Building long-term financial success involves more than securing a good job. Even a high-paying career might not be enough to create real wealth unless you understand basic financial concepts. In addition to building a financial safety net, you’ll need to grow your savings, practice lawful tax planning, and maximize your retirement accounts. Then, all the hard work you put in through your career will truly pay off.
Learn More: 5 Portfolio Diversification Techniques Millionaires Use — and You Can Use, Too
Check Out: 10 Used Cars That Will Last Longer Than the Average New Vehicle
Here’s a look at the key terms that every first-generation American should know when it comes to investing, taxes, insurance and retirement planning, including the foundational basics that underlie all of them.
If you’re looking to make informed financial decisions and build generational wealth, you should become familiar with each of these concepts.
1. Compound Interest
Compound interest is simply “interest paid on interest.” If you have $1,000 and earn a 10% return, you’ll have $1,100. If you earn another 10% the following year, you’ll have $1,210. In the first year, you earned $100, but in the second year, you earned $110 because you earned interest on your interest.
Over time, the effects of compound interest can be dramatic. Let’s say you start with a $10,000 investment and earn an annual return of 10% for 30 years. With simple interest, you’d earn $1,000 per year, for a total balance of $40,000 (your original $10,000 plus the $1,000 you earned each year for 30 years). But with compounding, that $10,000 becomes about $174,494 after 30 years — far more than simple interest and a vivid example of why starting early matters.
Explore More: 8 Truths Any Competent Financial Advisor Will Tell You About Legacy Planning
2. Diversification
Diversification refers to blending a mix of different types of investments in your portfolio so that you can reduce risk while preserving return. Owning different asset classes, such as stocks, bonds and real estate, can be a way to level out the ups and downs of your portfolio because these investments don’t always move the same way at the same time.
Within an all-stock portfolio, owning so-called “defensive” stocks that hold up better during market downturns can reduce the downside risk of more aggressive growth stocks.
3. Net Worth
Your net worth is simply your total assets minus your total liabilities. Assets include the value of your home, car, 401(k), savings and investment accounts and other possessions. Liabilities include your mortgage, auto loan, credit card balances and any other debts.
4. Emergency Funds
An emergency fund equal to three to six months’ worth of living expenses is an essential building block of a solid financial plan. Having this money in place will help keep you out of debt when you encounter a financial emergency, such as a medical bill not covered by insurance, an unexpected car expense or home repair and more. It can also lower your stress level, as you know you’ll have money set aside for life’s inevitable surprises.
5. Investments
Investments are assets that are expected to generate income and/or capital appreciation over time. Investing is how you grow your money and fight the eroding effect of inflation. Here are some popular types of investments:
- Stocks: Shares that represent ownership in a company. Often used for long-term capital appreciation; some stocks also pay income in the form of dividends.
- Bonds: Loans to governments or corporations. In exchange for your principal, which is returned at the stated maturity date, you receive regular interest payments.
- Mutual funds: Pools of money from individual investors managed by professionals; each investor owns a share of the fund proportionate to their investment. Mutual funds can be an easy way to diversify.
- Exchange-traded funds (ETFs): Funds that trade on exchanges like stocks. ETFs can be passive (tracking an index) or active, and they often offer lower costs and intraday trading flexibility compared with individual mutual funds.
- Alternative investments: Items such as precious metals, commodities, real estate or collectibles that can provide diversification beyond a stock/bond mix.
6. Inflation
Inflation means the prices of goods and services generally rise over time, which reduces the purchasing power of your money. If you have $100 in your pocket, you’ll be able to buy more with that money today than you will 10 years from now. Investing — rather than letting large amounts of cash sit idle — is the usual way to try to stay ahead of inflation.
7. Taxes
Taxes are another knife that can cut into your money. When it comes to investing, what matters is not what you earn but what you keep. That’s why tax-aware planning is important: contributing to tax-advantaged accounts and holding investments for longer than one year can reduce your taxes legally.
For example, long-term capital gains (on assets held more than one year) are taxed at lower rates than short-term gains, and some taxpayers pay a 0% long-term capital-gains rate if their taxable income is below certain thresholds.
8. Tax-Advantaged Retirement Plans
Traditional IRAs and 401(k) plans often let you take a tax deduction on your contributions, lowering your current taxable income. Money in these accounts grows tax-deferred until withdrawal. As an added bonus, many companies offering 401(k) plans also provide matching contributions, allowing you to grow your balance even faster.
Roth IRAs don’t offer an upfront deduction, but qualified withdrawals are generally tax-free, meaning both contributions and earnings can come out tax-free if you meet the rules. That trade-off (pay tax now vs. later) is a key planning decision for many looking to build wealth.
9. Insurance
Insurance transfers the risk of large, unexpected losses to an insurer in exchange for premiums you pay. Homeowners insurance protects against catastrophic property loss. Life insurance can replace income and protect beneficiaries if you die unexpectedly. Liability insurance shields you from lawsuits and judgments. These policies are tools to protect the assets you build through work and saving.
Looking to build a legacy? Check out our Life to Legacy guide for expert advice and smart moves you can make today.
More From GOBankingRates
- 5 Steps to Take if You Want To Create Generational Wealth
- I'm a Financial Advisor: My Clients Who Retire Early All Do These 3 Things
- 4 Things You Should Do if You Want To Retire Early
- Dave Ramsey: The 3 Worst Mistakes People Make When Trying To Build Wealth
This article originally appeared on GOBankingRates.com: Financial Literacy: 9 Key Terms Every First-Generation American Should Know
