Do you have a budget you stick to each month? Do you know how to save and invest your money wisely? The ability to understand different aspects of personal finance and apply them to your unique situation is, unfortunately, not a skill everybody has. Perhaps this is why the average American household carries more than $100,000 in debt.
With a better understanding of what financial literacy is, why it’s important, and its basic pillars, you could improve your chances of achieving long-term financial success in your life.
What Is Financial Literacy?
Specifically, financial literacy refers to a person’s understanding of various components of personal finance. This includes key concepts and skills that range from personal money management to budgeting, investing, and saving.
Financial literacy is a broad term encompassing numerous skills and concepts, but many of them build upon each other. It is also worth noting that financial literacy includes both short- and long-term financial strategies, from saving for a down payment on a house to saving for retirement 20-plus years down the road.
Why Is Financial Literacy Important?
These days, financial literacy is more important than ever, especially when there is seemingly so much pressure everywhere consumers look to spend money. Having strong financial knowledge about such topics as basic money management, debt management, retirement savings, and building an emergency fund can make a huge difference in a person’s lifelong financial situation and quality of life.
Unfortunately, studies have found that only about 57 percent of adults in the United States are financially literate. This means the remainder lacks the financial education and knowledge to make sound financial decisions on a day-to-day basis. As a result, they may be less likely to have a substantial retirement fund and more likely to accumulate debt.
With a strong foundation of financial literacy, you can confidently create budgets, choose (and contribute to) the best retirement account for your needs, pay down debt wisely, and make more confident financial decisions overall. In many ways, basic financial literacy empowers you to take control of your finances rather than letting them control you.
Pillars of Financial Literacy
The three main pillars of financial literacy include debt, budgeting, and saving and investing. By better understanding what these three pillars entail and how they relate to one another, you can bolster your knowledge to make sound and confident financial decisions.
While most Americans are in debt, the reality is that some types of debt are objectively better than others. By understanding different kinds of debt and how they can affect aspects like your credit score and monthly budget, you can plan accordingly.
Some common types of debt include:
- Student loans – This refers to outstanding balances on loans you take out to pay for school, such as a degree or certificate program at a college or university.
- Credit card – This is accumulated debt on credit card accounts. These types of debt are often associated with very high interest rates, which is why it’s essential to pay down credit card debt as quickly as possible.
- Mortgages – This refers to debt taken on because of a home loan. Having mortgage debt isn’t necessarily “bad” because a home is an asset that can grow in value over time. Still, it’s crucial to have a strategy in place to pay down your mortgage without the potential for missing payments or going into foreclosure.
- Auto loans – This is money borrowed to pay for a vehicle, whether it be for purchase outright or a lease term.
From a debt standpoint, it’s also critical to note the importance of knowing (and controlling) your debt-to-income ratio: the amount of debt you currently have versus the amount of money you’re bringing in. Ideally, you’ll want to keep this radio under about 40 percent for your financial well-being. Likewise, many lenders want to see these ratios below 40 percent for loan applicants; thus, your debt-to-income ratio can greatly affect your ability to borrow money in the future.
One of the smartest things you can do to save more money and avoid unnecessary spending is to create a budget—and stick to it. A budget is a means of assessing the amount of money you bring in (usually monthly) versus the money you spend each month.
In creating a budget, you can often see where you need to rein in your spending and where you may be able to put more money into a savings account or investments. Having an established budget, you can better balance your income and expenses while working toward financial goals for the short and long term.
Not sure where to begin with creating and adhering to a budget? Plenty of free and paid tools are available that make the process easier and faster than ever. Some resources to consider here include:
- Mint – A free online budget tracker that seamlessly syncs with your current bank accounts to help paint a better picture of your spending and saving habits.
- You Need a Budget (YNAB) – A desktop and mobile app that offers more in-depth budgeting tools. This platform is not free to use, but it does come with a free trial period.
- Expensify – A platform that creates expense management systems for both personal and business use. Available with several membership plans at different price points.
- Goodbudget – A home budgeting app available on Android and Apple devices that helps users create budgets, pay off debt, and save for larger expenses. Both free and paid plans are available.
Saving and Investing
Another key aspect of financial literacy is that of saving and investing. A crucial concept to understand here is compound interest, which is essentially interest earned on your interest. From a savings standpoint, compound interest can add up significantly over a long period—making it a good idea to invest early and invest often.
By knowing how to wisely save and invest your money, you could save up for those larger purchases like a home or new car while setting yourself up for future success.
Feeling overwhelmed by the number of investment options? Investments can be confusing, but it’s helpful to have a basic understanding of some of the most common investment vehicles, which include:
- Stocks – Ownership in a small portion of a publicly traded company.
- Bonds – A loan you provide to a company or the government in exchange for a larger repayment down the road.
- Mutual funds – A means of investing in a portfolio of different stocks, bonds, or other securities.
- Exchange-traded funds (ETFs) – A type of investment fund traded exclusively on stock exchanges. ETFs can include a variety of bonds, stocks, debts, commodities, and the like.
Additional Components of Financial Literacy
Along with the basics of debt, budgeting, and saving and investing, be aware of a few additional components of financial literacy that can affect your overall financial health and well-being.
Emergency Fund Planning
Having a solid emergency fund in place can save you from financial stress and other problems if or when you run into a financial roadblock, such as a large and unexpected house repair.
In an optimal situation, an emergency fund should consist of anywhere from three to six months’ worth of living expenses. This might seem like an unrealistic amount of money to save, but with a little careful budgeting, you could gradually build your emergency fund each month.
Saving for retirement is crucial—and the earlier you get started, the more you’ll be able to harness the power of compound interest to make your money work for you. There are numerous options when it comes to retirement accounts, so it’s important to know the differences so you can ultimately choose the account type that is right for you.
- 401(k) – One of the most common types of retirement accounts, a 401(k) is tax-advantaged and generally offered by employers. In some cases, employers may even match contributions to these accounts up to a certain amount.
- Traditional IRA – This is an individual retirement arrangement that allows individuals to contribute pre-tax or after-tax dollars. Typically, gains on this kind of retirement account are not taxed until you make a withdrawal.
- Roth IRA – This is a special type of IRA where individuals pay taxes on contributions, but all future withdrawals are tax-free.
- 403(b) – This is another type of employer-sponsored retirement fund that combines elements of a Roth IRA with a traditional 401(k), using after-tax contributions.
While insurance may not seem like it would be closely related to financial literacy, in reality, knowing how to shop for and choose insurance coverage is critical to your financial well-being. This remains true whether you’re purchasing an insurance policy for yourself (like life insurance or health insurance) or for your home or vehicle. Understanding insurance terminology (such as coverage limits and deductibles) can ultimately help you choose the policy that would best protect you from large expenses.
Paying taxes might be a pain, but knowing how to accurately report your earnings and take advantage of deductions and credits is key to your financial health. Regarding taxes, there are a few specific things you should know, including:
- Your tax bracket – This refers to how much your income is taxed based on how much you make each year.
- Tax-advantaged accounts – These encompass any accounts you may have open (or plan to open) that may allow for delayed taxation or other tax advantages.
- Employer-sponsored retirement plans – Contributions you or your employer make to retirement plans need to be reported when you file your tax return.
- Financial advisor – In some cases, consulting with a financial advisor is the best way to ensure your taxes are done correctly and you aren’t leaving money on the table.
When it comes to personal finance, there are a couple of items to focus on as you aim to grow your financial literacy:
Start with your bank accounts, including any checking and savings accounts you currently have open. Are these the right accounts for you? If you are paying exorbitant monthly fees or earning a low interest rate on a savings account, it may be time to take your money elsewhere.
Ideally, credit card balances should be paid off in full each month to avoid accruing interest. However, if you do have to carry credit card debt, it’s critical to choose a card with the best terms, including the lowest interest rate. You may also want to look into a credit card that rewards you for your purchases and comes with a low (or no) annual fee.
Expand Your Financial Literacy at JWU
Not only is financial literacy an essential life skill—but with so many Americans lacking basic financial knowledge, the demand for skilled finance professionals also continues to grow. More than ever, Americans need knowledgeable financial managers, analysts, budget analysts, and similar experts to guide them. In fact, according to the U.S. Bureau of Labor Statistics, the demand for financial analysts is expected to grow 8 percent between 2022 and 2032 alone.
A degree in finance could help you launch a rewarding degree in the finance sector, and Johnson & Wales University’s College of Professional Studies is proud to provide both undergraduate and graduate-level degrees in finance to suit your needs. For added convenience, these programs are offered 100 percent online, so you can take your financial education to the next level while working at your own pace.