The Covid-19 pandemic has wreaked havoc across the world. With the rapidly expanding contagion, it has disrupted “normal” as we know it and changed the way the world works. In response, everything that can be done online has gone online. Whether it is jobs, schools, or colleges, everyone is adapting to the new normal compelled by the coronavirus global emergency. The result?
A world where most learning is happening via the Internet. Amidst all this, what has also been widely affected is the financial stability – both at an individual and a global level. Financial literacy which becomes the need of the hour to help teach masses the n=importance of learning financial transactional management skills for the same along with financial planning for an individual.
On the plus side, the coronavirus global emergency has opened up a whole new world of e-learning, thanks to the ready availability of sophisticated online learning tools and resources. The coronavirus pandemic has also forced us to introspect and catch up on things we always planned on doing, but never really acted on. So, while we have the time and resources available to us, wouldn’t this be a great opportunity to improve financial literacy online?
Financial literacy refers to the ability to use relevant skills and knowledge to manage one’s money effectively in order to secure one’s financial situation. In simple words, financial literacy equips one with the knowledge to make financial decisions to achieve financial stability. It involves the understanding of making, spending, saving, and investing money to enhance your financial capability.
But, why is it necessary to be financially literate? Let us understand with an example.
Take the case of Raj, a college student, who will soon be a working man. As of now, he relies on his parents for a monthly allowance or pocket money for his expenses. Raj requires money for traveling to and from college. He also spends on leisure activities such as going to the movies, eating out, hanging out with his friends, and so on. Now, if he exhausts the entire amount on leisure activities (a want), he will not have adequate money for his travel (a need). Also, if Raj spends all of his monthly allowance by the 15th of the month, he wouldn’t have any left for the rest of the month. This is where financial literacy and financial planning come in, which will empower Raj to differentiate between a need and a want. Raj can also learn to use his monthly allowance effectively so that the money lasts him the entire month. In fact, he will also be able to save some money for the future.
Further, financial literacy can equip Raj to take the right financial decisions, especially when Raj begins to earn a salary.
Like Raj, it is essential for each individual to become financially literate and understand basic financial terms as early as possible, particularly if they are planning for higher education or are about to start their career in today’s times of economic uncertainty.
The first step in becoming financially independent is to become financially literate. This starts with developing an understanding of some basic finance terms. These terms are essential for financial planning, especially when you decide to avail loans or invest your money. These can be categorized as follows:
Accounting terms: A basic understanding of accounting terms such as Budget , Balance Sheet and Net Worth is essential to gauge whether one qualifies for credit or loan and to invest in various instruments.
Loan-related terms: Interest rates, Collateral, Debt-to-Income Ratio, Credit Score, and Down Payment are must-know terms before applying for a loan. Further, terms such as mortgage, which is one of the long-term sources of finance, are also necessary to be understood for future financial plans.
Economic terms: A general knowledge of economic terminology such as inflation, fiscal deficit, and Monetary & Fiscal Policy can not only keep your knowledge up-to-date but also help you understand how the broader economic situation will impact your financial planning. Further, it helps understand important government data such as the Economic Survey and the Annual Budget which contain vital information about the country’s economy.
Personal Finance and Investment terms: Developing basic knowledge regarding stock market, forex, and insurance is also essential for financial planning & analysis.
1. Budget: A budget is defined as a financial plan for a specific period. It typically includes estimates of income and expenses for a particular period. Making a budget is based on assumptions about your future spending and expected income. For example, as a college student, your income may be your pocket money, and your expenses may include next year’s fees, books, etc. As someone who is about to start working, your income may be your future salary and your expenses may include personal expenses, loan EMIs, etc. Thus, a budget helps you monitor your future cash flows effectively and plan in advance to make room for emergency spends. A budget is a very useful tool in financial planning as it helps manage one’s finances or money in the short or long term.
2. Balance Sheet: A balance sheet is a statement of position of one’s assets and liabilities as of a given date. Assets are items or properties owned by you that may have present or future value and are available to meet your obligations. Simply put, assets are what you own, and liabilities are what you owe.
For example, the phone you own is an asset, but the loan you have borrowed to buy it is a liability. Similarly, your educational qualification is also an asset (although an intangible one) because it can generate income for you. At the company level, a machine used to manufacture products is an asset, while a loan from the bank is liability.
A balance sheet provides a snapshot of your current financial position. Balance sheets are useful to lenders for gauging your credit worthiness, that is, to understand whether you are eligible for a loan.
3. Interest rates: Before understanding interest rates, let us understand what is “interest”. Interest is simply money paid regularly for the use of money borrowed. For example, if you borrow some money from your friend, your friend will not only expect you to repay the entire amount you borrowed but also an additional fee for the time he let you use his/her money. Thus, interest is the additional money to be repaid on the amount borrowed as loan.
This interest is paid regularly at a specific rate. This rate is referred to as the “interest rate.” Thus, when you borrow a student loan of Rs.10 lakh for a period of 10 years from the bank, the bank will charge you interest on it. Say, the interest rate is 10% annually, you will repay Rs.1 lakh every year for 10 years to the bank and an interest of Rs1 lakh (10% of Rs.10 lakh) annually. The interest rate is effectively the time value of money.
4. Inflation: Do you ever think that certain things that you buy now were available for lower prices just a few years ago? What caused the rise in the prices? Inflation! Inflation is the general rise in the prices of goods and commodities and affects most items of daily use. It is often seen as a spoilsport because it reduces one’s purchasing power over time. Here’s how.
Suppose you bought a pack of 5 notebooks for Rs.100 three years ago, that is, for Rs.20 each. The same set of notebooks now cost Rs.150. So now, each notebook costs you Rs.30! That means you could buy for Rs.20 what you can now buy for Rs.30 (50% higher!). In other words, you can now buy fewer notebooks with Rs.100 than you could earlier! So, the value of your money has eroded, or the purchasing power of your money has fallen. This is the effect of inflation.
5. Credit score: A credit score is a three-digit number that denotes how well you have managed your credit or past borrowings. The higher the credit score, the better.
Why is a good credit score important? A credit score allows lenders to see how you have handled your loans in the past. It is based on parameters such as whether you have paid your EMIs on time in the past, the number of accounts you have, your total current outstanding, etc. These records are seen as a mirror to your future financial behaviour and affect a lender’s decision to lend you money.
Credit scores can range from 300 to 850. A high credit score has several benefits such as low interest rate on your loans and credit cards, better chances of loan approval, and higher limits on your credit cards. A low credit score will make it difficult for you to borrow and could also affect your employment prospects as employers want to hire financially prudent people.
6. Stock market: A stock market, like any other market, is a place of exchange (buying and selling) of stocks. A stock is part ownership in a business. Basically, when you buy a company’s stock, you own a share of that company/business to the extent of the money you invest. Thus, if you buy a stock of Reliance Industries (RIL), you begin to own a share in RIL’s business to the extent of your contribution.
In the stock market, stocks trade (that is, are bought and sold) at prices that move up or down when the market is open. These stock prices are often a reflection of an investor’s opinions regarding a company’s future profits. Stock markets are a great avenue to invest your surplus money in order to participate in businesses you believe in.
7. Fiscal Deficit: Fiscal Deficit is the difference between the government’s total revenue and total expenses. Simply put, fiscal deficit represents the shortfall in the total income earned by the government compared to its total expenses. A fiscal deficit occurs when the government spends more than it earns. The government bridges this gap by borrowing.
Fiscal deficit is typically represented as a percentage of a country’s gross domestic product (the total value of finished goods and services produced in a country within a specific period.)
Government revenue includes income from taxes and non-tax revenues such as interest and dividend receipts. Government expenditure includes capital and revenue expenditure as well as interest payments on government-issued securities.
A high fiscal deficit is not always bad as it may portray the government’s spending on pushing infrastructure development such as highways and airports.
8. Net Worth: Net worth is your net financial position. It is calculated as the excess of assets over your liabilities. Thus, net worth = total assets – total liabilities.
For example, if you currently own a total of Rs.2,00,000 in the form of gadgets, clothes, and cash and owe your parents Rs.20,000 which you borrowed as an advance, your net worth as of now is Rs.1,80,000.
One’s net worth can also be negative. This is when what you owe is more than what you own. For example, a student with a student loan of Rs10 lakh but Rs2 lakh in assets has a net worth of -Rs.8 lakh.
9. Mortgage: Mortgage is a type of loan that you can avail from a lender for the purpose of buying a home or land. A mortgage is secured with a collateral, that is, if you fail to pay back the loan at the expected time, the lender has the right to take away your collateral to make good the loss.
Mortgage terms typically range from 15 years to 30 years or even longer. Further, there are different types of mortgage depending on whether you opt for a fixed or an adjustable interest rate. Many other types of mortgage are available with lenders, giving several flexibility options to borrowers.
10. Insurance: Insurance means protection against a possible event. Life gives no guarantees of what is to come. A single event can change your life drastically. This may be the death of a loved one or an accident. Such events can have deleterious financial consequences. Is there a way you can secure yourself financially should such a thing happen? Yes, there is. Insurance!
The basic premise on which insurance works is that you pay regular premiums on a plan with predefined benefits. If during the time that you are covered by the insurance, an untoward event against which you hold insurance occurs, you get the predefined benefits, conditions applied!
For example, if your house is covered by property insurance and it catches fire, you can claim the amount agreed upon between you and the insurance company at the time of signing the contract. Insurance has increasingly become a necessity, particularly in today’s times.
11.Collateral: As discussed before, collateral is the security you offer the lender in the event of you not honouring your loan repayment. The lender has the right to seize the collateral if you default on your loan payments.
Collateral can be real estate or any other asset you own, depending on the type of loan you avail. For example, you can offer your fixed deposits in the bank as collateral for some loans. For a home loan, the home that you borrowed for itself becomes collateral.
12. Debt-to-Income Ratio: The debt-to-income ratio is a ratio of your total debt (liabilities) to your total income at a certain point in time. It is generally used to compare your monthly repayment obligations to your gross monthly income. Gross monthly income refers to your total income without deducting taxes.
This ratio is useful when calculating the amount a person earns to repay his/her debt. The lower the ratio, the better. Let us understand this with an example:
Suppose you earn Rs.50,000 per month and you have an EMI of Rs.20,000 due every month. Your monthly debt to income ratio would be 20,000/50,000 = 0.40 or 40%.
Typically, one needs to have this ratio between 40 to 50% to qualify for a loan. A lower ratio gives an added comfort to the lender regarding your ability to repay your loan. It also qualifies you for additional loans.
13. Down Payment: Down payment is an initial payment you make when you purchase something. It is basically your share of payment apart from the loan amount.
Most lenders have a fixed percentage of the price of the asset to be purchased as down payment. For example, typically, for home loans in India, one needs to make a minimum down payment of 20% of the property value. Thus, if you need to purchase a house worth Rs.30 lakh, you would have to pay Rs.6 lakh as down payment from your own pocket. You can only avail a loan of a maximum of Rs24 lakh from the lender.
14. Forex: Forex means foreign exchange. Forex refers to the exchange of one currency for another. It is a mechanism of converting one currency to another, for example, from US dollars to Indian National Rupee. Forex is useful not only for banks and companies but also for individuals.
The forex market works 24 hours a day, five days a week. It is the most liquid market in the world. Forex prices keep fluctuating and are affected by interest rates, inflation, government policy as well as trade data. It is through forex rates that we know that the INR is currently hovering around 75/USD.
Understanding forex is useful when accepting payments in other currencies, traveling abroad, and also accepting or sending remittances abroad.
15. Monetary & Fiscal Policy:
Monetary policy includes all central bank activities carried out to manage the flow of money and credit in the economy. On the other hand, fiscal policy includes the government’s activities and decisions regarding taxation and expenditures. Monetary & fiscal policy are essential to regulate the economy.
The change in interest rates by the RBI is an example of monetary policy, while a change in taxation slabs by the Government of India is an example of fiscal policy.
Congratulations! Now that you have gone through the key finance terms, you are on track to gain financial independence. Let us first go through the meaning of the same – it’s basically the ability of being financially equipped to take care of one’s own living expenses without having to rely on someone else for the same. One of the key steps to financial independence is financial literacy. Knowledge is power and the right knowledge about being independent is something that actually helps and individual grow in the right direction.
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