The first part of this series was published last week. You can check it out here.
The following terms might help you understand better the world of personal finance. This is by no means exhaustive.
Emergency Fund: This is an account for funds (money) set aside in case of the event of a personal financial difficulty, such as loss of a job, a debilitating illness or an unforeseen major repairs to your home. Most financial professionals recommend between 3-6 months of your monthly expenses (not your income) in your emergency fund. So for example, if it takes about $3,000 to run your household in a month, you should keep between $9,000 – $18,000 in a dedicated account (preferably a high-yield online savings or money market account). Personally we use Ally bank and they currently give 1.85% APY in their online savings account.
Equity (Home Equity): The fair market value of a home minus the unpaid mortgage principal and liens. You build up equity in a home as you pay down your mortgage and as the property value increases.
Escrow: An account held by an impartial third party on behalf of two parties in a transaction. During the home-buying process, the buyer will deposit a specified amount in an escrow account that neither party can access until the terms of the purchase contract, such as passing an inspection, have been fulfilled and the sale is completed. An escrow account can also hold money that will later be used to pay your homeowners insurance and property taxes. You can put money in escrow every month, so that when your premiums and taxes are due, you have enough to cover those bills.
Exchange-Traded Funds (ETF): This is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors. It is very common with millennial investors, especially those who use robo-advisors to invest.
Foreclosure: When a borrower is in default on a loan or mortgage, the creditor can enact a legal process to claim ownership of the collateral property. Foreclosure usually involves a forced sale of the property where the proceeds go toward paying off the debt.
Garnishment: When a creditor receives legal permission to take a portion of your assets (bank account, salary, etc.) to repay a delinquent debt.
Hard Inquiry: A record of a business request to see your credit report data for the purpose of an application for credit. Hard inquiries appear on your credit report each time you complete an application for a credit card, loan, cell phone, etc. Hard inquiries remain on your credit report for 2 years but are only included in your credit score for the first 12 months.
Home Equity Line Of Credit: Often called a HELOC, is an open-ended loan that is backed by the part of a home’s value that the borrower owns outright. This type of loan is used much like a credit card. You can use a HELOC to borrow large sums of money with a relatively low interest rate. These types of loans should however be used with caution. If a borrower is unable to pay back the loan for some reason (loss of job, illness, etc.) they risk loosing the home they used as collateral.
Index (Stock or Bond): Stock and bond market indices consist of a hypothetical portfolio of securities representing a particular market or a segment of it. The S&P 500 (Standard & Poor’s 500) and the US Aggregate Bond Index are the most common benchmarks for the American stock and bond markets, respectively.
Index Funds: Because you cannot invest directly in an index, index funds (these are essentially mutual funds) are created to track their performance. These funds incorporate securities that closely mimic those found in an index, thereby allowing an investor to bet on its performance, for a tiny fee. An example of a popular index fund is the Vanguard S&P 500 Index fund with the ticker symbol, VFINX, which closely mirrors the S&P 500 index.
Interest: The money a borrower pays for the ability to borrow from a lender or creditor. Interest is calculated as a percentage of the money borrowed and is paid over a specified time.
Itemized Deduction: A qualified expense that the IRS allows you to subtract from your AGI (Adjusted Gross Income) that helps further reduces your taxable income. Itemized deductions can include mortgage interest you paid, property taxes on your real estate, state and local income taxes, medical and dental costs, or gifts to charity. Itemized deductions must be noted on IRS form Schedule A when you file your taxes. See Standard Deductions later.
Jumbo Mortgage: A loan that exceeds the limits set by Fannie Mae and Freddie Mac (the largest mortgage investors), usually when the loan amount is more than $450,000 in most of the country. Also known as a non-conventional or non-conforming loan, these mortgages usually have higher interest rates than standard loans. These kind of loans are typically common in high-cost of living areas where real estate is very expensive (hello CA, NY).
Layaway: A method of paying for merchandise through several installments; the merchandise is set aside for the client until it is paid for in full. Stores like Wal-Mart offer this service, aimed at indigent customers
Liabilities: The debts and other financial obligations of a person or company; the opposite of assets.
Lien: A legal claim against a person’s property, such as a car or a house, as security for a debt. A lien (pronounced “lean”) may be placed by a contractor who did work on your house or a mechanic who repaired your car and didn’t get paid. The property cannot be sold without paying the lien. Tax liens can remain on your credit report indefinitely if left unpaid or for 15 years from the date paid.
Loan Origination Fee: A fee charged by a lender for underwriting a loan. The fee often is expressed in “points”. A point is 1% of the loan amount.
Loan-to-Value Ratio (LTV): The percentage of a home’s price that is financed with a loan. On a $100,000 house, if the buyer makes a $20,000 down payment and borrows $80,000, the loan-to-value ratio is 80%. When refinancing a mortgage, the LTV ratio is calculated using the appraised value of the home, not the sale price. You will usually get the best deal if your LTV ratio is below 80%.
Mortgage Refinance: The process of paying off and replacing an old loan with a new mortgage. Borrowers usually choose to refinance a mortgage to get a lower interest rate, lower their monthly payments, avoid a balloon payment or to take cash out of their equity.
Mutual Funds: A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s investments and attempt to produce capital gains and/or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus. Mutual funds can be actively managed or passively managed. Passively managed mutual funds are often synonymous with Index Funds (see above). Theoretically and statistically, this is the most cost-effective and most efficient way to invest for the average individual investor. It is the lazy man’s way of investing without having to do any research, yet using index funds will guarantee you will beat more than 80% of professional and individual investors who invest actively.
Net Worth: The difference between your assets and liabilities. You can calculate yours by adding up all of the money or investments you have, including the current market value of your home(s) and car(s), as well as the balances in any checking, savings, retirement or other investment accounts. Then subtract all of your debt, including your mortgage balance, credit card balances and any other loans or obligations. The resulting net worth number helps you take the pulse on your overall financial health. It makes sense to calculate your net worth at least once yearly; it gives you a broad idea of how you are doing financially.
Overdraft: The extension of credit by a lending institution which allows withdrawals to exceed deposits in a bank account.
Payday Loan: This is usually a small, short-term loan that is secured by the borrower’s next paycheck. The interest charged on these loans is often astronomical. It is similar to Title Loans, whereby you give the lender the title to your car as collateral. As a general rule, do NOT ever get a payday or Title loan!
Permanent Life Insurance: A type of policy that provides coverage over the lifetime of the insured and also offers a component called cash value that you can tap into while you’re still alive. Using the cash value, however, means you could reduce your death benefit and may owe taxes. Premiums for permanent life insurance are typically much more expensive than for Term Life Insurance. For the majority of people, the latter is preferable.
PITI: Acronym for the four elements of a mortgage payment: Principal, Interest, Taxes (Property taxes) and Insurance (Homeowners insurance)
Pre-Approval Letter: A document from a lender or broker that estimates how much a potential homebuyer could borrow based on current interest rates and a preliminary look at credit history. The lender usually would include in this letter, what they call a Good Faith Estimate (GFE). Having a pre-approval letter can make it easier to shop for home and negotiate with sellers. It is better to have a pre-approval letter than an informal pre-qualification letter.
Pre-Payment Penalty: A fee that a lender charges a borrower who pays off their loan before the end of its scheduled term. This is often charged to subprime borrowers (those with poor credit). Do well to look at the fine print in your mortgage documents to make sure there is no pre-payment penalties, especially if you want to pay your mortgage off before the end of its scheduled term.
Pre-Qualification Letter: A non-binding evaluation of a prospective borrower’s finances to determine how much he or she can borrow and on what terms. A pre-qualification letter is a less formal version of a pre-approval letter.
Principal: The amount of money borrowed with a loan or the amount of money owed, excluding interest.
Premium: The payments you make to an insurance company to maintain your coverage. You can pay premiums monthly, quarterly, semiannually or annually.
Private Mortgage Insurance (PMI): It’s a type of insurance that mortgage lenders require when homebuyers provide a down payment of typically less than 20%. The premiums are usually tacked onto the amount homeowners pay each month. For some mortgages, once your LTV ratio reaches 80%, you no longer have to pay PMI, but in some cases, it is permanent for the life of the loan. PMI typically costs between 0.5% to 1% of the entire loan amount on an annual basis. This means that on a $100,000 loan you could be paying as much as $1,000 a year – or $83.33 per month – assuming a 1% PMI fee. My general rule of thumb is if you don’t have a 20% down payment, you’re not ready to buy a home yet.
Rebalancing: The process of buying or selling investments over time in order to maintain your desired asset allocation. For example, if your target allocation is 60% stocks, 20% bonds and 20% cash, and the stock market has performed particularly well over the past year, your allocation may now have shifted to 70% stocks, 10% bonds and 20% cash. If you wanted to return to that 60/20/20 asset allocation, you’d have to sell some stocks and buy some bonds.
Repossession: When a loan is significantly overdue, a creditor can claim property (cars, boats, equipment, etc.) that was used as collateral for the debt.
Reverse Mortgage: A mortgage that allows elderly borrowers to access their equity without selling their home. The lender makes payments to the borrower with a reverse mortgage. The loan is repaid from the proceeds of the estate when the borrower moves or passes away.
Settlement: An agreement reached with a creditor to pay a debt for less than the total amount due. Settlements can be noted on your credit report and can negatively impact your credit score. The only time it is a good idea to settle a debt is if the debt has already gone to collections or is significantly past due. Settling a debt that is current and in good standing can have a severe negative impact on your credit score.
Soft Inquiry: A type of inquiry that does not harm your credit score. Soft inquires are recorded when a business accesses your credit data for a purpose other than an application for credit. Soft inquiries include your request to see your own credit report and employment-related requests. This type of inquiry is recorded by the credit bureaus but does not usually appear on a credit report purchased by you or a business.
Standard Deduction: A standard amount that can be used to reduce your taxable income if you decide not to itemize your deductions. Your standard deduction is based on your tax-filing status, and it’s the government’s way of ensuring that at least some of your income is not subject to tax.
Stocks: Also called equities or shares, stocks give you ownership in a company. When you buy stocks, you become a company shareholder, giving you a claim on part of that company’s assets and earnings.
Stock Market: This is an everyday term we use to talk about a place where stocks and bonds are “traded” – meaning bought and sold. For many people, that is the first thing that comes to mind for investing. The goal is to buy the stock, hold it for a time, and then sell the stock for more than you paid for it. You can see the definitions of some basic stock market terms here and here.
Term Life Insurance: A type of policy that provides coverage over a set period, generally anywhere from 10 to 30 years. If you die within the set term, your beneficiaries receive a payout. If you don’t, the policy expires with no value.
Unsecured Debt: A loan on which there is no collateral. Most credit card accounts are unsecured debt.
Utilization Ratio: The ratio between the credit limits on your accounts and the outstanding balances. This ratio shows lenders how much of your available credit you are using overall. If you use credit card and want to keep your score high, aim to keep your utilization ratio <30%.
Were you familiar with all these terms? Did you learn a new term here? Which common ones did I miss? Comment below.
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4 thoughts on “Common Personal Finance Terms And Their Meanings II”
Thanks for simplifying the terms, it makes more sense.
There are soo many financial terms. Thanks for isolating the most important ones here. I will link back to some of these terms in my blog posts.