What Is Financial Literacy? (And Why It’s Super Important)

Last updated on October 4, 2023

➤ What is Financial Literacy?

Financial literacy encompasses the ability to grasp and effectively apply a range of essential financial skills, such as managing personal finances, creating budgets, and making sound investment choices.

It is a lifelong journey of learning that forms the cornerstone of one’s relationship with money. The earlier you embark on this journey, the more equipped you become, as knowledge is the linchpin of financial success.

➤ Why is Financial Literacy important?

Lately, financial products and services have become increasingly prevalent in society.

Unlike earlier generations of U.S. residents who primarily made cash purchases, today, various credit products such as credit cards, debit cards, and electronic transfers have gained popularity.

According to a 2021 survey conducted by the Federal Reserve Bank of San Francisco, 28% of all payments were made using credit cards, while only 20% were conducted with cash.

In our modern world, where finance plays a vital role, lacking financial literacy can have severe consequences for an individual’s long-term financial well-being. However, research indicates that financial illiteracy is widespread, with 66% of Americans being attributed to this lack of financial knowledge by the Financial Industry Regulatory Authority (FINRA).

Financial illiteracy can lead individuals into several pitfalls, including accumulating unsustainable debt burdens. This may result from poor spending decisions or a failure to plan for the long term. Consequently, it can lead to adverse outcomes such as poor credit, bankruptcy, housing foreclosure, and other detrimental financial consequences.

The good news is that there are now more resources available than ever for individuals who wish to educate themselves about the intricacies of finance. One noteworthy example is the U.S. government-sponsored Financial Literacy and Education Commission, which provides a wealth of free learning materials.

Furthermore, financial literacy serves as a shield against falling victim to financial fraud, an increasingly common type of crime in today’s world.

➤ How can Financial Literacy help you?

Financial literacy encompasses a wide range of essential skills, including but not limited to:

1. Household Budgeting: Understanding how to create and manage a household budget is a fundamental aspect of financial literacy. It involves tracking income and expenses to ensure financial stability.
2. Debt Management: Financially literate individuals are adept at managing and paying off debts effectively. They can evaluate different debt repayment strategies and choose the one that suits their financial situation.
3. Credit and Investment Products: Evaluating the tradeoffs between various credit and investment products is crucial. This requires a working knowledge of key financial concepts like compound interest and the time value of money.
4. Mortgages: With the significance of mortgages in real estate, understanding how mortgages work and making informed decisions regarding home loans is part of financial literacy.
5. Student Loans: Many individuals rely on student loans for education. Being financially literate includes knowing how to navigate the complexities of student loans, including repayment options and interest rates.
6. Health Insurance: Health insurance is vital for managing healthcare costs. Financial literacy extends to understanding health insurance policies, deductibles, and coverage options.
7. Self-directed Investment Accounts: In an era of self-directed investing, individuals must grasp how to manage investment accounts effectively, make informed investment decisions, and diversify their portfolios.
8. Short-term and Long-term Financial Strategies: Financial literacy covers both short-term and long-term financial planning. The strategy chosen depends on factors such as age, time horizon, and risk tolerance.
9. Tax Impact of Investment Decisions: Financially literate individuals recognize how their investment decisions today can affect their tax liabilities in the future. They make informed choices to optimize tax outcomes.
10. Choosing Investment Vehicles: Knowing which investment vehicles are best suited for various financial goals is essential. Whether saving for a home purchase or retirement, understanding the most appropriate investment options is part of financial literacy.
11. Adapting to Financial Innovations: Financial literacy also includes keeping up with innovations in finance, such as e-wallets, digital currencies, buy now/pay later schemes, and P2P lending. These products can be convenient and cost-effective, but consumers must be educated to assess them properly and use them to their advantage.

➤ Why does Financial Literacy matter?

From managing daily expenses to forecasting long-term budgets, financial literacy plays a crucial role in our lives. It helps us plan and save for retirement, steering clear of excessive debt that could lead to bankruptcy, defaults, and foreclosures.

If you’re a younger individual, retirement may seem distant. However, it’s one of the best goals to start saving for early on. The earlier you begin, the more your investments will grow through compounding over time. Consider kickstarting your savings journey with an employer-sponsored retirement account, such as a 401(k).

The U.S. Federal Reserve System Board of Governors, in its 2020 report on the Economic Well-Being of U.S. Households, discovered that many Americans are ill-prepared for retirement.

More than a quarter of respondents had no retirement savings, and less than 40% of those not yet retired believed their retirement savings were on track. Among those with self-directed retirement savings, over 60% lacked confidence in making retirement decisions.

Low financial literacy has left millennials—the largest segment of the American workforce—vulnerable to severe financial crises, as per research by the TIAA Institute. Even among those who claim to have a high understanding of personal finance, only 19% could correctly answer fundamental financial questions.

Additionally, 43% reported using costly alternative financial services, like payday loans and pawnshops. Over half of millennials lack an emergency fund covering three months’ expenses, and 37% are financially fragile, meaning they can’t come up with $2,000 within a month in case of an emergency.

Millennials also grapple with substantial student loan and mortgage debt, with 44% feeling burdened by debt.

While these issues may appear personal, their ramifications are far-reaching, impacting the entire population. The 2008 financial crisis serves as a stark reminder of how a lack of understanding of mortgage products, leading to vulnerability to predatory lending, can have wide-ranging effects on the economy. Financial literacy is a matter of broader economic health with implications for all.

➤ What are the benefits of Financial Literacy?

Financial literacy offers a multitude of advantages, ultimately empowering individuals to make informed decisions and lead financially secure lives.

Here’s why financial literacy is so crucial:

1. Preventing Costly Mistakes: Financial literacy acts as a safeguard against potentially devastating financial blunders. For instance, understanding the intricacies of floating-rate loans and the rules governing traditional individual retirement accounts (IRAs) prevents individuals from making costly errors that can impact their financial wellbeing.
2. Emergency Preparedness: Financial literacy equips individuals with the knowledge and tools to prepare for unforeseen emergencies. Whether it’s losing a job or facing unexpected expenses, being financially literate means having a plan in place to soften the financial blow when life takes an unexpected turn.
3. Achieving Goals: Financial literacy empowers individuals to budget effectively and save strategically. This enables them to set realistic expectations, stay accountable to their financial objectives, and chart a course toward achieving even the most ambitious goals. While a dream may seem out of reach today, a well-thought-out plan can significantly improve the odds of turning it into reality.
4. Boosting Confidence: Imagine making a life-altering decision without access to all the essential information. Financial literacy provides individuals with the confidence to tackle significant life choices, knowing they are well-informed and less likely to be caught off guard by unforeseen financial outcomes. With financial knowledge, they approach decisions with confidence, reducing the likelihood of negative surprises.

➤ How to Improve Financial Literacy

Becoming financially literate means learning skills that help you manage your money wisely. It’s never too late to start. Here are some easy strategies:

1. Make a Budget: Keep track of your money. Write down what you earn and what you spend using an app, paper, or Excel. Include income (like your paycheck), fixed costs (rent, bills), spending on fun stuff (eating out, shopping), and savings.
2. Pay Yourself First: Save money before spending it. Pick a goal, like saving for college. Decide how much to save each month and put that away first.
3. Pay Bills on Time: Make sure bills are paid when they’re due. You can set up automatic payments or use bill-pay apps to help. Sign up for reminders so you don’t forget.
4. Check Your Credit Report: Get a free credit report every year from Equifax, Experian, and TransUnion at AnnualCreditReport.com. Look for mistakes and report them. Get one report every four months to keep an eye on your credit.
5. Know Your Credit Score: A good credit score gets you better deals on loans and credit cards. Monitor it with a free service or a paid one for extra protection. Be smart with your credit to keep your score high.
6. Manage Debt: Use your budget to tackle debt. Spend less and pay more toward your debts. Start with the ones with the highest interest rates. If you have lots of debt, talk to your lenders about better terms or join a debt counseling program.
7. Invest in Your Future: If your job offers a 401(k), use it and contribute as much as your employer matches. Think about an IRA for more savings. Build a mix of investments, like stocks and bonds. If you’re not sure, get advice from financial pros to plan for retirement.

Remember, anyone can become financially literate. Start today!

➤ Financial Literacy in action

Meet Mary, a high school teacher who’s passionate about teaching financial literacy to her students. She knows that these skills will benefit them throughout their lives. Here’s how she does it:

1. Personal Budgeting: Mary starts with the basics. She teaches her students how to create and stick to a budget. They learn how to manage their money wisely.
2. Debt Management: Mary explains how to handle debt responsibly. Her students understand the importance of paying off loans and credit cards on time.
3. Education and Retirement Saving: Mary introduces the concepts of saving for education and retirement. Her students learn about the value of long-term planning.
4. Insurance: Mary covers the importance of insurance. Her students understand how it can protect them from unexpected expenses.
5. Investing: Mary teaches her students about investing. They learn how to make their money grow over time.
6. Tax Planning: Mary even dives into tax planning. Her students grasp the basics of income taxes and how to plan for them.

Thanks to Mary’s lessons, her students are well-prepared for life’s financial challenges. Whether it’s renting an apartment, landing their first job, or simply enjoying fun activities, they have the knowledge to make smart financial decisions.

Concepts like interest rates, compound interest, and budgeting empower them to manage student loans, avoid excessive debt, and maintain good credit scores. And as they move forward, topics like income taxes and retirement planning will continue to serve them well, no matter their path after high school.

Mary’s commitment to financial literacy ensures her students are equipped for a successful financial future.

➤ Financial Literacy: FAQ

Why is Financial Literacy so important?

Financial literacy is like a compass that guides you through life’s financial journey. Here’s why it matters:

Early Financial Security: When you’re financially literate from a young age, you gain the tools to secure your future. Without it, you might stumble into debt traps, make poor spending choices, or lack long-term financial plans.

Avoid Pitfalls: Financial literacy is your shield against pitfalls. It keeps you from drowning in unsustainable debt, making reckless financial decisions, and suffering from poor credit, bankruptcy, or foreclosure.

How to increase my Financial Literacy?

Becoming financially savvy involves learning and applying various skills:

1. Budgeting: Create a budget to track income and expenses.
2. Debt Management: Manage and pay off debts wisely.
3. Credit & Investments: Understand credit and investment products.
4. Saving: Be diligent about saving.
5. Credit Report: Check your credit report regularly.
6. Investing: Plan for your financial future.

What are the key personal budget rules?

Simplicity is key, and two popular budgeting methods are widely used:

1. 50/20/30 Rule: Allocate your income into Needs (50%), Savings (20%), and Wants (30%).
2. 70/20/10 Rule: Divide your income into Expenses (70%), Savings/Debt Reduction (20%), and Investments/Charitable Donations (10%).

What are the key principles of Financial Literacy?

Financial literacy revolves around five core principles:

1. Earning: Learn how to make money.
2. Spending: Make wise spending choices.
3. Saving: Save for the future.
4. Borrowing: Understand loans and credit.
5. Protecting: Safeguard your financial well-being.

What’s an example of Financial Literacy?

Imagine a high school student transitioning to college. Financial literacy comes into play as they decide which school to attend and how to finance their education. They consider saving from their after-school job, the terms of their loan, and opportunity costs.

In this example, financial literacy extends to savings, employment, budgeting, loans, and financial planning. With financial literacy, the student can make informed decisions and set themselves up for long-term success. It’s a skill that lasts a lifetime.

➤ Financial Literacy: Final thoughts

Financial literacy is your guide to making informed money decisions. It empowers you to:

• Budget Wisely: Prepare a budget to manage your finances effectively.
• Save Adequately: Determine how much to save for your future.
• Choose Smart Loans: Understand loan terms and make favorable choices.
• Master Credit: Grasp the impact of credit decisions on your financial health.
• Plan for Retirement: Recognize diverse retirement investment options.

These skills enable you to make intelligent financial choices and act responsibly in managing your money. Financial literacy is the key to a secure financial future.

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