What Is Financial Literacy?
Financial literacy is having the knowledge and understanding of financial principles to manage money in a wise, and effective manner.
So, there are essentially two parts to financial literacy: knowing how to manage money, and actually doing it. You see, anybody can learn the principles of money management. But to become truly financially literate, you need to take it one step further, and implement good financial principles in your own life.
Why Is It Important?
Financial Literacy is important, because without a proper understanding of personal finance, and the skills necessary to manage money effectively, financial success becomes extremely improbable. Meanwhile, the likelihood of financial struggle increases.
Plus, money is easy to mismanage, because it only takes a few decisions to wreck your financial future. However, if you take the time to learn how to properly manage your money, and then apply that knowledge to your financial life, you will build wealth over time.
Who Needs Financial Literacy Skills?
In this world, every person gets to choose their career path. If you love math, you can become an engineer. If you love writing, you can start a blog, or write a book. If you love biology, you can become a doctor. If you are entrepreneurial, you can start a business; the choices are endless. But, no matter which career path you choose, you will be working for the same thing–money. So, to answer the original question of who needs financial literacy skills — everyone!
People will spend years of their life getting degrees in a countless number of career fields, but the skill that everybody needs to have–managing money–gets overlooked by the majority of them. The good news is, it doesn’t take years to become financially literate. You can learn the basics of good financial management by reading a couple of books, and you can become financially literate over the course of just a few weeks.
What Are The Benefits Of Financial Literacy?
Some of the most important benefits of being financially literate include:
One of the quickest ways start struggling with money is to take on debt. Therefore, by equipping yourself with sound financial skills, you are more likely to avoid the financial hardship that–so often–accompanies debt.
Higher Net Worth
Every personal financial decision can be boiled down to a single outcome–it will either increase, or decrease your net worth. So, gaining a better understanding of how money works will help you to make better choices in your finances, and therefore increase your net worth.
Less Financial Struggle
Most people know what it is like to struggle with money, but very few understand what it is like to succeed. Improving your knowledge of personal finance will increase your chances of experiencing success with money.
Better With Household Finances
Paying your bills on time, and managing your household expenses responsibly is a side effect of good financial know-how. So, the more you improve your financial skillset, the better your household financial situation will become.
The Main Components Of Financial Literacy
From knowing how to pay your bills and manage your household expenses, to investing and earning interest, the more you know about personal finance, the better your chances of achieving success become. But, with so many different components to personal finance, where should you start?
Well, after a lot of thinking, I put together this beginner’s guide to the core components of financial literacy. These fundamentals lay out the basics of money, and are a great first step on your road to financial literacy.
Contrary to what you might think, having a net worth is not just for the rich and famous. In fact, everybody has a net worth, and you should know yours. But in order to know your net worth, you first need to understand what it is, and how it is calculated.
Your net worth is made up of 2 parts: assets and liabilities. But what are those?
An asset is anything you own outright that can provide future monetary value. Some good examples of financial assets are: the money in your bank account, any money you have invested in the stock market, real estate you own outright (e.g. the appraised value of your house minus any amount you owe on your mortgage). In its most basic form, you can think of an asset like this: if you were to sell it, the asset is worth the amount of money you would get to keep.
A liability is anything of monetary value that you owe to somebody else, whether that be a bank, organization, or individual. Examples of liabilities in personal finance, are: your mortgage, car loans, student loans, personal loans, credit card debt. If you owe money to anybody else, the amount you owe is a liability. Important note: a liability does not have to carry interest. If you paid for something with a loan, or a credit card that offered 0% interest, it is still a liability.
So, now that you have a basic understanding of assets and liabilities, how do you calculate your net worth?
Calculating Your Net Worth (With Example)
The equation for calculating your net worth is pretty simple. You just subtract the monetary value of your liabilities from the monetary value of your assets. The equation looks like this:
Assets – Liabilities = Net Worth
Let’s run through a basic example using the following lists of assets and liabilities:
Total Assets = $341,500:
Home Value = $300,000
Savings Account = $7,500
401K = $12,000
Car Value = $22,000
Total Liabilities = $313,500
Mortgage Principal Remaining = $240,000
Total Credit Card Debt = $3,500
Student Loan Debt = $40,000
Amount Owed on Car Loan = $30,000
Total Net Worth = $28,000
So, in this example, you can see that by adding up the total value of the assets, and subtracting the total value of the liabilities, this person’s net worth would be $28,000.
Is It Possible To Have A Negative Net Worth?
In short, yes, it is possible to have a negative net worth, and unfortunately, many people do. In fact, when my wife and I first calculated our net worth, ours was negative.
So what should you do if you have a negative net worth? The answer is, get rid of your liabilities. In other words, get out of debt. My wife and I got out of debt, and we now enjoy a positive and growing net worth, and you can too! For a little debt free inspiration check out our post, 10 Inspiring Books To Read While Getting Out Of Debt.
Earning An Income
When it comes to your own personal finances, everything starts with your income. In order to save, spend, invest, and pretty much anything else, you must first earn an income. In the case of financial literacy, it is important that you understand the 2 different types of income: active and passive. That is what we are about to cover.
When you go out and perform a service, or sell a product in exchange for money, you are earning an active income. Every dollar you actively earn requires your participation. Active income can come in the form of commissions, hourly wages, tips, or a salary.
Passive income is the holy grail of income, because it doesn’t require you to actually be present to earn it. You don’t have to actively perform a service, or sell a product to earn a passive income, which is why you can make it while you sleep. It is important to note that passive income does require “up front” work. The difference, is that the work you do, continues to earn money long after you are finished. Some good examples of passive income are: investments that earn interest, selling a digital info-product or course, and owning rental properties.
I decided not to lump saving and investing into the same category, because I believe they should be considered 2 separate things. Saving money is the process of setting aside a portion of your income to either, act as a buffer between your current circumstances and future uncertainty, or to prepare for a future purchase. Saving is about piling up a “liquid” amount of money to be there when you need it. It is smart to save for things like: emergencies, car purchases, a down payment on a home, medical expenses, having a baby, vacations, and weddings.
Investing is the act of dedicating your money to an asset with the idea that it will make a profit, and grow your net worth.
This is an essential part of personal finance, and the direct path to wealth. So, it is a concept that is worth your time. Some examples of investments are: real estate, mutual funds, stocks, ETFs, and index funds. But no matter what you investments you choose to make, there is one key concept that you need to understand: compound interest over time.
Compound Interest Over Time
Compounding interest is the concept of earning interest that then also earns interest. Let me explain.
If you invest $100 in the stock market today, and over the course of the next year it earns a 10% return, you will have earned $10 from interest. Now, if you were to add the $10 you made to your original investment of $100–thereby making your investment $110–and you were to earn 10% interest next year, you would make $11. If you were to continue this process for 50 years, that original $100 would grow to become $11,739.
Now, that scenario assumes you invested $100, one time. What’s even more powerful, is that if you were to invest $100 every month for 50 years, assuming the same 10% annual return, with compounding interest, you would end up with $1,471,343.
Compounding interest over a long period of time is how people become very wealthy, and why investing is such an important concept for you to learn and understand.
A Budget is a set plan for what you will do with your money, and the compass that will guide your financial decisions and behavior. In other words, it is the plan of attack for your personal finances. This is why budgeting is so important for you to understand. For a complete, in-depth guide on budgeting, check out our post, How To Make A Budget: 10 Simple Steps That Actually Work.
For some reason, I have found that taxes are often left out in articles about financial literacy, but this is a giant mistake. While you do get to vote on whether or not to raise or lower taxes, it is illegal to just disregard them and not pay. Which is exactly why it is imperative that you at least gain a basic understanding of taxes. So, here are some basic tax concepts you should know.
3 Types Of Taxes You Need To Understand In Personal Finance
- Income Tax
- Taxes imposed by federal, state, and local governments on the income of individuals and businesses. These are the taxes that are pulled out of your paycheck.
- Property Tax
- Taxes imposed by local governments on real estate. The amount you have to pay is based on the value of the property you own, and is therefore subject to change over time.
- Sales Tax
- Taxes imposed on the sale of any goods or services. These taxes are imposed by state and local governments, so the actual tax percentage can vary greatly. In fact, many states don’t impose a sales tax at all.
Put simply, debt, is any amount of money that you owe to somebody else. But, before you go borrowing money, there is a lot more information you should understand. From the basic principles and terminology, to the long-term effects it can have on your ability to build wealth, it is in your best interest to gain a full understanding of debt.
Full disclosure: at BeTheBudget, we strongly recommend that you live a debt-free lifestyle. This means getting out of debt if you are in it, and avoiding debt it if you aren’t. We have come to this conclusion through our own experiences and observations of the negative effects of debt. We have been down the debt-filled path, and it only proved harmful to our financial future. So, if our debt-free opinions shine through in the following section, at least you will understand why.
All that being said, understanding the basics of debt is still a crucial part of financial literacy. So, here are a few things you need to know.
Related: Check out our Debt Payoff Calculator to find out how long it will take you to get out of debt using the Snowball Method.
Debt Terminology (Basics)
- This is the original amount of money borrowed, and/or the remaining amount of money owed at any point during the loan term, not including interest. For example, if you took out a $20,000 loan to purchase a car, your principal would be $20,000. Then, if you paid off $2,000 of the original loan amount (not including interest payments), your principal would be $18,000. Keep in mind, each monthly payment you make on a loan includes interest, so only a portion of your monthly payments actually counts toward the principal.
- Interest Rate
- The interest rate on debt is the amount of money in addition to the principal that you are required to pay, expressed as a percentage (e.g. 4.79%). Interest rates come in 2 forms:
Fixed Interest Rate
An interest rate that is guaranteed not to change throughout your loan term.
Variable Interest Rate
An interest rate that can periodically change throughout your loan term.
- The interest rate on debt is the amount of money in addition to the principal that you are required to pay, expressed as a percentage (e.g. 4.79%). Interest rates come in 2 forms:
- This is an item of economic value that serves as a means for a lender to recoup the amount of money borrowed in the case of a borrower that fails to pay back a debt in accordance with the agreed upon terms. For example, if you take out a loan to buy a car, and you fail to make the payments, the lender can repossess the car you purchased, and sell it to somebody else in order to make back the money you borrowed and didn’t pay back.
Types of Debt
When it comes to borrowing money, there are multiple classifications of debt. However, when it comes to the absolute basics of financial literacy, it is important that you understand, two of them.
- Secured Debt
- In general, a secured debt, is a debt incurred with the purpose of purchasing a particular item that will–in most cases–serve as its own collateral. For example, when you take out a loan to buy a house, the house itself will serve as collateral. That way, if you ever fail to pay back the loan, the lender can repossess the house, and sell it to recoup the money you borrowed.
- Unsecured Debt
- Basically, unsecured debt, is debt without collateral. A great example of unsecured debt is a credit card. You are given access to a limited amount of money that you can then borrow and spend without any collateral to protect the lender. It is for this exact reason that credit cards carry such high interest rates. Think of it like this, no collateral means more risk for lenders; and more risk for lenders leads to higher interest rates.
The loan term, is the agreed upon timeline and structure in which a debt will be repaid. For example, if you take out a loan to purchase a car and agree to pay back a lender in 60 months, the loan term would be 60 months.
In the case of debt, amortization is the set schedule by which a borrower will pay down a loan–including any associated interest, taxes and fees–over a series of fixed installments. For example, the amortization schedule of a $200,000, 15-year mortgage (180 months), with a fixed interest rate of 4.75%, would set your monthly payment will be set at $1,556.66.
The significance of an amortization schedule, is that the balance between interest and principal changes over the course of time, while maintaining the same monthly payment. For example, in the same 15-year mortgage mentioned above, if we break out the first and the last monthly payments into interest and principal, they would look like this:
First Monthly Payment
Principal Payment = $764.99
Interest Payment = $791.67
Last Monthly Payment
Principal Payment = $1,550.52
Interest Payment = $6.14
A number assigned to borrowers, that helps lenders assess your creditworthiness, and likelihood to pay back a loan.
The Long-Term Effects Of Debt
If you want to make sound financial decisions, it is important that you understand the long-term effects that debt can have on your life, especially in regard to your ability to build wealth. One of the best pieces of advice I ever heard in regard to finance, went something like this, “Wealthy people earn interest. Broke people pay interest. All you have to do to become either, is decide which route you will take.” I’m not sure who originally said that, and I might be paraphrasing it a bit, but it is an extremely valuable point. Paying interest does not make you wealthy.
To prove my point, here’s an example from my own life.
At the time my wife and I committed to a debt-free lifestyle, we were in $34,101 of debt, which we then paid off over the course of 6 months. If we had instead, never taken on all that debt, and invested the money in a mutual fund with a 10% average annual rate of return, over the next 30 years, that $34,101 would grow into over $684,000. Can you say “poor” decision-making?
How To Improve Your Financial Literacy?
There is always room for improvement when it comes to handling your money. Whether you have a net worth of one-million dollars, or one-hundred dollars, you should never stop learning. In fact, the more money you have, the more value you should place on financial education and improvement.
So, with that in mind, here are some tips, and resources to help you continually improve your financial knowledge, and acumen.
The very first step you should take to improve your finances, should be to get on a budget. Budgeting helps you corral your finances, and get control of your spending. For more information on starting a budget, I highly recommend you read our post on How To Make A Budget. By following the steps laid out in that post, we are able to save thousands every month, and we are confident that it will help you drastically increase your savings as well.
Take A Personal Finance Class
If you really want to improve your personal finances, one of the best things you can do is take a personal finance class. The only thing you need to be sure of, is that your instructor is knowledgeable, and has implemented good financial practices in his or her own life.
For online classes, you should check out Udemy.com; or, for a more in-depth experience, we recommend Financial Peace University.
Read About Finance
Reading about personal finance should be one of your top priorities. So, if you are looking for a couple good books or blogs, here are our favorite resources.
Define Financial Goals
Too many people want to improve their finances, but most people never actually sit down and create a plan to get there. If you have a desire to get out of debt, write it down, and plan out how you will do it. If you want to become a millionaire in the next 10 years, that’s awesome; but you aren’t just going to stumble into one-million dollars; develop a monthly investing plan that will get you there.
You can achieve just about anything with a clearly defined plan. So, define some financial goals, and start taking steps to achieve them.
If you want to lead a life of financial stability and success, understanding how money works should be high on your priority list. From budgeting to building wealth, every piece of knowledge you gain is a tool that will help you make stronger and stronger financial decisions.So, get out there and improve your financial literacy. You will thank yourself later.