Personal Finance

7 Key Components of Financial Literacy

Financial literacy is the ability to understand and implement certain valuable skills that can improve your money management. Developing a strong foundation of financial literacy can make it easier for you to achieve your financial goals and avoid certain pitfalls that can harm your financial well-being.

As you take steps to improve your financial literacy, here are some key components that can round out your knowledge and understanding.

1. Interest

Whether you're earning it or paying it, interest can have a profound impact on your finances.

For example, let's say you borrow $20,000 to buy a car with an 8.75% interest rate and five-year repayment term. In this scenario, your monthly payment would be roughly $413, and you'd owe about $4,765 in interest over those five years.

But if you managed to get the same loan terms but with a 4% interest rate instead, the monthly payment would drop to about $368, and you'd pay only $2,100 in interest.

On the flip side, if you're saving money for retirement, investing $100 per month for 30 years with a 7% return in the stock market would give you a $116,945 investment account balance. But if you wait ten years before you begin, you'd only have $50,754.

This is all due to compound interest. If you have a loan, the interest the lender charges is calculated based on the principal balance of the loan plus interest that has accrued since your last payment, creating a compounding effect.

The same goes for investments. Over time, the interest you earn in the form of investment gains is compounded based on your contributions plus the gains you've earned in the past.

As a result, it's important to try to avoid high-interest debt and try to invest your money early and often.

2. Budgeting

Your budget is one of the most important components of your financial plan because it dictates where your money goes.

If you don't have a budget, it's easy to spend money each day as you see fit. But at the end of the month, you may end up with little to no cash left over that you can use to work toward your financial goals. In some cases, you may even spend more than you earn, which often results in high-interest credit card debt.

With a budget, on the other hand, you can map out how you want to spend your money at the beginning of each month. You can budget for things like retirement contributions, emergency savings, or a down payment fund. You can also evaluate how you've spent money in recent months and make adjustments to be more effective with your money management.

To create a budget, start by calculating your average monthly income over the past few months. Then write out all of your expenses and categorize them, so you can get a basic understanding of where your money has been spent. Once you have this information, you'll know where you can cut back and reallocate those funds toward goals that are important to you.

3. Debt Management

For many, debt is the biggest obstacle to reaching their financial goals. Certain types of debt, including credit cards, short-term payday loans, and other high-interest debts, can be financially crippling. Even student loans can be a major roadblock, even if the interest rates aren't too high.

Take some time to learn how to approach your debt, including which debts to pay off first and how to achieve that goal. Depending on your situation, the process of paying off loans and credit cards can take a few months to several years, so it can be easy to get discouraged.

But learning the basics of managing your debt and creating a battle plan can make a significant difference in your attitude toward your debt and your progress in paying it off.

4. Credit

Having a good FICO^® Score is foundational to your financial health and success. Not only can a high FICO Score make it easier to qualify for loans, but it can also help you secure better terms such as lower interest rates and reduction of fees.

Your FICO Scores are determined by five factors:

Payment history
Amounts owed
Length of credit history
Credit mix
New credit

Making on-time payments, keeping your credit card balances low, and avoiding new credit unless you need it are all ways you can build a positive credit history. Check your credit scores often to understand how your actions impact your FICO Scores, and also review your credit reports regularly to address potential issues that could damage your FICO Scores.

5. Identity Theft Protection

Identity theft can be devastating to your FICO® Scores and to your life. This can occur when someone manages to steal your personal information, such as your Social Security number, login credentials for online accounts, or credit card information.

Certain forms of identity theft are easy to clean up. For example, if someone uses your credit card fraudulently, you can simply report it to your credit card company, which will send you a new card and remove the fraudulent charge from your account.

However, if someone uses your information to open credit accounts in your name or file fraudulent health insurance claims or tax returns, it can take months or even years to recover.

Tips to help prevent identity theft include:

Keeping your credit cards, debit cards, and personal information safe.
Using virtual private networks (VPNs) when you browse on public Wi-Fi networks.
Watching out for phishing scams, where fraudsters pose as legitimate companies to steal your information.
Locking your mobile devices to stop criminals from accessing them.
Using unique passwords for your online accounts.
Checking your credit reports to spot potential fraud and address it before it makes matters worse.

6. Savings

As part of your budgeting, it's important to make savings a priority. First in line is your emergency savings, which can make it possible to weather unexpected financial difficulties as they arise.

Financial experts typically recommend having three to six months' worth of living expenses set aside in a savings account. While that can take years to accomplish, even a few hundred dollars can act as a buffer in many situations.

Retirement savings are also crucial, as noted previously through the power of compound interest. If you work for a company that offers a 401(k) or similar retirement plan, make monthly contributions, especially if your employer will match what you save.

Including savings in your budget is important to accomplishing your financial goals. To go one step further, consider setting up automatic transfers from your checking account to your savings accounts. This can take away the stress of remembering to do it every month and remove that money from your checking account, so you're less likely to spend it.

7. Financial Goals

Achieving financial security can be a lifelong pursuit, but it can be challenging to make progress toward it without concrete goals. This can include:

Short-term goals like emergency savings.
Mid-term goals like saving for a down payment on a house.
Long-term goals like retirement and education savings.

Because every situation is different, it's important to focus on the goals that are most important to you. Write them down, along with plans that will help you achieve them, and try to be as specific as possible.

At times, you may need to reevaluate your goals. While there are some things in your financial life that you can't control, there is also a lot you can. By evaluating your goals and progress once or twice a year, you'll be able to focus more on what you can control and work toward reasonable ends.

Ben Luthi

Ben Luthi has been writing about money and travel for seven years. He specializes in consumer credit and has written for several major publications and industry leaders, including U.S. News and World Report, Fox Business, Wirecutter, Experian, and Credit Karma.