20 commonly misunderstood financial terms you need to know

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Think about the first time you rode a bike: was it scary at first? Didn’t you start pedaling, feeling the wind on your face and wondering why you were scared?

Learning to manage your money is no different, and it starts with building your financial vocabulary.

Learning financial terminology can seem daunting, but many of these terms are easy to understand once properly explained. And the more you understand them, the better you will be able to make sound financial decisions.

Read these 20 often misunderstood terms to boost your financial word bank today.

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Paid Financial Advisor

A paid financial advisor helps you manage your money without receiving any commission on the products or solutions they offer you. Instead, you’ll pay them directly through a fixed fee, hourly rate, monthly retainer, or percentage of assets under management (AUM).

Asset allocation

Asset allocation refers to how you allocate money between different types of investments. What percentage do you have in shares? How much of your portfolio is devoted to bonds? How diverse is your portfolio as a whole? All of this information is your asset allocation.

Compound interest

Compound interest is interest that accumulates over time, based on your total account balance, in both principal and interest. It can work for you or against you.

When it comes to saving and investing, compound interest is your best friend. This interest grows on both your original principal and any past interest you have earned on that principal. However, when it comes to borrowing, compound interest can quickly add to the amount you owe.

Rebalancing

Rebalancing involves making changes to your asset allocation by buying and selling in a way that moves money toward specific types of investments. If you have set a target asset allocation – such as 60% stocks and 40% bonds – you will continually rebalance to ensure that you remain invested at that original target asset allocation.

So over time you can adjust your investments to include more stocks or fewer bonds, for example, to bring you back to your initial target asset allocation.

Amortization

Amortization sounds complex, but it’s actually quite simple: it’s simply the process of making a pre-determined monthly payment of debt, for a pre-determined length of time. Although your monthly payment remains the same, the combination of principal and interest charges that make up that payment changes. When you start paying off your debt, you will pay more interest.

You’ll usually hear this term in reference to mortgage amortization, where you might agree to pay the same monthly payment for up to 30 years, for example.

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Capital gains

Capital gains refer to the increase in value of an asset between the time you bought it and the time you sell it. For example, if you buy shares at $5 a share and later sell them at $10, that represents a capital gain of $5.

Escrow

In real estate, an escrow account holds and protects buyer funds during the home buying process.

For example, the buyer can use the escrow account to make a good faith deposit so the seller knows they are serious about the purchase. However, the seller cannot touch the deposit while it is in escrow, so the buyer’s money is safe until the sale is complete.

Escrow accounts are sometimes used later by your mortgage lender to store money for your property taxes and home insurance.

Major

The principal of a loan is the amount borrowed before adding any interest. If you take out a $5,000 personal loan, that $5,000 is the principal.

You will have to pay additional fees and interest charges depending on the amount of your principal, so the sooner you pay off that principal balance, the sooner you pay off the loan.

Annual percentage rate

The annual percentage rate (APR) of a loan or line of credit is the annual amount of interest you will pay on that debt, plus other fees. It is expressed as a percentage, such as “3%” or “24.99%”.

If you’re not sure what APR you’re paying on your loans or credit cards, check your monthly statements. You should find the APR there.

FICO score

Your FICO score is a measure of your creditworthiness. It’s a type of credit score that tells lenders how well you manage your debts and how likely you are to make payments on time.

FICO scores range from 300 to 850, and borrowers with scores above 670 are generally considered more reliable.

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Delinquency

When you fall behind on your monthly debts, the account goes into overdue. It’s a fancy way of saying your payments are overdue.

If you are behind on your credit card or loan payments, try to catch up or make arrangements with your debt issuer within 30 days to avoid your debt being considered overdue.

Fault

The defect is more serious than the delinquency. At this point, you’re so behind on your monthly payments that the debt issuer isn’t sure you’ll catch up.

When you are in default, the consequences can be serious. For example, if you default on a car loan, your lender could seize the car.

Bankruptcy

Bankruptcy is a legal procedure that allows you to discharge or erase outstanding debts. You can also use bankruptcy to protect your property when you enter into a legally binding payment plan with your debt issuers.

Bankruptcy has serious and lasting impacts on your finances, so it is generally used as a last resort.

Prime

Your insurance premium is the amount you pay to the insurance company in exchange for coverage. You can pay premiums monthly, quarterly, semi-annually, or once a year.

Term life insurance

Term life insurance is life insurance that lasts for a certain number of years. If you die within that time, your term life insurance policy takes effect and your beneficiaries receive a payment. If you outlive the term of the policy, however, the insurance returns no cash value.

Whole life insurance

Whole life insurance is a permanent life insurance policy that lasts as long as you pay the premiums. A portion of your premium is invested on your behalf, creating cash value that you may be able to tap into during your lifetime.

Standard deduction

When you file your taxes, you can choose to take the standard deduction, a fixed amount that the federal government allows each taxpayer to use to reduce their taxable income. If you take the standard deduction, you cannot take itemized deductions.

Detailed deduction

When you detail your tax deductions, you calculate your depreciation one by one. Itemized deductions still reduce your income, but they require additional planning and documentation. Taxpayers generally only itemize if it reduces their taxable income more than the standard deduction.

Net value

Net worth isn’t just for billionaires – we all have net worth. It’s a simple calculation that compares your assets to your liabilities.

To determine your net worth, add up the total value of your assets. Next, calculate your total liabilities. Subtract this number from your total assets. The result is your net worth. The higher this number, the better.

The time value of money

You know the saying “a bird in the hand is worth two in the bush”? That’s Time Value of Money (TVM) in a nutshell. TVM means the money you have now is more valuable than the money you might get in the future.

Why? Not only can the value of a dollar decrease over time, but you can invest the money you have today to generate more money tomorrow. You can’t guarantee the same results for money you don’t already have.

At the end of the line

An important part of sound money management is talking. When you know the jargon, you can read contracts with a keener eye. You can communicate more effectively with lenders, advisors and accountants. You can ask smart questions and get better answers.

Be sure to learn key financial terms whenever you get the chance. Also, be intentional about sharing your expertise. You will expand your own vocabulary and also improve the knowledge of those close to you, bringing each of you one step closer to financial freedom and generational wealth in the process.

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This article 20 Commonly Misunderstood Financial Terms You Need to Know originally appeared on FinanceBuzz.

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