Author: Matthew Frankel, CFP® | August 23, 2018
Are you financially literate?
There’s a serious financial literacy problem in America. There’s little personal finance education that takes place in schools, and families don’t have open conversations about money nearly as often as they should. As a result, many Americans don’t know some important financial terms that could help boost their long-term financial health. With that in mind, here are 21 terms that all Americans should know, understand, and apply in their financial lives.
Like several of the terms on the list, compound interest is one that most people have heard, but that isn’t well-understood by far too many.
There are two main ways interest can be paid. There’s simple interest, which refers to the same amount of interest being paid every year. Bonds pay simple interest -- that is, if a $1,000 bond pays 5% interest for 30 years, you’ll receive $50 the first year, $50 again in the second year, and so on.
On the other hand, compound interest refers to the interest being paid on the principle and any accumulated interest. A $1,000 investment at 5% compound interest would pay $50 the first year, but the second year you’d get 5% of $1,050, or $52.50.
You might be surprised at the long-term effect of compound interest. The stock market has historically returned about 10% annually. A $10,000 investment at 10% simple interest for 30 years would grow to $40,000. On the other hand, a $10,000 investment at 10% compounded would grow to more than $174,000 in the same time period.
Many investors focus on the dividend yields of their investments, while others focus on share price growth. Total return is the combination of the two.
For example, if a stock pays a 4% annual dividend yield and the stock’s price rises by 8% this year, its total return would be 12%. Total return is important to keep in mind, because maximizing your total returns year after year is the way to get rich over time.
Simply put, tax-deferred means delaying the payment of tax until some point in the future. A traditional IRA is a form of tax-deferred investment account. Qualified individuals can deduct their contributions to their traditional IRA from their current-year taxes, but their eventual withdrawals from the account will be considered taxable income.
Here’s the beauty of tax-deferred investing. In a tax-deferred account, you can buy and sell investments over the years, without having to pay a dime of capital gains tax. You also won’t pay any tax on dividends paid by your investments. This tax-deferred treatment can help maximize your long-term compounding power, which we discussed on the first slide.
A tax-exempt financial instrument is one that you’ll never have to pay tax on. The interest on most municipal bonds is tax-exempt, to name one common example.
Another major example of a tax-exempt investment vehicle is a Roth IRA. Unlike a traditional IRA, you don’t get a current-year tax deduction for Roth IRA contributions. However, you’ll enjoy the same tax-free compounding year after year with no capital gains or dividend taxes. And qualified withdrawals from a Roth IRA are 100% tax free, even if the account’s value has ballooned to the millions of dollars.
In other words, once you deposit money into a tax-exempt Roth IRA, you may never pay another dime of tax on the money generated by those contributions, no matter how much.
APR stands for “annual percentage rate” and in many cases is used interchangeably with the term “interest rate.” However, APR takes interest one step further and tells you the true cost of borrowing money.
Here’s an example of a situation where APR is especially important to know. Let’s say that you need to borrow $20,000 and you get offered a loan at 6% interest for four years, compounded monthly. However, the loan comes with a $1,000 origination fee. When taking the origination fee into account, you’re paying an APR, or real borrowing cost, of 8.65%. All of a sudden, this loan doesn’t look like quite as good of a deal.
Most Americans know what a credit score is, but many don’t realize that when it comes to credit scoring, there’s the FICO score, and a bunch of much smaller competitors. Specifically, the FICO score is used in more than 90% of lending decisions, so if you know your actual FICO score, you’re probably seeing the credit score a lender would see if you apply for credit.
The FICO score ranges from 300 to 850, with higher scores being better. The average American consumer has a FICO score of 700. There’s no specific definition of a “great” FICO score, but generally speaking, a 760 or higher will qualify you for the best interest rates on whatever you’re trying to buy.
In plain terms, equity refers to the amount of something you own. In personal finance, the most common use of the term is in reference to home equity -- specifically, for the purpose of home equity loans.
As an example, let’s say that your house is worth $300,000, but that you owe $250,000 on your mortgage. In this case, your equity in the home would be $50,000. The term can also be applied to the equity you have in your car, in a business, or in pretty much anything else.
Equity is also used in reference to owning stock in a company. For example, mutual funds that own stocks are often referred to as equity mutual funds. This makes sense -- after all, a share of stock represents a portion of ownership in a company.
Fixed-income is an investment term that typically refers to bonds but can be used for any investment that pays an equal amount of money at set time intervals.
As an example, let’s say that you buy a bond with a face value of $1,000 with a coupon interest rate of 6%. Since bonds generally pay interest semi-annually, you can expect to receive $30 in income from this bond every six months.
Also known as the DTI ratio, this is an important personal finance term, especially when you’re trying to buy a home. When evaluating your mortgage application, your credit score is only one piece of the puzzle. Your lender will consider several other things, including your debt-to-income ratio.
For example, if you earn $5,000 before taxes each month and your total debt payments (mortgage, auto loan, student loan, etc.) add up to $2,000, your debt-to-income ratio is 40%. Mortgage lenders ideally like to see total debt-to-income ratios of 36% or less, including your expected mortgage payment, although it’s not uncommon for a lender to stretch this to 45% or even more for otherwise-qualified borrowers.
This is another one of those terms that lots of people know, but don’t really understand why it matters so much.
In simple English, inflation is the phenomenon of rising consumer prices over time. Historically, inflation in the United States has averaged just over 3% per year. In other words, if something costs $100 this year, you can expect it to cost roughly $103 next year. Of course, inflation isn’t this predictable, but you get the idea.
The reason this is so important for you to know is that it means that your money will become less valuable over time. For example, if you have $1,000 in cash today, you can expect that same handful of cash to have less than $740 in purchasing power in 10 years.
This is why investing is so important. Money kept in cash is virtually guaranteed to lose value over time. On the other hand, investments can not only help you keep up with inflation but can outpace inflation over long periods of time.
Diversification refers to the principle of spreading your investment dollars around among different types of investments, in order to spread out your risk.
Here’s a simplified example. If 100% of your investment portfolio is invested in Apple stock, and the next iPhone turns out to be a total flop, it could be absolutely devastating to your life savings. On the other hand, if Apple is just one of 20 stocks you own of companies in a variety of industries, each of which makes up 5% of your portfolio, a major drop in Apple’s stock price would be nothing more than a somewhat-bad day.
Dollar-cost averaging is my personal favorite way to buy stocks and guarantees me a mathematically-favorable purchase price.
In a nutshell, dollar-cost averaging refers to investing a fixed dollar amount at regular time intervals in order to build an investment position.
Let’s say that a certain stock you like is trading for $10 right now and you want to invest $3,000. Instead of investing all $3,000 right now, you might decide to invest $1,000 now, a month from now, and two months from now. A month from now, the stock trades for $8 per share, and two months from now, the stock rebounds to $10.
Your first investment would buy 100 shares, while your second investment would buy 125 shares, and your third would add another 100. So, you’d have a total of 325 shares at an average price of $9.23. Meanwhile, the average price of the stock between the three dates you made your purchases was $9.33.
Capital gains refers to the profit (or loss) you make when selling an asset you own. And there are two things you should know about capital gains.
First, capital gains aren’t taxed until you sell the asset. Even if you paid $1,000 for a stock investment that’s now worth millions, the IRS can’t touch a cent until you sell it.
Second, long-term capital gains are taxed at lower rates than short-term gains. The IRS defines a long-term capital gain as a profit on an asset you owned for over a year, so keep this in mind when you’re thinking of selling an investment at a profit.
I mentioned on the previous slide that capital gains are taxed when you sell an investment at a profit. Conversely, capital losses result when you sell an investment for less than you paid.
The good news is that the IRS effectively subsidizes your investment losses by allowing you to use capital losses to offset your capital gains for tax purposes. Even if you don’t have any capital gains, you can use up to $3,000 in capital losses to reduce your other taxable income, and you can carry over any excess to next year’s taxes. This concept is known as tax-loss harvesting and can help you reduce your taxes in the unfortunate event that an investment doesn’t go your way.
Yield is an important concept in income investing and is the amount of income you receive from an investment expressed as a percentage of the investment’s current value, typically on an annual basis.
For example, a dividend stock that you bought for $100 per share that pays a quarterly (four times per year) dividend of $1.00 would have a dividend yield of 4% per year.
Net worth is an important personal finance concept, as it can give you an overall picture of your financial health. You can calculate your net worth rather easily by subtracting all of your liabilities (debts) from your assets (things you own).
For example, if my house, cars, savings, investments, and other things I own add up to $800,000 and I owe a total of $500,000 on my mortgage, auto loan, student loans, and to various other creditors, my net worth would be $300,000.
Modified versions of net worth are also used in some circumstances. For example, some net worth calculations related to eligibility to make private equity investments exclude the value of the investor’s primary residence.
Cash flow is a simple concept that can give you a good sense of whether you’re spending money at a reasonable rate, or if you need to cut back. It is calculated by simply taking the money you have flowing in and subtracting the money that flows out.
For example, let’s say that you earn $5,000 per month from your job. The taxes that come out of your paycheck, all of your bills and other obligations, money you put into investments, and the incidental day-to-day spending for the month add up to $4,800. So, your cash flow for this month is $200. If you calculate your cash flow and get a negative number, it’s a pretty good bet that your current spending habits aren’t sustainable long-term.
Asset allocation refers to how your investable assets are put to work. For example, if you have a $100,000 investment portfolio with $70,000 in stock investments and $30,000 in bonds, you would say that you have a 70% stock, 30% bond allocation.
As a rule, asset allocation should gradually become more conservative as you get older -- meaning that less of your assets should be allocated to volatile instruments such as stocks, with more in lower-volatility investments such as bonds or even cash.
One rule of thumb says that you should subtract your age from 110 to find your ideal stock allocation, with the remainder of your portfolio invested in bonds. For example, I’m 36, so this implies that about 74% of my investments should be in stocks, with the other 26% in bonds.
Rebalancing refers to periodically adjusting your investments to maintain a desired asset allocation, and can be especially important in times when the stock market performs especially good (or poorly).
Let’s say that you want to maintain a 70% stock, 30% bond allocation, so you invest $70,000 of your $100,000 portfolio in stocks, with the other $30,000 in bonds. Over the next two years, the bond market is rather flat (stays the same price), but the stock market jumps by 50%. So, now your stocks are worth $105,000, while your bonds are still worth $30,000. A quick calculation shows that your stocks now make up nearly 80% of the total value.
This is certainly a good problem to have, but even so, your portfolio would have become too stock-heavy. So, to rebalance your portfolio, you could sell some of your stock investments and use the proceeds to buy bonds in order to get back to your desired 70/30 allocation.
Here’s an extremely important investment principle to understand. Seemingly small fees can rob you of thousands of dollars over the years.
When investing in mutual funds (including those in your 401(k)) and ETFs, the fees you’re paying are expressed with a metric known as the expense ratio. This is the amount of money that is deducted annually to cover the fund’s expenses, expressed as a percentage of its assets. For example, a 1% expense ratio implies that for every $10,000 you have invested in the fund, you’ll pay $100 in annual investment fees.
Comparing expense ratios and switching to lower-cost funds that accomplish your objectives is an excellent and easy way to boost your long-term return potential.
Rule of 72
The rule of 72 is a personal finance rule that helps investors determine the real-world effect of compound interest. It says that if you divide the number 72 by an investment’s annualized return, it will tell you the amount of time in years it will take that investment’s value to double. For example, an investment that compounds at 10% per year would take 7.2 years to double in value.
Applying these can boost your financial health
None of these financial terms and the concepts behind them are exceptionally complicated, yet they can have a profound impact on your financial life. Just to name a couple of examples, understanding mutual fund expense ratios and choosing lower-cost options can increase your eventual retirement nest egg by tens of thousands of dollars. And, understanding the concept of APR can help you choose the best mortgage for you -- not just the one with the lowest stated interest rate.
Matthew Frankel, CFP® owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.