The Most Important Financial Terms Everyone Should Know
Cost factor. Base rate. Depreciation. As with technology , the world of finance is filled with acronyms and terms that may seem foreign to many. So, we’ve created a financial glossary for you that explains the important but often confusing concepts of money.
This is by no means an exhaustive list. If you’re looking for a quirky financial term (like Investopedia, Debt Coverage Ratio, or DSCR ), check out this impressively large online financial dictionary . But think of it as a resource and a tutorial – the terms below are the terms most people come across the most. You need to know this when you are managing your money, investing, or just talking about finance.
401 (k) : 401 (k) is a type of retirement savings plan offered by many companies to their employees (about half of companies offer it). When you sign up for your employer’s 401 (k) plan , you can contribute a portion of each salary that is invested so that it increases over time. With traditional 401 (k), your contributions are deducted from your pretax paycheck and your savings are tax deductible until you withdraw your money for retirement.
Other employer-sponsored retirement savings plans include 403 (b) plans for tax-free or nonprofit employees, 457 plans for state and local government employees, and savings savings plans (TSP) for federal employees.
Why you need to know this: Most companies will deposit a certain amount of money that you deposit into your 401 (k). It’s like getting free money and you shouldn’t give it up . Even if they don’t offer a match, automatically saving for retirement is one of the most important financial steps you can take.
Depreciation: When you get a mortgage or car loan, you may be presented with a repayment schedule that shows your monthly payments and their effect on your total debt. Depreciation refers to the regular payments over time to pay off a debt and includes both principal (the amount of money borrowed) and interest (the amount you charge the lender for the privilege of the loan).
Why you need to know this: With a depreciation chart or calculator , you can figure out how much home equity (the value you can use) you will have in your home at any given time, or figure out how much extra you would spend. you have to pay every month to pay off the loan faster. A depreciation chart can also be motivating by showing you how you can reduce your debt each month.
Annual Percentage Rate : Annual Percentage Rate. This is the interest rate that you will pay on a loan (for example, a credit card debt that you do not pay on time) or earn on an investment over one year, including fees.
APY: APY (Annual Percentage Yield) is similar to Annual Percentage Yield, except that it takes into account the compound interest you earned or paid during that year (see the compound interest entry below for a full explanation). APY includes the interest you have already accumulated in your calculations, so it is higher than the APR. This is why banks advertise APY for savings accounts but APY for loans and credit cards.
Why you need to know: The annual interest rate is useful for comparing loans such as offering one credit card with an offering of another, or one mortgage loan from another. However, APY is more realistic and you can calculate it yourself .
ARM: No, not part of your body. ARM in the financial world means adjustable rate mortgages. This is a mortgage with an interest rate that changes periodically after a certain number of years. Your interest rates are initially lower, but then can grow (or sometimes decrease) in 5, 7 or 10 years, which makes them more risky compared to mortgage loans with fixed interest rates, which have the same interest rate throughout the loan expires.
Why You Need to Know This: ARM models rise and fall with the market, so they’re not for the faint of heart. Learn about adjustable and fixed rate mortgages at Bankrate .
Diversification. Diversification is the phrase “don’t put all your eggs in one basket” in the financial industry. When you invest, you want to put your money in several different areas to reduce your risk. You don’t want to invest all your money in tech companies, for example, just to lose it all in another dot-com crash . (Bubbles occur in any industry, even when buying tulip bulbs .)
Asset allocation is a diversification strategy in which you allocate money between different types of investments called asset classes . How much you invest in each activity depends on your goals, risk tolerance, and schedule. Three main asset classes:
- Cash: Yes, we define cash. But when it comes to investing, this can mean not only physical money (your coins and paper bills), but also money in your savings account, money market account, and government bonds that can be easily and quickly converted into cash.
- Bonds: When you buy a bond – be it a US corporate, government, or municipal bond – you are essentially lending money to an organization or government at interest. Bonds come with a specific maturity (when the bond can be redeemed). For example, US Treasury bonds are used by the government to pay off federal debt. They pay a fixed interest rate every six months until maturity (10 to 30 years). Some bonds are considered safe investments compared to junk bonds, which have a higher risk but a higher potential payout.
- Shares: A share is an ownership interest in a public or private company. When you buy shares in a company, you become a shareholder, and when the company is doing well, your investment grows. However, when things go wrong, the same thing happens with your investments in stocks.
Why you need to know this: Diversification, including asset allocation, helps balance risk and reward when investing (say, in your 401 (k)). Our beginner ‘s investment guide and article on choosing investments for a retirement account can help you get started.
Bear market and bull market: Bear market and bull market are terms to describe the stock market and investing. They are easy to distinguish when you consider the characteristics of the animals. In a bull market, everything is moving forward: investors are confident that they are making a lot of purchases, more companies are entering the stock market, and more money is being invested in the stock market as a whole (technically, a bull market means that the market has risen in value by at least 20% ). In a bear market, investors retreat (like hibernating bears). Prices start to fluctuate and fall, and people wait and see more before investing additional money in stocks and bonds.
Why You Need to Know This: These are good terms to know, but not exactly the terms on which your investment strategy is based. After all, even experts often find it difficult to tell if we are in a bear or bull market. However, knowing these terms will help you understand when people are talking about market conditions or when everyone is optimistic (bullish) or pessimistic (bearish) and will keep you from being carried away by the crowd.
Capital Gains and Loss: If you sell something for more than you spent to acquire it, it is a capital gain. If you sell it for less than your original purchase price, it will result in a loss of capital. The IRS taxes capital gains, but allows you to deduct capital losses from your taxes. These gains and losses are usually associated with investments such as stocks and bonds, but they also include property such as real estate and even jewelry or art. See How Capital Gains Tax works at How Stuff Works .
Why you need to know this: You will want to consider taxes when deciding to sell an investment, especially at the end of the year . Find out how investments affect your taxes here .
Compound Interest: Do you know how a lie just leads to another lie, and the problem just grows exponentially? This is how compound interest works. Let’s say you invest $ 100, which increases 10% per year, or $ 10. Its cost is now $ 110. Next year it will grow by another 10%, but this time that 10% is equal to $ 11, since its cost was higher. Your investments are growing at a faster rate each year due to previous interest.
Why You Need to Know This: Compound interest is one of the most powerful forces in the universe . It can make you quickly run into debt or make you richer while you sleep. This is perhaps the most important financial concept that everyone, including children, needs to grasp. The diagram below shows how powerful compound interest can be (just using the power of time to increase savings), and this Khan Academy video explains the concept in more detail .
Credit Report and Credit Rating: Your credit report is basically a compilation of your credit history – the lines of credit you have taken (such as credit cards, mortgages, and car loans), your debt payment history, your account balances, and other details. Three credit bureaus in the United States, Experian, TransUnion and Equifax, collect this information and your basic personal information (such as name and address) and share it with lenders and other companies . Your credit score is similar. It is based on your history of handling credit card debt and other debts, but this is a score that credit bureaus assign to you individually to assess your “credit worthiness.”
Why you need to know this: If you are looking to get a new mortgage or other loan, your credit rating and history are of paramount importance. Bad or nonexistent credit history can also make it difficult to pay for cable TV services , rent an apartment, or even get a job. Check and improve your credit score before making any major financial moves.
Dividends: Dividends are the portion of a company’s profits that they pay to their shareholders. They are usually paid quarterly. I bought one share of The Walt Disney Company when my daughter was born and every quarter we get a check for about $ 1.86. This is normal taxable income, although we could reinvest it and buy more shares.
Why do you need to know: again, the knowledge that , as a taxable various investments , will help you keep more of your money. Investments that regularly generate higher dividends, such as small-cap stocks, are better suited for tax-efficient retirement accounts than for regular investment accounts.
Averaging the dollar value: Let’s say after every paycheck, you put $ 100 into your retirement account, buying the same mutual funds or stocks. This is an example of dollar value averaging – a strategy where you put a certain amount of money in an investment regardless of the stock price. When stock prices are low, you buy more stocks; when prices are high, you buy fewer stocks. Instead of trying to “buy low and sell high,” which is risky, you stick to a conventional investment plan that takes emotion out of the equation . You can just install it and forget (for the most part).
Why you need to know this : This is what most people do when they invest in their 401 (k) or other retirement plan – they automatically buy as many fund shares or stocks as they can, based on the set amount of the contribution. This is a smart investment strategy if you have been investing for a long time, although it is not so ideal if you have a large amount of money to invest (for example, if you just won the lottery).
Expense Ratio: This is the annual fee charged by the mutual fund for things like operating costs, management fees, administration fees, and other fees incurred by the fund. If you, for example, have $ 10,000 invested in a fund, fund administrators can charge 2% annually for managing the fund (or $ 200!). Historically, funds with lower expense ratios (eg index funds , see below) have outperformed managed funds with higher expense ratios.
Why you need to know this: When choosing an investment, pay attention to the expense ratio. This is the first number to look out for when investing in a mutual fund. Most investment experts, including Warren Buffett, John Bogle, and Charlie Munger, agree that for the average person, the best way to invest is to invest in low-cost index funds . Your investment is likely to do more good.
IRA: An IRA or Individual Retirement Account is another type of retirement savings account. However, unlike 401 (k) s, IRAs can be opened by individuals – this does not have to be sponsored by your employer. You can deposit income up to a set maximum dollar amount in Traditional IRAs, Roth IRAs, Simple IRAs, or SEP IRAs. Check out some of the differences in our beginner’s guide to opening an IRA (and why everyone is obsessed with a Roth IRA ).
Why you need to know: You don’t need to invest in your employer’s 401 (k) plan. If they offer a match with your 401 (k) fees, take them, but IRAs may have better investment options (with lower expense ratios!) Than 401 (k). If you’re a freelancer or your company doesn’t have a retirement plan, you’ll want to brush up on your IRA options .
Mutual fund: A mutual fund is a collection of stocks, bonds and / or other assets managed by an investment company such as Vanguard or Fidelity Investments . When you invest in a mutual fund, your money is pooled with other investors, and the investment company buys and trades assets in accordance with the mutual fund’s goals, such as earning dividend or interest income (income funds are great if you are close to going out on pension). You will find these stated objectives in the fund’s prospectus . Mutual funds allow you to buy stocks in hundreds of different companies without having to make or control all those investments in your portfolio. They are easy to buy and sell, but they also come with management costs (as described in the section on cost ratios).
Index funds are a special type of mutual fund that attempts to track or match the market index, such as the Standard & Poor’s 500 (S&P 500), which is based on the market value of 500 large US publicly traded companies. Index funds usually have lower expense ratios because they are not actively managed by people trying to outperform the market. Instead, they are simply trying to imitate the stock market.
Why you need to know this: Mutual funds may be the easiest way to get started investing in stocks and / or bonds, but they are not the only option and you will still have to choose from hundreds if not thousands of mutual funds. invest. Know the basics of mutual funds and their comparison with the same ETF or exchange traded funds, so you know where your money is going. Again, index funds are the best way out for most people because of their lower expense ratios.
Net Worth: Compound interest may be the most important financial concept, but net worth is your most important measurement of wealth . This is the difference between your assets (savings and investments – things that cost money) and your liabilities (your debts).
Why you need to know this: When you focus on and track your net worth , you move to a more realistic idea of how much you really have. This is a better measure of your financial progress than your income. After all, if you’re in a lot of debt, you can have a six-figure paycheck and still live paycheck to paycheck.
Base rate: The base rate is the lowest interest rate that banks charge their customers. If you have an excellent credit rating, you may be offered a loan “at the rate” or even lower than the basic one. The base rate is pegged to interest rates set by the Federal Reserve System (or “the Fed”). When they raise the target federal fund rate, the base rates go up. When you receive a credit card offer or other loan offer, it can be presented as “base plus [some percentage]” – this percentage is a measure of your risk, the premium you pay for the loan, based on your credit rating, income, assets and other factors.
Why you need to know this: When looking for a loan, you need to get it as close to the prime list as possible so that you don’t pay more than you need to in interest. If you are offered a loan at a good rate, you can rest assured that the banks consider you worthy of credit.
Deferred Tax : Deferred tax means deferring tax on your income at a later date. If you invest in a traditional IRA or 401 (k), the money you put aside from your paycheck into your retirement account is now tax deductible. Investment income is tax deductible until you withdraw it. Other account types, such as the Roth IRA, also offer tax advantages, but work in the opposite way when it comes to taxes. For example, with a Roth IRA, you pay taxes on your income before investing, but when you withdraw during retirement, you are not taxed on either the money invested or the profits – this is tax-free growth. Learn about delayed and tax-free growth here.
Why you need to know: Tax deferral helps you to defer taxes and save more money. Some types of investments are best invested in tax-deferred accounts and others in taxable or Roth accounts, so in order to make the most of your money it is helpful to know the difference and find out if you should use a Roth IRA. or traditional IRA .
Despite the jargon of many financial terms, these and similar terms are easier to understand than they might appear at first glance. Also, don’t let the jargon hold you back: you don’t need to know what the price-to-earnings ratio is before you can start investing in a retirement fund, and you don’t need to know what PMI (or private mortgage insurance) is. start saving a down payment to buy a house. You will learn some of the terms along the way, but hopefully the ones above will help you deal with the most common financial situations now.