Study Guide for Financial Literacy Test
Spring 2014
Name: _____________________________
Investing:
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Securities and equities (capital gains or losses, dividends, historical performance of
stocks or the advantages of owning securities, primary vs. secondary markets)
o 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.
o Historical performance of stocks: Up and down but average 9-10%
o 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)
o 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)
o 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 bonds
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Mutual funds – what they are, how they work, who manages the fund
o An 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
o “Don’t put all your eggs in one basket” - create a portfolio that includes multiple
investments in order to reduce risk.
Dividends
o A 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).
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Treasury bills
o A 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:
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Source of income
o Earned Income: Income derived from active participation in a trade or business,
including wages, salary, tips, commissions and bonuses.
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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 stock
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Exemptions (aka allowance) and how they work
o If 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.
o 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 liquid
o The ability to convert an asset to cash quickly and with minimal impact to the
price.
o 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?
o 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.
o Fees are uncommon and illegal in some states. Less than 3% of gift cards have
fees.
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Discretionary income and budget surplus
o The 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.
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Money orders – high rate of counterfeits
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A 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.
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Why does the US currency have value
o Its 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 costs
o The 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.
o 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 inflation
o Inflation 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 producers
o When 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.
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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.
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Role of the treasury department
o The United States Department of the Treasury is the government (Cabinet)
department responsible for issuing all Treasury bonds, notes and bills.
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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:
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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 maturity
o Sold by banks, certificates of deposit (CDs) are low-risk –- and relatively lowreturn — 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.
o 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.
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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.
o 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.
o 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.
o Which charge the highest interest rates on loans (pawnshops, payday lenders,
tax preparers, finance companies)
o 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
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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.
o 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.
o Banks vs. credit unions: Credit unions generally charge lower interest rates.
o 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 union
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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 works
o A 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
o “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 money
o The 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
liquid
o Liquid assets: Those that can be converted to cash easily, with little effect on
value. Examples: most stocks, money market instruments and government
bonds.
o 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.
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Member-owned financial co-operative. These institutions are created and
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Rule of 72
o The '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).
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Repayment of student loans
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You 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).
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Tax anticipation loans
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A 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:
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Credit card cash advances
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A 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.
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Truth in lending act
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A 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.
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Consequences of paying the minimum payment due on a credit card bill
o Your credit score will fall
o Your monthly bills start to balloon
o Your credit card costs skyrocket
How does the degree of risk influence the interest rate charged for credit
o Higher risk = higher interest rate
o Lower risk – lower interest rate
Debt to credit ratio
o Amount of available credit you are using
o Example: Owe $1,000 on your credit card with a $10,000 limit = 10% ratio
o Ratio should be kept low (<30% on revolving credit)
Credit reports
o Report detailing your use of credit
 Identifying 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 credit
 Public record and collection information
 Such as: bankruptcies, liens, law suits, judgments and collections
3 leading credit reporting agencies (Equifax, TransUnion, Experian)
o Should have same info, but don’t always
o Should check once/year for accuracy
Consequences of a lost or stolen credit card
o Identity theft, use of your credit
o Protections: Depends on card, but if reported immediately, not responsible for
charges
The length of debt repayment and impacts on cost
o Longer you take to pay, the more you pay in total (accumulating interest)
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What to do if a person thinks he/she is the victim of identity theft
o Report to creditors and credit reporting agencies
o Watch credit report carefully for several months
Characteristics of predatory loans
o Giving 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)
o Secured = has collateral tied to it in case of default (home mortgage, car
financing)
o Unsecured = no collateral (credit cards)
Pawnshops
o Offer collateralized loans
 Bring in item of value, get loan of percentage of value
 Pay back with interest
 If unpaid, item is forfeited to the pawnshop and considered paid in full
 Does NOT affect credit score, doesn’t require a credit check or bank
account
Insurance:
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How insurance works – concept of sharing risk
o Insurance 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 premium
Insurance deductible – what happens to the premium when the deductible is raised or
lowered
o Deductible=The amount you have to pay out-of-pocket for expenses before the
insurance company will cover the remaining costs.
o A lower deductible creates higher premiums (cost for insurance coverage),
higher deductible creates lower premiums.
Collision coverage –when do consumers normally terminate this coverage
o Collision Insurance will reimburse the insured for any damage sustained to their
personal automobile that is due to the fault of the insured driver.
o 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 insurance
o A 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.
o The policy pays out upon death only – no savings or investment component.
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Whole life insurance
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A 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.
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Health insurance – HMO insurance and co-pays
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An 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
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(sometimes called "providers").
o Co-pays: paid by the insured person each time a medical service is accessed.
Renters insurance
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Covers possessions within the home and isolated events not covered in the
property insurance held by the owner.
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Disability insurance
o Disability 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 insurance
o Increase deductible, purchase a low profile car, drop unneeded coverage, drive
less, safety discounts, student discounts, combine policies
Financial Planning:
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Determine Net Worth and definition and examples of assets, liabilities and net worth
o Net worth = value of assets – amount of liabilities
o Assets: real estate, stock investments, bank accounts, cash
o Liabilities: debts, loans (mortgage, car, student, etc.)
Retirement – how different plans and accounts work and when taxes are paid on funds
o Pensions, 401K, Traditional IRA (Individual Retirement Account), Roth IRA
o A 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.
o 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" payment
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Traditional 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.
o 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 least
o Inflation: 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 owners
o Deflation: 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 taxes
o A 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:
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Roles of SEC, Federal Reserve (the Fed), FDIC, CFPB
o SEC (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.
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The Fed: The central bank of the United States and the most powerful financial
institution in the world. Roles:
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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.
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Supervising and regulating banking institutions to ensure safety of the U.S.
banking and financial system and to protect consumers’ credit rights.
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Maintaining financial system stability and containing systemic risk.
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Providing financial services – including a pivotal role in operating the national
payments system – to depository institutions, the U.S. government and foreign
official institutions.
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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.
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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.