What Is Financial Literacy and Why Is it Important?

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Financial literacy is the confident understanding of concepts including saving, investing and debt that leads to an overall sense of financial well-being and self-trust.

It starts by building basic knowledge of money matters, and while Americans could certainly improve on this score, they've made gains in recent years. Respondents answered an average of just 52% of personal finance questions correctly on the 2020 TIAA Institute-Global Financial Literacy Excellence Center (GFLEC) Personal Finance Index. The index asks questions that gauge participants' understanding of debt management, investment risk, savings options and other financial topics.

Each year since the TIAA Institute-GFLEC survey began, the average percentage of questions answered correctly has increased—from 49% in 2017 to 52% in 2020. While there's more work to be done to educate consumers about their finances, Americans are moving in the right direction.

What Does It Mean to Be Financially Literate?

The goal of financial literacy is to establish a feeling of control over your finances while also using money as a tool to freely make choices that build greater life satisfaction, according to a 2015 report by the Consumer Financial Protection Bureau (CFPB). Additional goals include the ability to navigate unexpected issues like job loss and to set and work toward financial goals.

When you're financially literate, you understand how to allocate your income toward various goals simultaneously—not just to ongoing expenses, but to savings, debt repayment and an emergency fund too. You have the tools to thoroughly research and evaluate loans, credit cards and investment opportunities. Even if you don't have a lot of disposable income to help you reach all of your financial goals, financial literacy will help you know how to prioritize them and make strides when you're able to.

Financial literacy in action can look like:

  • Increasing your retirement savings rate every time you get a raise
  • Maintaining three to six months' worth of expenses in an emergency fund, and replenishing it after you've withdrawn money from the account
  • Comparing promotional periods on balance transfer credit cards so you have an extended time to pay off debt
  • Checking your credit report regularly

Why Is Financial Literacy Important?

Financially literate consumers not only manage money with more confidence, but also have a better chance of handling the inevitable ups and downs of their financial lives by understanding how to prevent and manage issues as they arise.

That can mean keeping a close eye on their bank and credit card accounts so they're aware of potential fraud as soon as possible, or being able to recover from a costly unexpected car repair quickly thanks to ample cash savings. On the other hand, financial literacy can help consumers save diligently for things that matter to them, such as a vacation or their child's college education.

Here are the ways financial literacy can affect your life:

  • Understand how much you earn and spend. When building financial literacy, making a budget is one important way to establish a true understanding of your income and expenses. Once you have a budget, you can continue to track spending and revisit your spending plan regularly. There are many budgeting methods—such as the zero-based or 50/30/20 plans—so choose the one that you're most likely to stick to.
  • Repay and avoid debt. Seeking out the lowest interest rates when comparing loan terms can save a substantial amount over time, and so can paying off credit card balances each month so you don't accrue interest charges. If you already have debt, financial literacy can help you choose the best methods to get out of debt, either on your own or with the help of a reputable expert like a nonprofit credit counselor.
  • Protect yourself from debt and bankruptcy. A crucial way to prevent debt from building is to create an emergency savings account. A financially literate saver knows how much to set aside—ideally three to six months' worth of expenses—and aims to keep it at that level at all times.
  • Work toward a secure retirement. Whatever your other short-term plans, save for retirement at the same time. When you've become financially literate, you'll have a better idea how much to save, what type of retirement you want and how to get there.

How to Become Financially Literate

Don't let the fear of jumping into the financial world, or a sense that you're "just not good with money," prevent you from improving your financial knowledge. There are small steps you can take, and resources that can help you along the way.

  • Look for free resources. To start, take advantage of free tools that might already be available to you. For example, your bank, credit union or credit card issuer might track your spending patterns on its website or app. Several banks and Experian also offer free credit score monitoring. You can use these tools to get an initial grasp of where your money is going and where you stand with your credit.
  • Check with your employer. Find out whether the company you work for offers free financial counseling or an employee financial wellness program. You may be able to speak with a financial professional as part of your suite of workplace benefits, which can give you early insight into the areas you most need to focus on (like saving, retirement, budgeting or debt reduction).
  • Look into credit counseling. Expert help is also available from credit counseling agencies, which employ counselors certified in budgeting and debt payoff techniques. If you have the means, you could also consider working with a financial advisor such as a certified financial planner. They can help with financial goal-setting, tax planning, saving for college and retirement, and paying down debt. Search for a certified financial planner in your area or one you can work with remotely using databases like the XY Planning Network or the Garrett Planning Network.
  • Seek out resources from well-regarded nonprofits and agencies. They can teach you the basics about finance on your own time. Some go-to organizations include:
    • Consumer Financial Protection Bureau: This federal agency provides many online consumer resources, including guides on how to approach major financial decisions like paying for college and getting an auto loan.
    • Financial Planning Association: This membership organization for financial planning professionals posts resources with helpful information on various life events and complex financial topics, such as estate planning and divorce.
    • Jump$tart Coalition for Personal Financial Literacy: A network of national nonprofits, Jump$tart offers financial education for K-12 students and also collects many free financial literacy resources on its website.
    • National Foundation for Credit Counseling (NFCC): Member organizations of the NFCC offer credit counseling locally and remotely, and the NFCC's website includes free planning tools and calculators that can help you budget and plan for retirement.

What Does Credit Have to Do With Financial Literacy?

One of the central reasons to build financial literacy is to grow and protect your credit score, which is a crucial component of your financial life.

With a good or excellent credit score, you can qualify for lower interest rates on loans and credit cards, credit cards with attractive and money-saving perks, and a range of offers for financial products, which gives you the chance to choose the best deal.

But to improve credit, you need to know what factors contribute to your score. Payment history has the biggest impact on your FICO® Score , the credit score most commonly used by lenders, accounting for 35% of it. Pay all bills on time to keep this important element of your credit as strong as possible. Next you'll want to focus on credit utilization, or the amount of revolving credit you use compared to your credit limits. This is another important factor in your FICO® Score. Ideally, pay off credit card balances each month to keep your credit utilization as low as possible.

Check your credit score, bank accounts and credit card balances regularly to maintain a clear understanding of your finances. When you view your credit report, you'll be able to see whether your credit card balances are too high, for instance, or if you've missed a payment and need to course-correct so you don't miss any more.

The Power of Financial Literacy

Ultimately, the best outcome of your commitment to financial literacy will be increased confidence in yourself. When you have the knowledge you need to make informed decisions, you'll be able to trust that you can avoid going into debt or investing with too much risk. From there, you can create and pursue financial goals that will most support your vision for a happy life.