Loudoun County Public Schools



Study Guide for Financial Literacy TestSpring 2014Name: _____________________________Investing:Securities and equities (capital gains or losses, dividends, historical performance of stocks or the advantages of owning securities, primary vs. secondary markets)When you sell a capital asset, the difference between the amounts you sell it for and your basis – which is usually what you paid for it – is a capital gain or a capital loss.Historical performance of stocks: Up and down but average 9-10%Primary market: The primary market is where securities are created. It's in this market that firms sell new stocks and bonds to the public for the first time (IPO – Initial Public Offering)Secondary market: The secondary market is what people are talking about when they refer to the "stock market". This includes the New York Stock Exchange (NYSE), NASDAQ and all major exchanges around the world. The defining characteristic of the secondary market is that investor’s trade among themselves.What is a bull market (remember U in bull – market goes UP vs. a bear market)The use of "bull" and "bear" to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These actions are metaphors for the movement of a market. If the trend is up, it's a bull market. If the trend is down, it's a bear market.Bonds – purpose, how they work, interest feature, tax free feature of municipal bondsMutual funds – what they are, how they work, who manages the fundAn investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors.Diversification“Don’t put all your eggs in one basket” - create a portfolio that includes multiple investments in order to reduce risk. DividendsA distribution of a portion of a company's earnings (profits) to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share).Treasury billsA short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks).Money:Source of incomeEarned Income: Income derived from active participation in a trade or business, including wages, salary, tips, commissions and bonuses.Unearned Income: Any income that comes from investments and other sources unrelated to employment services. Examples: interest from a savings account, bond interest, alimony, and dividends from stockExemptions (aka allowance) and how they workIf you are not claimed as a dependent on another taxpayer's return, then you can claim one personal tax exemption. The exemption reduces your taxable income just like a deduction does, but has fewer restrictions to claiming it. If you are married and file a joint tax return, both you and your spouse each get an exemption.The IRS allows you to take additional exemptions for each dependent you claim. Frequently, the source of these exemptions are the children who live with you for more than half the year, are under 19 years old (or under 24 if a full-time student) and who don't provide more than half of their own financial support during the tax year.Liquidity – what does it mean, what financial products are liquidThe ability to convert an asset to cash quickly and with minimal impact to the price. Examples: Cash, Most stocks, money market instruments and government bonds.Money market accounts: It is the organized exchange on which participants can lend and borrow large sums of money for a period of one year or less.It is the organized exchange on which participants can lend and borrow large sums of money for a period of one year or less.Gift cards – how do they work – fees?A gift card is a restricted monetary equivalent is issued by retailers or banks to be used as an alternative to a non-monetary gift.Fees are uncommon and illegal in some states. Less than 3% of gift cards have fees. Discretionary income and budget surplusThe amount of an individual's income that is left for spending, investing or saving after taxes and personal necessities (such as food, shelter, and clothing) have been paid. Discretionary income includes money spent on luxury items, vacations and non-essential goods and services.Money orders – high rate of counterfeitsA certificate that allows the stated payee to receive cash on-demand, usually issued by governments and banking institutions. A money order functions much like a check, in that the person who purchased the money order may stop payment. Why does the US currency have valueIts value is only based on what we can get in exchange for it. Or put it another way, money has value as long as other people believe the money you give them can be exchanged for the goods and services they desire in the future.Opportunity costsThe cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%).Who is hurt the most and least with inflationInflation is a general increase in prices and a corresponding decrease in money's purchasing power.People hurt the most: Those on fixed incomes (retired people)People hurt the least: Borrowers and producersWhen individuals, businesses, and governments borrow, it is usually at a fixed rate of Interest that had some expected level of inflation built into it. If higher than expected inflation occurs, then the real value of the borrower's debt is reduced. Assume that banks lend billions of dollars at a fixed nominal interest rate of 5%. If inflation were to unexpectedly increase from 2% to 4%, then borrowers' real interest rate paid would be reduced from 3% to 1%. In simpler terms, the money that was lent was more precious than the money being repaid.Another group that benefits from an increase in consumer prices in the short run is producers. When unexpected inflation occurs, consumer prices rise while wages paid to employees remain relatively stable. This allows producers to experience higher profits for a time until wages adjust to reflect the higher prices consumers are paying.Role of the treasury departmentThe United States Department of the Treasury is the government (Cabinet) department responsible for issuing all Treasury bonds, notes and bills.The U.S. Treasury is responsible for the revenue of the U.S. government, but here are some other key functions:- Printing of bills, postage, Federal Reserve notes, and minting of coins- Collection of taxes and enforcement of tax laws (through the IRS)- Management of all government accounts and debt issues- Overseeing U.S. banks Banks:Pay yourself first (savings) – Put money into savings each month as if it were a bill. At least 10% of your income should go into savings. It’s recommended you have 6-8 months of expenses saved. CD – what is it and what happens if you cash it before maturitySold by banks, certificates of deposit (CDs) are low-risk –- and relatively low-return — investments suitable for cash you don’t need for months or years. If you leave the money alone during the investment period (known as the “term” or “duration”), the bank will pay you an interest rate slightly higher than what you would have earned in a money market or checking account. All gains from CDs are taxable as income.CDs are among the safest investment a person can make. The interest rate is determined ahead of time, and you’re guaranteed to get back what you put in, plus interest once the CD matures.Traditional CD: You receive a fixed interest rate over a specific period of time. When that term ends, you can withdraw your money or roll it into another CD. Withdrawing before maturity can result in a hefty penalty.Liquid CD — This kind of account allows you to withdraw part of your deposit without paying a penalty. The interest rate on this CD usually is a little lower than others, but the rate is still higher than the rate in a money market account.Zero-coupon CD — This kind of CD does not pay out annual interest, and instead re-invests the payments so you earn interest on a higher total deposit. The interest rate offered is slightly higher than other CDs, but you’ll owe taxes on the re-invested interest.Institutions that give loans – banks, credit unions, pawnshops, finance companies, payday lenders, tax preparers. Which charge the highest interest rates on loans (pawnshops, payday lenders, tax preparers, finance companies)Pawnshops: You are given a short-term loan in exchange for leaving a personal item, such as jewelry or an electronic device, as collateral. If you pay back the loan, including interest, on time, you get the item back. You may be able to renew the loan by paying the interest. However, if you fail to repay or renew the loan, your item can be sold. The APRs for pawn shop loans are typically around 120-300 percent, much higher than the rate charged on credit cards. Many pawn shops also charge additional fees for insurance and storage.Payday lenders: A payday lender allows you to borrow against your future income. You give them a postdated check, which is deposited if you do not pay back the loan. The APR (interest expressed as an annual percent rate) is usually over 200 percent and can go much higher if you refinance the loan instead of paying it off as soon as it comes due.Banks vs. credit unions: Credit unions generally charge lower interest rates. Tax preparers: short-term consumer loans, usually 24 to 48 hours, secured by a taxpayer’s expected tax refund, and designed to offer customers quicker access to funds.What is a credit union and the advantages of using a credit unionMember-owned financial co-operative. These institutions are created and operated by its members and profits are shared amongst the owners. Advantages: Lower interest rates for loans, higher interest rates for savings accounts and investments because they are a non-profit and pass savings to customer/owner. Overdraft protection – how it worksA line of credit that banks offer to their customers to cover their overdrafts. Overdraft protection kicks in when a customer writes a check for more than the amount in their account. Banks usually charge interest on the amount used to cover the overdraft. Compound interest – what is it and how does it work“interest on interest,” It will make a deposit or loan grow at a faster rate than simple interest, which is interest calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest.Time value of moneyThe idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.Liquid financial products (savings and checking accounts) vs. products that are less liquidLiquid assets: Those that can be converted to cash easily, with little effect on value. Examples: most stocks, money market instruments and government bonds.Less liquid (Illiquid): The state of a security or other asset that cannot easily be sold or exchanged for cash without a substantial loss in value. Illiquid assets also cannot be sold quickly because of a lack of ready and willing investors or speculators to purchase the asset. Examples: Housing, stocks that have no buyers. Rule of 72The 'Rule of 72' is a simplified way to determine how long an investment will take to double, given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors can get a rough estimate of how many years it will take for the initial investment to duplicate itself.For example, the rule of 72 states that $1 invested at 10% would take 7.2 years ((72/10) = 7.2) to turn into $2. In reality, a 10% investment will take 7.3 years to double ((1.10^7.3 = 2).Repayment of student loansYou must repay a student loan even if your financial circumstances become difficult. Your student loans cannot be canceled because you didn’t get the education or job you expected, or because you didn’t complete your education (unless you couldn’t complete your education because your school closed).Tax anticipation loansA Refund Anticipation Loan (RAL) is a loan that is offered by many tax preparation companies to people against their income tax return. These loans are based on the full amount of the tax refund. Loans can be had for the entire amount or a partial amount of the anticipated refund. When the check arrives at the tax preparer’s office, the loan is paid in full, with interest, and any remaining balance is issued to the recipient. Many people use this program for its quick access to money without considering the high interest rates attached. Credit:Credit card cash advancesA service provided by many credit card issuers allowing cardholders to withdraw a certain amount of cash, either through an ATM or directly from a bank or other financial agency. Cash advances typically carry a high interest rate - even higher than credit card itself - and the interest begins to accrue immediately. On the plus side, cash advances are quick and easy to obtain in a pinch. Truth in lending actA federal law enacted in 1968 with the intention of protecting consumers in their dealings with lenders and creditors. The Truth in Lending Act was implemented by the Federal Reserve through a series of regulations. The most important aspects of the act concern the pieces of information that must be disclosed to a borrower prior to extending credit: annual percentage rate (APR), term of the loan and total costs to the borrower. This information must be conspicuous on documents presented to the consumer before signing, and also possibly on periodic billing statements. Consequences of paying the minimum payment due on a credit card billYour credit score will fallYour monthly bills start to balloonYour credit card costs skyrocketHow does the degree of risk influence the interest rate charged for creditHigher risk = higher interest rateLower risk – lower interest rateDebt to credit ratioAmount of available credit you are usingExample: Owe $1,000 on your credit card with a $10,000 limit = 10% ratioRatio should be kept low (<30% on revolving credit)Credit reportsReport detailing your use of creditIdentifying information (name, address, etc.)Account information (date opened, balance, payment history)Credit inquiries (companies who’ve checked your credit)Important because it shows if you’ve been seeking new creditPublic record and collection informationSuch as: bankruptcies, liens, law suits, judgments and collections3 leading credit reporting agencies (Equifax, TransUnion, Experian)Should have same info, but don’t alwaysShould check once/year for accuracyConsequences of a lost or stolen credit cardIdentity theft, use of your creditProtections: Depends on card, but if reported immediately, not responsible for chargesThe length of debt repayment and impacts on costLonger you take to pay, the more you pay in total (accumulating interest)What to do if a person thinks he/she is the victim of identity theftReport to creditors and credit reporting agenciesWatch credit report carefully for several monthsCharacteristics of predatory loansGiving unfair and abusive loan terms to borrowers Showing lower interest than actually paying, making it seem they can afford more than they can, using collateral against default, high fees, etc.Collateral (secured vs. unsecured)Secured = has collateral tied to it in case of default (home mortgage, car financing)Unsecured = no collateral (credit cards)PawnshopsOffer collateralized loansBring in item of value, get loan of percentage of valuePay back with interestIf unpaid, item is forfeited to the pawnshop and considered paid in fullDoes NOT affect credit score, doesn’t require a credit check or bank accountInsurance:How insurance works – concept of sharing riskInsurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premiumInsurance deductible – what happens to the premium when the deductible is raised or loweredDeductible=The amount you have to pay out-of-pocket for expenses before the insurance company will cover the remaining costs. A lower deductible creates higher premiums (cost for insurance coverage), higher deductible creates lower premiums. Collision coverage –when do consumers normally terminate this coverageCollision Insurance will reimburse the insured for any damage sustained to their personal automobile that is due to the fault of the insured driver.People typically drop this coverage when their car’s value is low enough that the cost of the insurance deductible and premiums aren’t worth paying Term life insuranceA policy with a set duration limit on the coverage period. Once the policy is expired, it is up to the policy owner to decide whether to renew the term life insurance policy or to let the coverage end.The policy pays out upon death only – no savings or investment component. Whole life insuranceA life insurance contract with level premiums that has both an insurance and an investment component. The insurance component pays a stated amount upon death of the insured. The investment component accumulates a cash value that the policyholder can withdraw or borrow against. Health insurance – HMO insurance and co-paysAn HMO is a type of health insurance plan that gives you access to certain doctors and hospitals, often called network or contracting doctors and hospitals (sometimes called "providers").Co-pays: paid by the insured person each time a medical service is accessed. Renters insuranceCovers possessions within the home and isolated events not covered in the property insurance held by the owner. Disability insuranceDisability insurance offers income protection to individuals who become disabled for a long period of time, and as a result can no longer work during that time period. Employees who've paid the Federal Insurance Contributions Act (FICA) tax for a certain amount of time, are eligible to receive the Social Security disability income insurance.How to reduce the cost of auto insuranceIncrease deductible, purchase a low profile car, drop unneeded coverage, drive less, safety discounts, student discounts, combine policiesFinancial Planning:Determine Net Worth and definition and examples of assets, liabilities and net worthNet worth = value of assets – amount of liabilitiesAssets: real estate, stock investments, bank accounts, cashLiabilities: debts, loans (mortgage, car, student, etc.)Retirement – how different plans and accounts work and when taxes are paid on fundsPensions, 401K, Traditional IRA (Individual Retirement Account), Roth IRAA pension is a retirement account that an employer maintains to give you a fixed payout when you retire. It's a kind of defined benefit plan.Your payout typically depends on how long you worked for your employer and on your salary. When you retire, you can choose between a lump-sum payout or a monthly "annuity" paymentTraditional IRA: An individual retirement account (IRA) that allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax-deferred (no capital gains or dividend income is taxed). Taxes are paid at the time of distribution/withdrawal. Roth IRA: With a Roth IRA, you make contributions with money on which you've already paid taxes. Your money can then potentially grow tax-free, with tax-free withdrawals in retirement, provided that certain conditions are met.Inflation, deflation, depression – who suffers most and leastInflation: A general increase in prices and fall in the purchasing power of money. Government tries to keep it to 2-3%. Most hurt: lenders and those on fixed incomes (retired)Least hurt: minimum wage earners, middle class home ownersDeflation: Reduction in the general level of prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.Taxes – graduated income taxesA tax that takes a larger percentage from the income of high-income earners than it does from low-income individuals. Taxpayers are broken down into categories based on taxable income; the more one earns, the more taxes they will have to pay once they cross the benchmark cut-off points between the different tax bracket levels.Regulatory Agencies:Roles of SEC, Federal Reserve (the Fed), FDIC, CFPBSEC (Securities and Exchange Commission): A government commission created by Congress to regulate the securities markets and protect investors. In addition to regulation and protection, it also monitors the corporate takeovers in the U.S. Role is to protect the investing public against fraudulent and manipulative practices in the securities markets.The Fed: The central bank of the United States and the most powerful financial institution in the world. Roles: Conducting national monetary policy by influencing monetary and credit conditions in the U.S. economy to ensure maximum employment, stable prices and moderate long-term interest rates. Supervising and regulating banking institutions to ensure safety of the U.S. banking and financial system and to protect consumers’ credit rights.Maintaining financial system stability and containing systemic risk.Providing financial services – including a pivotal role in operating the national payments system – to depository institutions, the U.S. government and foreign official institutions.FDIC (Federal Deposit Insurance Corporation): The U.S. corporation insuring deposits in the U.S. against bank failure. The FDIC was created in 1933 to maintain public confidence and encourage stability in the financial system through the promotion of sound banking practices. The FDIC will insure deposits of up to US$250,000 per institution as long as the bank is a member firm.CFPB (Consumer Fraud Protection Bureau): A regulatory agency charged with overseeing financial products and services that are offered to consumers. Role is to protect and educate consumers about the various types of financial products and services that are available. ................
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