Personal Finance, Part 3

Question 1: Identify and briefly explain some of the reasons for the spread between interest earned and interest charged.

Answer 1: Each financial institution has a spread, or difference, between the amount of interest an individual earns from an account and the amount of interest charged for loans and other services. The primary reason for the spread between the amount of interest earned and the amount charged is that banks and other financial institutions make their profit and cover their expenses with the interest they earn on loaning money that has been deposited. For example, an individual deposits $50,000 into a savings account that earns 2 the bank would then take a portion of that money and loan it to another individual at an interest rate of around 7 promised to the depositor and keep the extra 4-5 percent.

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Question 2: Explain the difference between simple and compound interest rates.

Answer 2: The appropriate amount of interest to be paid on a loan that uses simple interest rates can be determined by multiplying the principal (the total amount borrowed) by the simple interest rate for the period of the loan. For example, if an individual has a $10,000 loan with a 6 interest compounded semiannually, the interest the first time it compounds would be $600 ($10,000 x 6), so the annual interest payment would be $1,236 ($600 + $636.

Question 3: Explain the process of creating a personal budget.

Answer 3: A person planning a personal budget first should add up his or her annual income and cash on hand. Then, he or she should construct a list of all of normal expenses, separating necessary expenses from luxury expenses. Necessary expenses are important to day-to-day survival, and may include housing, food, utilities, transportation, and insurance. Luxury expenses are not necessary for survival, but rather improve quality of life; they include things like entertainment, jewelry, restaurants, and vacations. After adding up necessary expenses, the person should subtract that amount from the his or her total annual income. The money left over from the annual income should then be budgeted for savings, and anything left after that for luxury expenses.

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