Financial literacy is poor in America. About half to two-thirds of Americans don’t understand some basic financial concepts such as compounding interest, future dollars, budgeting, or most financial planning topics and methods. So, if you’re already unsure what those terms I just mentioned are, keep reading! There’s some basic terms to learn and we’ll learn what they mean AND how they apply to your life.

  • Financial literacy – “the ability to use knowledge and skills to manage financial resources effectively for a lifetime of financial well-being.” Basically, this is how well-versed you are with different financial terms and concepts as well as how to apply them to your own financial situation to be successful. This is what the ultimate purpose of this blog!
  • Budget / Spending Plan – while not perfectly synonymous, I will be using these two terms as just about the same thing. A spending plan is “an itemized plan for how you are going to spend your money for a given time period” and I refer to “budgeting” as the process of developing your spending and savings plan.
  • Net Worth – your net worth = your assets minus your liabilities. Net worth = Assets – Liabilities.
  • Assets – these are things you own that have value that you could There are typically 3 subsets of assets:
    • Cash/Cash equivalents – cash, savings/checking/money market accounts or short-term (< 90 days) CDs. The bottom line is that “cash” means it’s easy to access quickly.
    • Investments – individually owned stocks and bonds, mutual funds (stock/bond), precious metals (gold, silver, etc.), collectibles you would sell that are worth value (not just old!), investment real estate (e.g. rental properties), ownership interests in a business, vested pension benefits, and long-term CDs. Typically, these assets are sub-divided further into taxable, tax advantaged, and retirement assets.
    • Use assets – these assets are difficult to sell. They include the house you live in (if you own it or have a mortgage), automobiles, boats, recreational real estate (e.g. lake house you use), personal items such as clothing, jewelry, etc. These are things you own that do have value, but you likely wouldn’t sell them unless it’s a last resort. Technically it adds to your net worth, but only in theory because you wouldn’t readily sell it unless you absolutely had to. Life insurance and its cash-value is difficult to categorize.
  • Liabilities – anything that you owe money on. This is the outstanding (still owed) principal balance as of today. For example, if you owe $100,000 on your home and it’s worth $200,000, then your house would be an asset for only $100,000 ($200,000 – $100,000). So, for people that “own” a lot of things but hardly any are paid for they’ll have a low net worth due to their debt on these items. Liabilities are what become concerning when we think of risk of default or bankruptcy.
    • Debt – anything you owe money on. Revolving debt refers to credit cards you carry a balance on and are continually paying. These are not good! But it refers to anything that is a liability. As a general principle, stay out of debt! It’s easier to build wealth when you’re not in a hole of debt! Having said that, there may be scenarios when taking on some debt is acceptable, but run the numbers, it’s rarely as often as what people go into debt!
  • Statement of Financial Position – an itemized list of what is owned (your assets), what is owed (your liabilities) and your net worth at a specific time. This can help you track your progress over time, so you can see yourself move towards a higher net worth.
  • Cash Flow Statement – reveals the inflows (all of your income: salary, wages, investment/interest income, rental income, tax refund, or any money that comes in) and outflows (money you put into savings, investments, payment of debts such as your mortgage, car loans, other bills, etc.) of cash over a given time-period. This gives you an idea of your spending, saving, and investing patterns.
  • Gross Income – this is your entire paycheck PRIOR to taxes and other withdrawals being taken out. For example, this is your total paycheck before medicare, income, retirement contributions are automatically taken out.
  • Net Income – this is the amount of your paycheck that is left after your taxes are taken out. Often, this is the amount that actually gets deposited into your bank account (unless you have to pay quarterly taxes, in that case budget those!). I believe in budgeting based off your net income instead of gross because, you really don’t have control over your tax rate since it’s income-based. So, it’s easier to budget off the net income. Then, you know how much money you actually have for a month or year to allocate to different categories.
  • Diversification – don’t put all your eggs in the same basket! By owning one single stock/company you assume all the risk that that one company will do well and not go out of business. The principle of diversification says that you should spread your investments out to multiple stocks/funds to decrease the risk of loss and optimize returns.
  • Mutual Funds – a collection of ownership in multiple companies that are collectively bought and held together. You would buy a “share” of the mutual fund. By buying one share of the mutual fund, you own a portion of the performance of the entire portfolio known as the net asset value. Mutual funds are typically “actively managed.” They are typically strategically organized with the intent to beat the market (usually the S&P 500 Index is the comparison benchmark). Mutual funds can be stock mutual funds or bond mutual funds.
  • Index Funds – a mutual fund that tracks a specific index (such as the S&P 500, NASDAQ, Dow Jones, Russell 1000/2000/3000). These are typically referred to as passively managed, meaning that they are set at one time and set to match the current index’s performance due to owning the exact same percentage of shares that the companies represent in their respective index. These essentially represent “the market” in different indexes. The most popular index fund is the S&P 500 index fund that is set to exactly track the S&P 500. By owning one share of the index fund, you own a small slice of each of those 500 companies.
  • Stocks – a share of ownership in a company. Typically, you would buy a certain number or dollar amount of stock in a particular company. This refers to owning stock(s) in a single company whereas a mutual/index fund would be owning shares in multiple companies.
  • Bonds – are essentially loans made to large organizations. There are high quality grades of bonds and low quality (i.e. “junk bonds”). These typically have a lower rate of return than stocks due to less risk of default. Typically, people own a percentage of both stocks and bonds known as asset allocation.
  • Asset Allocation – refers to two things most often in investing. Asset allocation is crucial to optimizing your expected rate of return on your investment! I highly recommend learning as much as possible about asset allocation before you start investing so you understand what you’re doing and why you’re doing it. That will keep you from freaking out in a bear market as well as from getting too excited in a bull market!
    • First – refers to the stock:bond ratio. You must decide how much of your money you allocate to stocks and how much to bonds. Typically, this ratio shifts from a higher stock:bond ratio early in life towards a lower stock:bond ratio as you near retirement age.
    • Second – refers to the different types of stocks or mutual/index funds you own. Now we are talking about the percentage of your money you invest in domestic (American) stocks vs. international (either Pacific Rim/Asia, Europe, Emerging markets, etc.) or could refer to different asset classes such as owning shares of healthcare mutual funds vs. financial company mutual funds vs. real estate.
  • Certificates of Deposit (CDs) – a savings certificate with a fixed maturity date with specified interest. Typically, a low rate of return, these may have a place in your investment portfolio for money you know you’ll want in a relatively short amount of time but you can’t afford to risk investing in the stock market in case of a market downturn before you need the money. These are a safer investment, hence the lower rate of return.
  • Retirement Accounts – this generally refers to accounts that are tax advantaged in which your money either grows tax free (Roth IRA) or tax advantaged (Traditional IRA/401k) where you invest non-taxed money and then pay taxes on it when you withdraw it. There are multiple other retirement options such as SEP IRAs, etc. We’ll cover these more specifically in the future on investing. These investments are tax advantaged and as such, are specifically for retirement. You should not plan on contributing to these and withdrawing the money for use until you are older than 59.5 years old or you will pay a 10% penalty as well as taxes!! This is long-term saving!
  • Vested – to become vested means that you have worked at a company long enough to keep their retirement contribution match. Usually this might be 2-3 years or it will be “if you stay at the company for 3 years, you will be 50% vested but if you stay at the company for 6 years you will be 100% vested.” The percentage you are vested is the percentage of the company’s “match” that they contribute to your specific retirement savings plan.
  • Investing – typically we are generally referring to placing money into stocks, bonds, etc. to grow the money faster than a savings account. We’ll cover a lot more specifics on investing in the future! Investing is honestly when personal finance really starts to pay off because it’s when you start seeing your pile of retirement money add up to something and you gain some momentum!
  • Interest – the money you are paid for allowing an institution (usually a bank) to borrow your money. When you have money in a savings account at the bank and they’re paying you 0.01% to use your money while it’s in the account. Normal bank savings accounts have horribly low interest rates at less than 0.10%!!! This is terrible! “High” interest rate savings accounts range from 0.75% to 1.0% – this is better than a typical bank, but still horrible! Savings accounts are NOT where you save money for your future! These are where you save your emergency savings or cash that you know you will need in the near future (~1-3 years) and don’t want to risk investing it in the stock market and losing value on it.
  • Compounding Interest – when you have invested your money and earn interest on it, that interest is yours and is added to the principal. The next year you earn more interest on your original principal + the interest = compounded interest! Basically, you invest some money and it makes interest. Then you make more interest on the money you invested AND the interest it already made! You start making money on money you never even made! This has been called the “8th wonder of the world” by Ben Franklin. And it is! Either you learn how to make your money make money for you, or you will work for money your entire life and always cut it close.
  • Dividends – a payment made by a company to its shareholders that is a portion of the company’s earnings. Dividends are a great thing, although they do create a tax burden. But hey, you’re making money from your money! Dividends can be automatically reinvested or withdrawn. It’s generally recommended that if you’re young you select the automatically reinvest option. Then, every time you get paid a dividend (usually quarterly) you’ll automatically buy more shares of that company or mutual fund with money you didn’t have to earn! Now, as you near retirement or are in retirement, dividends can provide an excellent source of income.
  • Rule of 72 – this is a formula used to estimate how long it will take for your investment to double in value over time. The formula is 72 divided by the expected rate of return = number of years your money will have to be invested to double its value. For example, to keep things simple, if we were to invest $10,000 at an expected rate of 7% annual return the formula would look like this: 72 / 7 = 10.2 years for your $10,000 to double to $20,000.
  • Future Dollar Value – the value of your money at a future date taking into account the impact of inflation in today’s dollars. For example, in 10 years how much will $100 be worth? We might do the calculation and find it’s worth $125 today. This is useful for business or building projections. Can also be applied to some personal finance projects. Should you build a garage this year with the extra money you have or is it better to save the money and build the garage in 2 years (not taking into account any other factors aside from the value of the money)?
  • Credit / Credit Score – your FICO (Fair Isaac & Company) score is calculated by how you handle debt. Dave Ramsey says it’s an “I love debt score” and he’s not wrong; 100% of the score is dependent upon debt. The score helps lenders determine what their risk of loaning you money that they don’t get paid back with interest; it’s their risk of losing money on you. So, a lower score means you’re a higher risk to loan money to whereas if you have a FICO score over 800 you’re very low risk; so you would get a lower interest rate. Now, interestingly, if you stay out of debt and don’t borrow money it won’t improve your FICO score. Having said that, a FICO score is important for borrowing money to buy a house or a car. If you have defaulted (failed to pay off or failed to pay on time) your previous debt you’ll have a low score and will have to pay a higher interest rate – because you are a liability to the borrower! This is how interest works against us – when we borrow money we pay interest instead of saving and making interest! Think about that next time you want to take out a loan.
  • Amortization – the repayment time period for a loan. Usually in table format, this is helpful as it shows you how much money you are wanting to borrow, the interest rate you’re borrowing the money at, the length of time it will take you to pay back, and finally – how much money you are going to spend on interest! Every time I’ve looked at one it’s shocking to see how much “more expensive” buying something really is if you borrow money to buy it. $10,000 cars become $14,000 cars by the time they’re paid off, etc. And the bigger the loan (think houses) the more you’re paying in interest. These are very useful tables to look at prior to buying a house, car, or anything. They help you figure out how a bigger down payment can save you a ton of money or how much you can save in interest by paying off the loan early.
  • Principal – the amount of money you have either deposited into savings or investments OR the amount of money you have borrowed. Whether it’s for you or against you, interest is calculated based off the principal.

As we go I’ll continue to update this list, but this is a solid start of some general terms/ideas to keep in mind as we go.

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