You hear money jargon everywhere — whether in conversation, online or blaring from the TV and radio.
Yet, how many of us know what terms such as APY, expense ratio and index fund actually mean?
If confusion over money talk makes you feel dumb, we have a way to get over it. Following is a detailed look at some of the most important money terms.
These terms are crucial not only if you want to improve your current financial situation but also if you want to ensure you don’t outlive your savings in retirement.
1. 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 also fees and other charges associated with taking out a loan.
A mortgage APR, for instance, includes the interest rate as well as costs like mortgage broker fees and discount points.
So, the APR of a financial product may be higher than the interest rate for the same product. And you should compare 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.)
2. Annual percentage yield (APY)
Annual percentage yield, or APY, is the yearly amount you earn on savings, or the amount that you pay to borrow, expressed a percentage.
Like APR, APY includes the interest rate and sometimes other costs associated with taking out a loan. The key difference between the two 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).
3. Asset allocation
Asset allocation refers to the mix of the different types of assets that you own, and what percentage of your money is in each type of asset. 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.
If all of your money was invested in real estate during the last housing crash, for example, 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.
4. 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 interest that’s 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, as your account balance grows, each new interest payment is based on a larger base amount.
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! Leave that $ 5,000 for 20 years, and the snowballing effect of compounding grows the account to more than $ 7,400.
The higher the interest rate you earn, the more spectacular the results of compounding. Calculate compound interest with this calculator from the U.S. Securities and Exchange Commission.
Compounding can work against you when you borrow money.
For example, if you are making a minimum credit card payment of 2% a month on a $ 5,000 credit card balance with a 20% interest rate, it would take you nearly 44 years to pay off the debt and cost you more than $ 20,000 in interest alone, according to a Debt.com’s credit card payoff calculator.
5. 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 easily can save you tens of thousands of dollars over the life of a loan. And having a low credit score can prove costly.
For example, a 30-year, $ 500,000 mortgage with a fixed rate of 3% would cost you about $ 259,000 in interest over 30 years, a FreddieMac mortgage calculator shows. If the rate was 4%, you would pay about $ 359,000 in interest — $ 100,000 more.
There are many types of credit scores, but the most widely used are FICO scores, which are created by Fair Isaac Corp., 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, which Money Talks News founder Stacy Johnson has attained. Here’s how he did it, and here’s how you can improve your score.
To learn how to get your credit score for free, check out “7 Ways to Get Your FICO Credit Score for Free” or “15 Ways to Get Your Free VantageScore Credit Score.” (VantageScore credit scores are a lesser-used alternative to FICO scores.)
6. Diversification
Diversifying your investments and other assets is, in essence, putting 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 sector of the market. Examples are mutual funds that invest in:
- Growth and income (dividend) stocks
- Large company stocks
- Small company stocks
- Stocks of domestic companies
- Stocks of international companies
7. Exchange-traded fund (ETF)
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.
For Money Talks News founder Stacy Johnson’s take on this subject, check out “Should I Invest With ETFs?”
8. Expense ratio
An expense ratio is the 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.
The U.S. Securities and Exchange Commission’s Investor.gov website provides this example: 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. Another fund with a 10% annual return but an expense ratio of only 0.5% after 20 years would return $ 60,858.
Compare the costs of owning mutual funds, especially when choosing retirement investments, to make sure fees don’t take a big bite out of gains you’re expecting to live on. You can do this using the Financial Industry Regulatory Authority’s free Fund Analyzer tool.
9. 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, as Money Talks News founder Stacy Johnson details in “Are Actively Managed Mutual Funds Better Than Index Funds?”
According to Morningstar, the asset-weighted average expense ratio among passively managed funds was 0.13% in 2019. Among actively managed funds, it’s 0.66%.
10. Inflation
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 January 1981 would require $ 60.13 in January 2021, the Bureau of Labor Statistics’ inflation calculator shows.
The Federal Reserve, the nation’s central banking system, is aiming for inflation to average around 2% long-term. That means that if your long-term savings isn’t earning a return of at least 2%, it’s losing value. And inflation could shoot much higher than that 2% target.
One way to make sure your money lasts despite inflation, especially if retirement is a ways off, is to choose high-reward investments like stocks. Index funds are one relatively safe way to do that. If you’re already retired, check out “5 Ways Retirees Can Lower Their Inflation Risk.”
11. 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, such as by a person (active funds), or passively managed, such as by a computer (index funds).
12. 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. Money Talks News founder Stacy Johnson does this every month.
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. You want to see your net worth generally rise as you get older.
To compute your net worth:
- Add up the value of your major assets: for example, your home, car and all the money in your savings, checking and retirement accounts.
- Add up the value of your debts: for example, your remaining mortgage principal, car loans, student loans and credit card balances.
- Subtract No. 2 from No. 1.
While more than 1 in 10 U.S. households had a negative net worth as of 2017, according to a 2020 U.S. Census Bureau report, the median household net worth was $ 104,000 in 2017 (meaning half of households had a higher net worth and half had a lower net worth).
13. 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.
14. Rebalancing
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. Rebalancing is step No. 3 in “Year-End Review: Evaluate Your Investments in 15 Minutes.”
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