Have you ever traveled to a place where they speak English, but the people have a heavy accent and a different dialect? You have a vague and slowly formed idea of what they are saying, but it can make you feel confused. Most of us feel that same confusion when dealing with personal finance issues.
Money Talks… But Do You Speak the Language?
Personal finance uses a whole other language, set of rules and way of thinking. Money talks, but it has its own way of saying things. Don’t feel bad if you don’t always understand.
Financial Concepts You Need to Know
Some financial concepts are indeed complicated, but most can be understood if you slow down. Here are a few plain language definitions to help you understand what money is trying to say.
We are also supplying links that enable you to easily apply the concepts to your own situation. Sometimes the best way to understand something is not by listening to a chattering expert, but through trial and error.
Here are a few of the financial terms we all have been exposed to, but may not fully grasp.
Inflation
Inflation is when the prices for goods and services go up and the purchasing power of the dollar goes down. As an example, Sam Ewing is quoted as saying, “Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”
Most working households can tolerate inflation if their wages are growing at the same rate or faster than inflation. However, in retirement it can be especially difficult to keep income on pace with inflation.
We have been lucky over the last 10 or so years because inflation has remained very low. A dramatic increase in inflation will seem like Ronald Reagan’s characterization of it: “as violent as a mugger, as frightening as an armed robber and as deadly as a hitman.”
See how different inflation rates might impact your retirement plans.
Assets
In the world of personal finance, assets refers to property owned by a person or company. However, you would not necessarily include everything you own as assets. You would only include things of value that could be available to pay off debts, commitments, or legacies.
Other words nearly synonymous with assets include holdings, resources, investments, and possessions.
Add up your assets with the retirement calculator.
Diversification
You know about diversity – people of different backgrounds and cultures. Diversification in finance is similar, it simply means having your money in different kinds of holdings. If your assets are well diversified it might mean that you keep your money in a variety of ways: cash, stocks, mutual funds and real estate.
You can also think about how to be diversified within one kind of asset class. If you own stocks, you might want to own a wide variety of companies in different types of industries. And if you own one type of company, you might want to diversify to all companies in that category.
Financial professionals think that assets should be diversified because if one type of investment is problematic, another one might do well.
Assess your diversification and other risks with the retirement calculator.
Hedge, Hedging, Hedges
You know what it means to hedge your bets.
A hedge is a kind of plan B. A hedge is a financial strategy that tries to take away risk. There are many easy and complicated ways to hedge your finances. Being diversified is one way to hedge.
Cash Flow
Cash flow in personal finance refers to the amount of money being paid out every period and the amount of money coming in every period.
- Positive cash flow means that you are spending less than you are earning.
- Negative cash flow means that are earning less than you are spending.
Use the retirement calculator to assess your cash flow now and projected throughout your retirement.
Rate of Return
The rate of return refers to the profit or the loss on an investment over a specific period of time, expressed as a proportion of the original investment. So, if you invested $1,000 and after one year your investment was worth $1,100, your annual rate of return would be 10%.
See what happens to your retirement savings at different rates of return.
Risk Tolerance
Risk tolerance is defined on Investopedia as the degree of variability in investment returns that an investor is willing to withstand. If you can afford to lose significant money within a specific time period, then you have a high risk tolerance. If you need to be able to access the income, then you have a low risk tolerance.
Assumptions
When you are calculating your finances, you sometimes need to make assumptions. Assumptions in financial models are the inputs that we are uncertain about. For example, we don’t know if our investments will do well or not, but if we want to predict how much money we will have in 10 years, we have to assume some kind of rate of return. The assumed rate of return is an assumption.
Assumptions that can dramatically impact your retirement planning include:
- Rate of return on investments
- Inflation – the cost of goods and services
- Housing inflation – home prices do not always rise or fall at the same rate as general inflation
- Medical cost inflation – medical costs have been rising dramatically faster than general inflation.
When retirement planning, it is useful to see what happens to your financial security with different values for different assumptions.
Set your own values for assumptions and explore what happens to your plans.
Home Equity
Home equity is the value of ownership in your home. If you have paid off your mortgage, your home equity is equal to the current value of your home. However, most people who own their homes also have a mortgage. The home is yours, but you borrowed money to buy it. Home equity is the value of your home less the amount you still owe on the mortgage.
The amount of home equity you own grows every time you make a mortgage payment against the loan principle. Your home equity can also grow as the home appreciates in value.
Home equity can be a powerful way to fund your retirement. You can downsize and release the equity or get a reverse mortgage if you want to stay put.
Use a retirement calculator to explore how using your home equity might impact your overall retirement plan.
Present Value/Future Value
This should be simple. Present value simply refers to what something is worth now. Future value refers to what something will be worth in the future given a set of assumptions.
It seems obvious, but it can get a little bit tricky to think about when you are planning your retirement. Consider your home. It may be worth $400,000 now. If you have an assumption of 1.5% for appreciation, then the future value of the home in 20 years is $550,000. However, if it appreciates at only 1%, then the future value is only $500,000.
Now imagine that you want to downsize at a point in the future to release home equity, you need to be able to calculate the future value of your current home as well as the future cost of a smaller residence so that you can estimate how much money you will have access to at that time.
Lifetime Income
Lifetime income refers to income that you will receive for as long as you live, no matter how long that turns out to be. Guaranteed lifetime income will be there no matter what.
Social Security will continue to send you checks whether you live to 85, 105 or longer. Social Security is reliable guaranteed lifetime income.
When planning for retirement, you ideally want to establish a lifetime income stream that equals your expenses. The most common sources of guaranteed lifetime income are Social Security, most pensions, and lifetime annuities.
You might also have unguaranteed lifetime income sources from rental property or other investments.
Add up your lifetime income (as well as income from other sources) in the retirement calculator.
