What Is Financial Literacy and Why Is it Important?

Financial literacy is more than just the knowledge you need to make responsible financial decisions. It’s also the ability to put that knowledge to good use. Those who are financially literate can create a budget and manage their checking account. They understand how credit cards work and how to use them without racking up debt. And they know what is involved in saving for their future financial needs like college, a home, or retirement.

 

SOME STATS AROUND FINANCIAL LITERACY

The U.S. National Strategy for Financial Literacy 2020 defines financial literacy as the “key to unlocking the foundations of economic opportunity and powering a strong resilient economy,” which means it’s not just YOUR financial literacy that matters. All of us must be literate to create a resilient economy!

According to The 2021 National Financial Capability Study, greater financial literacy leads to greater financial capability. Those who scored higher on financial literacy tests also spent less than their income, had three months’ worth of emergency funds set aside, and had a retirement account. Financially literate people are more likely to have low balances on their credit cards and pay them off in full, thus avoiding high interest payments. They are also less likely to need emergency loans, which often come at a high price.

ARE PEOPLE BECOMING LESS FINANCIALLY LITERATE?

Though educational systems are starting to bring financial education into the classroom, the transition has been slow, which means most who are reading this blog have had little to no formal education about their finances. Finance is a skill that people need to use throughout their lives, so it is frustrating that so many were brought up studying difficult concepts like calculus and algebra without a mention of balancing checkbooks.

Investopedia offers some compelling reasons why adults are becoming less and less financially literate as the years pass. In essence, the average person is taking on more decision-making responsibility for a larger range of financial products and services that are more complex than ever before. In a society where choices abound, whether you’re buying a car or your morning coffee, financial options are no different and can feel daunting to even the bravest of souls.

 

HOW CAN YOU IMPROVE YOUR FINANCIAL LITERACY?

So, how can you improve your financial literacy without jumping straight into the anxiety pool? In my experience, it’s best to take complex topics, like this one, slooooow. Get the lay of the land (figure out what you need to know), mark the path (make a list of those things), and take it step by step.

What you need to know will depend on what you already know and how literate you want to be, but here are some basic areas to start with.

 

Budgeting: A good budget can provide you with a solid financial foundation. It offers insight into how much money is entering your household each month, how you tend to spend your money, and how much money you need to cover necessary expenses for the month. It helps you determine how much you can save and what types of things you can afford to buy.

When I say that your budget can create a solid financial foundation, what I mean is this: To use the budget, you will have to gain control over your spending habits, which will help you save more money. The money you save can provide stability by helping you cover emergency expenses, help you reach future financial goals, and support you during the loss of a job or when you want to take a lower-paying job that you enjoy more. You don’t necessarily need a budget to do this, but it is one of the most helpful tools you can use to get started toward financial stability.

Creating a budget is easier than ever these days. There are many free budgeting apps to choose from and some not-so-free apps that are well worth the money, offering a variety of features and options. If you don’t like apps, you can go old school and create your own budget fairly easily as well. The process is not terribly difficult, but if you do it by hand, you may have to go back to it a few times to add things you forgot on the first round. The great thing about going old school is that it allows you to become better acquainted with how you use your money.

 

Taking on and managing debt: You don’t need to take on debt, but it can be necessary for establishing good credit and purchasing large items like a car or a home. Before you take on debt, you need to understand a few things:

• How will the interest rate on your debt increase the amount you owe?
• How much will the payments be to eliminate the debt?
• When will the payments end?
• How will missed payments affect your credit score? (see “Understanding your credit score” below.)

Different types of debt are used to cover specific types of purchases and carry different interest rates. Secured debt usually has the lowest interest rates because the collateral used to secure the loan provides security for the lender in the case that you default on the loan. Unsecured debt, which you might use to cover the cost of home furnishings or an emergency trip, will come with a higher interest rate. Credit cards, which are considered revolving debt in that, unlike a loan, you can continue to borrow over and over again, have the highest interest rate. It’s important to know what type of debt you are taking on and find the lowest-interest option for your purchases.

 

Understanding savings accounts and how to use them: When it comes to saving money, there are a multitude of options out there. As with debt, each savings option comes with an interest rate that is generally set based on how much time the bank gets to hold onto your money. In other words, if you give them a lot of time to take your money and invest it in other loans, securities, etc. (which allows them to make interest on your money), the more interest they’ll funnel back to you.

For example, with a regular savings account, you can remove all your money at any time without penalty. Because the money has to remain available to you and can’t be used by the financial institution, regular savings accounts tend to have lower interest rates than other types of savings vehicles. A money market account may have limits on the amount of money you can withdraw at any given time and they tend to offer higher interest rates than a regular savings account. Certificates of deposit (CDs) hold onto your money for a set period of time, usually three months or more, and offer yet higher interest rates than regular savings or money market. And your retirement account, which is designed to hold onto your money until you retire and includes stocks and bonds, will generally offer the highest interest rates.

As you consider where to save your money, you’ll want to think about how much access you need to your money. In general, you’ll want to keep the money you use to pay bills in a checking account so that you can move it as needed. The money you want to save but have quick access to, including emergency funds, should be in a regular savings account or maybe a money market account so that you are making some interest on your funds but can still get to it quickly if you need it. Money you won’t need for a while may be appropriate for a higher-interest CD. If you place it in a CD, you’ll want to choose a term that makes sense for you and will allow you to remove the money, penalty-free, before you’re likely to need it. Anything above that, you may want to place in your retirement account, so you have it when you’re no longer bringing in an income.

 

Understanding your credit score: Credit scores have become an extraordinarily important component of financial hygiene. Your credit score tells lenders how likely you are to pay off your loans and helps them determine what kind of interest rate to offer you. If you have great credit, you’ll likely get much better rates than someone with a lower credit score, which means you’ll pay less money overall for the purchase you’re making. Credit scores also come into play, more and more, in things like getting a job or renting an apartment, where the employer or landlord uses it to determine the accountability of the person they are hiring or renting to. It is therefore very important to keep your score in good health.

Credit can seem like a complicated topic but here some of the most important steps you can take to keep your credit healthy include the following:

• Pay your loans and credit cards on time.
• Borrow only as much as you can afford to borrow (find out what the monthly payments will be and make sure they fit in your budget).
• Keep track of your credit report to ensure that it is free of erroneous or fraudulent charges.

Because your credit score is dynamic and constantly changing depending on your financial activities, it can rise or fall in any given week or month. You will want to check your credit report regularly to see how healthy your credit score is and to catch fraudulent charges. If you find that your credit is losing ground over time, all is not lost. There are some simple steps you can take to repair your credit.

 

Saving for retirement: The best time to start saving for retirement is when you’re young. Unfortunately, most people don’t even think about it until they’re in their mid-thirties and are have accumulated debt. Once they get on top of their debt, it can be difficult to create a comfortable nest egg before retirement.

Compound interest is what makes saving young a wise choice. For example, if you begin investing $200 per month at the age of 25 for only ten years and earn 10%, compounded monthly (.83% per month), by the age of 65, you’ll have invested $24,000 and will have about $819,491 to show for it upon retirement (note that you saved for ten years only and stopped until retirement at age 65). If you begin investing the same amount of $200 at age 40 and save until retirement at age 65, you will invest a total of $60,000 and have only $267,578 to retire on. As you can see, the younger person invested a lot less and earned a lot more over the lifetime of the investment than the older person. This is the beauty of compound investing and why it’s important to take advantage of it by beginning to invest as early as possible.

With all of that said, most people don’t start investing at the age of 25. If you haven’t already started, the next best time to start saving for retirement is right now. There are many options for retirement saving, including an employer-sponsored account like a 401(k) or an Individual Retirement Account (IRA) (traditional or Roth). Most people start with those tools because they are tax-deferred, and some employers offer matching funds on sponsored accounts. There are a lot of investment tools out there, though, so it’s good to speak with your financial advisor to find the right mix for you.

 

HOW CAN YOU CONTINUE TO BUILD YOUR FINANCIAL LITERACY?

In today’s world, there are many ways to improve your financial literacy—books and audiobooks, podcasts, websites, blogs, and videos. And if you learn better in person, you can attend virtual workshops or work with a certified financial counselor or the branch manager at your local credit union or bank. One way to approach your financial education is to challenge yourself to reach certain goals each week or month. In other words, you could subscribe to a financial blog and challenge yourself to read at least one article a week. Or commit to reading one financial book every three or four months. It’s easier to build knowledge when you set a goal, so take a moment now to consider what goal you can set to improve your financial literacy by the end of the year. It doesn’t have to be monumental. Small steps are still steps.