Glossary of Financial Terms: 15 Must-Know Definitions
In a recent survey, only 37 percent of participants were considered to have a passable level of financial literacy.1 The number sounds low, but it’s not hard to see why more than 60 percent of participants had trouble answering basic financial questions. The financial field is packed full of special terms, abbreviations and concepts many people don’t come across day to day. It can be tough to differentiate between concepts when you’re someone simply looking to make the best financial decisions for you and your family. But when it comes to your money, you always want to be in the know. That’s why we’re providing 15 must-know definitions below you can use to make more informed decisions moving forward.
Banking Terms to Know
Net Worth
Your net worth is found by subtracting your liabilities (or debts) from your assets. To determine this, add up everything you have of value, including investments, money in the bank, the current value of your car and home, etc. Then, subtract any money owed, including credit card debt, student loans, mortgage balances and any other debts. The remainder is your net worth. Knowing your net worth is a good report card to understand the health of your family's finances and should grow over time. When your net worth grows, either your assets are growing or your liabilities are shrinking, or both.
Compound interest
Compound interest is the interest you earn on interest. It sounds confusing, but it can be an effective way to gradually increase your wealth over time. In the context of a bank account, this is interest that is incurred based on the original deposited amount plus its original interest. For example, if you deposit $1,000 into an account with a five percent compounding interest rate, in the first year you’ll have $1,050 (the original $1,000 plus five percent, or $50). As you enter the next year, that five percent interest rate will apply to the $1,050 (the original amount plus its interest already accrued). By the end of that year, you’ll have $1,102.50.
FICO Score
FICO, which is an acronym for Fair Isaac Corporation, is a method used to determine how credible a borrower may be. This score is typically dependent on factors including total debt owed, length of credit history and previous payment performance. A FICO score can be between 300 and 800. The higher your score, the better a chance, in general, you have at obtaining loans or other forms of financing. If you bank with Chase, I recently found that they will provide your FICO score, and monitor your credit, if you enroll in their Credit Journey program. Please be advised this is not an endorsement for Chase or their credit monitoring program.
APR
APR stands for annual percentage rate. This refers to the amount of interest gained in an account. It does not include compound interest.
Certificate of Deposit
Often referred to as a CD, this is an account in which you agree to deposit a certain amount of money and leave it in the account for a predetermined length. In doing so, you will receive an interest rate that is typically higher than those found on checking or savings accounts. If you break the CD prior to its maturity, which is possible, usually the penalty is the bank or credit union keeps the accrued interest and you get your initial deposit back.
Investment Terms to Know
Asset Allocation
When developing your portfolio, asset allocation refers to the process of dividing your assets into different asset classes. The most popular asset classes include stocks, bonds and cash or cash equivalents. Typically, your asset allocation is determined based on several factors including risk tolerance and time horizon. Holding Coca-Cola stock at Charles Schwab and at E*Trade is not what is meant by dividing your assets; you hold the same asset in different locations.
Capital Gains
This is the amount of value an asset has gained or increased since the original purchase. Capital gains are typically used to describe an increase in value of stocks or real estate. It’s important to note, however, that these gains are only shown on paper until the actual entity is sold. Furthermore, capital gains are divided into two flavors: short term and long term. If you buy an investment and sell it within 365 days of the purchase, the gain is short term and added onto your current year income. If you sell the investment after 365 days, you qualify for long term capital gains which are taxed at a lower rate than short term.
Rebalancing
Rebalancing is the process used to help maintain the proper asset allocation for your specific needs. This is a necessary part of keeping your asset allocation in check as stocks, bonds and other assets are sold or purchased or gain and lose value over time. By adhering to this strategy, you may minimize the emotions tied to your portfolio because you're following a strategy. You will also default into the "buy low, sell high" cliche, which makes sense when hearing it, but hard to implement.
Mutual Funds
When choosing to invest in a mutual fund, or ETF (exchange traded fund), you are pooling your money together with other investors into one account that is then managed by a professional or automated, like an index fund. These types of investments can include the most common asset classes including stocks, bonds, cash, and cash equivalents (such as a certificate of deposit). The actual mechanics between mutual funds and ETFs vary, but the main point is they are vehicles that pool money among many investors that is then spread out over many investments.
Custodial Account
In the broadest sense, a custodial account is any account that is managed by another party. Typically, that party will have a fiduciary duty to manage the account in the holder’s best interest. In terms of investment accounts, the manager could be the brokerage firm you’ve put in charge of handling your investments. The term custodial accounts is also used to describe accounts that have been set up by a parent or legal guardian for a minor.
Insurance Terms to Know
Beneficiary
In the event you were to pass away while owning a life insurance policy, the beneficiary is the person who would receive the insurance payout after your death.
Umbrella Insurance
Umbrella insurance is a type of liability insurance designed to provide blanket coverage protecting most aspects of your financial life. Specifically created to cover you in the case of a lawsuit, this coverage steps in when you’ve reached the liability limits on your auto insurance or other types of insurance.
Term Life Insurance
Term life insurance is designed to offer coverage only during a designated period. When you select the term, you often have the choice to choose the length, such as 10, 20, 30+ years. Should you die unexpectedly or prematurely during this predetermined time span, your beneficiary will receive an insurance payout.
Premium
This is the actual amount your insurance plan costs you to have. You’ll typically pay your premium on a month to month or annual basis.
Risk Classification
When determining the premium on an insurance policy, the provider will evaluate your risk classification among other factors including the length of the policy, your age, etc. In terms of life insurance, providers will determine your risk classification based on several variables including your smoking status, body mass index (BMI), and medical history.
Whether you’re looking to dive deeper into the world of investments or take a second look at your current insurance policies, it’s important to have a basic understanding of the concepts and terms the professionals you speak with will be using. This can help you make more informed decisions as you move forward in navigating the financial services industry.
1 http://www.usfinancialcapability.org/results.php?region=US
This content is developed from sources believed to be providing accurate information. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.