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What is Financial Literacy?

Financial literacy is one of the most important steps in creating financial freedom for yourself. Unfortunately, financial literacy is on the decline in the United States.

According to the Financial Industry Regulatory Authority (FINRA) study, only 34% of Americans can answer four out of five basic financial literacy questions — down from 42% a decade earlier. The most staggering results are of those between the ages of 18 and 34, who showed the largest drop in financial literacy over the past decade.

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In this article, we’ll explain what financial literacy is, why financial literacy is so important, and how you can improve your financial literacy.

What is Financial Literacy?

Financial literacy is a knowledge and understanding of financial topics. It touches on important personal finance topics like earning, budgeting, saving, and spending. Having financial literacy can help someone become financially stable, enjoy a comfortable lifestyle, and reach their future financial goals.

According to MyMoney.gov, a product of the Federal Financial Literacy and Education Commission created by Congress, there are five basic principles of financial literacy:

  • Earn: It’s important to understand, not only how to earn money, but also the ins and outs of knowing more about what you’re actually earning versus paying. For example, understanding this principle includes knowledge of the details of your paycheck, what your money is going toward, and what taxes are withheld. It also includes having an understanding of your workplace benefits and how to increase your earnings.
  • Save & Invest: There’s a lot that goes into this important financial principle. First, you should understand how to start saving and where to save. Next, you should understand how to set financial goals and track your progress. This principle also includes a knowledge of what an emergency fund is and how to build one. Finally, learning to save and invest requires that you learn about investing for retirement and more.
  • Protect: Risk management is one of the most important parts of financial literacy, but one that’s often forgotten about. Under this principle, you should learn how to maintain your financial records in case of an emergency. You should also have an understanding of the proper insurance policies you need and how to prepare for the future, including after your death. Finally, this principle requires that you have an understanding of financial scams and how to protect yourself from them.
  • Spend: You might think this principle sounds easy — after all, most of us don’t have a problem spending money. This principle is less about how to spend and more about how to spend responsibly. It includes learning about how to budget and spend within your means and how to track your spending. It also includes a knowledge of how to set short-term and long-term financial goals and fit them into your budget.
  • Borrow: This final principle of financial literacy is all about learning how to borrow money responsibly, whether it be through loans, credit cards, and more. First, this principle requires that you have knowledge of the different types of borrowed money available. Next, you should understand borrowing terms, including how repayment works and how APRs work. You should also understand how to manage debt, including not taking on more debt than you can afford. Finally, this principle requires knowledge of credit reports and scores and how borrowing affects your credit.

Why is Financial Literacy Important?

Financial literacy is critical in helping us to manage our money effectively and reach financial freedom. Considering many Americans’ financial situation have gotten worse instead of better in recent decades, financial literacy is even more important. Below we’ll talk about a few reasons why financial literacy is so important.

One of the reasons financial literacy is becoming so important is because Americans today have more debt and less in savings. However, being able to pay off debt and save are two of the most important factors that can lead someone to financial success. Here are a few statistics that show just how much Americans could benefit from financial literacy:

And at the same time that financial literacy is declining, people are becoming more responsible for their own financial success. The price of college has risen at a rate considerably higher than inflation, meaning most young people start their adult lives with student loan debt weighing down on them.

People are also more responsible for their own retirement. Fewer companies now offer pension plans and Social Security isn’t enough to provide a comfortable retirement. Simultaneously, inflation is increasing the cost of living and people are living longer, meaning the amount people need to save for retirement continues to grow.

Finally, financial literacy is critical to help reduce economic inequality. It’s no surprise there are major gaps when it comes to income and wealth. Black Americans are paid less than white Americans at every income and education level, and the gap only rises in higher earnings brackets. Historically, the mean net worth of white Americans has been more than four times that of black Americans and Latinx Americans.

This data shows us that not only can financial literacy help improve people’s lives on an individual level, but also on a systemic level.

How to Improve Your Financial Literacy

Improving your financial literacy is key to reaching financial success, but it’s easier said than done. In this section, we’ll break down a few simple steps you can take to improve your financial literacy and get ahead.

1. Look for educational resources

Before you can take any meaningful steps in improving your finances, you should first find ways to increase your knowledge of personal finances. Luckily, there are more free resources than ever available online.

Nonprofit organizations and government agencies provide personal finance information and tips online. Many banks and credit unions also offer personal finance education for their members. Finally, there are countless free websites and social media accounts that can teach you most of what you need to know about personal finances for free.

If you’re in a situation to pay for help, you might also consider hiring a credit counselor, financial planner, or financial coach to help you learn the ropes.

2. Get a handle on your budget

Your budget is the most foundational part of your personal finances, and getting a handle on it is key to reaching any other financial goals.

To take control of your monthly budget, you’ll need to know two things: how much you earn and how much you spend. Start by writing down your monthly income from all sources. Next, figure out where your money goes each month. If there’s a discrepancy between those numbers and you’re spending more than you earn, you’ll have to find ways to cut back.

3. Track your spending

Budgeting isn’t something you do once and then are done. Instead, it’s an ongoing process that takes time. Each month, track your spending to ensure you aren’t spending more than you can afford. Knowing how much you’ve spent at all times can help you change course if you’ve gone over budget.

Not sure how to track your spending? Consider using a budgeting app like Personal Capital, Mint, or You Need a Budget. Those programs link to your bank accounts and credit cards and automatically import your transactions and track your spending.

4. Work on paying off debt

If you have debt, you can make major progress in your personal finances by paying it off. The two most popular debt payoff methods are the debt snowball and debt avalanche. The debt snowball is when you prioritize your smallest debts, while the debt avalanche is when you prioritize the debts with the lowest interest rates.

5. Build your emergency fund

Building an emergency fund is critical to creating a solid financial foundation for yourself. This fund can help you cover emergency expenses and replace your income temporarily if you lose your job. Experts generally recommend having between three and six months of expenses in your emergency fund.

Not only will your emergency fund help you pay for emergencies, but it will also help you avoid debt. When you can’t afford to pay for an emergency out of pocket, you may end up putting it on a credit card. Then you accrue interest, which means your financial emergency ends up costing you far more than if you had covered it in cash.

6. Understand how credit works

As you’re working to improve your financial literacy, it’s critical that you understand how credit works and know your own credit situations.

First, your credit report and credit score show lenders how responsible you are with money. The worse your credit, the harder the time you’ll have qualifying for a loan or credit card. Additionally, any loans you do qualify for are likely to have higher interest rates to make up for the increased risk the lender takes on by lending you money.

Your credit impacts far more than your ability to borrow money. Most property managers use credit as a way to gauge how responsible a tenant you’ll be. If you have poor credit, a landlord may assume you won’t pay your rent, and you may struggle to get an apartment.

Many employers — especially those in the financial industry — also run credit checks when hiring employees. If you have poor credit, it could hold you back from getting a job.

7. Start investing for the future

One of the final steps you should consider to improve your financial literacy and your financial situation is to start investing for the future. Most people start investing for the first time in a workplace retirement plan like a 401(k) plan. If you don’t have a 401(k) available to you, consider opening an individual retirement account (IRA) to invest for retirement on your own.

You can also invest for future goals other than retirement. If you’re saving for your child’s education or your dream home, a brokerage account is a perfect place to save, since investing can give you a considerably higher return than a savings account.

Our Take

  • Financial literacy is a knowledge and understanding of important financial topics, including earning, saving & investing, protecting your finances, spending, and borrowing.
  • Financial literacy can help you reach your financial goals, help you avoid undesirable financial situations, and help reduce economic inequality.
  • There are many ways to improve your financial literacy, including looking for educational resources, getting a handle on your budget, saving for emergencies, and more.

Are you ready to start taking control of your finances? Personal Capital can help. Our free financial dashboard offers a variety of tools to help you with budgeting, savings, net worth, retirement, and more.

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Joshua McClellan contributed to this article.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Erin Gobler is a money coach who helps people pay off debt and reach their big financial goals without giving up spending on the things they love.
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