10 money terms to understand if you want to be rich
by Cameron Huddleston
Do you ever have those dreams where you’re back in high school and fear failure because you haven’t studied for a test? Many people have the same uneasy feeling about their personal finances when they don’t know the language of money.
Such a lack of knowledge can do a lot more harm than just one bad grade.
Here are 10 essential terms you must know so you can improve your financial literacy and take control of your money.
You’ve likely seen this acronym on your credit card or loan statements. It stands for “annual percentage rate” and represents the total cost of borrowing money annually.
The APR is not the same thing as the interest rate, said Brandon Hayes, an Atlanta-based certified financial planner and vice president of oXYGen Financial. The interest rate is simply the interest charged on a loan and — unlike the APR — does not include any additional fees or charges you have to pay to borrow.
“While they both help you evaluate loans, the APR is the best way to see the total cost — rate and fees,” Hayes said. The APR is the figure you should look at when comparing loans. If two lenders are charging the same interest rate but the APRs are different, the loan with the lower APR is likely the better deal.
2. Asset allocation
Asset allocation is the mix of asset types — stocks, bonds and cash investments — you are using to meet investing goals. Think of it as “spreading your investments in different buckets that help spread the risk of having too much concentrated in too few places,” said Michael Kay, a CFP and president of Financial Life Focus, a financial planning firm in Livingston, N.J.
If you’re saving for retirement, you shouldn’t allocate 100 percent of your money to a single stock. Your nest egg could disappear if the company that issued the stock doesn’t perform well or goes out of business.
It also might not make sense to put all your money into an asset that doesn’t offer much potential for growth, such as a money market account earning less than 1 percent. The key is to allocate your assets to balance risk and reward.
3. Compound interest
Nobody is sure whether it’s true, but Albert Einstein is reported to have called compound interest the eighth wonder of the world. Fortunately, you don’t have to be a Nobel Prize-winning physicist to understand how compound interest works.
Simply put, compound interest is the interest calculated on both the principal — the amount borrowed or deposited — and the interest that has accumulated. Compound interest on an investment can help your money grow faster.
Consider this example: If you invest $1,000 and earn 5 percent annual compound interest, you would have $1,050 after a year. The next year, your investment would grow to $1,102.50 because interest would grow on the $1,000 principal and the $50 accrued interest. Over 30 years, it would grow to $4,321.94.
Even small investments can grow to big sums over time thanks to compound interest. “The value of compounding money and rate of return can be extremely powerful for those who understand it.,” Hayes said. “Investors who start saving at a younger age have the ability to have millions of more dollars than those who start later in life.”
However, also note that because it includes the interest that grows on interest, compound interest also can make debt grow faster.
4. Dollar-cost averaging
Dollar-cost averaging refers to purchasing the same amount periodically — such as each month or each year — of an investment or many investments, even as markets go up and down. If you’re contributing a set amount from each paycheck into a 401k or other workplace retirement account, you’re dollar-cost averaging.
The opposite strategy is timing the market — trying to buy stocks when prices are low and sell when prices are high. Timing the market is one of the mistakes to avoid as a rookie investor. Kay said dollar-cost averaging “takes out the emotional aspect of investing, provides discipline to save over time, and allows you to not have to try and time the market.”
5. FICO score
FICO is an acronym for Fair Isaac Corporation, which invented the FICO credit risk score. Most lenders use this three-digit number to determine your credit risk, according to myFICO.com, the consumer division of FICO.
If your score is low, you might have trouble getting credit, or might have to pay higher interest rates than people with higher scores. So it’s important to know what goes into a credit score, Hayes said.
FICO scores range from 300 to 850 and are calculated using information in your credit report — which includes information about the types of credit and overall amount of credit you have.
“Payment history and credit utilization make up 65 percent of your credit score,” Hayes said. “So make sure you are paying your payments on time and that you aren’t using too much of your credit each month, or else this can negatively impact your score.”
6. Fixed vs. variable rate
When getting a loan, you might be given the choice of a fixed rate or a variable interest rate. It’s important to understand the difference between these two types of rates because it can affect the total cost of your loan.
A fixed interest rate will stay the same over the term of the loan, said Michael Hardy, a certified financial planner and vice president with Mollot & Hardy, a financial planning firm in Amherst, N.Y. A variable rate will change based on interest rates or the market. It might start low but could rise over time if interest rates rise, forcing you to make bigger monthly payments.
“In a low interest rate environment — like the one we are in — it is often better to get a fixed interest rate that protects you from interest rates going up over time,” Hardy said.
PMI stands for “private mortgage insurance,” and lenders require it if you make a down payment of less than 20 percent of a home’s price. PMI protects the lender if you default on a mortgage. It also increases your cost of borrowing to buy a home.
“This can add to your monthly mortgage payment and can impact your monthly savings goals,” Kay said. If you can’t make a 20 percent down payment, you should talk with your lender to see which loans are available that might help you avoid paying PMI.
Of all the money terms, this one is often the least understood, Kay said. “People associate risk with the stock market but fail to see other risks that present equal or greater risk,” he said.
Some people are afraid to take the risk of losing money in the stock market. However, if they put all of their money in safe investments with a low rate of return, they run a bigger risk that inflation will grow at a faster rate than their investments. That would leave them with less purchasing power.
When it comes to financial planning, Kay said people also need to consider the other risks they face, such as interest rate risk, tax risk and the risk of a loss of income due to a disability or death. They need to examine risk through a wider lens, he said, and prepare for the financial what-ifs in life.
When you engage in a “rollover,” you roll your retirement balance into another qualified retirement account, Hays said. If you contribute to a workplace retirement plan such as a 401k and then leave your job, you have the option to keep the funds in your former employer’s plan or roll them into an IRA or another qualified retirement account.
“This is an important term to understand, since it’s your money and you should know how to move it if you leave your job,” Hays said. It’s best to roll a 401k balance directly into a retirement account with your new employer, or into an IRA. If you cash out the money instead, you’ll have to pay income taxes and a 10 percent penalty on the withdrawal.
If you have investments in a tax-deferred account, the earnings on those investments aren’t taxed until you withdraw the money, Hardy said.
“This allows for all the gains to continue to earn interest, which has a compounding effect,” he said. “If you compare the growth of an account that is tax-deferred to that which is not, you will notice that the tax-deferred account could have a value over 20-plus years of as much as 25 percent more.”
Traditional IRAs and 401ks are tax-deferred accounts. Not only do you avoid paying taxes on the earnings in these accounts until you withdraw the money, but you also avoid paying taxes on the amount you contribute. Contributions to a traditional IRA can be deducted when you file a tax return, and contributions to a 401k come out of a paycheck before taxes. For example, if you earned $100,000 and contributed 10 percent to your 401k pretax, then your reportable income would be $90,000, Hayes said.
On the other hand, a post-tax account such as a Roth IRA or Roth 401k gives you the tax benefit when you withdraw the money. Contributions are made with after-tax dollars, so there’s no upfront tax benefit. But withdrawals in retirement are tax-free. A post-tax account can be a better option if you expect your income-tax rate to be higher when you withdraw the money than when you contributed it, Hayes said.
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