Mastering Your Finances: The 5 Principles of Financial Literacy

To many, the world of finance is incredibly intimidating; filled with complex terms and concepts not intended to be understood by mere mortals. This, thankfully, is a misconception. Financial literacy is well within the reach of anyone of any level of education.

Building your financial literacy level probably is not high on your to-do list. But, learning how to manage your money is an imperative life skill. With the vast array of books, blogs, podcasts, and much more accessible today for free, it is hard to go through all the information. Even more so, there are fundamentals of finance that are more important to know such as how to manage loans, debt, budgets, insurance, and investing to name a few. But first what does financial literacy even mean?

What Is Financial Literacy?

Financial literacy is the ability to comprehend and apply basic economic principles, such as personal finance management, investing, and budgeting.

Financial literacy is essential for making wise financial decisions, achieving financial goals, and preparing for retirement. A person with solid financial literacy understands financial concepts such as debt management, compound interest, interest rates, and financial planning.

So how do you become financially literate? Some high schools and colleges offer courses in money management, but if yours didn’t, or you’re looking for a refresher, start with a few simple concepts. According to the Financial Literacy and Education Commission, there are five key components of financial literacy: earn, spend, save and invest, borrow, and protect.

Earn: Understanding your paycheck

You must first determine your income before you can begin spending, saving, and investing. This part is simple if you make the same amount each month. Examine your paycheck carefully to determine your gross and net income, as well as any other deductions, such as employer-provided health insurance or a retirement plan.

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. These can be broad, as in the popular 50 30 20 budgeting rule, or specific, for those of us who want to get into the nitty gritty of our spending habits.

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 money in a designated emergency fund 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. Most financial planners suggest setting aside at least 10% of your take-home pay each month for retirement savings in a 401(k), IRA, or both.
• Saving for a big purchase. Whether you’re hoping to buy a car, a home, or pay for graduate school, 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.

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. Maybe you borrowed money as a college student and are currently dealing with student loans or credit card debt. 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.

Protect: Preventing fraud and purchasing insurance

Once you’ve established a reliable budget and investment strategy, it’s critical to safeguard the money you’ve earned. This includes checking your bank accounts and credit card statements regularly for errors or suspicious activity, keeping documents and passwords secure to avoid scams and identity theft, and purchasing adequate insurance to protect yourself in the event of an emergency.

The Upshot

The topic of personal finances is confusing and overwhelming to more people than you may think. This illustrates a need for many of us to better understand and utilize the various educational tools around to learn how to better use our money. Remember these five components — earn, spend, save, borrow, and protect — as you improve your financial literacy and beginning better spending habits.