Why Financial Literacy Is so Important – Credit & Debt

Table of Contents

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• Declining Financial Literacy

• What Is Financial Literacy?

• Trends Making It More Important

• Why It Matters

• The Bottom Line

Declining Financial Literacy

In past generations, cash was used for most daily purchases; today, it's rarely flashed—particularly not by younger shoppers. The way we shop has changed as well. Online shopping has become the top choice for many, creating ample opportunities to use and overextend credit—an all-too-easy way to accumulate debt, and fast.

Meanwhile, credit card companies, banks, and other financial institutions are inundating consumers with credit opportunities—the ability to apply for credit cards or pay off one card with another—and without the proper knowledge or checks and balances, it is easy to get into financial trouble.

Many consumers have had 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.

Every few years, FINRA, the finance and banking regulator, issues a five-question test as part of its National Financial Capability Study, which measures consumers' knowledge about interest, compounding, inflation, diversification, and bond prices. Only 34% of those who took the test got four out of five questions correct, which suggests that the basic economic and financial principles that underpin these problems are widespread, touching every state in the country in different ways.

Key Takeaways

• Financial literacy is the education and understanding of various financial areas including topics related to managing personal finance, money, borrowing, and investing.
• Trends in the U.S. show that financial literacy among individuals is declining, with only 34% of respondents correctly answering four out of five questions posed by FINRA on the topic.
• At the same time, financial literacy is more important than ever as people manage their own retirement accounts, trade personal assets online, and carry student, medical, credit card, and mortgage debt.

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 issues an average family makes when trying to balance a budget, buy a home, fund the 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 to Germany, 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 (though in general, the later do 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 that found that choosing the right investment for a retirement savings plan was more stressful than a visit to the dentist.

Trends Making Financial Literacy More Important

Compounding the problems associated with financial illiteracy, it appears financial decision-making is also getting more onerous for consumers. Five trends are converging that demonstrate the importance of making thoughtful and informed decisions about finances:

1. Consumers are shouldering more of the financial decisions: Retirement planning is one example of this shift. Past generations depended on pension plans to fund the bulk of their retirement lives. Pension funds, managed by professionals, put the financial burden on the companies or governments that sponsored them. Consumers were not involved with the decision-making, typically did not even contribute their own funds, and they were rarely made aware of the funding status or investments held by the pension. Today, pensions are more a rarity than the norm, especially for new workers. Instead, employees are being offered the ability to participate in 401(k) plans, in which they need to make investment decisions and decide how much to contribute.
2. Complex options: Consumers are also being asked to choose among various investment and savings products. These products are more sophisticated than in the past, asking consumers to choose among different options offering varying interest rates and maturities, decisions they are not adequately educated to make. Deciding on complex financial instruments with a large range of options can impact the consumer’s ability to buy a home, finance an education or save for retirement, adding to the decision-making pressure.
3. Lack of government aid: A major source of retirement income for past generations was Social Security. But the amount paid by Social Security is not enough, and it may not be available at all in the future. The Social Security Board of Trustees reported that by 2034 the Social Security trust fund may be depleted, a scary prospect for many. So now, Social Security acts more like a safety net that barely provides enough for basic survival.
4. Longer life spans: We are living longer. This means we need more money for retirement than prior generations did.
5. Changing environment: The financial landscape is very dynamic. Now a global marketplace, there are many more participants in the market and many more factors that can influence it. The quickly changing environment created by technological advances such as electronic trading makes the financial markets even swifter and more volatile. Taken together, these factors can cause conflicting views and difficulty in creating, implementing and following a financial roadmap.
6. Too many choices: Banks, credit unions, brokerage firms, insurance firms, credit card companies, mortgage companies, financial planners and other financial service companies are all vying for assets creating confusion for the consumer.

Why It Matters

Financial literacy is crucial to help consumers save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy, defaults, and foreclosures. A 2008 study from financial services company TIAA-CREF 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 in interest. 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 that arose from a lack of understanding of mortgage products. 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.

The Bottom Line

Any improvement in financial literacy will have a profound impact on consumers and their ability to provide for their future. 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—all while having to decipher more complex financial products and options.

Learning how to read financially is not easy, but once mastered, it can ease life's burdens tremendously.