Financial Literacy: Definition, Importance, and Key Principles

by Rosemarie Hardison
financial literacy

Managing your finances—saving more, spending less, avoiding debt, and planning for a secure future—is a key component of personal fulfillment and success. To do this like a pro, you would need a firm grasp of the five principles of financial literacy, which we will delve deeply into in this article.

What is financial literacy?

The term financial literacy refers to a set of competencies crucial to managing your financial life. It’s about understanding various concepts like investing, budgeting, borrowing and repaying debt, saving, and building and improving credit, and how all of these can be applied to real-life situations.

Why is financial literacy important?

When you’re financially literate, handling your finances becomes less of a headache, and you’ll be in a better position to quickly and efficiently achieve your goals, no matter what surprises may come your way. It empowers you to create a secure future. You’ll avoid costly mistakes, and there will be an improvement in your critical thinking and problem-solving skills. Are you financially literate? If your answer is no, then no worries. We’ve provided a few steps to help you achieve financial literacy.

How to become financially literate?

Financial literacy is based on five guiding principles. They lay the groundwork for wise money management and provide a strong financial base. Learning about and practicing them can improve your financial position both now and in the future. You can implement these principles as follows.

If you experience difficulty implementing them yourself, consider hiring a financial advisor to help you gain proficiency in this field. Leadar, with its huge database of business contacts, can assist in this regard.

1. Earning

Your income determines how you live and how much money you will have in the future. It serves as the foundation of your financial prospects and your lifestyle altogether. Try making saving for your retirement a priority. Retirement is expensive. A useful rule of thumb is to save up enough money to sustain your current way of living during retirement—anywhere between 70 and 90 percent of your pre-retirement income. 

It’s never too early or too late to start saving for retirement, so do yourself a favor and start now. The earlier you start, the more you’ll save, and the better your quality of life will be during retirement. Be sure not to withdraw from your retirement savings because you will lose principal, interest, and maybe even tax benefits. You may also face withdrawal penalties. 

2. Investing and saving

Developing a budget enables you to set aside money for investments and savings. It will help you monitor where your money goes each month and cut out unnecessary expenses as much as possible. That way, your wealth will increase, and you’ll be empowered to undertake major financial projects—buying a house or building your retirement fund, for example. 

3. Managing your debt and borrowing

Wise borrowing practices enable you to build a good credit history while making major purchases—a car, your home, or paying for higher education. However, it’s advisable to refrain from accumulating excessive debt, as this can significantly impede your capacity to invest in the future and save. Too much debt hinders financial progress, so getting out of debt will be a plus for you. 

Your mortgage, for example, accounts for most of your personal debt, and you’re usually stuck with payments for two to three decades. It would serve you well to get out of your mortgage. It can save you a lot of money that can be applied toward other important aspects of your life. 

It’s never easy to get out of debt, but if you continue making only minimum payments to your creditors, you may become trapped in debt, lasting several years before you can dig yourself out. Maybe you feel like it’s already taking all that you have to keep up with your monthly bills, much less if savings were to be included in that. 

Consider listing your debts from smallest to largest, working toward paying off the smallest ones first, and then applying the money you used to pay toward your next largest debt. Continue in this way until you’ve cleared them all. If you have multiple loans, debt consolidation may be another option for you. Your circumstances and objectives will determine which action is best for you. 

4. Budgeting

When you receive your salary, it’s advisable that you practice either the 80-20 strategy or the 50-30-20 budgeting approach. The 80-20 approach involves allocating 20% of your income toward personal savings while 80% is used to cover your expenses. The 50-30-20 strategy, on the other hand, recommends allocating 50% of your income toward your needs, 30% toward your wants, and 20% toward savings and investments.

5. Protecting your financial assets

It’s imperative to safeguard your financial assets—your budget, savings, and investments. You can achieve this by getting insurance coverage or establishing an emergency fund. Insurance companies allow you to pay a premium to transfer your risk of financial losses to them. With an emergency fund, you set aside some monthly money for financial emergencies or unplanned expenses. 

Start small and make it automatic. That way, it’s off your mind, and you’ll avoid spending the money instead. When, where, how, and how much you save are all up to you. You can start off small—whatever you can afford at the time. It will come in handy when you’re faced with unexpected expenses. Try to save up $1,000, and then increase the amount so that you’ll have enough to cover your living costs for at least six months in any event.

Key Takeaways

Financial literacy—the ability to make wise money choices—results from an understanding and practice of five principles: protecting assets, saving, spending, earning, and borrowing. Financial literacy skills are perhaps just as fundamental as reading and writing because they enable you to make more informed and effective financial choices that will enhance your overall financial welfare and make you financially self-sufficient and stable.

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