Financial Concepts Explained
Build a solid foundation with clear explanations of essential financial concepts. Understanding these principles will help you make better financial decisions.
The eighth wonder of the world - how your money grows exponentially over time.
- Compound interest is interest calculated on the initial principal and accumulated interest from previous periods.
- The formula: A = P(1 + r/n)^(nt), where A is final amount, P is principal, r is annual rate, n is compounding frequency, and t is time.
- Starting early makes a huge difference due to the exponential nature of compounding.
- Even small amounts can grow significantly over long periods.
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A key metric lenders use to assess your ability to manage debt payments.
- DTI is calculated by dividing total monthly debt payments by gross monthly income.
- Front-end DTI includes only housing costs (typically should be under 28%).
- Back-end DTI includes all debt payments (typically should be under 36%).
- Lower DTI ratios indicate better financial health and loan approval chances.
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The true cost of borrowing money, including interest and fees.
- APR includes the interest rate plus additional fees and costs.
- It provides a more accurate picture of loan costs than interest rate alone.
- Lower APR means lower total borrowing costs.
- Always compare APRs when shopping for loans or credit cards.
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Why a dollar today is worth more than a dollar tomorrow.
- Money available now is worth more than the same amount in the future due to earning potential.
- Inflation reduces purchasing power over time.
- Investment opportunities allow money to grow.
- This concept underlies all financial decision-making.
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How to distribute investments across different asset classes.
- Diversification reduces risk by spreading investments across asset types.
- Common allocation: stocks, bonds, real estate, commodities.
- Age-based rule: 100 minus your age = percentage in stocks.
- Rebalancing maintains desired allocation as markets change.
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Your financial safety net for unexpected expenses.
- Typically 3-6 months of living expenses in easily accessible savings.
- Protects against job loss, medical emergencies, or major repairs.
- Should be in high-yield savings account or money market fund.
- Build gradually - even $500 can prevent debt accumulation.
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A strategy to reduce the impact of market volatility on investments.
- Investing a fixed amount regularly regardless of market conditions.
- Reduces average cost per share over time.
- Removes emotion and timing from investment decisions.
- Works well with retirement accounts and index funds.
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The fundamental relationship between investment risk and potential rewards.
- Higher potential returns typically come with higher risk.
- Risk tolerance varies by individual circumstances and timeline.
- Diversification can reduce risk without sacrificing returns.
- Understanding your risk capacity is crucial for investment success.
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Essential Financial Formulas
- A = Final amount
- P = Principal (initial amount)
- r = Annual interest rate
- n = Compounding frequency
- t = Time in years
- PMT = Monthly payment
- P = Principal loan amount
- r = Monthly interest rate
- n = Number of payments
Expressed as a percentage. Lower is better for loan approval.
Quick way to estimate how long it takes for money to double.
Apply Your Knowledge
Now that you understand these concepts, put them to work with our financial calculators.