14 Money Terms to Learn
You hear money jargon everywhere — whether in conversation, online, or TV/radio. Yet, how many of us know what terms such as APY, expense ratio, and index fund actually mean? For those who do know, this will be a good refresher. However, if confusion over money talk makes you feel lost, we have a way to get over it. Following is a detailed look at some of the most important money terms. So hopefully, the next time you see or hear these terms you will know exactly what it means.
- Annual Percentage Rate (APR)
APR, which stands for “annual percentage rate,” is the annual cost you pay to borrow money, expressed as a percentage. It reflects an interest rate and sometimes fees and other charges associated with taking out a loan. A credit card, for instance, includes the interest rate, and it may vary depending on your credit score.
So, the APR of a financial product may be higher than the interest rate for the same product. And it would help if you compared APRs, not interest rates when you shop for a loan. The federal Truth in Lending Act requires lenders to disclose the APR, among other figures, in writing when offering a loan.
- Annual Percentage Yield (APY)
Annual percentage yield, or APY, is the yearly amount you earn on savings, or the amount you pay to borrow, expressed as a percentage.
Like APR, APY includes the interest rate and sometimes other costs associated with taking out a loan. The key difference is that APY also includes compound interest, while APR does not. So, compare APYs when you are shopping for savings accounts and certificates of deposit (CDs).
- Asset Allocation
Asset allocation refers to the mix of the different types of assets you own and the percentage of your money in every kind of asset. For example, stocks, bonds, real estate, and cash are common asset types or asset classes. Putting your money in different assets — known as “diversification” — allows you to balance risk and reward to suit your own situation, including your risk tolerance and financial goals. For example, if all of your money was invested in real estate during the last housing crash, you probably lost a big chunk of your net worth, at least for a while. You likely would have fared better if you had invested less money in real estate and directed some of your money into stocks, bonds, and cash savings, which would have shielded more of your net worth from the housing crash.
- Compound Interest
Money may not grow on trees, but it can grow by what’s often called the “magic of compound interest.” Compound interest is earned on an existing balance that includes both the principal and the interest that has built up over time. Compounding speeds up your earnings because each new interest payment is based on a larger base amount as your account balance grows. For example, say you open a $5,000 savings account paying 2% interest annually and don’t touch it. After one year, you’d earn about $100 in interest and your balance would be around $5,100. But after five years, do you think you’d have more or less than $5,500?The answer is more! That’s because each year, you’re earning interest on the interest already paid to you as well as on your original balance, or your principal. That’s compounding! The higher the interest rate you earn, the more spectacular compounding results. Unfortunately, compounding can work against you when you borrow money. For example, making a minimum credit card payment of 2% a month on a $5,000 credit card balance with a 20% interest rate would take you nearly 44 years to pay off the debt and cost you more than $20,000 in interest alone.
- Credit Score
A credit score is a three-digit number designed to predict the likelihood that you will repay a loan or credit card charge. It represents your “creditworthiness.” A score differs from a credit report, which is a detailed record of your credit history, although credit scores are based on information from your credit history. Lenders use credit scores to decide whether to lend money or extend credit and at what interest rate. So, it pays to have a high credit score. Generally, the higher your score, the more you can borrow for, say, a home or car loan — and the lower the APR will be. Having a high credit score can easily save you tens of thousands of dollars over the life of a loan. And having a low credit score can prove costly. There are many types of credit scores, but the most widely used are FICO scores, which Fair Isaac Corp. creates, aka FICO.FICO says it scores you based on:
- Your on-time payment history (comprises 35% of your score)
- The amounts you owe, especially as a percentage of how much credit you have available (30%)
- The length of your credit history (15%)
- How much new credit you’ve sought recently (10%)
- Your mix of credit cards, mortgage loans, installment loans, and other debt (10%)
FICO scores mainly range from 300 to a perfect 850.
In essence, diversifying your investments and other assets puts your cash eggs in many different baskets. Diversification is important because it minimizes risk. Investors diversify by putting money into different types of investments, such as stocks and bonds. Another example is investing in a mix of stock types, such as buying a variety of mutual funds, each of which focuses on a different market sector. Examples are mutual funds that invest in:
- Growth and income stocks
- Large company stocks
- Small company stocks
- Stocks of domestic companies
- Stocks of international companies
- Exchange-Traded Fund (ETFs)
Exchange-traded funds, or ETFs, are a type of investment that is traded on an exchange like individual stocks are. ETFs are often designed to mirror the performance of a particular index, like the Standard & Poor’s 500 index, for example. One advantage that ETFs have over mutual funds is that they generally do not require a minimum investment, which means even people with little money to invest can use them. For example, to invest in Vanguard’s S&P index fund, you need at least $3,000. But you can invest in the company’s S&P ETF for the price of one share.
- Expense Ratio
An expense ratio is an annual cost of owning a mutual fund — the operating expenses — expressed as a percentage. Expense ratios might look small, but they can add up to a lot of money over time. If you invest $10,000 in a mutual fund with a 10% annual return and an expense ratio of 1.5%, after 20 years, you would have roughly $49,725.
- Index Funds
An index fund is a type of mutual fund designed to merely mirror the overall performance of a market benchmark, such as a stock market index. For example, S&P 500 index funds are designed to match the movement of the S&P 500 stock market index, which includes 500 of the largest publicly traded companies in America. Because index funds don’t need stock pickers, they need little management and tend to charge lower fees than actively managed mutual funds, whose managers try to beat the market.
You know $20 doesn’t buy what it used to. As you get older, it will buy even less. That’s inflation, eroding the purchasing power of money and leading to higher prices over time.
If you’re working and seeing your wages go up, a little inflation won’t seem like a big deal. But if you stop working, or you’re setting aside money that must last for as long as you live, inflation can sour your plans.
What $20 could buy in December 1981 would require $59.32 in January 2021.
- Mutual Fund
A mutual fund is a basket of different stocks or bonds. It offers the chance to invest in many companies or bonds, making it less risky than investing in individual stocks or bonds. Mutual funds can be actively managed by a person (active funds) or passively managed by a computer (index funds).
- Net Worth
Your net worth is all of your assets minus all of your liabilities. In other words, it is the value of everything you own after subtracting what you owe. Computing your net worth gives you a snapshot of where you stand financially. Tracking how your net worth changes over time will show you whether you’re heading in the right direction financially — and how your money habits can raise or lower it.
- Opportunity Cost
You often have to give up something to get something you want. The value of what you give up is the opportunity cost. For example, if you quit a $100,000-a-year job to go back to school for two years, your opportunity cost is at least the money you would have made if you had kept working during that time — $200,000. And it could be even higher — for example, if you had invested some of that money in the stock market and made a handsome additional return on it.
As investments grow or shrink in a portfolio, the allocations change. At the end of a good year for stocks, for example, you may have more invested in stocks — and less invested in bonds — than your asset allocation plan intends. So, you can buy or sell shares — or rebalance — to get investments back in line with your plan.
- Annual Percentage Rate (APR)