Financial Literacy: What Is It And Why Is It So Important To Teach Teens

What Is Financial Literacy?

Financial literacy is the ability to understand and effectively use various financial skills, including personal financial management, budgeting, and investing. When you are financially literate, you lay the groundwork for a smart relationship with money, setting the stage for a lifelong journey of financial learning. The sooner you become financially literate, the better off you'll be, as education is key to a successful financial future.

Key points:

- Financial literacy involves understanding a variety of important financial skills and concepts.

- Financially literate individuals are generally less vulnerable to financial fraud.

- A strong foundation in financial literacy supports various life goals, such as saving for education or retirement, using debt responsibly, and running a business.

- Key aspects include creating a budget, planning for retirement, managing debt, and tracking personal spending.

- Financial literacy can be enhanced through reading books, listening to podcasts, subscribing to financial content, or consulting financial professionals.

Understanding Financial Literacy

In recent decades, financial products and services have become increasingly prevalent. While earlier generations often purchased goods primarily with cash, today's society uses a variety of credit products such as credit and debit cards and electronic transfers. According to a 2021 survey by UK Finance, over 50% of payments in the UK were made using contactless methods, with cash transactions continuing to decline.

Given the importance of finance in modern society, a lack of financial literacy can significantly impact an individual's long-term financial success.

Pitfalls of Illiteracy

Being financially illiterate can lead to many problems, such as accumulating unsustainable debt, poor credit, bankruptcy, housing foreclosure, and other negative consequences. Thankfully, there are now more resources than ever for those wishing to educate themselves about financial topics. For example, the UK government-sponsored MoneyHelper service offers a range of free learning opportunities.

Financial literacy can also help protect individuals from financial fraud, which is becoming increasingly common.

Scope of Financial Literacy

Financial literacy encompasses a wide range of skills, including household budgeting, managing and paying off debts, and evaluating credit and investment products. These skills often require knowledge of key financial concepts such as compound interest and the time value of money.

Financial literacy can cover both short- and long-term financial strategies. The strategy you use will depend on factors such as your age, investment time horizon, and risk tolerance. Understanding how investment decisions made today will impact your tax liabilities in the future is also crucial.

Financial products such as mortgages, student loans, health insurance, and self-directed investment accounts have grown in importance. It is imperative for individuals to understand how to use them responsibly. It's also important to know which investment vehicles are best to use when saving, whether for a financial goal like buying a home or for retirement.

Other developments in finance such as e-wallets, digital money, and peer-to-peer (P2P) lending can be convenient and cost-effective but require that consumers be educated adequately to use them to their advantage.

Why Financial Literacy Matters : It Supports Financial Well-Being

Day-to-day living expenses, living within your means, short-term borrowing, long-term budget forecasting—all require financial literacy. Proper financial management throughout life helps ensure that you can plan and save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy, defaults, and foreclosures.

A 2022 survey by the Financial Conduct Authority (FCA) found that many UK residents are not prepared for retirement. Around 32% indicated that they have no retirement savings, while only 24% felt that their retirement savings were on track. Among those with self-directed retirement savings, about 60% admitted to feeling low levels of confidence in making retirement decisions.

Millennials' Challenge

A lack of financial literacy has left many millennials—the largest share of the UK workforce—unprepared for financial crises. Research by the Money Advice Service showed that even among those who reported having a high knowledge of personal finance, only 25% could correctly answer questions about fundamental financial concepts.

Furthermore, a significant number reported using expensive alternative financial services, such as payday loans and pawnshops. More than half lacked an emergency fund to cover three months' expenses, and many were financially fragile, defined as being unable or unlikely to come up with £1,000 within a month in the event of an emergency.

Millennials also carry large amounts of student loan and mortgage debt. The lack of understanding of financial products can lead to widespread vulnerability to predatory lending and other financial pitfalls. Financial literacy is crucial for the economic health of individuals and society as a whole.

Benefits of Financial Literacy

Broadly speaking, the benefit of financial literacy is that it empowers individuals to make smarter decisions about their finances. Financial literacy can prevent devastating financial mistakes, prepare people for financial emergencies, help individuals reach their goals, and boost confidence.

Strategies to Improve Financial Literacy Skills

Developing financial literacy involves learning and practising skills related to budgeting, managing, and paying off debts, and more. It means understanding and using credit and investment products wisely. Here are several practical strategies to consider:

Create a Budget

Track your monthly income and expenses using an Excel spreadsheet, paper, or a budgeting app. Include income, fixed expenses, discretionary spending, and savings.

Pay Yourself First

Choose a savings goal, decide how much you want to contribute towards it each month, and set that amount aside before allocating the rest of your expenses.

Pay Bills Promptly

Make sure your payments are always sent on time by setting up automatic debits or using bill-pay apps, and sign up for payment reminders.

Get Your Credit Report

In the UK, you can request a free credit report from each of the three major credit reference agencies—Equifax, Experian, and TransUnion—through their websites. Review these reports and dispute any errors.

Check Your Credit Score

A good credit score enables you to obtain the best interest rates on loans and credit cards. Monitor your score via a free credit monitoring service. Be aware of what can raise or lower your scores, such as credit inquiries and credit utilisation ratios.

Manage Debt

Use your budget to stay on top of debt by reducing spending and increasing repayment. Develop a debt reduction plan, such as paying down the loan with the highest interest rate first. If your debt is excessive, contact lenders to renegotiate repayment, consolidate loans, or find a debt counselling programme.

Invest in Your Future

If your employer offers a pension scheme, be sure to sign up and contribute the maximum to receive the employer match. Consider opening an Individual Savings Account (ISA) and creating a diversified investment portfolio. Seek financial advice from professional advisors if necessary to help you determine how much money you will need to retire comfortably and develop strategies to reach your goal.

Example of Financial Literacy

Emma is a secondary school teacher who incorporates financial literacy into her curriculum. She educates her students on personal budgeting, debt management, saving for university and retirement, insurance, investing, and tax planning. These concepts help her students manage their finances as they transition into adulthood.

Why Is Financial Literacy Important?

Financial literacy provides individuals with the tools and resources needed to be financially secure. The lack of financial literacy can lead to overspending, unsustainable debt, poor credit, bankruptcy, housing foreclosure, and other negative consequences.

How Do I Become Financially Literate?

Becoming financially literate involves learning and practising various skills related to budgeting, managing and paying off debts, and understanding credit and investment products. Basic steps include creating a budget, keeping track of expenses, making timely payments, saving money, checking your credit report, and investing for your future.

What Are Some Popular Personal Budget Rules?

Two commonly used personal budgeting methods are the 50/30/20 and 70/20/10 rules. The first involves dividing your after-tax, take-home pay into needs (50%), wants (30%), and savings (20%). The second recommends dividing your after-tax income into expenses (70%), savings or debt reduction (20%), and investments and charitable donations (10%).

What Are the Principles of Financial Literacy?

The five broad principles of financial literacy are earning, spending, saving, borrowing, and protecting your money. Understanding these principles helps individuals make informed financial decisions and secure their financial future.

The Bottom Line

Financial literacy is the knowledge of various aspects of personal finance and the ability to make smart decisions about money. It includes preparing a budget, knowing how much to save, recognising favourable loan terms, understanding what impacts credit, and distinguishing different investment options for saving for retirement. Financial literacy helps individuals handle their personal finances responsibly, protecting the well-being of their financial futures.