Financial literacy for beginners includes the fundamental tools need to make sound financial decisions.
Yet, unfortunately, it’s a topic left out of most academic curriculums.
And so, unless we are fortunate enough to have our parents advise us on the ins and outs of personal financial management, we are left to teach ourselves.
But where to start?
This article will teach you 9 core components of financial literacy for beginners and give you the tools you need to build your skills.
Ready?
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What is financial literacy?
Financial literacy is the ability to budget, manage, and invest your money with confidence and effectiveness and understand the basic principles of personal finance.
From taxes to credit scores – when you’re financially literate, you have a secure foundation for a lifelong, healthy relationship with money.
Financial literacy is for everyone. And it’s never too early to start.
Why is financial literacy important?
Simply being alive is expensive.
And if you want to enjoy the life that’s draining your bank account without living paycheck to paycheck or fearing bounced checks, that takes planning, which requires having a basic understanding of personal finance.
So why is personal financial literacy important?
Because without it, you’re more likely to sabotage your dreams and goals by making poor financial decisions. But with financial literacy, you can achieve stability.
You can make sound investment decisions to feel secure in your ability to retire one day, even if your job doesn’t offer a pension or 401(k).
Or to send your kids to college and also take family vacations. Or eliminate your student loan debt. Have emergency savings. Buy a house. You can control your money, rather than money having control over you.
Financial literacy makes all of this possible.
9 keys to financial literacy for beginners
As mentioned earlier, when you’re financially literate, you can effectively manage your money, and have long-term financial planning strategies and a budget.
But to get to this point, you must understand the basic terms and principles of personal finance.
The 9 core concepts for beginners are:
- Income
- Taxes
- Bank Accounts
- Debt
- Credit Cards
- Budgeting
- Investing
- Compound Interest
- Credit Scores
Let’s explore each in detail.
Income
Income is an inflow of money received from working, providing services or products, and investing.
From this inflow, we pay our bills, save for retirement, and buy that shiny new car.
There are two types of income:
- Active
- Passive
Active income is money we earn from ongoing work. You get a paycheck for showing up to your 9-5 every day. Or your clients pay you for the services offered. If you are not actively putting effort into your work, you won’t earn any income.
Passive income is income earned through minimal to no action. The gains you make on your investments. Or royalties earned on stock images. Rental properties. Sales form a print-on-demand business. You may need to put in the time or a large sum of money at the onset, but from there on out, little to no effort is required to continue earning an income.
Traditionally, we earn active income in our 20s-40s, begin to shift towards passive income in our 50s-60s, and, once we retire, all of our income is passive.
Taxes
Taxes are mandatory fees paid to the government by individuals and corporations to fund the infrastructure we all use: roads, the post office, public schools, and elder care services like Social Security and Medicare.
There are three types of taxes you need to be aware of (and pay!) to be financially literate:
- Income tax
- Property tax
- Sales tax
Income tax is taken out of your active and passive income. Your employer will automatically deduct income taxes from your paycheck and submit them to the government on your behalf. If you’re self-employed, you will pay the government a portion of your income directly. Income tax may be charged at the federal, state, and local levels, depending on where you live.
Property tax is based on the value of your property–such as a house or land (and sometimes smaller possessions, such as a car or boat). Property tax is charged locally.
Sales tax is charged when purchasing an item or service–in other words; it’s included in the overall price you pay for something. Sales taxes may be charged at the local or state levels.
If you don’t pay your taxes, you will be charged a penalty fee each month you fail to pay. And the longer you go without paying your taxes (especially income taxes), the more likely the government will put a lien on your property, such as your house.
In extreme cases, the government may charge you with tax evasion, which could result in up to five years in jail. (So pay your taxes.)
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3. Bank accounts
Bank accounts are a safe and secure way to store money.
You should have financial knowledge about 4 types of bank accounts:
- Checking Accounts
- Savings Accounts
- Certificates of Deposit
- Money Market Accounts
Checking accounts are easily accessible, offering unlimited deposits and withdrawals. They often come with cards, known as debit cards, that can be used to pay for goods and services without carrying around cash or else used at an ATM to take some money out of your account. Checking accounts are best used for day-to-day spending.
Savings accounts are similar to checking accounts in that they offer a safe place to deposit your money. Still, they differ in that they earn interest. Additionally, savings accounts often limit how often you can withdraw from the account. They are best used for a short-term saving financial goal (like vacation funds) or emergency savings.
Certificates of deposits (or CDs) are bank accounts that hold your money for a set time (a few months to 3-5 years). You cannot access your money without incurring a fee for premature withdrawal during this time. In exchange, you’ll earn interest, and typically at a higher interest rate than in a traditional savings account.
Money market accounts are a hybrid of checking and savings accounts. For example, you may be able to use a debit card and checks with a money market account like you would with a checking account but earn interest like you would with a savings account.
The reason bank accounts are so important is that they are typically insured by the Federal Deposit Insurance Corporation (FDIC), which means that, in the event your bank fails, you are protected from losing up to $250,000.
4. Debt
Debt occurs when you borrow money from a third party, typically in the form of a loan or credit card.
We’ll talk about credit cards in the next section–so let’s focus on loans for now.
Most people will take a loan out when making big purchases, like college tuition, cars, houses, and home improvements. The lender, usually a bank, agrees to give you money now in exchange for a promise that you will pay the cashback in a certain amount of time plus interest.
The are two main types of loans:
- Secured
- Unsecured
Secured debt is when, in addition to the promise that you will pay back the borrowed funds, you will offer collateral (i.e., an asset like your house or car) if you don’t pay back the loan. Secured loans may offer lower interest rates than debt (thanks to the guarantee to the bank that they can seize your property if you don’t pay back the loan). But, they are also risky to the borrower because they could lose the assets offered as collateral–which may mean losing your home.
Unsecured debt is not backed by other assets, making it much less risky for you (the borrower) but riskier for the lender. As a result, interest rates tend to be steeper on unsecured debt than on secured debt.
Examples of secured debt included home mortgages and auto loans. Examples of unsecured debt include medical bills, personal loans, and student loan debt.
5. Credit cards
A credit card is effectively a tangible loan.
You borrow money from a financial institution when you use a credit card to buy a product or service. You are then liable for paying borrowed funds back to the bank.
And, like a loan, interest is charged on your credit card debt. But often at a much higher rate (17.19% to 24.45%).
Where credit card debt differs from other debt is in the perks credit cards offer.
Here are the different types of credit cards available and the parks you can enjoy by using them.
- Rewards
- Cash back
- Travel
- Store
Rewards cards give you points for each purchase–1x per dollar spent. And on certain purchases, like airfare, gas, groceries, and restaurants–rewards cards often offer points up to 5x points per dollar. The points you earn are redeemable for statement credit (a reduction in your outstanding balance), gift cards, travel discounts, and members-only shopping sites.
Cash back cards give you cash back on eligible purchases, typically around 1 to 2 cents per dollar spent, and sometimes higher for those categories mentioned above.
Travel cards are similar to rewards cards, but the points earned are redeemable only on travel costs like hotels, flights, and TSA pre-check. Some travel cards can also be much more specific than general rewards cards. For instance, you may get a travel card with a particular airline, like Delta, that rewards you with “miles” redeemable on Delta flights or for checked baggage.
Store cards can only be used at specific stores. Points from store cards are redeemable on purchases made in that store. You may also receive extra perks, such as free alterations, event invitations, or coupons.
6. Budgeting
Budgeting is setting limits on and knowing where you’re spending.
To set up your budget, set aside 1-2 hours and use the following formula:
| Step | Calculation |
|---|---|
| Monthly Income | A |
| Debt | B |
| Fixed Expenses (rent, bills, etc.) | C |
| Emergency Savings | D |
| Other Savings (vacation, retirement, etc.) | E |
| Discretionary Spending | F=A-B-C-D-E |
If your monthly expenses are more than your monthly income, or your discretionary spending (the amount of money you have to put towards groceries, eating out, shopping, and other day-to-day activities) is unrealistic, take some time to figure out what you can cut.
For instance, do you really need a monthly plant delivery subscription? Can you do yoga at home?
Don’t call it quits on this step until A minus B, C, D, E, and F equals zero. Your discretionary spending budget is realistic based on your actual spending habits. That’s when you know you’ve accounted for every dollar and you’re not setting yourself up for failure.
Hint: For additional resources on building an effective budget, check out the following articles.
- 11 Secrets to Budgeting & Money Management With Confidence
- Understand Need vs. Wants for an Accurate (Honest) Budget
- 17 Money Mindset Books To Read Now To Unlock Wealth
7. Investing
Investing is the input of cash into an asset or business in the hopes of receiving a profit in return.
Common types of investments include:
- Stocks
- Bonds
- Real estate
Stocks When you invest in the stock market, you effectively buy a tiny piece of a company. And by investing in the company, the financial rewards they reap are yours. But some companies fail. And so, while you get a chunk of the gains when a company is flourishing, you also take on losses when a company fails. The risk of investing in a company that fails makes investing in the stock market equally rewarding and risky.
Both governments and businesses offer bonds and, in nature, act as a loan from you to the borrowing party. In return, they agree to pay back the loan plus interest.
Real estate investments are properties you own solely for generating a return, such as rental properties. Today, you can also invest in real estate portfolios, so you own many different properties (sort of like the stock market, but with residential buildings).
8. Compound interest
Compound interest is earned not only on the amount invested or saved but also on the interest earned from prior periods.
In short, compound interest is earning interest on interest.
As a result of compound interest, the earnings growth rate is significantly faster than if compounding did not occur.
For example, let’s assume you put $1,000 in a savings account with 3% interest. 5 years later, without compounding interest, you would have earned $150 in interest. But with compounding interest, you would earn $159.27.
$9.27 may not seem like much, but that difference increases over time.
9. Credit scores
A credit score predicts your financial stability and responsibility, including how likely you are to pay your bills on time.
Lenders or landlords commonly use a credit report to determine the riskiness of offering you a mortgage, a lease, an auto loan, or a credit card–the better your credit scores, the better interest rates you may receive.
Your credit score will (usually–but ultimately determined by the credit scoring entity) range from 300-850 and are based on the following components (among others) including in your credit report:
- History of paying your bills on time
- How frequently you’ve applied for additional debt
- Current levels of debt
- How many loans or credit cards you already have
- Occurrences of foreclosure and bankruptcy
A good credit score is above 670, and a poor score is anything below 670.
Can financial literacy for beginners be self-taught?
Absolutely!
There are unlimited resources are available to learn everything you need to know.
To give yourself a financial education, take these two steps:
- Learn
- Take action
But remember, although this article is geared towards beginners, it’s a lifelong learning process–it can’t be rushed. There will always be something new to learn.
Learn
To give yourself a financial education, take advantage of the wide range of content available, including:
- Financial literacy books
- Personal finance podcasts
- Finance blogs
- Mr. Money Mustache
- Making Sense of Cents
- Cultivating Cash (shameless plug ;))
Also–don’t underestimate how much you can learn from your friends, family, or financial advisor.
Take action
The other half of improving your financial literacy is taking action.
This means setting, actively working towards, and achieving financial goals, regardless of what life throws your way.
Pay off your debts.
Start saving towards retirement.
And check in on your finances consistently–weekly, monthly, and annually.
Financial literacy for beginners: take action now to become an expert in no time
Wherever you are in life–it’s never too late to improve your financial skills.
So make a promise to yourself to learn about financial literacy and take action towards your goals.
Read. Listen. Apply.
Earn. Save. Budget. Invest. Pay your taxes.
P.S. Automate your learning journey by subscribing to the Cultivating Cash newsletter.
