Financial Literacy: A Definition

What is financial literacy?

Financial literacy is defined as the possession of knowledge and skills that enable informed and effective money management.

That’s a broad definition, but the term can mean different things to different people.

To understand the nuances of what financial literacy is and how people understand it, we spoke to personal finance experts across a range of industries. They represent a wealth of different backgrounds and spaces in which financial literacy is taught and learned. We asked all of them a simple question with a not-so-simple answer: “What is financial literacy?”

Here’s what they had to say.

Expert perspectives: What's the definition of financial literacy?

	What is financial literacy? “Financial literacy is the end result of the financial education process. When students are financially literate they can make informed financial decisions that can aid in improving their well-being.” Paul Goebel, Director, Student Money Management Center at the University of North Texas
	What is financial literacy? “It’s empowering people to have a successful life. My quote has always been ‘knowledge is power,’ the more you know the better off you’re going to be. And financial literacy, to me, is giving financial tools to financially empower individuals so that they can create a better financial life for themselves.” Cherry Dale, Director of Financial Education, Virginia Credit Union
	What is financial literacy? “Financial literacy to me is just the understanding of various financial concepts and how they can interplay with your life. So understanding what various terms are in the financial world and how they might apply to your life. The big thing for us has always been just taking this a step further and applying financial wellness to it. So understanding—once you know these concepts—how they can lead to different behavior changes on yourself and that’s where we start getting into the wellness territory.” Phil Schuman, Director, MoneySmarts Program at Indiana University
	What is financial literacy? “To me, financial literacy is having an in-depth knowledge of your own personal finances and the impact of your decisions on your financial stability. Because one of the things that we learn very quickly is students and even their parents have a basic financial literacy knowledge...one of the things that we work on is understanding how your behaviors impact that. Most people are financially literate, but they’re making decisions that are detrimental in the long-term by having short-term gratification.” Dameion Lovett, Campus Director and Overseer, Financial Education Program at the University of South Florida
	What is financial literacy? “We empower students for financial success by providing financial literacy information, resources, and programs. We believe that financial literacy is an appreciation of the long-term benefits of financial literacy and economic education. It’s not something that should be taken lightly—it’s something that’s very real and transferrable for any socioeconomic background. We believe that it’s a tool that‘s necessary for success later in life. And it’s not just budgeting and saving—it’s life skills.” Latoya Goree, Director, Office of Financial Literacy at UMKC
	What is financial literacy? “When working with adolescents, I usually focus on personal finance through the lens of behavioral economics and the overarching psychology of the human experience. Awareness and knowledge are critical, but transformative financial literacy requires skills developed through application, failure, experience, growth, and practice (lots of practice). In the end, to me, financial literacy is the ability to successfully navigate our predatory consumeristic society with sufficient financial resources to support our individual definitions of well-being.” Travis Cook, Education Specialist, Utah State Board of Education
	What is financial literacy? “Financial literacy, especially for students, includes knowing what your resources are, so if you don’t understand something, you know who to ask. Also, knowing that the decisions that you are making now—no matter what stage of your life you’re in or how small the decision—are going to affect you in some way financially in the future. Finally, understanding what the practical impacts of those decisions are is also a key component to financial literacy.” Laura Zamborsky, Coordinator, $avvy $eawolf Program at the University of Alaska Anchorage

Components of financial literacy

Financial literacy breaks down into two parts: knowledge and skills.

For knowledge, financial literacy is defined by an understanding of the core concepts of personal finance—interest rates, credit scores, and the purpose of an emergency fund, for instance. When put into practice, this knowledge provides the foundation needed to make informed decisions that contribute to long-term financial health.

For skills, knowledge needs to be complemented by the ability to perform tasks that support robust personal finance. For instance, someone who is financially literate will know how to use online banking apps, request a credit report, and do something as simple as write a check.

The particular knowledge and skills that define financial literacy can be divided into six categories:

1. Spending and saving
2. Credit and debt
3. Employment
4. Investing
5. Risk management
6. Decision-making

These categories are reflected in the national financial literacy standards issued by Jump$tart Coalition and the Council for Economic Education.

Financial literacy: Knowledge

Spending and saving

• Understand different payment methods. There are important differences between credit cards and debit cards and other forms of payment. Credit cards are essentially a form of borrowing, but debit cards draw directly from your bank account. Checks also draw directly from your bank account, so make sure there’s enough to cover the expense.
• Understand how banking works. Banks provide a secure way to store money. Funds can be deposited or withdrawn in person, at ATMs, or by using the bank's website or apps. Banks also offer useful services. A checking account is designed for everyday transactions. A savings account is better for accruing interest.
• Saving provides money for future purchases. Saving means choosing to set aside money now for future needs, goals, and emergencies. This might include short- or long-term financial goals, recreational activities and purchases, or an emergency fund. An emergency fund is money that is saved for unexpected costs such as job loss, medical bills, or car repair.
• Needs vs. wants. Expenses can be divided into two categories: needs and wants. “Needs” are essentials—food, housing, etc. “Wants” are luxuries—things that would be nice to have but can be done without. Some items can be both needs and wants. For instance, food is certainly a need. However, an expensive meal at a restaurant is a want.

Credit and debt

• What’s credit? Credit is a financial tool that allows you to buy something now and pay for it later. Forms of credit include credit cards, personal loans, and mortgages. Using credit comes at a cost—interest is charged.
• The difference between credit reports and credit scores. A credit report is a detailed account of a borrower’s credit history. It’s collected and maintained by the credit bureaus. Payment history and other factors contained in the report are used to generate a credit score (between 300 to 850) that reflects a borrower’s creditworthiness. The higher the score, the more confident a lender can be that a loan to the person will be repaid.
• Financial missteps can hurt your credit score. Missed payments and loan defaults are reported to the credit bureaus and added to your credit report. They can stay on your report for up to seven years and negatively impact your credit score. Since lenders look at your score when considering whether to grant a loan or offer a credit card, any negative marks will impact your ability to receive credit, a loan, and even rent an apartment. A lower score will also increase the cost of using credit.
• Credit has different costs. Credit isn’t free. You pay in the form of interest to borrow someone’s money. This is often expressed as an annual percentage rate, or APR. An APR is the annual amount owed in interest for borrowing money. The higher the APR, the more expensive the credit. Various types of fees—such as fees assessed for late or missed payments—also affect the cost of credit.
• A lower credit score affects creditworthiness and your cost of borrowing. Creditworthiness is the determination made by lenders of the possibility that a borrower will default on debt obligations. It considers factors like repayment history and credit score. Consumers with a history of missed payments—and thus a lower credit score—are considered to be high-risk borrowers. As a result, these borrowers pay higher interest and fees in order to receive credit.

Employment

• Choices about education and skills can affect income. Earning potential and job satisfaction can be affected by a worker’s education, skills, and supply and demand for their labor. Typically, workers with higher levels of education, training, and experience earn higher incomes.
• Income is taxed. There are two types of income: earned and unearned. Earned income would include salary or commissions. Interest, dividends, and capital gains are examples of unearned income. There are many ways that income is earned, and each may be taxed at a different rate.
• Understand worker benefits. In addition to pay, many workers receive benefits from their employer. These benefits might include health insurance or employer-sponsored retirement plans.

Investing

• Understand investing. Investing means using money to earn more money. Many people invest in order to achieve future financial goals by building wealth. There are risks to some types of investing, however, such as selling stock investments for a loss.
• Time value of money. The time value of money is an important concept for investors. It refers to the potential for money to grow in value over time. Because of interest earned, money that’s invested today has greater value than the same amount of money if it were to be acquired and invested at a later date. Thus, the sooner money is received, the greater benefit it offers.
• Consequences of delaying investment. Because of the time value of money, delaying investment wastes the potential of money to earn interest and grow. Think of a retirement fund. Younger workers have the greatest potential for higher return on investments simply because they have a longer amount of time for their earnings to accrue interest before retirement.
• Economic conditions affect the stock market and investments. There are many factors that affect the stock market. A low inflation rate may result in a surge of selling in the stock market, whereas deflation is caused by a decrease in spending and revenue. Rising interest rates mean higher borrowing costs causing consumer spending and business investments to slow and reduce economic growth. Conversely, falling interest rates can stimulate economic growth. Even economic trends in foreign markets may impact the U.S. stock market.

Risk management

• The purpose of insurance. Insurance can protect you from significant financial costs related to things like medical emergencies or property damage. It allows you to pay a small cost now to avoid a large cost in the future that may be unaffordable. People manage the risk of monetary or physical loss through avoidance, acceptance, and reduction. Several types of insurance—such as insurance for homes, cars, or medical bills—allow people to minimize risk.

Decision-making

• Financial responsibility requires active decision-making. Financial health requires active decision-making and planning. It requires the application of sound financial information to individual circumstances. Life events—like illness, job loss, or divorce—may change a person’s financial circumstances and require appropriate adjustments.
• Know where to get financial advice. We all have questions. Part of financial literacy is knowing the right places to go for answers. Libraries, reputable online sources, and financial advisers are all sources of sound financial information.

Financial literacy: Skills

Spending and saving

• Create a budget. Create a budget to balance your income and expenses. Use it to plan how to allocate income to meet financial obligations and work toward future goals. If your financial circumstances change, your budget, and how much you spend or save, will change too.
• Schedule and manage bill payments. Know how and when to schedule bill payments. Will you pay online, via automatic payments, through an app, or by sending a check in the mail? The important thing isn’t which you choose but rather that you have a method that ensures your payments are consistently on time. Keep track of when bill payments are due each month and opt to receive payment reminders either by email, phone, or mail.
• Comparison shop. Know how to research the best price for a product before making a purchase. This allows you to avoid overspending. When researching, find comparable alternatives. For example, when at the grocery store, compare the price per ounce (the total dollar amount divided by the number of ounces) of similar food products to get the most value for your money.
• Build savings through the “pay yourself first” method. The “pay yourself first” method, also known as reverse budgeting, is building a spending plan around your savings goals. First, list your short- or long-term savings goals. Then, decide how much to contribute each month. Finally, put that money toward your savings account before allocating the rest of your budget to expenses.

Credit and debt

• Request your credit report. All consumers are entitled to receive a free credit report once a year from each of the major credit bureaus—Equifax, TransUnion, and Experian. Review your credit report to catch problems early. To dispute an error, tell the credit bureau what information is inaccurate. After an investigation, corrections or deletions will appear in 30 to 90 days.
• Monitor your credit score. Yearly credit reports aren’t the only way to check your credit score. You can also access and monitor changes to your score at any time with a free online credit check company. These sites don’t provide your official FICO, but they do provide a close estimation. Be conscious of financial decisions that raise or lower your score, such as utilization rate, timeliness of payments, credit length, and inquiries.
• Determine the most cost-effective method of making a purchase with credit. When using credit, assess whether the purchase justifies the pitfalls. For example, ask if you will you be able to pay it off in the grace period or if you will have a balance carried into the next month. How about taking out a loan? Compare the costs of credit. This might include interest rates, compounding frequency, fees, and loan length. Calculate the total cost of repaying credit under various interest rates and over different lengths of time.
• Develop a plan to manage excessive debt. If your debt becomes excessive and you’re missing payments, it’s important to develop a plan to effectively manage it so you can work to reduce it. Consider contacting lenders directly to regain control, renegotiate a payment plan, consolidate loans, or enter a debt-counseling program. Another option is to pay a third-party credit repair company to handle the matter. Use a budget to reduce spending and focus on repaying debt.

Employment

• Use a career plan to determine income potential. Explore jobs related to a career that both interests you and draws on your strengths. Then, determine your potential earnings based on your desired job, educational attainment, and skills. Develop a strategy to minimize the costs of post-secondary education or job training by researching scholarships, federal subsidies, and part-time work. Finally, outline a career plan that takes all of these factors into consideration.
• File taxes from employment. Do you know how to file your taxes? While most people who earn an income are required by law to file a return with the IRS, not everyone is. First, figure out your filing status. Then, gather all of your documentation, including a W-2 from employers or a 1099 for contract work. Hire an accountant to sort out your taxes or file yourself with an e-filing company.
• Calculate the future income needed to maintain your lifestyle in retirement. How much money will you need in retirement to maintain your current or expected standard of living? Identify sources of income in retirement, such as a retirement-savings account like a 401(k) or IRA, pensions, annuities, investments, home equity, or part-time work. Make a savings goal based on your desired income and the length of time until you retire. Take advantage of compound interest since this is the most assured method of building wealth for the future.

Investing

• Implement a diversified investment strategy. Consider starting a diversified investment portfolio. Typically, diversified portfolios have stocks, fixed income, and commodities. Keep a watchful eye on the market to know when to divest.
• Identify warning signs of investment fraud. Investment fraud is the illegal sale of deceptive financial information. The government and independent agencies combat fraud and oversee the financial services industry. Be skeptical of unsolicited communications from strangers. Don’t trust anyone who promises a high return in a short period of time or no- or low-risk investments. Beware of a broker giving “inside” information.

Risk management

• Compare costs to purchase insurance. Categorize and then determine the types of insurance you may need—renter’s insurance, auto insurance, homeowner’s insurance, and liability insurance, among others. List the factors that determine insurance premiums. Determine if there are any legal minimums in your state. Calculate your payment after accounting for exclusions and deductibles. Then, learn how to file an insurance claim, if needed.

Decision-making

• Identify sources of sound financial information. Search for sources of information that are objective, accurate, and up-to-date. Financial advice is available from libraries, online, professional financial advisors, and friends and family members, but make sure to vet your sources. Understand the most important factors to consider before hiring a professional financial advisor, attorney, tax advisor, or financial planner.
• Prepare a contingency plan. Use sound financial decision-making to prepare a contingency plan for an unexpected change in financial circumstances. A comprehensive financial plan includes financial goals, a budget, cash-flow management plan, investment plan, insurance plan, net worth statement, a will, and estate plan. Discuss financial plans or contractual obligations with any dependents or beneficiaries you may have.