Monday, March 1, 2021

7 money terms to know so you don't die broke

Knowledge is power, so think about how much better off you could be if you learn about your money.

"Financial education is key to unlocking the foundations of economic opportunity and powering a strong and resilient economy," says the U.S. Financial Literacy and Education Commission in a 2020 report noting people facing financial difficulties caused by the COVID-19 pandemic. Helping you access and understand financial resources will help you achieve greater financial recovery and resilience, it says.

However, our financial literacy rate is falling, not rising, the commission says. The average correct score on a six-question quiz about basic money decisions was merely three.

Most of us think we're financial geniuses, but we're not, says Emily Garbinsky, assistant professor of marketing at Notre Dame's Mendoza College of Business. "People generally hold positive illusions of being financially responsible because this enables them to feel good about themselves," she says, explaining her recent study about trying to change attitudes to help people save more money.

Decisions you make affect you in some way financially now and in the future. These seven terms are crucial not only for you to survive your current money situation but also to help you know how to make your money last at least as long as you do.

We'll start with where you are now.

Net worth

It's tough to feel positive about money if your net worth is negative. Your net worth is all of your assets minus all of your liabilities, or the value of everything you own after subtracting what you owe.

Computing your net worth gives you a snapshot of where you stand financially.

Tracking how your net worth changes over time will show you whether you're heading in the right direction financially -- and how your money habits can raise or lower it. You'll want to see your net worth generally rise as you get older.

To compute your net worth:

  1. Add up the value of your major assets: for example, your home, car, and all the money in your savings, checking and retirement accounts, and maybe the value of some big-ticket items such as jewelry, furniture and a 75-inch 4k TV.
  2. Add up the value of your debts: for example, your mortgage principal, car loans, student loans and credit card balances.
  3. Subtract No. 2 from No. 1.

While more than 1 in 10 U.S. households had a negative net worth as of 2017, according to a 2020 Census Bureau report, the median household net worth was $104,000 in 2017 (meaning half of households had a higher net worth and half had a lower net worth).

Compound interest

Money may not grow on trees, but it can grow by what's often called the magic of compound interest. Alas, so can debt.

For savings, compounding speeds up your earnings because, as your account balance grows, each new interest payment is based on a larger amount.

Say you open a $5,000 savings account paying 2% interest annually and don't touch it. After one year, you'd earn about $100 in interest and your balance would be around $5,100. But after five years, do you think you'd have more or less than $5,500?

The answer is more! That's because each year you're earning interest on the interest already paid to you as well as on your original balance. That's compounding! Leave that $5,000 for 20 years and the snowballing effect of compounding grows the account to more than $7,400.

Calculate compound interest with this calculator from the U.S. Securities and Exchange Commission.

Compounding works against you when you borrow money. That's why if you make a minimum credit card payment of 2% a month on a $5,000 credit card balance with a 20% interest rate, it would take you nearly 44 years to pay off the debt and cost you more than $20,000 in interest alone, according to  Debt.com's credit card payoff calculator.

Annual percentage rate (APR)

An APR, which stands for "annual percentage rate," is the annual cost you pay to use someone else's money to buy something.

It is often confused with "interest rate." That's because credit card interest rates that you see every month on your statements generally are stated as annual percentage rates. However, the APR on other types of debt, such as loans, reflects interest as well as fees and other charges.

A mortgage APR, for instance, includes the interest rate as well as costs like mortgage broker fees and discount points. Your car loan might have an origination fee included.

So, an APR is often higher than an interest rate. The federal Truth in Lending Act requires lenders to disclose the APR, among other figures, in writing when offering a loan.)

The money you pay for borrowing money is money you won't have around to enjoy later. The faster you pay off your credit card balances the more you'll save on interest payments. When you leave a credit card balance at the end of the month, you may start owing interest on any new purchase as soon as you say, "Charge it!", rather than owing interest only on your month-end balance.

Credit score

It pays to have a high credit score. Your credit score is a report card on how well you do repaying money you borrow -- your creditworthiness -- for home and car loans and using your credit cards.

A score differs from a credit report, which is a detailed record of your credit history. However, credit scores are based on information from your credit history.

Lenders look at your credit scores to decide if they should lend you money or extend credit, and at what interest rate. Generally, the higher your score, the more you can borrow (if you must) for, say, a home or car loan, and the lower the APR (see above) will be. This easily can save you -- or cost you -- tens of thousands of dollars over the life of a loan.

For example, a 30-year, $500,000 mortgage with a fixed rate of 3% would cost you about $259,000 in interest over 30 years, a FreddieMac mortgage calculator shows. If the rate were 4%, you would pay about $359,000 in interest -- $100,000 more.

There are many types of credit scores, but the most widely used are FICO scores, which are created by Fair Isaac Corp., aka FICO.

FICO says it scores you based on:

  • Your on-time payment history (comprises 35% of your score)
  • The amounts you owe, especially as a percentage of how much credit you have available (30%)
  • The length of your credit history (15%)
  • How much new credit you've sought recently (10%)
  • Your mix of credit cards, mortgage loans, installment loans and other debt (10%)

FICO scores mainly range from 300 to a perfect 850. So, a higher means you'll have more of your own money left after paying interest on what you borrow.

Inflation

You know $20 doesn't buy what it used to. As you get older, it will buy even less. That's inflation, eroding your purchasing power over time.

If you're working and seeing your wages go up, a little inflation won't seem like a big deal and may even be good for the economy overall. But if you stop working, or you're setting aside money that will last through a hopefully sweet retirement, inflation can sour your plans.

What $20 would buy in 1981 cost nearly $60 in December 2020, a Bureau of Labor Statistics calculator shows. In another 20 years, thanks to the same compounding mentioned above, with inflation even held at just 2% a year, what you can now buy for $60 will cost you close to $90 in 2041, another calculator shows.

To make sure your money lasts despite inflation, investigate low-risk investments such as insured high-yield savings accounts, CD's or Treasury securities or higher-risk aggressive investments such as index funds (see below) or stocks. Or you could also plan a lower-cost lifestyle.

Expense Ratio

It costs money to make money for you in a mutual fund.

A mutual fund is when you pool your money with other investors so fund managers can buy and sell mainly stocks or bonds for you. The cost of operating the fund is reflected in its expense ratio. Expenses can include management fees, advertising costs and even assembling and printing the fund's prospectus, the pamphlet that explains the fund's investment objectives, risks and, yes, those pesky fees.

The fees look like a tiny percentage of a fund's value. And you may not realize your paying them, as you don't write a check to cover them. They're taken from the fund. When it comes to fees, little things mean a lot, especially over time.

The Securities and Exchange Commission's Investor.gov website provides a great example: If you invest $10,000 in a fund with a 10% annual return and an expense ratio of 1.5%, after 20 years you would have roughly $49,725; another fund with a 10% annual return but an expense ratio of only 0.5% after 20 years would get you $60,858.

Compare the costs of owning mutual funds, especially when choosing 401(k) or IRA investments, to make sure fees don't take a big bite out of gains you're counting on to live on.

Index funds

An index fund merely mirrors the movement of a large basket of stocks reflecting the overall performance of the stock market. For example, the best-known S&P 500 index funds invest in the the 500 largest U.S. companies. Want a broader basket? A fund following the Russell 3000 Index will include stocks representing 98% of U.S. companies.

Because index funds don't need stock pickers, they need little management and take far fewer fees than funds whose managers try to beat the market.

The expense ratio of the Vanguard Russell 1000 Index fund, for example, was recently listed as 0.07%. Managed funds often range up to 2%.

Very few managed funds beat index funds like the S&P 500 over time, say analysts and even billionaire tycoon Warren Buffet. The S&P 500 averages about a 10% a year gain. So even if a managed fund beats the market by a percentage point or two, its fees may eat up the higher returns, meaning less money for you.

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