Not quite sure you’ve got a handle on basic personal finance terms? You’re not alone. The three most commonly missed questions on the National Finance Educators Council (NFCE) 2016 Financial Literacy Test pertained to important — but often misunderstood — personal finance terms like compound interest, and how to set financial goals and manage credit.
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Regardless of your age or earning power, it’s important to understand how common personal finance terms apply to your financial life: With this knowledge, you’ll be empowered to take control of your financial present and future.
Here are seven personal finance terms everyone should know:
1. Compound Interest
Compound interest can make the cash you invest or deposit into an interest-bearing account grow — and it can also make your credit card balance tough to pay down. It works by calculating interest on the initial principle balance and then on subsequent accumulated interest.
When it works to your advantage, compound interest grows the money you invest or deposit into an account, and compounds the interest you earn on it to increase the total account value over time. (Plug your own numbers into a compound interest calculator to see how it can help you reach your savings goals.)
On the flip side, when compound interest works against you, it can increase the balance on a loan or credit card that’s subject to compound interest rate charges (which may be calculated daily, monthly, semi-annually or annually).
2. Fixed Interest Rate v. Variable Interest Rate
A fixed interest rate typically won’t change, unless you miss a payment due date or otherwise fail to meet the terms of a loan or credit account (known as a penalty APR). There may be some circumstances when a fixed interest rate can increase, but only after you receive notice and an opportunity to opt-out of the increase.
Variable interest rates are based on a benchmark typically tied to a market interest rate. As that benchmark increased or decreases, the variable interest rate adjusts accordingly. An increase to your variable interest rate could push monthly loan payments higher than you can afford, and make loans more costly than you intend. In home financing, variable interest rate loans are sometimes called adjustable rate mortgages, or ARM loans.
3. Net Worth
Add what you own and subtract what you owe to arrive at your net worth, using a calculator like the one supplied by Bankrate. As the Huffington Post explains, your net worth can help you determine whether you’ve saved adequately relative to your debt, identify if you’re overexposed to any one asset class (like real estate) and measure financial progress throughout your life.
4. Asset Allocation
Investment or retirement strategies use asset allocation to diversify the investments you own; the goal is to improve your chances of earning maximum returns, while managing the degree of risk you take on in the process.
Your ideal asset allocation will change throughout your financial life — based on any number of factors, including the global economy, the amount of money you have to invest, your specific financial goals and how long you have to reach them.
5. Capital Gains and Losses
When you sell an investment that has increased in value, your profit is called a capital gain. Based on your income, the asset type and how long you’ve owned it, you could owe tax on profits from the sale, explains Bankrate.
If you sell an investment for less than you paid for it, you may be able to claim a capital loss, which may reduce the amount of tax you owe. If you have a combination of capital gains and losses, you may use a strategy called tax-loss harvesting to balance them out.
Capital gains and losses only apply when you sell an asset; you do not owe taxes simply because holdings in your investment or retirement accounts change in value.
6. Insurance Premiums and Deductibles
A premium is the amount of money you pay an insurer for the financial protection of an asset like a home, a car or your health (in the case of medical coverage); it may be paid monthly, quarterly or annually.
The deductible is the amount of money you agree to pay for damages or claims related to the asset covered in an insurance policy before the insurer will pay for a claim. A higher deductible may result in a lower insurance policy premium — and may require the policy holder to assume more financial responsibility in the process.
If your auto insurance policy has a $1,500 deductible, for example, you must pay up to that amount of money for a given claim out-of-pocket before the insurance provider will pay for damages beyond that amount.
7. Defined Contribution Plan
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A defined contribution plan refers to a retirement account — like a 401(k), 403(b) or similar retirement plan — that an employer offers to help employees save for retirement. Eligible employees designate how much money they want to contribute (up to a specific amount or the annual contribution limit), by way of payroll deductions.
Pretax contributions to retirement accounts may offer current tax advantages, by lowering an employee’s annual taxable income. (The future distributions are taxed when they’re made.)
CNN Money points out that employees who participate in defined contribution plans maintain ownership over the money invested in the plan when they change jobs.