Two-thirds of adult Americans can’t pass a financial literacy test, according to Forbes magazine. So, before we move into more complicated financial topics, we’d like to make sure you’re familiar with certain terms that are important to understand when it comes to talking about money. Here we will ground you in terms you hear often like inflation, interest, risk and credit, and will give you real life examples of how they operate in your life.
These are in no way meant to be exhaustive or definitive, but it’s important to have a basic understanding of these concepts before we move on to more complicated territory where the interplay of these becomes important.
Let’s start with inflation. There are many different kinds of inflation, but put simply, it can be defined as the increase in price of goods and services over time. Inflation increases your cost of living and decreases the spending power of each dollar you have, so that the money you have is actually worth less than it had been. Instead of buying $100 worth of goods, $100 will only get you $98 worth.
Monetary inflation refers to when the government prints more money that outpaces economic growth. Money loses its purchasing power, and therefore prices rise.
Credit is essentially deferment of payment or an extension of the time it takes to pay something off. Let’s say I own a grocery store and you live down the street from me. If you can’t pay at the time you want your groceries, I will extend you credit so you can pay me later.
Now, if you decide to skip town and not repay me, then that credit becomes your debt to me, and hopefully I added interest to our agreement, so that if you didn’t pay by a certain date, I get a little more than what you originally owed me. But if you don’t pay me, you are at higher risk of non-repayment and I am much less likely to extend any credit to you again.
Interest is essentially the cost of money. This rate is usually set based on a combination of factors, one being the probability of the lender receiving back their money.
When borrowing money, the interest rate is usually determined by the borrower’s credit score, used as a marker of the likelihood he or she will repay what they owe. If a person has a good track record of repayment, they will likely get a lower interest rate.
You could also consider your credit score as your “personal risk score” that lenders look at when evaluating how much credit to extend to you and interest rates. Instead of 10-12% for a good credit score, you’ll likely end up paying 22% or higher interest.
Interest rates are also determined by the actual thing being purchased. Some purchases are higher risk than others, and will therefore will be assessed with a higher interest rate. Cars are one example of this, when compared to say, a house. This is due to a number of reasons, the first being that the car will actively depreciate the minute you drive it off the lot, whereas a house, for example, will hold its value, and you’ve already paid a down payment. The likelihood of a house dropping in value that much is low.
Therefore a new car will have a higher interest rate because its value as an asset is consistently dropping. If you default on your payment and the bank has to come repossess the car, they likely won’t get as much money for it as you owe because of this.
An asset is something of value that you own that can be sold for currency, whereas a liability is what you owe. The difference between what you owe and your assets is called your “net worth”.
New car rates are low bc they are being financed by company selling the car so we can sell it to you today. Charge a lower interest rate so you can pay a higher price. Higher risk associated with transaction and that’s why rates are higher than home rates. These types of loans without collateral backing them are called unsecured debts. If the borrower defaults, it is much more difficult for the lender to recoup their money. Some examples of unsecured loans are medical bills and certain retail purchases.
Secured debts, conversely, are those that the borrower offers an asset as backing for the loan, so that if they don’t repay, the lender can come take that and recoup some of their losses. Examples of secured loans are mortgages and auto loans.
We hope you have a greater understanding of some of these basic financial terms. Next we’ll talk more about interest, specifically ways in which it compounds to work both for and against you.
Resources:
Christina Majaski, Investopedia. “Unsecured vs. Secured Debts: What’s the Difference?”
Steve Fiorillo, The Street. What is Inflation in Economics?