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 lack of these skills is called financial illiteracy.
- 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.
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, today various credit products are popular, such as credit cards, mortgages, and student loans. Other products, such as 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.
Although there are many skills that 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. Oftentimes, these skills require at least a working knowledge of key financial concepts, such as compound interest and the time value of money. Given the importance of finance in modern society, lacking financial literacy can be very damaging for an individuals’ long-term financial success. Unfortunately, research has shown that financial illiteracy is very common, with the Financial Industry Regulatory Authority (FINRA) estimating that some 66% of Americans lack financial literacy.
The lack of financial literacy can lead to a number of pitfalls. Financially illiterate individuals may be more likely to accumulate unsustainable debt burdens, for example, either through poor spending decisions or through a lack of long-term preparation. This in turn can lead to poor credit, bankruptcy, housing foreclosure, or 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 government-sponsored Financial Literacy and Education Commission, which offers a range of free learning resources.2
Financial literacy can also help protect individuals from becoming victims of financial fraud, which is a type of crime that is, unfortunately, becoming more commonplace.
Strategies to Improve Your 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. 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 in a budgeting app. Your budget should include income (e.g., paychecks, investments, alimony), fixed expenses (like rent/mortgage payments, utilities, loan payments), discretionary spending (non-essentials such as eating out, shopping, 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.
- Manage your bill-paying—Stay on top of monthly bills so that payments consistently arrive on time. Consider taking advantage of automatic debits from a checking account or bill-pay apps, and sign up for email, phone, or mail payment reminders.
- Get your credit report—Once a year, consumers can request a free credit report from the three major credit bureaus—Experian, Equifax, and TransUnion. Review it and dispute any errors by informing the credit bureau of inaccuracies.
- 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 on your information, one of the best credit monitoring services) and be aware of the financial decisions that can raise or lower your score, such as credit inquiries and utilization rates.
- 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 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 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 to develop strategies to reach your goal.
Example of Financial Literacy
Emma is a high school teacher who tries to teach her students about financial literacy. Through her curriculum, she attempts to educate 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 reasons that although these subjects may not be especially relevant to her students during their high school years, they will nonetheless prove valuable throughout the rest of their lives. 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.
Frequently Asked Questions
Why Is Financial Literacy Important?
The lack of financial literacy can lead to a number of pitfalls. Financially illiterate individuals may be more likely to accumulate unsustainable debt burdens, for example, either through poor spending decisions or through a lack of long-term preparation. This in turn can lead to poor credit, bankruptcy, housing foreclosure, or other negative consequences.
How to Become Financially Literate?
To become financial 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 the Popular Personal Budget Rules?
Two commonly used personal budgeting methods are the 50/30/20 and 70/20/10 rules and its their simplicity is what makes them popular. The former entails dividing your after-tax, take-home income pay into three areas namely needs, wants, and investments and/or payments to reduce your debt load. The 70/20/10 rule also follows a similar blueprint. It recommends that your after-tax, take-home income be divided into segments that cater to expenses, savings or reducing debt, and investments.