Financial literacy is one of the most important skills to learn in today’s world. However, it’s not one that’s always thoroughly talked about in schools, though we are slowly but surely improving on that front as time goes on.
However, that’s not going to be of much help to those of us who have already left school. Thankfully the proliferation of blogs, podcasts, YouTube channels, and other outlets have given people easy ways to learn more about finance outside of the traditional education system.
Today I’m going to show you why that is so important. Let’s talk about just how big a difference becoming financially literate can be for your life.
What is financial literacy?
The dictionary definition would define financial literacy as the possession of the set of skills and knowledge that allows an individual to make informed and effective decisions with all of their financial resources.
In plain English, it is the ability to figure out what financial decisions are likely to lead you to achieving your financial goals and having the ability to act on that knowledge.
So, how do we become financially literate? Assuming that you did not get enough financial education in school you will need to take things into your own hands. You do this by exposing yourself to new ideas from as many people and perspectives as you possibly can.
Read books, take classes, watch videos or look at blogs related to money just like you are now. Any of these can have very positive effects on your financial situation both in the present and future. They can introduce you to new ideas that you may not have come across on your own.
These may lead to you saving or making more money or even finding new passions. These outlets can reassure you during uncertain times that the world isn’t coming to an end and this too shall pass. This can be particularly helpful during less than ideal times.
They can encourage you when things are going well and help keep you motivated to continue working towards your goals. And perhaps most importantly (especially if you’re just starting and didn’t get much financial education when you were growing up) they can introduce you to so many new possibilities that get you excited about researching finance, that’ll get you thinking about what you can accomplish in your own life with your resources.
Statistics relating to the average American budget
Before we get into an example showing how big of a difference even a moderate level of financial literacy can make let’s discuss some statistics relating to the average American budget. Some light rounding has been done, but this should give us a general idea of what the typical American spends money on.
According to data gathered by the Bureau of Labor Statistics’ Consumer Expenditure surveys, the average American household spends almost $20,000 a year on housing costs. These costs include mortgage or rent payments, utilities, maintenance and repairs, property taxes, and other related fees. The median price of a home is approximately $300,000.
The average rent for a 1 bedroom apartment nationwide is $950, 2-bedroom apartments will run close to $1,200 a month. Transportation is the next largest category and it costs the average American about $9,000 annually. These costs include fuel, maintenance, repairs, public transit, plane tickets, and other related transportation expenses.
Food costs about $4,000 and dining out costs about $3,150. Healthcare costs about $4,600 a year. That includes health insurance as well as prescription medication, doctor visits, and other health-related expenses. We spend around $2,500 a year on personal care and clothing.
The clothing portion of that cost also includes related services such as tailoring and dry cleaning. We also spend almost $3,000 a year on various forms of entertainment like cable, concerts, movies, and subscription services.
Insurance costs can vary widely depending on your level of coverage and what type of insurance you’re looking for, but here are some rough averages. Renter’s insurance will run you about $180-$200 a year. Homeowners insurance averages between $1,000-$1,100 a year.
Term life insurance averages around $2,000 a year and whole life policies can be upwards of $5,000 annually. However, like I said this can vary quite a bit depending on what you’re going for.
Finally, giving and miscellaneous expenses amount to around $2,000 and $1,000 a year respectively.
The reason I bring these statistics up is it’s what we’re going to be basing most of the expenses of our first couple on.
The importance of financial literacy
In this example, we’re going to be looking at two couples who have just graduated from high school and are looking to start college at the end of the summer. They will both start with no debt to speak of and will be able to work all summer before starting college.
They will both earn the same amount of money from their jobs before, during and after school. In both cases, they will be earning $12/hr from their summer and school jobs and will have $60,000 a year in household income from salary after graduation.
As for other expenses, they will each be getting new cars once every 7 years. Our first couple will be buying new cars while our second couple will get their cars used. Both couples will be getting homes, but our first couple will be lucky enough to receive a full down payment as a gift from their parents while our second couple will have to save for the down payment themselves.
Where saving money is concerned, both couples will try to have enough money on hand to purchase their next cars outright. However, as you’ll see this won’t be possible all the time.
The down payment money will also go into savings for our second couple. The money that is put into savings will earn 2.5% in interest. The rest of the money that doesn’t need to be spent or saved will be invested. The money invested will be earning 8% interest. There will also be a dollar-for-dollar match for the first $1,800 invested each year. This equates to roughly 3% of our couple’s salaries.
The net worth of each couple will be determined by how much they have saved and invested. It will not include the value of their home, but I will mention those at the end separately. With that out of the way, let’s get into the example and see just how big of a difference financial literacy can make on our lives.
Bill and Mary
Bill and Mary have just graduated from high school and are looking to go to college. As I mentioned, they will work the summer after graduating from high school and during college for $12/hr. During summers, they work full time and during the school year, they work 20-hours per week. Therefore, Bill and Mary make about $10,000 the summer before college and $31,200 a year combined while going to school.
Once Bill and Mary graduate they will get new jobs that each pays $30,000 a year for a total household income of $60,000 annually. Bill and Mary attend 4-year universities in state which cost them about $25,000 per year to attend. These numbers are based on averages gathered by valuepenguin.com.
The $25,000 per year includes all tuition, fees, books, and other expenses relating to their education. Between food, transportation, and the occasional fun night out Bill and Mary spend an additional $850 a month. Therefore, in total, they spend just over $60,000 a year while in school.
Four years go by and unfortunately for Bill and Mary they racked up a lot of students’ debt. All told, they will graduate with over $100,000 in student loans. Assuming 4.5% interest their student loan payments will be over $1,000 a month! After graduating from college, Bill and Mary’s budget looks similar to the average American budget in most respects.
They spend around $20,000 in housing costs, $9,000 on transportation, $4,600 on healthcare, $2,500 for clothing and personal care, a little over $7,000 for food and dining out, and about $1,000 for miscellaneous expenses. In total, they spend everything they make. However, there are still a few things worth noting. First is their insurance bill. They will spend about $6,000 a year for all their insurance. This is because they have a whole life insurance policy (which is generally more expensive dollar for dollar than term life), pay homeowner’s insurance (which is generally more expensive than renter’s insurance since there’s more to cover), and have two cars to insure.
Another thing to notice is that they aren’t doing any charitable giving, saving, or investing because they can’t afford to with their other expenses. Lastly, their entertainment budget is essentially zero. They had to cut that to make their debt payments each month. Unless they were to find some other source of income or slash their current expenses somehow, this is likely to be how they live for the next several years.
At the age of 33 Bill and Mary’s student loans are finally paid off. As a result, their expenses drop to about $50,500 a year. This also means that they can finally increase their entertainment budget. I’m going to assume that from this point forward they spend right about the average of $3,000 a year on entertainment.
20 years later at the age of 53, their home is paid off which drops their housing cost significantly. Based on their $240,000 mortgage and assuming a 3.85% interest rate (which is right about average as of the time of this writing) for a 30-year loan, Bill and Mary’s annual expenses will fall to about $39,750 a year. 40 years after graduating from high school Bill & Mary will have a paid-for home.
They will no longer be financing their cars and will have a net worth of $75,000. Additionally, they bought their home for $300,000 with the help of their parents 34 years ago. They haven’t moved since, which is pretty unusual but it certainly has helped them financially.
Assuming the value of their home grew by 3% per year their home would be worth $820,000 today. So between their savings, investments, and home, they are worth a whopping $895,000! That’s pretty good considering they carried so much debt that they couldn’t save for the first several years of their careers.
But how much better could they have done if they played their cards a little differently?
John and Jane
Let’s find out by comparing them to John and Jane. John and Jane may not have all the answers but they have researched personal finance and investing. They have learned enough to make some different choices than Bill & Mary did. The first difference comes in the form of where they go to school.
Bill and Mary graduated from high school and went straight to a 4-year University. John and Jane decide to get their first two-years done at a local community college. As it turns out this is a lot cheaper. According to data from valuepenguin, the average cost of a community college is $4,800 per year.
Therefore, John and Jane will be spending $9,600 per year between the two for their first two years of college. They will then transfer to a 4-year university to complete their bachelor’s degree just like Bill and Mary.
This will cost them the same $25,000 per year, per person as it did for Bill and Mary. In total, their college education will set them back almost $120,000. That’s certainly a lot, but it’s far more manageable than the $200,000 than Bill and Mary spent on their education.
Assuming their non-education expenses and incomes were the same as Bill and Mary, John and Jane would graduate with about $20,000 in student loans. However, this is where we see the second difference between the path Bill & Mary took and the one John and Jane are taking.
John and Jane noticed that their salaries weren’t going to be able to pay for their college in full so they decided to start researching how to make money outside of a job. They learned about side hustles and eventually started one where they flip items on places like the Facebook marketplace for a profit.
They net about $12,000 from this side hustle and since it doesn’t take much time they will continue doing it after graduation. John and Jane graduate and get jobs that pay them a combined $60,000 a year.
With their side hustle, this makes their household income $72,000 annually. However, the differences between John and Jane’s working life and that of Bill and Mary’s doesn’t stop there.
John and Jane want to supercharge their finances while they’re young and able to get the most out of compounding interest. There’s also something to be said about spending more of their money on things that they care about most. As a result, they decide to save on big-ticket items like housing and transportation.
John and Jane don’t buy a house right after graduating from college. They make good money but haven’t had a chance to finish paying off their student loans or save up a good down payment yet. However, they still want to keep their housing costs down, so they find some roommates to get an apartment with.
As I said earlier, the average rent for a 2-bedroom apartment nationwide is a little under $1,200 a month. If we assume John and Jane split the costs evenly with their roommates and also assume that utilities and other apartment related expenses add another $400 a month onto the total housing costs then John and Jane’s portion of the costs will be $800 a month.
$800 a month for housing costs is $9,600 a year which is about $10,000 less than the typical American pays for shelter. To save money on transportation, John and Jane buy one used car for the two of them and they buy it with cash. This will mean that they have to look for carpooling options to work, either with coworkers or by taking turns dropping each other off, but for now, that’s okay with them.
The next time they’re shopping for cars they can get one for each of them. This strategy accomplishes a couple of things. First, they only have one car to repair and maintain. And second, they only have one car to pay insurance on. Statistically speaking, the average American household has about 2.6 cars. So I don’t think it’s beyond belief that John and Jane could cut their transportation costs in half with this strategy.
With the insurance and transportation savings, this strategy keeps approximately $5,000 a year more in John and Jane’s pocket when compared to Bill and Mary. The last strategy John and Jane used to save money is to limit the amount of times that they eat out. As I said, the average American spends over $3,000 a year eating out and $4,000 on groceries. By limiting their dining out expenses John and Jane’s total food costs come out to about $5,000 a year. While most of the money John and Jane saved with these strategies go toward their investments, some will go to savings and other things. John and Jane will need to save $20,000 every 7 years to pay for their new cars and will need $60,000 for a down payment on their future $300,000 home.
The home will be on a 15-year mortgage with an interest rate of 3.3% (once again the rough average for 15-year mortgages as of this writing). The monthly payment will be just shy of $1,700. We had Bill and Mary get their home right out of college at the age of 23. I will have John and Jane get their house at the age of 27 since that’s when they would’ve saved up enough to make the down payment.
They will also rent out their unused rooms to help offset the cost of housing. Their rental income is assumed to be $500 a month. John and Jane will be spending $1,700 a year on entertainment (which is the average amount spent on entertainment minus the expense of cable).
They will be giving $2,000 to causes they believe in. And they will also be investing $2,000 a year toward their kids’ future college fund starting when he or she is born and continuing until he or she turns 18. The investments will be in an ESA for their son or daughter can withdraw the money for college tax-free. I’m going to assume that their child is born the year they move into their new home.
Everything else will be kept the same as it was in Bill & Mary’s example. Based on this scenario John and Jane would have their home paid off when by the time they’ve turned 43. This will lower their annual expenses by about $20,400 a year. Two years later their son or daughter will graduate from high school with over $80,000 sitting in his or her college fund.
This means that John and Jane no longer need to save money into the ESA which lower their annual expenses by an additional $2,000. And 40 years after John and Jane graduated from high school they have a paid-off home, a kid who has graduated from college mostly, if not entirely, debt-free, and a whopping $4,500,000 to their name.
Their house was originally valued at $300,000 when they bought it 30 years ago. Assuming the value of their home grew by 3% per year their home would be worth $728,000 today. So between their savings, investments, and home, they are worth a whopping $5,228,000! That’s over five times the net worth Bill and Mary ended up with.
John and Jane have set themselves up for a sweet retirement. Based on the 4% rule their 4.5 million dollars would give them a $180,000 a year income for the rest of their life! That’s how important becoming financially literate is. And that’s why I and so many others like me online try to teach it.
We’re very fortunate here in America that we can live a pretty comfortable life even if our decisions weren’t ideal or if we got a late start as Bill and Mary did with their savings. But we also have an amazing opportunity to set ourselves up for an extraordinary life both now and in the future if we take the time to learn about how money works and how we want to work with money.