What is Financial Literacy and Why Is It Important?
What is financial literacy?
Financial literacy is defined as the possession of knowledge and skills that enable informed and effective money management.
That’s a broad definition, but the term can mean different things to different people.
To understand the nuances of what financial literacy is and how people understand it, we spoke to personal finance experts across a range of industries. They represent a wealth of different backgrounds and spaces in which financial literacy is taught and learned. We asked all of them a simple question with a not-so-simple answer: “What is financial literacy?”
“Financial literacy is the end result of the financial education process. When students are financially literate they can make informed financial decisions that can aid in improving their well-being.”
Paul Goebel, Director, Student Money Management Center at the University of North Texas
“It’s empowering people to have a successful life. My quote has always been ‘knowledge is power,’ the more you know the better off you’re going to be. And financial literacy, to me, is giving financial tools to financially empower individuals so that they can create a better financial life for themselves.”
Cherry Dale, Director of Financial Education, Virginia Credit Union
“Financial literacy to me is just the understanding of various financial concepts and how they can interplay with your life. So understanding what various terms are in the financial world and how they might apply to your life. The big thing for us has always been just taking this a step further and applying financial wellness to it. So understanding—once you know these concepts—how they can lead to different behavior changes on yourself and that’s where we start getting into the wellness territory.”
Phil Schuman, Director, MoneySmarts Program at Indiana University
“To me, financial literacy is having an in-depth knowledge of your own personal finances and the impact of your decisions on your financial stability. Because one of the things that we learn very quickly is students and even their parents have a basic financial literacy knowledge...one of the things that we work on is understanding how your behaviors impact that. Most people are financially literate, but they’re making decisions that are detrimental in the long-term by having short-term gratification.”
Dameion Lovett, Campus Director and Overseer, Financial Education Program at the University of South Florida
“We empower students for financial success by providing financial literacy information, resources, and programs. We believe that financial literacy is an appreciation of the long-term benefits of financial literacy and economic education. It’s not something that should be taken lightly—it’s something that’s very real and transferrable for any socioeconomic background. We believe that it’s a tool that‘s necessary for success later in life. And it’s not just budgeting and saving—it’s life skills.”
Latoya Goree, Director, Office of Financial Literacy at UMKC
Why does financial literacy matter?
Financial literacy is important because it equips people with an understanding of basic financial concepts to inform their real-world financial decisions. With this knowledge in hand, they’re better able to manage their money, make sound decisions, and maintain healthy spending and budgeting habits, which over time can lead to financial wellness.
The importance of financial literacy becomes especially clear when considering the financial challenges that many people face:
- 55% of working Americans say they’re behind on retirement savings
- Credit card debt has reached its highest point ever.
- 57% of Americans can’t afford a $1,000 emergency expense.
- 58% of Americans are living paycheck to paycheck.
- Student loan debt has reached $1.6 trillion in the United States.
Given the above statistics, it might not be surprising that nearly two-thirds of Americans can’t pass a basic test of financial literacy.
How to know if you are financially literate
To gauge your own financial literacy, consider asking yourself the following questions:
- Can I create and maintain a budget? A budget is essential for tracking your income and expenses, identifying areas to cut costs, and ensuring you live within your means.
- Do I understand the importance of an emergency fund? A solid emergency fund can help you weather unexpected expenses without resorting to high-interest debt.
- Am I aware of the different types of credit and their impact on my financial health? Understanding credit cards, loans, and their respective interest rates can help you manage debt responsibly and maintain a good credit score.
- Can I explain the basic principles of investing? This includes understanding concepts such as risk and reward, diversification, and compound interest.
- Am I knowledgeable about various investment options? This includes stocks, bonds, mutual funds, exchange-traded funds (ETFs), and retirement accounts like 401(k)s and IRAs.
- Do I have a plan for retirement savings? Knowing how to save for retirement and the benefits of starting early is crucial for long-term financial security.
- Am I familiar with the concept of insurance and its role in protecting my assets? This includes understanding the importance of life, health, auto, and home insurance, as well as how premiums, deductibles, and coverage limits work.
- Can I interpret basic financial statements? This skill can help you assess the financial health of a company before investing in its stock or make sense of your own financial situation.
- Do I have a grasp on financial terminology? Understanding key financial terms and concepts is necessary for making informed decisions about your money.
How to learn financial literacy concepts
Financial literacy is acquired by learning financial concepts and practicing them. Many people receive informal financial education from family members or role models—parents who teach their children how to write a check, for instance. However, formal financial instruction from a trusted provider offers a more comprehensive and reliable education. Schools, banks, and nonprofit organizations are just a few of the sources that offer financial education. Online resources include the following:
- EconEdLink: Classroom-tested online finance lessons designed for K-12 students but great for learners of all ages.
- InCharge: A nonprofit dedicated to empowering consumers through personal finance education and educational partnerships. Online resources include ebooks, calculators, and games.
- MoneyWi$e: A partnership between Consumer Action and Capital One, this program combines free, multilingual financial education curricula with regional meetings and roundtables to train community-based organization staff.
- Better Money Habits: A collaboration between Bank of America and Khan Academy, this site includes animated videos to cover financial literacy basics as well as more in-depth topics.
- Money Smart: The FDIC’s program provides free tools for people of all ages to increase their financial literacy. Resources include lesson plans, videos, podcasts, and games.
- TheLending: Standards-aligned online courses that teach the fundamentals of personal finance: spending, budgeting and saving, credit, and debt and loans.
How to practice financial literacy
After you have established a basic understanding of the financial literacy concepts, it is time to apply that knowledge toward making informed financial decisions and establishing healthy money-management habits.
Build an Emergency Fund
Another vital concept is understanding the importance of saving and establishing an emergency fund. An emergency fund should cover three to six months' worth of living expenses, serving as a financial safety net during unexpected events like job loss or medical emergencies. Setting up a high-yield savings account and consistently contributing to your emergency fund is a crucial step towards financial stability.
Manage Debt and Credit
Becoming financially literate also requires understanding different types of debt, such as credit cards, loans, and mortgages, along with their respective interest rates. It's essential to recognize the impact of debt on your credit score and overall financial health. Developing a plan to pay off high-interest debt and maintain a good credit score is key to managing your finances effectively.
Invest Wisely
Mastering the basic principles of investing, including risk and reward, diversification, and compound interest, is essential for financial literacy. Familiarize yourself with different investment options, such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs), and begin investing according to your risk tolerance, time horizon, and financial goals.
Plan for Retirement
Understanding various retirement savings vehicles, like 401(k)s, IRAs, and Roth IRAs, is crucial for long-term financial security. It's important to recognize the benefits of starting to save for retirement early and create a retirement savings plan that works for you. Consistently contributing to your retirement accounts will help you achieve your financial goals.
Understand Insurance
Learning about the purpose of different types of insurance, including life, health, auto, and home insurance, is vital for financial literacy. Understand the concepts of premiums, deductibles, and coverage limits to ensure you have adequate protection for your assets. Regularly evaluate your insurance needs and adjust your coverage as necessary.
Navigate Taxes
Familiarizing yourself with the basics of income taxes, tax deductions, and tax credits is an important aspect of financial literacy. Understand the tax implications of various financial decisions, such as investments and retirement contributions, to make informed choices and optimize your financial situation.
Set and Achieve Financial Goals
Finally, learning how to set realistic short-term and long-term financial goals is essential for financial success. Develop a plan to achieve your financial goals, complete with milestones and timelines, and monitor your progress regularly. Adjust your plan as needed to stay on track and accomplish your objectives.
Examples of financial literacy
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| Meet Jane, a 35-year-old professional who has not yet focused on her financial literacy. She struggles with managing her personal finances and faces a few financial challenges.
Jane doesn't keep track of her income and expenses, which often leads to overspending on non-essential items, like frequent shopping sprees and dining out. As a result, she struggles to save money and lives paycheck to paycheck. Without understanding the importance of an emergency fund, Jane has no savings set aside for unexpected events. When her car breaks down, she's forced to rely on high-interest credit cards to cover the repair costs, adding to her debt. Jane has not planned for her retirement and is unaware of the benefits of her company's 401(k) plan. She misses out on the employer match, which could have significantly boosted her retirement savings. In terms of credit management, Jane often carries a balance on her credit cards and only pays the minimum amount each month. This practice increases her debt and negatively impacts her credit score, limiting her access to favorable loan terms in the future. Unfortunately, Jane's lack of financial literacy results in a cycle of debt, little to no savings, and an uncertain financial future. |
Meet Tom, a 35-year-old professional who's recently gotten serious about managing his finances and educating himself on the importance of financial literacy.
First, Tom creates a budget by tracking his income and expenses. He identifies areas where he can cut costs, such as dining out less and opting for a cheaper phone plan. By sticking to his budget, Tom is able to save more money each month. Recognizing the importance of an emergency fund, Tom sets a goal to save three to six months' worth of living expenses. He opens a high-yield savings account and consistently contributes to it until he reaches his goal. With a solid emergency fund in place, Tom turns his attention to retirement planning. He learns about the power of compound interest and decides to invest in his company's 401(k) plan, contributing enough to receive the full employer match. As part of his financial literacy journey, Tom also learns about credit management. He checks his credit score and ensures that he's using his credit card responsibly by paying the balance in full each month and keeping his credit utilization low. Over time, Tom sees the positive impact of his newfound financial literacy. His savings grow, he feels more secure about his financial future, and he is better equipped to make informed decisions regarding his money. |
Expert perspectives on why financial literacy is important
“For college students, financial literacy is important because the formula for college success today only has two factors: grades and money. Professors and instructors thoroughly educate students on academic requirements and grading policies. It’s often new financial responsibilities and realities that campuses are not adequately educating or preparing students for success. Research has even shown that students are more likely to drop out of school because of “outside pressures” than poor grades. Student success is no longer constrained to classrooms or defined by academic performance alone. The future success of our students relies on providing opportunities for them to learn, develop, and strengthen core life skills they need today and more importantly tomorrow as successful graduates. Our team is proud to be creating a new paradigm within higher education by bringing the topic of money out of the shadows. We have become national leaders in our field by confirming that personal financial education services are no longer an exception for today’s students—they are an expectation.”
Paul Goebel, Director, Student Money Management Center at the University of North Texas
"I think if people truly understand the way that financial systems work at an early age, or even later on in life—if they’ve made poor decisions but learn how they can go back and fix them and start planning for the future—they can then encompass that and take the steps to make a better life for themselves."
Cherry Dale, Director of Financial Education, Virginia Credit Union
"Financial literacy, for me, the most personal debt I have...between my wife and I we paid off $110,000 of debt in five years, because we just learned how to organize our finances in such a way that allowed us to do that. You know, we don’t make a ton of money, but by learning the process and learning what you can do to better organize your life through financial literacy, you can accomplish things a heck of a lot faster and more efficiently."
Phil Schuman, Director of the MoneySmarts Program at Indiana University
"Financial literacy is important because it’s pretty much one of the things that will encompass just about every aspect of a person’s life. So even in families, even in marriages, lots of the hard times that people will have are gonna revolve around money. In the system that we live in, everything revolves around money. We’re in a capitalist society, so it’s to everybody’s benefit to know as much as they can about being wise about their money so that they can at least give themselves some type of stability in the future."
Dameion Lovett, Campus Director and Overseer of the Financial Education Program at the University of South Florida
“Financial literacy is important because it allows an individual to understand and maximize whatever level of income they earn. It helps people transform their lives. That’s why we do it, and that’s why it’s important.”
Latoya Goree, Director, Office of Financial Literacy at UMKC
“My hope is that with increased financial capability, more of us will be able to transition from surviving to thriving. Resulting in sufficient resources to support our own ever-changing, highly subjective pursuit of ‘happiness'.”
Travis Cook, Education Specialist, Utah State Board of Education
“Financial literacy is important because understanding your finances seeps into every area of your life, whether you think it’s going to or not. If you bury your head in the sand and don’t understand what’s happening in your financial world, or you don’t ask the right questions, you can be at a severe disadvantage to attain financial success.”
Laura Zamborsky, Coordinator, $avvy $eawolf Program at the University of Alaska Anchorage
The bottom line
Financial literacy is an essential skill that can truly change lives. It empowers people to take the reins of their personal finances, make informed decisions, and work towards a stable and secure financial future. By mastering key concepts like budgeting, saving, investing, planning for retirement, managing credit, and understanding insurance, individuals can lay a strong foundation for financial success.
Being financially literate not only helps avoid common money traps but also opens doors to opportunities for growing wealth and achieving financial goals. Taking the time to become financially savvy can lead to a more confident, fulfilling, and worry-free relationship with money, ultimately enhancing overall well-being and happiness.
