1 Financial Literacy
CHAPTER
LEARNING OUTCOMES
The learning from this chapter will enable students
get familiarized with the concept of financial literacy
know why financial literacy is important for every individual
understand the basic terms associated with financial literacy
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 dictio-
nary, 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 bank-
ruptcy 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.
FINANCIAL LITERACY
Financial literacy refers to the knowledge and understanding of various finan-
cial 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.
1.3
1.4 UNIT 1 : FINANCIAL PLANNING AND FINANCIAL PRODUCTS
Financial decisions are something which an individual is bound to make through-
out 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”.
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 financ-
es 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 deci-
sions. 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 expendi-
tures, 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 ed-
ucation 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
CH. 1 : FINANCIAL LITERACY 1.5
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 bene-
fitted. 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 op-
tions 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.
1.6 UNIT 1 : FINANCIAL PLANNING AND FINANCIAL PRODUCTS
Thus, to summarize a financially literate person is
u Much better prepared for the financial emergencies
u More capable of achieving his/her financial goals
u Much more confident in his/her financial decisions
u Is less stressed out about the financial obligations
FINANCIAL LITERACY BASIC VOCABULARY
Annual Percentage Rate
Annual Percentage Rate or APR is the rate which is paid by a person on the mon-
ey borrowed in the course of a year. It is indicated in the form of a percentage.
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.
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.
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.
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 out-
standing liabilities and obligations. It is also a fresh start for the people who
are unable to honour their obligations.
CH. 1 : FINANCIAL LITERACY 1.7
Borrower
A borrower is a person who receives or uses something which belongs to some-
one 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.
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.
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.
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.
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 spec-
ified 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.
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
1.8 UNIT 1 : FINANCIAL PLANNING AND FINANCIAL PRODUCTS
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.
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.
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.
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.
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.
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.
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 in-
clude job loss or unexpected medical bills. The idle size of the emergency fund
CH. 1 : FINANCIAL LITERACY 1.9
should be between 6 months’ salary to 12 months’ salary. It should be kept in
liquid assets which can be easily converted into cash.
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.
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).
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.
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.
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 choos-
es 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.
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Pay yourself first
Pay yourself first or PYP is a budgeting strategy where like food and rent, sav-
ing 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.
Predatory lending
Predatory lending includes all the lending malpractices like unfair and abu-
sive 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 pred-
atory mortgages, payday loans, overdraft loans, excessive credit card debt, and
instant tax refund loans.
Principal
The principal is the amount of money which is borrowed by an individual and
needs to be repaid. It does not include interest.
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 cal-
culated 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.
Time value of money
Time value of money or TVM is a concept which states that the value of a ru-
pee 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.
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.
CH. 1 : FINANCIAL LITERACY 1.11
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.
REVIEW QUESTIONS
1. What do you mean by financial literacy?
2. Why is financial literacy important?
3. Explain the following terms.
a. Comparison Shopping
b. Predatory Lending
c. Pay yourself first
d. Bankruptcy
e. Opportunity Cost
f. Bait and Switch
g. Rule of 72
PRACTICAL EXERCISES
1. You just started this course on financial literacy, so you must be curious
to know that if being financially literate is so important then are people
doing something about it. Thus, you are required to conduct a financial
literacy survey and see how it differs among different demographics.
2. Raj is your friend. He informed you that he wants to buy a laptop. When
you asked which laptop he wants to buy and how he arrived at the deci-
sion, he informed you that he selected it randomly without any research.
Since you just started with the course of financial literacy in your cur-
riculum, his approach didn’t fit you well. You are required to explain to
him the importance of comparison shopping and why thorough research
is important. Also, assist him in performing the analysis and arriving at
the final choice. Document the whole process. (Classify all the available
alternatives based on their attributes and rank them according to his
preference).
