April is Financial Literacy Month, and it is a great time to get back to the basics of finances, setting financial goals, and doing what you need to in order to build a solid financial foundation. One way you get handle on your finances is to understand the following 8 financial terms:
1. Interest: This is the right to claim participation or a share in something. Most often, interest represents the money charged by a lender for the privilege of allowing you to borrow it. If you get a loan, you pay a premium, usually expressed as an annual percentage of the loan balance. The more of a risk you are, the higher the interest you pay. However, interest can work in your favor. When you provide money to others, by investing in bonds or buying stocks, you receive a return in proportion to what you have put in (assuming, in the case of many investments, that the value has increased).
2. Asset: An asset is something that provides value. It has positive economic value, and can be converted into cash (hopefully with some hope of return). Assets can include investments that are doing well, property and cash, among other items. Assets offer a return, meaning that you have the potential to be on the receiving end of interest.
3. Liability: This is an obligation you have. It means owe someone something. This is debt. Not only do not have money available, but you often pay interest as well. Your credit card loans, auto loans and even your mortgage represent liabilities. Also, if you have items that depreciate in value over time, that can be considered a liability.
4. Net worth: Understanding your net worth is very important. Net worth expresses the worth of your holdings after you have subtracted out your obligations. To figure your net worth, you add up the total value of your assets (including the market value of your home). Then you add up the total amount of your liabilities (including what you owe on your mortgage) and subtract it from your asset total. What’s left over is your net worth. This can provide you with a helpful starting point for any financial plan.
5. Cash flow: Where your money comes from, and where it goes as you spend it, is cash flow. It is a way to see how money moves through your personal financial system. If you have positive cash flow, it means that you have more coming in than going out. Negative cash flow means that you are spending more than you earn. Looking at your cash flow can help you determine whether you need to change habits to work toward a positive cash flow situation.
6. Five C’s of credit: These are used to determine whether or not you will get a loan, and, if you are approved, what sort of interest rate you will have. These C’s include capacity, character, capital, collateral and conditions. You have to show that you have the ability to handle a loan, and that your past history (your character) show that you are responsible. Understanding what you need to do in order to be approved for credit can help you make better financial decisions.
7. Inflation: As time passes, the cost of goods and services rises. This is known as inflation. What takes $1.00 to purchase now, may take $1.25 or $1.50 or $2.00 to purchase in the future. Inflation erodes your purchasing power. Understanding this can help you plan for the future, choosing to invest in assets that are likely to help you overcome the ravages of inflation.
8. Asset allocation: When you purchases assets, it is important to have them spread out in a way that is likely to help you beat inflation, while limiting your risk of loss. This means deciding how much of portfolio should go into stocks, bonds, cash and other investments. Your asset allocation should reflect your financial goals and how much time you have to reach them.