Money word of the week – helping understand key financial phrases and ideas

Welcome to Mouth Money’s Word of the Week, a weekly dive into essential personal financial phrases and words. We want to help simplify complex financial jargon and empower your understanding of money.

Money can be a complex subject, but understanding important financial phrases and concepts is essential for making informed financial decisions.

Each week, we’ll shine a spotlight on a single word or financial phrases that relates to personal finance. We’ll explore the terminology that impacts your understanding of money and how finance works.

Our goal is to make personal finance more approachable. It doesn’t atter if you’re a seasoned investor or just a beginner with your money.

“Word of the Week” aims to be a valuable resource for improving your knowledge of financial phrases and understanding of money concepts.

1. Asset

An asset refers to something of value that you own or control. Assests can potentially generate income or appreciate in value over time.

Assets are a key component of growing wealth over time to achieve financial goals, such as saving for retirement, buying a home, or funding children’s education.

These can take various forms including: cash, investments such as stocks, bonds or crypto, property, vehicles (particularly classic cars), collectibles, valuables such as jewellery or gold, businesses or intellectual property.

Assets are typically categorised into two main types:

1. Liquid Assets can be quickly converted into cash without significant loss in value. Examples include cash, savings accounts, and highly liquid investments such as stocks and bonds.
2. Illiquid Assets are less easily converted into cash and may take time to sell without incurring significant costs or loss of value. Property, business interests (which aren’t listed on the stock market), and some collectibles fall into this category.

Check back next week for another of the key financial phrases you need to know!

2. Pension

A pension is a savings pot with specific tax rules to help people fund their retirements. This pot is typically funded through contributions made during a person’s working life from a combination of the individual and their employer.

There are several types of pensions in the UK but the main ones are:

• State Pension: This is a benefit provided by the government and is based on your National Insurance contributions (NICs). You don’t accrue savings in a pot, instead you build NICs over years until you’re entitled to the full payment. It’s available when you reach age 66, but this is increasing in the coming years. The amount you receive depends on your NICs history.

• Workplace Pensions: Employers are obliged to offer ‘auto-enrolled’ workplace pensions as part of their benefits package. You and your employer both contribute to this pension pot. It’s managed by a pension provider chosen by your employer, with contribution levels set automatically as a percentage of your earnings.

• Personal Pensions: You can set up your own self-invested personal pension (SIPP). This is especially useful if you’re self-employed, don’t work full-time or want to consolidate old workplace pensions. You make contributions into this plan yourself, but you’ll have to make your own investment decisions unless you seek financial advice.

Retirement Age: You can access your pension savings from the age of 55 (this is changing to 57 in 2028). You have several options for what to do with your pension when you retire:

• You can take a portion of it as a tax-free lump sum.
• You can use the rest to provide a regular income which could incur income tax.
• You can keep your money invested and withdraw it as needed.

3. Liability

In personal finance, a liability refers to any financial obligation or debt that an individual owes to another party. It represents a claim against an individual’s assets or future income. Liabilities are typically classified into two main categories:

1. Current Liabilities: These are short-term obligations that are expected to be settled within a year or the normal term of a financial product. Common examples of current liabilities in personal finance include credit card debt, utility bills, medical bills, and short-term loans.
2. Long-Term Liabilities: These are obligations that extend beyond a year or the normal term of a financial product. Common examples include mortgages, car loans, student loans, and long-term personal loans.

4. Interest Rates

An interest rate is the cost of borrowing money or the return on investment for lending to others. It plays a crucial role in the financial system, informing the cost or reward of products such as loans, savings accounts, mortgages, and investments.

Here’s a breakdown of how interest rates work in personal finance: 

1. Economic indicators: 

• The Bank of England’s Monetary Policy Committee (MPC) sets the base interest rate for the UK economy. Changes in this rate have a ripple effect on other interest rates. For example, when the base rate is lowered, banks tend to lower their lending and savings rates, making borrowing cheaper but reducing returns on savings and vice versa. 

2. Borrowing money: 

• Loans: When you borrow money, such as through a personal loan or a credit card, the interest rate is the percentage that the lender charges you on top of the principal amount borrowed. This is the cost of borrowing money, and it’s typically expressed as an annual percentage rate (APR). The APR includes not only the interest but also any additional fees associated with the loan. 

• Mortgages: When you take out a mortgage to buy a home, the interest rate determines how much you’ll pay over the life of the loan deal. Mortgage interest rates can be fixed for a certain amount of time (usually two, three or five years) or variable (changing periodically, usually in relation to the Bank of England’s base rate). 

3. Saving and investing: 

• Savings accounts: When you deposit money in a savings account, the bank pays you interest on your savings. This interest is typically lower than the interest rates on loans because you’re essentially lending your money to the bank. Savings account interest rates can be variable or fixed. 
• Investments: In the context of investments, interest rates can affect various financial products. For example, bond yields are influenced by prevailing interest rates. When interest rates rise, bond prices tend to fall and yields rise. Additionally, the return on savings and investment products such as Individual Savings Accounts (ISAs) is influenced by interest rates. 

5. Portfolio

A portfolio is essentially a collection of all the financial assets that an individual or household possesses. It serves as a comprehensive list of a person’s or family’s financial holdings. Here are some key aspects to consider when understanding a personal finance portfolio: 

1. Financial Assets: A portfolio typically includes a wide range of financial assets. These can encompass: Stocks, bonds, real estate, savings and bank accounts, retirement accounts and other alternative investments such as gold or cryptocurrencies. 

2. Diversification: Diversification is a fundamental principle in portfolio management. By holding a variety of different types of asset, you can spread risk. This means that if one type of asset underperforms, other assets may offset those losses. Diversification helps manage risk and can enhance the potential for stable, long-term returns. 

3. Risk and return: The composition of a portfolio should align with an individual’s risk tolerance and financial goals. Riskier assets such as stocks have the potential for higher returns but come with greater volatility. On the other hand, safer assets such as bonds offer lower potential returns but are less volatile.  

4. Asset allocation: Asset allocation involves deciding how much of a person’s portfolio should be invested in each asset type or ‘class’. It depends on factors such as age, financial objectives, and risk tolerance. 

5. Long-term perspective: Building and managing a personal finance portfolio is often a long-term endeavour. It involves setting financial goals and working toward them over an extended period, which could span decades, especially when considering objectives such as retirement planning. 

6. Income generation: Some individuals use their portfolios to generate income, especially during retirement. Assets such as bonds and dividend-paying stocks can provide a steady stream of income. 

6. ISA

ISA stands for Individual Savings Account, and is a tax-efficient way to save or invest your money. ISAs offer several advantages compared to normal savings or general investment accounts:

• Tax: The interest or returns you earn within an ISA are tax-free. This means you won’t have to pay income tax on the interest from savings or gains from investments held within the ISA.
• Variety: There are different types of ISAs available, including Cash ISAs and Stocks and Shares ISAs or Lifetime ISAs (LISAs). Cash ISAs are tax-free versions of regular savings accounts, while Stocks and Shares ISAs allow you to invest in stocks, bonds, and other financial instruments.
• Annual allowance: Each tax year, you have an allowance for how much you can contribute to your ISAs without incurring tax. This limit is set by the government and may vary from year to year but is currently £20,000
• Flexible Access: You can access the money in your ISA at any time without penalties, making it a flexible savings or investment option. However depending on your account you can lose some of your allowance if you withdraw.
• JISAs: There are also Junior ISAs (JISAs) available for children, allowing parents or guardians to save or invest on their behalf, with the same tax advantages.
• Long-term savings: ISAs are often used for long-term financial goals such as buying a home, funding retirement, or building an emergency fund.

7. Emergency fund  

An emergency fund, often referred to as a “rainy day fund” or “savings buffer,” is a financial safety net that individuals or households set aside to cover unexpected expenses or financial emergencies.  

An emergency fund is typically a sum of money that you save and keep readily accessible in a separate savings account. Its primary purpose is to provide financial security and peace of mind during unexpected situations that could otherwise lead to financial hardship. These unforeseen circumstances might include: 

• Job loss: If you lose your job or experience a sudden reduction in income, your emergency fund can cover your essential expenses until you find new employment. 

• Medical expenses: The UK’s National Health Service (NHS) provides healthcare for residents, but if you are too sick to work this could leave you without an income.  

• Home repairs: If you face unexpected home repairs or maintenance issues, your emergency fund can be used to cover these expenses. 

• Car repairs: An emergency fund can help with unexpected car repair costs. 

• Legal issues: If you encounter unforeseen legal expenses, such as the need for legal advice or representation, your emergency fund can be a financial lifeline. 

• Urgent travel: Whether for family emergencies or other unexpected situations, having funds available for last-minute travel is vital. 

• Unforeseen bills: There might be unexpected bills or financial obligations that you didn’t anticipate, like a tax bill, which your emergency fund can cover. 

The typical recommendation is to have enough money in your emergency fund to cover at least three to six months’ worth of essential living expenses. This includes housing costs (rent or mortgage), utilities, groceries, transportation, insurance, and any other necessary bills.  

Building and maintaining an emergency fund is a crucial, as it provides a financial cushion and helps you avoid going into debt when unexpected expenses arise. It’s a proactive approach to financial security and stability in the face of life’s uncertainties. It’s essential to regularly review and replenish your emergency fund to ensure that it remains adequate for your needs in the UK’s ever-changing financial landscape. 

8. Compound Interest

Compound interest is where you earn interest not just on the money you have saved but also on any interest you have previously earned. For example, if you have £1,000 in a savings account paying 5% annually, in year one you’ll earn £50 in interest. But in year two you’ll earn £52.50 because you are getting 5% not just on your initial £1,000 but also the £50 previous year’s interest.

Compound interest is relevant in several areas:

• Savings Accounts: When you save money in a savings account, the interest earned on your savings is often compounded. This means that the interest you earn is added to your account, and in subsequent periods, you earn interest on the new, higher balance. Over time, your savings can grow significantly due to this compounding effect.

• Investments: If you invest in financial instruments like stocks, bonds, or mutual funds, the returns on your investments can also compound. This is particularly important for long-term investing, as reinvesting your earnings can help your investment portfolio grow exponentially.

• Loans and Debt: While compound interest is in your favour when you save money, it can also go against you when you borrow money. For example, if you owed £5,000 on a credit card with an annual interest rateof 17% a year, you would be charged £2.32 interest after one day. On day two, you are charged interest not just on your original £5,000 debt but also the £2.32 interest you have already accrued. So, the longer you leave that debt on the card, the quicker it will grow.

• Retirement Savings: In the UK, compound interest plays a significant role in retirement savings, especially through tax-advantaged accounts like Individual Savings Accounts (ISAs) and pension schemes. The compounding of investment returns over several decades can help you build a substantial retirement nest egg.

9. Credit Score

A credit score is a numerical measurement of an individual’s financial character. Credit scores can play an important role in personal finances because lenders and other financial institutions use individual credit scores to assess the risk associated with lending money to an individual, whether it’s for a credit card, a loan, a mortgage, or other forms of credit.

A higher credit score generally indicates that a person is a more reliable borrower, while a lower score suggests a higher credit risk.

In the UK, credit scores are typically based on the following factors:

• Payment history: This is one of the most important factors in determining your credit score. It assesses whether you’ve paid your bills, loans, and credit card payments on time. Consistently making on-time payments can positively impact your credit score, while late or missed payments can have a negative effect.
• Credit utilisation: This factor looks at how much of your available credit you are using. It’s generally recommended to keep your credit utilization low, ideally below 30% of your total credit limit. High credit card balances relative to your credit limits can lower your score.
• Length of credit history: The length of time you’ve had credit accounts can influence your credit score. A longer credit history generally reflects stability and can be beneficial.
• Types of credit: Having a mix of different types of credit accounts, such as credit cards, installment loans, and mortgages, can positively impact your credit score. Lenders like to see that you can manage different types of credit responsibly.
• Recent credit inquiries: When you apply for new credit, it can result in a “hard inquiry” on your credit report. Multiple hard inquiries in a short period can lower your score, as it may indicate that you’re seeking credit excessively.
• Public records and negative information: Bankruptcies, court judgments, and other adverse financial events can significantly harm your credit score.

In the UK, credit reference agencies such as Experian, Equifax, and TransUnion compile and maintain credit reports on individuals.

Lenders use these reports and the associated credit scores when making lending decisions. You can access your credit report for free from these agencies to monitor your financial history. A good credit score is essential for obtaining favorable terms on loans and credit products, including lower interest rates and higher credit limits. It’s also crucial for gaining approval for financial services like mortgages, rental agreements, and mobile phone contracts

10. Recession

A recession is a fall in economic activity across the economy, typically measured by a drop in the ‘gross domestic product’ or ‘GDP’ for six months or more.  

Recessions can be triggered in many ways, such as falling consumer confidence, a decline in business investment, high levels of public and private debt, financial crises, or external shocks such as natural disasters or wars. 

During a recession, businesses may cut back on what they create, leading to job losses and increased unemployment. Stock markets can experience declines, and individuals may witness a decrease in the value of their investments. Recessions can have a domino effect on various sectors of the economy as a result. 

From a personal finance perspective, these are important aspects to think about when the economy is in a recession: 

• Employment concerns: Job security becomes a significant concern during a recession. Individuals may face redundancies or reduced work hours, leading to a decrease in income. 
• Investment values: The value of investments, including stocks and real estate, may decline during a recession. This can impact individuals with investment portfolios, retirement income, or other assets such as property. 
• Debt: Access to credit may become more challenging as financial institutions tighten lending standards. Individuals may find it difficult to obtain loans or credit cards. 
• Emergency fund: The importance of having an emergency fund is heightened during a recession. A financial cushion can help cover essential expenses in the event of job loss or unexpected financial challenges. 
• Budgeting: Recessions often prompt a reevaluation of spending habits.  

11. Tax planning

“Tax planning” refers to the process of organising your financial affairs in a way that takes advantage of various tax laws and regulations to minimise your overall tax liability.  

The goal of tax planning is to legally reduce the amount of income or wealth that is subject to taxation, maximise tax deductions and credits, and optimise the timing of financial transactions to achieve the most favourable tax outcomes. 

Here are some key elements and strategies involved in tax planning from a financial standpoint: 

1. Income optimisation: Structuring your income in a way that minimises your taxable income. This can involve strategies such as spreading income over different years, taking advantage of tax-efficient investments, and optimising salary and bonus structures. 

2. Deductions and credits: Identifying and maximising eligible deductions and tax credits to reduce taxable income. This may include deductions for expenses related to education, homeownership, charitable contributions, and more. 

3. Investment planning: Choosing tax-efficient investment strategies that take advantage of tax-deferred or tax-free growth. This can involve utilising tax-advantaged accounts such as ISAs. 

4. Estate Planning: Structuring your estate in a way that minimises potential inheritance taxes. This may involve setting up trusts, making use of exemptions, and planning for the tax implications of passing on assets to heirs. 

5. Retirement planning: Contributing to retirement accounts to benefit from tax advantages and strategically withdrawing funds during retirement to minimise tax impact. 

6. Business tax planning: For business owners, implementing strategies to optimise business structure, take advantage of available tax credits, and manage income in a tax-efficient manner. 

7. Compliance: Ensuring that all financial activities comply with relevant tax laws and regulations to avoid penalties and legal issues. 

12. Finfluencers

“Finfluencer” refers to individuals who use social media platforms to share content related to personal finance, investment, budgeting, and other financial topics. Finfluencers leverage their online presence to provide financial guidance, tips, and insights to their followers. 

Similar to traditional influencers who focus on lifestyle, beauty, or fitness, finfluencers specialise in the financial domain. They often share their personal experiences, investment strategies, and money-saving tips with the goal of educating and inspiring their audience to make informed financial decisions. 

Finfluencers can be found on various social media platforms such as Instagram, YouTube, TikTok, and Twitter. They may collaborate with financial brands, share product recommendations, and engage with their followers through Q&A sessions or live streams. The rise of finfluencers reflects the increasing interest in financial literacy and the desire for accessible and relatable information on managing money in the digital age. 

While finfluencers might seem useful sources of financial information and experiences, people should be wary of receiving bad advice, or any kind of tips that might not be in their best interest. While some finfluencers are responsible with the information they give, others are definitely not trustworthy.  

Please note all the ideas expressed above are illustrative only. If you would like to consider tax planning measures for yourself, it is best to speak to a regulated financial adviser who can help.