What is financial literacy and why does it matter?

A worrying number of Canadians are stressed about their finances. Almost half of them are struggling to pay for day-to-day expenses, due to rising costs, and a large number of Canadians have a low level of financial well-being (confidence in their finances, now and in the future).

Not surprisingly, almost 50% of people on a low income score poorly when it comes to their financial well-being. This lack of financial confidence is not limited to low-income families, however. Of people with significant incomes (between $100,000-150,000), close to 20% also have a low score for financial well-being. Even a small percentage of high-income Canadians (around 3% of those with over $150,000 income) have low financial well-being.

Thankfully, having financial insecurity and a lack of financial confidence are not problems without a solution. Financial literacy (and the good habits it brings) can play a large part in improving anybody’s financial situation.

In this article, we’ll comprehensively answer the question: “what is financial literacy?” We’ll take a deep dive into what issues you could have if you have little or no financial literacy, the steps you can take to improve your financial literacy and some useful resources to help you start your financial literacy journey.

What is financial literacy?

Financial literacy consists of knowledge and a range of skills (and the habits that they can form) that help you to consistently make the right decisions around a large assortment of financial issues. This includes debt management, saving, budgeting and investing, among others.

These financial literacy skills give you the confidence to better navigate the world of finance, to improve your financial situation and boost your financial confidence. Without a decent level of financial literacy, you could come up against a wide array of financial challenges, including:

Not hitting your financial goals.
Struggling to save.
Dealing with mounting debt.
Paying bills late and damaging your credit score.
Being unable to cope with a financial emergency.
Having insufficient retirement savings/retirement income.
Struggling to be able to afford a home.

Thankfully, you don’t need a degree in finance or economics to have a good level of financial literacy. Below are the various ways to get a better understanding of personal finance and reach a much higher level of financial well-being and confidence.

How to improve your financial literacy skills

Improving your financial literacy won’t happen overnight, but if you take it step by step, you’ll soon start feeling more confident. These are some of the key areas you should focus on:

Budgeting, saving and reducing expenses

One of the most basic and important aspects of financial literacy is budgeting. Without a monthly budget, you’ll never know how much money you’ve got coming in or what you spend it on. Also, without a budget, the chances of spending more than you earn and getting into debt are far higher, while saving money can be impossible.

You can start budgeting by working out exactly what your income is (your take-home pay) plus your fixed expenses (such as your mortgage/rent and auto payments), variable expenses (such as groceries, gas, car repairs, credit card payments) and discretionary spending (all the fun stuff, such as meals out, sports events and concerts).

Once you subtract all your spending from your income, this will be the number you’ll work with to grow your savings and reduce your debt. If that number is small, or negative, then you need to either increase your income, reduce your expenses, or both.

There are numerous saving apps that make budgeting much easier. You can input your savings goals, track your bill payments and even receive fraud protection alerts. Most of these apps offer a free trial, and some offer a free version.

Find out more about budgeting in this in-depth article, How does budgeting work?

Paying bills on time and managing credit

Having a good credit score is a crucial part of financial well-being, and learning how to build it up is a key component of financial literacy. When you have a good credit score, you have far more borrowing options and are likely to pay considerably lower interest rates on any loans.

Conversely, having a poor credit score could make getting a mortgage very difficult or lead to being offered only higher interest rates for loans. One of the key ways to have a good credit score is to pay all your bills on time, every time. You can set up automatic bill payments with your bank or credit union, so you can avoid missed payments.

You can find out more about how to keep tabs on your credit score, how credit scores work and tips on how to improve your credit score in this article, What’s a good credit score in Canada?

Creating financial goals and a plan to reach them

This is where financial literacy gets serious. There’s no point in improving your financial knowledge and expertise if it doesn’t take you somewhere. Everybody should have financial goals, whether they’re saving for a down payment on a home, building up savings for your child’s post-secondary education or ensuring that you have a comfortable retirement.

It’s unlikely you’ll reach any of those goals without a realistic plan to back them up, however. A comprehensive financial plan will include ways to reach all your financial goals, including where the money will come from to save for them.

Discover all the details that go into a financial plan, how it helps you to achieve your financial goals (often faster), how it helps you achieve greater financial confidence, and how to get started in this article, What is financial planning? And why is it important?

Dealing with emergencies and the unexpected

A lesser-known aspect of financial literacy is being prepared for emergencies. The best laid financial plan can quickly fall off the rails if you’re not fully prepared to deal with anything that might come your way. This could be a major expense, such as needing a new roof, car or furnace, or an unexpected situation that puts your income at risk, such as a long-term illness or the death of a spouse.

Building an emergency fund is crucial to enable you to cope with any major financial emergency and keep your financial plan on track. Similarly, insurance can help you to overcome whatever challenges life may throw at you.

You can find out more about why an emergency fund is crucial, how much you need to save, how to save those funds and the best place to keep it in this article, Why you need to build an emergency fund.

And you can learn more about the types of insurance available, such as life insurance and critical illness insurance, and how they work, in this article, What kind of insurance do you need? Your life insurance needs typically change as you age; find out in what ways in this article, Five key milestones that call for life insurance. You can also learn about how an insurance strategy helped people at key moments in their lives, in our Lifelines of Advice series.

Many people don’t realize that insurance is not just essential for coping with the unexpected. It can also be used when you’re planning your will, to leave more money to your loved ones, make it more tax efficient and ensure that it’s fair to all of your beneficiaries. Read Life insurance is not just for emergencies to find out more.

Managing loans and debt

People with limited or no financial literacy can easily fall into high-interest debt, which can quickly build up and become overwhelming. Credit card balances, store cards and high-interest loans can make it difficult to get out of debt and put more money aside for savings.

Thankfully, there are financial strategies that can help you to reduce your level of debt. A key strategy is debt consolidation. This involves taking all of your high-interest debts and paying them all off by taking out a loan with a much lower interest rate.

There are several loan options that can help you to do this:

Home equity line of credit (HELOC).
Personal line of credit.
Debt consolidation loan.
Mortgage refinance.

For example, let’s say you owe $20,000 on a combination of credit and store cards, with an average interest rate of 22%. You’d need to pay $4,400 per year (or $367 per month) just to pay the interest. Here’s an example of how you could pay off this debt with a debt consolidation loan.

Let’s say you take out a loan of $20,000 with an interest rate of 7% and a term of six years (the length of time it would take to pay it off in full). Term loan payments would include both interest and principal payments (the amounts of your loan payment that go toward reducing the debt total). Therefore, your interest payments would be reduced each year as your total debt drops. Even in your first year, your interest payments would be well below $1,400, a far cry from $4,400.

Over the six years, your debt consolidation monthly payments would be $341 (less than you’re currently paying in interest only) and you’d pay off the entire debt in six years.

Let’s look at other options. If you’re a homeowner, you might be able to take out either a home equity line of credit (HELOC) or a mortgage refinance. A HELOC is a loan whereby you can borrow up to the maximum amount agreed by your financial institution. This amount will depend on how much you owe on your mortgage and how much equity you have in your home (equity is the value of your home minus any debts you owe against it, such as your mortgage).

Lenders will usually lend you up to 80% of the value of your home, minus your outstanding mortgage balance. The agreed amount then acts like the credit limit on your credit card; you can borrow as much as you like, up to the agreed limit. You can choose to make interest-only monthly payments or more (so you also pay down the borrowed amount).

Key advantages of a HELOC are that interest rates are usually very low (typically second only to mortgage interest rates), and repayments are very flexible.

With a mortgage refinance, when it comes to renew your mortgage, you may be able to take out a larger loan and use the extra money to pay off your debts. That money gets absorbed into your mortgage, leading to lower interest costs and smaller debt repayments. You gain by switching from high-interest debt to typically the lowest-interest-rate debt available. You also get to make debt payments over a longer period of time, which can make the debt far easier to manage.

You can find out more in these articles:

Investments and retirement planning

We can’t discuss financial literacy without mentioning investing. Having even a basic understanding of investing can go a long way to building an effective retirement plan. Some of the key strategies of investing (especially when you’re saving for retirement) are to start early and to diversify your investments. Starting early allows you to maximize the benefits of compound interest, as your investment growth accelerates significantly over time.

Diversification is the process of holding a wide range of assets to reduce potential risk. If you owned shares in just a handful of companies, and one company were to fail, you could lose a significant amount of your overall investments.

To diversify your investment portfolio, you’d want to consider holding assets from different geographical regions, different sectors (such as IT and health care) and different company sizes. A convenient and cost-effective way to have immediate diversification is to invest in mutual funds and/or exchange-traded funds (ETFs). These funds are like a basket of often hundreds or even thousands of different company shares.

To find out more, read this article: Diversifying a stock portfolio in Canada. And you can learn all about mutual funds here and ETFs here.

You would also want to hold your investments in the most tax-efficient accounts, such as a tax-free savings account (TFSA) and a registered retirement savings plan (RRSP).

A TFSA allows your savings to grow tax-free. Typically, investments grow from a combination of interest earned, dividends (these are payments made by some companies to its shareholders) and capital gains (the amount that your investments grow in value). By holding qualified investments in a TFSA, you’ll pay zero tax on any of the growth.

You can read more about TFSAs in our article, What is a TFSA? And why it should be part of your financial plan.

When it comes to saving for your retirement, an RRSP is extremely useful. Every dollar you save in an RRSP reduces your taxable income by a dollar. This means you typically receive a tax refund, which you can in turn put into your RRSP. Your RRSP investments grow tax-free for as long as they remain in the account.

You can learn more about how RRSPs help you to grow your retirement savings faster in our article, What is an RRSP and is it right for you?

Retirement planning isn’t just about saving for a comfortable retirement. It also involves building the most tax-efficient retirement income portfolio possible. By carefully structuring the way your portfolio is built and the way you withdraw from your savings (for example, a combination of interest, dividends and principal) you can reduce the amount of tax you’ll need to pay and maximize your retirement income. You can find out more about retirement planning here.

Taxes

Understanding how taxes work is a key part of financial literacy. Knowing how to file your taxes correctly (and doing so annually and on time) is crucial. It will not only ensure that you stay on the Canada Revenue Agency’s good side (you could be charged a substantial penalty for filing late) but it also opens up borrowing opportunities.

For example, whenever you apply for a mortgage, you’ll typically need to provide your last two years of tax returns to the lender. Your mortgage application could be turned down without them, so it pays to keep up to date with your taxes. An accountant or tax filing professional can help you to file your taxes, while ensuring you pay the least amount of tax legally possible.

It’s also important to know how to minimize the taxes on your investments and other assets. We’ve already mentioned the tax advantages of RRSPs and TFSAs, but understanding the different levels of taxation in investments can also help you to keep more money in your pocket.

There is also an array of tax-saving strategies that can be used to lower your tax bill; to find out more, read our article, What to focus on for year-end tax planning.

Estate planning

Estate planning is a crucial part of financial literacy. Some of its key components include:

Writing a fair and tax-efficient will.
Choosing an executor for your will.
Naming a power of attorney for health and financial decisions.
Using charitable donations to reduce taxes.

You can learn more on our webpage, Why estate planning is crucial.

Housing

Improving your financial literacy can help you understand how to save for a down payment on a new home faster (read all about the First Home Savings Account here), which kind of mortgage is a better option for you (learn about fixed vs. variable rate mortgages here) and what matters beyond getting the lowest mortgage rate (for example, prepayment privileges and portability).

Few people are aware that your mortgage should play an integral role in your overall financial plan. You can learn about the difference between a mortgage and mortgage strategy here.

Boost your financial literacy with these resources

For people looking to improve their financial literacy, there is a wealth of information available. Here are some resources to get you started:

How an IG Advisor can help you improve your financial literacy

Your IG Advisor can help you to improve your financial literacy and become more comfortable and confident as regards your finances. However, they also go much further, helping you to manage every aspect of your financial life, including:

Managing your cash flow (including budgeting and debt management).
Retirement planning (including building an investment portfolio).
Preparing for the unexpected with a tailor-made insurance strategy.
Planning for major purchases (such as a down payment on a home).
Estate planning (including your will, powers of attorney and charitable giving).
Introducing tax efficiencies into every aspect of your financial life.
Integrating home ownership into your financial plan with a mortgage strategy.
Maximizing your business’s success.

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