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Financial Literacy Defined
Financial literacy is the possession of skills, knowledge, and behaviors that allow an individual to make informed decisions to effectively manage their financial resources. It encompasses a wide range of skills, including budgeting, saving, investing, borrowing, debt, and avoiding fraud. In today's complex financial landscape, financial literacy is increasingly important for individuals to achieve their financial goals (Tamplin, 2023).
Components of Financial Literacy
Dorman (2023) indicates that there are 5 components of financial literacy: earn, spend, save, borrow, and protect. An alternative expression is budgeting, saving, investing, borrowing and managing debt, avoiding predatory loans, and detecting financial fraud.
- Budgeting is a fundamental
aspect of financial literacy. A budget is a plan that outlines an individual's
income and expenses over a specific period, typically monthly. By creating and
sticking to a budget, individuals can ensure that they allocate their money
effectively, prioritize their spending, and avoid overspending.
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Saving is another critical
component of financial literacy. Saving involves setting aside a portion of
income for future use, whether it is for emergencies, retirement, or specific
goals like buying a home or traveling. Understanding the different saving
options, such as savings accounts, certificates of deposit (CDs), and
retirement accounts like 401(k)s or IRAs, is essential for individuals to make
informed decisions about where to keep their savings and how to maximize their
returns.
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Investing is another aspect of
financial literacy that involves putting money into assets with the expectation
of generating a return. Investments can include stocks, bonds, mutual funds,
real estate, and other vehicles. Understanding investment principles, risk management,
and the impact of inflation and taxes on investment returns is crucial for
individuals looking to grow their wealth over the long term.
-
Borrowing and managing
debt
are also important topics in financial literacy. While borrowing can help
individuals finance significant purchases like a home or education, it is
essential to understand the terms of borrowing, including interest rates, fees,
and repayment schedules. Managing debt involves developing strategies to pay off
debt efficiently, avoid high-interest debt, and maintain a good credit score.
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Avoiding predatory
loans,
meaning unethical or deceptive lending practices that take advantage of
borrowers who lack understanding about loans, financial systems, or their
vulnerable financial situations. These practices can occur in various lending
products, such as mortgages, payday loans, auto loans, and even student loans. Common
characteristics of predatory lending include high interest rates, hidden fees
and charges, misleading or deceptive information,
impossible repayment terms, and pressure tactics. Predatory lending practices
can have devastating effects on borrowers, leading to financial hardship,
ruined credit, foreclosure, and even bankruptcy.
- Detecting financial fraud is another aspect of financial literacy. Fraud includes a wide range of deceptive practices aimed at unlawfully obtaining money, assets, or sensitive information from individuals or organizations. These schemes can vary in complexity and sophistication but involve manipulation, misrepresentation, or exploitation for illicit gain. Some common types of financial fraud include identity theft, phishing attempts, technology support scams, credit card fraud, and charity scams.
Education for Financial Literacy
By improving financial literacy, individuals can take control of their financial futures, make informed decisions, and work towards achieving their financial goals. Financial literacy education plays a vital role in empowering individuals to make sound financial decisions. It should start early, ideally in schools, yet only 20 states require that financial literacy be taught in high school (Tamplin, 2023). Adults need to continue their financial education throughout life to address their evolving financial needs and challenges during their lives. Governments, financial institutions, employers, and community organizations all have a role to play in promoting financial literacy through educational programs, resources, and tools.
References
Christenson, T. (2024, February 5). April is Financial Literacy Month. Moneyfit. https://www.moneyfit.org/financial-literacy-month/
Dorman, H. (2023, April 27). Five components of financial literacy. Milli Bank. https://milli.bank/blog/the-five-components-of-financial-literacy/
Lin, J. T., Bumcrot, C., Mottola, G., Valdes, O., Ganem, R., Kieffer, C., Lusardi, A., & Walsh, G. (2022). Financial Capability in the United States: Highlights from the FINRA Foundation National Financial Capability Study (5th Edition). FINRA Investor Education Foundation. www.FINRAFoundation.org/NFCSReport2021
Tamplin, T. (2023). Why financial literacy is important and how you can improve yours. Forbes. https://www.forbes.com/sites/truetamplin/2023/09/21/financial-literacy--meaning-components-benefits--strategies/
