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25 Financial terms everyone should know
Do you know your AGI from your ARM from your PMI? Or does the mere mention of those acronyms make you go, “Huh?”
If you don’t speak personal finance, don’t worry — we’re here to help.
We know that managing your money can sometimes make you feel like you’re learning a foreign language. So we compiled a handy glossary of must-know money terms that affect all aspects of your financial life.
Whether you’re confused about amortization or not sure what escrow, exactly, is good for, this primer will help you get up to financial speed.
Handy Banking and Credit Terms
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 credit worthiness. 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 620 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.
Handy Investing Terms
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 equivalents (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 strong 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.
Commonly referred to as fixed-income securities, bonds are essentially debt investments. When you buy a bond, you lend 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.
6. Capital gains
The increase in the value of an asset or investment — like a stock or real estate — 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.
The process of buying or selling securities 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 percent cash, 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.
To rebalance your portfolio, you could sell some of your stocks and reinvest the proceeds in bonds, or invest new money in bonds to bring the portfolio back to the original balance.
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. The two main types of stocks are common and preferred.
If you hold common stock, you can vote at shareholders’ meetings and receive dividends — however, you’re also lowest on the totem pole in the corporate ownership structure. Preferred stockholders have a higher claim on assets and earnings than owners of common stock (for example, they receive their dividends first), but they don’t have voting rights.
Handy Real Estate Terms
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.
An acronym for adjustable rate mortgage, a type of mortgage in which the interest you pay on your outstanding balance rises and falls based on a specific benchmark. ARMs usually start out at a fixed rate for a short period of time, and then the rate resets annually based on the benchmark, plus an additional amount.
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 may start out low, but then rise (sometimes significantly) after the fixed-rate period is over.
An account held by an impartial third party on behalf of two parties in a transaction. During the home-buying process, the buyer will deposit a specified amount in an escrow account that the seller can’t touch until the terms of the 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 homeowner’s 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.
Handy Career Terms
13. 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.
14. Defined-contribution plans
A retirement plan companies may offer as a benefit to their workers in which the employer, the employee or both make contributions on a regular basis. The 401(k) and 403(b) are the most common forms of defined-contribution plans. The money that goes into these accounts comes out of earnings pre-tax, so you don’t pay taxes on the amount you put away every year.
Qualified withdrawals (usually those you make at age 59½ or older) are taxed as ordinary income. The value of the retirement benefit is determined by its investment performance. Unlike with defined-benefit plans, the employee, rather than the employer, shoulders the investment risk in the account.
15. 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.
16. Stock options
An employee benefit that gives the owners of the option the right, but not the obligation, to buy their employer’s stock at a preset price and within a specified period or on a specific date. Companies often use these as management incentives.
For example, if a manager helps boost the value of the company’s stock above the price of his or her option, the manager can buy the stock at the lower price and pocket the gain if they sell. But all shareholders benefit from the increased value of the stock.
Handy Insurance Terms
17. Permanent life insurance
A type of policy that provides coverage over the lifetime of the insured and also offers an investment component called cash value. You can withdraw or borrow against that cash value after a surrender period. Premiums for permanent life insurance are typically more expensive than for term life insurance.
The payments you make to an insurance company in return for protection from financial losses within the scope of your policy. You can pay premiums monthly, quarterly, semiannually or annually.
19. Private mortgage insurance
A type of policy that mortgage lenders require when home buyers provide a down payment of less than 20 percent. Also called PMI, this protects lenders against loss if borrowers default on their payments, and the premiums increase 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.
20. Term life insurance
A type of policy that provides coverage over a set period, generally anywhere from five 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. The policy owner can decide to renew coverage after the term is over and can cancel at any time without penalty.
21. Umbrella insurance
A type of policy that provides additional liability coverage beyond what your home, auto or boat insurance may provide. You might consider umbrella insurance if you’re at risk for being sued for property damage or other people’s injuries, such as if you hire a nanny or other employees to regularly work in your home. Umbrella insurance can also protect your assets if someone sues you for slander or defamation of character.
Handy Tax Terms
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 fill out your AGI at the bottom of page one of Form 1040 when you file your taxes. Your AGI is used to determine your taxable income, minus any additional IRS-qualified deductions that you’re eligible to take.
A person who is financially dependent on your income, typically a child or an adult relative you may support. You can claim a tax credit or exemption for these dependents when filing your taxes, which reduces your taxable income.
24. Itemized deduction
A qualified expense that the IRS allows you to subtract from your adjusted gross income, which 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.
25. 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.