Some financial challenges might be out of your control, but financial planning can equip you to handle whatever comes your way. Being empowered to make good financial choices is called financial literacy, and it’s something that every human needs.
Lack of financial capability can make it hard to make major financial decisions like opening the right kinds of bank accounts, planning for retirement, and paying off personal debts from student loans or credit cards.
So how do you become financially literate?
According to the Financial Literacy and Education Commission, there are five key components of financial literacy: earn, spend, save and invest, borrow, and protect.
1. Earn: Understanding your paycheck
Before you can start spending, saving, and investing, you need to know how much money you make. If you make the same amount each month, this part is pretty easy. Take a good look at your paycheck to identify your gross and net income, and note any other deductions.
2. Spend: Creating a personal budget
A personal budget is just a plan for how you want to spend your money, but it’s also the most useful tool for achieving your financial goals. To create a monthly personal budget, you’ll need to track your spending over the course of one month, and then break everything down into categories.
3. Save: Determining your financial goals
Everyone knows it’s important to save money, but it’s hard to spend less than you earn without specific financial goals to work towards. Your financial goals will depend on your unique situation, but should include:
- Saving for an emergency fund. Setting aside some emergency money will give you peace of mind, and also prevent a financial setback from overtaking your life. Financial experts recommend having at least three months’ worth of basic living expenses in an emergency fund.
- Planning for retirement. The experts agree: The earlier you start saving for retirement, the better.
- Saving for a big purchase. Whether you’re hoping to buy a car, a home, or investing in yourself, the sooner you start saving, the less you’ll have to put aside each month.
- Paying off personal debts. Most people have some kind of debt, whether that’s student loans, credit card debt, or both. Check the interest rates on your loans: Paying off loans on time (or ahead of schedule) can save you thousands of dollars in interest.
4. Borrow: Credit cards, loans, and your credit score
Even if you’re a diligent saver, at some point you may have to borrow money to cover a large expense like a home or car. Borrowing isn’t necessarily a bad thing—as long as you know how to compare loans and maintain a healthy credit score.
APR (Annual Percentage Rate) is the key to comparing loans and credit cards. APR takes into account both the interest rate and fees to give you a more accurate idea of how much interest you’ll pay each year. A low APR means you’ll pay less interest over time, but how do you get one?
In general, the higher your credit score, the less interest you’ll be charged. That means that if you’ve had financial difficulties in the past, you can get stuck in a vicious cycle where all of your money goes to paying off interest. That’s why building healthy credit is one of the most important steps to becoming financially literate.
Keeping a balance on your credit card is one of the easiest ways to rack up debt, but choosing the right credit card and using it responsibly can actually help you improve your credit score.
5. Protect: Preventing fraud and buying insurance.
Once you’ve set yourself up with a solid budget and investment strategy, it’s important to protect the money that you’ve made. This means regularly reviewing your bank accounts and credit card statements for mistakes or suspicious activity; keeping documents and passwords secure to prevent scams and identity theft; and buying the right kind of insurance to protect yourself in the event of an emergency.
How to Assess Your Financial Literacy An easy way to assess your financial literacy is to ask yourself some questions about your own personal finances. • Do you know how to create a personal budget? • Do you have an emergency fund? • If you have debt, do you have a plan to pay it off? • Do you know your credit score and how to improve it?