Why Financial Literacy Is So Important

Why Financial Literacy Is So Important

Today, many consumers have little understanding of finances. In fact, a lack of financial understanding may underscore why many Americans struggle with saving and investing.

Every few years, the Financial Industry Regulatory Authority (FINRA) issues a short financial literacy test as part of its National Financial Capability Study. The test measures consumers’ knowledge about interest, compounding, inflation, diversification, and bond prices. Generally speaking, the study found that performance on the test correlated with key indicators of financial capability. On the most recent test, just over a third of respondents got four or more questions out of five correct, suggesting widespread financial illiteracy.

Some changes in consumer habits and financial products have made it harder for Americans to manage their finances. In the past, most people used cash for daily purchases. Today, they use credit cards more frequently. In 2019, credit use accounted for 27% of payments, up from 24% in 2017. The way we shop has also changed. Online shopping is now the top choice for many, which can make it easy to use and overextend credit, an all-too-convenient way to accumulate debt quickly.

Meanwhile, credit card companies, banks, and other financial institutions are inundating consumers with credit opportunities—the ability to apply for credit cards or pay off one card with another. Without the proper knowledge, it is easy to get into financial trouble.

Financial planning is long term, and people cannot depend on one-time windfalls such as the $1,400 stimulus checks distributed as part of the American Rescue Plan. Instead, individuals need to shore up their financial knowledge to manage their day-to-day financial lives while also taking a longer view for the future.

Key Takeaways

  • From budgeting to personal financial management, financial literacy is the ability to understand and apply various financial skills.
  • Financial literacy is important for many reasons. One main reason is that financial responsibility is increasing. Today, many people must manage their retirement accounts, student debt, mortgage debt, and online trading accounts, among others.
  • Trends in the United States show that financial literacy among individuals is declining, with only 34% of respondents correctly answering at least four out of five questions posed by FINRA on the topic.

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4 Basic Financial Skills

There are skills you must master in order to thrive:

  1. How to create a monthly budget
  2. How to set aside some money for the long term every month
  3. How to pay your bills on time
  4. How to check your credit score

What Is Financial Literacy?

Financial literacy combines financial, credit, and debt management knowledge that is necessary to make financially responsible decisions—choices that are integral to our everyday lives. Financial literacy includes paying off debt, creating a budget, and understanding the difference between various financial instruments. In sum, financial literacy has a material impact on families as they try to balance their budget, buy a home, fund their children’s education, or ensure an income for retirement.

A lack of financial literacy affects people in advanced economies as well as economically emerging or developing economies. From Brazil to Bulgaria to India, nations around the world are faced with consumers who do not understand financial basics.

Though financial literacy may vary with education and income levels, research shows that highly educated consumers with high incomes can be just as ignorant about financial issues as less-educated, lower-income consumers (though in general, the latter do tend to be less financially literate).

At the same time, for many people, thinking about personal finances is often anxiety-inducing. People reported that choosing the right investment for a retirement savings plan was more stressful than a visit to the dentist, according to the Organisation for Economic Co-operation and Development (OECD).

Click Play to Learn How to Improve Your Financial Literacy Skills

Trends Making Financial Literacy More Important

Compounding the problems associated with financial illiteracy, financial decision-making is likely getting more onerous for consumers. Four trends are converging that demonstrate the importance of making thoughtful and informed decisions about finances.

1. Some groups may be falling behind

When it comes to financial literacy, the playing field is far from level. Even amid the economic growth and strengthening employment of the past decade, the FINRA study found that the gap between haves and have-nots may be widening. The study also revealed disparities among different ethnic groups, with White and Asian adults showing more proficiency than Black and Hispanic survey respondents. White and Asian adults correctly answered 3.2 of the study’s six questions. Hispanic adults answered 2.6 of the six questions correctly, and Black adults were able to answer 2.3 questions correctly.

This disparity shows up among younger people as well. According to a 2018 PISA study, White and Asian 15-year-olds had relatively higher financial literacy scores than the overall U.S. average of the students tested. However, Hispanic and Black students had relatively lower scores.

2. Consumers are shouldering more financial decisions

Retirement planning is an example of the increasing responsibility Americans must take for their own financial security. Past generations depended on company pension plans, now known as defined-benefit plans, to fund the bulk of their retirement. These pension funds, managed by professionals, placed the financial burden on the companies or governments that sponsored them. Consumers were not involved with the decision-making, rarely contributed to their own funds, and were rarely aware of the funding status or investments held by the pension.

Today, pensions are more a rarity than the norm, especially for new workers. Instead, employees are usually offered the opportunity to participate in 401(k) plans or 403(b) plans, in which they need to decide how much to contribute and how to invest the money.

Social Security was a major source of retirement income for past generations, but the benefits paid by Social Security today no longer seem adequate for many people. What’s more, the Social Security Board of Trustees projects that by 2033, Social Security’s Old-Age and Survivors Insurance (OASI) Trust Fund (the source for retirees’ benefits) may be depleted. There are a variety of proposals for shoring up Social Security, but the uncertainty only increases the need for individuals to adequately save and plan for their retirement years.

The 2022 Investopedia Financial Literacy Survey found that Millennials and Gen Z plan to rely on 401(k)s while Gen X and Boomers plan to rely on Social Security. The survey also found that younger generations also plan to include cryptocurrency in their retirement plans as well.

Saying the Social Security Trust Fund will be depleted by 2033 doesn’t mean it’s bankrupt and that payouts will immediately cease. Rather, it means its reserves will be depleted, so that only 76% of benefits will be payable at that time.

3. Savings and investment options are more complex

Consumers are now often asked to choose from various investment and savings products. These products are more sophisticated than they were in the past, requiring consumers to select from different options that offer varying interest rates and maturities, decisions they often are not adequately educated to make. These choices can impact a consumer’s ability to buy a home, finance an education, or save for retirement, adding to the decision-making pressure.

Longer lifespans mean we need more money for retirement than earlier generations did.

Then, too, the number of institutions offering products and services can be daunting. Banks, credit unions, insurance firms, credit card companies, brokerage firms, mortgage companies, investment management firms, and other financial service companies are all vying for assets, creating confusion for the consumer.

4. The financial environment is changing

The financial landscape is dynamic. Now a global marketplace, it has many more participants and many more influencing factors. The quickly changing environment created by technological advances, such as electronic trading, makes financial markets even swifter and more volatile. Taken together, these factors can cause conflicting views and difficulty in creating, implementing, and following a financial roadmap.

Why Financial Literacy Matters

From day-to-day expenses to long-term budget forecasting, financial literacy is crucial for managing these factors. As mentioned above, it is important to plan and save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy, defaults, and foreclosures. Yet, in its Economic Well-Being of U.S. Households in 2020 report, the U.S. Federal Reserve System Board of Governors found that many Americans are unprepared for retirement. Over one-fourth indicated they have no retirement savings, and fewer than four in 10 of those not yet retired felt that their retirement savings are on track. Among those who have self-directed retirement savings, more than 60% admitted to feeling low levels of confidence in making retirement decisions.

Low financial literacy has left millennials—the largest share of the American workforce—unprepared for a severe financial crisis, according to research by the TIAA Institute. Even among those who report having a high knowledge of personal finance, only 19% answered questions about fundamental financial concepts correctly. Forty-three percent report using expensive alternative financial services, such as payday loans and pawnshops. More than half lack an emergency fund to cover three months’ expenses, and 37% are financially fragile (defined as unable or unlikely to be able to come up with $2,000 within a month in the event of an emergency). Millennials also carry large amounts of student loan and mortgage debt—in fact, 44% of them say they have too much debt.

Though these may seem like individual problems, they have a wider effect on the entire population than previously believed. All one needs is to look at the financial crisis of 2008 to see the financial impact on the entire economy that arose from a lack of understanding of mortgage products (creating a vulnerability to predatory lending). Financial literacy is an issue with broad implications for economic health.

Strategies to Improve Your Financial Literacy Skills

What Is Financial Literacy?

Financial literacy is the knowledge and application of various financial skills. These may include creating a budget, understanding how credit works, and saving for retirement. Financial literacy includes understanding different financial instruments, such as stocks, bonds, ETFs, and creating an investment plan.

Why Is Financial Literacy Important?

Financial literacy is important not only because financial literacy provides a foundation for informed financial decision-making, but because financial responsibility is increasing. In the past, for instance, employers would manage employees’ retirement accounts. Today, the individual assumes more of this responsibility via self-directed retirement accounts.

In addition, the scope of financial products has broadened and credit is more widely accessible, placing more choices in the hands of consumers.

What Is An Example of Financial Literacy?

One example of financial literacy is the management of day-to-day expenses. Consider a person who has an income of $3,000 each month. If they managed their expenses properly, they would keep their expenses at no higher than $3,000 to avoid going into debt.

The Bottom Line

Any improvement in financial literacy will have a profound impact on people and their ability to provide for their future. Recent trends are making it all the more imperative that consumers understand basic finances because they are now asked to shoulder more of the burden of investment decisions in their retirement accounts, all while having to decipher more complex financial products and options. Becoming financially literate is not easy, but when mastered, it can ease life’s burdens tremendously.