In 2004, Congress dedicated April as National Financial Literacy Month to emphasize the importance of financial literacy. When it comes to planning for retirement or preparing to meet your financial goals it is important to sit down and talk with a trusted financial professional. Most of us handle money on a daily basis, so it is important to have a thorough understanding of the fundamentals of financial literacy. Continue reading as we have identified five financial basics everyone should know including debt and credit scores, interest, the value of time, inflation, and identity theft and safety. Having a clear understanding of these important concepts can serve as a basis for your financial standings.
Basics #1: Debt & Credit Scores
Understanding the ways in which credit or debt can work with or against you should serve as the foundation of your financial knowledge. First it's important to understand that, it is not wise to avoid credit or debt altogether because of fear or intimidation. Instead, it is important to have a firm grasp on your financial standings and a plan for tackling debt responsibly.
This may be surprising to some but debt can be useful, when it is used correctly. However, when debt is misused, it can quickly spiral out of control. Missed payments can accrue interest or penalties and may impact your credit score in a negative way. However, debt that is managed responsibly can help you reach important financial goals like buying a car, purchasing a home, going to college, starting a business and more.
Your credit score is very important when applying for a loan and is one of the main factors lenders look at to judge your trustworthiness and qualification for mortgages, auto loans and other lending opportunities. Landlords and employers may also check your credit before renting to you or offering you a job. The calculation of your credit score is dependent on a variety of different factors including previous credit history, length of credit history, current debts, history of payments, missed payments, and more.
Basics #2: Interest
Interest can be a difficult concept to understand as there are two sides to interest including interest accrued on debt and interest accrued on savings.
When you take on debt (like credit card debt, an auto loan or mortgage), you will be responsible for paying back both the principal amount and the interest accrued on the loan. The interest is how a lender makes money on the loan and provides the borrower with an incentive to pay the loan back in full and on time.
When you have a savings account that accrues interest, the interest earned gets added to the principal or the total amount in your savings account. Then, interest is earned on the new, larger principal, and the cycle repeats. This continuous cycle is referred to as compounding interest, and it can be an integral part in growing your retirement savings - as the longer the interest has to compound, the greater the savings will grow.
Basics #3: The Value of Time
As a reminder, it is never too early to start saving whether it's for retirement, homebuying, a child’s education or whatever could be coming down the line. Actually, the earlier you start saving, the more you’ll be able to tuck away over time - especially with the power of compounding interest. Like mentioned above the longer your interest has to compound the more your savings will grow. This leverages the value of time to your advantage.
Basics #4: Inflation
Inflation is defined as the decline of purchasing power of your money over time. That means, with inflation, the dollar you earn today may not be worth a dollar in the future. Below are two important concepts to keep in mind regarding inflation.
Cash in a Mattress
Keeping all your cash under a mattress is not only unsafe, but it also literally costs you money since you are not earning interest. Hypothetically let's assume the annual rate of inflation is two percent, this means that for every dollar you keep under your mattress and you are not earning interest on, the value of your dollar would shrink in value to $.98 next year. Although this may not seem like a lot, it can add up quickly and by keeping your cash under the mattress you are decreasing the value of your hard earned money.
Rate of Return
Because inflation declines the purchasing power of your money, any returns you earn on your accounts may not be the “real” rate of return. Hypothetically, if your account earned a 6 percent rate of return over the last year, however, inflation was 1.5 percent, your real rate of return was 4.5 percent.
Basics #5: Identity Theft & Safety
One of the biggest threats we all face in life as the world shifts more towards doing everything online and digitally, is identity theft and the theft of financial and personal information. A cracked password or misplaced Social Security number can have significant consequences on your current and future finances.
A strong and unique password is essential for every site you use so that it is difficult for unauthorized personnel to gain access to your electronic accounts and personal information. A password manager can make this easier by generating and storing strong passwords automatically.
While this is a brief overview of some important financial concepts, it’s important to work with your trusted financial professional to discuss these topics further. As always, feel free to reach out to one of our financial advisors if you have questions about any financial basics. Be sure to use National Financial Literacy Month to reevaluate your current financial knowledge as you identify potential areas for improvement.