A Guide to Avoiding the High Cost of Financial Illiteracy

by Gary Foreman

The Cost of Financial Illiteracy photo

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 2020 study by the National Financial Educators Council, financial illiteracy cost an average of $1,634 per American adult last year. For the average married couple, that’s nearly $3,300!

They 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 $415 billion in 2020.”

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. Which is why we put put together this guide to avoiding 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 harder now than ever before.

There was a time just 40 years ago when the only residential mortgage was a 30-year fixed mortgage. And, only a few ways to apply for it. Learning about it was fairly simple. Today there’s a variety of different 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 it’s value.

The real purpose of a budget is to plan where you think you’ll spend your money and make sure that you’re not spending more than your income. Then afterwards, 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!

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% on it. 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 key 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.

How debt works

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

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 of time (like a 4-year car loan or a 30-year mortgage). Others will be open ended (like a credit card account or a homeowners line of credit).

Each loan will have it’s 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.

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 is 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. It’s common that 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 to translate the legalese typically found in contracts.

Basic Economics Everyone Should Know to Avoid Financial Illiteracy

What inflation is and what it does

Inflation is a measure of how much prices rise, typically stated as 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 a 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 a hard time finding a high paying job.

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 that the $4 you spent at Starbucks today can’t be deposited in 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.

Special Financial Literacy Skills to Learn As Needed

Buying a house

A great many of us will become home owners.

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 and the consequences will be yours if you skip this step.

Mortgages

Buying a home typically means taking on a mortgage.

There are a wide variety of mortgages available. Most are for a fixed length of time (often 15 or 30 years). Some have a fixed rate of interest, 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.

Buying a Car

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

And, it’s a decision that will have a large impact on 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 that 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 to you before you contact your first dealer.

Financing a car

In October 2020, according to Experian.com research, “the average term for new-car financing is just under 72 months.”

Did you know that many dealers make more money financing cars than they do 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.

Student loans

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

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.

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 report that would affect the interest rates they pay.

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 brother to read or that you won’t understand what you’re reading. Many an unsuspecting sole has been tripped up by the fine print. 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 could be contributing to your financial illiteracy and educate yourself little by little.

Because the financially literate are the ones who succeed financially!

Reviewed October 2021

About the Author

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. You can read Gary's full bio here. Gary shares his philosophy of money here. Gary is available for audio, video or print interviews.

Let us help you achieve your financial goals.

Subscribe to Financial Independence, our daily email newsletter. It doesn't cost anything. And, it could make a huge difference in the way you live!

Debt ChecklistSubscribers get Are You Heading for Debt Trouble? A Simple Checklist and What You Can Do About It for FREE!

Your Email:

Follow Us

We can help you gain control of your finances and live better...for less.

Subscribe to Financial Independence, our daily email newsletter. It doesn't cost anything. And, it could make a huge difference in the way you live!

Debt ChecklistSubscribers get Are You Heading for Debt Trouble? A Simple Checklist and What You Can Do About It for FREE!

Your Email:

Pin It on Pinterest

Share This