According to the S&P Financial Literacy survey, only 57% of those living in the U.S. are financially literate. It’s a finding that highlights the importance of understanding—and being able to make informed decisions—when it comes to your financial health.
Financial literacy is as much about what you know about money as it is about applying that knowledge to every financial decision. Taking a closer look at what financial literacy actually means is a step forward in learning how to improve yours.
What is financial literacy?
At its core, financial literacy is a person’s ability to understand and effectively apply different financial skills, such as budgeting, investing, saving, and other ways of managing personal finances. For instance, someone who is financially literate understands how to allocate expenses so that they’re not spending more than they earn. Financial literacy is not simply about financial understanding of terminology and concepts, but rather how these can apply to your life.
For example, an important financial literacy skill is managing and paying off debt. This skill requires you to understand some financial concepts like interest rates, opportunity costs, and how to budget your money to make on-time payments. Understanding interest rates and how they work is also important because it will affect the amount you pay back each month towards loans and the overall cost you’ll pay to borrow money.
If you’re using a loan to make a large purchase like a home, knowing how to manage your debt can help guide you to an appropriate loan for your financial situation—rather than one you can’t afford and risk defaulting on.
What are the main 5 components of financial literacy?
There are various financial literacy skills a person can learn and apply to different life events.
A budget is a plan where you allocate your funds based on income and expenses. Creating and maintaining a budget can play a significant role in your financial life. It’s one of the foundations of the other financial literacy concepts like saving and investing. Without sound budgeting skills, you might spend more than you save, which could lead to lack of savings or even debt.
There are tools such as budgeting apps and online tools through banking websites to help automate some of the budgeting process—like tracking your income and providing financial insights into your spending behavior. You can also use a spreadsheet. These resources can assist in tracking your expenses and making sure you have enough income to cover these costs, providing support as you hold yourself accountable for financial decisions, and help you understand when it’s time to make adjustments.
Saving money means setting aside some of what you’ve earned for financial goals or for emergencies. For instance, if you need unexpected car repairs, having money saved in a bank account or other readily accessible savings vehicle can help ensure you’ll be able to pay for repairs without getting into debt.
Learning how to save while still meeting your current financial obligations is what will help you reach your short- and long-term goals. If you and your family want to save enough money to go on a vacation, steps to reach that goal may include creating a timeline with a monthly savings plan. Or, opening a separate, high-interest savings account as a vacation fund to reach your goal.
Long-term goals like retirement are also important, but may require a different approach and skills, such as understanding how to predict how much money you’ll need to retire and researching the types of investment accounts that are best suited for your risk tolerance.
Another important aspect of saving money is to have a buffer in case unexpected financial situations arise. Emergency savings are part of a healthy financial life; creating one can be a step forward in helping to prevent having to take on debt to pay medical bills, for example.
Interest is the cost you pay to borrow money—such as from personal loans or paying for goods with credit cards. Learning how interest works can both help save you from paying too much and maximize earnings in certain types of financial accounts.
For instance, understanding interest rates and APR (annual percentage rates) can help you calculate how much money you could pay in interest when determining whether it’s a smart move to pay off a certain loan early.
Or, looking at different interest rates for accounts like high-yield savings accounts or certificates of deposit can help you pick the best account to earn more.
4. Credit management
Credit—the potential to borrow money or pay for goods at a later date—can be an important tool in your financial life as long as it’s well managed. For instance, having a high credit score helps you qualify for loans with lower interest rates, helping you save money. Or, it could help get a lease on the apartment in your favorite neighborhood.
Learning about credit also means understanding how to build, maintain, or strengthen your credit history. This could mean choosing the types of financial products that are better suited for your needs. For example, individuals with no to low credit scores might consider getting a secured credit card. This is a type of credit card where you’ll need to put down a cash deposit which acts as your line of credit.
Factors that affect your credit score the most include your payment history and credit utilization. The latter compares the amount of revolving credit you have (like your total credit card limit) and the balance on these accounts.
Other aspects when it comes to learning about how to manage credit well could also include learning how to dispute a credit report and how to negotiate with creditors.
5. Digital security
Identity theft is when someone steals your personal details such as your Social Security number, address, or credit card and uses it for their own gain. For example, someone uses this personal information to take out a loan in your name with the intention of not paying it back. Or, someone steals your credit card information and makes a bunch of purchases without your knowledge.
Identity theft is prevalent, especially as more people make purchases and conduct financial transactions online. For victims of identity theft, the consequences can be severe, including having money drained from your account and paying exorbitant fees to recover your identity.
These are among the reasons why it’s important to learn what makes you vulnerable to fraud and what preventative measures you can take, such as not logging into sensitive accounts on public Wi-Fi.
Benefits of being financially literate
Being financially literate offers benefits, including:
- Ability to save for savings goal in a sustainable way
- Ability to make informed decisions that will benefit you financially long term
- Increased credit score
- Not taking on too much debt burden
- Saving money on interest and other types of purchases
Strategies to improve financial literacy skills
To improve your personal finance literacy skills, you may want to consider looking at any gaps in your financial knowledge before taking measures to fill them. It’s also useful to take what you already know and apply that to your financial life.
Examples of strategies include:
- Calculating how much you need to afford your desired lifestyle.
- Setting aside money in regular intervals towards an emergency savings fund.
- Understanding the role a financial advisor can play in your financial well-being and how to work with one successfully.
- Tallying up all debits and deciding which techniques work best for paying them all off as soon as possible. You might consider the avalanche method of tackling highest interest debt first or the snowball method of prioritizing debt with the lowest balances.
- Creating a realistic budget by tracking spending habits, then looking for ways to trim spending in favor of saving.
- Looking into your employer-sponsored benefits, including retirement plans.
- Researching refinance or credit card debt consolidation loans and whether they might help save on interest or lower monthly payments.
The bottom line
Being financially literate helps you to create financial well-being. Armed with financial tools and other resources, as well as knowledge about budgeting, building credit, and saving for financial goals can help individuals confidently apply skills to build and strengthen financial life.