What is Financial Literacy?

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Definition:

Financial literacy represents understanding important financial concepts that enables someone to practice smart money management.

🤔 Understanding financial literacy

Those who are financially literate have the necessary skills and understanding to apply basic financial concepts in their lives. Financial literacy includes knowledge of necessary skills like budgeting and paying off debt. It also includes more advanced financial concepts like investing, utilizing compound interest, and implementing long-term financial planning strategies. Individuals who are financially literate have the resources to make responsible, educated decisions about their money and set themselves up for a more secure future. With the majority of American families living paycheck to paycheck, financial education and literacy are essential now more than ever. The foundation of this knowledge requires understanding how to effectively earn, save, invest, protect, spend, and borrow money.

Example

As Jenna enters her final year of high school, she signs up for a financial literacy class to prepare her for life after school. In this class, Jenna learns many of the basic financial concepts and skills she’ll need to use in college and beyond. She learns about debt, primarily through the lens of credit cards and student loans. Jenna also learns how to budget, how to balance her bank account, and how to save for retirement. Armed with this valuable information, Jenna is financially literate enough to make informed decisions for her future.

Takeaway

Having financial literacy is like having a driver’s license…

Everyone needs a driver’s license to drive on the road for the safety of themselves and others. Sure, you can physically drive without one. But if you get into a tough situation, there are likely to be consequences. Similarly, everyone should have basic financial literacy before becoming an adult and being responsible for their own finances. If they don’t, they’re likely to face costly consequences at some point.

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Why is financial literacy important?

Finances play a part in just about every area of our lives. Think of the home you live in, the car you drive, the food you feed your family, and the education your children get — These are some of the most critical aspects of your life, and they all cost money. And yet studies show that only 34% of Americans can pass a basic financial literacy test.

Having an understanding of financial concepts is beneficial in so many areas of life. When you become financially literate, you’re able to make more informed decisions. For example, a late 2018 survey found that almost 40% of Americans did not have an understanding of how a credit score works. And yet, your credit history determines whether you’re eligible for certain types of loans and credit. A higher credit score can help to lower your interest rate when you borrow money, which can save you thousands of dollars over the life of a loan — It could be more like tens of thousands of dollars over your lifetime.

There are also certain factors at play that make financial literacy more important today than it’s ever been. Other generations had a very different financial landscape — People used cash or checks for purchases instead of credit cards, and most financial matters didn’t take place online as they do today. Advances in technology have resulted in more payment methods to track.

It’s not only these technological advances that make financial literacy more critical today. Americans are taking on more and more responsibility for their financial futures. The Social Security Administration reports that their current funding mechanisms will only keep their programs fully funded until the year 2034. After that, they’ll only have 75% of the resources they need, leading many Americans to wonder whether they’ll receive the same retirement benefits previous generations did.

In addition to fears surrounding government retirement programs, employers are helping their employees plan for retirement differently than they used to. In previous decades, employers offered pension plans that guaranteed a certain amount of money for retirement. Today pensions aren’t as common, and more employers offer 401(k) plans instead. They still might contribute toward their employees' retirement accounts, but they generally don’t guarantee any benefits as they once did.

Financial literacy isn’t only important for those who have a lot of money to manage. On the contrary, it’s perhaps even more critical for those with less money to manage, because those individuals also have little money to spare. And in a country where most people live paycheck-to-paycheck, these households could benefit most from financial education.

As a financially literate person, you’re better able to make a plan for your money, reduce the amount of debt you have, save up for emergencies, and put away funds for a comfortable retirement.

What does it look like to be financially literate?

The Financial Literacy and Education Commission (FLEC) identifies five fundamental financial principles that are the building blocks for money management and financial success. If you can master these five concepts, you’ll be well on your way to complete financial literacy.

Earn

Do you know how much you earn through your job? What you earn isn’t just the amount you take home in each paycheck. Understanding your earnings means knowing your gross income (aka the amount you make before taxes and deductions), as well as knowing what happens to the money that doesn’t land in your bank account.

For this part of financial literacy, find out how much money your employer withholds for income, Social Security, and Medicare taxes. Also, make sure you know your employee benefits. What does your employer contribute to your health insurance and 401(k) plan? Additionally, find out how much of your paycheck goes toward those benefits.

Knowing this information ensures you don’t leave any potential employee benefits on the table. It also helps arm you with valuable information in the future when applying for new jobs.

Understanding the details of your take-home pay is also crucial information when it comes to budgeting — How will you know how much you can spend if you don’t know how much you make every month?

Save and Invest

Saving money is one of the most basic financial principles people learn, and yet most Americans don’t have enough in savings to pay for a financial emergency. To really consider yourself financially literate, this strategy should be at the top of your to-do list.

The FLEC recommends a few tricks to help you master your savings. One of the most important is to pay yourself first. By this, they mean to put money into savings before you spend it on anything else. They also recommend tracking your savings, so you know how much you have set aside for emergencies.

Saving for the future isn’t just about your bank savings account, either. It’s also about investing to help your money grow through the power of compound interest. Investing might seem intimidating at first, but it’s an important financial step (though the FLEC recommends not investing until you have at least three months of expenses in your emergency fund). If you aren’t sure where to start, consider talking to a financial advisor to walk you through the first steps and beyond.

Protect

You work hard for your money, and the last thing you want is to lose any of it. That’s why the FLEC educates consumers on the importance of protecting your wealth. One crucial component of protecting your money is buying insurance. Depending on your life situation, there are many different types of insurance you might need. Here are some common types of coverage:

  • Health insurance
  • Auto insurance
  • Life insurance
  • Homeowner’s insurance
  • Renter’s insurance

The FLEC also emphasizes the importance of arming yourself against fraud and those who try to scam you out of your hard-earned money. A good rule of thumb is that anything that sounds too good to be true probably is.

The final component of protecting your money is keeping a close eye on your credit. If someone steals your identity, it can take a severe toll on your credit history. Keeping an eye on your credit report and bank accounts will help ensure you catch any theft as soon as possible.

Spend

In a 2017 study, U.S. Bank found that only 41% of Americans say they keep a household budget. And yet the FLEC finds budgeting to be one of the most important principles for financial literacy and success. This component is one of the keys to meeting both short and long-term goals.

First, keeping a household budget makes sure you live within your means. It’s easy to see how consumers could quickly fall behind financially if they don’t know how much they earn or spend each month.

Tracking your spending also helps to ensure you’re getting the best deal and not letting clever marketing persuade you into spending. For example, let’s say you regularly find yourself impulsively buying clothes from the shop down the street. You never research your purchases ahead of time or shop around. Little do you know that another shop in town sells the same clothes for half the price. Tracking your spending makes you a smarter shopper.

Borrow

A study from The Pew Charitable Trusts found that 80% of American households carry some sort of debt. Because of that, it’s not surprising that the FLEC names borrowing as one of its core principles to understand in order to become financially literate.

Becoming an educated borrower takes a bit of work, but it’s worth it. First, be aware of your credit history and make sure you have a clean report — A big part of this is paying all of your bills on time.

It’s also important to understand the basics of interest. Almost every loan involves paying some sort of interest. The higher the interest rate, the more you’ll pay on top of your principal over the life of the loan. To minimize your costs, find the loan or credit option with the lowest possible annual percentage rate (APR).

Some forms of debt have notoriously higher interest rates than others. For example, credit cards usually have higher rates than loans. However, you can avoid interest costs on credit cards by paying off your purchases each month instead of carrying a balance.

Understanding the basics of borrowing will help you be a more informed consumer and reduce your costs over the long run. This knowledge allows you to truly understand the costs of borrowing money on top of the size of the loan you’re actually taking out.

How do you increase your financial literacy?

The bad news is that most Americans can’t pass a basic financial literacy test, according to studies by the FINRA Foundation. The good news is that there are plenty of resources available to help consumers achieve financial literacy.

The Financial Literacy and Education Commission has extensive information on its website to help you educate yourself on important financial concepts. They also have resources for teachers to help kids learn about money. Finally, the site includes calculators, budgeting worksheets, and checklists you can use to get your finances in order.

Many banks have also taken a role in educating their customers in matters of personal finance. In many cases, local banks and credit unions have a one-on-one relationship with their customers and can reach them in a way that other institutions might not be able to.

There’s no shortage of information available for those who are willing to look for it. The internet has loads of sources for financial education and tools that can help you manage your money more effectively. Following financial news is also a great way to understand the role that finances play on a local, state, national, and global scale.

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