Advanced Financial Terms
- November 8, 2020
- by Ashley Chorpenning
Here are a few advanced financial terms that you should know along your way to mastering your money.
Before you jump into other areas of personal finance, experts recommend having a budget. Creating a budget will help you understand what you should save, spend, and invest. Everyone manages their budgets differently, so it is important to find a method that works for you. Here are three of the most popular types of budgets that you might want to base yours on.
- Cash-only budget – The cash-only budgeting method is used when people choose to do all their personal spending with cash rather than debit or credit cards. Instead, they take out their budgeted amount in cash after they receive each paycheck and pay their bills. Then, people who use the cash-only budgeting system spend their cash on groceries, gas, and other items. When they run out of cash, they stop spending until their next paycheck. The goal is to have extra money left at the end of their pay period rather than time without money. The extra money is then saved or invested. If you have trouble managing your spending, this method might be best for you.
- Zero-based budget – A zero-based budget is implemented in advance. People who use this method plan every expense and allocate their budget toward these items specifically and subtract these expenses from their income. Ideally, they have money allocated for their saving, debt repayment, and investing goals as well. For example, the person starts with their salary then subtracts their bills then each of their expenses until they reach zero. With this budget, there is no money left at the end of the month because every dollar is spoken for.
- 50-30-20 Budgeting – This budgeting method states that 50% of a person’s after-tax income is spent on needs, 30% is spent on wants, and 20% is spent on savings or paying off debt. Needs include housing, groceries, and transportation. Wants include things like vacations, shopping, and dining out. Debt and savings typically include investments and other savings vehicles such as a retirement plan through your employer.
Once you’ve mastered budgeting, it’s important to understand how to get rid of your high-interest debts. Here are a few terms you should know regarding your credit cards.
- FICO Score – Your credit score, often measured by FICO, is an analysis that determines how risky a borrower you are. The highest score is 850, and anything over 740 is considered excellent while anything over 650 is considered good. Having a good credit score is essential if you want to borrow money for a mortgage or other expenses.
- Annual Percentage Rate (APR) – The APR is the annual interest rate that a credit card company will charge you for any outstanding balances. You can avoid paying interest by paying off your credit card in full each month.
- Balance Transfer – Some credit cards allow you to carry your debt from another card on to a new one. Typically, these new cards have 0% APR for the first year and charge a small fee to transfer your balance. This can be an effective way to pay off your credit card debt if the interest payments on your original card are too high for you to manage.
- Minimum Payment – Many credit cards allow users to carry a balance from month to month without paying the entire amount due. They only require a small portion of the balance to be paid. This portion is called the minimum payment and might change each month depending on your outstanding balance.
- Compound Interest – In credit cards, compound interest is the interest charged on the balance of the loan, which is then added to the balance of the loan. Then, the loan continues to compound each month. While compound interest can work in your favor when investing, it can cause you to accrue credit card debt very quickly.
If you are planning to take out a loan for any reason, it is important to know how it will affect your overall financial situation. You learned above that your credit score will be a major factor in your eligibility for different loans. Here are some other terms to keep an eye out for.
- Interest Rates – Interest rates are the amount that a bank or lending institution will charge you for borrowing money. The interest rate is represented as a percentage of the money you have borrowed.
- Principal – The principal is the amount that you borrow when you take out a loan.
- Outstanding Balance – The balance of a loan is the amount that you still must pay on the principal of your loan, plus any interest or fees.
- Amortization – Amortization is the process of paying off the initial cost of an asset or paying off your loan. You will likely make regular payments on your loan and are thus amortizing it.
Many people start investing when they get their first job. Investments are money set aside without the intention of using the money for a set period. This period might be several years or several decades depending on your financial goals. Here are some important investment-related
- Asset allocation – Asset allocation is an investing strategy in which you put sums of money in different investments to help mitigate your risk (typically stocks vs bonds). One factor in how you allocate your assets is how close you are to retirement.
- Rebalancing – Rebalancing is when you reallocate your investments back to your desired asset allocation percentages after they have drifted based on changes in the market. This should be done at least annual to ensure that you are taking on the right risk for your financial situation.
- Stock Market – The stock market is the platform on which publicly traded companies sell shares of their stocks. The most popular example is the New York Stock Exchange (NYSE).
- S&P 500 – The S&P 500 is a stock market index that measures the performance of 500 of the largest companies in the United States. Because it has companies from different industries, it is considered one of the best indicators of the overall health of the economy.
- Stocks vs ETFs vs Mutual Funds - A stock is ownership in an individual company. An ETF (exchange traded fund) trades like a stock but represents ownership in a group of stocks (like an index or certain sector of the economy) or ownership in a given type of asset (bonds, commodities, etc). A mutual fund is similar to an ETF in that it represents ownership in a wide range of assets, but only trades at the end of the day. Both mutual funds and ETFs are professionally managed by a team to ensure they assets they hold match their prospectus.
- See our Portfolio Allocation calculator for more.
- Tax Filing – Everyone that earns an income in the United States must file taxes. This means that they report their income to the government and either pay the taxes that are due or receive a tax refund if they’ve overpaid on their taxes throughout the year. There are many ways to file your taxes depending on if you’re married, single, or other factors.
- Tax Brackets – Tax brackets are the divisions at which the taxes imposed on someone’s income change. Any income earned past a certain amount is taxed at a higher rate. People change tax brackets in a few ways including when they earn more money or decrease their taxable income by making large donations.
- Standard Deduction – The standard deduction is the amount that people can use to reduce their taxable income. This is only applicable when you decide not to itemize your deductions. Your standard deduction is based on your filing status and helps to protect some of your income from taxation.
Even if you’re several years from retirement age, it is important to know how retirement saving works. Additionally, you should know what happens with your money after retirement age so that you can better plan for it.
- IRA - An individual retirement account (IRA) is a retirement account that you set up outside of your employer’s retirement fund if you have one. Each IRA has different tax benefits, but typically they have restrictions on how much you can contribute each year and when you can withdraw your money without penalty. IRAs are tax-deferred, which means that the money grows tax free, your contribution is tax deductible (up to a limit), but you do pay taxes when you withdraw the money in retirement.
- Roth IRA – A Roth IRA is not tax-deferred. Instead, contributions are post-tax but the big advantage is they grow tax free and are not taxed when you withdraw funds as a retiree. You can contribute up to $6,000 per year to a Roth IRA (there are income limits). If you need the money back there are rules that allow withdrawing the contribution without penalties.
- 401(k) - Many companies offer 401(k) retirement plans. Individuals can opt into this plan and often have their pre-tax contributions matched by their company. Contributing to a 401(k) reduces your taxable income when you contribute.
- Annuity - An annuity is an investment resulting in regular payments back to you over time, typically for the rest of your life. You will pay into the annuity either as a lump-sum or with payments over time. Then, when you retire or need the money, the money will be paid back to you over time.
- Safe Withdrawal Rate – The safe withdrawal rate is the amount of money as a percentage of the initial investment that can be withdrawn from an account each year without the account ever reaching zero. The account will never reach zero because the amount in the account will continue to earn interest, even when the safe withdrawal rate is taken out. You can explore this for your situation using our retirement drawdown calculator.
- Inflation - As time goes by prices generally go up. This effect is called inflation and it is good to understand how it factors into your financial planning.
- How much do you need for retirement? We talk about saving for retirement, but how much is enough, how do you know if you are on track? We wrote an entire piece dedicated to knowing how much is enough. We also created this saving for retirement calculator that can help you determine if you are on track.
The Bottom Line
As you seek to improve your finances, it is important to understand what you are working toward. By knowing the definitions of the words you’ll encounter as you research financial options, you will be able to have better conversations with financial advisors and make educated decisions regarding your financial future.