Last week, we covered why Financial literacy matters. If you missed the previous post, you can read it here.
This week we’ll be focusing on the 5 key areas forming part of Financial literacy: earn, spend, save and invest, borrow and protect to offer some practical advice.
Even pre-pandemic a lot of adults have been living from paycheck to paycheck. A situation that has just been aggravated by recent events with 63% of Americans now saying they’ve been living paycheck to paycheck since the pandemic. This is not down to a personal choice but mainly caused by increasing living expenses as well as stagnant wages. Especially when living paycheck to paycheck understanding what income people have now and in the future is crucial.
Income can be divided into active and passive income. A majority of individuals covers their living expenses with active income meaning income generated by employment or jobs and services offered as a contractor.
Passive income is income for which one doesn’t have to actively work. However, it does require some work upfront such as picking investments or renovating a flat to rent it out. The difference to active income is that this work continues paying long after the “actual job” of investing or renovating is done.
When earning money from employment it’s crucial to take the time to understand the differences between gross and net income. In many advanced economies between 10–40% of a person’s income can go towards taxes and social security. And on an advanced level, being aware of what others in a similar position with similar experience earn can provide some leverage in salary negotiations.
Spending money is a lot easier than earning it. Temptations like having a quick coffee to go each time when walking through the park can add up in the long run. However, as previously mentioned, it’s not rare for people to spend more than they earn which in the long run leads to accumulating debt.
The most essential activity to gain control over spending is budgeting. A budget is nothing more than a plan for what money is spent on. Having a budget helps avoid financial stress and unnecessary debt.
Creating a budget starts with making some educated guesses on how much money is spent each month. In the next step, this is compared to the actual spend in the following months. This exercise can reveal surprising insights.
Budgets don’t have to be seen as something set in stone. They are flexible and evolve with needs and income.
When creating a budget, it pays off to be honest with oneself about wants and needs. While it might be nice to order food 4, 5 times a week (especially with lockdowns), it’s not necessarily needed.
Budgets are not a quick-fix and only truly work when they’re being used for a longer time. This involves regularly reviewing the income and outflow of your finances. In case of a pay raise, the budget could be adjusted to be higher, while during economic hardship, setting aside more money seems sensible. Savings should form part of a comprehensive budget, as they represent money that isn’t spent.
Saving and Investing
Most experts recommend having enough savings to cover 3 to 6 months of living expenses. These can be tapped when unexpected events occur like job loss or personal tragedy.
Chances are, a majority doesn’t have this amount of savings to fall back on to except for citizens of Hong Kong. Despite the obvious benefits of a financial buffer, having savings also offers some peace of mind.
Apart from putting money aside for emergencies, paying debt or bigger purchases can be other occasions to save for. Saving is made a lot easier when the amount to be saved is directly deduced from the salary and put into a separate savings account. Additionally, countless modern banking apps offer the option to “round up” each purchase and put that money aside.
Nevertheless, just keeping your money in a bank account to save isn’t an optimal setting considering that bank accounts paying interest rates above inflation are non-existent. Therefore, saving and investing go hand in hand.
For rainy-day funds, liquidity matters. Yet, money that won’t be needed short-term can perfectly be invested.
More active investors can choose a broker and invest themselves or use a platform that defines their risk appetite and invest accordingly into a portfolio of different assets. More adventurous investors can look into lending platforms where others can borrow from them and receive a fixed interest rate in return.
Financial literacy also plays a big part in making borrowing decisions. Research suggests that lower financial literacy is linked to borrowing decisions that more likely lead to indebtedness. Making suboptimal choices isn’t something just happening in developing countries or in certain age groups. In fact, in the US 43% of millennials report having made use of expensive financial services like payday loans and pawnshops. It’s true that banks and other institutions are aggressively advertising credit cards and loans, but they don’t do so to help humanity but to make a profit.
Nevertheless, some things are just too expensive to pay for all at once with savings — this is a moment when borrowing makes sense. Take student loans for example or a mortgage to buy a property.
One important concept to internalise when it comes to borrowing is the concept of simple and compound interest. Knowing and being able to compare different APRs on loans offered puts individuals in the position to make the most cost-efficient choice for themselves and their financial health.
With an increasing number of people spending a lot of time at home and online, unfortunately, the number of frauds has picked up — and some of them can look quite realistic.
Whenever managing finances online, it’s best practice to pick safe passwords and set-up Multi-Factor Authentication to prevent account breaches.
Another important factor in protecting money is regularly reviewing transactions. This way, even if somehow a breach has happened and a fraudster got hold of credit card information, it can quickly be spotted and the card is blocked. Most mobile banking apps send push-notifications whenever a transaction happens, making it even easier to keep track.
To wrap it up, the first step in getting better with one’s finances is always awareness. That means starting analysing how much is earned, moving on to reviewing what is needed (spend), investing and saving what isn’t needed. Finally, it’s important to understand the concept of compound interest to make the best borrowing decisions and to protect your money.