Importance of Financial Literacy and Essential Financial Terms

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  • By Taxmann
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  • Last Updated on 14 June, 2023

Financial Literacy

Table of Contents

  1. Introduction
  2. Financial Literacy
  3. Importance of Financial Literacy
  4. Financial Literacy Basic Vocabulary
  • Check out Taxmann's Financial Literacy | UGCF, which is an authentic and comprehensive book on financial literacy. It aims to acquaint the reader with financial planning, financial products, banking & digital payments, investment planning & management, and personal tax with the help of solved problems, review questions, and practical exercises.

1. Introduction

The whole world has agreed that India is a country with massive growth potential and opportunities. But there is one big social evil which has continuously put a dampen on this growth potential i.e., poverty. According to the Oxford dictionary, poverty means “the state of poor”. Now, there are many reasons for such widespread poverty in the country and one of them which is agreed by all is a lack of financial knowledge. Everyone knows that resources are limited be it at a world level, national level or personal. The ability to derive the most out of these scarce resources is the need of the hour. Thus, we can say that financial literacy is the first step out of poverty. The research by Linfield (2011) revealed that people belonging to the age of 25 to 34 years is the “fastest-growing bankruptcy demographic”. There exists a strong argument for the requirement of financial literacy among all demographics. This book aims to provide basic skills one must possess to attain financial self-sufficiency for oneself and the family.

2. Financial Literacy

Financial literacy refers to the knowledge and understanding of various financial skills one must have to make efficient and informed financial decisions. It included skills related to saving, investment, taxation, etc. A financially literate person is better off at attaining his/her life goals than a non-financially literate one. The main objective is to safeguard oneself from financial fraud and distress.

Financial decisions are something which an individual is bound to make throughout his/her life time, one might as well learn about them. Warren Buffet aptly defined the need for basic financial know-how. He said that

“If you buy things you do not need, soon you will have to sell things which you need”.

3. Importance of Financial Literacy

Financial literacy education is important because it provides knowledge and skills for effective money management. Without financial knowledge, the actions and decisions that a person makes or does not make regarding savings and investments will not have a solid foundation. Financial literacy education helps to better understand financial concepts and allows one to manage their finances effectively. In addition, it helps to manage money effectively, make financial decisions and achieve financial stability. In addition, financial literacy provides in-depth knowledge of financial education and strategies that are indispensable for financial growth and success. It can also help a person get out of debt by adopting the best debt strategy.

It may impact the future of the youth through the most popular skills which are budgeting, cost management, debt repayment, and understanding of risk-return coordination on investment products. Acquiring these skills will require an understanding of basic financial concepts such as time, money, interest, annual sum and opportunity fees. With the diversity of credit products available in the market, such as credit card debt, debit card withdrawal opportunities and EMI, financial literacy is becoming increasingly important. Understanding debt and having a basic knowledge of finance will help people use these products responsibly.

Financial literacy always teaches people how to make important financial decisions. It also increases financial discipline and financial opportunities. This will lead to significant lifestyle changes such as saving money and investing regularly, managing debt effectively and achieving life goals effectively. In addition, financial literacy will ensure one’s financial well-being and will also protect people from financial fraud. A lack of knowledge of these skills leads to financial illiteracy. Financial illiteracy education leads to budget mismatch, high-income expenditures, debt collection, poor credit assessments, victims of financial fraud and other negative consequences.

Financial Literacy could be considered one of the most important forms of education in anyone’s life. Consider this example, if I give you $100 and ask you to invest it somewhere, 90% of people under such conditions wouldn’t even consider the stock market or mutual bonds and are likely to put the money into their bank accounts. However, if we teach them the way they can earn a greater percentage of return on mutual funds with slightly more risk, now more people are likely to invest in mutual funds, such is the power of financial literacy. Most of the time, we are faced with situations that want us to a rational informed decision, like

How much should I save today to get $2m when I retire?

How much should we spend on credit to not degrade our credit score?

Most importantly, an important part of our career as well, how much tax should I pay and how to invest properly to not pay taxes on our income?

It would be very hard for someone without appropriate financial knowledge to take correct decisions in all such concerns. On a career basis, one needs to plan out his career and based upon the plan, he needs to take the decision that can help him achieve his goals, like mentioned earlier, how much should I save today such that I have ` 2,00,00,000 when I retire? For someone who hasn’t heard about annuities and how things work, it wouldn’t be possible to take a decision. So financial literacy is equally important in our careers as well.

Today’s world is connected more than ever before so financially empowering people shouldn’t be as complex as it used to be. One can make people aware of hundreds of courses available online and encourage them to take them up, online forums on websites like Reddit or groups on Facebook can help people to spread awareness among people about the importance of financial literacy. Such methods are new and require people to connect with others to get benefitted. For people who fail to do so, the best way in the real world in organising workshops and meetups wherein people learn aspects of the financial world and express the issues they can face along with it.

A financially literate person can measure his/her long-term/retirement goal with ease and accuracy. He/she then can accordingly plan for a retirement fund and annual/monthly withdrawal during retirement as well as an inheritance at death. Thus, it can be said that financial literacy plays a very crucial role in the successful financial planning of an individual.

In the current scenario, more people are interested in tax-free investment/savings options. Thus, giving them knowledge about the non-traditional tool of investment and savings like SIP and mutual funds can help them to earn a better return on their investment and to create a larger retirement fund.

Even though, an individual is aware of high-yielding investment and savings options the investor does not use them due to their risk aversion. This is because these investment options carry risks higher than tax-free securities. Thus, a person with lower risk aversion does not use these non-traditional investment and savings options. Thus, individual characteristics affect retirement planning.

It is advisable, if an individual lack the much-needed financial knowledge and skills, they should not hide away from their lack thereof and go for professional help i.e., Financial Advisors. These financial advisors are there to assist you in making the most appropriate financial decision depending on the circumstances.

Thus, to summarize a financially literate person is

    • Much better prepared for the financial emergencies
    • More capable of achieving his/her financial goals
    • Much more confident in his/her financial decisions
    • Is less stressed out about the financial obligations

4. Financial Literacy Basic Vocabulary

4.1 Annual Percentage Rate

Annual Percentage Rate or APR is the rate which is paid by a person on the money borrowed in the course of a year. It is indicated in the form of a percentage.

4.2 Asset

An asset is something which holds monetary value i.e., it can be converted into cash. The purpose of an asset is to generate returns and create wealth. These assets can be tangible or intangible and include things like investment, real estate, cash, intellectual property, etc.

4.3 Bait and Switch

Bait and Switch is a type of retail sale fraud/scam where the seller tries to persuade customers by advertising deals which seem attractive but later on, are found to be non-existent or inferior and thus the buyer is offered an upsell. Such deals are too good to be true. It is an illegal trade practice and is subject to punishment when found guilty. However, it is very difficult to prove such malpractices, therefore the customers have to ensure vigilance on their part.

4.4 Bank

A bank is a for-profit financial institution which offers financial services to people which range from saving, borrowing, investment, etc. They are considered to be the key players in the dissemination of financial literacy and the promotion of financial inclusion.

4.5 Bankruptcy

Bankruptcy is a legal situation which arises when a person is not able to pay their debt or obligations. Under this, a legal proceeding is initiated where the assets of the person declared bankrupt are sold in order to pay off all the outstanding liabilities and obligations. It is also a fresh start for the people who are unable to honour their obligations.

4.6 Borrower

A borrower is a person who receives or uses something which belongs to someone else. The intention behind this is to return it bank within a specified time period often with some additional interest. For example, If a person takes a loan from a bank such person will be called a borrower of the bank.

4.7 Budget

A budget is a blueprint used to keep track of the income and expenses of an individual. People indulge in making budgets in order to ensure the appropriate utilization of their funds and to identify the areas where control is required. It is a major step towards financial discipline and attaining financial goals.

4.8 Comparison shopping

Comparison shopping is one of the popular strategies used by people to ensure efficient spending. Under this, while making a purchase customers indulge in comparing the alternatives which are available for the product they need to buy on different parameters and rank them. The one providing the most utility is preferred with the least cost being preferred. Every individual is advised to practice comparison shopping to stay financially disciplined and not indulge in impulse buying.

4.9 Credit

Credit is a financial arrangement between two parties where one party borrows the money and the other provided it. This facility helps people in making big purchases like car or house property which require a large sum of money and is very difficult to afford if require payment to be made in a single instalment. The cost is distributed across many years which reduces the financial burden on an individual. Examples of credit are credit cards and bank loans.

4.10 Credit card

A credit card is a card facility provided by banks and other credit institutions where the cards can be used to make financial transactions up to a certain limit for a specific time period say 1 month. All the credit accumulated after the specified time period can be paid off by the lender afterwards within a given time period. Default in repayment results in default charges. The credit is available till the card expiry date.

4.11 Credit report

A credit report is a document stating the credit history of an individual. It states all the important information about an individual’s credit position like pending loans, loans paid off, any default in loan repayment, etc. This report helps the lender to determine the customer’s credit score and depending on the score decisions are made regarding the availability and non-availability of the credit.

4.12 Credit score

A credit score is a three-digit number which represents the likelihood that the borrower will be able to honour their debt or not. It is calculated based on the information available in the credit report. In India, the credit score is issued RBI authorized companies like CIBIL, Equifax and Experian and it ranges from 300 to 900. The higher the score more is the chance of receiving credit at a lower interest rate. The ideal range of credit score is between 750 to 900.

4.13 Creditworthiness

Creditworthiness can be defined as the extent of confidence a lender can have in the borrower concerning his/her ability to loan repayment. It is determined based on how one has managed his/her past debts and obligations.

4.14 Debit card

A debit card is a card facility offered by banks to their customers for instant withdrawals of money from their savings accounts. It can be done through ATMs and micro-ATMs in rural areas. Since the amount is directly deducted from the bank account it does not cause any burden of debt on the customer. The banks charge a nominal fee for such a facility.

4.15 Debt

Debt is the money that is borrowed by one party from other. They can be in the form of personal loans, credit cards, car loans, home loans etc. They facilitate big purchases by individuals. Debt can be secured, unsecured, revolving, etc.

4.16 Default

Default is a situation where the borrower fails to honour his/her financial debt or obligation on the due date. Default is the second and more serious stage of non-payment that follows the stage of delinquency. Once a default happens, the lender reports it to the credit bureaus and sells it to the debt collection agency.

4.17 Emergency fund

An emergency fund is the pool of money which is kept aside for some uncertain events which may or may not occur and if they happen they have a detrimental impact on the financial well-being of an individual. These uncertain events include job loss or unexpected medical bills. The idle size of the emergency fund should be between 6 months’ salary to 12 months’ salary. It should be kept in liquid assets which can be easily converted into cash.

4.18 Expense

From an individual’s point of view, the expense is the amount of money which is spent by an individual on his/her livelihood. It included spending on food, education, travelling, housing, etc. One should make sure that his/her expenses are justified and not incurred on impulse, to ensure financial discipline.

4.19 Income

Income is the money earned by an individual through different sources like employment, business activity and investment. It is the main source of finance for sustaining one’s livelihood. Income can be classified into gross income and net income. Gross income is the total income earned irrespective of any costs. Net income is the total gross income less all the costs (expenses).

4.20 Interest

Interest is the certain percentage of the principal amount that the lender changes from the borrower for the loan facility. It can be classified into simple interest and compound interest. Simple interest is calculated on the initial principal amount borrowed. Compound interest is calculated on the principal amount as well as the interest accumulated throughout the years.

4.21 Need vs. Want

The essence of personal financial planning is the classification between need and want. The need is something which an individual cannot compromise i.e., such expenses are bound to incur like food, education, shelter, etc. Wants are something which an individual desire and they can be postponed like a luxury watch, designer bag, etc.

4.22 Opportunity cost

Opportunity cost is the value one loses while choosing between two or more alternatives. For example, an individual has to decide whether to sell his/her investment today hold it for some more time and then sell it. If he/she chooses to sell it now, the opportunity cost will be the value of gains which he/she could have earned if he/she held his/her investment for more time. It applies to any life situation.

4.23 Pay yourself first

Pay yourself first or PYP is a budgeting strategy where like food and rent, saving is also deemed as a need. While budgeting a certain sum of money is kept aside as saving and once all the needs (including saving) are met then only the person moves to satisfy wants. Thus, a certain sum of money is deposited in a savings account each month without compromise.

4.24 Predatory lending

Predatory lending includes all the lending malpractices like unfair and abusive terms and conditions, high and unjustified lending rates, high fees, etc. It involves the use of aggressive advertising in order to lure borrowers towards loans which are too good to be true and often force them to take what they don’t need, don’t want and can’t afford. Examples of the practice include predatory mortgages, payday loans, overdraft loans, excessive credit card debt, and instant tax refund loans.

4.25 Principal

The principal is the amount of money which is borrowed by an individual and needs to be repaid. It does not include interest.

4.26 Rule of 72

Rule of 72 is a quick and instant technique to estimate the amount of time (in years) it will take to double an investment at a given rate of interest. It is calculated by dividing 72 by the rate of interest. For example, if the rate of interest is 10% then the investment will double in approx. 7.2 (72/10) years. The time period estimated is in the presence of compounding.

4.27 Time value of money

Time value of money or TVM is a concept which states that the value of a rupee today is not the same as the value of a rupee in the future i.e., with time money loses its value or purchasing power. Thus, people prefer money today rather than tomorrow unless some added value is offered which compensates for the loss in value due to time.

4.28 Wealth

Wealth is the aggregate value of the assets held by an individual in his/her name. Wealth ensures an individual’s and his/her family’s economic well-being and financial security. Often wealth is confused with income which is wrong. Wealth is a stock concept whereas income is a flow concept. The net worth of an individual is a common expression of wealth.

The process of attaining financial literacy is never-ending. As the circumstances change, so does the required financial skills. So, it is advisable to start as early as possible, otherwise, there is no age limit to become financially literate.

Disclaimer: The content/information published on the website is only for general information of the user and shall not be construed as legal advice. While the Taxmann has exercised reasonable efforts to ensure the veracity of information/content published, Taxmann shall be under no liability in any manner whatsoever for incorrect information, if any.

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