Do you know why financial literacy is important? Many Americans think they have a strong handle on financial basics, but they may be surprised when actually putting their knowledge to the test.
According to the Financial Industry Regulatory Authority, 63% Americans are considered financially illiterate. In order to come to this conclusion, FINRA asked respondents a series of questions meant to test their knowledge of basic financial and economic principles most of us encounter in our day-to-day lives. The questions covered topics ranging from interest and inflation to bonds and mortgages, with the results being less than ideal. According to FINRA, it appears that most Americans “tend to have positively biased self-perceptions of their financial knowledge.”
Financial literacy is important because those with higher financial literacy are more likely to plan for retirement, have an emergency fund, and be less likely to engage in expensive credit card behaviors. But what, exactly, does it mean to be financially literate? What are some basic tenets we should all know in order for us to consider ourselves economically capable and knowledgeable?
Pillars of Financial Literacy
Depending on where you look, the basic pillars of financial literacy vary a bit. Some assert that there are as many nine, while others claim there are as little as four. Regardless, here are some basic financial principles all of us should know in order to lead healthy, secure financial lives.
According to the FINRA report mentioned above, 18% of Americans are living outside their financial means, meaning they’re spending more than what their household is bringing in. Basic budgeting practices are essential for ensuring you aren’t overextending yourself or putting yourself in danger of falling into extreme debt or bankruptcy. Budgeting is also an integral practice when it comes to maintaining steady business operations.
If you aren’t keen on budgeting best practices, you aren’t alone. Most parents don’t actively work to teach their children about healthy money management but, according to a University of Cambridge report, children’s money habits are formed by the age of 7. This means that many of us have grown up without a great deal of financial guidance. Like anything else in life, it’s tough to teach an old dog new tricks – but it isn’t impossible.
Budgeting can be learned at any age, and “late” is always much better than “never.” If you need a little extra help with budgeting, a few great apps to try are:
- You Need a Budget
- Or hire Pine & Company CPAs to help you create an individualized budget based on all of your personal particulars and goals
Nearly 50% of Americans would not be able to cover an unexpected $400 expense, according to the Federal Reserve. The thing is, we all know we should be saving, but how many of us do so strategically, with an end-goal in mind? And how much should we be saving, anyway?
Most finance experts agree that most of us should be saving somewhere around 20% of the take-home portion of our paychecks. Depending on how much you make, though, that number will vary. If you’re a high earner, responsible saving will probably mean saving a larger percentage of that paycheck while keeping your monthly expenses as low as possible in order to maintain your desired lifestyle.
For earners lower on the pay scale, however, saving 20% is likely as much as you can comfortably spare (and that’s okay, too). The key is ensuring that you live a lifestyle that lies responsibly within your budget after your bills have been paid and your monthly contribution to your savings account has been made.
3. The Ins-and-Outs of Compound Interest
If a ten-year-old child came to you and asked about compound interest and how it works, how would you answer? Could you answer? Unfortunately, the basics of earning and paying interest is another pillar of financial literacy that many fail to completely comprehend.
Albert Einstein himself considered interest to be the eighth wonder of the world: “He who understands it earns it. He who doesn’t pays it.”
Compound interest is a powerful double-edged sword. Contribute faithfully to your IRA throughout the course of your career, and you’ll enjoy the fruits compound interest can bear. On the other hand, get yourself into a position where you owe a large sum of money on a credit card with an extravagant interest rate, and you’ll bear the brunt of the oppressive cycle that comes along with being in debt.
Luckily, those with a solid understanding of compound interest (and the implications that come along with high interest rates and late payments) tend to manage money better overall and are less likely to find themselves in debt.
4. Investment Basics
Sure, playing the stock market can be a complex game. But, it’s important for all of us to understand the basics of investing for a few reasons. First, any sort of IRA or 401k involves investments and the performance of the stock market in general. Second, one of the overall purposes of being financially literate is so that someday you can find true financial freedom. The truth is, true financial freedom is rarely achieved without some form of investing.
Some investment concepts important to know involve how stocks and bonds work (and the difference between the two), risk diversification (not putting all your eggs in one basket), the tradeoff between risk and return, and the difference between investing for growth and investing for income.
“I need to brush up on my financial literacy – now what?”
As we mentioned above, it’s never too late to become financially literate. Even those considered to be financially literate may need to brush up in an area or two. Luckily, there are several authoritative (and free!) resources you can use to verse yourself well in the world of finance.
Some of these sources include free online courses, such as:
- Personal Finance 101: Everything You Need to Know
- Everything you need to know about personal finance in the U.S. presented through concise, engaging, animated videos.
- Personal Finance, Purdue University
- Manage your money more effectively by learning practical solutions to key investment, credit, insurance and retirement questions.
- Financial Literacy, Alison
- An introductory course about personal financial management.
- Fundamentals of Personal Financial Planning, the University of California-Irvine
- Intended to help those who cannot afford extensive planning assistance better understand how to define and reach their financial goals. It provides basic understanding so informed decisions can be made.
- Planning for a Secure Retirement, Purdue University
- A self-guided course meant to teach the basics of retirement planning. The modules include specific goals for the module, activities to complete, and sources for more information.
- Behavioral Finance, Duke University
- This course is intended for anyone who has taken at least one course in economics either in high school or in college and is interested in how our innate biases affect our financial decision-making.
Need some one-on-one financial guidance?
At Pine & Company CPAs, our services extend beyond tax preparation and accounting. We provide insight for new business start-ups, financial planning and growth consulting for businesses, counsel on which accounting software to use (we’ll even train you or your internal accounting person if necessary), assistance with payroll, and business health analytics. If you have financial questions, we’re here with the answers.
Learn more about our services here.