Financial Literacy – Its components and significance

Financial literacy is the possession of the set of skills and knowledge that allows an individual to make informed and effective decisions with all of their financial resources. Raising interest in personal finance is now a focus of state-run programs in countries including Australia, Canada, Japan, the United States and the United Kingdom. Understanding basic financial concepts allows people to know how to navigate in the financial system. People with appropriate financial literacy training make better financial decisions and manage money better than those without such training.

The Organization for Economic Co-operation and Development (OECD) started an inter-governmental project in 2003 with the objective of providing ways to improve financial education and literacy standards through the development of common financial literacy principles. In March 2008, the OECD launched the International Gateway for Financial Education, which aims to serve as a clearinghouse for financial education programs, information and research worldwide. In the UK, the alternative term “financial capability” is used by the state and its agencies: the Financial Services Authority (FSA) in the UK started a national strategy on financial capability in 2003. The US Government established its Financial Literacy and Education Commission in 2003.

Components of Financial Literacy :

There are five core competencies of financial literacy: Earning, Saving and Investing, Spending, Borrowing, and Protecting.

Earning –

“Earning” refers to bringing money home from a job, self-employment, or return on various investments. Most individuals earn money via employment in the form of a paycheck. The average employee pays between 28-30% of their gross income in taxes and other deductions before receiving their net income or take-home income. It is extremely important to understand gross versus net in a paycheck, in addition to understanding the federal, state and local individual income tax imposed on citizens and residents of the country.

Saving and Investing –

“Saving” and “Investing” deals with the understanding of financial institutions and services available to you. First of all, you should have a saving and a checking account to manage your own financial transactions. Start SAVING EARLY and PAY YOURSELF FIRST to help you understand the concept that saved money grows over time which also leads you to explore long-term investments for retirement planning.

Spending –

“Spending” is probably the most important concept because it is a personal reflection of your values, lifestyle, and your financial behavior. Differentiating between NEEDS and WANTS is the basic concept of controlling spending.  Budgeting is the most powerful and impact-full tool you can adopt to control spending to allow for saving and investing.

Borrowing –

“Borrowing”is acquiring debt to create assets. Most students have to borrow student loans to finance their educational goals, and with a financial plan for repayment, they can turn this investment in their education to their advantage. Mortgages or loans to buy homes are another form of borrowing or acquiring debt to create assets.  Business loans to create self-employment opportunity or build a business, and real estate investments, are also good examples of how borrowed money can be turned into assets and wealth accumulation.

Protecting –

“Protecting” deals with insurance, ID theft, and retirement planning. The idea is to stay protected at all levels in your life; on personal, health, and social levels. You will need to understand risk management, insurance coverage, identity theft protection, fraud, and scams, in order to master self and family financial protection in life.

Significance of Financial Literacy :

Financial Literacy helps in improving the financial knowledge of individuals. It brings clarity on basic financial concepts and principles such as compound interest, debt management, financial planning etc. It enables you to manage your personal finances efficiently. It helps in making appropriate financial decisions about investing, saving, insurance, managing debts, buying a house, child education, retirement planning etc. It helps individuals to achieve financial stability and financial freedom. It helps in understanding the difference between assets and liabilities. It helps in developing the skill sets required for better financial planning and managing your money. It provides in-depth knowledge on financial education and strategies which are indispensable for achieving financial growth and success. It helps you in generating, managing, saving, spending and investing money. It enables you to be debt free by inculcating financial knowledge and debt strategies.

In India, Financial Literacy has still not become a priority like other developed nations. Lack of basic financial knowledge results in poor investments and financial decisions. That’s why most people invest in short-term plans and physical assets to accomplish their personal goals which give lesser benefits and does not help in the economic development of the country. According to a global survey, about a staggering 76% of Indian adults do not understand basic financial concepts and are unfortunately financially illiterate even today. The survey confirms the financial literacy rate in India has been consistently poor as compared to the rest of the world. It is indeed high time for a developing country like India to realise the importance of financial literacy as such poor financial literacy rate can prove to be a major setback to India’s ambition of becoming an economic superpower in the coming years.

Financial Literacy has become one of the topmost priorities for most nations today as understanding basic financial concepts allows people to manage their wealth in a more organized way which in turn helps in the economic growth of the nation. It is proved that people with appropriate financial education and knowledge make better financial planning and makes the most of the available financial resources for maximum benefit. In the United States of America, financial literacy was initiated way back in 1908 by the American Credit Union Movement. In 1957, financial education was made mandatory by the state of Nevada and then other states followed. Australia also provides financial literacy education through customised programs. Singapore and Indonesia are among few of the Asian countries who have started this initiative and have taken the first step towards Financial Literacy.