I would define a person as truly financially literate when they can apply a holistic approach to making a key financial decision. By that I mean they can factor in the implications of a financial decision on other aspects of their financial life both short and long term. In order to be financially literate someone has to have a good handle on the following knowledge or skills:
- Budgeting and cash flow management and then apply these principles to their daily lives
- Retirement planning and sheltered retirement investment tools
- Understanding of assets allocation and basic investment approaches
- Understand the time value of money
- Understanding of economics and how changes impact their life
- Decent understanding of personal taxation
- Ability to look out and plan for the long term (as financial success only really comes over the long term)
- Can assess potential risks/opportunities and factor these into possible scenarios and outcomes
Although most of us are not financially literate, we can do extremely well financially if we only understand and can apply the first point above. Do you know how to budget and does one understand that getting ahead financially requires you to spend less than you earn? If one understands this simple rule and you live to it, then you have a real opportunity to live a financially rewarding life.
The people I refer to as financially illiterate are those do not apply that first rule above and live beyond their means. In terms of buying a house, these people will assume that if the bank is going to lend them 5 times their income, then they obviously can afford a house and will typically buy to the maximum of their debt capacity. There will be no longer term consideration as to whether higher interest rates will impact them or if they can properly save for retirement. These people often look to their realtor and mortgage broker for advice on the home they should buy and mortgage they should take on, but do they understand the problem with their biased advice?
Looking backwards the financially illiterate in Canada were generally spared from despair in retirement because most Canadians retired with a defined benefit pension plan which gave them a secure post employment income. Looking ahead twenty years, few outside of the public sector will retire with these types of pensions and therefore it is far more important today to understand financial concepts and apply them.