Personal financial literacy is important — no ifs, ands, or buts.
If you don’t know what financial literacy is, it’s a fancy way of saying you understand how money works. And, more importantly, you know how to make money work for you.
To be financially literate means you have the knowledge and skills you need to apply smart decision making when earning, borrowing, and investing your cash. Without it, managing your finances becomes a lot harder, and you may be more likely to make decisions that threaten your financial well-being.
Unfortunately, many Americans struggle with financial decision making. So, it might be good to take a moment out of your day to brush up on some of the basics. The MoneyKey guide to financial literacy goes over commonly misunderstood terms and concepts to help you make the right decisions.
Personal Financial Literacy Term No. 1: Compound Interest
To understand compound interest, we’ll need to breakdown simple interest first.
You’re probably familiar with this type of interest. You may have heard it if you’ve ever taken out an online loan or opened a savings account.
Here’s an example of how it works. Let’s say you have an investment of $100, and it comes with annual simple interest rate of 10 percent. Ten percent of $100 is $10. That’s $10 you’ll earn each year for however long you keep your investment.
- After one year, you would earn $10, to bring your total to $110.
- After two years, you would earn an additional $10 on the same $100, which would bring your total to $120.
- After three years — yep, you guessed it — you would earn an additional $10, which would bring your total to $130.
Anyone who’s handy with numbers will notice simple interest applies strictly to the initial principal of $100. At an interest rate of 10 percent, you’ll only ever earn $10 each year, regardless of how big your investment grows.
How is compound interest different?
With compound interest, you’re earning interest on more than just the principal. You’re earning interest on top of interest earned, too.
Assuming you still have that $100 investment, and the annual compound interest rate is 10 percent, it would look like this:
- After the first year, you would earn $10 to bring your total to $110.
- After the second year, interest is calculated on the new total of $110. Ten percent of $110 is $11, bringing your new total to $121.
- After third year, interest is calculated on the new total of $121. Ten percent of $121 is $12.1, bringing your total to $133.10.
Why does compound interest matter?
Compound interest has a profound affect on what you earn on investments. The bigger your investment grows, the bigger your interest payments become.
This means you may be earning more money with compound interest as opposed to simple interest if you can snag a high-yield savings account or specialized investment that uses compound interest.
But don’t forget, compound interest applies to more than just your investments.
Knowing how compound interest works is critical when shopping around for any loan, as you’ll be able to calculate how much you’ll owe on top of your principal.
Use an interest calculator if you’re unsure
Don’t worry — nobody expects you to be able to calculate compound interest off the top of your head. If you’re not sure how much compound interest will be on a deposit or online loan, use an interest calculator to help.
Sometimes, your bank or lender will crunch the numbers for you, too.
Here at MoneyKey, we go out of our way to outline how much interest applies to installment loans and payday loans online. You’ll see the breakdown in your loan agreement should you ever apply and be approved for a loan.
Personal Financial Literacy Term No. 2: Inflation
Inflation is a stuffy economic principle describing the general increase of prices and cost of living as time goes on. It also describes how the value of your money — or what’s called your purchasing power — decreases over time.
How does inflation affect you?
You don’t have to go back generations to see the effects of inflation. You can see it happening in real time whenever a store increases their prices.
An example is Starbucks. In the last year, the coffee company raised its prices by 1–2 percent to account for inflation.
A drip coffee that was around $1.95 two years ago may now cost around $2.15. Not only is a takeout coffee more expensive, but the money in your wallet now buys less in your favorite café.
For a more generalized view of inflation over time, you can see how the value of your money has changed by using the Bureau of Labor Statistic’s inflation calculator. This inflation calculator helps put the gradual increase in prices into perspective.
Why does inflation matter?
Understanding how inflation affects your money can help you prepare for the effects.
A good way to counteract inflation is by saving money in an account with a high compound interest rate. If you’re lucky, you’ll find savings accounts and other investments that promise higher returns than the rate of inflation.
This is especially helpful for long-term savings goals like retirement. You’ll want to make sure the money you earn in your 30s and 40s is valuable enough to support you in your 70s and 80s.
Personal Financial Literacy Term No. 3: Household Budget
Nobody wants to make a mistake with their money, but things happen. You might make a poor investment in a business that never takes off. You may lend money to a friend who never pays you back. Or maybe you take out a loan that you can’t afford.
The list of money mistakes goes on and on. But if you make one, your poor decisions may leave you with less cash than you need to face your living expenses.
A household budget may be able to help protect you from these mistakes. One of the better types of household budgets are typically a financial document that tracks your cash flow, showing you where your money is coming and going each month. It gives invaluable insights into the cost of running your household and how you’re spending your money day-to-day.
You may use this information to make positive changes to your living expenses or spending habits. By understanding how much money you need to cover your living expenses, you have a better chance of withholding enough of each paycheck to cover your bills.
By understanding how you typically spend your cash, you may also spot bad spending habits that have been stopping you from saving. If you eliminate enough of these bad habits, you can keep your summer budget in check. Any cash you manage to free up can go towards your savings.
Personal Financial Literacy Term No. 4: Credit
In the financial world, credit generally has two meanings.
- It may refer to a variety of loans consumers take out
- Credit may also refer to your history as a borrower
What kinds of credit are there?
Let’s start with the first definition. Credit is a broad term, but it’s generally a contractual agreement between a borrower and a lender, where a borrower gets something of value now with the agreement that they will repay the lender at a later date. This generally comes with interest.
There’s a wide variety of credit available. Some of the most popular types of personal loans include installment loans, student loans, and mortgages. Each one caters to a specific need and financial profile.
For example, you would take out a mortgage if you plan on buying a house, but you would take out an installment loan if you need help repairing a cracked window in your home and don’t have the savings to cover the cost.
Most lenders will look at your financial profile to determine the risk of lending to you. Some of the things they review are your income and employment history to ensure you have the means to pay back a loan.
What is a credit score?
This brings us to the second definition of credit, or your history as a borrower. Your credit history and score are important factors guiding lenders’ decisions to lend to you.
Your credit history is a record of the loans and credit cards you’ve taken out in the past seven to ten years. This history only includes the credit activity that has been reported to credit bureaus, as not all lenders do this. Your credit report shows insights into your performance as a borrower — like how often you pay your bills on time and how big of a balance you keep on your credit card.
Your credit score is a three-digit number representing your credit history. Scores fall into a credit rating range spanning 350–850.
The country’s most popular credit rating system, FICO, break downs this scale into five categories. The following table shows you their ranges:
750 – 850
700 – 749
650 – 699
550 – 649
549 – 350
If you have a score of 350, you have bad credit. And if you have a score of 850, you have excellent credit.
More likely, your score is somewhere between theses two extremes. Only a small percentage of people fall in the lowest and highest scores.
What credit score do you need?
Generally, many traditional lenders want to see you have a fair credit score or higher. This tells them you generally don’t max out your credit cards and that you typically pay your bills on time.
In other words, it shows you’ve handled credit responsibly in the past. From this, they assume you’ll manage their loan just as well, so they see you as less of a risk. As a result, they may approve your loan application and potentially offer you lower interest rates.
If your score dips below fair, you may have trouble finding loans from mainstream lenders. Traditional lenders may see your credit history and deem as you too much of a risk.
However, there may be some exceptions. There are some lenders that are willing to look beyond your credit history by offering personal loans for poor credit.
What are personal loans for poor credit?
Personal loans for poor credit include any financial product or service that offers an opportunity to people who typically may not be approved for traditional borrowing options.
Lenders of these types of personal loans may check your credit, but may not have very high restrictions on your score.
Instead, they look at things like your income and employment history to determine if you can afford these types of personal loans.
- Cash Advances: A cash advance is typically a short-term cash loan from a financial institution. These options may be used if someone needs help covering an unexpected and urgent expense between paychecks.
- Lines of Credit and Credit Cards: Some lenders offer credit cards or lines of credit to borrowers with poor credit. These cards often have lower credit limits and higher interest rates than other options.
- Installment Loans: These personal loans may help you make a big purchase or take on essential repairs. Unlike cash advances, you generally repay an installment loan over a series of scheduled payments or installments.
These types of personal loans may be easier to access with poor credit. However, they may come with higher interest rates and fees.
As a result, it’s important to apply for these types of personal loans only in emergencies.
Why is Personal Financial Literacy Important?
Personal financial literacy shows you how the financial system works, so you have the skills to make decisions that maximize your financial success. It gives you the skills to manage your money well and with intention, regardless of how much money you have.
You’ve already started your education today. Keep your eyes peeled for MoneyKey’s next post raising awareness of the importance of financial literacy. There’s a lot more to share when it comes to financial literacy, and we intend to help you every step of the way.
Posted in: Financial Tips