20 Basic Financial Terms They Never Taught Us In School
Mitochondria is the powerhouse of the cell.
Y = MX + B
The first two things that come to mind when I think about what I learned in school.
I don't know about you, but I haven't calculated the slope of something since chapter 4 of Pre-Algebra.
While school helped build the framework for learning, it didn't teach us the things we need to know to succeed in our adult life. We have to go out on our own, sift through pages of information in hopes of finding something:
1. That's accurate
2. Applies to our situation
3. And actually answers the questions we have
That can take up a lot of time so to get you going in the right direction, I've gathered a list of 20 basic finance terms and what they mean to provide a brief intro into the world of personal finance:
1. Bull Market
A bull market is when the stock market prices are continuously rising or expected to rise. So all of the growth that we saw in the stock market last year after it fell in March would be considered a bull market.
2. Bear Market
A bear market is when the stock market crashes more than 20%. In both the bull and bear market definitions I’ve mentioned the stock market - but commodities, real estate, and currencies can experience bull and bear markets as well.
3. Dollar Cost Averaging
Dollar cost averaging is where you invest a certain amount of money into the stock market over a period of time, regardless of how the market is performing. This is common with Roth IRA’s where you might invest $500/month over the course of a year to reach the $6,000 contribution limit.
4. Roth IRA
Not to be confused with the one-hit wonder Asher Roth, a Roth IRA is one of the most common retirement accounts and lets you invest after-tax money so the growth of the account is tax free.
For example, if you invested $5,000 into a Roth IRA this year and it grew to $500,000 at retirement, you would be able to withdraw that $500,000 completely tax-free.
Roth IRA’s are popular because they allow you to “lock in” your tax rate in the current year and no matter what the tax rate is in 40 years, your Roth IRA money will still be tax-free.
Another retirement account, however this is the one that’s typically set up with your employer. Your employer can take a certain amount of your paycheck before it’s received and send that portion to your 401(k) to be invested.
This gives you tax breaks in the current year however unlike the Roth IRA, you must pay taxes on the growth at retirement.
6. Traditional IRA
A traditional IRA is another retirement account that’s similar to a 401(k) in the sense that contributions are tax-deductible and the account grows tax deferred - meaning you’ll save on taxes the year you contribute and pay taxes at retirement.
For example, if you invested $6,000 to a traditional IRA, you can claim that $6,000 as a deduction on your tax return which will help lower your current tax bill and you won’t have to pay taxes until it’s time to withdraw the money at retirement.
7. Emergency fund
An emergency fund is the backbone of a solid financial foundation. It’s generally been recommended to save 3-6 of your monthly expenses in an emergency fund but after 2020, I’m leaning more towards 9-12 months for additional security.
An emergency fund isn’t a special type of account, rather just a separate savings account that you only touch in case of emergencies.
8. Credit score
Your credit score is basically a measure of how likely you are to repay debt. Credit scores range from 300-850 and the higher your score, the more trustworthy you are to lenders. Having a high credit score can help you get lower interest rates on loans such as your mortgage and car, which can end up saving you thousands of dollars throughout the term of the loan.
Your credit score is made of up 5 different categories:
- Payment history - determined by your track record of paying bills on time
- Credit utilization (amounts owed) - how much of your credit limit you use
- Length of credit history - how long you’ve had credit
- Types of accounts (credit mix) - includes credit cards, loans, etc.
- New credit - amount of new credit and hard inquiries you've received
9. Cash flow
Cash flow is simply the amount of money coming in (income) and money going out (expenses). Understanding your cash flow is important because it allows you to properly project amounts you’ll be able to save, invest, and gives you an understanding of where your money is going.
In simple terms, leverage is using debt to make a purchase. Leverage is commonly used in real estate and if you hear about a company being “highly leveraged”, it means that they have more debt than equity (ownership).
Leverage adds potential risk to investments, but can also amplify returns if used correctly.
Liquidity refers to how quickly an asset can be converted into cash without affecting the value of the asset. For example, a home would generally be considered illiquid because of the processes you have to go through to sell a home.
However having $10,000 in your bank account would be considered very liquid because that asset is already cash.
12. Risk Tolerance
Risk tolerance is the level of risk an investor is willing to accept from their investment portfolio. Investment decisions are based on your level of risk so it’s important to understand what your risk tolerance is before getting started.
For example, if someone was nearing retirement and needed their investments to fund their retirement lifestyle, they’d generally have a lower risk tolerance because they can’t afford to lose that money.
13. Capital gains tax
Capital gains are the difference between the price you purchased an asset and the price that you sold an asset. So if you bought one share of a stock at $50 and sold it for $100, you would report $50 in capital gains.
Now, there’s 2 different types of capital gains - short term and long term.
Short term capital gains apply when you buy an asset and sell it in under a year. The tax rates on short term capital gains are higher than long term gains reaching up to 37%.
Long term capital gains apply when you hold an investment for more than a year. The tax rates are more favorable and capped at 20% which encourages long term investing.
14. Withdrawal rate
Your withdrawal rate is the rate at which you take money out of your investment account, typically at retirement. So if you had a $1,000,000 portfolio and took out $50,000 per year, your withdrawal rate would be 5%. According to some studies, the ideal withdrawal rate to ensure you don’t run out of money in retirement is 3-4%.
15. Compound interest
Compound interest refers to when investments are growing not only from the original investment, but also from the additional interest or returns.
For example if you invested $100 and got a 5% return, you’d be up to $105. Now the following year you have $105 and if you get another 5% return, you’d get $5.25 instead of the same $5 because your returns compounded on top of each other.
It may not seem like much at the beginning, but over time compound interest turns into your best friend.
16. S&P 500
The acronym S&P 500 stands for Standard & Poor’s 500.
The S&P 500 is an index that tracks the performance of the 500 largest U.S. publicly traded companies. You can think of it like a pack of playing cards - the S&P 500 is the box and the cards inside are the 500 companies.
So when you hear “the S&P 500 is down” it means that as a whole, the price of those 500 companies has dropped.
ROI stands for Return on Investment and is commonly used to calculate investment returns. If you bought a share of Apple stock for $100 and it was worth $150 a year later, your ROI would be 50%.
This can be calculated by taking ($150 - $100) / $100
The acronym stands for exchange traded funds, and ETFs can be one of the best and easiest ways to begin investing for retirement. The reason ETFs are popular is because they’re low-cost and can consist of many different stocks which helps reduce risk.
For example, there’s ETFs that track the stock market as a whole so whatever the stock market is doing, your investment is doing the same. This works well for long term strategies as historically, the stock market has always recovered from previous lows.
APR stands for annual percentage rate. When you’re buying a car, you’re likely going to see APR rather than APY. Lenders usually use APR because it shows a lower interest rate since compound interest is not taken into consideration.
APY stands for annual percentage yield and while APR and APY sound similar, there’s a slight but important difference. APY takes into account the frequency of which interest is applied. This explanation from Investopedia breaks down the difference between APR and APY with a credit card example:
The Bottom Line
Having a basic understanding of personal finance terms is important because almost everything in our life is related to money. The school systems we grew up in failed to provide us with the necessary education so we have to take it upon ourselves to learn and thrive financially.
While this post doesn't cover every personal finance topic out there, hopefully you walk away from this with some new or interesting information.
Also, finding reliable and accurate information can take a surprising amount of time so a goal of this blog is to address common questions our generation has about money.