CFP® Book 1

College of Financial Planning

📚 GENRE: Business & Finance

📃 PAGES: 302

✅ COMPLETED: June 3, 2023

🧐 RATING: ⭐⭐⭐

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Short Summary

The first of several books on the road to becoming a CFP, General Financial Planning Principles, Professional Conduct, and Regulation covers a variety of financial concepts, including the role of an advisor, the different financial instruments available, how to evaluate your (or a client’s) financial health, how to use Time Value of Money calculations, and a lot more. 

Key Takeaways

1️⃣ Frugal Lifestyle — As a CFP, helping your clients live a frugal lifestyle is one of the best ways you can help them on their financial journey. Saving and investing money consistently and as early as possible will lead to huge rewards down the line.  

2️⃣ Real Estate — Between the tax benefits, potential rental income, and likely home appreciation, there are so many advantages that come with owning real estate and holding it over several decades. Taking out a mortgage to buy a home is often a great investment and a good use of debt. Stick to fixed rate debt to avoid potential swings in market interest rates. 

3️⃣ Eliminate Consumer Debt — Consumer debt is killer, especially credit card debt, which often comes with interest rates north of 15-20%. Your financial health is severely hampered by consumer debt — try to eliminate it as soon as possible. 

Favorite Quote

“The tax benefits of home ownership — particularly the itemized deductions for property taxes and home mortgage interest — are likely the reasons many people decide to buy a home… In addition, historically, in some areas of the country, the fair market value of homes has appreciated more rapidly than that of many other assets (including securities).”

Book Notes 📑

Ch. 1: Personal Financial Planning

  • The Financial Planning Process — There are seven key steps in the financial planning process. Certified Financial Planners are required to walk through each of these steps as they work with clients to develop a plan that meets their needs.
    • Step 1: Understand the Client’s Personal and Financial Circumstances — In this step, CFPs sit down with clients and acquire as much quantitative and qualitative information as possible. Your goal is to understand the client’s goals, values, health status, risk tolerance, current financial situation, and more. You want to get to know the client at a high level. 
    • Step 2: Identify and Select Goals — Step 2 is where you dive deeper into the client’s goals. Goals are critical to the planning process because they define what the client wants to achieve and direct the overall process. 
    • Step 3: Analyzing the Client’s Current Course of Action and Potential Alternative Course(s) of Action — Before making recommendations to a client, you must assess the client’s financial situation and determine if the client will reach his goals by continuing present activities. By analyzing and evaluating the client’s current course of action, you can accurately assess a client’s financial strengths and weaknesses.
    • Step 4: Developing the Financial Planning Recommendation(s) — After identifying and evaluating the alternatives and the client’s current course of action, you must develop the recommendation(s) expected to reasonably meet the client’s goals, needs, and priorities. The recommendations should be spelled out clearly so the client can understand them. 
    • Step 5: Presenting the Financial Planning Recommendations — Here is where you present your recommendations to the client. It’s important to be as detailed and clear as possible in your delivery. Many clients are unfamiliar with financial terms and concepts. 
    • Step 6: Implementing the Financial Planning Recommendations — If the client has allowed you to implement the agreed upon plan, this is where you carefully research, select, and acquire the stocks, bonds, and products that will help the client reach their financial goals. This is where you also coordinate with other professionals, like estate attorneys and/or accountants, to execute the client’s plan and get them set up for success. 
    • Step 7: Monitoring Progress and Updating — Monitor the progress of the client’s portfolio. If things aren’t going as expected, work with the client to make adjustments. It’s also possible that the client’s life situation and goals can change dramatically. It’s important to check-in on the client and the portfolio often.
  • Contextual Variables — The CFP Board considers things like age, marital status and dependents, financial status, net worth, income level, family status, special needs, and attitudes to be contextual variables that play an important role in forming a client’s financial plan. All of these factors matter, which is why it’s so important to get to know every aspect of a client’s life.
  • Phases of the Financial Journey — There are three main phases every person goes through on their financial journey. It’s important to determine where a client stands when first meeting with them.
    • Asset Accumulation Phase — The client is typically age 20-45 and is in the early stages of his financial journey. In this stage, the client usually has low net worth and is trying to build income while eliminating debt. Clients in this phase are usually more open to taking risks because they have time on their side.
    • Conservation Phase — The client is typically age 45-60 and is focused on retirement. In this phase, the client is increasing cash flow, assets, and net worth. Debt is also decreasing in this stage. In the conservation stage, clients are usually more risk averse than they used to be.
    • Distribution and Gifting Phase — In this phase, the client is age 60 and older and is focused on how they are going to distribute their wealth to their loved ones. This is also the stage where clients are enjoying the fruits of their labor, buying cars, houses, and fancy vacations. Clients in this stage really begin to lock in their estate planning objectives. 
  • Deferring to Your Team — There are certain aspects of executing a client’s financial plan that will require help from a different professional, like an estate attorney or an accountant. The CFP Board requires that if you do not have the competence to execute a certain task within a client’s plan, you must either gain the needed competence to complete the task or defer to a professional that does have expertise in that area. In the end, it’s all about doing what’s best for the client.
  • Chapter Takeaway — Ultimately, the role of a CFP professional is to work with clients to identify financial goals and objectives, understand the client’s current financial status, analyze the client’s current course of action, explore alternative courses of action, and recommend appropriate financial tools and strategies. The CFP is also responsible for helping the client execute the financial plan.

Ch. 2: Behavioral Finance, Communication, and Counseling Principles

  • Cognitive Errors — As humans, we all deal with cognitive errors and biases that can affect our decisions in all areas of life. Having an understanding of the different cognitive errors can help you negate them.
    • Illusion of Control — You believe you can control the outcome of an event when you cannot.
    • Money Illusion — You have a tendency to think one dollar has the same value today, tomorrow, and into the future, without considering inflation.
    • Conservatism Bias — You initially formed a rational view but failed to change that view as new information becomes available.
    • Hindsight Bias — You have a selective memory of the past and have a tendency to remember your correct views and forget your errors.
    • Confirmation Bias — You look for ways to justify your current beliefs.
    • Mental Accounting — You tend to place money into separate mental “accounts” based on the purpose of these accounts.
    • Cognitive Dissonance — You have conflicting attitudes, beliefs, or behaviors that cause a feeling of mental discomfort. This leads to changing some of your attitudes, beliefs, or behaviors to reduce your discomfort and feel more balanced.
    • Self-attribution Bias — You take credit for your successes and either blame others or external influences for your failures.
    • Outcome Bias — You tend to take a course of action based on the outcomes of prior events, ignoring current conditions.
    • Framing Bias — You process and respond to information based on the manner in which it is presented.
    • Recency Bias — You give recent information more importance because you remember it more distinctly.
  • Emotional Errors — In contrast to cognitive errors, emotional biases are not related to conscious thought and stem from feelings, impulses, or intuition. Your emotions (fear, greed, etc.) are driving your decisions. A few of the common emotional errors include:
    • Loss Aversion — You fear losses much more than you value gains, and you prefer avoiding losses to acquiring the same amount in gains.
    • Overconfidence — You believe that you control random events merely by acquiring more knowledge and consider your abilities to be much better than they are.
    • Self-Control Bias — You lack self-discipline and favor immediate gratification over long-term goals.
    • Status Quo Bias — You are comfortable with an existing situation, which leads to an unwillingness to make changes, even though the changes are beneficial.
    • Endowment Bias — You think an asset you own is worth more than it is because it is yours.
    • Regret Aversion Bias — You do nothing out of excess fear that your decisions or actions could be wrong.
    • Affinity Bias — You make decisions based on how you believe the outcomes will represent your interests and values.
  • Chapter Takeaway — Clients are human. We are all affected by cognitive and emotional biases. It’s beneficial to have an understanding of the biases we are susceptible to so we can help clients, and ourselves, avoid them when making financial decisions. 

Ch. 3: Financial Statements, Cash Flow Management, and Financing Strategies

  • Personal Balance Sheet — There are two main financial statements you need to prepare for a client using information they give you. One is the statement of financial position, also known as the personal balance sheet. Much like a company balance sheet, the personal balance sheet is a profile of what is owned (assets), what is owed (liabilities), and the client’s net worth. The formula for net worth is: Assets — Liabilities. The personal balance sheet is valuable because it gives you a nice “snapshot” of the client’s financial health at a given time, much like a company’s balance sheet. You can compare successive snapshots over time to easily identify trends in the client’s financial well-being. 
  • Personal Balance Sheet: Assets — On the personal balance sheet, assets are usually categorized into three main buckets. In some cases, the categorization of an asset depends in part on why the asset was acquired and/or how the client perceives and uses the asset. If a client, for example, sees a certain asset as an investment, it would go into Bucket 2. If he sees that same asset as a personal use asset, then it would go into Bucket 3. Some things, like life insurance, are hard to classify. All assets are listed at fair market value — the price you could sell the asset for today. The three asset buckets include:
    • Cash & Cash Equivalents — These are low-risk assets that may be readily converted to cash in the next year or less. This category will include money in things such as checking accounts, savings accounts, and money market funds. Some of these assets will be earmarked for a client’s emergency fund.
    • Invested Assets — Included in this category are stocks, bonds, mutual funds, gems, gold and other precious metals, collectibles, investment real estate, fine art, ownership, ownership interest in closely held businesses, vested pension benefits, and similar assets. Many financial planners find it helpful to separate invested assets into taxable plans, tax-advantaged plans, and retirement plans to quickly see how much of their clients’ invested assets could supplement emergency funds or be available for tax-advantaged investing.
    • Personal Use Assets — This category includes the client’s residence, automobiles, boats, and personal things such as furniture, clothes, jewelry, and similar assets.
  • Personal Balance Sheet: Liabilities — Liabilities can be listed in several different ways. One of the most popular ways is to list them in descending order based on the account balance, to reflect either the order in which payments are due or in the order of shorter-term to longer-term obligations. Current liabilities are those due within one year from the statement date and would be listed toward the top. Long-term liabilities are those that are due more than one year from the statement date and would be listed further down the list. 
  • Personal Balance Sheet: Net Worth — Net worth is the difference between assets and liabilities. It fluctuates from statement to statement depending on what happened between the dates that each statement is prepared. If a client is consistently doing the right things, their net worth should grow over time. 
  • Personal Cash Flow Statement — A personal cash flow statement reveals the client’s cash inflows and outflows over a specific period of time — monthly, quarterly, and often over one year. This statement reveals a client’s pattern of spending, saving, and investing. Unlike the personal balance sheet, this is not a snapshot of a client’s financial health; it’s more of a living, breathing statement that tracks cash flow activity. After subtracting outflows from inflows, you get a client’s net cash flow position for the time period you’re analyzing. 
  • Personal Cash Flow Statement: Inflows — Includes salary, interest and dividend income, rental property income, tax refunds, and other amounts received by the client. It’s what the client is bringing in. Think of it like revenue for a company. 
  • Personal Cash Flow Statement: Outflows — Outflows should be outlined in four primary buckets. In general, outflows are what the client is disbursing or what they are spending. When cash leaves their accounts — that’s an outflow. The four main buckets include:
    • Savings & Investments — This category should always lead the outflows list. This is where you include money that the client has saved and invested. Think of it as the money you take from your paycheck and put into your savings or investing account. 
    • Fixed Outflows — Fixed outflows are those that are easy to predict and are recurring expenses over which the client doesn’t have much control. Typical fixed outflows include debt payments, mortgage payments, and insurance payments. These are easy to monitor and track. 
    • Variable Outflows — Variable outflows are those over which the client can exercise some degree of control, such as expenditures for food, transportation, clothes, and entertainment. These are a little harder to track consistently, but the client has more control over these than they do with fixed outflows. 
    • Taxes — Income taxes, capital gains taxes, and more are listed here.
  • Ratio Analysis — Once you’ve completed the personal balance sheet and the personal cash flow statement, you can use financial ratios to tell a bigger story. Ratios provide perspective and help you make sense of the numbers in the two key financial statements. Ratios give the numbers meaning. 
  • Ratio Analysis: Debt-to-Income Ratios — Debt ratios help you understand where a client stands in regard to debt. If a client has excessive debt, especially consumer debt (i.e. credit card and auto debt), steps need to be taken to reduce that debt. Reducing debt frees up cash that can be spent on acquiring assets. Common debt ratios include:
    • Consumer Debt Ratio — This ratio allows you to understand how much monthly consumer debt a client is paying in relation to their monthly income. Consumer debt is basically any “bad” debt that isn’t related to a mortgage payment. This number should not exceed 20%. The formula:
      • Monthly Consumer Debt Payment / Monthly Net Income
    • Housing Cost Ratio — This ratio allows you to pinpoint monthly housing costs and monthly income. For the calculation, housing costs include monthly mortgage payment, property taxes, and homeowners insurance premium. This number should not exceed 28% of gross monthly income (income before taxes). The formula:
      • Monthly Housing Costs / Monthly Gross Income 
    • Total Debt Ratio — This ratio helps you pinpoint total monthly debt and total monthly income. The total amount of monthly debt should never exceed 36% of gross monthly income. The formula:
      • Total Monthly Debt / Monthly Gross Income 
  • Ratio Analysis: Liquidity and Net Worth Ratios — The current and assets-to-net worth ratios help you understand how a client’s assets stack up. You always want to help the client acquire assets.
    • Current Ratio — This ratio helps you understand if a client is prepared to cover liabilities quickly in the event of an emergency. A current ratio of 1.0 and up is preferred. This means the client has enough current assets to cover current liabilities. The formula:
      • Current Assets / Current Liabilities 
    • Net Investment Assets-to-Net Worth Ratio — This ratio compares the value of investment assets (excluding equity in a home) like stocks, bonds, etc. with net worth. You should have a ratio of at least 50%, and the percentage should get higher as you approach retirement. The formula:
      • Net Investment Assets / Net Worth
  • Interesting Fact — The interest you pay every month on your mortgage is tax deductible. Property taxes are also deductible. You can use the annual amounts to offset your taxes. This is one of the many reasons real estate investing is great. 
  • Have an Emergency Fund — An emergency fund contains cash or cash equivalents set aside to help with unexpected events, including job loss, medical issues, or major home repairs. The moneys need to be held in extremely liquid assets, like checking and savings accounts, money market accounts, CDs with a 90-day or less maturity, etc. As a general rule of thumb, an amount equal to 3-6 months of monthly expenses is considered adequate. 
  • Live Frugally! — Living a frugal lifestyle is one of the best ways to build your wealth. By living frugally, you are able to save and invest more money than you would if you were blowing cash left and right on consumer items. Find ways to cut costs and expenses. You should never use a credit card unless you are able to pay it off on full at the end of every month. Credit card debt is disastrous — interest rates are often north of 20%. If a client has credit card debt, make it a priority to eliminate it via the Snowball or Avalanche technique. You can also save some money by increasing your deductible on auto and homeowners insurance policies — you’ll save some money every month on insurance premiums. 
  • Pay Yourself First — With every paycheck you get, your first move should be to pay yourself by taking a portion of the check and investing it. Many financial planners recommend that clients allocate 10% of every check towards saving and investing, but 15-20% or more is even better. 
  • Sources of Borrowing — There are several different ways you can borrow money to acquire things in life. Debt is all about mindset and how you use it. Debt can be crushing if used poorly, but it can also allow you to acquire income-producing assets if uses correctly. Common sources of borrowing include:
    • Personal Loans — Think bank loans. These loans can be secured, unsecured, installment, or single payment. They can feature fixed or variable interest rates. These are the loans you use to buy houses. Although banks are the most common provider of personal loans, credit unions have become popular for their lower interest rates and personalized service. 
    • Credit Cards — Credit cards can be used for good or evil. A credit card that is used and paid off in full every month allows you to build your credit score, accumulate points, and even produce income via cashback. A credit card that is used and not paid off in full every month can come with sky-high interest rates of 20% and up. You should never use a credit card if you can’t pay it off in full every month. Credit card debt can absolutely bury you. 
    • Auto Loans — Try to avoid these. Vehicles depreciate quickly, meaning you can sometimes have an auto loan that exceeds the value of the vehicle. Not good. Only buy a car if you can use excess cash from your savings or checking account. 
    • Retirement Plans — You can actually borrow money from your Section 401(k) plan. Borrowing from your 401(k) often comes with a lower interest rate, but it also hurts the tax-deferred growth of the account, especially if the money isn’t paid back quickly. Only use this option if you are in a pinch and know you can pay it back quickly. 
  • Loan Classifications — A loan can be classified in several different ways and can come with various features. Some forms and features of loans are better than others. Common loan classifications include:
    • Secured Loan — A loan in which the person or entity making the loan maintains a security interest in the property or item being purchased with the borrowed money. The item (i.e. house) is used as collateral if the person isn’t able to pay back the loan. 
    • Unsecured (Signature) Loan — This is just a promise from the person borrowing the money that they will repay the loan. Nothing is backing the loan as collateral. If the borrower defaults on the loan, lenders can take legal action but most often end up settling the debt for less than the amount owed. 
    • Fixed-Rate Loan — This is a loan with a fixed interest rate. No matter what happens in the economy over the lifespan of the loan, the interest rate won’t move. This is preferred. 
    • Variable Loan — This is a loan with an interest rate that fluctuates based on going interest rates in the market. These are riskier than fixed-rate loans and therefore usually come with a lower initial interest rate at the start. 
    • Installment Loan — This is a loan that is paid back over time in installments. Mortgages are installment loans because you’re slowly paying it off every month. 
    • Single Payment Loan (Bridge Loan) — A bridge loan is one that is best for very short-term borrowing. The loan amount is paid back in one lump sum with interest at the end of the term. These types of loans are often used to provide funds for a time period between two transactions, hence the name. For example, a bridge loan can be used to help purchase a new house and it will be paid off almost immediately once the borrower then sells his old house. 
  • Interesting Fact — The FICO score is named after the Fair Isaac Corporation, the largest and best-known provider of credit scores.
  • Credit Score Categories — There are several factors that go into a person’s credit score. Each of the factors is weighted and ranked by overall importance. Overall, a long history of responsible credit use will gradually build your credit score over time.
    • Payment History — This category accounts for 35% of the credit score and is most heavily weighted because lenders want to know whether you are making payments on-time consistently.  Paying off your credit card in full every month will drive up your credit score.
    • Accounts Owed — This category accounts for 30% of the credit score rating. The category measures how much a person owes relative to how much credit they have available to them. If you are using up most of your credit allowance every month, that’s not what lenders want to see because they start to think you are overextending yourself and relying too much on your credit card. 
    • Length of Credit History — This accounts for 15% of the credit score and measures how many new accounts a person owns. Opening several new credit cards in a short amount of time will negatively affect your credit score. Too many accounts in general will hurt your credit score. 
    • Credit Mix — This accounts for 10% of the credit score and measures the different types of credit an individual has (i.e. credit cards, retail accounts, mortgages, auto loans, etc.). 
  • Buying or Leasing — Leasing basically means you’re renting something. These days, you can lease a lot of things, from homes and vehicles to equipment, jewelry, TVs, and more. The decision to buy or lease (rent) something really depends on your outlook and the asset itself. If the item has a limited useful life for you, it might be best to lease (rent). For example, if you are in one city and think you might end up moving sometime in the next 2-3 years, it makes sense to lease (rent) an apartment. If you plan to be in one spot for the foreseeable future, home ownership is better.
    • Quote (P. 98): “The tax benefits of home ownership — particularly the itemized deductions for property taxes and home mortgage interest — are likely the reasons many people decide to buy a home… In addition, historically, in some areas of the country, the fair market value of homes has appreciated more rapidly than that of many other assets (including securities).”
      • Takeaway — Property taxes and mortgage interest rates are tax deductible. This is one of the many reasons real estate investing is great. Home prices have also tended to appreciate most years. If you’re going to be somewhere for the long haul and the numbers make sense, buying property is always better than leasing. 
  • Mortgage Loans — Although there have been times where housing bubbles have led to a decline in home values, the price of homes has historically appreciated in value every year. Most financial planners agree that using debt to purchase a home is a good choice. The most significant cost of a mortgage is usually the interest payment on the outstanding principal. Interest rates vary from bank-to-bank, but they are usually similar and mirror the prevailing interest rate in the market set by the Federal Reserve. Some notes on a mortgage include:
    • Tax Benefits — As stated previously, there are several tax benefits that come with home ownership. Interest paid on your mortgage and property taxes are tax deductible. You can also defer paying capital gains taxes with the 1031 Exchange. Various maintenance expenses can also be used to reduce your taxes. There are a lot of tax advantages that come with real estate.
    • Loan-to-Value (LTV) — The LTV is the percentage of the value of the collateral real estate that is loaned to the borrower. The lower the LTV, the more equity the borrower has built into the property. 
    • Prime and Subprime Loans — Prime loans are those made to people with good credit. Subprime loans are those made to people with shady credit history. 
  • Types of Mortgages — There are many different home mortgage loans available to you. The best choice will depend on your life situation and financial goals. A few of the common mortgage options include:
    • Federal Housing Administration (FHA) Loan — These mortgages are backed by the federal government and were designed to make buying a home more accessible to people who may not qualify for a conventional 15 or 30-year mortgage. The key feature with an FHA is the very low down payment — these will allow you to put 3-5% down on a house rather than the conventional 20%. Sometimes an FHA will also have a lower interest rate as well. The downside is that these mortgages often come with mortgage insurance (PMI), so that adds to your costs. 
    • Conventional Mortgage — These loans are made by lenders in the private sector, like banks and credit unions. They conform to the dollar limit requirements of Freddie Mae and Fannie Mac. These are your traditional 15 or 30-year mortgages. It’s important to note that while a 30-year mortgage will have a lower monthly payment because the period is longer, a 15-year mortgage usually comes with a lower interest rate and you will end up paying far less in interest over the life of the mortgage compared to the 30-year. 
    • Fixed-Rate Mortgage — These are mortgages that come with a fixed interest rate throughout the stated period of the loan. 
    • Adjustable-Rate Mortgage (ARMs) — With an ARM, you’re dealing with a variable interest rate that can fluctuate every month, quarter, year, three years, or five years. Many ARMs do come with a cap that limits how much the interest rate can change. Because the interest rate can change and significantly affect your monthly payment, these are considered riskier. These should be used for short-term lending. If you want lower initial monthly payments and do not anticipate remaining in the home for a long time, an ARM might be a good choice. These aren’t great for long-term borrowing, though. 
    • Balloon Mortgages — These are mortgages in which the borrower makes fixed payments, which are based upon the established interest rate for a long-term mortgage. However, payments are made only for a short duration — frequently five or seven years — and then the borrower is required to pay off the remainder of the mortgage in a lump sum. The interest rate on a balloon mortgage is usually favorable over a typical 30-year mortgage due to the shorter time frame for repayment and the smaller risk to the lender of a variance in the prevailing interest rate. Although the balloon payment may be difficult for many borrowers to make, a balloon mortgage may be appropriate for borrowers who plan to sell their homes before the fixed payment period is over. Using these requires taking some calculated risks.
    • Graduated Payment Mortgage — This mortgage is payable over a long period, such as 30 years, and has a fixed interest rate. The payments are lower for the first few years of mortgage repayment, then they adjust to a higher fixed payment that continues for the remainder of the loan. This type of mortgage may be appropriate for people who anticipate increases in income with some certainty, enabling them to afford a higher payment in the future than they can currently afford. These mortgages also risky because the interest really piles up after the first few years of the loan period.  
    • Reverse Mortgage — These are available to people who are age 62 and older. These were designed as a special type of loan that allow senior citizens with limited income to stay in their homes until they either pass away or move to a nursing home. With a reverse mortgage, lenders are actually paying the homeowner steady streams of income. The homeowner retains title to the home, but incurs in increasing amount of debt with each payment from the lender. Once the homeowner no longer occupies the property (i.e. death or nursing home move), the debt must be repaid to the lender, usually by selling the home. The proceeds of the sale then go to the lender to pay off the debt. 
  • Refinancing a Home — There are several good reasons to refinance your home, but probably the best one is to take advantage of declining interest rates. If you secured a 7% fixed interest rate on your 30-year mortgage and market interest rates set by the Federal Reserve later decline to 3%, you can refinance your home and secure a new mortgage with an interest rate around 3%. Additionally, refinancing your home can allow you to pull out some built-up equity in your home that you can use for other investments. This is called a “cash-out refinance.”
    • Quote (P. 105): “One common refinancing pitfall is for individuals to continually refinance to a 30-year term. If a client has held a mortgage for some time, refinancing for another 30 years extends the time frame until the mortgage is fully paid off. For example, a client with 22 years remaining on a mortgage would add eight years to the ultimate pay off date by refinancing to a 30-year mortgage. The client may be better served by refinancing to a 20-year or 15-year mortgage so that the home is paid off in a similar time as originally planned.”
      • Takeaway — Try to match up the final pay off period when you refinance. Don’t just blindly refinance into another 30-year mortgage because that will extend the life of the home payment. If you’ve had the house for 10 years at the time of refinancing, get a new 20-year mortgage so you end up still paying off the home on schedule. 
  • Home Equity Loan — When you secure a home equity loan, you receive a lump sum in the amount of the loan. With this type of loan, you then repay the loan with equal monthly payments over a fixed term. You’re essentially taking a loan using your home equity as the lender. Your monthly loan payments go back into the home. 
  • Home Equity Line of Credit (HELOC) — A HELOC is like your house giving you a credit card. A HELOC provides a certain amount of credit from which funds can be drawn as needed. Because a HELOC is a line of credit, borrowers make payments only on the amount they actually borrow, not the full amount available. You are essentially using the equity you’ve built into your home to establish a line of credit. You then use this line of credit just like you would use a credit card. Just like a credit card, there is interest you have to pay on the HELOC.
  • Chapter Takeaway — Debt can be used as a lever to acquire income-producing assets that can significantly improve your financial life, or it can be used to crush you. It all depends on how you use it. Consumer debt like credit card debt and auto loans are terrible and can really do a lot of damage. Mortgages, on the other hand, can allow you to purchase homes that appreciate in value and can even deliver monthly rental income. Use debt responsibly! If you have bad consumer debt, do everything you can to pay it off. 

Ch. 4: Time Value of Money Concepts and Calculations

  • Time Value of Money (TVM) Calculations — This chapter discusses quite a few different useful time value of money calculations. These can all be used to help clients determine the capital needed today to achieve future financial goals or, in the case of future value calculations, what their future could look like if they invest a certain lump sum or stream of annuity payments. It’s important to note that all of the calculations discussed below can be done fairly easily on/with the help of a financial calculator. Here is a good online calculator: https://www.calculator.net/finance-calculator.html?ctype=startingamount&cyearsv=15&cinterestratev=2.75&cstartingprinciplev=-400%2C000&ccontributeamountv=28%2C800&ctargetamountv=0&cpy=1&ccy=1&ciadditionat1=beginning&printit=0&x=Calculate#cr
  • Future Value (FV) — The future value calculation allows you to see what a lump sum or steam of payments will be worth in the future at an assumed rate of return. The calculation is compounding principal and interest over time to determine what the money will be worth in the future. This calculation helps you determine what a client might be working with down the line. It can be helpful in determining a client’s retirement goals. 
    • Ex. Single Amount — Carlos received $13,000 from an inheritance and wants to invest it for the next 11 years. If he can earn 7.5% annually, how much will his account be worth at the end of 11 years? 
      • Answer — Using a financial calculator, the answer is $28,803.
  • Future Value & Annuities — In terms of the concept of time value of money, an annuity is a steady stream of equal and regular payments. Think dollar cost averaging here. An annuity due is when the annuity payments are made at the beginning of a period. An ordinary annuity is when the annuity payments are made at the end of each period. Making annuity payments at the beginning of each period will result in more growth simply because you are giving the investment more time to grow. This is why depositing the maximum annual amount allowed into your Roth IRA ($6.5k) the moment it is allowed is so important. 
    • Ex. Ordinary Annuity — Hector has been investing $2,000 at the end of every year for the past 18 years in a growth mutual fund. How much is the fund worth now assuming he has earned 10% compounded annually on his investment? 
      • Answer — Using a financial calculator, the answer is $91,198.
    • Ex. Fred has an investment account worth $185,000 and intends to add $24,000 to it every year for the next five years. Assuming a 5% annual return, what will his account be valued at in five years?
      • Answer — Using a financial calculator, the answer is $368,000. 
      • Note — Using a 10% annual return in the same scenario (the S&P 500 has returned an average of 11-12% per year since 1980) will lead to an account value of $444,466.
  • Present Value (PV) — Opposite of future value, the present value calculation allows you to see what you need to invest today to earn a certain amount in the future given an assumed interest rate (referred to as a “discount rate” for present value calculations because you are taking a future value and “discounting” it back to the present). The further into the future the money will be received (i.e. in the year 2090 or 2040) and/or the higher the interest (or discount) rate, the lower the PV. This calculation can help you determine what a client needs to invest today in order to generate a certain amount of money in the future to meet a certain financial goal. 
    • Ex. Single Amount — Kali thinks she needs a total of $100,000 in 10 years in order to pay for her granddaughter’s college education. If she can earn 7.5% annually (the discount rate) on her growth mutual fund, what single amount must Kali invest in that mutual fund today in order to achieve her $100,000 goal in 10 years?
      • Answer — Using a financial calculator, the answer is $48,519.
  • Present Value & Annuities — Just like future value, you can also determine the present value of a stream of consistent, repeated annuity payments (ordinary annuities or annuity due) using the present value calculation. 
    • Ex. Nick’s grandma plans to give him $5,000 at the end of every year for the next five years. Assuming a discount rate of 4%, what is the present value of these payments? 
      • Answer — Using a financial calculator, the answer is $22,259.
  • Rate of Return (I/YR) — The rate of return can be solved for using a financial calculator. If you need to help a client determine the rate of return they will need to get in order to achieve a certain monetary target given a certain amount of money they currently have, the calculator can help you find out what sort of return will need to be achieved. 
    • Ex. Solving for I/YR — Halia invests $1,000 today with the hope that in five years her investment will be worth $1,500. The investment will compound semiannually. What is the annual return (I/YR) Halia will have to achieve in order to reach her goal of $1,500 in five years?
      • Answer — Using a financial calculator, the answer is 8.28%. 
  • Number of Periods (N) — You can determine how many years an investment will take to grow to a certain amount using a financial calculator and solving for N. This calculation is very useful for seeing how long it will take to get to a certain target given a certain investment amount. As a shortcut, you can use the Rule of 72 to determine how fast money will double. To do this, take the annual return as a percentage and divide it into 72. The result is the number of years it will take to double your money. For example, 72 / 15% annual return = 4.8 years. Your money will double in 4.8 years at that rate of growth. 
    • Ex. Solving for N — Angela has an IRA with a current balance of $4,000. How long will it take for this account to grow to $20,000 at a 12% annual return?
      • Answer — Using a financial calculator, the answer is 14.2 years. 
  • Payment (PMT) — You can use also use a financial calculator to determine how much a monthly, quarterly, semiannual, or annual payment is going to be based on an investment and an assumed or stated interest rate. 
    • Ex. Solving for Equal Payments — Amul purchases a new car and finances $21,000 with a 5.9% auto loan over three years. Assuming each payment is due at the end of the month, what is the amount of Amul’s monthly car payment? 
      • Answer — Using a financial calculator, the answer is $637.91.
  • Amortization — Amortization refers to the repayment of a loan principal over time. It essentially refers to how much of your monthly loan payment is going towards principal and how much of it is going towards interest. In general, more of your monthly payment goes towards interest than principal at first. Over the life of the loan, the balance begins to shift towards principal until your very last payment, which will be all principle. This is essentially how equity is built in a house. The more principal you put into the house, the more equity you have in it. You can use a financial calculator to create amortization tables, which help you figure out how your loan is being directed towards principal and interest with each payment. The calculator can also show you how much total interest you will pay over the life of the loan. 
    • Quote (P. 125): “Amortization schedules are structured in such a way that more interest and less principal is being paid in the earlier payments, and over time the amount being applied to principal increases while the amount being applied to interest decreases.”
  • Single Sum With Annuity Payments — Many calculations you’ll want to run involve both a single sum and steady annuity payments. For example, you might have a client that wants to invest a lump sum of $8,000 into the index fund QQQ and then dollar cost average into QQQ by sending a steady stream of $500 annuity payments into the fund every month. The financial calculator can handle this. 
    • Ex. Future Value — An investor makes an initial deposit of 20,000 into a mutual fund. Each year following, he deposits an additional $2,500 into the fund. What will be the value of the account in eight years if the fund returns 9% annually?
      • Answer — Using a financial calculator, the answer is $67,422.
    • Ex. Present Value — A client would like to accumulate $300,000 for retirement, which will begin in 10 years. She can invest $10,000 at the end of each year toward this goal in an account earning 8% annually. What initial lump-sum deposit, in addition to the payment stream, is required for her to be able to meet this goal?
      • Answer — Using a financial calculator, the answer is $71,857.
    • Ex. Future Value — Fred’s Roth IRA is currently valued at $24,000. If he continues to invest the allowed $6,500 at the beginning of every year for the next 30 years at an assumed 10% rate of return, what will his account value be at the end of the 30 years?
      • Answer — Using a financial calculator, the answer is $757,346.
    • Ex. Periodic Payment — Shayla wishes to accumulate $90,000 for a future goal in seven years. She can deposit $32,000 today in an account earning 11% annual interest and plans to make an additional payment into the account at the end of each year. What periodic payment will be required at the end of each year to meet Shayla’s goal?
      • Answer — Using a financial calculator, the answer is $2,408.
    • Ex. Future Value (Monthly Annuity Payments) — Cynthia has just invested $5,000 into a stock index fund in her IRA and intends to deposit an additional $200 at the end of each month going forward. Calculate what her IRA account would be worth after 15 years of investing if she earns an average annual rate of return of 9%.
      • Answer — Using a financial calculator, the answer is $94,871.
      • Note — When doing these calculations involving monthly annuity payments on the calculator, you have to make sure to multiply the years (in this case 15) by 12 to get the correct payment period input. You also need to divide the annual rate of return (in this case 9%) by 12 to get the correct monthly rate of return input. The calculation will be off if you don’t remember these things when dealing with monthly, rather than yearly, annuity payment calculations.
  • Internal Rate of Return (IRR) on Uneven Cash Flows — The previous calculations assumed either single sum amounts and/or equal periodic annuity payments. In many cases, cash flows to and from an investment will not be equal and will not occur in convenient, regular intervals. Often, uneven cash flow happens. That’s life. Most of the calculations involving unequal cash flows will require solving for the compound return, also known as the Internal Rate of Return (IRR). As with the other calculations, a financial calculator will allow you to assess the IRR of an investment with uneven cash flows. 
    • Ex. Antique Chair — What is the average compound rate of return (IRR) that has been earned from investing in an antique chair that was purchased six years ago for $1,000, was repaired at the end of the second year at a cost of $450, and has just sold for $2,850?
      • Answer — Using a financial calculator, the answer is 13.25%.
    • Ex. Rental Property — Drake purchased a rental property four years ago for $128,900. His cash flows for each year were as follows. If the property is worth $145,000 at the end of the fourth year, what would Drake’s IRR be?
      • Year 1: Inflows of $6,000 | Outflows of $3,200
      • Year 2: Inflows of $6,600 | Outflows of $1,400
      • Year 3: Inflows of $7,400 | Outflows of $400
      • Year 4: Inflows of $8,400 | Outflows of $1,400
      • Answer — Using a financial calculator, the answer is 6.99%.
  • Net Present Value (NPV) — Capital projects and long-term investments (i.e. real estate) can be evaluated by discounting future cash flows at a given discount rate to determine their total present value. You then subtract the present value of the future cash flows by the cost of the initial investment to get Net Present Value (NPV). If the NPV is positive, it means that the investment would earn a greater return than the assumed discount rate (required rate of return). If the NPV is negative, it means the investor would earn less than the discount rate used. Once again, a financial calculator can help you do this fairly easily. The examples below are good ones.
    • Ex. Rental Property — Glenda is considering the purchase of some rental property. The owner is asking for $725,000, and the apartment units are expected to generate cash flows of $50,000, $55,000, $60,000, and $65,000 over the next four years. The property is expected to be worth $850,000 at the end of four years. What is the maximum amount that Glenda should pay for the property if her required rate of return is 9%?
      • Answer — Using a financial calculator, the answer is $786,704. If she pays anything above this price for the property, her return will be less than 9% assuming she actually generates the cash flow she is expecting. If she pays anything below this price for the property, her return will be greater than 9% assuming she actually generates the cash flow she is expecting. Given the findings above, the NPV of this property is $61,704 ($786,704 — $725,000). Also using the calculator, the IRR of the property if Glenda buys it at the $725,000 listing price and gets her expected cash flows is 11.47%.
  • Chapter Takeaway — Time Value of Money (TVM) calculations can help you determine what kind of initial investment will need to be made today to reach certain financial goals (PV), evaluate the return of potential long-term investments like real estate (IRR), determine if an investment’s current price will produce the kind of return you’re looking for (NPV) based on an assumed discount rate and future cash flows, create amortization tables on your mortgage, and forecast what your accounts might look like in the future given an assumed rate of return (FV). All of these calculations can be done fairly easily on a financial calculator. 

Ch. 5: Regulatory Requirements and Financial Institutions

  • RIA vs. IAR — If you are an investment advisor, you are classified as either an independent Registered Investment Advisor (RIA) or an Investment Advisor Representative (IAR) with a securities broker-dealer (who files as the RIA). An independent RIA would be an advisor who has his own business (i.e. those who Cambridge serves). An IAR would be an advisor who works for Vanguard, for example, and has investing clients. 
  • The Securities Act of 1933 — Think IPOs and new issues here. This act applies to most new, publicly issued securities. It requires public companies to register their securities with the SEC by issuing a registration statement (a prospectus) that provides full disclosure of material facts about the securities that the issuer is about the offer. The act is designed to help investors get the information they need to make informed decisions about new securities. 
  • The Securities Exchange Act of 1934 — This was a big one. Although the Securities Act of 1933 applies only to new issues, the Securities Exchange Act of 1934 extended regulation to existing securities. This act created the SEC. The act forbids market manipulation, deception, misrepresentation of facts, and fraudulent practices. The SEC was given the power to enforce this act. Other key features of this act include:
    • Registration — This act requires most broker-dealers, transfer agents, and clearing agencies, as well as the nation’s securities self-regulatory organizations (SROs) — including all securities exchanges — to register with the SEC. In this way, the SEC supervises and regulates many aspects of exchanges and the overall stock market. 
    • Financial Statements — The act requires that companies provide ongoing information about their business affairs by filing quarterly financial statements with the SEC, sending annual reports to shareholders, and filing 10-K reports with the SEC annually.
    • Executive Activity — The act allows the SEC to hold company insiders accountable for any fraudulent activity.
  • The Federal Bankruptcy Act of 1938 — This act provides for the liquidation of hopelessly troubled firms and provides for the reorganization of troubled firms that might be able to regroup and survive.
  • The Investment Advisors Act of 1940 — This SEC act established the fiduciary standard for RIAs who are deemed to be providing investment advice to clients. It basically told investment advisors that they have to act in the best interest of clients. The act was a direct consequence of the 1929 stock market crash where tipsters and salespeople were presenting themselves as legitimate advisors while investors, along with the entire country, suffered losses. The act made a distinction between trying to sell products, which is the primary function of a broker-dealer, and providing investment advice, which requires acting in the best interest of the client. The act considers you an investment advisor if you meet all of the following criteria:
    • Advice — You give investment advice. If you give advice, issue reports, or recommend to a client that they acquire a specific security, you pass this test.
    • Business — Any individual who provides financial planning services, including but not limited to investment advisory services for compensation, is in the business of providing investment advice.
    • Compensation — If you receive compensation for your investment advice, you pass this test.
    • Requirements, Thresholds, Exclusions, and Exemptions — To comply with the Advisors Act, all advisors who pass the ABC tests above have to register either with one or more states or with the SEC. It all depends on the AUM they have. There are certain exclusions from the Act’s definition of an investment advisor, as well as exemptions that allow certain people not to have to register. 
  • The Investment Company Act of 1940 — This act allowed the SEC to regulate certain financial products, most notably mutual funds. 
  • The McCarran-Ferguson Act of 1945 — This act asserts that unless federal law specifically states otherwise, insurance is to be regulated at the state level. States are required to implement and execute this regulation adequately.
  • The Securities Investor Protection Act of 1970 — This act established the Securities Investor Protection Corporation (SIPC) to oversee the liquidation of brokerage firms and to insure an investor’s account up to a maximum value of $500,000, of which only up to $250,000 can be cash balances, in the event of a brokerage firm (i.e. Fidelity) going bankrupt. The cost of this insurance is paid by members of SIPC. All brokers and dealers that are registered with the SEC, and all members of national securities exchanges, must be members of SIPC.
  • The USA Patriot Act of 2001 — In response to the terrorist attacks of September 11, 2001, this act requires broker-dealers, among others, to have internal policies, procedures, and controls to meet the ‘know your customer’ mandate, which was created to combat terrorism and money laundering.
  • The Sarbanes-Oxley Act of 2002 — This act was created in response to the Enron scandal. It toughened the accountability for accuracy of financial statements and financial information released by corporations. It also set stricter rules for the companies that audit corporations. This act led to the creation of the Chief Compliance Officer role at various corporations. CCOs oversee and manage compliance issues within an organization, ensuring that a company is complying with regulatory requirements and that the company and its employees are complying with internal policies and procedures.
  • FINRA — The Financial Industry Regulatory Authority (FINRA) was established in 2007 and is classified as a self-regulatory organization (SRO). SROs like FINRA were created by institutions within the industry to establish a higher level of self-regulation because these institutions were worried the government would do it if they didn’t. Therefore, although FINRA is under the purview of the government, the organization was established by the securities industry itself. Major functions of FINRA include:
    • Market Regulation — FINRA regulates, oversees, and monitors all trading on the Nasdaq Stock Market, American Stock Exchange, International Securities Exchange, Chicago Commodities Exchange, OTC markets, and corporate bond markets. FINRA also conducts onsite inspections of firms. 
    • Member Regulation — FINRA administers the licensing tests needed to sell various securities products, like the Series 7, Series 24, Series 66, etc. Continuing education is also provided by FINRA.
    • Enforcement — FINRA has the power to enforce punishment on securities firms and individuals who violate rules. 
    • Dispute Resolution — FINRA handles 90% of the securities arbitrations and mediations in the U.S. Mediation is an informal, voluntary, and nonbinding approach to dispute resolution in which the mediator tries to guide the parties to resolve the dispute rather than having the mediator impose a solution. In arbitration, an impartial person or panel hears the issues presented by both parties, studies the evidence, and then decides how the issues should be resolved. Arbitration is final and binding.
    • Advertising Regulation — FINRA evaluates advertising and communications regarding securities to ensure they are fair, accurate, and not misleading. 
  • FINRA vs. SEC — Any financial advisor or broker-dealer who wishes to sell securities must register with FINRA. FINRA regulates those involved in the sale of securities, while the SEC regulates those who offer investment advice (as well as the actual offering and sale of new securities). Therefore, some people in the industry have to register with both organizations. For example, an advisor receiving commission from both securities sales and fees for investment advice would be required to register under both the SEC and FINRA.
  • Financial Institutions — There are several different kinds of institutions that fall under the category of financial institutions. Some of the common ones include:
    • Banks — A bank is an organization approved by the federal or state government to accept deposits, pay interest on deposits, make loans, invest customer deposits in securities (this is how banks make money), issue cashier’s checks, provide safe-deposit boxes, and more. 
    • Credit Unions — Similar to banks. Credit unions tend to serve a specific region or group of people. The main difference between banks and credit unions is that banks are typically for-profit institutions while credit unions are not-for-profit and distribute their profits among its members in the form of dividends. 
    • Investment Banks — These organizations help businesses and municipalities bring new securities to the market by helping them underwrite the securities. Investment banks are very involved in IPOs. Investment banks also advise corporations on effective strategies to raise capital, raise capital for issuers by distributing new securities, buy securities from issuers and resell them to the public, and more.
    • Brokerage Companies — Think Fidelity or Vangaurd. These are organizations that facilitate transactions involving sales of securities or real estate. Brokers are agents that arrange trades for clients and change a commission. Dealers are principles that buy and sell securities for their own accounts. When dealers sell securities, they charge their clients a markup rather than a commission. 
    • Insurance Companies — These organizations give insurance protection to businesses and consumers. They typically take the premium collected from consumers and invest it in securities. That’s how they make a lot of money. 
    • Mutual Fund Companies — A mutual fund company pools money from shareholders and invests the funds in various types of securities, like stocks, bonds, and money market instruments. They are regulated by the SEC.
    • Savings and Loan Associations — The main purpose of S&Ls is to accept savings and provide home loans. S&Ls are not permitted to provide checking accounts.
    • Trust Company — Trust companies are typically owned by one of three entities (independent partnership, a bank, or a law firm), each of which specializes in managing estates and serving as the trustee for various types of trusts. 
  • FDIC Deposit Insurance — Everyone who deposits money in a U.S. financial institution is entitled to FDIC insurance. The basic FDIC-insured amount of a depositor is $250,000. So if you have $400,000 in a bank and the bank defaults, you will get $250,000 back. There are some exceptions to this, but this is the general rule. For example, deposits maintained in different categories of ownership (i.e. individual account, joint account, retirement account, trust) are considered separately insured. You therefore could end up with more than the $250,000 if your bank fails. 
  • Chapter Takeaway — A lot of the big securities laws and regulations in place today were in response to the knuckleheads of the late 1800s and early 1900s, which was the time period when marketable securities first became available on a large scale. There were tons of frauds (including bankers, company executives, and more) ripping people off and purposely misleading the public in these early, unregulated days. It was the Wild Wild West. Laws like the Securities Act of 1933, the Securities Exchange Act of 1934, and others established the SEC and put rules into place to prevent a lot of the fraud that led to the Crash of 1929 and the Great Depression of the early 1930s. 

Ch. 6: Professional Conduct and Fiduciary Responsibility

  • Code of Ethics & Standards of Conduct — CFP professionals are required to abide by the organization’s Code of Ethics and Standards of Conduct at all times. When providing financial advice and financial planning, they also have a responsibility to fulfill their duty as a fiduciary, manage conflicts of interest, and abide by the Practice Standards for the Financial Planning Process. Fulfilling all of these responsibilities comes down to being a good person, disclosing conflicts of interest, consulting specialists when you aren’t an expert on a certain topic, and holding the client’s interests above your own. 
  • Fiduciary Standard — As a CFP, and as a financial advisor in general, you have the responsibility to put the client’s best interests above your own. Failure to do so could result in some serious problems. The CFP’s Code of Standards document lays out three specific fiduciary duties all CFP professionals must follow: 
    • Duty of Loyalty — You must put the client’s best interest above your own. If there are any conflicts of interest, you must disclose them, obtain client consent, and manage the conflict. 
    • Duty of Care — You must act with the care, skill, prudence, and diligence required to help the client achieve their financial goals, taking into account the client’s entire profile (i.e. risk tolerance, age, objectives, personal circumstances, etc.). If you don’t have the required expertise in a particular area, you are required to acquire the knowledge needed to advise the client or consult an expert. 
    • Duty to Follow Client Instructions — At the end of the day, you have to do what the client wants, even if you believe it’s not the right move. The client has the ultimate say. 

Ch. 7: The Economic Environment and Consumer Protection Laws

  • Micro and Macroeconomics — Economics is broken into micro and macroeconomics, and supply and demand play a key role in both. Microeconomics is the study of how companies and organizations prioritize and deploy scarce resources. Macroeconomics is the study of the economy as a whole. Financial planners can use macroeconomic data to forecast the earnings potential of companies and to determine which asset classes might be more attractive. 
  • Price Elasticity — Price elasticity is the responsiveness of the quantity of a good demanded to changes in price. All goods differ in their elasticity in their relation to price. There are two types of price elasticity:
    • Elastic — These are luxury items like cars, boats, expensive jewelry, etc. When times get tough in the economy, people aren’t going to be spending their money on these things. They’re elastic. 
    • Inelastic — There are necessities like food and gas. When the economy isn’t great, people are still going to buy these items. These are inelastic goods.
  • Gross Domestic Product (GDP) — GDP is the total monetary value of all goods and services produced within a country over the course of a given year, including income generated domestically by a foreign firm (i.e. Toyota vehicles). GDP represents what is happening in any given country, and that is why it is such a widely followed number. The components of GDP include:
    • Consumption — Generally spending by individuals on durable and nondurable goods and services. Consumption is by far the largest component of the GDP in the United States, representing about 2/3 of the number.
    • Investment — Generally business spending on inventory, plants, and equipment, but including new housing purchases by consumers.
    • Government — Government spending, including federal, state, and local.
    • Net Exports — Total exports less total imports.
  • Gross National Product — Similar to GDP, GNP takes into account any production by a company both in-and outside the home country. It is not as widely followed as GDP. Most individuals are concerned most about what is happening within their own borders, and that is what GDP measures.
  • Fiscal Policy — Together, both Congress and the President make fiscal policy decisions. Neither branch of government can make a fiscal policy decision without the involvement of the other. The President may propose a certain fiscal policy action, such as raising income tax rates for the wealthy; however, unless Congress passes legislation to raise tax rates for high-income individuals, no change will occur. Two tools are used in exercising fiscal policy:
    • The Power to Tax — Tax changes affect the amount of corporate earnings, the amount of consumer disposable income, and the incentives for individual workers to produce.
    • The Power to Spend — Changes to government spending affect corporate earnings, as well as consumer demand. 
  • Monetary Policy — Unlike fiscal policy, the government isn’t involved in monetary policy; that belongs to the Federal Reserve, our central bank. By changing Monterey policy, the Fed has the power to control the overall money supply and affect future economic behavior. The Fed controls monetary policy in three ways:
    • Reserve Requirements — By requiring banks around the country to have certain cash reserves on hand, the Fed is able to control money supply. If the reserve requirements are high, banks have to hold more cash, meaning they have less money to loan to consumers, which means they raise loan interest rates, which ultimately discourages consumers from borrowing and spending money in the economy. If cash reserve requirements are low, banks have more money on hand to loan, which means they can lower loan interest rates, which encourages consumer borrowing and spending. 
    • Discount Rate — The discount rate is the only interest rate the Fed has direct control over. The discount rate is the rate at which banks can borrow from any of the federal reserve banks. When the Fed raises the discount rate, it increases the cost of borrowing from the Fed and discourages member banks from borrowing funds, resulting in a contraction of the money supply. The Fed lowers the discount rate when it wants to increase money supply. When banks are able to borrow funds from the Fed at lower rates and lend more money, they increase the supply of money in circulation and this stimulates demand.
    • Open-Market Operations — Depending on the intended economic outcome, the Fed can either sell government securities to banks and market makers or buy back government securities in the open market. If the Fed wants to expand economic activity, it will buy government securities from banks (they have no choice) in exchange for money, thereby increasing the money supply and driving down overall interest rates. If the Fed wants to contract economic activity, it will sell government securities to banks from its existing inventory, thereby decreasing the money supply, driving up overall interest rates, and reducing prices.
  • Deficit Spending & Government Bonds — In recent years, Congress has conducted a policy of deficit spending, meaning that government expenditures exceed revenues. This causes the government to sell securities to the public to finance these deficits (government bonds). As a result, market interest rates must eventually rise to the level of government-backed bonds because nobody is going to risk their money for a return that isn’t equal to a government bond, which is considered completely safe. 
  • Recession vs. Depression — A recession occurs when the GDP has experienced a decrease for two consecutive quarters or a minimum of six months. A depression is when the GDP has experienced a decrease for six consecutive quarters or a minimum of 18 months.
  • Inflation — Inflation is the rise in the average level of prices of goods and services. It’s dangerous because it eats away at the purchasing power of your money. The Consumer Price Index (CPI) is one of the most common measures of inflation, and is a data point that the Fed looks at closely as they discuss monetary policy. The CPI comes out once a month and monitors changes in the prices paid by consumers for a representative basket of goods. 
  • Deflation — Deflation hasn’t occurred in the U.S. since the Great Depression of the 1930s. When prices are falling, deflation exists. In general, a deflationary period is one where preservation of capital should be the primary concern — investments should center on very high-quality bonds. This is because, during deflation, issuers of bonds can have difficulty meeting their principal and interest payments. You want to make sure you’re in high-quality investments when deflation happens. 
  • Stagflation — Stagflation is the worst of both worlds; it is characterized by high unemployment and high inflation, and the general growth of the economy slows down as business output falls.
  • Bankruptcy — People and businesses can file for bankruptcy, but it comes with a lot of consequences. There’s usually a big negative impact on your credit rating, which impacts your ability to borrow. You would also be unable to obtain a home mortgage for a considerable period of time. Filing bankruptcy would also impact the relationship with other institutions that rely on credit scores, such as auto insurers. A bankruptcy will remain on your credit score for 10 years. Some of the types of bankruptcy include: 
    • Chapter 7 — Under Chapter 7 bankruptcy, you are permitted to keep certain assets, but all others are relinquished to pay back the cost of bankruptcy and the claims of creditors. Filing is limited to the liquidation of credit card bills or loans that are not secured by a house or other asset. Debts that cannot be eliminated by filing for bankruptcy include income taxes, student loans, and child support or alimony.
    • Chapter 13 — Under Chapter 13 bankruptcy, a plan is created under which the debtor will repay outstanding debts within a specific time period, normally 3-5 years. Usually the amount owed is reduced so that payments will be manageable. This form of bankruptcy is available for those whose debts fall below a certain threshold and who have regular income. If your income over the last six months is above the state median, you have to go with Chapter 13 bankruptcy because Chapter 7 bankruptcy is not available to you.
    • Chapter 11 — Chapter 11 bankruptcy allows a person or business a chance to reorganize and come out of bankruptcy.

Ch. 8: Education Planning

  • Rising Education Costs — The cost of a college education is rising faster than the rate of inflation. According to one 2019 report from the College Board, average inflation in college costs over the past decade is 2.2%. Over the same period, inflation has averaged 1.79%. This is why it’s important to save for a child’s college education early. Start saving as soon as possible. By starting early, you’re also able to take more risks with the investments you choose. As the child gets closer to age 18, you start to move the money into more conservative investments to preserve the money. 
  • Expected Family Contribution (EFC) — A student’s allotted financial aid is largely determined by the family’s EFC. Ultimately, the EFC is subtracted from the total cost of attendance to determine the amount of financial aid a student receives. Parental Income, Parental Assets, Student Income, and Student Assets are the four calculations that go into EFC. An important note — the equity in a personal home is not included in the EFC calculation. The EFC typically determines how much parental and student income and assets are present using a two year “look-back” period. This is why, if possible, you want to distribute money to a child when they are a junior or senior in college to work around that “look-back” period and receive the most financial aid possible.
    • Quote (P. 260): “Overall, a higher percentage of assets and income included increases the EFC and reduces the available financial aid. Parental assets and income are assigned a lower weighting in the EFC calculation than are student assets and income. Therefore, carefully consider the titling of assets when saving for education expenses.”
      • Takeaway — You want to be strategic with how you allocate and distribute your savings when it comes to paying for a child’s education. The EFC calculation is critical to financial aid, and students who have more assets and income on record increase their EFC score, which effectively reduces the amount of financial aid they will receive. 
  • Custodial Accounts: UGMA & UTMA — Custodial accounts were previously a popular way of income shifting and saving for college in a child’s name. The two popular custodial accounts are the Uniform Gift to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA). Both of these allow parents to place money and securities in the accounts. With an UTMA, you can even add in real estate.
    • Disadvantages — The big issue with both accounts is that once the child reaches the age of majority — either 18 or 21, depending on the state — they are able to access the funds and use them however they want, even if it’s not for schooling. Also, the child (not the parent) is considered the owner of the account with these — going back to the previous bullet, this means the child will receive a higher EFC score and therefore receive less financial aid. 
  • Coverdell Education Savings Account (CESA) — The total contributions to all CESAs for a beneficiary, who must be under age 18 when the contribution is made, cannot be more than $2,000 in a year in total. That means if 5 people donate to the account in one year, the total still has to be under $2,000. Although contributions to a CESA are not tax deductible for those contributing to the account, the earnings on the account get to accumulate income tax free. In turn, when a CESA is distributed to the student and used for the payment of qualified education expenses, the amounts distributed are free of income taxes and penalties, regardless of the age of the donor (until he reaches the maximum age of 30). Using the CESA to pay for private elementary and secondary education expenses (K-12) is allowed; the funds aren’t only limited to college education expenses. 
  • Section 529 Plan — This seems to be maybe the best education savings vehicle available. With a 529 Plan, anybody, regardless of how much they make for income each year, is allowed to contribute to the plan (not the case with some other plans). Contributions grow tax-free, and the recipient can withdraw funds tax-free as long as they are spent on education expenses like tuition, room and board, etc. Also, once the student reaches college, you can disburse as much to him/her as you want. Prior to college, the limit is $10,000 per year. The beneficiary of a Section 529 Plan does not gain control of the assets at the age of majority as with custodial UGMA and UTMA accounts. This means you can prevent the beneficiary from gaining access to the funds and spending them on whatever he/she wants. Finally, you can roll the account balance in a 529 Plan over to any family member if desired. There are two main types of 529 Plans:
    • Prepaid Tuition Plan — These are becoming less common. Only 11 states offer them now. This plan allows you to prepay future tuition at today’s tuition rates. The key word here is ‘tuition’ — these plans typically apply to tuition only (not room and board, books, etc.). Also, to make the most of this plan, the beneficiary usually has to go to school in the state that the account was set up. 
    • College Savings Plan — In this type of plan, tuition is not being pre-paid, but, rather, a tax-advantaged savings plan is established from which tax-free distributions are made to pay for qualified education expenses. With this plan, there are no restrictions as to where the kid can go to school; he can go in-state or out-of-state. Unlike the Prepaid Tuition Plan, the funds in this plan can be used on education expenses beyond just tuition (room and board, books, etc.).
  • Retirement Plans & College Expenses — Although it’s typically not recommended, you can borrow from your retirement accounts (401k, IRA, Roth IRA) to help pay for a child’s college expenses without incurring the 10% premature distribution penalty. When it comes to Roth IRAs, these can be great for supplementing a 529 Plan because contributions to Roth IRAs are used with after-tax dollars, meaning your contributions can always be withdrawn without tax or penalty. The earnings, however, cannot be withdrawn without penalty until age 59 1/2 unless there’s a good reason that meets the qualifications for a penalty-free withdrawal. 
    • Quote (P. 276): “As long as the participant withdraws roughly equal amounts from his retirement plan annually for at least five years following commencement of distributions, or until reaching age 59 1/2 (whichever is later), retirement money can be used for any reason.”
    • Quote (P. 276): “Roth IRAs can be excellent sources for accumulation or supplements to Section 529 Plans. Contributions to Roth IRAs can always be withdrawn without tax or penalty.”
    • Quote (P. 276): “By combining Section 529 Plans and Roth IRAs, a parent can manage the taxes that can occur when spending large chunks of money on education in a few years.”
  • Section 529 Plan & Estate Planning — A Section 529 Plan can be a nice estate-planning tool because contributions to a 529 Plan are removed from a contributor’s gross estate, and any balance in the 529 Plan is not included in a person’s estate for estate tax purposes. In other words, 529 Plan assets are exempt from federal estate taxes. This is significant because you can make annual contributions anywhere between $15,000-$150,000 (depending on certain circumstances). 
    • Ex. Emily — At the time of her death in 2023, Emily owned a home worth $6 million, retirement accounts totaling $3.5 million, stock worth $2 million, and bank accounts totaling $1 million. Over the years, she had also contributed to 529 accounts for several grandchildren; a total of $500,000 remained in these accounts at her death. Because the $500,000 in 529 accounts is exempt from estate tax, Emily’s taxable estate is $12.5 million, rather than $13 million. 
  • American Opportunity Tax Credit — This education-based tax credit can be used to offset your taxes. In 2021, this tax credit reduces a family’s tax dollar-for-dollar in an amount equal to 100% of the first $2,000 of qualified postsecondary expenses and 25% of the next $2,000 of qualified expenses incurred for the first four years of postsecondary education. Therefore, a maximum credit of $2,500 is allowed. Qualified expenses include tuition, fees, and course materials. Room and board are excluded.
  • Employer Assistance Programs — Employers are able to help their employees with qualified educational expenses. There are two sections in the IRS code that apply here and that an employer can use to support an employee with their qualified educational expenses. They are:
    • IRS Section 162 — This section allows an employer to provide an unlimited amount of educational assistance to an employee as long as this assistance is job related. These contributions are tax deductible for the business/employer who contributed them because they are considered “ordinary and necessary business expenses” and can therefore be claimed as deductions to offset part of the company’s tax bill. 
    • IRS Section 127 — This section allows an employer to provide up to $5,250 of non-job-related educational assistance to an employee as a tax-free employee benefit. For example, if an employee is attending night classes in pursuit of her MBA in a non-job-related field of study, the company can help the employee with qualified educational expenses up to $5,250 in a given year. 
  • Chapter Takeaway — As this chapter outlines, there are many ways to help save for a child’s college expenses. But the No. 1 thing to keep in mind, above all else, is to start as early as possible. The sooner you start, the longer the time horizon will be and the more time the money will have to grow. No matter which education saving vehicles you choose to use, start early.