Key Concepts & Terms in Personal Finance

In order to understand and succeed in personal finance, it is important to speak the language. Many terms are used universally, and articles and blog posts will assume you already know what these terms mean. Maybe you already do, but to make sure we’re all on the same page, let’s go through some of the key concepts and terms you will want to know when exploring the world of personal finance.

1. Budget: A budget is simply a plan for your money over a specified period of time. It details income, expenses, and savings, and allows you to allocate and track your money in order to meet your financial goals.

2. Income: Income is money gained from various sources that is available to be allocated in your budget. Note: This does not include gains that are locked away in investments like your 401(k) as those are not accessible (at least not easily). Income could come from your salary or wages, business profits, rental income or investment returns that are paid out to you.

3. Expenses: Expenses represent money spent on various items and services. This includes critical items like housing, food, and transportation, as well as discretionary items like entertainment and gym memberships. Managing your expenses effectively is a crucial skill for maintaining a balanced financial life.

4. Savings: Savings describes the portion of income set aside for future use or for emergencies. Building savings is critical to achieve financial stability and independence.

5. Interest: Money paid at regular intervals either as the cost of borrowing money or the return on savings or investments. This is usually expressed as a percentage and can have a significant impact on the cost of borrowing money or the return from investments.

6. Credit Score: A numerical score of an individual’s credit worthiness used to assess how likely an individual is to repay borrowed money. Note: This is NOT a measure of an individual’s financial success, contrary to popular misconceptions.

7. Compound Interest: Interest calculated on the initial principle amount and any accumulated interest. It can significantly increase savings and investments or increase debt over time. Each period, interest is calculated on the current balance of the account. This interest is then added to the balance so that the next calculation includes the interest. Credit card balances are a common example of compound interest.

8. Inflation: Inflation is the rate at which the general price of goods and services rises over time. As inflation increases the cost of goods and services, it erodes the purchasing power of money. This is why investing and growing wealth are important to outpace inflation.

9. Asset Allocation: refers to the distribution of investments across different asset classes, such as stocks, bonds, or real estate.

10. Financial Planning: The process of setting financial goals, assessing current financial status, and creating series of steps to achieve those goals. Financial planning involves many factors including budgeting, saving, investing, risk management, and retirement planning.

11. Retirement Planning: Setting aside funds and creating investment strategies to ensure your desired retirement. You should consider factors such as desired retirement age, desired lifestyle in retirement, current retirement savings, and how long you have to build your retirement savings. The earlier you start planning for retirement, the greater your savings can grow and the more flexibility you will have.

12. Risk Management: Risk management is the process of identifying potential events or costs that could negatively impact your personal finances and making plans to mitigate them. These could include health emergencies, accidents, or loss of income, to name a few. In some cases, insurance may be available to offload the financial risk.

13. Diversification: A risk management strategy for investments which involves spreading investments across different asset classes and/or sectors to mitigate damage should any single investment area perform poorly.

14. Liquidity: The ease with which an asset or investment can be turned into cash without a significant loss in value. Liquid assets are easy to access and can be used to cover immediate needs. Money is a savings account is an example of a very liquid asset, while money invested in a retirement account is much less liquid as withdrawing it (before the age of 59 ½) will result in penalties.

15. Debt-to-Income Ratio: A measure of a person’s debt obligations relative to their income. This is often used by lenders to gauge an individual’s ability to take on more debt, and is usually measured as monthly debt payments compared to monthly income. A high debt-to-income ration may preclude you from getting more loans. Note: This typically only looks at debts you owe, not monthly expenses. As such it can often overestimate your ability to take on more debt.

Understanding these concepts and terms empowers you to take charge of your financial life by making informed decisions. Increasing your knowledge of personal finance allows you to develop effective strategies for your financial future and makes you more confident in your financial decisions. It’s your financial life; take hold of it and steer yourself toward a better future.