If you ask me, the most intimidating thing about personal finance is the new vocabulary and money terms that come along with it.
With countless different retirement vehicles, investment options, credit and debt features, and savings accounts, it’s no wonder the topic is an intimidating one!
At ModMoney, I’m on a mission to demystify all of it, and the first step is a simple understanding of some basic personal finance terms. Let’s get started with the top seven money terms you definitely need to know.
Compound interest is just a fancier way of saying “interest on interest.” It’s an important term to know because it’s the engine that allows your savings to passively grow. When you put money into a savings account, your money earns interest each year. For every year that follows, you gain interest on your original savings, but also on the interest you have already earned (interest on interest). This phenomenon allows your savings to grow exponentially with time. And that is why it is so important to start saving early!
Your net worth may be the single most important metric for you to track and understand because it represents your entire financial position in one number. Your net worth is calculated as your assets minus your liabilities. Said otherwise, it’s the difference between everything you own and everything you owe. Your assets (what you own) are things like cash, savings, investments and retirement accounts. Your liabilities (what you owe) are things like credit card debt, a mortgage and student loans.
With the rising cost of college tuition, it’s totally normal for your net worth to be negative if you’re still paying down student debt. So don’t freak out! The important thing is having a plan in place to chip away at the things you owe. You can track your net worth using old fashioned pen and paper, but my favorite automated tool is Personal Capital.
Your credit score is a metric that credit card companies and other lenders use to determine how risky you are as a borrower. When you borrow or repay money, your activity is reported to the three credit bureaus, who each compile a credit report on you. That’s where your score comes from. Specifically, there are five factors that go into your credit score calculation, and it’s crucial to understand what they are and how to improve them. Your credit score can affect everything from the interest rate on your mortgage to the insurance on your car to the security deposit on your utility bill.
Many people consider stocks the cornerstone of investing. When you buy a stock, you are really purchasing a small ownership stake in a company. When that company performs well, its stock price will generally rise. Similarly, if the economy is doing well, the stock market exhibits strong performance. But the reverse can happen too, making stocks one of the riskier and more volatile asset classes to invest in.
Index funds and mutual funds
Investing in individual stocks can require a lot of research if you want to be informed about the companies you are investing in. Index funds and mutual funds are baskets of stocks that allow you to invest in a lot of individual stocks in one stop. This is a much more effective way to diversify your stock market investments without having to craft a portfolio of individual companies.
The difference between index and mutual funds lies in how they buy and sell their stocks. Index funds use a computer algorithm to manage their portfolios, and mutual funds are managed by a salaried human. As a result, index funds are cheaper than mutual funds (and recent research shows that they perform better too).
If you’re a beginner investor who is intimidated by all of this jargon, I highly recommend starting out with Wealthfront as your investment platform. They create a personalized portfolio based on your risk profile and do all the heavy lifting for you.
When you buy a bond, you are loaning money to the entity that issued that bond—usually a government or corporation. Just like with any other loan, the borrower will pay you interest during the bond’s term at the stated interest rate. Bonds are a safer place to park your money than stocks are, so as you get closer to retirement, you’ll want to shift your portfolio away from the stock market and into something a little less risky, like bonds.
A 401(k) is an employer-sponsored retirement plan that you can fund through setting aside a portion of your salary. You can then invest this money into stocks, bonds, index funds, mutual funds, or whatever other investment options your plan offers. The idea is that your investments will grow with time, leaving you a nice little nest egg to dip into when you hit retirement age.
A 401(k) also entitles you to tax deductions in the amount that you contribute every year. An important thing to remember about a 401(k) is that your employer will usually match a portion of your contributions. Don’t forget about this free money!