What is Financial Literacy and How Do You Get There?

If you have not heard, November is Financial Literacy month in Canada and so my blog this month is centred on what I believe are the 5 essential components to financial literacy. The definition from Wikipedia: “Financial literacy is the possession of the set of skills and knowledge that allows an individual to make informed and effective decisions with all of their financial resources.”

#1. Cashflow

I use cashflow instead of budgeting because I don’t want you to stop reading. When I start work with financial clients, regardless of how much they earn, we spend a lot of time analyzing what the family’s spending each month.

Creating and maintaining a cashflow is one of the most basic aspects of staying on top of your finances, and with my clients, we go one step further. For 6-8 weeks they go on cash only. They put away credit cards and debit cards and they use cash only. It forces them to plan meals which in turn helps cut down on impulse buying when they are at the grocery store or Costco. After being on cash, many clients find following a cashflow plan easier and are able to maintain one. It is interesting to see the clients after being on cash only armed with their bank statements and showing off that they have money in their bank account when in the past they were in overdraft. It empowers them to continue working toward saving rather than putting themselves in debt every month.

Anyone can create a cashflow/budget – there are lots of apps online. The bottom line is for you to look at your take-home pay rather than your gross pay when creating a cashflow plan.

#2. Impact of interest

While you may touch upon the concepts in school, it’s important to understand different aspects, like compound interest. Why? Not only can it help you save even more, but it can make the difference between borrowing a small amount and paying back much more than you need to for years to come. Understanding interest can impact your finances more than you likely realize, so it’s an important concept to gain a better understanding of early on in life… especially before applying for student loans, credit cards, and big ticket items like cars and houses.

#3. Saving versus spending

Saving is one of the best concepts to grasp as it is the key to maintaining a healthy financial situation. It’s easy to ignore things like retirement since it seems so far off in the future. Learning to save early on can help you gain the knowledge, practice and set of skills you’ll use throughout your entire life.

One of the challenges I see for clients, regardless of age, is how to save when there are only so many paycheques in a year and so many financial obligations. Well, it is not easy, however, what I ask clients to do first is open a high-interest saving account, such as a Tangerine account or Manulife Bank account. I suggest those types of accounts because I want the money to be moved out of their daily chequing/savings account so that it is not attached to their debit card. I ask them to start an automatic transfer that may range from $25-200 per month depending on their cashflow. I believe most clients can agree that $25 per month is feasible. Beginners can start working on this concept in the simplest sense, like saving money for a higher-ticket item they desire. Working toward a goal is key here and students need to understand there’s a lot of value in paying yourself first – because the bills will always be there. Having peace of mind? Well, that comes with practice, diligence and patience – all qualities you’ll develop when mastering your savings skill.

#4. The difference between good and bad debt

The most important consideration when using a line of credit or taking out a loan is whether the debt incurred is good debt or bad debt.

Good debt is something that will grow in value or generate long-term income. Taking out student loans to pay for a university or college education is an example of good debt. Typically, student loans have a lower interest rate compared to other types of debt. Another example of good debt is taking out a mortgage to buy a home. Even though mortgages are long-term loans (25 years in many cases), those relatively low monthly payments allow you to keep the rest of your money free for paying down credit cards or investments and emergencies.

Bad debt is incurred to purchase things that quickly lose their value and do not generate long-term income. Bad debt is also debt that carries a high-interest rate, like credit card debt. The general rule to avoid bad debt is: If you can’t afford it and you don’t need it, don’t buy it. If you go out to dinner and it costs $125 on your credit card, but you can’t pay the balance on your card for years, that dinner will eventually cost you over $200. So, before you make the reservation, decide if that dinner is worth it.

It is important to prioritize what debt you are going to pay off first. The snowball effect happens when you make the minimum payments for all the debts, then concentrate on one debt, usually the one with the highest interest and make additional payments until it is paid off. Then continuing with the next debt and doing the same thing. Once you have got yourself out of leaving a balance on your credit cards and lines of credit, it is important to not fall into that habit again.

#5. Understanding your investments

Whether you’re planning your financial future for the first time or reviewing your present plan, it’s important to establish clear financial goals, identify the resources you have to achieve your goals, and think very carefully about how much risk you are prepared to take with your money. Here are some questions to ask yourself.

  • How long will you be investing your money? Is it long term over 10 years or short-term, less than 2 years? Or is it somewhere in between?
  • How much money can you invest? Is it a one-time thing or will it be monthly?
  • How much of your investment are you willing to lose in the short-term in order to earn more in the long-term?
  • What type of investments interest you? Each type has a different threshold of risk; bonds are associated with low risk while stocks are considered higher risk, and there are other types in between.

So, it is important not to put your finances on the back burner. I believe you can start as early as today to make a change in how you manage your finances and improve your financial literacy.

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