Myths that Keep You Broke #6

Myth #6 - I Don’t Need to Know Money Terms:   

Many years ago, when I was first learning the terms as a part of becoming a Certified Financial Planner®, I heard someone ask the instructor, “How important is it whether or not I learn all these definitions?” He was referring to the terms we were studying in that session about present value and future value.

There are many terms the wealthy use when they talk about money, and the first thing to understand is that the wealthy do not think it is rude to talk about money. See Myth #5. It is crucial that to create wealth you need to understand some basic money terms.

As an example, not all interest is the same. When you understand the difference between simple interest and compound interest, you will vote to earn compound interest. Instead of just receiving interest on your principal, you want interest paid on your interest, which is compound interest.

When you understand the difference between the value of a dollar today (present value) versus the value of a dollar in the future (future value) you will know why a lottery winner who elects to take a $1 million dollar prize that would have been paid out over 20 years only gets $456,387 as a lump sum today (or less if an interest rate higher than 4% is used). This does not take into consideration any income taxes that would be due.

1. Interest is what a borrower pays a lender for the use of money. If you deposit money in a bank, you are the lender and the bank is the borrower. In this environment, the bank will pay you about 1% to borrow money from you. (This is a typical savings account.) If you borrow money from the bank, they are the lender and may charge you 6-10% interest. The difference between the 1% they pay on savings and the 6% they charge on a loan is called the “spread,” and this is how they make a profit.
2. Earnings are often confused with interest by people who do not know money terms. If you own a stock or a mutual fund, it may pay a dividend and grow in value over time. If you receive a 1% dividend and it grows in value by 8% over a one year period, the total earnings would be 9%. This is not interest, but total earnings. 1% is income and 8% is appreciation. If you see that a mutual fund or stock returned 22% over a one year period that could all be appreciation, with no income and has nothing to do with interest.
3. The cost of money refers to borrowing money to invest, whether in other stocks, a business, real estate or whatever. The point is that you should earn more money than the amount of interest you pay. This is the cost of money, also called the cost of funds. If I borrow money at 4% and I am able to invest it or loan it out at 10%, then I am the one earning the spread, and my cost of funds is 4%. You do not have to put money in the bank to earn interest. This is available to you through peer-to-peer lending, trust deeds, tax liens and other financial instruments like bonds.

There are so many more financial terms, I could write a whole booklet; debt coverage ratio, capitalization rates, amortization, depreciation, discounting, puts, calls, options, margin accounts, on and on.

When you come across a money term that you do not understand, you can learn more by typing it into Google. You can even do that with some of the terms I mentioned in the paragraph above. Regardless, if you intend to become wealthy, you do need to understand money terms.

To Your Prosperity,

Rennie