Expense ratio. Prime rate. Amortisation. The finance world is filled with acronyms and terms that might sound alien to many people. So we’ve created a financial glossary for you that explains important yet often confusing money concepts.
Photo by Mega Pixel (Shutterstock).
This isn’t a comprehensive list by any means. If you need to look up a peculiar financial term, consult this impressively large online financial dictionary. But think of that as a resource, and this as a primer — the terms below are the ones most people will run into most often. You’ll need to know these when managing your money, investing, or simply having a conversation about finance.
Amortisation:
When you get a mortgage or a car loan, you might be presented with an amortisation schedule, which shows your payments each month and how it affects the total amount you owe. Amortisation refers to making regular payment installments over time to pay off debt, and it includes both principal (the amount of money borrowed) and interest (the amount you’re charged by the lender for the privilege of the loan).
Why you need to know this: With an amortisation schedule or calculator, you can figure out how much equity (value you can tap) you’ll have in your home at a certain point in time, or figure out how much extra you’d need to pay every month to repay the loan down more quickly. An amortisation table can also be motivating by showing you how your debt can be whittled down each month.
APR:
APR stands for Annual Percentage Rate. It’s the interest rate you’d pay on a loan (such as credit card debt you don’t pay off when the bill’s due) or earn on an investment in one year including fees.
APY:
APY (Annual Percentage Yield) is just like APR, except it takes into account the compound interest you’d earn or pay over that year (see the compound interest entry below for full explanation). APY includes interest you’ve already accumulated in its calculations, so it is higher than the APR. This is why banks advertise the APY for savings accounts but the APR for loans and credit cards.
Why you need to know this: APR is helpful for comparing loans, such as one credit card offer versus another’s or one mortgage loan from another. The APY is more realistic, however, and you can calculate it yourself.
ARM:
No, not your body part. ARM in the financial world stands for adjustable-rate mortgage. It’s a mortgage with an interest rate that periodically changes after a certain number of years. Your interest starts out lower but can then go up (or sometimes down) after 5, 7, or 10 years — which makes them riskier compared to fixed-rate mortgages that have the same interest rate throughout the life of the loan.
Why you need to know this: ARMs go up and down with the market, so they’re not for the faint of heart.
Diversification:
Diversification is the financial industry’s equivalent of “don’t put all your eggs in one basket.” When you invest, you want to put your money in a few different areas to reduce risk. You don’t want to have all your money invested in tech companies, for example, only to lose all of it in another dot com crash. (Bubbles can happen in any industry, even tulip bulb-buying.)
Asset allocation
is a diversification strategy in which you spread your money across different investment types, called asset classes. How much you put in each class depends on your goals, risk tolerance and timeline. The three basic asset classes are:
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Cash:
Yes, we’re defining cash. But when it comes to investing it can mean not just physical money (your coins and paper bills), but also money in your savings account and money market accounts that can be easily and quickly be turned into cash.
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Bonds:
When you buy a bond you’re essentially loaning money to an organisation with interest. Bonds come with a defined term or “maturity” (when the bond can be redeemed). Some bonds are considered safe investments, compared to junk bonds that have higher risk but greater potential payout.
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Stocks:
A stock is a share of ownership in a public or private company. When you buy stock in a company, you become a shareholder and when the company does well, your investment goes up. When it does poorly, however, so does your stock investment.
Why you need to know this: Diversification, including asset allocation, help you balance risk and reward when you invest.
Bear market and bull market:
“Bear market” and “bull market” are both terms to describe the stock market and investing. They’re easy to tell apart when you consider the animals’ characteristics. In a bullish market, everything’s moving forward: investors are confident making a lot of buys, more companies are entering the stock market, and more money is being invested in the stock market overall (technically, a bull market means the market has risen in value by at least 20%). In a bear market, investors pull back (like bears hibernating). Prices start to hover and go down, and people wait and see more before investing additional money in stocks and bonds.
Why you need to know this: These are good terms to know, but not really ones to base your investment strategy on. After all, it’s often hard to tell when we’re in a bear or bull market, even for the experts. However, knowing these terms will help you understand when people are talking about market conditions or when everyone is feeling optimistic (bullish) or pessimistic (bearish) — and keep you from being swept up with the crowd.
Capital gains and losses:
If you sell something for more than you spent to acquire it, that’s a capital gain. If you sell it for less than your original purchase price, it’s a capital loss. These profits and losses are usually associated with investments, such as stocks and bonds, but they also include property, such as real estate and even jewellery or art. See how capital gains tax works on How Stuff Works.
Why you need to know this: You’ll want to consider taxes when you’re deciding whether to sell investments. Learn how investing affects your taxes here.
Compound interest:
You know how a lie just leads to another lie and the problem just multiplies exponentially? That’s pretty much how compound interest works. Say you make a $100 investment that goes up 10% one year, or $10. Its value is now $110. The next year, it goes up another 10% — but this time, that 10% equals $11, since its value was higher. Your investment is growing at a faster rate each year because of the previous interest.
Why you need to know this: Compound interest is one of the most powerful forces in the universe. It can cause you to quickly get buried under debt, or make you richer while you sleep. It might be the most important financial concept everyone — kids included — should learn. The chart below shows how powerful compound interest can be (just using the power of time to increase savings) and this Khan Academy video explain the concept in more detail.
Credit report:
Your credit report is basically a collection of your debt history — the lines of credit you’ve taken out (such as credit cards, mortgages and car loans), your debt payment history, your accounts balances and other details. This is used by banks and other creditors to assess your “creditworthiness.”
Why you need to know this: If you’re in the market for a new mortgage or other loan, your credit history is paramount. A bad or non-existent credit history could also make it difficult to pay for subscription services, rent an apartment, or even get a job. Before you make any major financial move, check and improve your credit score.
Dividends:
A dividend is a portion of a company’s profits that they pay out to their shareholders. They’re usually paid quarterly. I bought one share of stock in The Walt Disney Company when my daughter was born, and every quarter we get a check for something like $1.86. It’s regular, taxable income, although we could reinvest it and buy more shares.
Why you need to know this: Again, knowing how different investments get taxed will help you hold on to more of your money. Investments that regularly have higher dividends, such as small-cap stocks, would be better in tax-efficient retirement accounts than they would in a normal investment account.
Dollar-cost averaging:
Let’s say that every paycheck, you put $100 into your retirement account, buying the same mutual funds or stocks. This is an example of dollar-cost averaging, a strategy where you put a set amount of money towards an investment regardless of the share price. When share prices are low, you’ll buy more shares, when prices are high, you’ll buy fewer shares. Instead of trying to “buy low and sell high”, which is risky, you stick to a regular investment plan that takes emotions out of the equation. Instead, you can just set it and forget it (for the most part).
Why you need to know this: This is what most people do when they invest in a retirement plan — they automatically buy however many shares of funds or stocks they can, based on their set contribution amount. It’s a smart investment strategy if you’re investing over time, though it’s not as ideal if you have a large sum of money to invest (like if you just won the lottery).
Expense ratio:
This is the annual fee a mutual fund charges for things like operating costs, management fees, administrative fees and other fees incurred by the fund. If you have $10,000 invested in a fund, for example, the fund administrators could take out 2% every year for managing the fund (or $200). Historically, funds with lower expense ratios (such as index funds) out-perform managed funds with higher expense ratios.
Why you need to know this: When choosing your investments, look at the expense ratio. It’s the first number you should look for when investing in a mutual fund. Most investment experts agree that the best way for the average person to invest is to put your money in low-cost index funds. Your investments will likely do better.
Mutual fund:
A mutual fund is a collection of stocks, bonds, and/or other assets, managed by an investment company. When you invest in a mutual fund, your money is pooled together with other investors, and the investment company buys and trades assets according to the mutual fund’s goals, such as generating income from dividends or interest (income funds are great if you’re nearing retirement). You’ll find these stated goals in the fund’s prospectus. Mutual funds let you buy shares in hundreds of different companies without having to make or monitor all those investments in your portfolio. They’re easy to buy and sell, but also come with management costs (as explained in the expense ratio section).
Index funds:
Index funds are a particular type of mutual fund that tries to track or match a market index, such as the Standard & Poor’s 500 Index (S&P 500), which is based on the market value of 500 large, publicly traded US companies. Index funds typically have lower expense ratios because they’re not actively managed by people trying to beat the market. Instead, they merely try to mimic the stock market.
Why you need to know this: Mutual funds might be the easiest way to get started investing in stocks and/or bonds, but they’re not the only option, and you’ll still need to choose from hundreds if not thousands of mutual funds to invest in. Know the basics of mutual funds and how they compare to similar ETFs or exchange traded funds so you know where you’re money is going. Again, for most people, index funds are the best way to go because of their lower expense ratios.
Net worth:
Compound interest might be the most important financial concept to know, but net worth is your most important measurement of wealth. It’s the difference between your assets (savings and investments — things that are worth money) and your liabilities (your debts).
Why you need to know this: When you focus on and track your net worth, you’ll shift towards a more realistic view of how much you really have. It’s a better yardstick for your financial progress than your income. After all, if you have a lot of debt, you could have a six-digit salary and still be living paycheck to paycheck.
As jargon-y as many finance terms are, these and similar terms are easier to understand than they might seem at first. Also, don’t let the lingo hold you back: You don’t need to know what a price to earnings ratio is before you can start investing for retirement and you don’t need to know what PMI (or private mortgage insurance) is to start saving up a down payment to buy a house. Some terms you’ll learn as you go along, but the ones above will hopefully help you through the most common financial situations now.
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