Basic Concepts in Finance

Somewhere in between learning multiplication tables, history, or chemical formulas, you might think it would make sense for a grade school education to include information to help equip students for the financial realities of their future independence. Unfortunately, this is one area where the individual is often left to their own devices. Fiscal responsibility and foresight aren’t high school electives, but a lack of a thorough understanding of finance can set you up for serious pitfalls in the future. Knowing your way around money matters can set the stage for a more stable future.

If you feel a little lost when words like “liquidity,” “yield,” “rate of return,” and other financial phrases start to fly around, don’t worry — you aren’t alone. However, there’s no time to learn like the present. Successfully managing your money and establishing a solid foundation for your financial future begins with developing an understanding of basic finance concepts. Here’s what you need to know to get started.

Net Worth: The Number You Want to Know

It’s not just for lists of financial big shots around the world: net worth is an important concept even for the individual. What is the net worth of a person, though? In its simplest expression, it is the value of everything a person owns — cash, property with value, investments, etc. — minus the total your outstanding debts. If the number you get after adding everything up is greater than zero, that’s usually a good sign of financial health. If you’re “in the red,” though, it might be time to reconsider spending habits and put more effort towards paying down debt. While your net worth does not have as much of an impact on your day-to-day finances such as liquidity and cash flow might (more on those below), it’s an important overall barometer of your status. 

How do you figure out your net worth? Here’s an easy way to make a net worth calculation right now. First, determine what assets you have, both financial and non-financial. That means all the cash in your bank accounts, the approximate value of any vehicles or homes you own, plus the value of any stocks or bonds in your name. Now begin to add up the value of your debts: mortgages, car loans, personal loans, credit card debt, and so on. Subtract this number from your first sum — that’s your net worth.

Liquidity and Cash Flow

If your net worth is a look at your broader financial health, then your liquidity is a measure of how financially capable you are right now. Why is that important? If you aren’t very liquid, you’ll have trouble paying your bills and meeting other obligations. “Liquid” assets are those to which you have immediate access and which you can easily use to make payments — in other words, cash or something you can quickly to convert to cash. Illiquid assets are those which have value, but which are not easy to convert to cash. A home, for example, can add substantial value to your net worth, but not your liquidity; it may take many months to convert that real estate into cash you can use. Your goal should be to maintain enough liquid assets to avoid the need to convert any at all. 

An essential factor that contributes to the liquidity of your finances is your cash flow, a measure of how much you’ve impacted your financial status after meeting all your monthly obligations. If you’ve added money to your balance, you’ve achieved a positive cash flow. If you have less than when you started, your cash flow is negative. What is free cash flow? This alternative term also includes spending you undertake to make investments or maintain your assets — it’s just a more detailed look at your cash flow. 

With positive cash flow, your liquidity increases, and you are more likely to continue building up savings. On the opposite side of the spectrum, low or negative free cash flow indicates that you’re depleting savings and becoming more illiquid — and thus more likely to risk missing bills. If you’ve gone negative, it’s time to figure out how to make some changes. 

Making Investments

It’s important to look beyond the “now” when it comes to financial planning — retirement age might seem like it’s an eternity away, but it arrives before you know it. Setting up a financial safety net for yourself so that you can enjoy a comfortable retirement requires action today, and that means making your money work for you through investments. 

What are investments? While people might use the word to apply to things such as cars or appliances, that’s not strictly correct. An investment is a placement of your money into an asset of some type that you expect to appreciate over time. There are a few ways the average person can make investments. 

The Stock Market: This is what most people think of when they imagine investing — buying and trading stocks. Everyone loves to imagine what it would be like to buy the next Apple or Netflix before the stock price blows up, but building wealth through stock investments isn’t so flashy or easy. Instead, for the average person, it’s all about the long game. The market can change dramatically on a weekly or monthly basis, but your goal as an investor is to choose stocks that rise slowly over time. 

How does the stock market work? That’s a complicated question with big answers, but let’s stick to the basics for now. Companies want to raise money to operate, so they offer shares of their business; people then buy and sell these shares, with the price determined by the principles of supply and demand. The more profitable a business is, the higher and more stable its share price. The basic principle of “buy low, sell high” applies for stock market investors. If you have a 401(k) through work, you’re already invested in stock — only through funds that manage what stocks the money purchases. 

Real Estate: One of the most stable investments in terms of value, real estate refers to any property such as land or a building. Real estate has an inherent value that is relatively resistant to the types of swings in value that stocks experience. While real estate doesn’t always increase in value, it’s always in demand — so it is easier to invest and grow your investment on larger time scales. In some cases, real estate is even a vehicle for other investments, such as rental property. 

Taking Loans

Sometimes, you won’t have enough liquid cash available to make a major purchase or to meet an important financial obligation. In these cases, it may be time to consider taking out a loan. How do loans work? A financial institution, such as Resource One Credit Union near Houston, will evaluate your creditworthiness and, if approved, provide you with access to an agreed-upon amount of funds. Your lender doesn’t give you this money for free, though; you’ll pay interest. 

What are interest rates? Interest rates are the “fees” you pay for the privilege of borrowing money over a long period; it helps to reduce risk for financial institutions while also making loans a profitable product. Interest rates are expressed as a percentage of the total loan amount. Some rates “fixed” and do not change — these are typical for loans that come with a fixed monthly payment. Variable rates, though, are often used for credit cards to respond to changes in risk or creditworthiness.

Some of the loans you could seek include:

• Auto Loans, for spreading out the cost of purchasing a new or used vehicle over several years
• Mortgage Loan, for buying a home — usually comes with a fixed term of 15 or 30 years
• Home Equity Loans, for tapping into money you’ve already paid into your home, to make improvements
• Personal Loans, which may be used to fund business ventures, pay off debt, finance major purchases, and so forth. 

Remember, the amount you owe in loans and what you must pay each month will affect your cash flow and your liquidity — it’s important to avoid taking out more loans than you can handle, especially when you consider that credit cards are technically loans, too.

Equip Yourself for a Future of Financial Stability

It’s clear there’s a lot to learn, and we’ve only just scratched the surface with this guide. One could easily take a deep dive on any of these subjects, especially when it comes to making smart investments. How you manage your money, though, all begins with choosing a good financial institution. At Resource One Credit Union, a member-owned non-profit providing robust services that generate value for our partners, your journey can begin in one of our convenient locations. 
From establishing a savings account to building credit and even laying the foundation for retirement savings, visiting a Resource One Credit Union near Dallas today can help you make the first steps into your financial future. See where we’re located, or give us a call today. No one should be left in the dark when it comes to finance — we’re here to help shine a light on the topics you need to know.