Financial literacy is the understanding of basic financial concepts and proper money management. When you don’t have basic financial literacy achieving financial stability is nearly impossible.
Financial Literacy is More Important Now Than Ever
Over the past two decades, the financial landscape has become more accessible. That accessibility, while convenient and empowering, has created a more complex environment for people to navigate as they try to reach their financial goals.
Apps like Robinhood, Acorns, Personal Capital, and Mint have given people the power to monitor and take control of their money at a level that was unheard of just 20 years ago.
But why has this been the case? Why have investing apps exploded in popularity in the last few years? Why are there so many websites that suddenly appeared to help pay down debt and monitor cash flow?
The answer comes from broader economic shifts that have occurred over the years. For example, the rising cost of college has created a $1.5 trillion student loan debt crisis.
According to CNBC, the tuition in the 1987-88 school year was $3,190 at a four-year public college. By 2017-18 the price was $9,970, a 213% increase. The burden of student loans has made financial literacy important to help families pay down existing debt but also to make use of financial tools like the 529 college savings plan to offset the cost of college for their kids.
Financial literacy is also important because of the increased financial responsibility in retirement. Pension plans were once the most common way to achieve financial security but the availability of those plans began to fade. In 1998, 59% of Fortune 500 companies offered a pension. By 2019, that number dropped to just 16% as employers moved more in favor of the 401(k). Individuals are now required to choose their investments, choose the amount of money to invest, and have the discipline not to withdraw when the market is down. Many of these new financial apps and tools became popular to help solve these more complex issues.
What is Financial Literacy?
“Financial literacy means understanding the implications that policies, strategies, and even vehicles or instruments will have on my life and financial future, and confidently making informed decisions as a result,” said Danielle Desir, host of The Thought Card Podcast.
By this measure, the majority of Americans are failing at the subject. Despite having the world’s largest economy, the U.S. ranked 14th according to a 2016 Standard & Poor’s Global Financial Literacy Survey which found that only 57% of adults were financially literate.
In fact, 50% of Americans fail this basic 6-question personal finance quiz. This lack of financial literacy costs Americans $307 billion each year.
Related: Why Financial Literacy is Not Enough
Major Components of Financial Literacy
Because the nature of finance can be so personal, this is by no means a comprehensive list. Below are many of the core components of financial literacy.
Cash flow (aka budgeting): Financial literacy begins with knowing the amount of money coming in and going out. Being able to effectively track this and avoid being in the negative will dictate one’s ability to save, invest and create financial freedom.
Debt management and credit scores: As mentioned earlier, student loan debt has become a major factor — and in some cases impediment — in today’s financial landscape. Credit card debt also plays a factor here as well, as Americans hold over $750 billion in credit card debt.
Investing and retirement: The ultimate financial goal for many is financial independence. For some, this means having the ability to travel and not being required to report to a job that isn’t enjoyable. To reach any version of financial independence requires that the money you generate, compounds and grows over time. The longer that that money grows the more freedom one can attain.
Insurance (health, auto, life): A basic understanding of different types of insurance coverages is an important part of financial literacy. This is because, without insurance, there can be some very costly pitfalls that could ruin any financial goal. At its core, insurance transfers the risk of financial loss from the individual to an institution. This allows you to continue saving and investing your money without interruption instead of using it to pay for an unforeseen incident.
Taxes: Having a basic understanding of taxes can help enhance your financial decision-making. Common financial debates like the difference between Roth IRA or Traditional IRA are a tax question. The subject of taxes not only has an impact on your investment decisions, but may also include any properties you may own, your take-home pay, and how you operate your side hustle or business.
General economics: A high-level understanding of economics is often overlooked, but plays an important part in our financial lives. For example, interest rates can determine how quickly you can pay off debt, it can have an impact on how you approach investing, and it can play a role in your decision whether or not to buy a home.
Financial Literacy Must Meet a Higher Standard
Financial literacy will always be important, but that does not mean that it is a magic wand that can fix any financial issue.
For example, there have been plenty of studies that suggest that financial literacy classes are not effective at the middle and high school levels. This is because, for some, it could be decades before students encounter these concepts in real life.
This is not to say that financial literacy shouldn’t be taught at younger ages, but it does stress the need for continuing education and just-in-time education as well as experiential learning.
To illustrate this point, look no further than the state of New Jersey’s financial literacy curriculum that requires students to, “compare and contrast the advantages and disadvantages of various mortgages.” This is a valuable skill however the average homeowner is 31 years old while the oldest high school student is around 18 years old.
Researchers Daniel Ferdinance and John Lynch found that “many hours of instruction have negligible effects on behavior 20 months or more from the time of intervention.” This means that in less than two years, that information has eroded.
The Washington Post cited a study that financial education only accounted for a 0.1% change in financial behavior. A better approach is to front-load topics that are closer to students like student loans, credit cards, and budgeting and saving topics like homeownership as a requirement to go through the buying process.
Melody Wright, Money Coach and Certified Financial Education Instructor at Broke on Purpose added: “It’s one thing to read about the power of compound interest, but to be able to invest and experience it for yourself gives you a wholly different appreciation of the importance of investing in your retirement earlier rather than later.”