We know that the earlier you learn the basics of how money works, the more confident and successful you'll be with your finances later in life. It's never too late to start learning, but it pays to have a head start. The first steps into the world of money start with education.
Banking, budgeting, saving, credit, debt, and investing are the pillars that underpin most of the financial decisions we'll make in our lives. At Investopedia, we have more than 30,000 articles, terms, FAQs, and videos that explore these topics, and we've spent more than 20 years building and improving our resources to help you make financial and investing decisions.
This guide is a great place to start, and today is a great day to do it. Let's begin with financial literacy—what it is and how can it improve your life.
- Financial literacy is the ability to understand and make use of a variety of financial skills.
- Financial literacy in the United States is declining at a time when citizens increasingly need to make thoughtful and informed decisions in order to avoid high levels of debt and have adequate income in retirement.
- Some of the basics of financial literacy and its practical application in everyday life include banking, budgeting, handling debt and credit, and investing.
What Is Financial Literacy?
Financial literacy is the ability to understand and make use of a variety of financial skills, including personal financial management, budgeting, and investing. It also means comprehending certain financial principles and concepts, such as the time value of money, compound interest, managing debt, and financial planning.
Achieving financial literacy can help individuals avoid making poor financial decisions to help them become self-sufficient and achieve financial stability. Key steps to attaining financial literacy include learning how to create a budget, track spending, pay off debt, and plan for retirement. Educating yourself on these topics also involves learning how money works, setting and achieving financial goals, becoming aware of unethical/discriminatory financial practices, and managing financial challenges that life throws your way.
The Importance of Financial Literacy
Trends in the United States indicate that Americans' financial literacy is declining. In its National Financial Capability Study, conducted every few years, the finance and bank regulator FINRA poses a five-question test that measures consumers' knowledge about interest, compounding, inflation, diversification, and bond prices. In the latest study, only 34% of those who took the test answered four out of five questions correctly.
Yet making informed financial decisions is more important now than ever. Take retirement planning: Workers once relied on pension plans to fund their retirement lives, with the financial burden and decision making for pension funds borne by the companies or governments that sponsored them. Today few workers get pensions; some are instead offered the option of participating in a 401(k) plan, which involves decisions on contribution levels and investment choices. Those without employer options need to actively seek out and open IRAs and other tax-advantaged savings accounts.
Add to this people's increasing lifespans (leading to longer retirements), Social Security benefits that barely provide enough for basic survival, complicated health and other insurance options, more complex savings and investment instruments to select among—and a plethora of choices from banks, credit unions, brokerage firms, credit card companies, and more. It's clear that financial literacy is a must for making thoughtful and informed decisions, avoiding unnecessary levels of debt, helping family members through these complex decisions, and having adequate income in retirement.
Personal Finance Basics
Personal finance is where financial literacy translates into individual financial decision making. How do you manage your money? Which savings and investment vehicles are you using? Personal finance is about making and meeting your financial goals—whether that's owning a home, helping other members of your family, saving for your children's college education, supporting causes you care about, planning for retirement, and much more. Among other topics, it encompasses banking, budgeting, handling debt and credit, and investing. Let's take a look at these basics to get you started.
Introduction to Bank Accounts
Bank accounts are typically the first financial account you'll open, and are necessary for major purchases and life events. Here's a breakdown of which bank accounts you should open and why they are step one in creating a stable financial future.
Why do I need a bank account?
While the majority of Americans do have bank accounts, 6% of households in the United States still don't have accounts. Why is it so important to open a bank account? Because they’re safer than holding cash. Assets held in a bank are harder to steal, and in the United States, they’re insured by the Federal Deposit Insurance Corporation (FDIC). That means you’ll always have access to your cash, even if every customer decided to withdraw their money at the same time.
Many financial transactions require you to have a bank account in order to:
- Use a debit or credit card
- Use payment apps like Venmo or PayPal
- Write a check
- Use an ATM
- Buy or rent a home
- Receive your paycheck from your employer
- Earn interest on your money
Online vs. brick-and-mortar banks
When you think of a bank, you probably picture a building. This is called a “brick-and-mortar” bank. It means the bank has a physical building. Many brick-and-mortar banks also allow you to open accounts and manage your money online.
Some banks are only online and have no physical buildings. These banks typically offer the same services as brick-and-mortar banks, aside from the ability to visit them in person.
Which type of bank can I use?
Retail banks: This is the most common type of bank people have accounts with. Retail banks are for-profit companies that offer checking and savings accounts, loans, credit cards, and insurance. Retail banks can have physical, in-person buildings that you can visit, or be online-only. Most have both. Banks' online technology tends to be advanced, and they often have more locations and ATMs nationwide than credit unions.
Credit unions: Credit unions provide savings and checking accounts, issue loans, and offer other financial products, just like banks. However, they operate under the direction of elected board members. Credit unions tend to have lower fees and better interest rates on savings accounts and loans. Credit unions are sometimes known for providing more personalized customer service, though they usually have far fewer branches and ATMs.
Assets held in a credit union are insured by the National Credit Union Administration (NCUA), which is equivalent to the FDIC for banks.
Which types of bank accounts can I open?
There are three main types of bank accounts the average person will open:
- Savings account: A savings account is an interest-bearing deposit account held at a bank or other financial institution. Savings accounts typically pay a very small interest rate, but their safety and reliability make them a sensible option for saving cash you want available for short-term needs. They usually have some legal limitations on how often you can withdraw money, but they're generally incredibly flexible, so they're ideal for building an emergency fund, saving for a short-term goal like buying a car or going on vacation, or simply storing extra cash you don’t need in your checking account.
- Checking account: A checking account is also a deposit account at a bank or other financial institution that allows you to make deposits and withdrawals. Checking accounts are very liquid, meaning they allow numerous deposits and withdrawals per month, as opposed to less-liquid savings or investment accounts, though they earn little to no interest. Money can be deposited at banks and ATMs through direct deposit or other electronic transfer. Account holders can withdraw funds via banks and ATMs by writing checks or using debit cards paired with their accounts.
You may be able to find a checking account with no fees; others have monthly and other charges (overdraft, out-of-network ATM) based on, for example, how much you keep in the account or whether there's a direct deposit paycheck or automatic-withdrawal mortgage payment connected to the account. Lifeline and second-chance accounts can help those who have difficulty qualifying for a traditional checking account.
- High-yield savings account: A high-yield savings account is another type of savings account that usually pays interest 20 to 25 times more than the national average of a standard savings account. The trade-off for earning more interest on your money is that high-yield accounts tend to require bigger initial deposits, larger minimum balances, and higher fees.
You might be able to open a high-yield savings account at your current bank, but online banks tend to have the highest interest rates.
What’s an emergency fund?
An emergency fund is not a specific type of bank account, but can be any source of cash you’ve saved to help you handle financial hardships like job losses, medical bills, or car repairs. How they work:
- Most people use a separate savings account
- Fund should total enough to cover three-to-six months' worth of expenses
- Emergency-fund money should be off-limits for paying regular expenses
Introduction to Credit Cards
You know them as the plastic cards (almost) everyone carries in their wallets. Credit cards are accounts that let you borrow money from the credit card issuer and pay it back over time. For every month you don't pay back the money in full, you'll owe the amount you didn't pay back, plus interest, to the issuer. Note that some credit cards actually require you to pay them back in full each month, though this isn't common.
What's the difference between credit and debit cards?
Here is the difference:
Debit cards take money directly out of your checking account. You can't borrow money with debit cards, which means you can't spend more cash than you have in the bank. And debit cards don't help you build up a credit history and credit rating.
Credit cards do allow you to borrow money and do not pull cash from your bank account. While this can be helpful for large, unexpected purchases, carrying a balance–not paying back the money you borrowed–every month means you'll owe interest to the credit card issuer. By the fourth quarter of 2020, Americans owed $820 billion dollars of credit card debt, so be very careful when spending more money than you have, as debt can build up quickly and snowball over time.On the other hand, paying credit card bills on time helps you establish a credit history and a good credit rating. It's important to build a good credit rating, not just to qualify for the best credit cards but because you will get more favorable interest rates on car loans, personal loans and a mortgage.
What is APR?
APR stands for annual percentage rate. This is the amount of interest you'll pay the credit card issuer in addition to the amount of money you spent on the card. You'll want to pay close attention to this number when you apply for a credit card. A higher number can cost you hundreds, or even thousands of dollars if you carry a large balance over time. The average APR is about 20%, but your rate may be higher if you have bad credit. Interest rates also tend to vary by the type of credit card.
Which credit card should I choose?
Credit scores have a big impact on your odds of getting approved for a credit card. Understanding what range your score falls in can help you narrow the options as you decide which cards to apply for. Beyond your credit score, you'll also need to decide which perks best suit your lifestyle and spending habits.
If you've never had a credit card before, or if you have bad credit, you'll likely need to apply for either a secured credit card or a subprime credit card. By paying these back on time, you can raise your credit score and earn the right to credit at better rates.
If you have fair to good credit, you can choose from a variety of credit card types:
- Travel rewards cards. These credit cards earn points redeemable for travel like flights, hotels, and cars with each dollar you spend.
- Cash-back cards. If you don't travel often–or don't want to deal with converting points to real-life perks–a cash-back card might be the best fit for you. Every month, you'll receive a portion of your spending back, in cash or as a credit to your statement.
- Balance transfer cards. If you have balances on other cards with high interest rates, transferring your balance to a lower-rate credit card could save you money and help your credit score.
- Low-APR cards. If you routinely carry a balance from month to month, switching to a credit card with a low APR could save you hundreds of dollars per year in interest payments.
Be aware of your protections under the Equal Credit Opportunity Act. Research credit opportunities and available interest rates and be sure that you are offered the best rates for your particular credit history and financial situation.
How to Create a Budget
Creating a budget is one of the simplest and most effective ways to control your spending, saving, and investing. You can't begin or improve your financial health if you don't know where your money is going, so start tracking your expenses vs. your income, then set clear goals.
One budget template that helps individuals reach their goals, manage their money, and save for emergencies and retirement is the 50/20/30 budget rule—spending 50% on needs, 20% on savings, and 30% on wants.
How do I create a budget?
Budgeting starts with tracking how much money you receive every month, minus how much money you spend every month. You can track this in an Excel sheet, on paper, or in a budgeting app—it's up to you. Wherever you track your budget, clearly lay out the following:
- Income: List all sources of money you receive in a month, with the dollar amount. This can include paychecks, investment income, alimony, settlements, and money you make doing side jobs or selling crafts.
- Expenses: List every purchase you make in a month, split into two categories—fixed expenses and discretionary spending. If you can't remember where you're spending money, review your bank statements, credit card statements, and brokerage account statements. Fixed expenses are the purchases you must make every month. Their amounts don't change (or change very little) and are considered essential. They include rent/mortgage payments, loan payments, and utilities. Discretionary spending is the category for nonessential, or varying purchases you make on things like restaurant meals, shopping, clothes, and travel. Consider them as "wants" rather than "needs."
- Savings: Record the amount of money you're able to save each month, whether it's in cash, cash deposited into a bank account, or investments in a brokerage account.
Now that you have a clear picture of money coming in, money going out, and money saved, you can identify which expenses you can cut back on if necessary. Subtract the amount of expenses from your total income to get the amount of money you have left at the end of the month. If you don't already have one, put your extra money into an emergency fund to save three-to-six months' worth of expenses in case of a job loss or other emergency. Don't use this money for discretionary spending. The key is to keep it safe and grow it for times when your income decreases or stops.
How to Start Investing
If you're ready to start investing, you'll want to learn the basics of where and how to invest your money. Decide what to invest in and how much to invest by understanding the risks of different types of investments.
What is the stock market?
The stock market refers to the collection of markets and exchanges where stock buying and selling takes place. The terms stock market and stock exchange are used interchangeably. And even though it's called a stock market, other financial securities–such as exchange traded funds (ETF), corporate bonds and derivatives based on stocks, commodities, currencies, and bonds–are also traded in the stock markets. There are multiple stock trading venues. The leading stock exchanges in the U.S. include the New York Stock Exchange (NYSE), Nasdaq, and the Chicago Board Options Exchange (CBOE).
How do I invest?
To buy stocks, you need to use a broker. This is a professional person or digital platform whose job it is to handle the transaction for you. For new investors, there are three basic categories of brokers to choose from:
- A full-service broker, who manages your investment transactions and provides advice for a fee.
- An online/discount broker that executes your transactions and provides some advice, depending on how much you have invested. Examples include Fidelity, TD Ameritrade, and Charles Schwab.
- A roboadvisor, which executes your trades and can pick investments for you. Examples include Betterment, Wealthfront, and Schwab Intelligent Portfolios.
What should I invest in?
There's no right answer for everyone. Which securities you buy, and how much you buy, depends on the amount of money you're comfortable using, and how much risk you're willing to take. Here are the most common securities to invest in, in descending order of risk:
Stocks: A stock (also known as "shares" or "equity") is a type of investment that signifies ownership in the issuing company. This entitles the stockholder to that proportion of the corporation's assets and earnings. Essentially, it's like owning a small piece of the company. However, if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a company or its assets.
Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the company’s profits) if and when they are distributed, and sell your shares to somebody else. The price of a stock fluctuates throughout the day, and can be dependent on many factors, including the company's performance, the domestic economy, the global economy, news, and more. Investing in stocks can be considered risky because you're effectively "putting all your eggs in one basket."
ETFs: An exchange-traded fund (ETF) is a type of security that involves a collection of securities—such as stocks—that often tracks an underlying index, although ETFs can invest in any number of industry sectors or use various strategies. Think of ETFs as a pie containing many different securities. When you buy shares of an ETF, you're buying a slice of the pie, which contains slivers of the securities inside. This lets you purchase many stocks at once, with the ease of only making one purchase—the ETF.
ETFs are in many ways similar to mutual funds; however, they are listed on exchanges and ETF shares trade throughout the day just like ordinary stock. Investing in ETFs is considered less risky than investing in stocks because there are many securities inside the ETF. If some go down in value, others may maintain or increase in value.
Mutual funds: A mutual fund is a type of investment consisting of a portfolio of stocks, bonds, or other securities. Mutual funds give small or individual investors access to diversified, professionally managed portfolios at a low price. There are several categories, representing the kinds of securities they invest in, their investment objectives, and the type of returns they seek. Most employer-sponsored retirement plans invest in mutual funds.
Investing in a share of a mutual fund is different from investing in shares of stock. Unlike stock, mutual fund shares do not give holders any voting rights and represent investments in many different stocks (or other securities) instead of just one holding. Unlike stocks or ETFs that trade throughout the day, many mutual fund redemptions take place only at the end of each trading day. Similar to ETFs, investing in mutual funds is considered less risky than stocks because many securities are contained within the mutual fund, spreading out the risk across multiple companies.
Bonds: Bonds are issued by companies, municipalities, states, and sovereign governments to finance projects and operations. When an investor buys a bond, they're effectively lending their money to the bond issuer, with the promise of repayment plus interest. A bond's coupon rate is the interest rate the investor will earn. A bond is referred to as a fixed income instrument since bonds traditionally paid a fixed interest rate (coupon) to investors. Bond prices are inversely correlated with interest rates: When rates go up, bond prices fall and vice versa. Bonds have maturity dates, which are the point in time when the principal amount must be paid back in full or risk default.
Bonds are rated by how likely the issuer is to pay you back. Higher rated bonds, known as investment grade bonds, are viewed as safer and more stable investments. Such offerings are tied to publicly traded corporations and government entities that boast positive outlooks. Investment grade bonds contain “AAA” to “BBB-“ ratings from Standard and Poor's, and "Aaa" to "Baa3" ratings from Moody’s. Investment grade bonds usually see bond yields increase as ratings decrease. U.S. Treasury bonds are the most common AAA-rated bond securities.
These topics are just the beginning of a financial education, but they cover the most important and frequently used products, tools, and tips for getting started. If you're ready to learn more, check out these additional resources from Investopedia:
- Investopedia Academy
- Investopedia YouTube Channel
- Investopedia Dictionary
- Investopedia Stock Market Simulator