Understanding financial literacy - Here is what you need to know
Share this article:
By Rita Cool
Financial literacy is more than understanding how to work out a percentage, it is understanding how your finances impact your life. There are four fundamental pillars to financial literacy – debt, budgeting, saving and investing – which you should understand before you can achieve financial well-being.
Earning - The money that you receive for doing work, passive income from investments or annuity income from other sources. You don’t only earn by selling your time or goods but by earning dividend income, interest or commission. The more you earn the more you potentially have to spend.
Saving - This is creating a safety net by having money available in an emergency. Mostly done in a bank account, Money Market account, Tax Free Savings Account (TFSA) or access bond where the money put aside could get a positive return, e.g. interest gained or interest saved on bond repayments. Savings should not be exposed to volatile investments as you can’t take the risk that your money is less than what you put away just when you need to use it. Ideally this could be between 3-6 months’ worth of salary, so that if something happens where you can’t earn an income, or you need money for an expensive car repair, you don’t go into debt. Saving can also be used for short term purchases, for example to replace a fridge when it breaks so you don’t have to buy on credit which saves you the interest payments. Or you can save for a short term goal like a holiday.
Investing – This is normally done for a longer period and the value of your investment can go up or down, depending on what you have invested in. You can invest in a company privately or invest in shares of a company. You can also make use of a product through a Linked Investment Service Provider. These are companies that invest in a range of assets on your behalf through products like unit trusts, preservation funds, Retirement Annuities or TFSA. Your retirement funds are also invested and your retirement savings are therefore affected when the financial markets go up or down.
Spending - Everyone has expenses and has to spend some of what they earn. The trick is how you spend your money. Do you have a budget of what needs to happen with your money or do you spend everything you see in your account?
Borrowing - In most cases you should try to avoid borrowing money but it can also be beneficial in the correct circumstances. Borrowing money because you can get more return than the cost to borrow it is called leveraging. You can borrow money to buy a house that will increase in value over time and that gives you an asset over time. You can also borrow money to buy a company or to expand an existing one.
Protecting - In all cases you should protect your assets as well as income. You can take out insurance which pays in the event of your asset being stolen or damaged. You can take out life cover to give your family an income in the event of your death or take out disability cover to protect your income if you get sick and can’t work.
Budgeting - A budget is a list of all your fixed and flexible expenses set off against all your income to see if you have enough money to pay for everything each month. If you don’t have enough income you either have to cut your expenses or earn more. This is like splitting a cake between everyone who you need to pay. Don’t promise future cake so that eventually there is no future cake. Fixed expenses can’t be changed - like a bond or rent, car repayments and school fees. Flexible expenses are things that can change like entertainment and food. Don’t forget haircuts, car registration fees, monthly bank charges or birthday gifts. Remember to budget to pay yourself first by saving for retirement. This should also be a fixed expense. This does not mean treating yourself with gifts but investing in your financial security and financial future.
Interest Rate - This is the cost of borrowing money or lending money. If you borrow money you have to pay the lender interest. This can be a fixed rate or linked to the prime rate. You also get paid an interest rate for a positive bank balance and if you invest in bonds you get a fixed interest rate, or coupon rate. You will always get less interest for money you lend than for money you borrow. So don’t sit with money in the bank while you have expensive debts. Pay off your credit card or personal loans with this money. If the money in the bank account was your safety net, your paid off credit card could be your safety net in an emergency but until then you have the benefit of not having to pay high interest rates on the outstanding credit card.
Interest is normally shown as a percentage which means “parts of a hundred”. Cent means 100, the same as there are 100 cents in a Rand. As an example, every R100 you borrow you have to pay back another R9 on top of the R100. On a bond of R100 000 your interest each year that you owe that money is R9 000, or R750 per month. You also still have to pay back the R100 000, so the interest you pay to borrow money makes the overall purchase price of an item much more expensive.
Compound interest - This is the benefit of getting interest on interest or growth on growth. At the beginning it doesn’t look like your money is growing that well but over time, if you reinvest the growth your investment grows faster and faster without you having to do extra work.
Debt - If you have a lot of debt, the interest you pay becomes very expensive and eventually it is possible that you can’t pay off all the debt repayments. If this happens you need to work out a debt repayment plan. It is possible to consolidate your debt to reduce monthly payments, but this is only achieved because the loans are paid over a longer time and in the end you pay even more in interest. Your debt doesn’t reduce by consolidating it, it increases. If you can work out a debt repayment plan it might be possible to pay your debt sooner and therefore cost you less interest, than if you consolidated your debt.
Rita Cool is a certified financial planner at Alexander Forbes