Financial Literacy: What You Need to Know to Make Informed Financial Decisions

The world of finance can sometimes have this air of mystery and feeling just out of reach. Most of the time that’s because of common terms that are thrown around that not many people know the meaning of, making finance feel intimidating. Other times it’s because there is a lack of education around these topics and how it is entirely possible to become debt-free, achieve your financial goals, and hit the ground running with financial confidence. 

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That being said, you’ll want to bookmark this article because I’m going to go over, in-depth the terms you need to know, the in’s and out’s of the terms and why understanding financial terms is so important.

Retirement and Investing

The biggest factor in achieving your financial goals is investing your money to make it work for you and preparing for retirement. Both of these things are critical for making your life of financial freedom a reality. 

IRA vs. 401(k)

An IRA and 401(k) are both retirement accounts, they allow you to make contributions to the accounts with pre-tax or after-tax income. If you are employed and have a 401(k) you can also be contributing to an IRA account to maximize your retirement savings. 

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• IRA: Stands for Individual Retirement Account and is a tax-advantaged investment account. Contributions to an IRA may be tax-deductible, while withdrawals are typically taxed as income. Roth IRAs offer tax-free withdrawals, but contributions are made with after-tax dollars.

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• 401(k): A retirement savings plan sponsored by an employer that allows employees to contribute a portion of their pre-tax salary to a tax-deferred investment account. Many employers offer matching contributions providing an additional incentive for employees to save for retirement. 

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If you have an employer that has a 401(k) plan, taking advantage of that is critical because most employers will match your contributions, that’s extra money into your retirement savings. However, if you’re self-employed and don’t have an employer that sponsors a 401(k) plan, it’s important to invest in an IRA to ensure you’re still saving for retirement. 

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Because saving for retirement is such a critical part of financial freedom, ideally you should be contributing 15% of your income to some sort of retirement plan, whether it’s an employer sponsored 401(k) or an IRA. 

Mutual Funds

A mutual fund is an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks and bonds, or other securities. Mutual funds offer investors access to a diversified portfolio with relatively low investment amounts. 

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• Diversification: A risk management strategy that involves spreading investments across different asset classes, industries, and geographic regions to reduce exposure to any single asset or risk factor. Diversification helps minimize portfolio volatility and maximize returns over the long term.

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A typical stock mutual fund will include stocks from various companies, hence why it’s a great way to diversify your portfolio; however, there are seven different types of mutual funds. 

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• Stock 
• Index
• Bond
• Money Market
• Income 
• Hybrid
• Specialty

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The benefits of a mutual fund are having a diversified portfolio, they’re typically lower cost because you’re not investing in individual stocks, they are mutually funded and come without transaction fees. Mutual funds are also actively managed, which means that there is a group of experts managing these mutual funds with the goal of beating the standard stock market returns. They are very active in managing the mutual funds. 

Investing

Mutual funds are not the only type of investment fund, and for most investing is a type of financial strategy that is unknown and scary. But, let’s break down some of the terms and how they relate to investing as a general strategy. 

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• Compound interest: interest calculated on the initial principal and also on the accumulated interest of previous stocks. Over time, compound interest can significantly boost investment returns, making it a powerful wealth-building tool. 

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• Expense ratio: A measure of the operating expenses of an investment fund, expressed as a percentage of its average net assets. The expense ratio includes management fees, administrative costs, and other expenses incurred by the fund. Lower expense ratios are generally favorable for investors, as they result in higher net returns over time. 

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The expense ratio applies to all types of investment funds and is used as a marker to gauge the cost of operating the investment. That being said, the whole point of investing is to make your money work for you and create a sort of passive income stream, so how is that income calculated? 

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• Yield: This is the annual income earned from an investment, expressed as a percentage of the investment’s cost or current value. Yield can refer to interest income from bonds, dividends from stocks, or rental income from real estate. Understanding yield is essential for evaluating the income-generating potential of different investment opportunities.

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• Asset Allocation: The strategic distribution of investment funds among various asset classes, such as stocks, bonds, and cash equivalents, within a portfolio. Asset allocation is crucial for managing risk and achieving investment objectives. 

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Budgeting and Personal Wealth 

Unless you’re a business owner, financial literacy and being able to make informed financial decisions applies to our individual personal wealth and being able to achieve our financial goals and live debt-free. But, even if you don’t own a business, personal financial terms and literacy can still be intimidating.  What is your net worth? What’s your credit score and how does it affect your finances? Do you have an emergency fund and why is that important? 

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These are important questions to be asking yourself with regards to your personal wealth and financial literacy, so let me go over the in’s and out’s and some tips! 

Creating a Foundation

In order to build personal wealth and live a debt-free life, you need to have a solid foundation with which to build wealth. Do you know where you stand financially right now? Do you know your credit score and how that affects your overall financial health? Do you know your net worth? 

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• Net worth: the difference between an individual’s assets (cash, investments, real estate, and other valuables) and liabilities (debts and financial obligations). Net worth serves as a measure of an individual's financial health and overall wealth.

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Determining your net worth is the first step, which involves understanding your assets and cash flow, and your debt and other obligations. When you add all your assets and all your debts and subtract the two the resulting number is your net worth; however, net worth is not net income, it simply gives you the bigger picture of where you stand financially and how stable your finances are. Once you know your net worth, you can dig into the meat of your personal finances and determine what you need to do to build a solid foundation. 

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When you calculate your net worth, you have to add up all your debts and financial obligations, your credit score is a similar measure of your current financial situation, but it’s incredibly important for things like buying a house or a car, and your credit score is a significant number that banks and lenders use to determine your financial situation. 

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• Credit score: A numerical representation of an individual’s creditworthiness, based on their credit history and financial behavior. Lenders use credit scores to assess the risk of extending credit to borrowers, with higher scores indicating lower risk. 

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Your debt and financial obligations are a huge contributing factor to your credit score, so in order to create a solid foundation on which to build personal wealth, you need to pay down your debt and manage it effectively. Once your debt is under control you can start to budget, create a financial plan, manage your income, and ultimately have an emergency fund saved in case of emergencies – no this is NOT your credit card. 

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• Emergency fund: A reserve of cash set aside to cover unexpected expenses or financial emergencies such as medical bills, car repairs, or job loss. Building an emergency fund is a crucial step towards financial stability and helps prevent the need to rely on high-interest debt during times of crisis. 

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As I mentioned, an emergency fund is not your credit card. I know that most of you probably tell yourselves “it’s just for emergencies”, but I have been there and I know that it doesn’t end up happening like that. Truth be told, you need to have actual funds set aside for emergencies so you don’t have to worry about taking out a loan or feeling unsure of how you’re going to cover emergency expenses. 

Let’s Recap: Building Financial Literacy

All of the things I just covered are just the basics of growing your understanding of financial terms and important aspects of healthy financial habits you should know in order to truly take hold of your financial situation, build wealth, and live debt-free. 

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Every step of your financial journey is helping you build towards wealth, abundance, and increase. It’s so important to understand the basic terms and concepts surrounding finance in order to set yourself up for success. Understanding IRAs, 401(k) contributions, investments and the nuances and the concepts that are focused more on your personal finances like net worth and credit score, can give you a leg up in the world of becoming debt-free and building wealth. 

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