What Is Financial Literacy, and Why Is It So Important?
What Is Financial Literacy?
Financial literacy is the ability to understand and effectively use various financial skills, including personal financial management, budgeting, and investing. The meaning of financial literacy is the foundation of your 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.
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Understanding Financial Literacy
In recent decades financial products and services have become increasingly widespread throughout society. Whereas earlier generations of Americans 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 Board of San Francisco revealed that 28% of all payments were via credit card, with only 20% being made in cash.
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 also covers short-term financial strategy as well as a long-term financial strategy. 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 for retirement.
Fundamental Components of Financial Literacy
Financial literacy consists of several financial components and skills that allow an individual to gain knowledge regarding the effective management of money and debt.
Below are the fundamental components of financial literacy that should be learned.
1. Budgeting
In budgeting, there are four main uses for money that determine a budget: spending, investing, saving, and giving away.
Creating the right balance throughout the primary uses of money allows individuals to better allocate their income, resulting in financial security and prosperity.
In general, a budget should be composed in a way that pays off all existing debt while leaving money aside for saving and making beneficial investments.
2. Investing
To become financially literate, an individual must learn about the key components of investing. Some of the components that should be learned to ensure favorable investments are interest rates, price levels, diversification, risk mitigation, and indexes.
Learning about crucial investment components allows individuals to make smarter financial decisions that may result in an increased inflow of income.
3. Borrowing
In most cases, almost every individual is required to borrow money at one point in their life. To ensure borrowing is done effectively, an understanding of interest rates, compound interest, time value of money, payment periods, and loan structure is crucial.
If the criteria above are understood sufficiently, an individual’s financial literacy will increase, which will provide practical borrowing guidelines and reduce long-term financial stress.
4. Taxation
Gaining knowledge about the different forms of taxation and how they impact an individual’s net income is crucial for obtaining financial literacy. Whether it be employment, investment, rental, inheritance, or unexpected, each source of income is taxed differently.
Awareness of the different income tax rates permits economic stability and increases financial performance through income management.
5. Personal Financial Management
The most important criterion, personal financial management, includes an entire mix of all of the components listed above.
Financial security is ensured by balancing the mix of financial components above to solidify and increase investments and savings while reducing borrowing and debt.
Achieving an in-depth knowledge of the financial components discussed above guarantees an increase in an individual’s financial literacy.
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 several reasons:
Financial literacy can prevent devastating mistakes. Floating-rate loans may have different interest rates each month, while traditional 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 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 the individual 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 sets 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 they are less likely to be surprised or negatively impacted by unforeseen outcomes.
Strategies to Improve Your Financial Literacy Skills
Developing financial literacy to improve your finances involves learning and practicing a variety of skills related to budgeting, managing and paying off debts, and understanding credit and investment products.
Here are several practical strategies to consider.
Create a Budget—Track how much money you receive each month against how much you spend on 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 (say, a down payment for a home), 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—Experian, Equifax, and TransUnion—through the federally created website AnnualCreditReport.com.5 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.
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 scores, 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.
