Financial Literacy: The Key Components You Need To Know
If managing your money and paying your bills makes you feel anxious and overwhelmed, you’re not alone. According to a survey conducted by Capital One, 77% of Americans feel stressed about their personal finances.
Of those surveyed, 58% feel that their finances control their lives, and 68% aren’t sure they’ll have enough money to eventually retire. If you struggle with similar feelings, there’s a good chance you could use some help with your financial literacy. The knowledge you might gain from practicing these will be invaluable, especially as you reach retirement.
What Is Financial Literacy?
Financial literacy is the ability to understand and implement various money management skills. It includes, but is not limited to, the following skills:
- How to save for the future
- How to avoid taking on high-interest debt
- How to effectively use a credit card and repay debt
- How to balance a budget and pay your bills on time every month
Anyone lacking in these skill sets is considered financially illiterate, and it’s a growing problem today. Many people fail to understand basic financial principles and struggle to manage their money as a result.
As our world and financial systems become increasingly complex, financial literacy is more important than ever. Financially literate individuals are less vulnerable to fraud, make better spending decisions, and have less debt.
6 Key Components of Financial Literacy
Financial literacy is about having a solid understanding of managing your money and staying out of debt. Let’s look at the six fundamental principles you need to understand to master financial literacy.
Before you can pay your bills or start saving for the future, you need to understand how much money you make. This knowledge begins with understanding the difference between gross and net income.
Gross income is the amount of money you earn before taxes. So if you work a full-time job and earn $80,000 per year, that is your gross income. However, you do not have $80,000 available to spend — this is just the total amount you earn before taxes and deductions are taken out.
Your net income is your gross income, minus whatever you pay in taxes and deductions. This is typically the amount you see on each paycheck, and it’s your total take-home pay.
If you’re self-employed, then calculating your gross and net pay may be a bit more challenging. These terms can vary a bit depending on the type of business you run.
But in general, your gross revenue will refer to the annual income your business brings in each year. In comparison, your net income is the amount that’s left after you pay taxes and expenses.
Creating and sticking to a budget is a crucial aspect of financial literacy. Once you understand how much money you have to work with every month, you need to plan how you’ll spend that money.
Many financial experts recommend setting up a zero-sum budget. With a zero-sum budget, you’ll plan to spend every dollar you earn throughout the month.
After you finish paying your bills, saving, and spending, your checking account should be near zero at the end of the month. A zero-sum budget can help you keep a handle on fluctuating expenses and avoid overspending.
If you don’t follow a budget, it’s hard to know where your money is going and even harder to reach your financial goals. The right budgeting software can help you create and follow a monthly budget.
No matter how well you budget every month, it’s inevitable that financial emergencies will come up. When this happens, having an emergency fund can help you avoid going into debt. And if nothing does come up, you’ll have peace of mind knowing that you’re prepared for the unexpected.
To figure out how much money you should have in an emergency fund, figure out your average monthly budget and multiply it by six. Once you’ve saved up that amount, you’ll know you have enough money to cover six months’ worth of expenses.
Regardless of whether you have a full-time job, run a business, or have a side gig, anyone who earns an income is responsible for paying taxes. And the amount you pay will vary depending on how much you make and where you live.
Taxes are money collected by the federal government to fund government operations. If you live in the U.S., then you’re required to pay many different types of taxes.
For instance, everyone is required to pay income taxes to the federal and state governments. Federal income taxes will range from 10% to 37%. Large companies pay corporate taxes on its profits. And if you own a home, you can expect to pay state property taxes.
Those are all considered direct taxes and are based on a percentage of the total earnings. However, you may also be responsible for indirect taxes, which are added to transactions for goods and services.
If you’ve ever taken out a car loan or a mortgage to pay for a house, then you’re already familiar with the concept of credit. When you take out a line of credit, you’re borrowing that money under the agreement that you’ll repay the funds in the future with interest.
The 3 Major Credit Bureaus
Every time you borrow money from a financial institution, that information is shared with the three major credit bureaus: Experian, Equifax, and TransUnion. These bureaus collect information about how well you repay your debts, how much debt you have outstanding, and whether you miss payments.
This information is used to create your credit score, and it helps financial institutions decide whether or not to lend you money in the future. Learning how to maintain a healthy credit score is an essential aspect of financial literacy.
It’s essential to save for emergencies and short-term goals. But you should also have a plan to save for long-term financial goals like retirement. Doing this will ensure that you have enough to take care of your needs and live comfortably later in life.
To get started with investing, it can help to work with a certified financial planner. You’ll tell them about your financial goals and desired lifestyle, and they can make recommendations accordingly.
Are You Financially Literate?
So how do you know if you’re financially literate or if there’s still some work you can do? Here are a few questions you can ask yourself to figure this out:
Questions To Ask
- Do I create a monthly budget and plan for my bills, spending, and saving?
- Do I have a six-month emergency fund, or am I actively working toward saving one?
- Do I understand the difference between net and gross pay and how much money I have to spend every month?
- Do I understand the basics of credit and request a free annual copy of my credit report from the three major credit bureaus?
- Do I have any high-interest credit card debt or other consumer debt? If so, do I have a plan for how to pay it off?
The Bottom Line
Hopefully, you have a solid grasp of financial literacy and are building a healthy financial future. But if you aren’t, it’s not too late for you to get started. There are actionable steps you can take to understand how money works and manage your money better.
Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.
- Capital One. 2020. "Big-Picture Thinking Leads To the Right Money Mindset"
- Annuity.org. "Financial Literacy."
- IRS. 2020. "Adjusted Net Income Defined."
- Tax Policy Center. "How Do Federal Income Tax Rates Work?"
- IRS. "Business Taxes."
- Equifax. "What Is a Credit Report and What Does It Include?"