10 Confusing Financial Terms Explained
Do you ever listen to commercials or even go to your credit union or bank and they say things that just don’t really make sense to you? Or maybe you kind of know or you’ve heard them enough that you understand the concept, but don’t really get it? Here are 10 financial terms that often seem to confuse typical consumers that we hope to explain and give you a clearer understanding of these terms and how they impact your financial life.
1. APR and APY
a. APR is Annual Percentage Rate and is the annual rate charged for borrowing money. This includes any fees or additional costs associated with the transaction. It's a little broader than just the interest rate, since it includes any fees or other costs involved in obtaining the loan.
b. APY is Annual Percentage Yield. The definition of APY - APY is a percentage that represents the amount of interest an account earns in one year, including compound interest.
APY is a more accurate way to measure an investment's return than simple interest rates because it takes into account how often interest is compounded. When interest is compounded, it's added back to the balance, and future interest is calculated based on the new amount.
Now where’s what it really means. APY is only used for accounts that pay you money, like savings accounts, money market accounts, and CDs. It's important to note that APY's accuracy depends on the account owner not adding or withdrawing money from the account during the year.
So, APY is the rate you earn interest (money) and APR is the rate you pay interest (money).
2. Principal. The principal is the original amount of money you invest or borrow if it’s for a loan, therefore the amount before any interest or any earnings are added. For example, if you deposit $1,000 in a savings account, that $1,000 is your principal.
Same with a loan. If you are buying a car and the amount you borrow is $20,000, that’s your principal.
3. Interest. For a loan, the interest is basically the cost of borrowing money, and typically its a percentage of the principal. The percentage of interest you pay or earn depends on the terms of your loan or your savings account.
There are two main types of interest: simple and compound. Simple interest is calculated only on the principal amount. So, if you borrowed $1000 with simple interest, you pay interest on a $1000. For savings, if you deposit $1000 and that balance remains the same, you earn interest on that $1000.
Compound interest is admittedly a little more challenging to understand at times…
Compound Interest is the interest on a loan or deposit that is calculated based on both the initial principal amount and the accumulated interest from previous periods.
Let’s see if we can simplify that a bit. For a savings account, compound interest would be calculated on the principal plus any interest already earned. It's interest on interest. You earn money on what you deposited (or your principal) then on any interest you earn that is added to your balance, therefore you earn interest on that total amount.
For loans, like for your car or mortgage, they are typically going to us simple interest, so you your payments are set.
Something like Credit cards are ones that may use compound interest. An easy example is a credit card if you are carrying a balance on the card. Let’s say you charge $500 on your card. You will be charged interest on that amount. For example, if your card charges 10% interest on $500, thats $50. So now you would owe $550. That’s the cost of using the card services.
If you only pay part of that balance when the bill comes, for example $100 – that leaves you with a balance of $450. The next month, when the bill comes, you will owe that balance plus the interest on that balance. For this example, that was $450. Again at 10% interest, that’s $45. So now you add that $45 to the balance of $450 and your new balance you owe is $495. If you made any new charges during that time, then the interest will include whatever your new balance was with those charges.
So the interest you owe is compounding.
This is why we suggest paying your balances on your credit cards each month if you can or at the very least keep your balances low. The interest grows and is one of the reasons you often can’t get ahead on a credit card balance.
4. Amortization. This term refers to the process of spreading out a loan into a series of fixed payments over time. This would be for a loan that’s a set amount, like for a car. When you look at your payment schedule for your loan, each payment goes towards both the principal and the interest. In the beginning, a larger portion of the payment goes towards the interest, but as time goes on, more of it goes towards the principal as you pay down the loan. The interest is less because the principal balance is less. Your payment is a set amount each month, but less interest is charged because as you pay that principal amount down. As less interest is owed more of your payment goes to principal.
5. Credit Score and Credit Report. Credit is almost always a big topic and it feels like credit score is the main concern for many people. But a credit score and credit report are different things and they are both important.
A credit score is a number that represents your creditworthiness, or how likely you are to repay a loan. It's based on your credit history, including how much debt you have, how long you've had credit, and whether you pay your bills on time. Of course, the higher your score is, often the better rates you can qualify for, etc.
Your Credit Report is where all this information comes from. It’s where you can see balances and any issues with your credit like collections or any errors, which can be as simple as an incorrect mailing address. We recommend you check your credit report at least once a year to spot errors or even signs of identity theft early.
You’re entitled to a free credit report from each of the three major credit bureaus—Equifax, Experian, and TransUnion—every 12 months. You can also get a report from places like freecreditreport.com. This is giving you the information that is reported for your credit.
It’s important to stay on top of your credit report to ensure your credit score is accurately reflecting your financial habits and behavior.
6. Equity. You may hear this a lot especially for home owners when they are interested in selling, a second mortgage, line of credit or something similar.
Equity refers to the ownership of assets that may have debts or other liabilities attached to them. For homeowners, equity is the difference between the market value of a property and the amount still owed on its mortgage. While it can help for the loans we mentioned, it’s also important to build equity, as it represents the portion of the property you truly own.
7. Liquidity. Liquidity is the ease with which an asset can be converted into cash without affecting its market price. Highly liquid assets are things like cash or stocks because those can be sold quickly, whereas assets like real estate are considered less liquid because they take longer to sell.
8. Net Worth. I feel like people think they don’t have a net worth unless they are really wealthy, but that’s actually not necessarily the case. Net worth is the total value of your assets minus your liabilities. It gives you a snapshot of your overall financial health. For instance, if you have $100,000 in assets and $40,000 in liabilities, your net worth is $60,000.
9. Diversification. This is dealing with your investments. When you plan your investments, one of the things you look at is risk. If you are working with a financial advisor they will most likely discuss a risk management strategy with you to determine how much risk you want to take with your investments. Big risk is a double edged sword, right? Big return, but also risk of big loss. Maybe you prefer to invest on the safe side to not risk losing as much. A mix of investments within a portfolio is diversification. To clarify, your portfolio is all your investments. Your portfolio may be made up of several different investments with the idea being that a diversified overall portfolio will, on average, yield higher returns and but pose a lower risk than any individual investment found within the portfolio. The mix kind of balances it out so you don’t see huge losses but you are still making gains.
10. Yield. Yield refers to the income that’s generated by an investment, such as interest or dividends. This is expressed as a percentage of the investment's cost or current market value. It provides a snapshot of the income you can expect from an investment over a specific period, typically on an annual basis.
While we’re at it, let’s talk about return. Yield and return are both measures of an investment's performance, but they focus on different aspects.
Return, encompasses the total gain or loss on an investment, therefore, it will include both the income (yield) and any change in the investment's value, known as capital gains or losses. While yield focuses solely on the income component, return gives a more comprehensive view of an investment's performance because it accounts for the overall increase or decrease in value over time.
Understanding both of these can be truly beneficial in evaluating the performance of your investments.
So there you have it, the top ten financial terms that often confuse consumers. We hope this information was helpful in clarifying these concepts for you and that it can help you on your financial journey to financial success.