Why You Need to Know These 5 Commonly Misunderstood Financial Terms

You don’t need a degree in finance to effectively manage your money, but understanding a few basic financial concepts in more depth can help you make better informed decisions about your financial goals and how to reach them. As the saying goes, knowledge is power.

If you’re just getting started in your financial journey, here are five commonly misunderstood financial concepts that are important to know.

1. Net worth

According to 2019 Federal Reserve data, the median net worth of Americans was $121,700. But what exactly is your net worth, and how is it measured? It’s calculated using two important numbers:

• Total assets: This is the sum of the value of all the assets you own, including what’s in your checking and savings accounts; the balances of any retirement and investment accounts; and the current market value of tangible assets like your home, car and other valuables.

• Total liabilities: This is the total of all the outstanding debts you owe. This can include credit card balances, what’s left to pay on your mortgage, what you still owe on student loans and more.

Your net worth is your total assets minus your total liabilities. The number helps provide a snapshot of your overall financial health. A positive net worth is a sign that you’re probably in good financial shape. A negative net worth may suggest it’s time to take stock of your finances and make some changes. Paying down debt and increasing your savings are two ways to improve your net worth.   

2. Revolving credit

A credit card is a type of revolving credit account, but you’re not alone if you’re not sure exactly what that means.

A revolving credit account comes with a credit limit that allows you to make transactions up to that threshold. As you pay down your balance, you’re freeing up credit for you to use again.

When you carry a balance, you’re charged an interest rate and you’re on the hook for making a minimum monthly payment until it’s paid off. To avoid paying interest, you must pay your balances in full each billing cycle. Credit cards are the most common types of revolving credit, but a home equity line of credit, or HELOC, is another example.

Revolving credit is different from an installment loan, where you borrow a lump sum of money once that you repay with interest over time in fixed monthly payments. Mortgages, student loans, and auto loans are all examples of installment loans. Once the loan is paid off, there’s no “refresh” of credit; the account is closed.

While revolving credit can be easier to qualify for, the higher interest rates they tend to charge can compound quickly if you carry a balance. Make sure to build good credit card habits to help you use your card responsibly and avoid racking up debt.

3. Credit utilization ratio

Revolving credit is tied to your credit utilization ratio, which represents the amount of credit you’re using across all your available lines of credit. Let’s say you have three credit cards with a credit limit of $2,000 each; that gives you total available credit of $6,000. If your outstanding balances across all three cards add up to $3,000, your credit utilization ratio is 50 percent, because you’re using half of the credit available to you.

This calculation carries a lot of weight. The amount you owe across all your credit accounts makes up a third of your credit score, so most financial pros suggest keeping your credit utilization ratio below 30 percent. Lenders may view a high credit utilization ratio as a sign that you’ll have trouble making payments, so the lower your ratio, the better.

4. Traditional vs. Roth retirement accounts

If you’re saving for retirement, then you’re likely already familiar with two of the most common retirement accounts, 401(k) retirement plans and individual retirement accounts (IRAs). But not everyone is aware that both accounts come in two different “flavors”: traditional and Roth. The main difference is how your money is taxed going in and coming out.

How your contributions are taxed

With a traditional account, the money you contribute is pre-tax, which means it helps lower your taxable income. With a 401(k), your employer will deduct pre-tax dollars from your paycheck and deposit them directly into a 401(k) account on your behalf (as well as possibly match some contributions). With an IRA, some or all of your contribution can be claimed as a deduction on your taxes, depending on whether you meet certain IRS qualifications. (Note that IRAs have much lower contribution limits than 401(k)s.)

With a Roth account, your 401(k) or IRA is funded with after-tax dollars, which means you can’t get a tax break on your contributions now.

How your withdrawals are taxed

Because you didn’t pay taxes on your contributions to a traditional account, when it comes time to tap these funds for retirement, your withdrawals will be taxed as ordinary income. That’s why these accounts are often referred to as tax-deferred.

There’s also a 10 percent penalty for taking distributions before age 59½, and once you turn 72, you must begin taking required minimum distributions (RMDs).

With a Roth, however, because you already paid taxes on your contributions, your distributions will be tax-free. There are also some notable differences between a Roth 401(k) and a Roth IRA.

• While Roth 401(k)s are subject to the 10 percent early-withdrawal penalty on the investment earnings, with Roth IRAs, you can always access your contributions without penalties (just not the growth in your account).
• Roth 401(k)s are also subject to RMD rules, but Roth IRAs are not.
• The income limit for a traditional IRA dictates whether your contribution is tax deductible or not and both Roth or traditional IRAs are subject to income limits set by the IRS. 401(k)s, however, have no income restrictions.
• Not all companies offer a Roth 401(k) option, so be sure to check your benefits package to understand what types of accounts are available to you.

Knowing how to save for retirement in a tax-efficient way can get complicated, and more likely than not you’ll want a mix of different types of accounts. If you’re unsure what types of retirement accounts make sense for your situation, talk to a financial advisor and a qualified tax professional for tax advice.

5. Long-term care

No one really likes to think about losing the ability to be independent as you grow old, but it’s an important thing to plan for while you can still make important decisions for yourself. Roughly half of Americans who turn 65 today may need long-term care at some point.

Many people, however, equate long-term care with staying in a nursing home. In reality, long-term care is any help you need to safely take care of certain activities of daily living. This can include nursing homes, home-based professional care or, in some cases, caregiving from friends or family members.

But even with help from loved ones, it’s possible you’ll need to pay for certain long-term care costs yourself, and those costs can add up. According to Northwestern Mutual’s 2020 Cost of Care study, a full-time home health aide could cost more than $75,000 a year, while a private room in a nursing home averages $113,000 a year. Long-term care planning can help you prepare for these potential costs.