What is Financial Literacy?
Financial literacy is the ability to understand and proficiently apply diverse financial skills, including personal financial administration, budgeting, and investment strategies. Being financially literate provides a fundamental basis for a savvy interaction with money, establishing a launching pad for a continuous exploration into more sophisticated financial topics. Initiating this educational journey sooner rather than later proves advantageous, as knowledge serves as the cornerstone of financial success.
Between 2000 and 2022, financial products and services have become increasingly prevalent in society. While previous generations predominantly used cash for purchases, contemporary preferences lean towards various credit options, including credit and debit cards, as well as electronic transfers.
Given the significance of finance in today’s world, a lack of financial literacy is widespread and can significantly hinder long-term financial success for anyone.
Being financially illiterate can result in several pitfalls, such as a higher risk of accumulating debt due to poor spending decisions or a lack of long-term preparation. This, in turn, may lead to adverse consequences such as poor credit, bankruptcy, housing foreclosure, and other negative outcomes.
Fortunately, there are now more resources available than ever for those seeking to educate themselves about the intricacies of finance.
Scope of Financial Literacy
While financial literacy involves varying skills, some commonly cited examples include managing household budgets, understanding debt management, and evaluating the pros and cons of different credit and investment products. These skills often demand a basic understanding of financial concepts, including compound interest and the time value of money.
In addition to the traditional aspects of financial literacy, the significance of products such as mortgages, student loans, health insurance, and self-directed investment accounts has increased. This underscores the growing necessity for people to grasp how to use these financial tools responsibly.
Financial literacy extends to both short-term and long-term financial strategies, with the chosen approach influenced by factors like age, time horizon, and risk tolerance. It involves an awareness of how current investment decisions can impact future tax liabilities.
Furthermore, it entails knowing the most suitable investment vehicles for saving, whether for specific goals like home purchase or retirement. Also, emerging financial trends such as e-wallets, digital currency, buy now/pay later options, P2P lending, and other innovative products, though convenient and cost-effective, require consumers to be educated in order to assess their benefits accurately.
Why Financial Literacy Matters
From day-to-day expenses to long-term budgeting, financial literacy is key for effective management. It is important to plan and save adequately to ensure a stable income during retirement, steering clear of excessive debt that could lead to bankruptcy, defaults, and foreclosures.
Lack of financial literacy has left millennials ill-equipped for severe financial crises. Even those claiming high personal finance knowledge had less accuracy in answering fundamental financial concept questions. Some don’t even have an emergency fund and are unable to come up with $2,000 within a month in emergencies.
Millennials also grapple with substantial student loan and mortgage debt, ending up burdened by these excesses. Financial literacy even extends beyond personal concerns, having broad implications for economic health.
Benefits of Financial Literacy
Understanding financial matters empowers people, enabling them to make logical and wiser decisions. More specifically, financial literacy holds significance for different reasons.
It serves as a safeguard against potentially disastrous mistakes. For instance, loans with fluctuating interest rates and the limitations on withdrawing from your retirement account before your actual retirement carry long-term consequences. Financial literacy equips individuals to navigate their personal finances wisely, preventing costly errors.
Financial literacy also equips people to handle emergencies. Topics such as saving and emergency preparedness help people anticipate and be prepared for unforeseen events. Whether facing job loss or unexpected expenses, having financial literacy enables individuals to proactively mitigate the financial impact of such situations.
Moreover, financial literacy plays a key role in helping individuals achieve their goals. A deeper understanding of budgeting and saving empowers individuals to formulate plans that establish expectations, enforce financial accountability, and chart a course toward realising seemingly unattainable aspirations. Even if someone cannot afford their dream today, financial literacy enables them to strategise and improve their chances of making it a reality.
Also, financial literacy instils confidence. Imagine making life-altering decisions without possessing all the necessary financial information. Armed with knowledge about finances, individuals can approach significant life choices with greater assurance, knowing they are less likely to be caught off guard or adversely affected by unforeseen outcomes.
How to Improve Financial Literacy Skills
Developing financial literacy to enhance personal finances involves acquiring and applying various skills related to budgeting, debt management, and understanding credit and investment products. Regardless of your financial situation, it’s never too late to initiate positive financial habits.
Create a budget
Create a budget by tracking your monthly income and expenses using tools like an Excel sheet, paper, or a budgeting app. Categorise your budget into income sources, fixed expenses (rent, utilities, loans), discretionary spending (nonessentials like dining out, shopping, and travel), and savings.
Pay yourself first
Adopt the “pay yourself first” strategy by setting aside a predetermined amount for savings before allocating funds to other expenses. Identify a savings goal, determine a monthly contribution, and prioritise it over other expenses.
Pay bills on time
Stay organised with your monthly bills by ensuring timely payments. Explore options like automatic debits or bill-pay apps, and sign up for payment reminders through email, phone, or text.
Review your credit report
Request a free annual credit report from major bureaus. Check the reports for inaccuracies and dispute any errors with the credit bureau. Consider spreading out your requests throughout the year for regular monitoring.
Monitor your credit score
Keep tabs on your credit score using free credit monitoring services or premium options for added protection. Be mindful of financial decisions that impact your score, such as credit enquiries and credit utilisation ratios.
Debt management
Utilise your budget to manage debt effectively by cutting spending and increasing repayments. Develop a plan, prioritising repayment of high-interest loans. If needed, explore options like negotiating with lenders, consolidating loans, or seeking debt counselling.
Invest in your future
Secure your future by contributing to your retirement savings account. Explore the possibility of building a diversified investment portfolio. Consult with financial professionals to define your retirement goals and devise strategies for a comfortable retirement.
Example of Financial Literacy
Margot, a high school teacher, tries to impart financial literacy to her students through her curriculum. She offers knowledge on various financial subjects, including personal budgeting, debt management, education and retirement saving, insurance, investing, and even tax planning. The intention is to equip Margot’s students with essential skills that will prove valuable in their future endeavours, such as renting an apartment, securing a first job, or funding recreational activities like going to the movies.
Understanding concepts like interest rates, opportunity costs, debt management, compound interest, and budgeting is necessary. This knowledge can help students to navigate potential student loans for their college education, preventing the accumulation of debt and protecting their credit scores. Margot anticipates that certain topics, such as income taxes and retirement planning, will become invaluable for all students, regardless of their paths after high school.
FAQs
What personal budget rules are widely adopted?
Two frequently employed techniques for personal budgeting are the 50/20/30 and 70/20/10 rules, known for their straightforwardness.
50/20/30 involves splitting your after-tax, take-home income into three categories: necessities (50%), savings (20%), and discretionary spending (30%).
70/20/10, following a comparable structure, suggests allocating your after-tax, take-home income to cover essentials (70%), savings or debt reduction (20%), and investments and charitable contributions (10%).
What are the fundamental concepts of financial literacy?
There are five general principles that encompass financial literacy. While alternative frameworks might identify distinct elements, the primary objective of financial literacy remains to instruct people on earning, spending, saving, borrowing, and protecting their money.
Conclusion
Financial literacy is understanding how to make wise choices with money. This encompasses creating a budget, determining optimal savings amounts, selecting favourable loan terms, grasping the effects on credit, and discerning various retirement vehicles. These abilities empower individuals to make more informed decisions and exhibit greater responsibility in managing their personal finances.
DISCLAIMER: This article is for informational purposes only and does not constitute official advice.
