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 essential foundation for a smart relationship with money. This can help start a lifelong journey of learning about the financial aspects of your life. The earlier you start to become financially literate, the better off you'll be because education is the key to a successful financial future.
Key Takeaways
- The term “financial literacy” refers to understanding a variety of important financial skills and concepts.
- Financially literate people 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 of 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
Since about 2000, 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 made via credit card, with only 20% being made in cash.
Given the importance of finance in modern society, a lack of financial literacy can be very damaging to an individual’s long-term financial success.
Pitfalls of Illiteracy
Being financially illiterate can lead to many 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 financial topics. One such resource is the U.S. government-sponsored Financial Literacy and Education Commission, which offers a range of free learning opportunities.
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.
Financial literacy can cover short- and long-term financial strategies. The strategy you use will depend on several factors, such as your age,investment time horizon, andrisk tolerance. Financial literacy also encompasses knowing how investment decisions made today will impact your tax liabilities in the future.
Financial products such as mortgages, student loans, health insurance, and self-directed investment accounts have grown in importance. It is imperative for individuals to understand how to use them responsibly. It's also important to know which investment vehicles are best to use when saving, whether for a financial goal like buying a home or for retirement.
Other developments in finance such as e-wallets, digital money, and P2P lending can be convenient and cost-effective but require that consumers be educated adequately to use them to their advantage.
Why Financial Literacy Matters
It Supports Financial Well-Being
Day-to-day living expenses, living within your means, short-term borrowing, long-term budget forecasting. To manage these and other essential financial realities properly as you go through life, you must be financially literate.
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.
In its "Economic Well-Being of U.S. Households in 2022" report, the U.S.Federal Reserve SystemBoard of Governors found that many Americans are not prepared for retirement. Twenty-eight percentindicated that they have no retirement savings, while about 31% of those not yet retired felt that their retirement savings were on track. Among those who have self-directed retirement savings, about 63% admitted to feeling low levels of confidence in making retirement decisions.
Millennials' Challenge
Lack of 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 reported having a highknowledge of personal finance, only 19% answered questions about fundamental financial concepts correctly.
Forty-three percent reported using expensive alternative financial services, such aspayday loansand pawnshops. More than half lacked anemergency fundto cover three months’ of expenses, and 37% were 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 said they have too much debt.
Though these may seem like individual problems, they have a wider effect on the entire population than previously believed. The lack of knowledge of mortgage products prior to the 2008 financial crisis created widespread vulnerability topredatory lending. The financial impact of that crisis affected the entire economy.
Financial literacy is an issue with broad implications for economic health.
If you are a younger individual, retirement may seem years away. Yet it is one of the best goals to begin saving for. That's because the earlier you start, the longer your invested savings will have to compound and the more money you'll end up with. An employer-sponsored retirement account, such as a 401(k), can help.
Benefits of Financial Literacy
Broadly speaking, the benefit of financial literacy is that it empowers individuals to make smarter decisions about their finances. In addition:
- Financial literacy can prevent devastating financial mistakes: Floating rate loans may have different interest rates each month, while traditional individual retirement account (IRA) contributions can’t be withdrawn until retirement. For someone unaware of these and other financial facts, seemingly innocent financial decisions may have long-term implications that cost them money or impact life plans. Financial literacy helps individuals avoid making mistakes with their personal finances.
- Financial literacy prepares people for financial emergencies: Topics such as saving or emergency preparedness get individuals ready for uncertain times. Though losing a job or having a major unexpected expense can be financially impactful, an individual can cushion the blow by saving regularly.
- Financial literacy can help individuals reach their goals: By better understanding how to budget and save money, individuals can create plans that define expectations, hold them accountable to their finances, and set a course for achieving important financial goals. Though someone may not be able to afford a dream today, they can create a plan that can help make it happen.
- Financial literacy gives rise to confidence: Imagine having to make a life-changing financial decision without all the necessary information. With knowledge about finances, individuals can approach major life choices with greater confidence. They'll be more likely to achieve the outcome they desire and less likely to be surprised or negatively impacted by unforeseen outcomes.
Strategies to Improve Financial Literacy Skills
Developing financial literacy involves learning and practicing skills related to budgeting, managing, and paying off debts, and more. It means understanding and using credit and investment products wisely. 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 and how much you spend. You can use an Excel spreadsheet, paper, or 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 your payments are always sent to 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 each of 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 your credit regularly.
In a 2022 survey by the Federal Reserve, 27% of adults in the U.S. reported not "doing okay" financially. The number who reported not living comfortably increased from 2021.
Check Your Credit Score
A good credit score enables you to 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 personal information, use a credit monitoring service. In addition, be aware of what 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 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, saving for college and retirement, insurance, investing, and even tax planning. Emma’s students can and will use these concepts 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 credit cards, bank accounts, interest rates, opportunity costs, debt management, compound interest, and budgets, for example, could help her students start saving and manage the student loans that they might rely on to fund their college education. It could keep them from amassing dangerous levels of debt and threatening 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?
Financial literacy gives an individual the tools and resources they need to be financially secure throughout their life. The lack of financial literacy can lead to many pitfalls, such as overspending and accumulating unsustainable debt burdens. 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, making 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 first entails dividing your after-tax, take-home payinto 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 teach individuals about earning, spending, saving, borrowing, and protecting their money.
The Bottom Line
Financial literacy is the knowledge of various aspects of personal finance and the ability to make smart decisions about money.
It includes preparing a budget, knowing how much to save, recognizing favorable loan terms, understanding what impacts credit, and distinguishing different investment options that can be used to save for retirement.
The financial skills that come from financial literacy can help individuals handle their personal finances responsibly which, in turn, can help them protect the well-being of their financial futures.
