A Guide to Avoiding the High Cost of Financial Illiteracy

by Gary Foreman

Financial illiteracy may be costing you hundreds per year. Knowing more about these money basics can help you stop the loss and start building wealth.

According to a study by the National Financial Educators Council, financial illiteracy cost an average of $1,819 per American adult in 2022. For the average married couple, that’s about $3,640!

The Council concluded that “If we generalize the results to represent all of the approximately 254 million adults who live in the U.S., lack of financial literacy cost Americans a total of more than $436 billion in 2022.”

It’s true. None of us like to be thought of as illiterate, especially about something as essential as our finances.

Just remember. Illiteracy doesn’t mean ‘too stupid to learn’ – it just means that someone hasn’t had/taken the opportunity to learn. This is why we put together this guide to avoid the high cost of financial illiteracy. To help you gain the knowledge you need to get a little, or a lot, more money smart.

So, let’s do just that. Let’s take this opportunity to learn what it takes to become financially literate.

What It Takes to Become Financially Literate

First, let’s define what financial literacy is. “Financial literacy is the ability to understand and effectively use various financial skills, including personal financial management, budgeting, and investing.” (source: Investopedia.com)

The simple truth is that becoming financially literate is more challenging now than ever before.

There was a time just 40 years ago when the only residential mortgage was a 30-year fixed mortgage. And there were only a few ways to apply for it. Learning about it was pretty simple. Today, there are various mortgages to learn about and understand. Not to mention the variety of ways to apply for a mortgage.

Shopping for a credit card has become almost as complex as shopping for a new car. Even budgeting is more confusing as we try to sort through the various apps and budgeting methods that can be found online.

In the current world of finance, you need both general financial skills and the ability to learn about a specific money topic when the need arises.

Everyday Financial Literacy Skills Everyone Should Know

Budgeting

“Budget” may be a dirty word in your house, but the information a budget provides is essential.

Unfortunately, most people think a budget only keeps you from spending money. Perhaps if you think of it as a financial information system, it’ll be easier to recognize its value.

The real purpose of a budget is to plan where you think you’ll spend your money and ensure you’re not spending more than your income. Then, afterward, you can compare what actually happened to what you planned. If changes are needed, they’re easy to spot so you can take corrective action before big trouble happens.

Living without a spending plan (i.e., budget) is like driving with your eyes closed. Sooner or later, you’re going to have an accident!

Learn more:

• A Beginner’s Guide to Budgeting Success
• 3 Reasons Budgets Fail and the Key to Budgeting Success
• 9 Reasons You Can’t Stick to Your Budget

Compound interest

Compound interest is the secret ingredient to financial success. It can help you create financial comfort. Or, if you ignore it, it can lead to financial pain.

What is compound interest? It’s earning interest today on interest that you earned before. Suppose you could earn 10% interest on your savings. (I know, that’s high, but this is just to illustrate how it works.) You deposit $10 into your account and earn $1 interest in the first year. In the second year, you have $11 in the account and earn 10%. So you’ll earn $1.10 in the second year. The extra 10 cents is compound interest.

That might not seem like much, but it adds up, especially over longer periods of time. Without you lifting a finger!

That’s great if you’re saving money for retirement in your 20s, 30s, and 40s. Compound interest is a crucial ingredient for anyone wanting to build wealth.

But it’s a double-edged sword. Credit card companies earn a lot of money on compound interest. When you don’t pay your entire credit card bill, the interest you owe will be added to your account. And next month, you could be paying interest on last month’s interest. At 14% or more, it adds up quickly.

Learn more:

• The 10 Things You Need To Know About Compound Interest
• Using Compound Interest To Boost the Rate of Return on Your Savings
• Where Can You Earn a Good Compound Rate of Return?

How debt works

It’s highly unlikely that you’ll get through life without borrowing money. You may end up signing a contract to borrow cash for schooling, housing, transportation, living expenses and even vacations.

All loans will require you to repay the money you borrowed. Most will charge you interest for the privilege of borrowing the money. Some will be for a specific period (like a 4-year car loan or a 30-year mortgage). Others will be open-ended (like a credit card account or a home equity line of credit).

Each loan will have its own terms and conditions. The literate consumer reads and understands them before they accept the money. Some can hide big penalties if you violate their provisions.

Remember, too, that the interest rate you pay may be affected by your credit score. And that your credit score is affected by your current borrowing and past repayment performance.

Learn more:

• The Rule of 72 (or How To Easily Double Your Debt)
• 7 Monthly Bills Affected by Your Credit Score
• Debt Warning Signs You Shouldn’t Ignore

Contracts

A contract is an agreement between two people and/or corporations that is generally written but sometimes just spoken.

No one gets through life without entering into many contracts. Your credit card agreement is a contract. So are your student loan agreement and the papers you signed to buy your car.

Often, you don’t even need to physically sign a contract. A simple click on ‘agree’ will obligate you to the contract.

Many (most?) contracts will have a financial aspect. I’ll trade this item for X dollars. Commonly, failure to perform to a certain level will cause financial penalties to be applied.

You don’t need to be a contracts lawyer to get through life. You probably don’t need one to order something online from ClickHereMart. But if it’s something big or the contract is complicated, you’ll want to have an expert translate the legalese typically found in contracts.

Basic Economics Everyone Should Know to Avoid Financial Illiteracy

What inflation is and what it does

Inflation measures how much prices rise, typically stated as a percent of annual increase.

Why should you care about inflation?

Because it causes the things you buy/need to be more expensive. It also erodes the purchasing power of the money you’ve saved. Even at only 2 or 3%, prices will double every 24 years.

The law of supply and demand

The law of supply and demand affects virtually every financial transaction you make, whether it’s the price of ground beef at the grocery store or what you can make on your job.

The concept is simple. If the demand for something is higher than the supply of that thing, the price will go up. If the demand is less than the supply, the price will go down.

For instance, if drought causes fewer cattle to go to market, but the demand for steak stays the same, the price will increase.

Another example: if there are many graduates with degrees in art history but few jobs, they will have difficulty finding a high-paying job.

Learn more: Use the ‘Law of Supply and Demand’ To Save Thousands

Opportunity costs

This is another concept that will affect almost every financial decision you make. Again, the idea is simple.

You can’t spend the same money twice. That means the $5 you spent at Starbucks today can’t be deposited into your retirement account.

It also extends to credit availability. The mortgage payments you committed to consumed credit that isn’t available for an auto loan.

The lesson is to think about what you might be giving up when you make a purchasing decision.

Learn more:

• How Does Opportunity Cost Factor Into Your Finances?
• Using Opportunity Costs To Live a Happier Life

Special Financial Literacy Skills To Learn As Needed

Buying a house

A great many of us will become homeowners.

Buying a house is much different than buying a phone or bedroom furniture. There are a variety of things to consider. How old is the home? What condition is it in? Is there a homeowners association? What are the taxes? What is the neighborhood like? Are there crime issues? How are the schools?

Don’t count on the realtor (no matter how good they are) to anticipate and answer every question. It’s your responsibility; the consequences will be yours if you skip this step.

Learn more:

• How To Determine How Much House You Can Really Afford
• 12 Steps to Negotiating the Best Price on a House

Mortgages

Buying a home typically means taking on a mortgage.

A wide variety of mortgages are available. Most are for a fixed length of time (often 15 or 30 years). Some have a fixed interest rate, while others have interest rates that can change (a variable rate mortgage). Some short-term loans have a ‘balloon payment’ at the end.

Finding the right mortgage will require some effort on your part.

Learn more:

• Understanding Mortgage APR and Interest Rate
• How We Saved $34k in Interest on Our Mortgage Before Closing
• Managing Your Mortgage To Build Wealth

Buying a Car

After your home, a car is the most expensive item you’ll buy.

And it’s a decision that will significantly impact your finances. Many have found themselves ‘car poor’ due to troublesome car payments.

It’s also a decision that you don’t make frequently. The rules of buying a car have changed. Online options are available that make it easier to compare prices and negotiate with a dealer. The strategy you used four years ago when you last shopped may not be the best one to use now.

Take time to see what tools are available before contacting your first dealer.

Learn more:

• Bargaining for the Best Deal on a New Car
• 7 Car Dealership Fees and Services To Avoid
• How To Safely Buy a Used Car From a Private Party

Financing a car

In 2023, according to LendingTree research, the average term for new-car financing is 68.6 months.

Did you know that many dealers make more money financing cars than selling them?

That should tell you how important it is to know what you’re doing before you finance a car.

Take the time to research where money is available, what it will cost and what terms are possible before you visit the dealer.

Learn more:

• Things You Should Do Before Shopping for an Auto Loan
• Getting the Best Deal on New Auto Financing
• The Right Way To Prepay an Auto Loan

Student loans

Student loans can be a blessing or a curse. Like many financial tools, it depends on how you use them.

Using student loans correctly means understanding how they work. In many ways, they’re like other loans. You make regular payments that cover the interest you owe and a small portion of the amount borrowed.

But there are critical differences.

Unlike many loans, student loans can very rarely be included in bankruptcy. They are not easily discharged. If you don’t finish a degree or find an appropriate job, the loan doesn’t disappear. Lenders are often willing to write loans even if they think your degree has little value. They don’t mind you paying interest/principal on a student loan for many years into the future.

Learn more:

• Before Taking Out a Student Loan: Things To Know
• 5 Ways To Save on Student Loan Debt
• Determining If a College Degree Makes Financial Sense

Managing your credit reports and score

Whether you can borrow money and how much interest you’ll pay depends on your credit reports and credit score. Lenders use those reports to estimate how risky it is to lend you money. The greater the risk, the higher the interest rate.

The three credit reporting agencies have different formulas, but they’re all similar. They’ll look at your past payment history, your current use of credit, and how much you could borrow in the future.

You should check your credit reports at least once per year. Your credit score should be checked more than once a year.

Approximately one in four people have significant errors in their reports that would affect the interest rates they pay.

• Disputing and Correcting Credit Report Errors
• Managing Your Credit Score
• The Right Steps To Take To Rebuild Your Credit Score

When You Should Seek Professional Financial Help

Some financial decisions are complicated.

There’s no shame in seeking a professional to help you identify the important questions and help you answer them. If it’s a major decision (i.e., big money) and you’re not sure that you completely understand, it’s time to call in an expert.

No one likes to read page after page of legalese in a contract or agreement.

Unfortunately, that’s where the lawyers hide all the ‘gotchas’. They’re assuming that either you won’t bother reading or you won’t understand what you’re reading. The fine print has tripped up many an unsuspecting soul. If you don’t want to read it or can’t understand it, you’d be wise to have an expert do that for you.

The Sign of a Financially Literate Person

The world of personal finance changes continually. Your needs and circumstances also change.

The financially literate person continues to learn. They make an effort to pick up a little knowledge routinely and regularly, and they recognize when they need to seek professional help.

So, pick one or more of the aforementioned financial topics that you feel are contributing to your financial illiteracy and educate yourself little by little.

Because the financially literate are the ones who succeed financially!

Related:

• A Financial Literacy Test: How Knowledgeable Are You?
• A Money Dictionary for Improving Your Finances
• Get Financially Fit This Year: A 12-Step Plan
• Have You Grown Up Financially?

Reviewed October 2023

About the Author

Gary Foreman is the former owner and editor of The Dollar Stretcher. He's the author of How to Conquer Debt No Matter How Much You Have and has been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.