Our educational system has failed us pretty badly when it comes to financial literacy. In high school, we probably didn’t know what finance even meant. We were too busy giving the principle flak for being lame or dancing around the room with our fellow delinquent friends smoking marijuana (wait, that might just be scenes from The Breakfast Club, now that I think about it). In any case, everybody should know the following financial terms if they hope to get by as a fully functional adult.
1. Compound Interest
Compound interest can either be a thorn in your side if you owe it or a valued friend if you are accumulating it. If you are saving or investing money, then compound interest is interest that is paid on the principal sum you deposited or invested as well as any interest payments that have been added to it, earning you more money or interest on your interest. Hooray!!
When most of us think of interest, we think about owing money. But, compound interest can make a deposit or loan grow at a faster rate than simple interest. Simple interest is interest that is calculated only on the principal amount.
2. FICO Score
First off, it stands for Fair Isaac Corp. which is the company that first thought up this method for calculating credit scores. Depending on various factors such as payment history and your total debt or the total amount that you owe, a FICO score can either be closer to 850 (yay!) or closer to 300 (boo!). People who score below 620 might have some difficulty in procuring credit with a favorable (low) interest rate.
So, there are things called assets (what you own: like a car or a house) and then there are things called liabilities (this includes things like credit card debt and a mortgage on your house). When you take the difference between all that you owe and all that you own, you end up with your net worth. So add up everything you own and then subtract everything you owe. And voila! You have your net worth! It is important to know your net worth so that you understand how financially healthy you are.
4. Asset Allocation
Asset allocation is all about where you put your money (or, as they say, where you allocate your assets). You can choose to place money in stocks, bonds or actual cash dollars. Be careful where you choose to place money. For instance, while stocks may pay off in the long-term, they are also especially volatile and unpredictable. For this reason, a diversification of assets, as in not putting all your eggs in just one basket, is usually wise because you risk less and are still able to meet certain financial goals of yours.
Rebalancing is all about keeping track of your investments. In a diversified portfolio, some money may be invested in stocks, bonds, cash or CDs, for example. When the relative value of these investments changes because some gain value more quickly and others may even lose value (ugh!), you rebalance the percentages of your diversified portfolio — bringing them back to your desired percentage. Here’s an example of rebalancing from CNBC:
“Let’s say your target allocation is 60 percent stocks, 20 percent bonds and 20 percent cash. If the stock market has performed particularly well over the past year, your allocation may now have shifted to 70 percent stocks, 10 percent bonds and 20 percent cash. To rebalance your portfolio, you could sell some of your stocks and reinvest that money in bonds, or invest new money in bonds to bring the portfolio back to the original balance.”
6. Stock Options
This is good-old incentivizing from a company to its management. In other words, if a manager helps raise the company’s stock, then stock options allow the manager to buy their employer’s stock at a pre-set price. Managers are given the option to buy this stock at a lower price and then pocket the gain if they choose to sell it. This is a form of compensation that can be quite profitable depending on how the company performs and that, my friends, is what it is intended to encourage: performance.
7. Capital Gains
Capital gains refer to how much money property or an investment is worth at present, in relation to how much it was worth when it was originally purchased. This number really only exists on paper and is not that meaningful until the asset or investment is actually sold. Taxes must be paid when you sell a property or an investment at a profit, both on short-term gains (a year or less) and long-term gains (over a year).
Well, there you have it! Some important financial terms that we all should know. And now you can count yourself among the proud. The few. The a-little-bit more financially knowledgeable.
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