The five key components of financial literacy
Does the idea of making a major financial decision or even checking your bank account stress you out? You’re not alone. According to a 2016 report from the Federal Reserve, over half of Americans—across all income levels—are worried about their finances.
Some financial challenges might be out of your control, but financial planning can equip you to handle whatever comes your way. Being empowered to make good financial choices is called financial literacy, and it’s something that every adult needs.
What is financial literacy?
If you’ve heard the term financial literacy thrown around, it’s not about being fluent in accounting lingo (although that can help). According to the United States Treasury’s Financial Literacy and Education Commission, financial literacy is “the ability to use knowledge and skills to manage financial resources effectively for a lifetime of financial wellbeing.”
Lack of financial capability can make it hard to make major financial decisions like opening the right kinds of bank accounts, planning for retirement, and paying off personal debts from student loans or credit cards.
So how do you become financially literate? Some high schools and colleges offer courses in money management, but if yours didn’t, or you’re looking for a refresher, start with a few simple concepts. According to the Financial Literacy and Education Commission, there are five key components of financial literacy: earn, spend, save and invest, borrow, and protect.
Earn: Understanding your paycheck
Before you can start spending, saving, and investing, you need to know how much money you make. If you make the same amount each month, this part is pretty easy. Take a good look at your paycheck to identify your gross and net income, and note any other deductions, such as employer-sponsored health insurance or a retirement plan.
If you’re one of the 32% of Americans whose income varies from month to month, calculating your income can be a little more difficult, but it’s still important. Learn how to calculate gross and net income based on your historical earnings here. Once you’ve determined your monthly net income, you’re ready to spend (responsibly!) with a personal budget.
Spend: Creating a personal budget
A personal budget is just a plan for how you want to spend your money, but it’s also the most useful tool for achieving your financial goals. To create a monthly personal budget, you’ll need to track your spending over the course of one month, and then break everything down into categories. These can be broad, as in the popular 50 30 20 budgeting rule, or specific, for those of us who want to get into the nitty gritty of our spending habits.
Save: Determining your financial goals
Everyone knows it’s important to save money, but it’s hard to spend less than you earn without specific financial goals to work towards. Your financial goals will depend on your unique situation, but should include:
- Saving for an emergency fund. Setting aside some money in a designated emergency fund will give you peace of mind, and also prevent a financial setback from overtaking your life. Financial experts recommend having at least three months’ worth of basic living expenses in an emergency fund.
- Planning for retirement. The experts agree: The earlier you start saving for retirement, the better. Most financial planners suggest setting aside at least 10% of your take-home pay each month for retirement savings in a 401(k), IRA, or both.
- Saving for a big purchase. Whether you’re hoping to buy a car, a home, or pay for graduate school, the sooner you start saving, the less you’ll have to put aside each month.
- Paying off personal debts. Most people have some kind of debt, whether that’s student loans, credit card debt, or both. Check the interest rates on your loans: Paying off loans on time (or ahead of schedule) can save you thousands of dollars in interest.
Borrow: Credit cards, loans, and your credit score
Even if you’re a diligent saver, at some point you may have to borrow money to cover a large expense like a home or car. Maybe you borrowed money as a college student and are currently dealing with student loans or credit card debt. Borrowing isn’t necessarily a bad thing—as long as you know how to compare loans and maintain a healthy credit score
APR (Annual Percentage Rate) is the key to comparing loans and credit cards. APR takes into account both the interest rate and fees to give you a more accurate idea of how much interest you’ll pay each year. A low APR means you’ll pay less interest over time, but how do you get one?
In general, the higher your credit score, the less interest you’ll be charged. That means that if you’ve had financial difficulties in the past, you can get stuck in a vicious cycle where all of your money goes to paying off interest. That’s why building healthy credit is one of the most important steps to becoming financially literate.
Keeping a balance on your credit card is one of the easiest ways to rack up debt, but choosing the right credit card and using it responsibly can actually help you improve your credit score. Learn more about how credit cards work in our complete guide.
Protect: Preventing fraud and buying insurance
Once you’ve set yourself up with a solid budget and investment strategy, it’s important to protect the money that you’ve made. This means regularly reviewing your bank accounts and credit card statements for mistakes or suspicious activity; keeping documents and passwords secure to prevent scams and identity theft; and buying the right kind of insurance to protect yourself in the event of an emergency.
How to Assess Your Financial Literacy
An easy way to assess your financial literacy is to ask yourself some questions about your own personal finances.
- Do you know how to create a personal budget?
- Do you have an emergency fund that covers at least three months of basic living expenses?
- Do you have a plan for retirement?
- If you have debt, do you have a plan to pay it off?
- Do you know your credit score and how to improve it?
How to improve your financial literacy right now
If you answered no to some (or most!) of the questions above, don’t worry. There are a few concrete things you can do right now to take control of your finances and improve your financial literacy.
- Create a personal monthly budget. Your budget is the foundation of your financial health, and it’s pretty easy to get started. Learn how to create a personal budget here.
- Start an emergency fund. Experts recommend setting aside at least three months’ worth of basic living expenses in case of an unexpected financial burden like a layoff or large medical expense.
- Make a plan for retirement. The easiest way to start investing is with a retirement account: a 401(k), a traditional IRA, or a Roth IRA are all great options.
- Make a plan to get out of debt. If you’re caught in a cycle of debt, making a plan to pay it off can save you thousands of dollars in interest.
- Determine your credit score and learn how to improve it. Improving your credit score is another way to save money on interest. Learn how credit scores work here.
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