Financial Definitions

 

 

Here you will find definitions for a  number of common (and not so common) financial terms listed alphabetically.

We hope you find them useful.

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401K – A qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis. Caps placed by the plan and/or IRS regulations usually limit the percentage of salary deferral contributions. There are also restrictions on how and when employees can withdraw these assets, and penalties may apply if the amount is withdrawn while an employee is under the retirement age as defined by the plan. Plans that allow participants to direct their own investments provide a core group of investment products from which participants may choose. Otherwise, professionals hired by the employer direct and manage the employees’ investments.

Accelerated Payments – A term associated with making additional unscheduled payments on a loan at predetermined, or random intervals. Making additional unscheduled payments reduces the principal balance of the loan, meaning that more principal and less interest is paid off in subsequent payments. Making accelerated payments will lead to the early pay-off of a loan. Most loans have an amortization schedule that defines how much principal and interest will be paid with each scheduled payment, so that the loan will be paid-off at the end of an established term.  Also, the amount of interest paid with each payment is a function of the remaining principal balance of the loan at that time. The higher the rate of interest on a loan, the more beneficial it can be to make accelerated payments. The faster the borrower applies accelerated payments toward the principal balance of a loan, the more interest that is saved.

Account Freeze – An action taken by a bank or brokerage that prevents any transactions from occurring in the account. Typically, any open transactions will be cancelled, and checks presented on a frozen account will not be honored. Account freezes can be initiated by either the account holder or a third party.
An account may be frozen by government or regulatory authorities because of suspicious activity, suspected criminal activity, civil actions or liens filed against the account. Furthermore, a bank or brokerage account may be frozen when the account holder dies. Once the appropriate documentation is presented, a new account will be opened in the beneficiary’s name with access to the assets.

Account Inquiry – Any inquiry into an account, whether it be a depositary account or credit account. The inquiry can refer to past records, payments or other specific transactions, or any other entries relating to the account. Most financial institutions have a formal department that deals with account inquiries. Sometimes the term is used when there is a request to or from a credit agency about a particular consumer.

Account Sweep – A program where banks automatically transfer amounts in customer accounts that exceed (or fall short of) a certain level into a higher interest earning investment option at the close of each business day. In a sweep program, a bank’s computers analyze customer use of checkable deposits and “sweeps” funds into money market deposit accounts. This practice benefits the bank not the depositor since most consumer accounts have a fixed percentage yield if any.

APR - The annual percentage  rate that is charged for borrowing (or made by investing), expressed as a single number that represents the actual yearly cost of funds over the term of a loan. This includes any fees or additional costs associated with the transaction.

APY – Is the effective annual rate of return (yield) taking into account the effect of compounding interest. The APY is similar in nature to the annual percentage rate. Its usefulness lies in its ability to standardize varying interest rate agreements into an annualized percentage number.

ARM – (Adjustable Rate Mortgage) A type of mortgage in which the interest rate paid on the outstanding balance varies according to a specific benchmark. The initial interest rate is normally fixed for a period of time after which it is reset periodically, often every month. The interest rate paid by the borrower will be based on a benchmark plus an additional spread, called an ARM margin. An adjustable rate mortgage is also known as a “variable-rate mortgage” or a “floating-rate mortgage”.
Both 2/28 and 3/27 mortgages are examples of ARM’s. A 2/28 mortgage’s initial interest rate is fixed for a period of two years and then resets to a floating rate for the remaining 28 years of the mortgage. A 3/27 mortgage is typically the same as a 2/28 mortgage, except that the interest rate is fixed for three years and then floats for the remaining 27 years of the mortgage.

Average Daily Balance – A finance/accounting method where costs (and interest) are based on the amount(s) owing at the end of each day. Most department store credit cards use this system. Interest payable is calculated daily, this results in less interest payable because payments on the card lower the interest payable immediately.

Bank Deposits – Money placed into a banking institution for safekeeping. Bank deposits are made to deposit accounts at a banking institution, such as savings accounts, checking accounts and money market accounts. The account holder has the right to withdraw any deposited funds (as set forth in the terms and conditions of the account). The “deposit” itself is a liability owed by the bank to the depositor (the person or entity that made the deposit), and refers to this liability rather than to the actual funds that are deposited. When someone opens a bank account and makes a deposit, the account holder surrenders legal title to the deposit. The deposit becomes an asset of the bank; the account itself becomes a liability. In the United States, the Federal Deposit Insurance Corporation (FDIC) provides deposit insurance that guarantees the deposits of member banks up to $250,000 per depositor, per bank. Member banks are required to place signs visible to the public stating that “deposits are backed by the full faith and credit of the United States Government.”

Banknote – A negotiable promissory note issued by a bank and payable to the bearer on demand. The amount payable is stated on the face of the note. Banknotes are considered legal tender, and, along with coins, make up the forms of all modern money. Originally, objects such as gold and silver were used to pay for goods and services. Eventually, they were replaced by paper money and coins that were backed by precious metals.
Currently, banknotes (currency) are backed only by the government. Although in earlier times commercial banks could issue banknotes, the Federal Reserve Bank is now the only bank in the United States that can create banknotes.

Bankruptcy – A legal proceeding involving a person or business that is unable to repay outstanding debts. The bankruptcy process begins with a petition filed by the debtor (most common) or on behalf of creditors (less common). All of the debtor’s assets are measured and evaluated, whereupon the assets may be used to repay a portion of outstanding debt. Upon the successful completion of bankruptcy proceedings, the debtor is relieved of the debt obligations incurred prior to filing for bankruptcy. Bankruptcy filings in the United States can fall under one of several chapters of the Bankruptcy Code, such as Chapter 7 (which involves liquidation of assets), Chapter 11 (company or individual “reorganizations”) and Chapter 13 (debt repayment with lowered debt covenants or payment plans). Bankruptcy filing specifications vary widely among different countries, leading to higher and lower filing rates depending on how easily a person or company can complete the process.

Balloon Mortgage – A type of short-term mortgage. Balloon mortgages require borrowers to make regular payments for a specific interval, then pay off the remaining balance within a relatively short time. Some types of balloon mortgages can be interest-only for 10 years, and the final “balloon” payment to pay off the balance comes as one large installment at the end of the term. Balloon mortgages have the option for early repayment or can be set up similar to a 30-year fixed-rate mortgage with the embedded option. The total debt repayment of these loans is lower than that of conventional fixed-rate mortgages. Balloon mortgages take the form of interest-only loans or partially amortizing mortgages.

Biweekly Mortgage – A mortgage with principal and interest payments due every two weeks. A biweekly mortgage adds up to 26 payments per year, two payments more than a mortgage with semimonthly payments. These two extra payments lower the interest payments paid over the life of the mortgage. In addition, biweekly payments are usually lower than semimonthly payments. A biweekly mortgage is a simple and effective way for borrowers to decrease their interest costs and pay off their mortgages sooner. In most cases, there are no additional fees or commissions associated with setting up a biweekly mortgage as opposed to a monthly mortgage. However, there are other strategies that can accelerate the payoff of a mortgage sooner, saving even more in interest costs.

Cash Flow - A revenue or expense stream that changes a cash account over a given period. Your income (inflow) and Bills (outflow) are common examples of cash flow.

Compound Interest – Interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount.

Conventional Mortgage – A type of mortgage in which the underlying terms and conditions meet the funding criteria of Fannie Mae and Freddie Mac. About 35-50% of mortgages, depending on market conditions and consumer trends, are conventional mortgages. In other words, Fannie Mae and Freddie Mac guarantee or purchase 35-50% of all mortgages. Conventional mortgages may be fixed-rate or adjustable-rate mortgages.
The secondary market for conventional mortgages is extremely large and liquid. Most conventional mortgages are packaged into pass-through mortgage-backed securities, which trade in a well-established forward market known as the mortgage market. Many conventional pass-through securities are further securitized into collateralized mortgage obligations (CMOs)

Credit Card – A card issued by a financial company giving the holder an option to borrow funds, usually at point of sale. Credit cards charge interest and are primarily used for short-term financing. Interest usually begins one month after a purchase is made and borrowing limits are pre-set according to the individual’s credit rating.

Credit Reporting Agencies – This term refers to businesses that maintain historical information pertaining to credit experience on individuals or businesses. The data is collected from various sources,  most commonly firms extending credit such as credit card companies, banks and credit unions. They also collect information from public records, such as bankruptcies. Credit reporting agencies are generally one of two types: either individuals or businesses. The largest consumer credit reporting agencies are Experien, Equifax and Transunion. Under Federal Law, you are entitled to a free credit report each year. AnnualCreditReport.com is the ONLY authorized source for the free annual credit report that’s yours by law.

Credit Score – A statistically derived numeric expression of a person’s creditworthiness that is used by lenders to access the likelihood that a person will repay his or her debts. A credit score is based on, among other things, a person’s past credit history. It is a number between 300 and 850 – the higher the number, the more creditworthy the person is deemed to be.

Debt – An amount of money borrowed by one party from another. Many corporations/individuals use debt as a method for making large purchases that they could not afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.

Debt to Income Ratio (DTI) - A personal finance measure that compares an individual’s debt payments to the income he or she generates. This measure is important in the lending industry as it gives lenders an idea of how likely it is that the borrower will repay a loan. The higher this ratio, the more burden there is on the individual to make payments on his or her debts. If the ratio is too high, the individual will have a hard time paying their debts and accessing other forms of financing.

Deflation – A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum.

Depression – A severe and prolonged recession characterized by inefficient economic productivity, high unemployment and falling price levels. In times of depression, consumers’ confidence and investments decrease, causing the economy to shut down. The classic example of this occurred in the 1930s, when the Great Depression shook the global economy.

Discretionary Income – The amount of an individual’s income that is left for spending, investing or saving after taxes and personal necessities (such as food, shelter, and clothing) have been paid. Discretionary income includes money spent on luxury items, vacations and non-essential goods and services.

Equity – A stock or any other security representing an ownership interest. In the context of real estate, the difference between the current market value of the property and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying off the mortgage.

Federal Deposit Insurance Corporation (FDIC) – The U.S. corporation insuring deposits in the U.S. against bank failure. The FDIC was created in 1933 to maintain public confidence and encourage stability in the financial system through the promotion of sound banking practices. The FDIC will insure deposits of up to US$250,000 per institution as long as the bank is a member firm. Before opening an account with a financial institution, be sure to check that it is FDIC insured.

Fiat Money – Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Most of the world’s paper money (including US currency)  is fiat money. After World War II, a modified version of the gold standard monetary system, the Bretton Woods monetary system, was created as its successor. This successor system was initially successful, but because it also depended heavily on gold reserves, it was abandoned in 1971 when U.S President Nixon “closed the gold window”. Because fiat money is not linked to physical reserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation’s paper currency, the money will no longer hold any value.

FICO Score – The most widely used credit scoring system. FICO is an acronym for Fair Isaac Corporation, the company that provides the credit score model to financial institutions. There are other providers of credit scoring systems as well. Consumers can typically keep their credit scores high by maintaining a long history of always paying their bills on time and not having too much debt. A credit score plays a large role in a lender’s decision to extend credit and under what terms.  For example, borrowers with a credit score that is under 600 will be unable to receive a prime mortgage and will typically need to go to a sub-prime lender for a subprime mortgage, which will typically have a higher interest rate.

Foreclosure – A situation in which a homeowner is unable to make principal and/or interest payments on his or her mortgage, so the lender, be it a bank or building society, can seize and sell the property as stipulated in the terms of the mortgage contract. In some cases, to avoid foreclosing on a home, creditors try to make adjustments to the repayment schedule to allow the homeowner to retain ownership. This situation is known as a special forbearance or mortgage modification.

Forbearance – A postponement of loan payments, granted by a lender or creditor, for a temporary period of time. This is done to give the borrower time to make up for overdue payments. Basically, forbearance allows the borrower to put a temporary hold on his or her monthly payments, usually for up to one year. Forbearance is common for unemployed people with outstanding student loans. Typically, interest continues to accrue during forbearance.

Home Equity Line of Credit (HELOC) – A line of credit extended to a homeowner that uses the borrower’s home as collateral. Once a maximum loan balance is established, the homeowner may draw on the line of credit at his or her discretion. Interest is charged on a predetermined variable rate, which is usually based on prevailing prime rates.
Once there is a balance owing on the loan, the homeowner can choose the repayment schedule as long as minimum interest payments are made monthly. The term of a HELOC can last anywhere from less than five to more than 20 years, at the end of which all balances must be paid in full.

Hyperinflation – Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless. When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value.
When associated with wars, hyperinflation often occurs when there is a loss of confidence in a currency’s ability to maintain its value in the aftermath. Because of this, sellers demand a risk premium to accept the currency, and they do this by raising their prices. One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours.

Inflation – The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum. As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year. Most countries’ central banks will try to sustain an inflation rate of 2-3%.

Interest – Charged by lenders as compensation for the loss of the asset’s use. In the case of lending money, the lender could have invested the funds instead of lending them out.

IRA – An Individual Retirement Account. Traditional IRAs are held by custodians, such as commercial banks and retail brokers. Investors can place IRA funds into stocks, bonds, funds, and other financial assets deemed fit by the custodian. Assets, such as real estate come with heavy restrictions from the IRS, and may be taxed differently.  When the individual begins to receive distributions from a Traditional IRA, the income is treated as ordinary income and may be subjected to income tax. This differs from the Roth IRA. For people over the age of 50, higher annual contribution limits may apply if the IRA has been recently created or under-funded in previous tax years. Distributions are required to come out of the account by the time the owner reaches age 70.5.

Line of Credit (LOC) – An arrangement between a financial institution, usually a bank, and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement.
The advantage of a line of credit over a regular loan is that interest is not usually charged on the part of the line of credit that is unused, and the borrower can draw on the line of credit at any time that he or she needs to. Depending on the agreement with the financial institution, the line of credit may be classified as a demand loan, which means that any outstanding balance will have to be paid immediately at the financial institution’s request.

Loan to Value Ratio (LTV) – A lending risk assessment ratio that financial institutions and others lenders examine before approving a mortgage. Typically, assessments with high LTV ratios are generally seen as higher risk and, therefore, if the mortgage is accepted, the loan will generally cost the borrower more to borrow or he or she will need to purchase mortgage insurance. For example, Jim needs to borrow $92,500 to purchase a $100,000 property. The LTV ratio yields a value of about 92.5%. Since bankers usually require a ratio at a maximum of 75-80% for a mortgage to be approved, it may prove difficult for Jim to get a mortgage.

Mortgage – A debt instrument that is secured by the collateral of specified real estate property and that the borrower is obliged to pay back with a predetermined set of payments. Mortgages are used by individuals and businesses to make large purchases of real estate without paying the entire value of the purchase up front. Mortgages are also known as “liens against property” or “claims on property”.
In a residential mortgage, a home buyer pledges his or her house to the bank. The bank has a claim on the house should the home buyer default on paying the mortgage. In the case of a foreclosure, the bank may evict the home’s tenants and sell the house, using the income from the sale to clear the mortgage debt.

Personal Finance – All financial decisions and activities of an individual, this could include budgeting, insurance, savings, investing, debt servicing, mortgages and more. Financial planning generally involves analyzing your current financial position and predicting short-term and long-term needs. Personal finance looks at how your money and future is managed. Often individuals will seek advice from financial planners, but the use of software is also an option. Personal finance would include monitoring your spending, budgeting, and paying down debt.

Recession – A significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country’s gross domestic product (GDP).

Reverse Mortgage – A type of mortgage in which a homeowner can borrow money against the value of his or her home. No repayment of the mortgage (principal or interest) is required until the borrower move out of the home, dies or the home is sold. After accounting for the initial mortgage amount, the rate at which interest accrues, the length of the loan and rate of home price appreciation, the transaction is structured so that the loan amount will not exceed the value of the home over the life of the loan. Often, the lender will require that there can be no other liens against the home. Any existing liens must be paid off with the proceeds of the reverse mortgage.
A reverse mortgage provides income that people can tap into for their retirement. The advantage of a reverse mortgage is that the borrower’s credit is not relevant, and is often unchecked, because the borrower does not need to make any payments. Because the home serves as collateral, it must be sold in order to repay the mortgage when the borrower dies (in some cases, the heirs have the option of repaying the mortgage without selling the home).  These types of mortgages have large origination costs relative to other types of mortgages.  These costs become part of the initial loan balance and accrue interest. Senior citizen borrowers with good credit should carefully analyze the options of a more traditional mortgage, such as a home equity loan, against a reverse mortgage.

Roth IRA – An individual retirement plan that bears many similarities to the Traditional IRA, but contributions are not tax deductible and qualified distributions are tax free. Similar to other retirement plan accounts, non-qualified distributions from a Roth IRA may be subject to a penalty upon withdrawal. A qualified distribution is one that is taken at least five years after the taxpayer establishes his or her first Roth IRA and when he or she is at least age 59.5, disabled, using the withdrawal to purchase a first home (limit $10,000), or deceased (in which case the beneficiary collects). Since qualified distributions from a Roth IRA are always tax free, some argue that a Roth IRA may be more advantageous than a Traditional IRA.

Simple Interest, Simple interest is called simple because it ignores the effects of compounding. The interest charge is always based on the original principal, so interest on interest is not included.  This method may be used to find the interest charge for short-term loans where ignoring compounding is less of an issue.

Tax Deferred – Investment earnings such as interest, dividends or capital gains that accumulate tax free until the investor withdraws and takes possession of them. The most common types of tax-deferred investments include those in individual retirement accounts (IRAs) and deferred annuities.

Time Value of Money (TVM) – The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn or cancel interest, any amount of money is worth more the sooner it is received/used.