There are a lot of financial terms that often confuse people. However, it is essential to understand these terms in order to plan your finances more effectively. Here are a few of the most important personal finance terms that everyone should know.
1. Interest Rate
The interest rate is the fee a lender charges for letting someone else borrow their assets. It is a percentage of the amount lent to you (the principal) that you have to pay back in addition to the principal amount. It may be used in terms of borrowing money through a personal loan, but it can also be applied to loans for consumer goods, vehicles, buildings and other assets.
Loan Versus Savings Interest Rate
A loan’s interest rate is the amount you need to pay back in addition to the sum of your loan. The loan interest rate is the charge for your loan. It is computed by multiplying the interest rate to the total of your loan.
Meanwhile, the savings interest rate is the percentage your bank pays you for letting them use the money that you deposited to your savings account. This works similar to the loan interest rate, except you are the one receiving the interest, rather than the one paying the interest.
When you are applying for a loan, you should look for the lowest interest rate you can find. This means you will have to pay back less over time. On the other hand, you should find a bank with a high interest rate if you are looking to deposit your money in a savings account.
Note: If you have a variable interest rate, your interest rate may change over time, depending on the market.
2. Annual Percentage Rate (APR)
Simply put, the APR is the yearly interest rate on your loan or your savings. Since interest rates may change monthly, APR is used as an average for the interest rate for a year. You can compare loans using the APR and choose one with the lowest APR.
Note: APR does not take compounding interest into account.
3. Annual Percentage Yield (APY)
While APR is an estimation based on a simple interest rate, the APY is the actual interest rate you will get with compounding interest in mind. With this, you can compare different savings account even if they compound at different rates.
It can be solved using the following formula:
APY= (1 + r/n)n – 1,
“r” is the stated annual interest rate
“n” is the number of compounding periods each year.
For example, Bank A compounds daily at a lower interest rate, and Bank B compounds monthly at a higher interest rate. At first glance, it might seem like Bank B is the better choice. However, if you computed using APY, it could take into account the compounding interest, and you might end up having more money with Bank A, depending on how long you keep the money in their account.
4. Credit Report
Everyone should be familiar with a credit report. This is a statement created by a credit bureau using the information about your credit. Your credit report has all your basic information, credit records, credit payment history and public records. The following is included in your credit report:
- Credit accounts
- Credit limit
- Payment history
- Date of opening and closing of accounts
5. Credit Score
You probably know about your credit score. This is the number that reflects how well you can handle your credit. Using your credit history, different bureaus can give you a number between 300 to 850. Different creditors use this score to gauge how trustworthy you are for another line of credit, such as a personal loan, mortgage or new credit card.
People with a higher credit score tend to pay on time. Therefore, creditors are more likely to approve them for a new line of credit and give them a lower interest rate. On the other hand, people with low credit scores tend to have a bad credit history, including missed payments. Therefore, they may be denied new credit lines or offered a much higher interest rate to minimize the risks from creditors.
6. Net Worth
Your net worth is the value of all your assets, including accumulated wealth and properties, minus the liabilities you owe, such as loans. A higher net worth either means you have many assets under your name, or you have little to no liabilities.
Your net worth can be computed with a simple formula:
Net worth = Assets – Liabilities
Having a high net worth can mean you are financially stable, while low net worth means you may not be handling your finances as well. Aside from that, an increasing net worth means you are doing something good with your money, while a decreasing net worth over time means you have to take steps to avoid a lower net worth in the future.
Your assets are all your properties that have a monetary value. Since the value for most of your assets, except cash, cannot be determined exactly, you must check their market value by comparing similar assets that are recently sold in the market. Types of assets include:
- Checking and savings accounts
- Real estate
- Houses and cars
- Artworks and precious metals
- Intellectual property
- Accounts receivable
Liabilities are the opposite of assets. Your liabilities include everything you owe to another person or entity. Types of liabilities include:
- Any type of loan
- Accounts payable
- Income taxes payable
- Interest payable
- Outstanding expenses
- Mortgage payable
- Unearned revenue
9. Cost of Living
The cost of living is another important term in finance. It is the amount of money you need to cover all your basic expenses within a period of time and at a certain location. Since different states, for example, have different prices on their goods and properties, some places have a higher cost of living, especially in urban areas. Meanwhile, people in the suburbs or rural areas usually have a lower cost of living.
Basic needs such as housing, food, water, electricity, healthcare and even taxes are included. Sometimes, transportation is also added, especially to places where it is difficult to get around without a vehicle.
Liquidity is related to your assets. Liquidity is the term used to determine how easy it is to turn your assets into cash without affecting its market price. The easier it is to liquidate your assets, the better it would be if you hit a financial bump and need some extra cash.
11. Net Income
If you own a business, your net income is the amount you earned. You can calculate it by taking your amount of profit and subtracting all the expenses you have. This can also apply to individuals but using their daily expenses and salary to compute their net income. Typically, your net income is something you can add to accumulate wealth or to buy things that you want but are not a necessity.
12. Gross Income
Before tax deductions, the entirety of your paycheck is what you consider as your gross income. This can also include income from other sources not directly from your job, such as business income. This is the number used to calculate your income tax. Your net income (after taxes) will be lower than your gross income.
To secure your loan, creditors usually accept collateral or an asset that can be seized by the creditor if you failed to pay for your loan. They will then sell the collateral to recoup their losses from your nonpayment.
Creditors can determine if you qualify for a loan using your basic information, such as your credit score. Creditors use a soft inquiry to determine your credit history. However, it does not guarantee that your loan will be approved, but if you fail on this stage, the creditors will no longer make a hard inquiry to determine if they can lend you money.
Pre-approved is similar to pre-qualified but with a better indication that you can be approved for a loan. Creditors sometimes check credit bureaus for people who meet their criteria and send them an offer through mail or phone.
Appreciation is the increase in the value of an asset over time. Generally, it is a good idea to have assets that appreciate so that you will earn an income when you choose to liquidate these assets.
Depreciation, on the other hand, means the decrease of value over time. Because of this, some assets you own, such as cars, lose their value, and you can liquidate it for much less than you originally paid for.
18. Tax Deduction
The tax deduction is the amount that can be subtracted from your income before the government calculates how much tax you should pay. For example, married people received a tax deduction for $24,800 in the 2020 tax year if the couple filed jointly.
19. Tax Credit
While tax deduction can be subtracted from your income, the tax credit can be subtracted from the actual amount of tax you owe. Both tax deduction and tax credit can lower your tax liability.
20. Tax Refund
There is a nonrefundable tax deduction that can be subtracted from your taxes until it reaches $0, a refundable tax credit where you can receive a refund if your tax credit is bigger than your taxes, and partially refundable tax credits that can only be refunded until a certain amount.
Your dependents are people related to you that you give financial support to. Having a dependent entitles you to a tax credit depending on your dependent’s age and relationship to you, and your support and income.