Key Personal Financial Terms Everyone Should Know
It does not matter whether you hire an accountant or an advisor to handle your finances, understanding basic financial concepts will only help you manage your investments better.
Below is a glossary that describes the frequently used financial jargons.
Defined as a sustained increase in the general level of prices for goods and services, inflation reflects a reduction in the purchasing power per unit of money. The value of money is observed in terms of purchasing power, so the higher the rate of inflation, the lower is your purchasing power.
While it influences the economy it also affects the investors. It tells investors exactly how much of a return their investments need to make for them to maintain their standard of living. For example – if a certain stock returned 4% and inflation was 5%, then the real return on investment would be minus 1% (5%-4%). In India the inflation rate averaged 8.98 percent from 2012 until 2014.
Generating earnings from previous earnings is referred to as compounding. In Scripbox terms, making your money work hard.
For example, let’s say you invested INR 10,000 and it earned an interest if INR 1000 in the first year. Now, for the second year, if you don’t make any more investments and assuming the interest rate remains the same at 10%, you will generate an interest amount of INR 1100 for second year. The interest earned in the first year, generated additional interest in the second year. This way, your money keeps on growing until withdrawn. This is called compounding. It is one of the fundamental ways to build wealth.
Interest Rate (Floating, Fixed, and Reducing)
An interest rate is the rate at which interest is paid by borrowers for the use of money that they borrow from lenders.
A fixed interest rate stays constant throughout the duration of the loan however.
A floating interest rate is based on a base rate which is controlled by the RBI and can change over the duration of the loan. Floating interest rates can affect your interest payable and could increase/decrease your monthly instalment amount.
A reducing or diminishing interest rate is calculated on the outstanding loan balance every month. Interest Payable per Installment = Interest Rate per Installment * Remaining Loan Amount.
Time value of money
Time value of money is a concept based on the idea that the value of money available at the present time is worth more than the same amount in the future.
For example, INR 100 invested today for one year at a 5% interest rate will be worth INR 105 in the next year, therefore, INR 100 paid now and INR 105 paid one year later have exactly the same value.
Volatility refers to the amount of uncertainty or fluctuation in the value of an investment. In other words, volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value.
It is a rate at which the price of a security increases or decreases for a given set of returns. Volatility is measured by calculating the standard deviation of the annualized returns over a given period of time.
It is an investment strategy which aims to balance risk and reward. In other words, it is the process of deciding the proportion of your portfolio dedicated to various assets based on your goals, risk tolerance, and time sphere.
The three major asset classes include equity, real estate, and fixed income. Each of these classes reacts differently to different economic conditions. Hence it is wise to diversify your portfolio and spread your investments across multiple asset classes.
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The difference between your assets and liabilities is referred to as net worth. You can calculate your overall financial health by adding up all of the money and investments and subtracting all the debt from the grand total. The resulting amount is your net worth.
Credit score is a numeric representation of a person’s credit files and defines a person’s creditworthiness. It is used by lenders to assess whether the person will be able to clear off his debts.
Lenders use credit scores to determine who qualifies for a loan, at what interest rate, and what credit limits. The score ranges from 300 to 850 – the higher the number, the more creditworthy the person is deemed to be.
The increase in the value of an asset or investment, like a stock or real estate, above its original purchase price is called a capital gain.
Rebalancing involves buying or selling assets periodically 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. To rebalance your portfolio, you could sell some of your stocks and reinvest the amount in bonds and rebalance your portfolio.
Stocks are a type of investment or security which gives you part-ownership in a company. Also referred to as shares or equity, stocks give you a claim on part of the company’s assets and earnings. The more stocks you own, the higher is your ownership stake in the company.
There are two types of stocks, common and preferred. A common stockholder can vote at shareholders meetings and receive dividends. Preferred stockholders have a higher claim on assets and earnings than owners of common stock but do not have any voting rights.
A bond is a debt investment or a loan issued to a corporate or governmental entity for the purpose of raising capital. A bond is a promise to repay the principal along with the fixed interest for a defined period of time. Some bonds do not pay interest, but all bonds require a repayment of principal.
An equity investment generally refers to the buying and holding of shares of stock in anticipation of income from dividends and capital gains. However, in the context of real estate, it is the difference between the current market value of the property and the amount the owner still owes on the mortgage. In other words, it is the difference between the current value of the property and the amount that the owner owes against it.
Term insurance is a traditional form of life insurance which offers life coverage for a specified duration of time or a specified “term” of years. Term insurance provides only insurance cover and does not offer money back on maturity.
Available for a range of 10-30 years, term insurance is the cheapest and most recommended type of life insurance policy.
Premium for Life Insurance
A premium is an amount to be paid periodically for a contract of insurance. The premium amount is calculated based on several parameters like age, type of employment, medical condition of the insured person, etc. The premium amount can be paid in monthly, quarterly or annually for a defined period of time.