A recent study broke down financial literacy into five key concepts that people needed to understand in order to be considered financially literate.
Financial literacy is important. Without it, people are more vulnerable to bad credit, financial scams, payday loans, no credit check loans, and other things that can threaten financial health. But according to the National Financial Capability Study (NFCS), only 63% of Americans are financially literate. Do you know where you fall?
Generally speaking, financial literacy is the ability to use your skills, knowledge, and financial resources to make good financial decisions and effectively manage your money. In order to do this, you need a firm grasp on certain financial concepts.
The researchers behind the NFCS identified five key concepts to help them evaluate the financial literacy of their participants: compound interest, loan terms, inflation, risk and diversification, and interest rates and bonds. In order to be considered financially literate, participants needed to have a basic understanding of four or more concepts. Let’s take a look at each of these concepts in more detail.
Compound interest is a percentage that is added to a principal sum of money and its interest as it accrues over time on a deposit or a loan. In other words, it is interest on interest. Say you have $100 in a savings account with an interest rate of two percent that compounds annually. That means at the end of the year, you would have $102, and the next year, interest would be calculated on $102 instead of the original $100 deposit. By the end of the second year, you would have a total of $104.04, even though you didn’t add any more money to the account. It’s kind of like magic!
That’s the difference between compound interest and simple interest—simple interest would only be calculated on the principal amount, or $100 in our example.
Even though a two percent interest rate seems small, you can see how it can add up over time into something more significant. Because of this, compound interest can be your friend or your enemy. Sure compound interest is great when it comes to your savings account, but it’s not so great when the sum of money in question is a debt with the potential to grow, such as an installment loan.
That’s why it’s important to have a solid fix on compound interest. It can not only help you decide what kind of savings account is best for you, but it can also help you compare financial products, like loans and credit cards, and understand their real cost over time. Two loans could be for the exact same amount for the exact same length of time, but if one uses simple interest and one uses compound interest, one will clearly cost you less in the long run.
When you take out a loan, you agree to a set of conditions, including the amount to be borrowed, the interest rate, and the term of the loan, or how long you have to repay the loan. One key aspect of financial literacy is understanding how the term of your loan affects the size of your payment. This concept goes hand in hand with the concept of interest, which we just discussed.
Let’s say you want to take out a loan for $1,000, and you get to choose between a term of one year or two years. Which option would result in a smaller monthly payment? That would be the two-year term, since you are spreading the same amount of money over more months. A one-year term would be about $83 a month, while a two-year term would be about $42 a month.
Who wouldn’t choose the two-year term, you say? Well, unfortunately, things are rarely that simple. Interest is always a factor. Consider what would happen if your $1,000 loan came with a five percent interest rate that compounded annually. The longer your loan term, the more you would pay in the long run, even with smaller monthly payments.
Inflation is the rate at which the costs of goods and services rises over time. In other words, it affects the purchasing power of our dollar. Back in the day, there used to be something called penny candy because it—you guessed it—cost a penny. (Look, it’s even in the dictionary!) Even the cheapest of today’s candy costs more than a penny. That’s inflation.
Many people think a certain amount of inflation is a sign of a thriving economy but that too much inflation is cause for concern, since that would massively devalue the dollar. Inflation is something that our government (the US Federal Reserve, specifically) tries to regulate at around two percent a year. That doesn’t always happen, and the average inflation increase since 1921 has actually been 3.26% a year.
Inflation of more than 2% but less than 10% is called “walking inflation,” and it’s considered to be not great but manageable. When interest rates increase to the 10 to 20% range, it’s called “running inflation” and can cause big problems, especially because incomes don’t automatically rise with inflation.
Inflation can also be different depending on what you’re talking about. For example, housing costs may rise over time at a different rate than food costs.
One key thing to think about is how inflation might affect you over the course of your lifetime. Let’s think about that savings account again and the purchasing power of the dollars inside of it. What if the interest rate of your savings account is 2%, but the average annual inflation rate is 3%? In 10 years, will your savings have more, less, or the same purchasing power as it does now? The answer is less. And if you don’t even have a savings account and your $100 is instead tucked away in a sock drawer earning 0 percent interest, your dollars’ purchasing power would be even less.
Risk and diversification.
Risk is a term that is used in investing as a way to characterize a financial decision’s degree of uncertainty and/or potential for loss. The higher the risk, the greater the degree of uncertainty and the potential for loss. Investors generally don’t make risky decisions unless the potential payout it great enough to justify it. Ever heard of the phrase “high risk, high reward”?
For ordinary people, the most likely place they encounter risk is when it comes to their retirement account, which is usually made up of a portfolio of different types of investments. Accounts with a wide variety of assets are less risky than those with few. This is called “diversification.”
Let’s say you come into $1,000 and decide you want to invest it. You’re deciding between (A) putting it all in the stock of one rising-star tech company or (B) contributing to a portfolio that will invest portions of the money in dozens of different assets, including the tech company’s stock. Sure, if you go with option A, that tech company could take off and your $1,000 could turn into $1 million. Or it could go bankrupt tomorrow and you could lose everything. If you go with option B, the majority of your money is still safe in other assets.
Interest rates and bonds.
A bond is a type of investment in which you loan an entity (like the government or a company) money to be paid back at a fixed date (aka the “maturity date”) with a fixed interest rate. It’s kind of like the tables have turned, and instead of, say, owing to the government on a $1,000 student loan, it owes you on the loan.
Governments and companies sell bonds to investors when they are trying to raise funds, and investors know exactly what the maturity date and interest rate are when they buy them—they do not change over time. And that brings us to a key takeaway when it comes to financial literacy: The value of a bond fluctuates depending on what the prevailing interest rates are at any given time. More specifically, as interest rates rise, bond prices go down. The opposite is also true.
Improving your financial literacy.
Now that you’ve read this post, you’re financially literate, right? Well, maybe. According to this recent Bloomberg article, achieving and maintaining financial literacy is difficult. It’s not something you earn once and keep forever. In fact, experts think that financial literacy is something that requires constant practice, which is not something average people have the opportunity to do. This might mean that, in order to be prepared for the times where you do need financial literacy, you may need to seek out ways to learn and practice your skills.
To improve your financial literacy and money management skills, check out the free standards-aligned courses that we offer through OppU.
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