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What is Financial Literacy

Scope of Financial Literacy

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. These skills often require at least a working knowledge of key financial concepts, such as compound interest and the time value of money.

Other products, such as mortgages, student loans, 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.

Financial literacy also covers short-term financial strategy as well as long-term financial strategy. Financial literacy encompasses knowing how investment decisions made today will impact your tax liabilities in the future. This also includes knowing which investment vehicles are best to use when saving for retirement.

Benefits of Financial Literacy

Holistically, the benefit of financial literacy is to empower individuals to make smarter decisions. More specifically, financial literacy is important for a number of reasons:

  • Financial literacy can prevent devastating mistakes. Floating rate loans may have different interest rates each month, while traditional IRA contributions can't be withdrawn until retirement. Seemingly innocent financial decisions may have long-term implications that cost individuals money or impact life plans. Financial literacy helps individuals avoid making mistakes with their personal finances.

  • Financial literacy prepares people for emergencies. Financial literacy topics such as saving or emergency preparedness get individuals ready for the uncertain. Though losing a job or having a major unexpected expense are always financially impactful, an individual can cushion the blow by implementing their financial literacy in advance by being ready for emergencies.

  • Financial literacy can help individual reach their goals. By better understanding how to budget and save money, individuals can create plans that set expectations, hold them accountable to their finances, and sets a course for achieving seemingly unachievable goals. Though someone may not be able to afford a dream today, they can always make a plan to better increase their odds of making it happen.

  • Financial literacy invokes confidence. Imagine making a life-changing decision without all the information you need to make the best decision. By being armed with the appropriate knowledge about finances, individuals can approach major life choices with greater confidence realizing they are less likely to be surprised or negatively impacted by unforeseen outcomes.

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 with 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 (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.

  • Pay Bills Promptly—Stay on top of monthly bills, making sure that payments consistently 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 the three major credit bureaus—Experian, Equifax, and TransUnion—through the federally created website AnnualCreditReport.com.5 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 yourself regularly.

In a 2021 survey by the Federal Reserve, 22% of adults in the United States reported not being okay financially and not living comfortably financially.6

  • 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 for your information, use one of the best credit monitoring services). In addition, be aware of the financial decisions that can raise or lower your score, 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 individual retirement account (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, 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.

Why Is Financial Literacy Important?

The lack of financial literacy can lead to a number of pitfalls, such as accumulating 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, 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, being diligent about 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 former entails dividing your after-tax, take-home income pay into 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 educate individuals on how to earn, spend, save, borrow, and protect their money.

What Are Some Examples of Financial Literacy?

As a high school student transitions to college, they may be faced with the daunting task of deciding which school to attend and how to finance their education. This may including how much money they should be saving from their after-school job, how the terms of their loan will work, and what opportunity costs existing throughout their decision-making process.

In this example, the student will make more financially responsible decisions if they are more financially literate. Financial literacy in this example extends to savings, employment, budgeting, loans, and financial planning. Using financial literacy and making smart decisions, the student can set themselves up for long-term success.

The Bottom Line

Financial literacythe knowledge of how to make smart decisions with money. This includes preparing a budget, knowing how much to save, deciding favorable loan terms, understanding impacts to credit, and distinguishing different vehicles used for retirement. These skills help individuals make smarter decisions and act more responsibly with their personal finances.

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