Importance of Financial Literacy

Banks and other institutions are persuading consumers with credit opportunities—the ability to apply for credit cards or use credit checks to pay other credit balances – and without the proper knowledge – it is easy to get into financial trouble. In past generations, cash was used for virtually every purchase. Today, cash is rarely used. The way we shop has changed as well. Online shopping has become the top choice for many younger shoppers, creating ample opportunities to use and overextend credit, an all too easy way to accumulate debt, fast. Many of these consumers have very little understanding of finances, how credit works and the potential impact on their financial well-being for many, many years. In fact, the lack of financial understanding has been signaled as one of the main reasons behind savings and investing problems faced by many Americans.

What Is Financial Literacy?

Financial literacy is the confluence of financial, credit and debt management and the knowledge that is necessary to make financially responsible decisions—decisions that are integral to our everyday lives. Financial literacy includes understanding how a checking account works, what using a credit card really means, and how to avoid debt. In sum, financial literacy impacts the daily decisions an average family makes when trying to balance a budget, buy a home, fund their children’s education and ensure an income at retirement.

A lack of financial literacy is not a problem only in emerging or developing economies. Consumers in developed or advanced economies also fail to demonstrate a strong grasp of financial principles in order to understand and negotiate the financial landscape, manage financial risks effectively and avoid financial pitfalls. Nations globally, from Korea to Australia, or from Germany to the U.S., are faced with populations who do not understand financial basics.

The level of financial literacy varies according to education and income levels, but evidence shows that highly educated consumers with high incomes can be just as ignorant about financial issues as less educated, lower income consumers. Although in general, lower income individuals tend to be less financially literate. And it seems consumers are hesitant to learn. The Organization for Economic Co-operation and Development (OECD) cited a survey conducted in Canada which found choosing the right investment for a retirement savings plan was more stressful than a visit to the dentist.

Why It Matters

Financial literacy is crucial to help ensure consumers save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy and foreclosures. A few years ago, a study showed that those with high financial literacy plan for retirement and in essence have double the wealth of people who do not plan for retirement. Conversely, those with low financial literacy borrow more, have less wealth and end up paying unnecessary fees for financial products. In other words, those with lower financial literacy tend to buy on credit, and are unable to pay their full balance each month and end up spending more on interest fees. This group also does not invest, has trouble with debt and a poor understanding of the terms of their mortgages or loans. Even more worrisome, many consumers believe that they are far more financially literate than they really are.

And while this may seem like an individual problem, it is broader in nature and more influential on the entire population than previously believed. All one needs to do is look at the financial crisis of 2008 to see the financial impact on the entire economy from a lack of understanding of mortgage products and the subsequent defaults. Financial literacy is an issue with broad implications for economic health and an improvement can lead the way to a global economy that is competitive and strong. (For more, see: The 2007-08 Financial Crisis in Review.)

The Bottom Line

Any improvement in financial literacy will have a profound impact on consumers and their ability to provide for their future while avoiding the pitfalls of debt. Recent trends are making it all the more imperative that consumers understand basic finances because they are being asked to shoulder more of the burden of investment decisions in their retirement accounts while having to decipher more complex financial products and options. The tasks are not easy but a better understanding and more knowledge can ease the burden tremendously.

This article first appeared in Investopedia.

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