Why is Financial Literacy Important?

Young adults and even older teenagers may be asked to make life changing financial decisions, yet often lack the basic financial literacy to do so wisely. How could you chose how much to borrow for college when you don't even have a job or know how to balance a checkbook?

In 2017, the National Endowment for Financial Education (NEFE) released a study about young people and financial literacy. They found that only 24% of young adults had good financial literacy. Clearly, there is a disconnect between what young adults think they know about their financial health, and what they actually do. Here's a closer look at why is financial literacy important to students and young adults.

What is Financial Literacy?

Financial literacy is a term that means having an understanding of personal finance. This can include managing money, investing money, handling debts, and even running a small business, all of which young people need to understand. Financial literacy can help further mean positive habits that help people with their money. Your money could either drive your life, or you could use your money to create the life you want. It all boils down to financial literacy. With the knowledge that fuels good habits, you may be able to retire earlier or enjoy a few more vacations or luxury purchases.

Yet many young people who lack financial literacy end up drowning in debt, as these statistics show. The NEFE study found that 53% of young professionals felt they had too much debt, and many started gathering that debt in college. So why is financial literacy important? Financial literacy as a college student could help you avoid this and other common money mistakes.

Are You Financially Literate?

If you're like many young adults, chances are your financial literacy could improve. Are you financially literate, or do you need a bit more education in this area? Ask yourself these questions:

  1. Can you create a monthly budget that includes savings, basic expenses, and debt reduction?
  2. Do you have debt? If so, are you actively reducing it?
  3. Are you aware of how much money you need to pay three months of living expenses in an emergency?
  4. Do you have enough money in the bank to get through a serious financial emergency, like job loss, without borrowing?
  5. Are you aware of the types of insurance you need to protect your investments and other financial resources?
  6. Do you understand how interest, including compound interest, works? Can you use it to grow your investments or protect you from debt?
  7. Are you aware the investments and insurance are not the same?

If you ask yourself these questions and find that you're lacking, then it's likely time to brush up on your financial literacy.

How to Build Financial Literacy?

If you look at these facts and find that your financial literacy is lacking, what can you do? There are specific steps you might take to build financial literacy. These could include learning key financial terms, learning how to use credit well, and learning how to budget.

Key Financial Terms All College Students Should Know

If you are building your financial literacy, a vocabulary lesson is the place to begin. Learn these common terms:

  • Accrue: This means to accumulate and is usually used in reference to interest.
  • Annual Percentage Rate (APR): The APR is the amount of interest paid on a debt each year. If a loan has an APR of 25%, then you will typically pay a quarter of the balance each year in interest and other fees.
  • Bankruptcy: This is a last ditch effort when debt loads have become unbearable. This is a formal government filing that usually forces the debtor to liquidate their valuable belongings first, pay off debts, and start fresh. It creates serious damage to your credit score.
  • Budget: Your budget is your plan for your money. When you give each dollar you receive a "job," you are in control and may make plans for the future.
  • Credit Bureaus: Equifax, Experian, and TransUnion are the three credit bureaus who collect information about credit use for every person in the country. They tabulate that data into a credit report, which influences your credit score.
  • Credit Score: This score shows your creditworthiness. The number, between 300 and 850, comes from the Fair Isaac Corporation (FICO) using the credit reports from the credit bureaus. A score above 700 is considered "good credit."
  • Compounding: Interest that builds on itself. Every time the account earns or is charged interest, the past interest is added to the principal. This might help investments and debts both grow, so understanding how it works is critical.
  • Interest: Interest might be good or bad. On investments, interest helps your savings grow. On debts, interest charges you for the privilege of borrowing money. Interest rate is expressed as a percent.
  • Investment: Money you set aside in the hopes of earning a profit on that money.
  • IRA: Tax free savings you could use to save for retirement. The earlier you start, the better!
  • Payday Lending: This type of loan lets you borrow money that you pay back out of your next paycheck. While it promises fast cash, the interest rates tend to be astronomical!
  • Principal: Amount of money due on a loan before interest. This is what you need to pay off to avoid further interest charges.
  • Stocks: Stocks are a piece of a company you buy in hopes of earning revenue. These are a type of investment.
  • Taxes: Taxes are the money you pay to the government to help cover the public services you enjoy as a citizen of your state or country.
  • W2/W4: You get these tax forms when you're employed. To get a job, you must complete a W4. To do your taxes, you'll get a W2 from your employer.
  • 401(k): Another retirement plan, the 401(k) is quite commonly offered by employers. Sometimes, employers will even match the contributions you make to this plan.

Learning to Use Credit Well

Debt could be a dangerous road to go down, but sometimes you do need to borrow money. While paying cash for a house would be perfect, not everyone can get to that financial position in their early adult years. You may find that you need a mortgage to buy your home.

To be a responsible borrower, you must understand how interest works. When you take out a loan or charge something to a credit card, you must pay back the amount with interest. If you have a loan of $5,000 and a 5% interest rate charged once per year, you will actually pay an additional $250 in interest, so you will pay back $5,250.

Unfortunately, most loans do not have a flat interest rate charged once per year. Rather, they have an APR that compounds daily. So, that 5% divided by 365 is 0.0137 percent. Every day that you carry a balance, 0.0137 percent is added to that balance. The balance goes up, so the next day even more interest is added. Over time, you'll likely owe more than $250 by the time you pay off the loan at the end of the year.

Your credit card companies will have a minimum payment that you have to pay each month. Paying this keeps the account from going delinquent. However, if you pay just that minimum balance, typically most of the payment goes towards your interest, not your principal. Thus you could be trapped in the debt for many years, unless you pay more than the minimum.

So should you avoid credit cards altogether? When possible, it may be helpful, but sometimes you have to have a little bit of information on your credit history to help build your credit score. One way to use credit cards is to make small purchases, and pay them off in full every month, until you build your credit sufficiently.

How to Make a Budget

Finally, to be financially literate, you should be able to build and use a budget. A budget takes stock of the money you earn and compares it to the money you spend, ensuring every dollar gets a job. To make a budget, you should add up all the money you bring in every single month. Then, add up all of the money you need to spend on your living expenses and bills. Make sure you include savings in the budget.

If your budget's balanced, you should have more money coming in than going out. If it's not, then you need to look for ways to cut expenses or find a way to earn more income in order to balance the budget.

While this process sounds simple, it can be hard to stick to a budget. Make sure the budget has some flexible spending you could use for fun purchases, and take a look at it every month to make adjustments where needed. Make your budget work for you, and you could quickly learn to control your money.

Facts About Financial Literacy

So now that you've started building your financial literacy, don't stop! This is a serious concern for college students and young adults, because this is the time to build this knowledge base to help improve your financial future. Here are some facts that help show you why now is the time to build your financial literacy.

Why Is Financial Literacy Important

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Clearly, financial literacy is an area that today's college students and young adults could use some improvement. As you think about your future after college, make sure that learning to manage your money is a part of it so you may be well prepared for what comes.