What Is Financial Literacy?
Financial literacy is the ability to understand and effectively use various financial skills, including personal financial management, budgeting, and investing. When you are financially literate, you have the foundation of a relationship with money, and it is a lifelong journey of learning. The earlier you start, the better off you will be, because education is the key to success when it comes to money.
- The term “financial literacy” refers to a variety of important financial skills and concepts.
- People who are financially literate are generally less vulnerable to financial fraud.
- A strong foundation of financial literacy can help support various life goals, such as saving for education or retirement, using debt responsibly, and running a business.
- Key aspects to financial literacy include knowing how to create a budget, plan for retirement, manage debt, and track personal spending.
- Financial literacy can be obtained through reading books, listening to podcasts, subscribing to financial content, or talking to a financial professional.
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Understanding Financial Literacy
From about 2000 to 2022, financial products and services have become increasingly widespread throughout society. Whereas earlier generations of U.S. residents may have purchased goods primarily in cash, various credit products are popular today, such as credit and debit cards and electronic transfers. A 2021 survey by the Federal Reserve Bank of San Francisco revealed that 28% of all payments were via credit card, with only 20% being made in cash.
Given the importance of finance in modern society, lacking financial literacy can be very damaging to an individual’s long-term financial success. Even so, research shows that financial illiteracy is very common, with the Financial Industry Regulatory Authority (FINRA) attributing it to 66% of Americans.
Being financially illiterate can lead to a number of pitfalls, such as being more likely to accumulate unsustainable debt burdens, either through poor spending decisions or a lack of long-term preparation. This, in turn, can lead to poor credit, bankruptcy, housing foreclosure, and other negative consequences.
Thankfully, there are now more resources than ever for those wishing to educate themselves about the world of finance. One such example is the U.S. government-sponsored Financial Literacy and Education Commission, which offers a range of free learning resources.
Financial literacy can help protect individuals from becoming victims of financial fraud, a type of crime that is becoming more commonplace.
Scope of Financial Literacy
Although many skills might fall under the umbrella of financial literacy, popular examples include household budgeting, learning how to manage and pay off debts, and evaluating the tradeoffs between different credit and investment products. These skills often require at least a working knowledge of key financial concepts, such as compound interest and the time value of money.
Other products, such as mortgages, student loans, health insurance, and self-directed investment accounts, have also grown in importance. This has made it even more imperative for individuals to understand how to use them responsibly.
Financial literacy can cover short-term financial strategy as well as long-term financial strategy, and which strategy you take will depend on several factors, such as your age, time horizon, and risk tolerance. Financial literacy encompasses knowing how investment decisions made today will impact your tax liabilities in the future.
This also includes knowing which investment vehicles are best to use when saving, whether for a financial goal like buying a home or for retirement. This is not to add the novelties in finance such as e-wallets, digital money, buy now/pay later, P2P lending, and other new financial products that can be convenient and cost-effective but require potential consumers to be educated to assess them adequately to their advantage.
Why Financial Literacy Matters
From day-to-day expenses to long-term budget forecasting, financial literacy is crucial for managing these factors. It is important to plan and save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy, defaults, and foreclosures.
If you are a younger individual, retirement may seem years away. While it is a ways in the future, it is also one of the best goals to start saving for, because the earlier you start, the more you’ll have compounded down the line. One investment vehicle to start with is an employer-sponsored retirement account, such as a 401(k).
In its Economic Well-Being of U.S. Households in 2020 report, the U.S. Federal Reserve System Board of Governors found that many Americans are unprepared for retirement. More than one-fourth indicated that they have no retirement savings, and fewer than four in 10 of those not yet retired felt that their retirement savings are on track. Among those who have self-directed retirement savings, more than 60% admitted to feeling low levels of confidence in making retirement decisions.
Low financial literacy has left millennials—the largest share of the American workforce—unprepared for a severe financial crisis, according to research by the TIAA Institute. Even among those who report having a high knowledge of personal finance, only 19% answered questions about fundamental financial concepts correctly. Forty-three percent report using expensive alternative financial services, such as payday loans and pawnshops. More than half lack an emergency fund to cover three months’ expenses, and 37% are financially fragile (defined as unable or unlikely to be able to come up with $2,000 within a month in the event of an emergency).
Millennials also carry large amounts of student loan and mortgage debt—in fact, 44% of them say they have too much debt.
Though these may seem like individual problems, they have a wider effect on the entire population than previously believed. All one needs is to look at the financial crisis of 2008 to see the financial impact on the entire economy that arose from a lack of understanding of mortgage products (creating a vulnerability to predatory lending). Financial literacy is an issue with broad implications for economic health.
Benefits of Financial Literacy
Holistically, the benefit of financial literacy is to empower individuals to make smarter decisions. More specifically, financial literacy is important for a number of reasons.
- Financial literacy can prevent devastating mistakes: Floating rate loans may have different interest rates each month, while traditional individual retirement account (IRA) contributions can’t be withdrawn until retirement. Seemingly innocent financial decisions may have long-term implications that cost individuals money or impact life plans. Financial literacy helps individuals avoid making mistakes with their personal finances.
- Financial literacy prepares people for emergencies: Financial literacy topics such as saving or emergency preparedness get individuals ready for the uncertain. Though losing a job or having a major unexpected expense are always financially impactful, an individual can cushion the blow by implementing their financial literacy in advance by being ready for emergencies.
- Financial literacy can help individuals reach their goals: By better understanding how to budget and save money, individuals can create plans that set expectations, hold them accountable to their finances, and set a course for achieving seemingly unachievable goals. Though someone may not be able to afford a dream today, they can always make a plan to better increase their odds of making it happen.
- Financial literacy invokes confidence: Imagine making a life-changing decision without all the information you need to make the best decision. By being armed with the appropriate knowledge about finances, individuals can approach major life choices with greater confidence realizing that they are less likely to be surprised or negatively impacted by unforeseen outcomes.
Strategies to Improve Financial Literacy Skills
Developing financial literacy to improve your personal finances involves learning and practicing a variety of skills related to budgeting, managing, and paying off debts, and understanding credit and investment products. The good news is that, no matter where you are in life and financially, it’s never too late to start practicing good financial habits.
Here are several practical strategies to consider.
- Create a budget: Track how much money you receive each month against how much you spend in an Excel sheet, on paper, or with a budgeting app. Your budget should include income (paychecks, investments, alimony), fixed expenses (rent/mortgage payments, utilities, loan payments), discretionary spending (nonessentials such as eating out, shopping, and travel), and savings.
- Pay yourself first: To build savings, this reverse budgeting strategy involves choosing a savings goal, such as paying for higher education, deciding how much you want to contribute toward it each month, and setting that amount aside before you divvy up the rest of your expenses.
- Pay bills promptly: Stay on top of monthly bills, making sure that payments consistently arrive on time. Consider taking advantage of automatic debits from a checking account or bill-pay apps and sign up for payment reminders (by email, phone, or text).
- Get your credit report: Once a year, consumers can request a free credit report from the three major credit bureaus—Equifax, Experian, and TransUnion—through the federally created website AnnualCreditReport.com. Review these reports and dispute any errors by informing the credit bureau of inaccuracies. Because you can get three of them, consider spacing out your requests throughout the year to monitor yourself regularly.
In a 2021 survey by the Federal Reserve, 22% of adults in the United States reported not being OK financially and not living comfortably financially.
- Check your credit score: Having a good credit score helps you obtain the best interest rates on loans and credit cards, among other benefits. Monitor your score via a free credit monitoring service (or, if you can afford to and want to add an extra layer of protection for your information, use one of the best credit monitoring services). In addition, be aware of the financial decisions that can raise or lower your score, such as credit inquiries and credit utilization ratios.
- Manage debt: Use your budget to stay on top of debt by reducing spending and increasing repayment. Develop a debt reduction plan, such as paying down the loan with the highest interest rate first. If your debt is excessive, contact lenders to renegotiate repayment, consolidate loans, or find a debt counseling program.
- Invest in your future: If your employer offers a 401(k) retirement savings account, be sure to sign up and contribute the maximum to receive the employer match. Consider opening an individual retirement account (IRA) and creating a diversified investment portfolio of stocks, fixed income, and commodities. If necessary, seek financial advice from professional advisors to help you determine how much money you will need to retire comfortably and develop strategies to reach your goal.
Example of Financial Literacy
Emma is a high school teacher who tries to inform her students about financial literacy through her curriculum. She educates them on the basics of a variety of financial topics, such as personal budgeting, debt management, education and retirement saving, insurance, investing, and even tax planning. Emma’s students can and will use these concepts later in life for things like renting an apartment, getting a first job, or even just paying for fun activities such as going to the movies.
Understanding concepts such as interest rates, opportunity costs, debt management, compound interest, and budgeting, for example, could help her students manage the student loans that they might rely on to fund their college education and keep them from amassing dangerous levels of debt and endangering their credit scores. Similarly, she expects that certain topics, such as income taxes and retirement planning, will eventually prove useful to all students, no matter what they end up doing after high school.
Why Is Financial Literacy Important?
Being financially literate from a young age gives an individual the tools and resources they need to be financially secure later in life. The lack of financial literacy can lead to a number of pitfalls, such as accumulating unsustainable debt burdens, either through poor spending decisions or a lack of long-term preparation. This, in turn, can lead to poor credit, bankruptcy, housing foreclosure, or other negative consequences.
How Do I Become Financially Literate?
Becoming financially literate involves learning and practicing a variety of skills related to budgeting, managing and paying off debts, and understanding credit and investment products. Basic steps to improve your personal finances include creating a budget, keeping track of expenses, being diligent about timely payments, being prudent about saving money, periodically checking your credit report, and investing for your future.
What Are Some Popular Personal Budget Rules?
Two commonly used personal budgeting methods are the 50/20/30 and 70/20/10 rules, and their simplicity is what makes them popular. The former entails dividing your after-tax, take-home income pay into three areas: needs (50%), savings (20%), and wants (30%). The 70/20/10 rule also follows a similar blueprint, recommending that your after-tax, take-home income be divided into segments that cater to expenses (70%), savings or reducing debt (20%), and investments and charitable donations (10%).
What Are the Principles of Financial Literacy?
There are five broad principles of financial literacy. Though other models may list different key components, the overarching goal of financial literacy is to educate individuals on how to earn, spend, save, borrow, and protect their money.
What Are Some Examples of Financial Literacy?
As a high school student transitions to college, they may be faced with the task of deciding which school to attend and how to finance their education. This may including how much money they should be saving from their after-school job, how the terms of their loan will work, and what opportunity costs exist throughout their decision-making process.
In this example, the student will make more financially responsible decisions if they are more financially literate. Financial literacy in this example extends to savings, employment, budgeting, loans, and financial planning. Using financial literacy and making smart decisions, the student can set themselves up for long-term success.
The Bottom Line
Financial literacy is the knowledge of how to make smart decisions with money. This includes preparing a budget, knowing how much to save, deciding favorable loan terms, understanding impacts to credit, and distinguishing different vehicles used for retirement. These skills help individuals make smarter decisions and act more responsibly with their personal finances.