Personal finance is one of those things that suddenly pop up on the radar of “adulting” as soon as you receive your first steady paycheck. It is seldom taught in school and is absent from college education as well, unless finance classes are explicitly taken. In spite of this, as a responsible adult, you are expected to understand how the entire system revolving around personal finance works.
But have no fear. This article will demystify most of the jargon related to banking, investments, loans, income tax, and retirement savings. A lot of the commonly used personal finance terms shall no longer seem like a foreign language.
The following are the 30 personal finance terms that you should definitely know:
Banking and Credit Terms
1. Compound Interest
Let’s begin with probably the most frequently used term in most personal financial situations: interest. Simple interest is calculated by applying an interest rate on the principal (the initial amount of money owed or lent).
Compound interest is determined by applying interest on the initial principal, as well as on interests from previous periods. For example, if interest is being compounded yearly, then the interest at the end of the second year is estimated by fitting the interest rate to the sum of the initial principal and previous interest.
So the interest for the subsequent period is no longer just on the initial principal, but on the interest added from the previous period as well. It is, in short, the interest on previous interest and grows much faster than simple interest. Compound interest can be on your financial assets, as well as liabilities.
2. Net Worth
Net worth is the difference between the monetary value of all your financial and non-financial assets and total outstanding liabilities. You can calculate it by adding all the money you have in various accounts, including checking, savings, investment, and retirement accounts.
Also, add the monetary value of your non-financial assets, such as your home, vehicle, jewelry, and other valuables. From this, subtract all the debt you have in terms of loans, home mortgage balance, credit card balance, and other financial obligations. The resulting number is your net worth. It’s a useful indicator of your financial health.
APY stands for annual percentage yield. It is the amount you earn from your investments or money kept in an account in a year. This also includes compound interest on the previous balance of the investment or account.
4. Credit Report
A credit report is a detailed summary of your credit history. This report can include credit history information, such as late payments, loans, bankruptcy, and personal information, such as your address, social security number, and other details.
Based on data reported by financial institutions that you transact with, credit bureaus keep adding information to your report over time. Three well-known credit bureaus are TransUnion, Experian, and Equifax.
5. Credit Score
A credit score is a numerical used by banks and other financial institutions to measure your creditworthiness. It is based on factors that indicate the way you have used credit in the past, such as payment history, late payments, length of credit history, and other activities.
Lenders use the credit score to determine if giving you a loan is a safe credit risk. An example of a credit score is the FICO rating used in the US. A FICO score ranges between 300 and 850, and the higher the score, the more creditworthy you seem.
When a financial institution makes a payment on your behalf due to insufficient funds in your checking account, your account gets a negative balance. Your account is then considered overdrafted.
Banks usually charge a high fee, called the overdraft fee, or try to recover the negative balance by deducting money from your credit card. It is best not to find yourself in the situation of being overdrafted with a financial institution.
Investment and Stock Market Terms
7. Asset Allocation
Asset allocation is the strategy of balancing risk and reward to create a diversified portfolio of asset classes. This strategy can be based on your investment goals, risk tolerance, and time horizon of the funds that you are planning for.
The primary asset classes are bonds, stocks, cash, and cash alternatives, such as certificates of deposit, real estate, futures, commodities, and financial derivates. Diversification is a common asset allocation strategy where the investment portfolio is spread across various asset classes to mitigate risk.
Stock is a form of security that gives its owner a proportional share of ownership of a company or corporation. If a company has 20 shares of stock to offer, then owning 4 gives you 20% ownership of the company. Owning stocks gives you a claim to dividends and assets. There are two kinds of stocks: preferred and common stocks.
When people talk of stocks, they are mostly talking about common stocks. Owning common stocks gives you voting rights, dividends (a share of the money that a company makes), and the right to be paid back in case the company goes bankrupt.
Bonds are a debt instrument used typically by the government or corporations to raise money. They are also known as fixed-income securities and are basically investments in debt. By investing in a bond, you lend money to a financial entity for a specific period at a fixed rate.
Buying a bond does not make you a shareholder, but gives you a share of the entity’s income in the form of fixed interest payments over regular intervals of time. At the bond’s maturity date, you get back the loaned amount.
Rebalancing is the selling or buying of investments in various asset classes to maintain the asset allocation of your choice. The weighting of the portfolio is adjusted to keep the original or desired level of risk. For example, if the initial asset allocation was a split of 40% stock and 60% bond and the stock market fell, then the proportion of stock in your portfolio may have fallen to 33%. In this case, you may want to buy more stock to return your portfolio to the original asset allocation of a 40/60 split.
11. Capital Gains
A capital gain occurs when the value of an asset or investment exceeds the price at which it was purchased. A capital gain is only on paper and not realized until the asset or investment is sold. Capital gains are taxed,+ depending on how long you have held the assets.
The kinds of taxes on capital gains based on holding period are:
- Short-term capital gains (STCG) tax: Tax paid on investments that have been held for a year or less.
- Long-term capital gains (LTCG) tax: Tax paid on investments that have been held for more than a year.
12. Mutual Funds
A mutual fund is an actively managed pool of investments made by multiple investors that contains a variety of securities. These securities can be stocks, bonds, cash, or derivates. Mutual funds are run by active managers who invest capital on behalf of investors for a fee.
An exchange-traded fund is a passively managed pool of securities. It is not run by managers and often tracks a particular index. ETFs are similar to mutual funds in many ways but are traded on the stock exchange like stocks. ETFs have an associated price that allows them to be bought and sold quickly.
An ETF can contain a diverse set of investments, such as stocks, bonds, commodities, and other investments. A well-known ETF is the S&P 500, short for “Standard & Poor’s 500 Index.”
The S&P 500 tracks the top 500 companies in the United States based on market capitalization. So when someone says that “the S&P 500 is up 10%,” that means that the values of the biggest 500 companies in the US have increased by 10% on average.
14. Amortized Loans
Amortization is paying off a debt in regular payments over fixed intervals of time. A loan that has been broken into smaller installments of equal value to be paid periodically is called an amortized loan. These installments include an interest in addition to the portion of the amount owed for that period.
For example, your mortgage on the cost of your home is amortized into monthly installments based on the total cost and interest that you’ll keep on paying until the loan is paid back completely.
15. Fixed-Rate Loans
A fixed-rate loan is an amortized loan where the rate of interest is fixed for the lifespan of the loan payments. With fixed-rate loans, the loan installments that you pay remain firm and do not vary over time – even if interest rates rise.
For example, if you get a fixed-rate mortgage, then you’ll pay monthly installments calculated at the same rate throughout your loan period, even if house-loan rates go up. Fixed-rate loans, thus, protect you from fluctuations in interest rates. However, they may prove to be costly if interest rates go down.
16. Adjustable-Rate Loans
Adjustable-rate loans, as the name suggests, are loans where the rate of interest is not fixed over the life of loan repayment. Interest rates rise and fall depending on market trends, and your installments increase or decrease accordingly. Most adjustable-rate loans start out as fixed-rate loans in the short-term, with rates resetting annually after the fixed-rate period is over.
For example, if you buy a house on a three year ARM (adjustable-rate mortgage), that means that you have a fixed-rate interest period for three years. After three years, the interest rate changes based on the terms of your mortgage agreement. So your monthly installments may be low during the fixed-rate period of three years, but they will increase significantly after new rates are applied.
A co-signer is someone who acts as a guarantor and takes responsibility on a loan but does not hold any rights to the asset in question. A co-signer does not own any title interest in the asset and cannot occupy or use it. For example, if your father agrees to be a co-signer for your mortgage, he acts as a guarantor on your behalf for the bank. He, however, holds no ownership or title over the property and cannot occupy it without your permission.
An escrow account is an account held by a third party on behalf of the buyer and seller. The third-party acts as an agent (escrow) for both parties and is responsible for disbursing funds on the basis of terms agreed upon by both parties.
For example, during the purchase of a home, you transfer a set amount of money to an escrow account that neither you nor the home-seller can access until the conditions of the contract, such as passing a home inspection, are met and the sale is completed.
Refinancing is the process of replacing an existing debt obligation, such as a mortgage, with a new loan under different terms of repayment. You may want to refinance your mortgage for a variety of reasons: to lower your rate of interest; to lower monthly installments; or to change your loan from an adjustable-rate mortgage to a fixed-rate mortgage and vice versa. You can refinance your existing loan with a new loan to get repayment terms best suited for you.
20. Private Mortgage Insurance
Private mortgage insurance, also known as PMI, is a kind of insurance that lending institutions require when the down payment made by the homebuyer is typically less than 20%. It is meant to protect the lender in case of non-payment of loan installments. The premiums for the insurance are generally added to the monthly mortgage installments. Depending on the terms of the mortgage, these premiums can run for the entire lifespan of the loan or until a condition is fulfilled.
Income Tax Terms
21. Adjusted Gross Income (AGI)
Adjusted gross income, or AGI, is your gross income minus the deductions specified by the IRS. For most individual income tax calculations, AGI is more relevant than the gross income. Your taxable income is your adjusted gross income minus the allowances available for itemized deductions and other exemptions. While filing your taxes, Form 1040 has to be filled out.
22. Itemized Deductions
The IRS allows certain qualified expenditures to be deducted from your AGI to make your taxable income lower. These expenses can be related to specific services, products, or contributions and are listed on Schedule A of Form 1040. Interest on mortgage payments, medical costs, and donations to qualified charities are examples of itemized deductions.
23. Standard Deduction
A standard deduction is an amount subtracted from your AGI if you decide not to itemize your deductions. As a taxpayer, it is up to you to determine whether you want to claim a standard deduction or itemize your deductions. You can choose whichever option reduces your tax bill more. The standard deduction depends on your tax filing status and is the government’s way of making sure that at least some portion of your income is tax-exempt.
24. Withholding Tax
Withholding or retention tax is a tax paid by the payer of income to the government instead of the recipient. This tax is called so because an amount is withheld from an employee’s salary and paid directly to the government. It is a credit against the income taxes a taxpayer must pay during a financial year.
Retirement Savings Terms
25. Defined-Benefit Plans
Defined-benefit plans are retirement plans, such as pensions, sponsored by the employer. These retirement incomes are calculated based on factors such as duration of employment, salary history, age, and other considerations. The benefits are typically paid for life and are sometimes adjusted for inflation.
26. Defined-Contribution Plans
Defined-contribution plans are retirement plans that allow employees to contribute some of their income to an account for retirement. The employer may choose to match this contribution or a portion of it. These contributions are tax-exempt, as long as withdrawals are not made before retirement age. The 401(k) is an example of a defined-contribution plan.
27. Roth IRA
Roth IRA is an individual retirement account that has after-tax money. Since the tax is already paid on the contribution in the income year, the money grows tax-free and can be withdrawn without paying taxes in retirement.
28. Traditional IRA
A traditional IRA is an individual retirement account that has pre-tax money as contributions. Earnings in a traditional IRA can grow tax-deferred because annual donations made to this retirement fund are tax-deductible. However, taxes have to be paid on investment growth when the money is withdrawn in retirement.
29. Contribution Limit
The maximum amount of income that you can contribute to a retirement plan in a given tax year is called the contribution limit.
30. Required Minimum Distributions
Required minimum distributions, also known as RMDs, are minimum amounts that must be withdrawn annually from traditional IRAs and retirement funds that are employer-sponsored. The RMDs must be made after reaching the age of 70 ½. Once removed, the money is taxable.
Lacking basic financial knowledge can leave you vulnerable to a seemingly unfriendly finance system. This glossary of 30 personal finance terms discussed above is going to help you grasp the basics of personal finance and be in control of your financial future.