Investing Investing Basics

20 Commonly Misunderstood Financial Terms You Must Know

These financial terms aren’t as complex as they appear.

By Sarah Sheehan

Edited by Chris Kissell

Updated Dec. 17, 2024

Think about the first time you rode a bike: Was it scary at first? Didn’t you start pedaling, feel the wind on your face, and wonder why you were ever afraid?

Learning how to manage your money is no different, and it starts with building your financial vocabulary.

Learning financial terminology can feel intimidating, but many of these terms are easy to grasp once they’re properly explained. And the more of them you understand, the better you’ll be at making wise money decisions.

Read through these 20 commonly misunderstood terms to boost your financial word bank today.

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A fee-only financial adviser helps you manage your money without receiving any commissions from the products or solutions they offer you.

Instead, you’ll pay them directly via a flat fee, an hourly rate, a monthly retainer, or a percentage of assets under management (AUM).

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Asset allocation

Asset allocation refers to how you divide money across different kinds of investments. What percentage do you have in stocks? What proportion of your portfolio is devoted to bonds? How diverse is your portfolio as a whole?

All of that information is your asset allocation.

Compound interest

Compound interest is interest that accumulates over time, based on your total account balance, both principal and interest. This can either work for you or against you.

When it comes to saving and investing, compound interest is your best friend. This interest grows on both your original principal and the past interest you have earned on that principal.

When it comes to borrowing, however, compound interest can increase the amount you owe at a rapid rate.

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Rebalancing

Rebalancing involves making changes to your asset allocation by buying and selling in a way that shifts money to specific types of investments.

If you have set a target asset allocation — such as 60% stocks and 40% bonds — you will continually rebalance to make sure you remain invested according to that original target asset allocation.

So, over time, you might adjust your investments to include more stocks or less bonds, for example, to get you back to your original target asset allocation.

Amortization

Amortization sounds complex, but it’s actually pretty simple: It’s just the process of making a predetermined monthly debt payment for a predetermined length of time.

While your monthly payment remains the same, the mix of principal and interest charges that make up that payment changes. At the beginning of your debt payments, you’ll pay more interest.

You’ll usually hear this term in reference to mortgage amortization, where you might agree to pay the same monthly payment for up to 30 years, for example.

Capital gains

Capital gains refer to how much an asset’s value has increased from the time you bought it to the time you sell it. For example, if you buy stock at $5 a share and later sell it for $10, that’s a $5 capital gain.

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Escrow

In real estate, an escrow account holds and protects funds from the buyer during the homebuying process.

For example, the buyer can use the escrow account to make a good-faith deposit so the seller knows they’re serious about the purchase. The seller can’t touch the deposit while it’s in escrow, however, so the buyer’s money is safe until the sale is complete.

Escrow accounts are sometimes later used by your mortgage lender to store money for your property taxes and homeowners insurance, too.

Principal

A loan’s principal is the amount borrowed before any interest is added on. If you take out a $5,000 personal loan, that $5,000 is the principal.

You’ll incur additional fees and interest charges based on your principal amount, so the faster you pay down that principal balance, the faster you pay off the loan.

Annual percentage rate

The annual percentage rate (APR) of a loan or line of credit is how much yearly interest you’ll pay on that debt plus other fees. It’s expressed as a percentage, like “3%” or “24.99%.”

If you’re not sure what APR you’re paying on your loans or credit cards, check your monthly statements. You should find the APR listed there.

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FICO score

Your FICO score is a measure of your creditworthiness. It’s a type of credit score that tells lenders how well you manage debts and how likely you are to make on-time payments.

FICO scores range from 300-850, and borrowers with scores above 670 are generally considered more reliable.

Delinquency

When you fall behind on your monthly debt obligations, the account enters delinquency. This is a fancy way of saying that your payments are past due.

If you’re late on your credit card or loan payments, try to catch up or make arrangements with your debt issuer within 30 days to avoid having your debt marked as delinquent.

Default

Default is more serious than delinquency. At this point, you’re so far behind on your monthly payments that the debt issuer isn’t sure you’ll catch up.

When you go into default, the consequences can be serious. For example, if you default on an auto loan, your lender might seize the car.

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Bankruptcy

Bankruptcy is a legal process that lets you discharge, or clear, past-due debts. You can also use bankruptcy to protect your property as you enter into a legally-binding payment plan with your debt issuers.

Bankruptcy has serious and long-lasting impacts to your finances, so it’s typically used as a last resort.

Premium

Your insurance premium is the amount you pay to the insurance company in exchange for coverage. You might pay premiums every month, every quarter, twice a year, or once a year.

Term life insurance

Term life insurance is life insurance that lasts for a set number of years. If you die within that time frame, your term life insurance policy kicks in, and your beneficiaries receive a payout. If you outlive the policy term, however, the insurance returns no monetary value.

Whole life insurance

Whole life insurance is a permanent life insurance policy that lasts as long as you make the premium payments. A portion of your premium is invested on your behalf, building cash value that you might be able to tap into while you are still alive.

Standard deduction

When you file your taxes, you can choose to take the standard deduction, a fixed amount that the federal government allows every taxpayer to use to reduce their taxable income. If you take the standard deduction, you can not take itemized deductions.

Itemized deduction

When you itemize your tax deductions, you calculate your write-offs one by one. Itemized deductions still reduce your income, but they require additional planning and documentation.

Taxpayers usually only itemize if it lowers their taxable income more than the standard deduction does.

Net worth

Net worth isn’t just for billionaires — we all have a net worth. It’s a simple calculation that compares your assets to your liabilities.

To figure out your net worth, add up the total value of your assets. Then, calculate your total liabilities. Subtract that number from your total assets. The result is your net worth. The higher this number, the better.

Time value of money

You know the saying, “a bird in the hand is worth two in the bush”? That’s time value of money (TVM) in a nutshell. TVM means that money you have right now is more valuable than money you might get in the future.

Why? Not only can the value of a dollar decrease over time, but you can invest the money you have today to generate more money tomorrow. You can’t guarantee the same results for money you don’t yet have.

Bottom line

An important part of protecting your finances is talking the talk. You can communicate more effectively with lenders, advisers, and accountants by asking smart questions and getting better answers.

Make it a point to learn key financial terms every chance you get. Be intentional about sharing your expertise too.

You’ll expand your own vocabulary and also elevate your loved ones’ knowledge, moving each of you one step closer to financial freedom and generational wealth in the process.

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