Financial literacy: vocabulary for four money topics

Financial literacy is not knowing about money. It is being able to read a financial document and say what it does and does not tell you, and being able to compare two offers that have been written so as not to be comparable.

This page covers the four things people do with money: earn it, spend it, borrow it, and protect it. In each, the words come in pairs that sound like synonyms and are not.

No current rates, limits or thresholds appear below; they vary by product and can change. The final section names US sources for checking current figures.

What to take away

Earn

Gross pay is what was earned before anything is taken off. Net pay is

what arrives. The gap is deductions, and which deductions apply depends on tax rules and any withholding you have agreed to. In the US, federal tax rules are administered by the IRS, and state tax rules may also apply. The same two words apply to a business's revenue and profit, but in a different sense, and the entries on business vocabulary keep those apart.

Salary is a fixed amount for a period, regardless of hours. Wages are paid per hour or per unit. Commission is paid per sale. A bonus is discretionary or conditional, and the distinction between those two words in your contract decides whether you can rely on it.

Owners of the business they work in need three more words.

A salary paid by the company to its owner is employment income. A dividend or distribution is a share of profit paid to an owner as owner.

A drawing is money the owner of an unincorporated business takes out: not income in the accounting sense, but a reduction of the owner's capital.

Which of these you receive changes what tax is due and when, and the rules differ by entity type and by country. Ask a qualified tax adviser in your jurisdiction before the first payment, not after.

Income and cash flow in personal finance are the same pair as in business. Income is what you earned in the period. Cash flow is what arrived and left. Irregular earners live on the second and are taxed on the first, and the gap between them is why a good year can end with an unpayable tax bill.

Spend

A budget is a plan for spending, made in advance. A forecast predicts what spending will be. Actuals are what happened.

Most people keep only the third and call it a budget. The skill is in the comparison. Budget against actuals shows where your plan was wrong. Forecast against actuals shows where your model of yourself was wrong. Those are different lessons.

Fixed costs do not change month to month; variable ones do. Committed costs are the ones you cannot stop at will (a lease, a contract with notice), whether fixed or variable. Committed is the word that matters when income drops, because it is the floor below which spending cannot fall quickly.

Saving is money set aside and kept as cash or its near equivalent, where the amount is safe and the return is low. Investing is exchanging money for an asset whose value can rise or fall. Neither is better; they answer different questions. Saving answers "will the money be there when I need it". Investing answers "will it grow". Money that must be there on a known date is savings by definition, whatever it is called.

Within saving, an emergency fund covers unplanned losses of income or unplanned costs. A sinking fund covers a planned cost that falls irregularly: an annual insurance premium, a replacement vehicle. They are often kept in one account and should not be, because spending the sinking fund on an emergency leaves the planned cost unfunded and invisible.

Inflation is the general rise in prices over time. Nominal values are in the money of their day; real values have been adjusted for inflation. A savings balance that is unchanged in nominal terms has fallen in real terms if prices rose. The US Bureau of Labor Statistics publishes the Consumer Price Index (CPI), a widely used official measure of inflation.

Borrow

This is the section where the words cost the most money.

An interest rate is the price of borrowing, expressed as a share of the amount for a period. The annual percentage rate, or APR, is a standardized borrowing-cost measure in US consumer-credit disclosures. The Truth in Lending Act and Regulation Z set calculation and disclosure rules for covered credit; APR includes certain charges, but not necessarily every cost.

For covered US consumer credit, compare APRs calculated under the same disclosure rules. Do not treat APR as total cost by itself: the repayment schedule, fees not included in APR and timing can also matter. The Consumer Financial Protection Bureau (CFPB) provides consumer guidance on credit.

Simple interest is charged on the original amount only. Compound interest is charged on the amount plus interest already added. Over one period they are the same. Over many periods they diverge, and the divergence accelerates. The public Investor.gov Compound Interest Calculator lets you see the divergence on your own figures rather than on an illustration someone else chose. Any illustration of this is arithmetic, not a forecast: a balance that grows by a tenth each period is not ten-tenths larger after ten periods, because each tenth is taken of a larger amount.

Secured borrowing is backed by an asset the lender can take if you default. Unsecured borrowing is not. Secured is usually cheaper because the lender's risk is lower, and the cost of that is that the asset is at stake. The word guarantee belongs here: a personal guarantee on a business loan can make the owner's personal assets available to the lender if the business cannot pay, subject to the agreement and applicable law. That can collapse the line between personal and business money in exactly the situation where you most wanted it.

The wording of the agreement is a separate problem again. Terms like default and remedy may be defined by the agreement and applicable law, rather than by ordinary usage, and the reading habits set out under corporate jargon can help you spot what a clause is not saying.

A credit report is the record of your borrowing and repayment history, held by a credit reporting company such as Equifax, Experian or TransUnion. A credit score is a number derived from that record by a formula the scoring body chooses. The report is the evidence; the score is one interpretation of it.

In the United States, the Fair Credit Reporting Act (FCRA) gives consumers rights to access and dispute information in their credit reports. The CFPB offers guidance on those rights, and state law may provide additional protections.

Debt is an amount owed. A liability is any obligation, including debt and things that are not yet due. Default is a failure to meet an obligation; what counts as default can depend on the agreement and applicable law, and it can be triggered by more than missing a payment.

Two loans, same headline rate, same term: one interest-only and one amortizing. The monthly payment on the first is lower and the total cost is higher, because nothing has been repaid until the end. The number that was compared was the wrong number.

Protect

An insurance premium is what you pay for cover. The excess or deductible is the part of a loss you carry before the insurer pays.

The limit is the most the insurer will pay. The exclusions are the events and circumstances it will not pay for at all.

A cheap policy is usually cheap on one of the last three, and the premium alone tells you nothing.

Insurance transfers a defined risk to an insurer for a fee. Assurance, in the traditional usage, covers an event that is certain to happen at an uncertain time. A warranty is a promise by a seller about a product, and it is not insurance, though it is often sold beside it.

Diversification is holding assets whose values do not move together, so that one loss is not everything. Hedging is taking a position designed to offset a specific risk. The first reduces exposure to the unknown; the second reduces exposure to something you have named. They are both protection, and they protect against different things.

Net worth is what you own less what you owe, at a point in time, and Income is what you earn over a period. A high income and a low or negative net worth are compatible, and so are the reverse.

Most financial decisions move one without damaging the other. That is the same question business owners face, which business acumen treats from the business side.

Where the numbers live

For the current figures that this page deliberately leaves out, the sources are stable even when the numbers are not:

The US Financial Literacy and Education Commission (FLEC) presents My Money Five, a framework organized around earning, saving, spending, borrowing and protecting. It is a useful checklist beyond the US, though the rules and authorities differ by country.

Common questions

Do I need to understand this if I have an accountant?

Yes. An accountant records and reports; the decisions are yours, and you cannot delegate a decision whose terms you cannot read. The relationship works best when you can ask a precise question, and precise questions need the vocabulary.

Which pair causes the most expensive mistakes?

For individuals, interest-only against amortizing, because the comparison looks complete and is not. For owners, salary against dividend against drawing, because the tax consequences arrive a year later.

Is there a single document I should be able to read?

A loan agreement. If you can find the principal, the rate, how often it is applied, the term, the fees, what counts as default and what security is given, you can read almost anything else. Deciding whether to sign it is then a question of the kind set out under decision skills.

What about investing?

It is a separate subject with its own vocabulary, and the only piece of it that belongs here is the saving and investing distinction above. Money you need on a date is savings. Everything else is a question for a regulated adviser in your jurisdiction, not for a glossary.