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Chapter 3 Your Personal Finances 15
Stocks, Bonds,
Mutual Funds,
Money Market
Instruments
3. Your Personal Finances
Whenever you own things of value (called “assets”) and have access to money (also an asset), you
are looking after your finances, in one way or another. Personal finance is the term used to describe
this management of your assets. The two key elements of personal finance are how you make your
money and how you spend your money — your cash flow. How you plan and manage your money is
the focus used in this document.
Cash Flow
Making money represents all the ways you receive cash. You might make money by working at a
job, by buying and selling stocks, or even winning the lottery. These are your sources of incoming
cash. Spending money is something that most people find easy to do. Spending represents the uses
of your cash. Together, making money and spending it represent the basic concept of cash flow —
how money flows in and out of your accounts: Cash in, minus Cash out.
Making Money (Cash In)
There are two primary types of money you can make: earned income and unearned income. These
are general categories, but they are good terms to show the basic difference between money you
work for and other money you receive. Earned Income Most people think of making money by finding
a job and getting a salary or an hourly wage. This usually means working for a business,
organization, or the government. Or, you might become an author and earn royalties from your
books. You could also be self-employed and earn a salary from your business. Earned income is
money you get from your employment, that is, what you earn for yourself in your profession, career,
or job. But there are other ways to make money. Unearned Income If you start a business, your
company might generate profits for you. You might receive inheritance money or trust fund income
from your relatives. You might receive gifts; or you might get lucky and win money from bingo, or
betting, or the lottery. The most common way to produce more income than you yourself can earn
is to put your money to work for you and to let it earn more money for you. This type of income
generally comes from interest on savings or from gains on selling things you own. While the tax law
calls this “unearned income,” it doesn’t happen by itself. You have to work at managing your money
carefully in order to make it grow.
Spending Money (Cash Out)
Spending money is easy! Making sure you spend within your means is not. When deciding how to
spend your money, you must plan both for your current expenses and for your future financial goals.
Your current expenses cover the essential cost of living — expenses such as housing, transportation,
food and clothing. Additional discretionary expenses will be budgeted to cover optional expenses like
entertainment, extra clothes, hobbies, education, and charitable donations. Discretionary expenses
are those expenses over which you have more control, and which are not mandatory for you to live
and earn your wages. But you should also consider the future, and your family’s future. You may
have children to put through university. You may need a bigger house for your family. And, you
need to plan for your retirement, when you stop earning wages and live off your savings and other
benefits eligible to you. Regardless of what your specific goals are, part of how you “spend” your
cash is likely to include putting some money aside to meet your future financial
requirements.
Assets, Liabilities, and Net Worth (Equity)
When you apply for a loan, the bank will want to know your net worth. Net worth is an
indicator of your personal wealth. If you are looking to your future, you can watch the
change in your net worth as a mark of progress towards your future goals. But, what is
net worth? To answer that question, you have to understand assets and liabilities.
Assets
An asset is an item of economic value, which you own, and which is cash or could be sold for cash. It
is important to distinguish between an item of economic value and an item that may only have
sentimental value. While something may be emotionally important to you, if no one will buy it, then it
is said to have no cash value and is not considered an asset.
Liabilities
A liability is a debt — money or equivalent monetary value of things that you owe someone else. You
have liabilities to your telephone company for using their service. You may have credit card bills, a
mortgage, a car loan, or other types of borrowings or payments due.
Net Worth (Equity)
Net worth, also called equity, is the total worth of the things you own (your assets) minus all your
debts (your liabilities). Or, you can think of it as the amount you would have left over if you sold all
your assets and paid off every single one of your debts today. If the number is positive and growing,
that is good. If your net worth is negative and shrinking, you may be in financial trouble.
Net Worth = Assets — Liabilities
To determine your net worth, make a list of all your assets and liabilities. Then subtract the liabilities
from your assets. Keep in mind that the cash value of your assets is what they are worth if you sold
them today, and not what you may have paid for them. Your liabilities are what you owe as of today,
not the original amount, or last month’s bills. Here is an example of a net worth calculation:
Net Worth Calculation, as of June 30, 2003
Original Cost Current Value
Assets
Cash on Hand $ 150
Cash in Checking Account 1,100
Cash in Savings Account 2,650
$ 150
1,100
2,650
Personal Use Assets:
-Automobile 25,000
- House 150,000
13,000
175,000
Investment Assets:
-Stocks, Bonds, Mutual Funds 50,000
- Other - Stamp Collection 500$229,400
70,000
1,500
$263,400
Original Amount
Liabilities
Bills, Unpaid $ 750
Credit Cards, Unpaid Balance 2,300
Automobile Loan 20,000
Mortgage (loan) for the House 120,000
Personal Line of Credit Loan 5,000
$ 750
2,350
10,000
110,000
2,000
Other Loans & Obligations:
-Family Loan 10,000
- Income & Property Taxes Due 0
- Personal Guaranty of Son’s Car Loan 15,000
$173,050
Net Worth = Current Value of Assets — Liabilities
10,000
0
13,000
$138,100
$125,300
Chapter 4. Your Assets
Your assets represent everything you own which has an economic value. Assets can be either
cash or something which could be sold for cash. Almost everything you own and use for your own
personal purposes now, or which you are saving for the future, is an asset, because most
possessions have some economic value. Assets may also be categorized or described as:
• Cash
• Investment Securities
• Capital (non-cash) Assets
• Investment Property or Personal Use Property
Cash
Your cash assets include money which you have on hand in your wallet or elsewhere in your
possession, money you have deposited in bank accounts, plus any checks or money orders which
you have received but not yet cashed.
Investment Securities
Investments are assets which you have obtained in order to provide future increases in value.
The increases may come from periodic payments you receive of interest income or dividends, or
from appreciation. Appreciation means increases in the value of an item, so you can sell it at some
future date for more money than it cost you to buy it. Be careful when using the term
“investments,” because it can refer to several different things. Some people use the word
“investments” to mean things like stocks, bonds, mutual funds, and certificates of deposit. However,
it is more correct to call these items investment securities. With an investment security, you are
given a piece of paper – a contract – which secures your ownership share of a certain asset. If you
look back at the definition of investments in the first paragraph above, you will realize that
investments mean much more than investment securities. Investments can also be actual, physical
property you own: these are capital assets.
Capital Assets
Assets other than cash are often called capital assets (also called capital property and sometimes
fixed assets). A capital asset is a physical item you own which usually cannot instantly be converted
into cash, and which is usually held for a long period of time. Capital assets can include:
 Real estate
• Automobiles
• Art and antiques
• Jewelry and gems
• Gold, silver, and precious metals
• Collectibles (stamp collections, coin collections, etc.)
• Even animals can be capital property, for instance a racehorse, as long as there is a resale value.
Note: For tax purposes, capital assets include your stocks, bonds, and mutual funds. What is common among
all capital assets is that liquidating your property (converting it into cash) may take time. This is
because there you cannot instantly sell a capital asset. For this reason, capital assets are usually
considered long term investments.
Investment Property or Personal Use Property
Capital assets that are used for investment property are generally those which you do not use
on a day-to-day basis. Investment properties are those assets you buy with the hope of selling at a
gain. If you buy something for your own use or if you will never sell it, and then it is not investment
property. Capital assets are classified as either investment property or personal use property (noninvestment property) for two reasons:
1. Personal Financial Planning — you do not usually purchase something for your personal use in
hopes of reselling it for a gain, an increase in monetary value. Its value to you is in having and
using it. On the other hand, investment property is purchased for a future potential gain, and not for
personal use.
2. Income Taxes — when you sell any capital assets, capital gain income tax rules apply. If you
decide to sell personal use property, there may be special capital gain exemptions for these
transactions.
Your car depreciates (loses value) the more you drive it. So, this
would not be considered an investment. If, however, you owned an
antique classic car which you only drove on special occasions and kept
in good running order, this could be considered an investment property.
Similarly, a baseball card collection or coin collection that you keep in
mint condition would be an investment, as long as you might sell it
someday. If you will never sell it, then it is not investment property.
The most common types of capital assets used for investment property are:
• Real estate
• Precious metals
• Gems
In all these cases, there are normally markets for buying and selling. Many other assets can be
investment property, but often things like art and collectibles are kept for personal enjoyment and
not for resale.
Chapter 5 Your Liabilities


Credit
Loans
A liability is a debt — money or equivalent monetary value of things that you owe someone
else. In your personal finances, your liabilities represent the money you owe on the goods and
services which you purchased but have not completely paid for yet. This includes repaying any
money borrowed to buy these things. Your liabilities also include any guaranties you may have made
for other people’s loans. A loan guaranty makes you responsible for payment of the debt if the other
people who borrowed the money do not make their own payments. Your liabilities can be classified
in the following categories:
• Unpaid bills
• Unpaid credit card balances
• Bank loans
• Rents and leases
• Family loans and loan guarantees
• Unpaid taxes
Your bills and taxes are normally paid off in a short period of time. Credit card balances and
loans are paid off over a number of installments. Guaranties may never be paid by you, but since
you are ultimately responsible for payment, any amounts you guaranty are a liability and reduce
your net worth. All of these liabilities represent types of borrowing, debt or credit, because in all
cases you (or someone you have guaranteed) have received something of value before it has been
paid for fully.
Borrowing, Debt, Loans, and Credit — What Are They?
Borrowing, debt, and credit can be three terms for the same thing.
Borrowing is to receive something of value, with a promise of giving
something of equal or greater value back at some point in the future. You
can borrow your neighbor’s lawn mower, or borrow $100 from your parents,
or borrow money from a bank to buy a car. Debt or Loans, in financial
terms, normally refer to a formal type of borrowing. It is an obligation
(usually money) documented in a contract or legal agreement. You owe
someone else and must make payment by a specified date. Borrowing money from a bank to buy a
car would be a debt documented in a loan agreement.
Credit has three different common definitions:
1. Sometimes it is used to mean the same thing as debt. For example, at a store’s checkout counter
the attendant might ask you, “Are you paying by cash or credit?” Here credit means you will not pay
for the merchandise today, but agree to pay either your credit card company, or your account at
that store when you get their bill.
2. It can also refer to your capacity to borrow, or the maximum amount of financial borrowing you
can do. For example, if you are approved for a $20,000 loan to buy a car, then that is the maximum
you can borrow from the bank to buy a car. If your credit card company provides you with a credit
limit of $5,000, you cannot charge amounts over a total balance of $5,000 at any given time.
3. The third definition of credit is a refund or reduction. This comes from accounting terms (debits
and credits). If you return a purchase to a store, you may have heard someone say, “We’ll credit
your account for this amount.” There are many different types of borrowing options. Some are
specialized for the type of purchase, for example mortgages are for buying real estate. Others can
be general loans for purchasing a variety of goods and services, for example credit cards. When
deciding which type of credit to use, understand the advantages and drawbacks of each, so that you
select the best option for your situation. For large borrowings, you should get professional financial
advice to help you make your selection.
Why Do People Borrow?
Being able to borrow money allows you to have things before you can
afford to pay for them. You may take a mortgage out on your home. Then you
live there while you pay off the debt. You might take a loan out to buy a car, and
pay the loan off while you are driving the car. Having the ability to borrow can improve your lifestyle
and provide greater comfort than you might be able to otherwise afford. Without the ability to
borrow, you would only be able to buy things by paying the full purchase price up front with cash.
Debt must be managed, to avoid borrowing too much so that the repayment requirements
limit your cash available for basic necessities like food and shelter. Some governments which have
overspent in the past are now paying millions of dollars a month in interest on the debt from this
overspending. Personal debt is a lot less than this, but it can still cause hardship in repaying if you
build up too much debt.
Only you can decide the importance of your purchases and loans. But debt is not free, so you
must manage your debt and current purchases against your ability to repay the debt.
Interest Payments
When you borrow money, you usually have to pay back more than the amount you borrow.
This additional payment is called interest. Interest is the fee charged by the lender for the use of the
borrowed money. The interest due is usually stated as an annual percentage (the interest rate) of the
principal (the amount borrowed). Every payment you make on a loan goes first to pay for the current
amount of interest due, and the remainder is used to reduce the amount of unpaid principal.
Credit Ratings
If someone asks you if you have good credit, they are using credit to refer to your ability to
take on more debt, and if you have a history of paying your debts on time. This is also called a
credit rating. A credit rating is based on your history of borrowing and repayments. If you have
never borrowed before, then you may find you have “no credit rating.” It is always good to have a
“good credit rating.” This means that you pay your debts and meet your financial obligations on
time, and that you may have the ability to borrow more and repay it if needed.
People with bad credit have a history of not repaying their debts on time. If you have a bad
credit rating, it will be difficult to borrow money in the future. People with no credit rating have no
history of borrowing documented. It may also be difficult to borrow money if you have no credit
rating.
Credit bureaus are governed by state/provincial laws. They track information on personal uses
of credit — how much you borrow, when you pay it off, and how prompt you are in paying your
loans and other obligations like phone and electrical bills. Most of this information is kept on file for
up to seven years. Banks, credit card companies, and other lenders will
check your credit rating as part of their process in deciding to lend you
money or not. You can get a copy of your own credit report by contacting
your local credit bureau (check the telephone book’s yellow pages). There
may be a small fee for the service, and it may take two or three weeks to
obtain a written report. If you are unsure of how to obtain a copy of this
report, contact your banker or financial advisor.
Revolving Credit and Loans
Revolving Credit
Some debt arrangements allow you to borrow and repay and then
borrow again. These are types of revolving credit, because you can go round and round – borrowing,
paying back, and borrowing again – as long as you meet monthly minimum payments and do not
exceed the total credit limit assigned to you. A maximum credit limit is established and there are
terms for minimum monthly payments. Then you decide how much you are going to borrow and how
much above the minimum you will pay each month. Credit cards, personal lines of credit from your
bank, and overdraft protection on checking accounts all operate in this manner.
Loans
Contrary to revolving credit, most loans are one-time borrowings, where all the money is
provided when you sign the loan in one lump sum, and a fixed repayment schedule is set up. If you
want to borrow more money later, you have to take out a new loan. Car loans, mortgages (loans to
buy real estate), home improvement loans, and other personal loans are all set up in this fashion.
Loans can be obtained from banks, credit unions, trust companies, and other
financial institutions – including your life insurance company. What is common
to them all is that there is a contractual agreement to repay the money
loaned, plus a given interest fee over a specified number of payments. The
repayment term, payment amounts and interest rates vary by type of loan,
the type of lending institution, the riskiness of the loan for the lender, and the
credit worthiness of the borrower. People who borrow money are called
debtors: they owe a debt to repay the lender a certain amount of money. The
lender is also sometimes called the creditor: this is the person or organization
which has provided credit and loaned the money.
Secured and Unsecured Loans
All loans are either secured or unsecured. A secured loan means you have pledged another
asset against this debt. If you default on the loan, you lose the pledged asset. This is standard for
car loans and real estate mortgages. Here the pledged asset is what you are buying. For example, if
you don’t make your car loan payments, your car can be repossessed. If you don’t make your
mortgage payments, you could lose your house. If this is done, the creditor sells the repossessed
asset to pay off the balance of the loan. Unsecured loans have no pledged assets backing them up.
You will have a lower borrowing limit if the loan is unsecured, because the financial institution’s
risk of loss is higher if you don’t repay the loan.
Rents and Leases
Rents are agreements to pay for the use of an asset, usually to occupy certain space or
to use certain goods. You might rent a car by the day. You can rent parking spaces and apartments
by the month. You rent videos and DVD movies by the night. These are all types of rentals. You
never own the asset; you only pay to use it for a while. A lease is a contractual agreement which
allows you to have use of an asset over a long time (an apartment, a car, etc.) while making regular
payments over a set time frame. Some leases, like an apartment lease, are just a long term rent.
That is, you have no rights to purchase or own the asset at the end of the lease. So these
assets are not part of your net worth. Other leases provide you the option to purchase the asset at
the end of the lease. Depending on the lease, this purchase price might be the market value of the
asset at that time, or a nominal charge like $1. These are called financing leases, and they are
actually types of loans. You have a fixed repayment period, regular payments, and interest (usually
a fixed rate). If you have an option to purchase or lease an asset, you should compare the costs, tax
impacts, and benefits between taking out a personal loan to purchase and leasing. If you have
ownership rights in the asset, then you should list the asset and the liability as part of your net
worth calculation.
Family Loans and Loan Guarantees
You may also receive loans from friends and family from time to time. Family loans are
usually informal lending arrangements. These loans often have no written agreement, and may not
require interest payments or set repayment terms. You might also be asked to loan a family
member money at some point in time. Or you might be asked to guaranty the loan someone is
taking out. A loan guaranty is also called co-signing a loan. If you guaranty a loan, it means that if the
borrower neglects to make the loan payments, you are then legally required to make the payments.
You hopefully will never pay anything on these guarantees, but because you might have to do so,
these guarantees are considered liabilities and reduce your net worth.
Consumption, Income, and Wealth Taxes
Taxes are funds that must be paid to the government in order to enable the government
to pay for its operations; such as public schools, road maintenance, garbage collection, etc. Federal,
state/provincial, and county/municipal levels of government each have rights to charge certain types
of taxes. One way to look at taxes is to determine if they are charges on your:
• Consumption of goods,
• Income from wages and investments, or
• Wealth from owning investments and capital assets.
Consumption tax is levied on goods and services you purchase.
Income tax is assessed on your earnings — whether from wages,
interest income,
dividend income, capital gains income, gambling income, or other types of cash and value you
receive.
Your wealth is your net worth. So wealth tax is a charge made based upon your net worth. The
US and Canada do not have a wealth tax, but many other countries do. For instance you might have
to pay a higher income tax rate if your net worth were over a certain amount in countries with a
wealth tax. And while the US and Canada does not have a wealth tax, there are taxes on parts of
your wealth. What comes closest to a wealth tax is real estate (property) tax. This tax is based on
the value of your real estate. You pay it for as long as you own the property. Depending on the type
of tax, you may pay the tax as part of your purchase (sales tax), receive a periodic bill for your
taxes (real estate tax), or be required by law to make withholdings from your wages and fill out
forms each year (income tax). Taxes are similar to other liabilities — if you do not pay them on
time, you will be charged interest and penalty charges.
Chapter 6. Managing Your Assets and Liabilities
Whenever you choose to spend money, save it, give it away, or invest it, you are
making a personal finance decision that will affect you in some way or another – either
today or in the future. Making good personal finance decisions starts with
understanding your own personal financial requirements and goals, and then
understanding the options that are available to you for reaching your goals. The better
you understand your goals and options, the better you will position yourself for the
financial future you desire. Money management is a major cause of stress for people
all over the world. By planning your financial future early in life and assessing your needs regularly,
you can minimize your stress while maximizing your personal wealth.
Setting Goals and Planning
Most people have goals and dreams for the future. Realizing them often depends on your
financial resources, which means the better you manage your money today and in the future, the
greater the chance you will be successful. By setting goals, planning, and investing your money
wisely, you are taking the first and most important steps to realizing your goals and dreams.
Setting Goals
To set your personal goals, think about what you want in the
future, for yourself and your family. Do you want a large home? a
vacation cottage in the country? a sports car? A comfortable
retirement income? to have two children and send them both to
university? Make a list of your goals. Set reasonable goals, or at
least be willing to revise your goals to match the realities that you
will face in the future. Some of the most common goals which
impact your personal finances are:
• Education and training programs
• Career
• Marriage and family
• Homes
• Cars
• Vacations
• Money
• Retirement income
You may have other goals, like learning to play a musical instrument, owning certain assets, and
more.
Planning for Your Future
Now that you have goals you wish to reach, you have to plan how you might
achieve them. Think of this as a road map. You are at the beginning of a journey, and
your goals are the destination. In between these points there are various routes.
Several may lead to your goals. Others will take you away from them. The first step is
to estimate how much money you think each of your goals will require. Then
determine how many years you have until you need this money. You may find that
your goals are not all at the end of your journey, but that several are along the way in
a time line. This process may seem a daunting task to start with. But the important thing is to have
a plan and to start acting on it.
Investing
Investments are assets which you have obtained in the hope that these assets will increase
your wealth. Investing is the process of buying and selling assets to increase your wealth. The gains
might come from interest or income generated by the investment. It might come from the increased
value from the time of purchase to the time you sell. Or, it might come from a combination of both
income and increased value. This is a very broad definition. It covers many types of investments,
from savings accounts, to investment securities and capital assets. Like forks in the road, each
investment option has different characteristics and risk. These will be discussed in more detail in
subsequent chapters.
Start Today!
One of the most important rules of personal finance is to start on a plan today. If
your plan shows you can only invest $5 or $50 a month, that is a start toward
reaching your goals.
Monitoring Your Financial Health
The three most important tools in monitoring progress towards your financial goals
are:
• Cash Flow
• Budget
• Portfolio Management
Cash Flow
Your cash flow consists of money coming in and going out. What come in are the sources of your
cash, or income, and what goes out are called the uses of your cash, or expense. Income can be
categorized as earned or unearned. As discussed in Chapter 3, this is either money from your
employment or money from other sources. Income can also be categorized as regular (or recurring) or
one-time. Examples of these different types of income are:
Expenses are your bills and purchases. Some expenses are required in order for you to live and earn
your wages, for instance food and clothing. However, even with these mandatory living expenses
you often have choices of how much to spend. For example – should you rent or buy a house? Other
expenses are more optional, or discretionary, such as how much to spend on entertainment. It is
also important to differentiate between fixed and variable
expenses.
Fixed expenses are bills which tend to be the same each month or
year, such as
rent. Variable expenses are those which change often. Usually
you have
some control over your variable expenses. Here are some
examples:
positive cash
If you have more income than expense, you are said to have a
flow (“in the black”). If your expense is higher than your income you have a negative cash flow (“in
the red”).
Determining your cash flow helps you to project if you will have a cash shortfall or surplus. If
you have a shortfall, you will either have to cut back your spending, earn more money, or borrow
money. If you have a surplus, you can decide if you are going to spend it or invest it. To determine
cash flow, pick a period of time (such as a month) and record all money coming in and going out, as
well as how much money you currently have. Note that not all liabilities are paid in the same
periods. For example, real estate taxes are generally paid every six months, and insurance is usually
an annual charge. You may find it easier to show a reserve (money you set aside each month) for
the monthly portion of these less frequent charges in your cash flow.
Budgets
A budget is an itemized list of estimated expenditures and the expected ways to pay for them, for a
given time period. By budgeting you can manage your finances better, and watch to make sure you
don’t spend more money than you budgeted. In addition to income and expense items, budgets
often include planned amounts for savings or investment. For instance, you might have money taken
out of your paycheck for a retirement plan. Or, you might make monthly payments to a savings
account. These are uses of your cash that may remove it from easy access, but the money is still
yours. Think of it as paying yourself. The main difference between a budget and a cash flow is that
budget use estimates and cash flows use actual amounts. A budget is an estimate, done before the
money is earned and spent. A cash flow shows actual results of earnings and expenses. It is also useful
to compare your budget with what actually happened. This helps you to make your future budgets
more accurate.
Portfolio Management
A collection of investments is known as a portfolio. Portfolio management means watching all
your investments, and balancing your various investment needs. The most common portfolio
management issues are:
• Liquidity
• Investment Income
• Growth/Capital Gain
• Risk
• Tax Planning
Liquidity means how
easily your investment could be cashed and used. If
you are saving for your retirement,
you won’t need the cash for many, many years.
However, if you’re saving for this year’s vacation, you have to be sure you will have the cash
available in time for your trip. Investment Income Some types of investments make periodic payments
of interest or dividends: this is called investment income. If you need investments to generate regular
income without selling assets or reducing the principal amount, then you must choose investment
options which will do this. Growth/Capital Gain The value to some investments is not periodic income,
but the increase in the overall value of the asset. When you sell the asset, you receive more money
that you paid for it. This is called growth or capital gain. In many cases this growth can exceed the
sum of all the interest you might have received from another investment. Unlike interest income and
dividends, you must sell this asset to get cash back and any capital gain. Risk is uncertainty.
Whenever there is an unknown future, there is risk. Many investment decisions you make will carry
a risk that the investment will not provide the future value you expect. You might lose some of your
money or even all of it. Or, you might gain a little or a lot. Each investment carries a certain risk
that it will not perform as anticipated. It is likely that your portfolio will have a blend of different risk
levels.
Tax Planning
Another part of your portfolio management is tax planning. You must plan the most
advantageous manner for investing with your income taxes in mind. Certain investments provide
ways to reduce or defer tax payments. For example, there are many retirement plans which defer all
taxes until the time you use the money after you retire. Government bonds are usually tax exempt.
If you want to avoid current income tax on your investments, your portfolio may include some tax
exempt or tax deferred investments.
Insuring Your Life and Assets
There are no guarantees in life, but you can pay a reasonable cost to insure against the
unexpected loss of certain assets, and even your life. There are three major categories of insurance
products:
• Those used as investments.
• Those used to pay for the costs of loss or damage.
• Medical and health insurance.
Annuities and certain types of life insurance are used as investment instruments. Other
insurance guards against your financial loss to property (house, car, possessions, travel, lawsuit
claims, slander), or your health and ability to earn a living (medical, loss of use, or disability
coverage). Insurance is a contract, called a policy. You, the insured, pay a specific sum or series
of payments (called premiums) to the insurer or underwriter. In return for your money, the insurer
agrees to guaranty against the loss of certain specified risks, up to specified limits. You can insure
many things, but some insurance may be so expensive that you decide to do without it. The most
common types of insurance purchased are:
• Life Insurance
• Health Insurance
• Automobile Insurance
• Property Insurance
Life Insurance
Like the name implies, life insurance insures your life. That is, it pays an
individual whom you name, your beneficiary, a certain amount of money when you die.
There are exclusions: for instance, death by suicide is not covered. Why do you need life
insurance? Obviously the benefit does not go to you. But the life insurance payment to your
beneficiary can be used to:
• Cover the costs of your funeral and settling your estate, and
• Provide your family members with financial security.
Buying life insurance is important, and it can be confusing. There are a number
of policies to choose from, and it is often difficult to compare one to the other
when you are shopping for the right policy. Some insurance companies offer policies which include a
savings component. In these cases there is monetary value to you in your lifetime, in addition to the
death benefit, the amount paid to your beneficiary upon your death. The basic types of life insurance
policies can be broken down into two major categories: term life and whole life. Annuities are a third
category. Annuities are primarily a savings vehicle, but they pay a death benefit and are considered
an insurance product.
Do You Need Life Insurance?
The best way to decide this is to ask yourself, “Would my death create a financial hardship for
anyone?” If the answer is “yes,” you need life insurance. Some people recommend buying life
insurance when you’re young so that the premiums will be low. If your death would not create a
financial hardship on anyone, then you may wish to invest the money instead of spending the money
on insurance premiums. High wealth individuals should also consider the tax impact on your
estate. When properly structured the life insurance death benefit may be completely exempt from
estate taxation. So your beneficiaries could use it to pay the taxes on your estate.
How Much Do You Need?
This is more difficult to determine. Some people just pick a number out of the air. Some people use
a number equal to four or five times their annual income. Others take a more analytical approach:
What would immediately need to be paid?
• Funeral expenses
• Estate taxes and probate costs
• Mortgage
• Debt
• Children’s college funds
What would your family need to maintain their standard of living?
What other income would your family have after you are gone?
• Social Security (US) or Social Insurance (Canada) benefits
• Retirement benefits
• Savings and investments
• Their own wages and earnings
What economic factors do you have to consider?
• Inflation
• Interest rates
It is complex, especially when you try to estimate how much inflation will erode the future insurance
benefit. Insurance agents can help you with these estimates. Ultimately, it will probably come to a
compromise between the future benefit you would like to have and what you can
afford today.
Health Insurance
Health insurance is recommended in the US and usually is available through your
employer’s group plans. In Canada basic health coverage is provided to all residents, but
supplemental plans may be desired to cover prescriptions, dental care, and when traveling out of
your home province. Other insurance options include coverage for the possible loss of your ability to
earn a living: disability coverage, or for specialized professions, loss of use (e.g. a surgeon would
insure his hands).
Automobile Insurance
Certain amounts of automobile insurance are mandatory by law. Most drivers carry more than legal
requirements to pay for damages and cover lawsuits from others.
Insurance
coverage usually includes payment for damage to the vehicle, and medical
costs from
personal injury if you cause an accident.
Property Insurance
Your mortgage lender will require that you purchase certain amounts of insurance against damage to
the house you are buying. Homeowner policies usually cover both the structure and a
specified amount of personal goods within it. If you do not own your home, you can
also purchase insurance for just your personal belongings, and not the building itself.
Special high-value items should be identified separately to your insurer, for example
— computers, jewelry, boats, antiques, coin or stamp collections, etc.
Other Insurance
Other types of liability insurance and short term coverage for travel and goods are also available.
Specialty coverage can range from personal liability insurance to pet insurance. To decide if you
should have the coverage, consider the risk that such a loss might occur, and then the cost of the
loss versus the cost of insurance.
Living and Retiring Comfortably
By calculating your net worth and keeping an eye on your cash flow, you can begin to
determine what your future financial health might look like. If you expect to retire at a young age,
then you will need to build up enough net worth to be able to do so, including factors such as
inflation. Or you can simply plan to balance your current life style with enough investment to assure
a comfortable retirement at a later time in your life. There are trends for investment portfolios in
“an average person’s” lifetime. Many people find they are not “an average person,” and their
financial requirements are different, or they don’t have the expected investment portfolio for their
age level. So an investment timetable should be used only as a general guideline. It is never too
late to start saving and investing. But your age, family responsibilities, and financial commitments
may require you to adapt the investment strategy to your specific situation. In your younger years,
you will want to look to long-range growth investments. You may be able to afford to take some
higher risks, as you will have time to adjust for losses. As you grow older, you will continue to
diversify your portfolio of investments. Then, as you approach your retirement, consolidate your
holdings and reduce the amount of high risk investments. During retirement years, you will likely
wish to have more income generating investments and low risk to give you security.
Early Years
To Mid 30s
Get started!
Growth-oriented.
Mid 30s –
Late 40s
Build value
and
invest!
Diversify.
Growthoriented.
Retirement Years
PreRetirement
Years
Late 40s –
Retirement
Consolidate!
Diversify but
reduce
amount of
high risk.
60 and over
Security!
Income-oriented.
More conservative.