What is Financial Literacy and Why is it Important?

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What is Financial Literacy?

Being able to make informed financial decisions means being financially literate. The basis of making informed financial decisions lies in understanding financial literacy, which is being able to use financial skills such as borrowing, saving, budgeting, and investing and understanding how they work in order to avoid financial problems and build wealth. Being financially literate has many benefits, and a strong foundation may allow you to achieve various life goals, whether it be to save for education or retirement, start a business, or simply accumulate wealth.

Why is Financial Literacy so Important?

In our world where consumer habits and financial products are continuously changing, it is becoming increasingly difficult for people to manage their finances. With credit cards and online shopping gaining popularity, it has become easier for us not only to shop but accumulate debt. With many people left unemployed and financially vulnerable during the pandemic, it has become more important than ever to be able to make informed financial decisions, and although being able to manage your money may seem like an intuitive skill, only 57% of young adults age 35 or below in the United States are financially literate according to the Milken Institute. To make better financial decisions, we need to have a basic grasp of the four fundamental pillars of financial literacy.

1. Debt

In short terms, debt is money a person uses that isn’t their own. For whatever reason that may be, debt handling and managing is a vital skill for anyone planning or not planning to take out a loan or borrow money from a different source. The immediate time a person takes money from an external place, they are deemed to be in debt. This borrowing of money can be from a multitude of different places, most notably: banks, through the usage of credit cards, short-term loans, or payday loans. More specifically, you can also have debt for certain assets such as houses, which come in the form of mortgages. As a result of this accumulation, knowing the strategies to deal with and keep up with installments to relieve this debt is one of the four fundamental pillars of financial literacy.

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​Debt can be split into two categories, good and bad debt. Good debt usually consists of money put aside for absolutely indispensable needs, some of which are the payment of a house, cultivating businesses, and funding education. These examples, in the long run, can help those who take out money for these causes have a more straightforward time in paying off the debt, rather than struggling to make payment deadlines. On the other hand, bad debt typically consists of borrowing money or using a credit card for things that don’t benefit the person or set them up in the future to pay the debt back easily. In other words, they primarily involve leisurely goods such as expensive clothes, vacations, and more.

2. Saving

The pillar of saving is one that can be most useful when set up early and done properly. It encompasses the idea that a majority of a person’s income should be put aside for financial security and future wellness, with the remaining percentage being used in the present. The utilization of this money can be categorized into three different parts. ​

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Firstly, it is used for realizing future goals, primarily through the means of sending children to university, paying off loans/debts, or securing a peaceful retirement, where the imminent idea of sustaining a normal life is not a worry. Secondly, the right implementation of savings eases a lot of added pressure when it comes to unexpected casualties. These include home or car repairs, illnesses, or unemployment. The money allocated for these circumstances should usually last 3–5 months. Thirdly, the accumulation of a little bit of money can also be used for spending on certain leisurely items, like vacations every once in a while.

3. Budgeting

The third pillar of financial literacy is budgeting — knowing how to plan, manage and effectively utilize your money.

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Being aware of where your money goes is absolutely crucial for financial security. Allocating short and long-term expenses allows you to keep track of your money, make wiser choices and refrain from impulse buying.

​The golden rule: the money coming in (your total income) should always be greater than money going out (your total expenses)!

4. Investing

Last but not least, investing is the fourth pillar of financial literacy. It’s perhaps what people find the most challenging due to fears of risks and uncertainty and losing their money altogether. So make sure to know exactly what you are investing in.

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Investments can be understood as your second source of income. The aim of all investments is to accumulate worth over time so that you have more money than what you originally invested. It’s all about placing your money into something that will generate profit over time, such as shares or real estate.

As you work towards growing your wealth and a financially secure future, invest some time into understanding the four pillars of financial literacy.

Key Tips

  1. Avoid using credit cards

​Although it might be absolutely necessary to take on debt for extenuating circumstances and emergencies, taking on debt for an extravagant lifestyle is never a good idea. Saving your money to buy your dream car, use a newer phone or buy your favorite dress is better than relying on future cash inflow to pay off your debt. The extra interest you have to pay is also not great for your finances.

2. Pay your debt on time

Even if the amount is insignificant, it may have large effects for you in the future as paying your debt on time is one of the most significant factors that affect your credit score. If you need to take a mortgage in the future, your credit score will be the single biggest factor that affects your mortgage rate. A mortgage rate a few percentage points higher may translate to thousands of dollars more interest payments in the future.

3. Start saving for retirement early

​Because of how compound interest works, saving small amounts of money in the early years of your life may have a greater impact on your total savings than saving larger amounts of money in the later years of your work life.

4. Start an emergency fund

​You will never know when the next disaster will hit you or your community. Having an emergency fund will allow you to avoid liquidity problems and may prevent you from selling off your property below its market value in times of crisis.

5. Take good care of your health

Especially if you are in a country that does not have universal health care, a minor injury can cost you your life savings if you are uninsured. Researching and finding the best insurance plan for yourself and your family, therefore, is extremely important.

6. Set a budget a stick to it

Setting a budget that goes according to your means and income is one of the best ways to not go overboard and stay within your reasonable limits. It also ensures that you are allocating only a certain amount of your income to spending and the rest for other sections like investing and saving.