Imagine you win a lottery of $1.3 billion today. How would you spend it?
You’re probably thinking, ‘Well, the probability of that ever happening is next to improbable.’ So let’s bring it down a bit. Imagine you came into an unexpected windfall of $10,000 today. How would you spend it?
The principles that apply to managing $10,000 also apply to $1.3 billion. If you have no idea how to maximize billions, you probably won’t know how to maximize thousands either. And since as far back as 2001, research has consistently shown that people who come into unexpected money end up spending it all with little to show for it.
And the problem is financial illiteracy.
Insurance, like your daily expenses, requires a good knowledge of financial concepts for optimal use.
According to the U.S Financial Literacy and Education Commission (2020), financial literacy is defined as “the skills, knowledge and tools that equip people to make individual financial decisions and actions to attain their goals; this may also be known as financial capability, especially when paired with access to financial products and services.”
Simply put, financial literacy is having a good understanding of money and how to use it.
What is finance?
Finance is an umbrella term for the management and control of money in all its forms. From cash to capital assets, securities and credit, finance is the study of money. This makes it vital in planning and decision-making processes.
There are 3 main categories of finance, and they all affect us daily.
Personal finance deals with how individuals and households manage money. It involves the financial planning of your income to achieve your short-term and long-term goals which could be buying a car or saving for college. We’re constantly handling money; either receiving or giving them away. Being able to control how your money comes in and where it goes to, is the core of personal finance. It encompasses strategies, programs, and teachings that help individuals reclaim control of their cash flow.
Personal finance depends on how you use finance concepts like savings, investments, budgeting, insurance, and income, among others. Having a good knowledge of them will help you differentiate between good and bad financial choices, and become financially independent and secure.
This type of finance deals with how businesses manage their resources. It is concerned with maximizing profits and shareholder value while keeping in line with the business’s short- and long-term financial goals. It involves budgeting, investments, bond offerings, and other activities that help keep the business afloat and profitable.
Corporate finance can also be considered a department in a company which handles the day-to-day cash flow, develops financial strategies, and makes decisions such as whether to pay out dividends or issue stocks. It encompasses the entirety of financial dealings that relate to a business. Some common activities are capital budgeting, capital investing, dividend distribution, and so on.
Public finance focuses on the government and how they handle money. The money is made up of contributions from citizens through tax, and revenue on investments. Public finance also covers government expenditure on public-facing infrastructure like medical facilities and schools. It is limited to public funds and how they are used to run the economy through strategic policies. There are three categories of public finance; public revenue, public expenditure, and public debt.
This type of finance affects both citizens and foreign stakeholders as it influences the country’s economic stability and, ergo, business relationships with other countries or partners. Public finance management is a broader term that deals with how public finance is appropriately allocated to different sectors and utilized. It involves macroeconomic and microeconomic responsibilities like debt management, inflation, taxation, economic growth, and so on.
10 Financial Concepts You Need To Know
You know that cash you rake in for doing stuff or selling things? That’s your income! It’s the reward for your hard work or investments. For regular folks, income usually means what we bring home from jobs, gigs, and the occasional tips. But if you’re running a business, it’s what comes in from all those sales.
- Gross income: Think of it as the grand total for your smarts, skills, and things you’ve sold.
- Net income: That’s what’s left in your pocket after you’ve taken out the chunk for taxes and those pesky expenses that come with being an adult.
Knowing your way around these terms and the different types of income is gold for your money game. We’re talking about three main flavors: Active income (when you’re putting in the elbow grease), Passive income (when your money works for you), and Portfolio income (from your mix of investments).
In simpler words, expenses are the bucks we shell out to get something back, a bit like a give-and-take with our wallets. We come across expenses in our daily lives, such as buying groceries or paying phone bills. They are costs we take on in exchange for something we want. However, in the financial world, it takes on a more defined meaning; the cost of business that is deducted from revenue to arrive at net income.
There is nothing you can do to avoid taxes…. this is what we like to call your “silent partner.” I’m sure you can relate to having someone in your life who always expects you to pay for something…? Annoying right? Yup, that’s our government. Every time, and I mean every time you get paid, a portion of your money is assigned to the government, known as taxes. Now this pertains to you, the individual, and the business.
Not only is your income taxed, but you can be taxed on your houses, cars, investments, and other valuables. You may ask, “What does the government do with this money?” Well, they claim to use the funds to maintain roads and buildings and provide public schooling, funding, and other resources. Now although every citizen is obligated to pay taxes, that still doesn’t explain why the US is over $30 trillion in debt. We’ll save that topic for another day. 🙂
These are the valuable tools in your possession that you hang onto, crossing your fingers for them to give you benefits down the road. Think properties, investments, or even stashed cash. The cool thing about assets is that they’re like the superheroes of your finances – they swoop in to either fill your pockets with extra dough or prevent your pockets from getting emptier. Wrap your head around how these assets work their magic on your money, and you’re well on your way to crafting your financial game plan and mastering the art of insurance juggling.
There are different types of assets; Current assets, which are short-term economic resources like bonds and savings; Fixed assets, which are long-term resources like real estate and retirement accounts; Tangible assets, which are physical to touch like land and cars; and Intangible assets which are not physically visible like trademarks and patents.
Liabilities play the opposite game of assets. They’re the things you’ve got in your possession that send your cash running and future benefits waving goodbye, mostly to other businesses or folks. In simpler terms, a liability is like a financial IOU, a “hey, I owe you” note in the money world. But hold on, not all liabilities are like thunderclouds on a picnic day. Some can actually be pretty friendly, especially if you know how to play the liability management game. They can be your financial sidekicks, helping you bankroll your dreams and supercharge your value game.
Liabilities can either be current or non-current. Current liabilities are short-term financial obligations that must be settled within a year, such as bank overdrafts and accrued expenses. Non-current liabilities, on the other hand, can be settled after one year such as mortgage debt.
6. Time value of money
This is one of the most significant concepts in finance, as it affects how you perceive and manage resources. Imagine you’ve got a wad of cash in your pocket right now. It’s like a shiny, golden goose egg that you can use to buy things, invest, or squirrel away for later.
Now, fast-forward to the future. That same wad of cash might not have the same oomph. It could get bitten by the depreciation bug, nibbled on by inflation gremlins, or worse, have to bail you out of a financial emergency. In essence, today’s dollars are worth more than tomorrow’s, like a dollar bill with a magical growth potion.
Understanding this concept helps drive financial decisions such as investing now to earn interest in the future rather than having the money sit idly and lose value. The same also applies to insurance, as you spend a sum of money on premiums to earn a greater sum later in life.
7. Compound interest
Here’s the lowdown on compound interest: it’s not your run-of-the-mill interest. It’s the cool older sibling that earns interest on the initial amount you put in and the interest you’ve already racked up. It’s like getting paid for being paid. Let that sink in for a moment.
You know who’s a big fan of compound interest? Banks and financial institutions. They’ve got this secret sauce, and it’s called multiplying money. They lend out cash, and thanks to compound interest, they’re basically turning their dollars into a small army of dollars. It’s like their money is breeding but in a good way.
Here’s the kicker – you can wield this mighty concept too. Imagine your money doing a little dance of joy every time you invest it. The more you invest, the more it earns. It’s like having a money-making machine that doesn’t stop. Just think about it – you can be chilling on a beach somewhere, and your money back home is doing all the heavy lifting for you. It’s like having your own personal finance minion.
Let’s imagine you have a principal amount of $500 with a 5% interest rate; at the end of year one, you’d have $525. If the $25 interest is left with the principal, at the end of year two, you’d have an interest of $26.25, bringing your total balance to $551.25. This is how your interest keeps growing even though the rate remains the same.
8. Cash Flow
This concept revolves around the movement of funds in your personal or business account. Don’t confuse it with profits; it’s more like a show-and-tell of what’s coming and going from your ownership. Cash flows play a key role in your financial strategy, unveiling the sources of your income and the spots where your money bids you goodbye.
An investment refers to something acquired with the aim of producing future income. It’s all about things that tend to grow in value over time. One notable contrast between investments and assets lies in how we view them. Assets can be sold for what they’re worth, whereas investments are primarily anticipated to yield income down the road. Think of bonds, stocks, and the like as examples.
Here you dish out some of your cash to an insurance company. In return, they graciously shoulder the burden of your surprise expenses down the road. Think health hiccups, mortgage mayhem, car conundrums, and more, all tailor-made to fit your life’s greatest hits. Consider it a pact that kicks into action for as long as you keep the premium faucet flowing.
Insurance, as a financial concept, can be seen as an investment vehicle for achieving security and stability. It maximizes the concept of the time value of money as well as compound interest to accumulate money for future use. When done right, it becomes an asset but if not properly managed, it can become a liability to its owner.
What is Insurance?
According to Forbes, “Insurance is a legal contract between the insured (individual or company who take the policy) and the insurer (a company which provides insurance), where the latter pays the specific amount of money to the former, in case any unfortunate event or crisis arises such as sudden demise, accidental injuries, damage to vehicle or house, etc.”
Insurance is using the money you have today to buy money for the future.
Importance of Insurance
Having an insurance policy provides you with many benefits, such as:
- Pays for unforeseen expenses: Your insurance takes care of unexpected crises like accidents, sudden death, and so on.
- Provides an inheritance for your beneficiaries: Upon death, the insurance company pays out death benefits to your beneficiaries, which they can then use to meet their needs.
- Generates long-term wealth: With insurance, you can accumulate wealth throughout your life by making regular premium payments.
- Provides loans at competitive rates: Depending on the type of insurance, you can borrow funds with ease and at cheaper rates than traditional banks and financial institutions
- Provides tax-free retirement funds: Upon retirement, money from the policy can be used to sustain yourself without having to pay taxes on it.
Types of Insurance
There is always uncertainty about the future. No one is sure if or when they’d suffer a car accident, a medical complication that could put finances in the red, or even a job loss. Some prepare for these scenarios by saving money in a bank account and hoping they have enough to cover the expenses if they do occur. For others, they get insurance policies that are guaranteed to foot the bills if these circumstances happen.
There are different types of insurance policies to cover the different types of uncertainty.
Health Insurance: This insurance type covers medical treatments and health emergencies. They could be gotten as part of your employment package or directly from health insurance companies or government-subsidized programs. The insurance pays for or contributes to daily procedures like eye check-ups, and dental care, and they can be extended to cover hospitalization, maternity care, and more.
Auto Insurance: Auto insurance takes care of unexpected accidents or damages to your vehicle. Depending on your chosen coverage, this insurance type can also cover third-party damages including injuries to your person as well as your passenger, and the other affected vehicle. Also damages gotten as a result of natural disasters or burglaries are taken care of.
Home Insurance: This type of insurance covers the house, its contents, and its structure in the event of any losses. The insurance company foots the bill for fire outbreaks, natural disasters, man-made accidents, theft, and more. Home insurance can be taken out by homeowners to provide coverage for its structure and general hazards, while tenants can also take out insurance to protect their belongings in the house.
Life Insurance: Life insurance is a type of insurance that financially supports those you care about. When you die, the insurance company pays out death benefits to your beneficiaries and depending on your type of life insurance, the company can support you through life-changing situations such as a disability or retirement. It may be a term life insurance covering a fixed period or a permanent life insurance covering the full lifespan.
Now it’s important to note that life insurance doesn’t have to only be related to death. There are many ways permanent life insurance can solve your financial goals. Clients pay off debt, reduce taxes, invest, and create legacies, for example, using whole life insurance.
Understanding insurance terminology
There are some terms you need to know to make the most of your insurance policy:
A premium is what you pay to the insurance company for the policy coverage. The insurer sets the price based on certain factors such as age, and health condition, among others. You can pay annually, semi-annually, quarterly or monthly. The premium must also be regularly paid or you could lose the policy and accumulated death benefits.
Also known as insurance living benefits, additional riders are optional packages that provide extra benefits to a standard insurance policy. They are often low in cost and involve minimal underwriting, making them a suitable choice if you want to extend or restrict your coverage options.
It may be difficult to find a policy that meets all your specific needs, so getting add-on riders helps you customize your policy. Some examples are additional riders, meaning adding more cash you can access in your policy; term conversion riders meaning adding more death benefits to your policy at an affordable cost, long term care, meaning paying for medical expenses.
Not to be mistaken with cash flow, the cash value is the sum of money accumulated in your permanent life insurance policy. When you pay your premiums, a part of it goes towards your death benefits while the rest goes towards the cash value and insurance charges.
A major benefit of cash value is that you can borrow against it for your present needs at low interest rates, and pay back if or when you decide to.
This is the amount of money you’ll receive if you cancel the policy before maturity or death (in the case of permanent life insurance). It is the cash value of the policy minus fees, penalties, and other charges incurred for terminating the policy. Once a policy is surrendered, you lose the death benefits and it may be impossible to restore that policy.
Starting out in finance can be a bit overwhelming, especially when you want to know the best decisions to take regarding your money. Here are some resources to help make the process better:
- Informed Financial Decisions With TVM Calculator
- How To Read A Bank Statement: Everything You Need To Know
- Life Insurance Illustrations: Everything You Need To Know
- 7702 Plan: Everything You Need To Know
- Financial Needs vs Wants – How to Budget The Right Way?
You can also get help from professional insurance advisors to guide you through these concepts and design the right financial plans for your goals.