Financial Literacy
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Why Financial Literacy Matters
Financial literacy - the knowledge and skills needed to make informed financial decisions - is essential for success in adulthood. Understanding concepts like budgeting, interest, and credit helps you avoid debt, build wealth, and achieve financial goals.
Budgeting Basics
The 50/30/20 Rule
A popular budgeting framework that allocates after-tax income:
- 50% - Needs: Housing, utilities, groceries, insurance, transportation
- 30% - Wants: Entertainment, dining out, hobbies, subscriptions
- 20% - Savings/Debt: Emergency fund, retirement, paying off debt
Understanding Interest
Interest is the cost of borrowing money (or the return on saving it). Understanding how interest works is crucial for making good financial decisions.
| Type | Formula | Description |
|---|---|---|
| Simple Interest | I = P x r x t | Interest calculated only on the principal |
| Compound Interest | A = P(1 + r/n)^(nt) | Interest calculated on principal + accumulated interest |
Where: P = principal, r = annual interest rate, t = time in years, n = compounding frequency per year, A = final amount
The Power of Compound Interest
Albert Einstein reportedly called compound interest "the eighth wonder of the world." Starting to save early, even small amounts, can grow significantly over time. $100/month at 7% annual return becomes over $120,000 in 30 years.
Credit and Debt
- Credit Score: A number (300-850) that indicates creditworthiness. Higher is better.
- APR: Annual Percentage Rate - the true cost of borrowing, including fees
- Good debt: Investments in assets that appreciate (education, home)
- Bad debt: High-interest debt for depreciating items (credit cards for consumption)
Key Financial Terms
- Net worth: Assets minus liabilities (what you own minus what you owe)
- Emergency fund: 3-6 months of expenses saved for unexpected costs
- 401(k)/IRA: Tax-advantaged retirement savings accounts
- Inflation: The rate at which prices increase over time, reducing purchasing power
Examples
Example 1: Simple vs. Compound Interest
Problem: You invest $1,000 at 5% interest for 3 years. Compare simple and compound interest (compounded annually).
Simple Interest:
I = P x r x t = 1000 x 0.05 x 3 = $150
Final amount: $1,150
Compound Interest:
A = P(1 + r)^t = 1000(1.05)^3 = $1,157.63
Interest earned: $157.63
Compound interest earns $7.63 more over 3 years.
Example 2: Monthly Budget
Scenario: Maria earns $3,000/month after taxes. Apply the 50/30/20 rule.
- Needs (50%): $1,500 - rent, utilities, groceries, car payment, insurance
- Wants (30%): $900 - entertainment, dining, hobbies
- Savings (20%): $600 - emergency fund, retirement contributions
Example 3: Credit Card Math
Scenario: You have a $5,000 credit card balance at 18% APR. If you only pay the minimum ($100/month), how long to pay off?
Answer: Over 9 years, paying nearly $4,500 in interest (almost doubling the original balance).
This illustrates why paying only minimums on high-interest debt is costly.
Practice
Solve these problems. Answers are provided below for self-checking.
1. Calculate simple interest on $2,500 at 4% for 5 years.
2. If you earn $4,000/month after taxes, how much should go to savings using the 50/30/20 rule?
3. What is the difference between APR and interest rate?
4. Calculate the final amount if $500 is invested at 6% compounded annually for 4 years.
5. Why is starting to save early so important?
Click to reveal answers
- I = P x r x t = 2500 x 0.04 x 5 = $500 in simple interest
- $4,000 x 0.20 = $800/month should go to savings and debt repayment
- Interest rate is the basic percentage charged on borrowed money. APR (Annual Percentage Rate) includes the interest rate plus additional fees and costs, giving a more complete picture of the true cost of borrowing.
- A = P(1 + r)^t = 500(1.06)^4 = 500 x 1.2625 = $631.24
- Compound interest works better over longer periods because you earn interest on your interest. Starting early gives your money more time to grow exponentially. Even small amounts invested early can outgrow larger amounts invested later.
Check Your Understanding
1. Why is compound interest more powerful than simple interest?
Show answer
Compound interest is calculated on both the principal and accumulated interest, creating exponential growth. Simple interest only calculates on the original principal. Over time, compound interest grows much faster because you're earning "interest on interest."
2. How does inflation affect savings?
Show answer
Inflation reduces the purchasing power of money over time. If your savings earn less than the inflation rate, your money is actually losing value in real terms. That's why investing (with higher potential returns) is important for long-term savings, not just keeping money in low-interest accounts.
Next Steps
- Review any concepts that felt challenging
- Move on to the next lesson when ready
- Return to practice problems periodically for review