Personal Finance
Second Edition
Bajtelsmit
Chapter 3
Budgeting and Cash Management
©2020 John Wiley & Sons, Inc. All rights reserved.
Chapter 3 Learning Objectives
1. Develop, implement, and monitor a household budget.
2. Explain why cash management is an important
component of your financial plan.
3. Identify and evaluate the types of financial institutions
that provide cash management services.
4. Evaluate checking and savings account choices based on
liquidity, safety, and cost.
5. Select appropriate tools for dealing with cash
management problems, and protect yourself from
identity theft.
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Learning Objective 1
Develop, implement, and monitor a household budget.
LO 1
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3
Factors Affecting Household Budgets
• A budget is a plan for future spending and saving
• Unplanned outlays can interfere with ability to achieve
financial goals
• Other factors that have an impact on budget decisions
Family size and makeup
o Age and education of household members
o Sources and amount of income
o Money attitudes
o
LO 1
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Average Household Budget Allocations for
Different Age Groups
LO 1
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The Budgeting Process: Forecasting and
Implementing
• Forecasting future income and expenditures
Annual and/or monthly forecasts
o Estimate changes in future income
o Estimate fixed and variable expenses
o Record-keeping format
o
• Implementing your budget
o
o
LO 1
Calculate net cash flow = total cash inflows less total cash
outflows
Reconciling a budget is the process of adjusting income
and spending so that expenses do not exceed income
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The Budgeting Process: Monitoring and Revising
• Monitoring your budget
o
o
A budget variance occurs when your actual expenses are
different from your budgeted expenses
• Identify small cash leakages as soon as possible
• Ensure large irregular cash expenses do not cause
financial hardship
Track actual spending and compare to budgeted spending
• Revising your budget
o
o
LO 1
Review financial goals and progress
Increase emergency fund for unexpected events
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Money Attitudes and Household Budgeting
• Differences in money attitudes and spending
behavior are a major cause of conflict in
relationships and can lead to deceptive behavior
• Reduce the risk of problems by setting ground rules
with regard to spending and disclosure
LO 1
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Learning Objective 2
Explain why cash management is an important
component of your financial plan.
LO 2
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The Role of Cash in Your Financial Plan
• Cash management is a foundational component of
your financial plan
o
Includes all decisions related to cash payments and shortterm liquid investments
• Costs of holding cash
o
o
Opportunity cost of investing those dollars to earn a
higher rate of return
Easier to spend when most accessible
• Benefits of holding cash
o
o
o
LO 2
Managing monthly transactions
Preparing for cash emergencies
Making a temporary investment
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How Much Should You Hold in Cash?
• Advice ranges from two to eight months of regular
expenses
• Having alternative sources for cash reduces the
need to hold cash on hand
• Amount of cash reserves depends on income risk
If you have a high risk of job loss, you might consider
holding a relatively large amount in cash
• For example, sales commissions
o If you have a secure job and alternative sources of funds
for emergencies, then you might hold enough cash to
meet your transaction requirements
o
LO 2
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Rules of Effective Cash Management
• Balance your checking account every month
o
o
More likely to stay on budget
Less likely to incur overdraft charges
• Pay your bills on time
o
Reduces costs and improves credit rating
• Pay yourself first
o
Set aside money to achieve your financial goals before
paying other expenses
• Evaluate alternative accounts and providers
o
LO 2
Maximize service and minimize fees
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Learning Objective 3
Identify and evaluate the types of financial institutions
that provide cash management services.
LO 3
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Depository Institutions
•
Commercial banks
o
o
•
Savings institutions
o
•
o
o
A special form of mutual depository institution
Offer similar accounts and services as banks, but are nonprofit
Lower loan rates and higher deposit rates
Internet-based financial institutions
o
LO 3
Primarily mortgage lenders, but offer many of the same accounts and
services as commercial banks
Credit unions
o
•
Get their funds from checking and savings account deposits
Provide financial services, including business and personal loans,
mortgages, and credit cards
Lower costs and competitive loan and deposit rates
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Non-Depository Institutions
• A mutual fund is an investment company that sells shares to
investors and then invests the pool of funds in a selection of
stocks, bonds, or other assets
• A life insurance company sells life insurance policies, intended to
provide financial security for dependents in the event of the
death of the policy owner
• A brokerage firm is a company that facilitates investors’
purchases of stocks, bonds, and other investments
• A financial services firm offers one-stop shopping for checking
and savings accounts, insurance products, loans, and mutual fund
investments
• An online payment processor provides a limited set of cash
management services, primarily to facilitate the transfer of funds
LO 3
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Evaluating Financial Institutions
• Determine whether the financial institutions can
provide all the products you need to manage your cash
effectively
• Pricing may vary dramatically across institutions, both
for interest rates and fees
• If you need to transact business in person, consider
whether service is good and if hours are sufficient
• Evaluate whether locations and ATMs are convenient,
and consider the quality of online access
LO 3
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Learning Objective 4
Evaluate checking and savings account choices based on
liquidity, safety, and cost.
LO 4
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Criteria for Evaluating Cash Management
Accounts
• Liquidity
o
Features that limit liquidity include minimum balance
requirements, limitations on withdrawals, and number of
transactions allowed
• Safety
o
o
Risk of default, whether deposits are federally insured
Fixed or variable interest rate
• Costs and after-tax interest
o
o
LO 4
Interest rates and fees vary
Compounding periods – how often interest is calculated
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Annual Percentage Yield (APY)
• Financial institutions are required to report the APY on all
interest-earning accounts
• APY adjusts for different compounding periods and any
interest-like fees to make comparisons easier
Equation 3.1 Annual percentage yield
m
 1 + Nominalrate 
( APY ) = 
 − 1
m
where m = number of compounding
periods per year
LO 4
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One-Year Certificate of Deposit Rates,
2001–2019
LO 4
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Cash Management
• Consider having several accounts that vary in liquidity,
cost, and interest
Transaction account to pay bills
o Highly liquid savings account for short-term
emergencies
o Higher yield savings for longer term
o
LO 4
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Checking Accounts
• Regular checking accounts
Do not pay interest
o Monthly service charge may be waived with minimum
balance
o May charge fees for other services, such as debit cards
o
• Interest-earning checking accounts
Higher minimum balance requirement
o Typically earn less than savings accounts
o
LO 4
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Comparison of Checking Account
Alternatives
TABLE 3.4 Comparison of Checking Account Alternatives
Type of Account
Advantages
Disadvantages
Regular Checking
Highly liquid.
No interest paid on balances.
If offered by bank or savings institution, insured by FDIC.
May limit number of checks written per month.
No monthly fee if minimum monthly balance is maintained.
May impose higher fees for various services,
including stop payments, fund transfers,
certified checks, and debit cards.
Interest paid on balance.
Rates are very low.
Highly liquid.
Rates may be reduced or eliminated if account
drops below stated minimum.
May include other services, such as debit cards, certified
checks, and fund transfer.
May charge fees for some services.
Interest-Earning Checking
If offered by bank or savings institution, insured by FDIC.
No monthly fee if minimum monthly balance is maintained.
Money Market Account
Pays higher interest than other checking alternatives.
Limited to small number of withdrawals per
month.
Higher minimum balance than other checking
alternatives.
Not FDIC-insured.
LO 4
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Demand Deposits versus Time Deposits
• A demand deposit account allows withdrawals at
any time
o
o
Liquid, so pays low interest rates
Regular savings accounts are demand deposits
• A time deposit account requires a minimum period
of time before funds can be withdrawn
o
o
LO 4
Interest is forfeited and a fee may be charged if funds are
withdrawn before the end of the minimum period
Certificates of deposit (CDs) are time deposits
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Certificates of Deposit (CD)
• Most common type of time deposit account
o
o
o
o
o
o
LO 4
Leave money on deposit until maturity
If withdraw funds early, may incur a fee as well as a reduction
in interest
At maturity, will automatically roll over into a comparable CD
unless financial institution notified otherwise
FDIC insured
CDs of longer duration and/or larger deposit amounts have
higher interest rates
Investors can “ladder” CDs of differing maturity to reduce
liquidity risk without giving up much return
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Money Market Savings
• Money market mutual funds
Investors’ funds are pooled to purchase short-term,
low-risk financial assets
o Mutual fund is riskier than savings accounts and CDs
o
• Not FDIC insured
• Interest rates not guaranteed
• Money market deposit accounts
Bank demand deposits
o FDIC insured
o Interest rate varies with money market securities
o Fairly high minimum balance required
o
LO 4
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U.S. Savings Bonds
• Short-term, low-risk, and exempt from state and local
income taxes
• Held for minimum of one year, and subject to three-month
interest penalty if redeemed in less than five years
• Series EE bonds
o
o
Fixed rate of interest
Guaranteed to double in value in 20 years
• Series I bonds
o
LO 4
Offer protection from inflation by adjusting the face value
on which interest is calculated
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The Rule of 72
• Approximates how long it takes to double your money
at a given rate of interest
o
The approximation is 72 divided by the interest rate
Example: You have invested $5,000 in U.S. Series EE savings
bonds at 1.2% fixed interest. How long would it take for
your money to double without the government guarantee?
Time to double =
72
= 60 years
1.2
The government guarantee of doubling
in 20 years is a great deal
LO 4
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Learning Objective 5
Select appropriate tools for dealing with cash management
problems, and protect yourself from identity theft.
LO 5
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Overdrafts
• If you write a check or use your debit card when there
isn’t enough money in your account to cover the
payment, you will be charged an overdraft fee
o
You may owe another fee to the retailer or vendor if your
payment was rejected
• Keep careful track of cash flows, particularly automatic
payments
• Sign up for overdraft protection on your account, which
gives you an automatic loan to cover the overdraft
LO 5
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Cash Management Problems and Solutions
• Receipt of a bad check
o
If the check is rejected for insufficient funds, you will be
charged a fee even though you were not at fault
• Stop payment on a check also requires a fee
• If you need to send or receive money in a hurry
Wire funds between banks for a fee
o Western Union and MoneyGram have high fees
o
• Those without bank accounts (and “underbanked”)
spend 5% of net income on unnecessary fees
LO 5
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Identity Theft
• Victims of identity theft have been denied loans, lost job
opportunities, and had their finances and credit ruined
• Common methods of identity theft:
o
o
o
o
o
o
o
LO 5
Dumpster diving – Seeking bills and statements in trash
Skimming – Electronically stealing card numbers and PINs
Phishing – Sending fraudulent emails to get information
Rerouting – Receiving a victim’s mail
Stealing – Theft of wallets and purses, personnel records
Pretexting – Using false pretenses to obtain financial
information, such as by posing as researcher or bank
Data breaches – Hacking into companies and governments
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How to Avoid Identify Theft
TABLE 3.6 How to Avoid Identify Theft
•
Always use security software with firewall
and antivirus protections.
•
Do not click on links in or download
attachments from suspicious emails.
•
Check your credit card statements for
accuracy before paying the bill. Shred all
financial statements before throwing them
away.
•
Never give out your credit card number or
personal information over the phone or
online unless you are the one who made the
contact and you trust the security provided
by the business or website.
•
Check your credit report regularly, and
cancel unused credit card accounts.
•
Do not give out your Social Security number,
and don’t print it on your checks.
•
Do not access sensitive information using
public wifi networks.
•
Mail bill payments at the post office or from
a locked mailbox.
•
Do not carry extra credit cards and IDs.
•
Use strong passwords and change them
regularly.
LO 5
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Copyright
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