- Financial literacy involves understanding the concepts and best practices around various financial topics related to money management.
- The five main components of financial literacy are earning, spending, saving and investing, borrowing and protecting your money.
- Financial literacy can lead you to be more organized and responsible with your money, helping you reach your financial goals.
Financial literacy is confidently understanding the skills and knowledge around various financial topics related to personal money management. It includes the five components of earning, spending, saving and investing, borrowing and protecting your money.
Financial literacy involves gaining financial knowledge and education that empowers you to feel secure in handling your finances while working toward financial goals. Why is financial literacy important? Understanding the main components of financial literacy is crucial to managing your finances well. Keep these essential tips in mind to help you get where you want to be.
Understanding financial literacy: 5 main concepts
There are five key components of financial literacy: earning, spending, saving and investing, borrowing and protecting money. Financial literacy is the ability to dedicate income toward multiple goals — things such as savings, emergency funds, debt payments — while managing current expenses.
1. Earning money
If you are earning money, you should have a place to store this income. The main options for storing money are two types of bank accounts: savings accounts and checking accounts.
What’s the difference between checking and savings accounts? Checking accounts are meant for frequent transactions, such as direct deposit of paychecks, paying bills and more. Savings accounts are meant for storing and growing money that you don’t need to touch frequently. There are benefits to having both: one enables you to easily transact in daily life, whereas the other helps you grow your money.
To make sure you're saving regularly, set up automatic recurring transfers into a savings account, or you can also set up multiple savings accounts earmarked for specific purposes.
Individual savings accounts can be designated for a vacation expense, upgrading to a new apartment, purchasing a home and/or vehicle or even for upcoming birthday and holiday celebrations. By setting up the automatic transfers, you “force” yourself to put money aside and will be less likely to stray from your budget.
Once you know where to store your income, you should also understand how taxation on your earnings works. Your gross pay is subject to federal, state and local taxation before you come away with your take-home pay (otherwise known as "net pay"). Taxes will vary depending on the places in which you work or live.
2. Spending money
Allocating money toward bills and other monthly expenses is part of effective financial planning. Your individual bill total may vary, but commonly held wisdom suggests that about half your take-home pay should go toward necessities. This may include mortgage payments, a mobile phone plan and groceries, to name a few.
There’s a difference between spending on needs versus wants. Needs consist of your everyday essentials: paying the electric bill, rent and more. Wants are non-essential items, such as new clothing or a streaming service subscription.
A budget helps you address where money is being spent monthly. Budgets also help you determine how much you can save every month and where you can cut back on unnecessary expenses. Saving money can help you build an emergency fund for unexpected expenses or help you afford long-term goals.
3. Saving and investing money
Earning income comes with the opportunity to save and invest your hard-earned money. Your budget will help you determine how much you can save and invest. If you pay yourself first — allocating money to savings and investments before any other expenses — you can continuously build savings and budget accordingly.
Saving and investing are critical for building long-term financial security. This might mean saving for retirement or to pay for college. You can choose to save money in a savings account or, alternatively, invest your money in stocks, mutual funds and bonds. If you want to get started with investing, you can speak to a financial professional for tailored guidance.
For savings outside of a standard bank account, use employer-provided resources to better comprehend the benefits of maximizing your 401(k) contribution while taking advantage of the employer match, if applicable. Also, consider yearly contributions to an IRA as a supplemental nest egg for retirement or a savings vehicle for a first-time home purchase.
4. Borrowing money: Loans and other debts
At some point or another, most people borrow money, which inevitably must be repaid. These debts take many forms, but common examples include mortgages, credit card balances, auto loans and student loans.
Regardless of how you choose to borrow, it's crucial to understand the terms of the debt you're taking on, including details like interest rate (be it simple or compound interest), grace periods, how to pay and when payments are due. Misunderstanding terms and managing debt poorly can be expensive and may damage your credit for years to come.
To that end, keep on top of your credit history and score by using credit monitoring tools when possible. Your credit score will be a major determining factor in the rates and fees you’ll potentially pay when borrowing money. The best way to bolster your credit is to simply manage all debt wisely by paying on time and keeping balances low.
5. Protecting money
Another element of financial literacy is knowing how to protect your money to reduce the risk of identity theft or fund depletion.
Having an overall idea of the components that affect your credit score is key to maintaining good credit and protecting your money. Your credit utilization ratio, or the ratio of revolving credit balances to available credit, significantly affects your credit score. Keeping a low ratio is a good way to not only improve your credit score but also ensure you have credit available when you need it.
You'll also want to regularly check your credit report to spot any outstanding payments or discrepancies. Beyond getting a sense of your financial situation, spotting errors can help improve your credit, since inaccurate information can negatively affect your credit score.
Another way to protect yourself from adverse financial situations is to create and then add to emergency funds and nest eggs, from which you can access money in case of an emergency. This practice can help you avoid going into debt or needing to borrow money for unexpected expenses. Savings accounts are a good place to establish and maintain these funds.
If you’re investing for a long-term goal, it’s important to have the right asset allocation. This means having the right blend of investments that can help position you for growth while including more conservative investments designed to lessen risk.
Why is financial literacy important?
Understanding personal finance management is important for a number of reasons. Being more financially literate can help you boost many aspects of your financial life, such as:
- Financial competency: Financial literacy offers you a holistic way to understand your finances, helping you make confident financial decisions toward achieving both short- and long-term goals.
- Money management: Understanding financial best practices can enable you to better manage your money, both in how you handle your income and in the ways in which you spend.
- Organization: Knowing where to store and invest money can help you keep your finances organized, enabling you to plan confidently when it’s time to make decisions.
- Responsibility: When you have a sense of how to spend and save smartly, you can make responsible decisions around your finances.
- Financial security: Financial literacy can create security and stability for you in the future by helping you learn to save money now.
- Knowledge sharing: Understanding financial literacy topics can often influence loved ones and friends to learn more about their own personal finance management.
Financial literacy is an ever-evolving process, and a variety of financial resources are available to help you continue to gain knowledge.
How to improve your financial literacy
Depending on your financial background and current finances, acquiring and acting on financial knowledge can take time. However, just being cognizant of financial literacy, on the whole, is an excellent first step.
To help on your journey, you can embrace some of these ways to learn more about specific financial products and literacy topics, such as
- Employer resources: Your employer may offer financial services and education to help you become more financially literate, such as financial counseling, tools and trackers or retirement planning.
- Online resources: Many online resources, host valuable information for increasing your financial literacy. Many of them are free and easy to access.
- Financial advisors: Seeking help from a financial advisor with experience in financial planning can help you become more financially literate, as they are a source for expert knowledge and can speak to your individual questions and needs.
Becoming more financially literate can lead to a better understanding of your own financial decisions. In turn, you can use your newfound knowledge to pay off debts, save for retirement or just become more knowledgeable about financial information.