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20 Financial Terms You Should Definitely Understand

Two smiling girls have coffee timeWhen you hear or read terms such as AIM, net worth or AGI does it make you go “huh”? If so, you’re certainly not alone. There are a lot of financial terms kicking around out there that many people don’t understand. Financial gurus are especially fond of tossing around terms such as asset allocation or amortization without providing any sort of explanation – with the assumption that you’ll just know what they’re talking about. Here to make matters a bit simpler are explanations of 20 terms associated with money that you definitely should understand.

FICO score

Your FICA score is a three-digit representation of your credit history. Banks and other lenders use your score to measure how creditworthy you are. If you’re wondering what FICO means it’s an acronym for the company that used to be Fair Isaac Corporation and that developed the methodology for calculating credit scores. FICO scores go from a low of 300 to a high of 850 and, of course, the higher your score the better the terms you’ll get on your next credit card or loan.

Compound interest

This is the interest that you earn on whatever amount you deposit when you’re investing or saving plus any interest you’ve accumulated over time. On the other hand, if you’re borrowing money it’s the interest that’s charged on the original amount you borrowed as well as any interest charges that are added to your outstanding balance over time. As you might guess, it’s much better to earn compound interest on your savings then to pay it on the money you borrow.

Net worth

This is the difference between your liabilities and your assets. The way you calculate yours is by adding up all of the money or investments you have such as the current market value of your house and car as well as any balances you have in checking, savings, retirement or other investment accounts and then subtract your debts. This will need to include your credit card balances, mortgage balance and any other obligations or loans. The net worth number you get will help you understand how financially healthy you are.

Asset allocation

This is the process you use to choose what percentage of your portfolio that you’d like to invest in various asset classes. It’s based on your personal risk tolerances, time horizon and your goals. Bonds, stocks and cash or the equivalent of cash (think CDs) are the three major types of asset classes.

Bonds

These are essentially investments in debt. In other words, when you purchase a bond you are lending money to a government or corporation for a specific amount of time at a fixed interest rate. When you do this you receive interest payments periodically over time. When the bond matures, you get the loan amount back.

Rebalancing

When you buy or sell securities over time in order to maintain your desired allocation of assets it is called rebalancing. As an example of this if you’re allocating 60% stocks, 20% cash and 20% bonds and the stock market has done well over the past year, you might rebalance your allocation to 70% stocks, 20% cash and 10% bonds.

Capital gains

Capital gains is the amount that an asset or investment increases in value over its original purchase price. However, this gain is just a paper gain until you actually sell the asset. In contrast, a capital loss is when your asset or investment decreases in value. When you sell an investment, you pay taxes on both short-term capital gains and long-term capital gains. On the other hand, if you suffer a capital loss this could help reduce your taxes.

Amortization

This is when you pay off your debt in fixed payments over a specific amount of time. As an example of this your mortgage is amortized with monthly payments that are computed based on the amount of money you borrowed, plus the interest you will be required to pay over the life of the loan.

ARM

This is short for adjustable rate mortgage. It’s the kind of mortgage where the interest you pay increases or decreases based on a particular benchmark. These mortgages generally start out with a fixed rate for three to five years and the interest rate then resets every year thereafter based on some benchmark, plus an additional amount. As an example of this, if you have a five-year ARM your interest rate will be set for the first five years after which it will increase or decrease based on your mortgage’s terms.

Escrow

This is an account that is kept by an independent third party on behalf of two other parties to a transaction. For example, if you are buying a house, you will deposit money into an escrow account that the seller can’t withdraw until the contract’s terms have been fulfilled and the sale completed.

Defined-benefit plan

This is a retirement plan sponsored by an employer such as a pension where you get a specific retirement benefit based on some formula. This formula may include your earnings history, age and length of employment. You as the employee may or may not be obligated to contribute anything to the plan. Many companies no longer offer these plans due to their high costs.

Defined-contribution plan

Many companies now offer these retirement plans as a benefit to their workers. This is where the employee or maybe both the employee and employer make contributions on a regular basis. The most common example of this type of plan are 401(k)s and 403(b)s. One of the biggest advantage of these plans is that you don’t pay taxes on the amount you put in every year.

Stock options

This is an employee benefit where the owners of the option have the right to buy their employer’s stock at a preset price and within a specific period or on a specified date. These are often used by companies as management incentives. For example, if an executive helps boost the company’s stock value above the price of his or her option, the manager could then buy the stock at the lower price and pocket the gain when she or he sells it.

Permanent life insurance

Permanent life insurance is a kind of policy that provides coverage over the insured’s lifetime and also has an investment component called cash value. After a certain period of time, the policyholder will be able to borrow or withdraw against the cash value of the policy. As a rule, the premiums paid for a permanent life insurance policy will be more expensive than for term life.

Term life insurance

Term life is a policy that covers you over a set period which can be anywhere from five to 30 years. If you die during that set period of time, your beneficiaries get a payout. If you don’t, the policy will expire with no value. Of course, you can always decide to renew coverage after your term is over. Plus you can cancel at any time without penalty

Private mortgage insurance

If you want to buy a house and have a down payment of less than 20%, the mortgage lender will require you to get this type of insurance. It is also often call PMI. Its purpose is to protect lenders against a loss if you default on your payments. If you are required to get private mortgage insurance this will increase the premiums that you will pay every month.

Umbrella insurance

Umbrella insurance is a type of policy that offers extra liability coverage beyond what is provided by yoVideo thumbnail for youtube video 10 Signs That Your Financial Management Skills Suck!ur home, boat or auto insurance. If you feel you’re at risk for being sued for other people’s injuries or property damage you might consider buying this type of insurance.

AGI

AGI is an acronym for adjusted gross income. It is calculated as your gross income minus certain IRS-specified deductions. When you file your taxes you fill out your AGI at the bottom of page 1 of Form 1040. It is used to determine your taxable income minus any IRS-qualified deductions.

Itemized deductions

These are expenses that the IRS lets you subtract from your adjusted gross income, which reduces your taxable income even further. This can include mortgage interest you paid, dental and medical costs or gifts to charity.

Standard deduction

If you decide not to itemize your deductions this is a standard amount you can use to reduce your taxable income. It will be based on your tax-filing status and it’s the federal government’s way of ensuring that at least some part of your income is not taxed.

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