. Escrow is an earmarked fund, accumulated by the mortgage company and used to pay the home insurance and property taxes. The mortgage company wants to make sure these costs are paid with certainty because the company could suffer a big loss if taxes or insurance were not paid.Mortgage
So, the mortgage lender will require an annual income of at least $28,000 to carry of mortgage of $100,000. See Planning above for advice on how much house to buy. About 65 percent of households in the US own their own housing.
The seller bears the cost of the real estate broker, usually 6 percent of the selling price. If the buyer uses an agent, half of the fee goes to the buyer's agent, half to the seller's agent. There are fees for title insurance, placing the mortgage, and an appraisal. If one sold one house and bought another of identical value, one would be out about 10 percent of the value of the house in transactions costs.
Inspection
The buyer will want to assure that the property is the seller's to sell, that the deed properly describes the property, and that the property is sound. In many states, the mortgage company will require title insurance. The title insurance company will check court records to assure that no lawsuits or other financial claims are outstanding against the property. It will also assure that the property has been surveyed. A termite inspection is required, a test for radon may be required in some places. The buyers should make the final purchase contingent on a physical inspection by a qualified building inspector to get professional information about the quality of construction, roofing, plumbing, drainage, electrical, and the like. Negotiate the price downward for the cost of correcting problems. For more information, try The Complete Guide to Buying Your First Home : Roadmap to a Successful, Worry-Free Closing by R. Dodge Woodson, Dodge R. Woodson 1992 ($13.59 at Amazon.com). Econ 279 Theory of Urban Structure discusses real estate and housing.
Decisions with regard to families have significant financial consequences. Cohabitation generally lowers housing costs and may allow economizing on other expenses. Two can live more cheaply together than separately. Commingling of funds by unmarried cohabitants is unwise because each can then spend the total balance without the permission of the other. If the two should move apart, there is no legal protection against one's partner taking all the funds.Marriage
From a financial point of view, marriage creates financial obligations and opportunities for the two parties. Opportunities include the ability to pool investments for lower risk and higher return, marital exclusions under the estate tax, and, depending on relative incomes, advantages or disadvantages under the income tax. (Persons with nearly equal incomes are likely to be disadvantaged, those with unequal incomes are likely to be advantaged.) The fact of marriage provides a measure of financial protection when two potential earners act as one. One can more easily sustain a spell of unemployment, a financial set back, or invest in education while being supported by the other.
The obligations arise because the assets of the two partners are pooled by marriage. If the marriage should dissolve, each will have claim to a significant share of the pooled assets.
Marriage may also bring children and children bring financial opportunities and obligations. The opportunities relate to income tax exemptions and estate planning. The cost of rearing a child to maturity will likely include the cost of larger housing, constraints on location for stability and for access to schools, and the cost of schooling.
For more advice on the financial implications of marriage, try Money and Marriage : Making It Work Together : A Guide to Smart Money Management and Harmonious Communications by Steven Pybrum (1996, Amazon.com $14.36) Econ 286 Economics of Human Resources addresses a number of issues in the economics of families.
Divorce
Divorce is costly. Not only are assets split, but the cost of living increases. Thus, persons who divorce typically suffer a substantial reduction in standard of living. Minor children add substantially to the cost and difficulty of divorce.
For more information, try The American Bar Association Guide to Family Law : The Complete and Easy Guide to the Laws of Marriage, Parenthood, Separation, and Divorce , 1996 ($10.40 at amazon.com) or Divorce and Money : How to Make the Best Financial Decisions During Divorce (3rd) by Violet Woodhouse, Victoria F. Collins, Robi Leonard, M. C. Blakeman, 1996 (Nolo Press, $21.59 at Amazon.com). A rancorous divorce is not only difficult for the parties and especially their children, but also will entail substantial legal fees. An uncontested divorce with an amicable division of property may require a legal fee as low as $150 to record an agreement. In a contentious divorce, legal fees for both parties may consume as much as ten percent of the joint assets. A contentious divorce makes the pie smaller.
Income is the primary base for taxes collected by the Federal Government. Income comes from labor earnings, that is, wages and salaries, and from wealth, that is, interest, dividends, and capital gains. Labor income and income from wealth are often treated differently. Econ 254 Public Finance addresses the Federal Tax system in some detail.Social Security Tax
The largest federal tax is the FICA [Federal Insurance Contributions Act] or Social Security Tax and it is a tax on earnings. The employee pays half of the tax, about 7.65% , and the employer pays a matching amount. The 6.2% of the 7.65% funds the retirement system. This tax is capped at earnings of about $75,000 per year (the cap rises with inflation each year). This payment is the basis for the retirement benefit under Social Security. One should seek a statement of covered wages and estimated retirement benefit from Social Security every few years to assure that the taxes are being entered correctly. (Call 1-800-772-1213 to request a form for getting a statement of one's Social Security tax paid and a forecast of benefits.) The remaining 1.45% of the 7.6% funds part of Medicare and it is uncapped. FICA is paid starting with the first dollar earned and is withheld from paychecks. The taxpayer has no obligation to file a tax form for FICA unless one is self employed. FICA applies only to earnings, not to income from financial assets.
Income Tax
The second largest federal tax is the personal income tax. It applies to both earnings and to income from financial assets. Employers are required to withhold an amount from paychecks that approximates the expected income tax liability. When an individual has income for which there is no withholding (e.g. self employed income, income from financial assets), an estimated payment is to be made quarterly. Failure to pay estimated taxes will result in penalties. On April 15, one is required to file an income tax return that establishes definitively one's income tax liability. Tax payments withheld by employers, plus estimated payments paid by the individual, count toward the final bill. If one's tax liability is less than what has been paid, one gets a refund. About three- fourths of tax filers get refunds. (Taxpayers would be somewhat better off paying some tax on April 15 than in receiving refunds because they could earn interest on the funds until they are paid in taxes.)
Standard Deductions
Under the income tax, the first dollars of income are untaxed. Each filer (individual or household) may claim exemptions and standard deductions based on the number of persons in the household). When income is less than the level of exemptions and deductions then zero taxes are due and the full amount of taxes withheld will be refunded. For a family of four, the exemptions and standard deductions come to about $16,000 per year (the amount goes up with inflation each year).
Progressive Rates
Income beyond the level of exemptions and deductions is taxed at progressive rates. That is to say, the first tens of thousands of dollars is in a bracket that is taxed at 15 percent. Income beyond the top of the first bracket is taxed at the rate in the next bracket, namely 28%. There is a 31% bracket, a 36% bracket, and a top rate of 39.6% that applies on taxable income (that is after the exemptions and deductions) over $250,000 for an individual or joint return.
Itemizable Deductions
Certain expenditures are deductible from gross income only if one keeps detailed records and so lists them item-by-item. Charitable contributions, medical expenses, interest on a home mortgage, state and local income and property tax payments, and business expenses when one has business income, are all examples of expenditures which may be itemized as deductions. One will only choose the itemized deductions if they are larger than the standard deductions. One must maintain careful records and receipts to substantiate claims for itemized deductions. These may be checked if one is audited by the IRS. Only about 20% of households itemize deductions.
Capital Gains
When one sells an asset, the increase in value from the time of its purchase is called a capital gain. In general, capital gains are considered to be income, as are interest and dividends earned by investments, and are thus taxable as income. The tax law of 1997 introduced complex new rules for the taxation of capital gain that makes taxability contingent on the length of time one has held an asset. Professional tax preparation help may be necessary. Capital gains in a primary residence are exempt up to $500,000 for a married couple, half that for an individual.
Popular guides to the federal income tax include (with Amazon prices) H&R Block 1998 Income Tax Guide (Annual) by H & R Block Tax Services ($12), The Ernst & Young Tax Guide 1998 ($12.76), J.K. Lasser's Your Income Tax 1998 (Serial) by J.K. Lasser ($11.96).
Taxation of Retirement Savings
Taxes have implications for investing. One can shelter income from the income tax by placing it in an individual retirement account (IRA) or other qualified retirement plan, such as a 401(k) plan (for employees of corporations), a 403(b) plan (for employees of nonprofit organizations), or a SEP plan (for self-employed individuals). (Qualified means that it meets the IRS's rules.) One will pay income tax on the funds when they are withdrawn, say for retirement. The income earned within the sheltered fund is taxed only when withdrawn. A dollar of tax paid later costs less because one can earn interest on it in the meantime. A tax delayed is a tax reduced.
Here is an example of the value of deferring taxes. Suppose that one puts $300 per month into savings that earns 7.5 percent per year. If each year the interest earned bears a tax of 28 percent, then the after-tax rate of earnings is 5.4 percent. The savings earns an after-tax rate of interest of 5.4 percent, and that is the rate that compounds. After 25 years, one will have accumulated a balance of $188,574 after taxes are paid. If, instead, one has put $300 of after-tax dollars into a tax deferred investment earning 7.5 percent, in 25 years, one will have a balance of $261,257 before taxes. The total interest earned over the 25 years is $171,557. Applying the 28 percent tax rate to the interest gives a tax liability of $48,036 at withdrawal in year 25. The after-tax net is then $213,221. The investor is ahead by $24,647, a more than 13 percent increase over the taxable investment.
Some investments may be made with before-tax dollars (that is, the amount of the investment can be deducted from current income), making the whole balance of the investment subject to tax at withdrawal. The investor will be even further ahead with the investment when payments made into the investment may be deducted from taxable income in the year the investment is made.
State and local governments also collect taxes, but the mix of services and taxes varies widely. Some states rely primarily on sales taxes and have no income tax. Some rely on income taxes and have no sales taxes. Many have both sales and income taxes. Only New Hampshire has neither a sales nor an income tax. Local governments typically depend on property taxes but the level of property taxes varies widely from place to place.At the same time, the level of services varies widely. In a rural area, there may be no police and fire services, no refuse collection, no parks, and schools may be at a distance. The quality of road maintenance and snow removal may vary widely. Some communities pay higher taxes and enjoy more government services. Others pay lower taxes and accept lower quality of services. The quality of management of local governments also varies. Some municipalities do a better job of turning tax dollars into valuable services than do others.
State Income & Sales Taxes
Many states piggyback their income taxes on the federal income taxes. Employers withhold tax payments, and a state income tax return is due on April 15 in parallel with the federal.
Sales taxes are paid with purchases. Some states collect on groceries and clothing, some do not. The sales tax payment on an automobile may be significant. Generally, sales taxes are not paid on personal services, for example, hair cuts and lawyers.
Property Tax
Property taxes are paid on an estimated value of one's home. The median effective property tax rate across the country is 1.6%, so a house worth $100,000 would have a $1,600 property tax bill each year. Effective rates twice this are found in some northern cities and rates half the national median are found in some southern and western cities. The property tax is often thought of as a tax for local schools and roads.
One's property tax bill is determined in a two stage process. First, the assessor determines the value of the property. Second, the local government sets the rate (sometimes called a millage rate because it is expressed in thousandths of dollar of assessed value.) The property tax assessor will appraise the property to establish an estimate of its market value, call this the appraised value. By law, the assessor may be required to fix an official assessed value that is a fraction of the appraised value. (In Tennessee, single family houses are assessed at 25 percent of appraised value.) Nationally, assessments average just slightly more than half the appraised market values, reflecting systematic under appraisal as well as official fractional assessment. The property tax rate (the millage) applies to the assessed value. If a property is assessed at a higher proportion of its true market value than the average for the jurisdiction, then that property will be paying a disproportionally high (and unfair) property tax bill. One can appeal one's appraisal.
Some jurisdictions collect property taxes on the value of automobiles and other personal property. Businesses also pay property taxes on their tangible assets. Jurisdictions with large business assets may have lower personal property taxes and higher property values. Most households with mortgages will pay their property tax through the escrow fund part of their mortgage payments as mentioned above. Econ 279 Theory of Urban Structure considers local governments and property taxes.
Write a will and revise it every five years or whenever your financial, personal, or family situation changes significantly (that is, you win the lottery, get married or divorced, or have children). A will allows one to direct one's estate to the beneficiaries one designates and, when carefully written, allows one to limit exposure to estate taxes. The states have default estate plans that usually call for one's parents (if living) to inherit from a person who dies without children or a spouse. Even if you don't have much wealth, creating a simple will might be a good idea just to avoid the state's default plan which is usually contrary to the wishes of most people. An unmarried person may want to leave money to a friend, school, other charity, brother or sister instead of parents.Estate Tax
When net worth exceeds $500,000, it is important to lay plans for an estate so as to keep estate taxes low. In 1998, when one dies with a net worth over $625,000, one will likely have an estate tax liability. (The threshold amount will rise over the years just ahead to $1,000,000.) The top estate tax rate is 65 percent, so the estate tax can cut deeply. One can reduce estate tax liabilities by giving money away to heirs well in advance of death. One can give $10,000 per year per recipient without triggering the estate and gift tax. A married couple can give $20,000 per year per recipient. State governments also have death taxes, some use the estate tax, others an inheritance tax. An estate tax is a tax on the net worth of the person who dies. An inheritance tax is a tax on the amount received by heirs. An inheritance tax will generally be lower when the estate is spread among more heirs.
Not all property will pass via will. Contracts take precedence over wills. A life insurance policy is a contract. You can designate beneficiaries in life insurance policies in ways that keep the proceeds of the life insurance out of one's estate. Many people hold their houses and bank accounts as joint tennancies with right of survivorship; these pass to the survivor without going through probate, that is, without becoming part of the estate.
Trusts
One can also create trusts. A trust is a fiduciary relationship where the legal title to the property held in trust (the corpus) belongs to the trust and the benefits of the trust (the income) may belong to someone else. Trusts allow current income from the trust to be used for one purpose while the capital is committed to another purpose. Trusts are separate taxpaying entities and may be used to protect money, to keep creditors away and to keep spendthrift relatives from wasting funds, as well as to avoid taxes.
A tax credit applies so that no tax is due until estates exceed $625,000. There is also an unlimited marital deduction. So, when the first partner in a marriage dies, that person's estate may pass to the surviving spouse untaxed. However, when the second partner dies, only one $625,000 exemption is available. By acting before either partner dies, the pair may reduce the total estate tax liabilities by putting the assets of the partner who dies first in a trust rather than allowing it to pass to the surviving spouse. In this way, the first to die can take advantage of the $625,000 exemption. The trust may provide that the income be used for the surviving spouse but that the capital value of the trust will be distributed to children (or others) after the second spouse dies. In this way, the $625,000 exemption of the second to die is available to shield from tax the second-to-die's assets.
A difference between a will and a trust is that a will must be formally executed: witnessed by three persons. A trust can be created by one person without formalities.
One can also reduce estate taxes by making charitable contributions that may be deducted from the tax. The American Bar Association Guide to Wills and Estates : Everything You Need to Know About Wills, Trusts, Estates, and Taxes 1995 ($13.00 at Amazon.com.) reviews estate planning. Parsons Technologies offers family law software, Quicken Family Lawyer for $39.95. The estate tax is often considered in Econ 254 Public Finance.
In the 1980s, a prominent Vanderbilt alumnus died intestate, that is, without a will. His estate was worth more than $100 million. More that $20 million went to the federal estate tax. A simple will written by an attorney may cost about $600.
Health Emergencies
One might also create a living will and a durable power of attorney to allow trusted persons to provide for you should be become incapacitated. A durable power of attorney will designate a person to make financial decisions for you. A durable power of attorney for health care empowers your designate to make decisions about your medical care if you are unable to do so. In a living will, one can make organs available for transplant and specify what medical procedures you wish in dire circumstances. Give your parents, spouse, or a friend the authority to act as you would wish. Try A Good Death : Taking More Control at the End of Your Life : Choice in Dying the National Council for the Right to Die by T. Patrick Hill, David Shirley, 1992 ($9.56 at Amazon.com).
When issues become a little more complex, hire help. Charles A. Jaffe, The Right Way to Hire Financial Help : A Complete Guide to Choosing and Managing Brokers, Financial Planners, Insurance Agents, Lawyers, Tax preparers (Cambridge, MA: MIT Press, 1998) offers advice on how to choose an advisor. ($17.50 at Amazon.com.)
copyright, 1998, Malcolm Getz
revised: May 6, 1998