Understanding the principles of financial literacy is key to unlocking financial freedom. In a previous post I answered the question What is financial literacy. In summary it is understanding how money and personal finances work. There are some basic principles of financial literacy that apply to everything. If you know these then you will have a good foundation to build on.
7 Key Principles of Financial Literacy
- Know how much money you earn
- Spend less than you earn
- Time value of money
- Effect of compounding
- The real cost of debt
- Pay yourself first
- Risk versus return
In the last post I explained the first 4, now lets look at the first last 3 in detail and see if we can answer the relevant questions.
The real cost of debt
- What are the different types of debt?
- Is there good debt and bad debt?
- What is a credit record and how does it affect me?
- How do loans work?
- How much interest am I paying?
Pay yourself first
- What does this mean?
- How can I pay myself first?
- How does it help me?
Risk vs Return
- What types of investments are there?
- Why is risk vs return important?
- How do investments work?
- Is it risky investing?
5. Understanding the cost of debt
Debt and buying on credit is such a common practice today. The most common are loans to buy a house or a car and consumer accounts for clothing or furniture and then credit card debt. It is very easy to get this debt and it allows you to buy what you want. The problem is that it is incredibly expensive. Usually, you are paying a huge premium, sometimes double the actual cost of what you bought.
Debt is expensive
The reason is the time value of money. If you borrow money today then you need to pay that money back in the future. The person or bank lending you that money is losing out on the interest. So they will charge you that interest to recover the value of their money. By the time you repay them you will have covered their interest lost as well as additional profit for them.
The longer the loan the more it will cost you and the higher the interest rate the more it will cost you. If you buy a house for R1M and pay it off over 20y at 9% interest then the total cost will be R2.159M . So you pay more interest than the price of the house.
If you buy a TV for R10 000 and pay it off over 2 years at 20% interest then it will cost you R 14 869. That’s 1.5 times more than the price.
Types of debt
Long term debt at low interest is just as bad as short term debt at high interest. Buying a house is long term debt and can be considered good debt as you are buying an asset, something that will maintain or increase its value over time.
Short term debt is for cars and consumer items, all of these items lose their value over time so they are regarded as bad debt. Credit cards are also bad debt. The reason is that you buy consumables or experiences that will have been consumed even before paying off the debt.
If you don’t manage your debt properly you can land up with a poor credit score. If you don’t know your credit score then you should find out what it is and how it works.
The payments that you make on a loan are made up of 2 portions, the principal payment and the interest payment. The principal is the amount you paid for the house. For our R1M house the payments over 20 years would be R8 997pm for 240 months, which adds up to R2.159M. The house cost is R1M and the interest cost is R1.159M.
For the first payment the principal portion is R1 497 and the interest portion is R7 500. Only after 149 months or 12 years does the principal portion become more than the interest portion. The last payment in month 240 the principal portion is R8 930 and the interest portion is R67. The graph below shows how in the first 12 years you are mainly paying interest, then only after 12 years do you start paying off more of the actual house value.
As you can see debt can be very expensive. The interest cost can be high and will increase the cost of your purchase significantly.
Debt should be completely avoided for smaller items like clothing, furniture and holidays and even extended credit card debt. Debt does allow us to by items that cost a lot of money like houses and cars. But this should be used very carefully and fully within your affordability range. Always buy using as big a deposit as possible with the ability to pay off this debt as fast as possible.
Debt should always only be a temporary state. You should be working to a situation where you are debt free and never have to use debt again for anything. This is one of those principles of financial literacy that you cannot ignore.
6. Pay yourself first
I am sure that you have heard the saying pay yourself first, but what does that mean.
There is a well know quote from Warren Buffet that goes “Do not save what is left after spending, but spend what is left after saving”.
If you have a pension fund or RA with a company then you are halfway to paying yourself first. I bet you don’t even realise it. You have that gross salary but a portion of that is deducted immediately, even before the money hits your bank account. That is called paying yourself first. Problem is this is just the bare minimum that you need.
We work hard for the money that we earn every month. Yet it only takes a few days for that money to disappear after month end. Then you wonder how are you supposed to save any. The trick is to plan upfront and plan your saving before all the money runs out. Principles of financial literacy like this can make a world of difference.
Our main priorities seem to be to pay the bills for living expenses, buy food and then by stuff for ourselves. Yet we all know that we should be saving for emergencies, planning for our retirement or even just saving up for that special holiday. But because these aren’t planned and left to the end we don’t have money left.
You also need to be building that emergency fund, supplementing your retirement savings and planning for kids’ education and possibly holidays. So work out your budget and allow for some of this money. Then set up an auto transfer to a savings account or to an investment account as soon as you get paid.
Besides the discipline of this practice it will also serve as an automatic brake on your spending. You won’t have any idle cash sitting in your account waiting to be spent. When you look at your account it will be emptier and you will know that you can’t just spend. It’s a trick to make you feel like you don’t have money to spend when in fact you have saved and invested it.
7. Risk and return
The risk with money is that we will lose it if we don’t look after it. Everybody wants to make more money but that too comes with risks. When it comes to investing there is a simple rule, the higher the return the higher the risk. When it comes to principles of financial literacy then risk and return can mean success or failure.
Comparing Investment Risks
The least risky is to keep your money in a safety deposit box, but then you get no return. Keeping your money as cash in the bank is the next least risky, but the interest rates are low so your returns are low too. The highest returns come from equity, investing in company shares on the stock market, but this is the highest risk too. The graphic below shows how all the different investment options relate to each other.
The low risk options are also usually the easiest to understand. Like a deposit in a savings accounts, you deposit the money, the bank guarantees you 5% interest and you get paid this interest every month.
Equities are more complicated, the return is not guaranteed, if the company performs well and the economy is doing well then you will have a fantastic return. But if the company does badly or the economy fails you could have negative returns so you lose money, that is the risk that you take. The complexity comes in knowing how to choose the right equities.
If it sounds too good to be true it usually is
A good rule of thumb to remember is if it seems too good to be true it probably is. So don’t trust any investment that says there is no risk but guarantees huge returns. Also if you don’t understand how the returns are possible then it is too risky for you. You have to balance the risk with the returns to suit your comfort and knowledge levels.
Don’t be put off by the risks, they can be mitigated by understanding, doing your homework and investing for the long term. Equities especially are volatile and risky in the short term, less than 5 years. However over the long term they are less risky and more consistent in their returns.
Investing your money wisely is a critical part of achieving wealth. Remember the compounding effect? Well this is how you harness that by investing your money.
Unlocking Financial Freedom
If you can grasp all of these principles of financial literacy then you are well on your way to creating wealth. The ultimate goal of most people is to achieve financial freedom. This means that you are financially independent of earning a salary every month.
You will have enough money to cover your expenses without having to work. Either you have saved up enough money to live on until you die, or your money provides you with enough income to cover your monthly expenses.
This is just a brief introduction to some of the most important principles of financial literacy. There are many more and each of them is a subject on their own. Knowing and understanding these principles has helped me to take control of my finances and plan for financial freedom. It is now up to you to go and find out more about these and implement them.
You shouldn’t take any of this as advice, consult a professional financial advisor for that. This is merely what has worked for me and my experience. Comment below on what have been the most important principles for you in improving financial literacy.