Understanding basic financial literacy terms can help you make smart decisions along your wealth creation journey.
Learning basic financial literacy terms is one of the best first steps you can take on your wealth-creation journey.
Your ability to grasp common financial concepts contributes to the choices you’ll make about how to spend your income, savings goals and other decisions that will significantly impact your life.
Generally speaking, the more financially literate a person is, the better financial outcomes they experience.
You don’t have to come from an economically privileged background to achieve financial literacy. Understanding basic financial literacy terms is accessible to anyone, and learning even a few key terms will help you establish a foundation for how you handle your money. That foundation will affect major financial opportunities, including your ability to buy a home.
“Lack of financial literacy can be a huge barrier to making good financial decisions,” says Brandee Harrington, a long-time real estate agent, real estate investor and advocate for generational wealth building. “When my clients are ready to buy a home, the ones that have done their homework stand out and experience financial success in other areas as well.”
To that end, we’ve put together a list of basic financial literacy terms that will help you build a framework for your financial life.
The basic financial literacy terms you need to know
A 401(k) is an investment account typically offered to employees as part of an employer-sponsored retirement program. It is funded with pre-tax funds, usually in the form of payroll deductions. You can start making penalty-free withdrawals from this account at the age of 59 ½, at which time it will be taxed as ordinary income. There are some exceptions that allow you to make withdrawals or take out loans against this account, such as for purchasing a home.
If you are self-employed, you may be able to set up a Solo 401(k).
APR stands for annual percentage rate. This number represents the interest you pay each year on any borrowed money, such as a credit card balance. APRs most often refer to credit card debt, but they can be used to explain the interest paid on mortgages, personal loans or car loans as well.
Bonds are a type of investment. They are debt instruments that can be issued by a corporation or government entity that needs to raise money. They sell bonds to the public with a specified interest rate and maturity date, which means they are effectively borrowing money from the public.
The maturity date is when the bondholders receive payment from the corporation or government, and they receive the original amount loaned plus any interest that has accrued.
Bonds can also be traded on the bond market, where their value can increase. They are sometimes considered less risky than other securities, such as stocks.
A budget is a spending plan for your money. To create a budget, you look at your income and divvy it up toward your expenses, such as your housing payment, other bills, groceries, commuting costs and extras such as entertainment and dining out.
Organizing your budget can help you determine whether you are living within your means or whether you need to reduce your expenses or increase your income. A clear budget will also help you prioritize goals such as building an emergency fund, paying off debt or saving for a big expense such as a home or once-in-a-lifetime vacation.
Cash flow is the difference between your income and expenses each month. For instance, if you earn $3,000 per month and your expenses add up to $2,800 per month, then your cash flow would be $200 per month. If your expenses exceed your income, then you are said to have negative cash flow.
Certificates of deposit
Commonly referred to as CDs, certificates of deposit are a type of savings account that offers a higher interest rate than regular checking or savings accounts. In exchange for the higher rate, you must commit your funds to the bank for a specific period of time, ranging from one month up to ten years. Some people use this strategy to earn interest on money they cannot easily access without paying an early withdrawal penalty.
Debt-to-income ratio (DTI) represents the amount of debt you have in relation to your income. DTI is a key component in qualifying for a home loan because mortgage lenders must ensure that you can afford your monthly mortgage payment in addition to your existing debts.
A down payment is an amount you pay toward a purchase, such as a car or a home, while financing the rest of the purchase with a mortgage or auto loan. The down payment reduces the amount of money you need to borrow, which saves you money long-term since you’ll pay less interest over time. It also reduces your lender’s risk, since they are not financing the entire purchase.
There are a number of no-down payment and low-down payment mortgage options that enable homebuyers to qualify for a home without putting down a large amount. These include:
These Down Payment Assistance (“DPA”) programs are often offered at the state or local level through Housing Finance Authorities and Bond Programs.
Compound interest is a feature of some investments and debts in which interest accrues on both the principal amount invested or borrowed, as well as on the interest earned or accrued on that amount.
Let’s say you invest $1,000 in an account that earns 5% interest each year. At the end of the first year, the account will have $1,050 in it. The next year, interest will accrue on the $1,102, earning you an additional $55.10. The third year, interest will accrue on $1,157.10, and so on and so forth. In this way, your earnings grow even if you don’t increase the principal investment.
On the flip side, your debts can accelerate quickly due to compound interest as well. Let’s assume you open a credit card with an interest rate of 15%. You make a $1,000 purchase with the card. If you don’t make a payment, you’ll be charged $150 in interest, so you’ll owe $1,150 the next month. If you fail to make a payment again, you’ll owe $1,322.50, since you’ll be charged 15% on $1,150.
You can see how quickly compound interest can escalate.
Your credit history is a record of how you have managed credit in the past, including credit cards, mortgages, student loans, auto loans and personal loans. Lenders review your credit history to see whether you typically pay your bills on time and how much debt you’re carrying compared to how much credit you have available. Credit histories offer a snapshot of your behavior as a borrower.
Your credit score is a three-digit number that reflects the overall status of your credit profile. There are different scoring models, but your score will generally be between 300 and 850.
If you have a low credit score, lenders may perceive you as a credit risk and charge you higher interest rates for the money you borrow. In some cases, they may only approve your application for new credit once your credit score improves.
Here are the factors that go into determining your credit score:
- Payment history
- Amounts owed
- Credit mix (the different types of credit accounts you have)
- New credit (number of recently opened credit accounts or recent credit inquiries)
- Length of credit history
This is a savings account that you set aside to cover expenses in case of an emergency, which might include a job loss, illness, major home repair or other unexpected expenses. It’s a good idea to have six months of expenses saved up in your emergency fund.
Employer-sponsored retirement account
This is an investment option provided by your employer to support your retirement savings goals. They might offer many types of accounts, such as 401(k)s, IRAs and profit-sharing plans.
These plans can be a convenient way to start investing and saving for retirement. With an employer-sponsored plan, your company will often match your contributions and make it easy for you to participate by offering payroll deductions to fund your accounts.
This is the fee you pay to borrow money. For instance, when you get a mortgage loan, your lender will charge an interest rate for the money you borrow to pay for your home.
Investing involves putting money into assets that yield a greater return than a savings account would. Unlike a savings account, investing is not risk-free. There is a chance that your investment could lose some or all of its value.
Over a longer period of time investments tend to appreciate in value, though they may experience temporary dips in value from time to time. You can invest in assets such as stocks, commodities, currencies, art, real estate, businesses, etc.
A Roth IRA is a type of retirement savings account that is funded with after-tax money. That means that when you begin making penalty-free withdrawals starting at age 59½, those withdrawals are not taxed.
You can withdraw your Roth contributions before 59 ½ years old but not any gains you may have earned on those investments. There are limits to how much you can contribute to a Roth IRA each year, and there are income limits on who can open a Roth IRA account.
A stock represents investment ownership in a corporation. You can buy one or more shares of stock in publicly traded companies.
If you invest in stocks, you can hold them over the long term with the expectation that they will increase in value. Some stocks also offer additional benefits beyond appreciation called dividend income. Some people use dividend payments from the stocks they own as a way to supplement their income.
This is a type of retirement savings account funded with pre-tax money and is taxed as ordinary income upon withdrawal. Penalty-free withdrawals start at age 59½.
Like a Roth IRA, a traditional IRA has limitations on the amount you can contribute each year. Though there are no income limits on contributing to this account, there are limitations on the amount of tax deductions you can claim from contributing to this account.
The bottom line on basic financial literacy terms
Familiarizing yourself with basic financial literacy terms can jumpstart your personal finance education, sparking new ideas for your next money moves and shining light on areas where you may want to learn more. Becoming financially literate takes time, but it is possible for anyone, regardless of where you begin.
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