When I think back to my school days, I can recall learning about lots of different things. Way back in grade school, I learned the parts of speech, the state capitals, and how to multiply fractions. When I moved on to high school, I studied more sophisticated subjects, such as trigonometry and Shakespeare’s plays.
But there’s one lesson my school never taught me: how to handle money.
As it turns out, I’m far from alone in this. In a 2016 survey, when Bank of America asked 18- to 26-year-olds across the United States what they wish they’d learned more about in school, all the top answers were related to personal finance. Over 40% of students would have liked to learn more about investing, 40% wish they’d learned how to do their taxes, and 26% wish they’d learned how to handle monthly bills. Fewer than one out of three respondents said their high-school education had done a satisfactory job of teaching them good financial habits.
As this survey shows, financial literacy — the ability to understand money and finance — is a subject that matters to Americans. Unfortunately, too many of us aren’t learning enough about it. This lack of financial education has many of us living paycheck to paycheck, unable to save for retirement, buy homes, or even pay for unexpected expenses such as car repairs.
What Financial Literacy Means
Being financially literate means having a basic understanding of issues related to money and finance, especially your own personal finances. If you’re financially literate, you can:
- Pay all your household bills
- Create a household budget and follow it (this can easily be done with Tiller)
- Open a bank account and keep track of your balance to avoid overdraft fees
- Figure out how much you’re paying for a credit card or other loan
- Check your credit score and take action to improve it
- File an income tax return
- Invest in a 401(k) plan or other workplace retirement plan, including choosing the right investments
- Set up an account to save for college (look into an account with CollegeBacker)
- Calculate your net worth
- Shop for a mortgage loan
- Spot a financial scam
- Protect your personal information from identity theft (consider signing up for Identity Guard)
Unfortunately, many Americans can’t meet this standard. A 2018 survey by the TIAA Institute found that a majority of Americans “lack the knowledge necessary to make routine financial decisions.” On a test of basic financial concepts in eight areas — earning, consuming, saving, investing, borrowing, insuring, understanding risk, and finding financial information — the average U.S. adult was able to answer only half the questions correctly.
Why Financial Literacy Matters
Money affects your life every day. You handle it every time you go shopping, visit the bank, or pay a bill. Often, you deal with money in ways you don’t even notice, such as having your paycheck directly deposited into the bank or your 401(k) contribution taken automatically out of your salary.
Your financial IQ affects every single decision you make about money: how you earn it, spend it, save it, and invest it. It helps you make ends meet on a daily basis, choose the right credit card, save for college, choose investments, and plan for retirement. Your chances of meeting pretty much any financial goal, from getting out of debt to buying a house, depend on how financially literate you are.
The Growing Importance of Financial Literacy
These days, financial literacy is more important than ever — not because money matters more than it used to, but because dealing with it has become more complicated. Several trends in the modern world make it more necessary than ever to understand your money and how it works.
1. The Shift to Individual Retirement Planning
Fifty years ago, most American workers didn’t have to worry about how they’d manage during retirement. They could count on pensions from their employers as well as Social Security benefits.
However, few companies these days offer pensions, and the Social Security trust fund is running out of money, making it likely that benefits will be cut. That means most workers have to fund their own retirement through workplace plans such as 401(k)s or an IRA you set up through a robo-advisor like Betterment.
It’s become your responsibility to figure out how much you’ll need to retire, set aside money in a fund, and invest it wisely so it will grow. And since Americans are also living longer than we used to, you’ll have more years of retirement to fund than you would have had in the past.
2. Increasing Options
As Americans have to make more choices about our financial future, the number of financial products we have to choose from has grown dramatically. If you’re looking for a place to park your savings, you don’t automatically go down to your local bank; you can select from several types of banks, including multinational banks, community banks, online banks like CIT Bank, and credit unions. And you have to consider not only the bank itself, but also what type of account to open: savings, checking, money market, or CD.
It’s the same with just about any financial product you can name. There are hundreds of different credit cards, multiple types of mortgages, a variety of retirement plans, and countless investment options. Even if you want to stop worrying about it and hand your finances over to a professional, you have to decide what kind of financial professional you need and which one is the right person to take care of your money.
3. More Information
If you have more financial decisions to make these days, at least there’s plenty of information available to help you. You can pick up the morning paper or turn on the radio to hear all about the latest ups and downs in the market, whether interest rates are expected to rise or fall, and how changes in government policy could affect the economy or particular sectors of it. And if you want more details, there are endless sources of financial advice to consult: books, newsletters, podcasts, websites, TV commentators, and even YouTube videos.
But having all this information doesn’t make your financial choices easier. In fact, it makes them a lot more complicated. For starters, there are so many sources of information out there that you can’t possibly pay attention to all of them, so you have to decide which ones are most important and reliable.
Even once you know what sources to focus on, the sheer volume of facts they throw at you is still an awful lot to take in. A simple decision such as choosing a fund for your 401(k) can become insanely complex as you try to factor in everything you’ve heard and read about the economy. There are so many factors to consider that you could make a full-time job out of just trying to make sense of them all.
Problems Caused by Financial Illiteracy
As money matters have grown more complicated, the number of Americans who have a good grasp of them has declined. In the 2018 National Financial Capability Study conducted by the FINRA Foundation, only 34% of respondents could successfully answer at least four out of five questions about basic financial concepts. That’s a drop from 37% of respondents in 2015, 39% in 2012, and 42% in 2009.
This lack of financial intelligence can be very costly for Americans. In a 2019 survey of 1,500 adults by the National Financial Educators Council, respondents estimated that they had lost an average of $1,230 in the past year because they didn’t understand personal finance well enough. Nearly one in five said their lack of knowledge had cost them $2,500 or more.
There are several specific problems linked to this lack of financial literacy:
1. Growing Debt
The Federal Reserve reports that Americans as a nation now owe more than $4 trillion in consumer debt. According to the 2018 FINRA study, 19% of Americans spent more than their income in the past year, not counting major purchases such as a house or car. More than one in five respondents in the FINRA study had medical bills that were past due.
2. Costly Debt
Americans aren’t just borrowing more money than ever; they’re borrowing it in particularly costly ways. Nearly 30% of FINRA respondents had borrowed money in the past five years through some form of non-bank loan, such as a payday loan, auto title loan, pawnshop, or rent-to-own store. More than one in three respondents said they had paid only the minimum on a credit card at least once in the past year. One out of 11 respondents said they were underwater on a home loan, owing more on the mortgage than the house was worth.
3. Lack of Emergency Savings
More than half of all FINRA respondents didn’t have an emergency fund that could cover all their bills for three months or more. A 2018 report by the Federal Reserve found that one in five Americans would not be able to cover even a $400 emergency expense without borrowing money or selling something.
Pro tip: If you don’t have an emergency fund set up, start today. Open a Savings Builder account from CIT Bank. You’ll earn a generous APY, and you’ll be able to afford an unexpected expense if it pops up.
4. Lack of Retirement Savings
According to the Federal Reserve, less than 40% of Americans believe they are saving enough for retirement. One out of four say they have no retirement savings at all.
How to Evaluate Your Financial Literacy
Perhaps you’re reading this and thinking, “Well, maybe the average American has trouble understanding finance, but I don’t.” And maybe you’re right about that — or maybe you’re not. In the FINRA study, 71% of respondents gave themselves high ratings — at least five points out of seven — for financial IQ, yet only 34% of them could answer four out of five relatively simple questions about money management.
So if your own impressions aren’t a reliable way to evaluate your financial literacy, what is? There are two things to look at: your financial habits and your knowledge of basic financial concepts.
Your Financial Habits
Financial literacy is essential to every aspect of your financial life. Without it, you’ll have trouble sticking to a budget, investing money, or even paying all your bills. So it follows that if you’re doing a good job with all these things, your financial IQ is probably pretty solid.
Here are some good habits that go along with strong financial literacy.
1. You Have a Budget (and Stick to It)
Having a household budget is the most reliable way to keep your spending below your income and set aside money for savings each month. However, merely making a budget with a company like Personal Capital isn’t enough to keep you on track; you actually have to follow it. In a 2018 GuideVine survey of 1,000 American adults over 30, 66% of respondents said they had a household budget, but 70% of them added that they struggled to stick to it. Men overspent their budgets by an average of $125 per month, while women — despite their lower average incomes — overspent by just $71 per month.
If you have trouble sticking to a budget, perhaps the problem is that the traditional way of making one, with strict limits for spending in different categories, doesn’t work well for you. You might be better off with a budget alternative that’s more flexible, such as setting aside a certain amount for savings each month and doing as you like with the rest.
2. You’re Debt-Free
Debt is a problem that feeds on itself. When a big chunk of your income each month goes to pay interest on your debts, it becomes harder to live on what’s left, forcing you to borrow more to make ends meet. By contrast, becoming debt-free makes it easier to save for college, retirement, and other long-term financial goals.
However, financial experts generally agree that there’s good debt and bad debt. Borrowing money to buy a house or get a college education can make you financially better off in the long run, while borrowing to pay for a wedding or vacation won’t. Paying off a mortgage or student loans can be helpful, but having this type of debt isn’t necessarily a sign of financial illiteracy.
3. You’re Well-Insured
Insurance is a necessity, not a luxury. It’s the only way to protect your financial assets — your home, car, and even investments — against a disaster that could wipe them out.
One type of insurance everyone needs is health insurance, which can keep high medical costs from wiping out all your savings and then some in case of a serious illness. On top of this, there are several other types of insurance you might need depending on your circumstances:
- Auto Insurance. If you own a car, the law requires you to carry liability insurance to cover any damage you cause to other drivers in an accident. Depending on the age of your car, it could also be worth carrying collision coverage, which pays for damage to your car in an accident that you caused, and comprehensive coverage, which protects you against theft or vandalism. If it’s been a while since you shopped around for auto insurance rates, head over to Allstate and Liberty Mutual and see if their rates are lower than what you’re paying today.
- Homeowners or Renters Insurance. Anyone who owns a home needs homeowners insurance. It covers your costs if your home suffers damage from a natural disaster, as well as protecting you from liability for accidents on your property. Most policies also cover theft and other damage to personal property. Just like with auto insurance, it’s important to shop around every couple of years to make sure you’re getting the lowest rates. PolicyGenius gives you quotes from up to 10 different companies within minutes. If you rent your home, you can buy renters insurance to protect you against theft and damage to your belongings.
- Life Insurance. The point of a life insurance policy isn’t to protect you personally; it’s to protect your family from financial loss if you die. It will cover your funeral expenses and help make up for the loss of your income, buying your family members time to get back on their feet financially. If you don’t have a life insurance policy, you can apply with Ladder in five minutes and get an instant decision.
- Umbrella Insurance. If you have a lot of assets, your auto and homeowners policies might not be enough to protect them if you get sued. That’s what umbrella insurance is for. It protects your assets in case of any lawsuit, no matter what kind it is.
4. You Have an Emergency Fund
Having an emergency fund can mean the difference between weathering a financial disaster and being driven into debt. If you break a tooth, your car breaks down, or your furnace stops working, you can use this money to cover the expense rather than turning to credit cards. It can even see you through a period of unemployment.
Ideally, you should have three to six months’ worth of living expenses stashed away in safe investments such as a savings account, CDs or a money market account. However, even a small emergency fund of $1,000 or so will help you get through a minor crisis without borrowing.
5. Your Retirement Savings Are on Track
A final test of financial literacy is having enough saved for retirement. This doesn’t mean that you need to have enough saved to retire on right now, only that you’re on track to have enough by the time you reach retirement age. According to Fidelity, you should have one year’s salary saved by age 30, six times your salary by age 50, and 10 times your salary by age 67.
Unfortunately, most Americans aren’t coming close to these numbers. A 2019 report by the Economic Policy Institute found that Americans in their early to mid-30s have only $32,602 saved up on average. People nearing retirement in their late 50s and early 60s typically have only $243,559. So if you’re meeting the milestones set by Fidelity, that’s a good sign that you’re financially literate.
Your Financial Knowledge
Handling your personal finances well is the best way to show that you’re financially literate, but it’s not the only way. TIAA and FINRA both tested Americans’ financial literacy by asking them questions about a variety of financial concepts. Only 34% of FINRA respondents and 16% of TIAA respondents could answer 80% of the questions correctly. And in a 2014 test by Standard and Poor’s, only 57% of Americans could correctly answer five questions on four basic financial concepts.
Here’s a sampling of the questions asked in these tests. How many of them can you answer?
Question 1: Compound Interest
Suppose you have $100 in a savings account earning 2% interest each year. Assuming you leave the money in the account, making no deposits or withdrawals, do you know how much money you’ll have in the account at the end of five years? To make this easier, let’s make it multiple-choice: Will you have more than $102, less than $102, or exactly $102?
The correct answer is “more than $102.” Your $100 will earn 2% interest, or $2, in the first year — so after just one year, you’ll have $102 in the account. You’ll earn 2% interest on that $102 in the second year, and you’ll continue earning 2% on your new, slightly higher balance each year after that. At the end of five years, you’ll have a little more than $110.
Question 2: Inflation
Suppose that, while you’re earning 2% each year on your savings account, the inflation rate is 3%. At the end of five years, will the money in your account buy more than it would today, less than it would today, or exactly the same amount?
The answer is that, at the end of five years, the money in your account will buy less than it can today. Although you’re adding money to the account every year, the cost of goods and services is growing faster than your savings are. Thus, even though the balance in your account is growing, your real buying power is shrinking.
Question 3: Diversification
Let’s say you decide to take your $100 out of the bank and put it into some other investments so that you can earn more money. Which is safer: investing your $100 in the stock of a single company or putting it into an index fund that covers a large chunk of the stock market?
The answer that the index fund is a safer investment. If you put all your money into the stock of just one company, and that company goes bust, you’ll lose everything. An index fund, by contrast, has built-in diversification, spreading out your money across multiple companies’ stocks. Even if one of those companies goes bankrupt, you’ll lose only a small portion of your investment.
Question 4: Loan Terms
You’re preparing to buy your first home. You have a choice of two mortgage loans: a 30-year fixed-rate mortgage at 6% interest or a 15-year mortgage at the same rate. Which one will cost you more in interest overall?
The answer is that the 15-year mortgage will cost you less overall because you’ll pay it off faster. Both loans cost you 6% per year on the outstanding balance — that is, the amount you still have left to pay — not the amount you initially borrowed. With a 15-year loan, you’ll pay down your balance faster, so you’ll end up paying less than half as much in total interest as you would with a 30-year loan. The downside is that each monthly payment on the 15-year loan will be higher because you’ll have to pay a bigger chunk of the principal each time.
How to Improve Your Financial Literacy
If you answered all the above questions correctly, congratulations; you’re more financially literate than the average American. Chances are, your personal finances are also in better-than-average shape. Your financial intelligence is helping you live within your means, manage debt, and save for retirement.
However, if you had trouble with some of the questions — or if you’re struggling with some of your financial goals — then you could probably stand to learn a little more about money. And even if your financial IQ is pretty high already, it never hurts to know more.
Fortunately, there are many ways to increase your financial literacy, including:
1. Online Articles
Check out the archives here at MoneyCrashers for information on a wide variety of financial topics. You can learn how to fix a broken budget, boost your savings, rebuild damaged credit, pay off credit card debt, and choose investments for your 401(k) — and that’s just scratching the surface.
Head down to your local public library and check out the selection of books filed under personal finance, getting out of debt, investing, home buying, financial independence, or any other financial topic that interests you. A few classic personal finance books to look for include “The Total Money Makeover” by Dave Ramsey, “Your Money or Your Life” by Vicki Robin and Joe Dominguez, and “The Millionaire Next Door” by Thomas Stanley and William Danko.
Numerous radio shows and podcasts deal with money matters. Check out “The Dave Ramsey Show” for overall money advice, “So Money” to learn more about business matters, “Smart Passive Income” to learn about ways to earn passive income when you’re not working, and “Planet Money” for information about the economy.
If you prefer visual infotainment, you can choose from a wide assortment of TV shows and YouTube videos about investing and personal finance. Tune into “Mad Money” on CNBC for advice on investing, “The Profit” on CNBC or Hulu for business, and The Financial Diet on YouTube for money tips for young people.
If you’d like to learn about any financial topic in more depth, consider taking a class. Many colleges offer courses you can take online for a modest fee or even free. Your local community college may also offer finance courses at reasonable prices. You can find online financial courses on websites like Udemy and Coursera.
6. Financial Professionals
Finally, if you really want to get a handle on your personal finances, talk to a financial professional. An accountant can offer financial advice about your taxes, an investment advisor can help you choose investments, and a financial planner can help you get a better grasp on your financial situation as a whole.
Pro tip: If you’ve considered hiring a financial advisor to guide you through these important choices, check out SmartAsset. Answer a few questions, and they’ll provide you with three vetted advisors in your area.
Improving your financial literacy doesn’t just help you. As you learn more about money, you can use what you learn to teach your children — or any children who are a part of your life, such as nieces and nephews, students, neighbors, and friends.
By passing your financial knowledge on to them, you can help the next generation be better prepared to deal with money. Just as growing up with the Internet and smartphones has made the kids of today more tech-savvy than their parents, growing up knowing more about money — such as the basics of budgeting, the dangers of debt, and the power of compound interest — will make them more ready to navigate the tricky world of modern finance. With luck, when they reach adulthood, they won’t make the same mistakes as many Americans today.