Financial Literacy Definition – Investopedia
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Investopedia / Paige McLaughlin
Financial literacy is the ability to understand and effectively use various financial skills, including personal financial management, budgeting, and investing. The meaning of financial literacy is the foundation of your relationship with money, and it is a lifelong journey of learning. The earlier you start, the better off you will be because education is the key to success when it comes to money.
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In recent decades financial products and services have become increasingly widespread throughout society. Whereas earlier generations of Americans may have purchased goods primarily in cash, various credit products are popular today, such as credit and debit cards and electronic transfers. A 2021 survey by the Federal Reserve Board of San Francisco revealed 28% of all payments were via credit card, with only 20% being made in cash.
Given the importance of finance in modern society, lacking financial literacy can be very damaging to an individual’s long-term financial success. Unfortunately, research has shown that financial illiteracy is very common, with the Financial Industry Regulatory Authority (FINRA) attributing it to 66% of Americans.
Being financially illiterate can lead to a number of pitfalls, such as being more likely to accumulate 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, and other negative consequences.
Thankfully, there are now more resources than ever for those wishing to educate themselves about the world of finance. One such example is the government-sponsored Financial Literacy and Education Commission, which offers a range of free learning resources.
Financial literacy can help protect individuals from becoming victims of financial fraud, a type of crime that is becoming more commonplace.
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.
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:
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.
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.
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.
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.
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.
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%).
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.
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.
Financial literacy the 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.
Federal Reserve Bank of San Francisco. "2022 Findings From the Diary of Consumer Payment Choice."
Financial Industry Regulatory Authority. "U.S. Survey Data at a Glance: Financial Knowledge and Decision-Making."
U.S. Department of the Treasury. "Financial Literacy and Education Commission."
Mastercard NuData Security. "2020 Fraud Risk at a Glance."
AnnualCreditReport.com. "The only source for your free credit reports. Authorized by Federal Law."
Board of Governors of the Federal Reserve System. "Economic Well-Being of U.S. Households in 2021."
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