By Frank Kamuntu
Being financially illiterate can lead to many 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 U.S. 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.
Scope of Financial Literacy
Although many skills 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 can cover short-term financial strategy as well as long-term financial strategy, and which strategy you take will depend on several factors, such as your age, time horizon, and risk tolerance. 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, whether for a financial goal like buying a home or for retirement. This is not to add the novelties in finance such as e-wallets, digital money, buy now/pay later, P2P lending, and other new financial products that can be convenient and cost-effective but require potential consumers to be educated to assess them adequately to their advantage.
Why Financial Literacy Matters
From day-to-day expenses to long-term budget forecasting, financial literacy is crucial for managing these factors. It is important to plan and save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy, defaults, and foreclosures.
If you are a younger individual, retirement may seem years away. While it is way off in the future, it is also one of the best goals to start saving for, because the earlier you start, the more you’ll have compounded down the line. One investment vehicle to start with is an employer-sponsored retirement account, such as a 401(k).
In its “Economic Well-Being of U.S. Households in 2022” report, the U.S. Federal Reserve System Board of Governors found that many Americans are unprepared for retirement. Twenty-eight percent indicated that they have no retirement savings, and about 31% of those not yet retired felt that their retirement savings are on track. Among those who have self-directed retirement savings, about 63% admitted to feeling low levels of confidence in making retirement decisions.
Low financial literacy has left millennials—the largest share of the American workforce—unprepared for a severe financial crisis, according to research by the TIAA Institute. Even among those who report having a high knowledge of personal finance, only 19% answered questions about fundamental financial concepts correctly. Forty-three percent report using expensive alternative financial services, such as payday loans and pawnshops. More than half lack an emergency fund to cover three months’ expenses, and 37% are financially fragile (defined as unable or unlikely to be able to come up with $2,000 within a month in the event of an emergency).
Millennials also carry large amounts of student loan and mortgage debt—in fact, 44% of them say they have too much debt.
Though these may seem like individual problems, they have a wider effect on the entire population than previously believed. All one needs is to look at the financial crisis of 2008 to see the financial impact on the entire economy that arose from a lack of understanding of mortgage products (creating a vulnerability to predatory lending). Financial literacy is an issue with broad implications for economic health.
Benefits of Financial Literacy
Holistically, the benefit of financial literacy is to empower individuals to make smarter decisions. More specifically, financial literacy is important for several reasons.
- Financial literacy can prevent devastating mistakes: Floating rate loans may have different interest rates each month, while traditional individual retirement account (IRA) contributions can’t be withdrawn until retirement. Seemingly innocent financial decisions may have long-term implications that cost individuals money or impact life plans. Financial literacy helps individuals avoid making mistakes with their personal finances.
- Financial literacy prepares people for emergencies: Financial literacy topics such as saving or emergency preparedness get individuals ready for the uncertain. Though losing a job or having a major unexpected expense is always financially impactful, an individual can cushion the blow by implementing their financial literacy in advance by being ready for emergencies.
- Financial literacy can help individuals reach their goals: By better understanding how to budget and save money, individuals can create plans that set expectations, hold them accountable to their finances, and set a course for achieving seemingly unachievable goals. Though someone may not be able to afford a dream today, they can always make a plan to better increase their odds of making it happen.
- Financial literacy invokes confidence: Imagine making a life-changing decision without all the information you need to make the best decision. By being armed with the appropriate knowledge about finances, individuals can approach major life choices with greater confidence realizing that they are less likely to be surprised or negatively impacted by unforeseen outcomes.
