Key financial terms
Whenever you hear someone speak personal finance, do you feel like you’re learning a foreign language? Don't worry — we're here to help. We know that your finances don’t come with a technical-support hotline, so we compiled a handy glossary of must-know financial terms. Whether you're confused about amortization or not sure what escrow, exactly, is good for, this primer on financial terms will help you get up to speed.
Financial terms for banking and credit
1. Compound Interest. When you're investing or saving, this is the interest that you earn on the amount you deposit, plus any interest you've accumulated over time. When you're borrowing, it's the interest that is charged on the original amount you are loaned, as well as the interest charges that are added to your outstanding balance over time.
Think of it as “interest on interest.” It will make your savings or debt grow at a faster rate than simple interest, which is calculated on the principal amount alone.
2. FICO Score. A number used by banks and other financial institutions to measure a borrower’s creditworthiness. FICO is an acronym for the Fair Isaac Corporation, a company that came up with the methodology for calculating a credit score based on several factors, including payment history, length of credit history and total amount owed. FICO scores range from 300 to 850, and the higher the score, the better the terms you may receive on your next loan or credit card. People with scores below 650 may have a harder time securing credit at a favorable interest rate.
3. Net Worth. The difference between your assets and liabilities. You can calculate yours by adding up all of the money or investments you have, including the current market value of your home and car, as well as the balances in any checking, savings, retirement or other investment accounts. Then subtract all of your debt, including your mortgage balance, credit card balances and any other loans or obligations. The resulting net worth number helps you take the pulse on your overall financial health.
Financial terms for investing
4. Asset Allocation. The process by which you choose what proportion of your portfolio you'd like to dedicate to various asset classes, based on your goals, personal risk tolerance and time horizon. Stocks, bonds and cash or cash alternatives (like certificates of deposit) make up the three major types of asset classes, and each of these reacts differently to market cycles and economic conditions.
Stocks, for instance, have the potential to provide growth over time, but may also be more volatile. Bonds tend to have slower growth, but are generally perceived to have less risk. A common investment strategy is to diversify your portfolio across multiple asset classes in order to spread out risk while taking advantage of growth.
5. Bonds. Commonly referred to as fixed-income securities, bonds are essentially investments in debt. When you buy a bond, you’re lending money to an entity, typically the government or a corporation, for a specified period of time at a fixed interest rate (also called a coupon). You then receive periodic interest payments over time, and get back the loaned amount at the bond’s maturity date. Bond prices tend to move in the opposite direction of interest rates — that is, when interest rates rise, bond prices typically fall.
6. Capital Gains. The increase in the value of an asset or investment — like real estate or stock — above its original purchase price. The gain, however, is only on paper until the asset is actually sold. A capital loss, by contrast, is a decrease in the asset’s or investment’s value.
You pay taxes on both short-term capital gains (a year or less) and long-term capital gains (more than a year) when you sell an investment. By contrast, a capital loss could help reduce your taxes.
7. Rebalancing. The process of buying or selling investments over time in order to maintain your desired asset allocation. For example, if your target allocation is 60 percent stocks, 20 percent bonds and 20 percentcash, and the stock market has performed particularly well over the past year, your allocation may now have shifted to 70 percent stocks, 10 percent bonds and 20 percent cash. If you wanted to return to that 60/20/20 asset allocation, you’d have to sell some stocks and buy some bonds.
8. Stocks. Also called equities or shares, stocks give you ownership in a company. When you buy stocks, you become a company shareholder, giving you a claim on part of that company’s assets and earnings.
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Financial terms for real estate
9. Amortization. This is the process of paying off your debt in regular installments over a fixed period of time. Your mortgage is amortized using monthly payments that are calculated based on the amount borrowed, plus the interest that you would pay over the life of the loan.
10. ARM. An acronym for adjustable rate mortgage, it’s a type of mortgage in which the interest you pay on your outstanding balance rises and falls based on how interest rates are changing in the larger market. ARMs usually start out at a fixed rate for a short period of time, which then resets annually.
For example, if you have a five-year ARM, you will have a set rate for the first five years. Then the rate will change based on the terms of your mortgage. This means your monthly mortgage payment could start out low, but then rise (sometimes significantly) after the fixed-rate period is over.
11. Escrow. An account held by an impartial third party on behalf of two parties in a transaction. During the homebuying process, the buyer will deposit a specified amount in an escrow account that neither party can access until the terms of the purchase contract, such as passing an inspection, have been fulfilled and the sale is completed.
An escrow account can also hold money that will later be used to pay your homeowners insurance and property taxes. You can put money in escrow every month, so that when your premiums and taxes are due, you have enough to cover those bills.
12. Fixed-Rate Mortgage. A mortgage that carries a fixed interest rate for the entire life of the loan. With a fixed-rate mortgage, you don’t have to worry about your payments going up if interest rates rise. The downside is that you could be locked into a more expensive mortgage if interest rates go down.
13. Private Mortgage Insurance. Also known as PMI, it’s a type of insurance that mortgage lenders require when homebuyers provide a down payment of typically less than 20 percent. The premiums are usually tacked onto the amount homeowners pay each month. For some mortgages, once your loan-to-home-value ratio reaches 80 percent, you no longer have to pay PMI, but in some cases, it is permanent for the life of the loan.
Financial terms for job benefits
14. Defined-Benefit Plans. Employer-sponsored retirement plans, such as pensions, in which the employer promises a specified retirement benefit based on a formula that may include an employee's earnings history, length of employment and age. The employee may or may not be required to contribute anything to the plan. Because of their high costs, many companies no longer offer this type of benefit.
15. Defined-Contribution Plans. A retirement plan companies may offer as a job benefit, which lets employees contribute some of their own money into an account for retirement. The employer may also choose to match a certain amount of those contributions. The 401(k) and 403(b) are the most common forms of defined-contribution plans. The money that goes into these accounts also typically provide a tax benefit, as long as you don’t make withdrawals prior to retirement age (age 59½ or older).
16. Executive Compensation. The pay and benefits package provided to senior executives, which is usually different from what's offered to the typical employee. Executive compensation often includes a base salary, bonuses, incentives based on the company’s earnings (such as stock options), income guarantees in the event of a sale or public stock offering, and a guaranteed severance package. These packages are typically negotiated individually and spelled out in employment contracts.
Financial terms for insurance
17. Permanent Life Insurance. A type of policy that provides coverage over the lifetime of the insured and also offers a component called cash value that you can tap into while you’re still alive. Using the cash value, however, means you could reduce your death benefit and may owe taxes. Premiums for permanent life insurance are typically more expensive than for term life insurance (more on term life insurance below).
18. Premium. The payments you make to an insurance company to maintain your coverage. You can pay premiums monthly, quarterly, semiannually or annually.
19. Term Life Insurance. A type of policy that provides coverage over a set period, generally anywhere from 10 to 30 years. If you die within the set term, your beneficiaries receive a payout. If you don’t, the policy expires with no value.
Financial terms for taxes
20. AGI. Short for adjusted gross income, your AGI is calculated as your gross income (e.g., what you earn from your job, a pension or from interest on investments) minus certain IRS-specified deductions. You calculate your AGI Form 1040 when you file your taxes. Your AGI serves as the basis for helping to determine your taxable income as well whether you qualify for certain credits or deductions.
21. Dependent. A person who is financially dependent on your income, typically a child or an adult relative you may support. You may be able to claim certain tax credits or deductions for these dependents on your taxes.
22. Itemized Deduction. A qualified expense that the IRS allows you to subtract from your AGI that helps further reduces your taxable income. Itemized deductions can include mortgage interest you paid, medical and dental costs, or gifts to charity. Itemized deductions must be noted on IRS form Schedule A.
23. Standard Deduction. A standard amount that can be used to reduce your taxable income if you decide not to itemize your deductions. Your standard deduction is based on your tax-filing status, and it's the government’s way of ensuring that at least some of your income is not subject to tax.
All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.
Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.
As an avid financial enthusiast with a deep understanding of various financial concepts, I've delved into the intricacies of personal finance, investing, and real estate. My expertise is grounded in practical experience and a comprehensive grasp of key financial terms, making me well-equipped to guide others through the complexities of the financial world.
Let's break down the essential concepts discussed in the provided article:
1. Compound Interest:
- Definition: Interest earned or charged on the initial amount deposited or loaned, along with accumulated interest over time.
- Significance: It accelerates the growth of savings or debt compared to simple interest.
2. FICO Score:
- Definition: A numerical representation of a borrower's creditworthiness, calculated by the Fair Isaac Corporation based on factors like payment history, credit length, and total debt.
- Significance: Higher scores lead to better loan or credit card terms; scores below 650 may result in challenges securing favorable rates.
3. Net Worth:
- Definition: The difference between assets and liabilities, offering insight into overall financial health.
- Calculation: Assets - Liabilities = Net Worth.
- Significance: A metric to gauge financial well-being by considering all financial elements.
4. Asset Allocation:
- Definition: Determining the proportion of a portfolio allocated to different asset classes based on goals, risk tolerance, and time horizon.
- Asset Classes: Stocks, bonds, cash or cash alternatives.
- Significance: Strategy to manage risk and optimize growth in diverse market conditions.
- Definition: Fixed-income securities representing debt investments with periodic interest payments and a return of the principal at maturity.
- Behavior: Prices move inversely to interest rates.
- Significance: Offers slower growth with perceived lower risk compared to stocks.
6. Capital Gains:
- Definition: The increase in the value of an asset or investment above the original purchase price.
- Taxation: Subject to taxes upon selling.
- Significance: Tax implications on both short-term and long-term gains.
- Definition: Adjusting investments to maintain the desired asset allocation.
- Example: Selling stocks and buying bonds to restore a target allocation.
- Significance: Ensures alignment with investment goals amid market fluctuations.
- Definition: Ownership shares in a company, conferring rights to assets and earnings.
- Alternative Terms: Equities, shares.
- Significance: Implies ownership and potential for both growth and volatility.
- Definition: Repaying debt through regular installments over a fixed period, common in mortgage payments.
- Significance: Structured debt repayment method.
10. ARM (Adjustable Rate Mortgage):
- Definition: Mortgage with an interest rate that adjusts based on market conditions after an initial fixed period.
- Risk: Monthly payments may rise after the initial fixed-rate period.
- Significance: Offers flexibility but introduces interest rate uncertainty.
- Definition: An account held by a neutral third party during a transaction, commonly used in home buying.
- Use: Holds funds until contract conditions are met; covers insurance and property taxes.
- Significance: Ensures financial security in real estate transactions.
12. Fixed-Rate Mortgage:
- Definition: Mortgage with a constant interest rate for the entire loan duration.
- Advantage: Predictable payments unaffected by interest rate fluctuations.
- Disadvantage: May result in higher payments if market rates decline.
13. Private Mortgage Insurance (PMI):
- Definition: Insurance required for mortgages with down payments below 20%.
- Duration: May be permanent or cease when the loan-to-home-value ratio reaches 80%.
- Significance: Protects lenders against default risk with lower down payments.
14. Defined-Benefit Plans:
- Definition: Employer-sponsored retirement plans, promising a specified benefit based on factors like earnings history and length of employment.
- Trend: Becoming less common due to high costs.
15. Defined-Contribution Plans:
- Definition: Retirement plans where employees contribute, often with employer matching (e.g., 401(k) or 403(b)).
- Tax Benefit: Contributions often offer tax advantages.
16. Executive Compensation:
- Definition: Pay and benefits for senior executives, including bonuses, stock options, and severance packages.
- Negotiation: Customized packages negotiated individually.
17. Permanent Life Insurance:
- Definition: Lifelong coverage with a cash value component that can be accessed while alive.
- Trade-off: Accessing cash may reduce the death benefit and could incur taxes.
- Significance: Combines insurance with a savings component.
- Definition: Payments made to maintain insurance coverage.
- Frequency: Monthly, quarterly, semiannually, or annually.
19. Term Life Insurance:
- Definition: Policy providing coverage for a specific period; no value if the policy expires.
- Payout: Beneficiaries receive a payout if the insured dies within the term.
20. AGI (Adjusted Gross Income):
- Definition: Gross income minus IRS-specified deductions.
- Role: Basis for determining taxable income and eligibility for credits or deductions.
- Definition: A person financially reliant on the taxpayer, such as a child or supported adult.
- Tax Implication: May qualify the taxpayer for specific credits or deductions.
22. Itemized Deduction:
- Definition: IRS-allowed subtraction from AGI for qualified expenses (e.g., mortgage interest, medical costs).
- Documentation: Noted on IRS form Schedule A.
23. Standard Deduction:
- Definition: Fixed amount reducing taxable income if the taxpayer opts not to itemize.
- Basis: Determined by tax-filing status.
In conclusion, navigating the financial landscape becomes more accessible with a solid understanding of these key terms. Whether managing investments, real estate, job benefits, insurance, or taxes, this primer serves as a valuable guide for individuals seeking financial literacy.