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What is Financial Literacy and Why is it Important?

Financial literacy is the cognitive understanding of financial skills like budgeting, investing, borrowing and saving. When you have financial literacy, you know how to manage personal finances and make better financial decisions. It teaches you the fundamentals of money like budgeting, saving, investing, debt management, and giving.

Financial literacy helps you to prepare for financial roadblocks like the loss of a job. Besides, you are able to maneuver through tough economic times, thereby relieving you financial distress. In this article, we are going to focus on what financial literacy is, its key components, and why it is important.

What is the Best Definition of Financial Literacy?

Financial literacy is having a cognitive understanding of financial components and skills like budgeting, saving, investing, taxation, and borrowing. When you get financial literacy, you are able to save, invest, pay your bills, borrow money responsibly and plan for retirement.

Financial literacy gives you a foundation for a good relationship with your money and how to manage it. The earlier you learn about financial literacy, the faster you achieve financial freedom. Financial literacy is not taught in school, but it is something that requires a fundamental understanding of personal finances.

What are the 5 Principles of Financial Literacy?

Financial literacy is the possession of financial skills that helps you make good financial moves. It helps you put your money to the right use. People who are literate about money know how to use a sinking fund, know how to budget and how to use 401(k). The following are the 5 key components of financial literacy.

1. Understand Your Earning

To become financially literate, you need to understand your paycheck. You need to know how much you make and how to spend it. Besides your regular income, you also learn how to make a passive income through investments. This way, you can boost your earnings. 

2. Budgeting and Spending

Budgeting is one of the 5 principles of financial literacy. To become financially literate, you need to plan your finances well. Budgeting is basically planning how you are going to use your money. You set aside money for expenses, debt, investment, and savings.

When coming up with a budget, use the 50/30/20 rule. This means that 50% of your earnings should be spent on essentials, 30% on wants, and 20% should be set aside as savings. Budgeting makes you financially responsible and helps you use the money for the right purpose.

Read also: Why is budgeting important in life?

3. Saving and Investing

One of the 5 key components of financial literacy is knowing how and when to save and invest. From your earnings, you need to set aside 20% and redirect it into a checking account. When you get your paycheck, make sure to pay yourself first, and keep the money in a savings account. When you start saving early, you get the benefit of compounding interest.

When you save, don’t stop there. Invest your money. Investing is a great way to grow your money. Some of the ways you can invest are in shares and stocks, real estate, bonds, mutual funds, and annuities.

4. Borrowing

The other component of financial literacy is managing debt. Financial literacy helps you to manage debt and learn to be responsible about borrowing. There are good debts and bad debts. You can use debt to build wealth.

When you borrow, you need to repay the debt. Financial literacy thus helps you learn how to balance creating income from debt and how to repay it. You are also able to keep your debt in a manageable level. 

5. Financial Management or Protecting

Financial management is the other key principle of financial literacy. It involves knowing how to mix all other principles of financial management. This means that you know how to mix all other principles like budgeting, saving, investing, and borrowing.

Besides, you also get to know how to protect your money from your spending. You protect your funds from theft, insurance, and fraud. You also plan for your retirement so that you will still have income sources even after retiring.

What is the Importance of Financial Literacy?

Financial literacy is a skill that everyone who wants to gain financial freedom and independence should have. What then are the benefits of having financial literacy? They include the following:

  • Helps you make better financial decisions
  • Helps you grow your money through investments
  • Helps you get out of the debt trap by helping you manage your debt
  • Helps you easily reach financial goals
  • Helps you come up with a structured budget
  • Reduces financial stress and anxiety

What is Financial Literacy for Students?

Financial literacy for students helps them know how to budget, invest, borrow and make money work for them. The earlier you learn financial literacy; the faster money starts working for you. As such, it is important for students to learn financial literacy and put it into practice. By so doing, they can take advantage of compounding interest on their savings and investments.

Summary of What Financial Literacy is and Why it is Important

Financial literacy is the cognitive understanding of financial skills and how to manage personal finances. Key principles of financial literacy like budgeting, investing, borrowing, saving, and protecting your money help you manage your finances well and grow your money. Besides, financial literacy helps you ease financial stress and anxiety. It also helps you be financially responsible and make money work for you.

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