What is Financial Literacy?
The Four Foundations of Financial Literacy
A friend of mine’s son started kindergarten last year. The young boy excelled at math and art, but he struggled with reading. For him, reading was a chore. It was hard work with little payoff. My friend had to be diligent in making sure his son read each and every night. Because given the chance, his son would have been off playing instead.
The problem wasn’t that the boy didn’t like reading. He loved to have his dad read for him all the time. The problem was that learning to read was hard and it was easier to let others do it for him. Over this summer, however, it finally clicked. Now my friend’s son won’t stop reading. He keeps asking to go to the library. He spends hours on the couch reading books. He loves reading.
Like most kids his age, my friend’s son was having a hard time moving from illiterate to literate. But once he got over the hard part of gaining literacy, he soared.
As adults, most of us know how to read. We’ve gone through the struggle and frustration of becoming literate. Thankfully, that is one thing our schools do well. But for most adults there is one type of literacy that is sorely lacking — financial literacy.
Our schools do well at teaching reading, writing and arithmetic, but they are horrible at preparing people to work with money. Nearly every person who graduates from school is financially illiterate.
If you want to be rich, you must have a high level of financial literacy.
The good news is that you can become financially literate. It will take hard work, a lot of study, and trial and error—but the dividends will be worth it.
The key to becoming financially literate is to understand the four foundational principles of financial literacy.
#1 - The Difference Between an Asset and a Liability
Many people think they know what an asset is. For instance, you probably think your house is an asset—but it’s not. The truth is that just as there are two definitions of an asset.
Accountants use one definition that requires lots of financial calisthenics to make people and companies feel richer than they really are. This keeps them employed and their clients blissfully ignorant.
The rich use another definition grounded in simplicity and reality. An asset is anything that puts money in your pocket and a liability is anything that takes money out of your pocket.
Your house is not an asset because it takes money out of your pocket each month. Even if you own your house outright, you still have to pay for the taxes, maintenance and more out of your own pocket.
But if you own a rental property, that can be an asset—if it puts money in your pocket each month in the form of cash flow. When your tenant pays rent, they cover your mortgage, maintenance, taxes, and more.
#2 - Cash Flow Versus Capital Gains
Most people invest for capital gains. The rich invest for cash flow.
Simply put, investing for capital gains is like gambling. You invest your money and hope the price goes up. For instance, many people buy a house hoping they’ll be able to sell it for more money later. In the meantime, they have to pay their mortgage and home expenses. Money goes out of their pocket. It becomes a liability.
The problem is that when you invest for capital gains you have no control over whether the price goes up or down, and the bigger issue is, if you do make a profit, you pay the highest rate in taxes.
Conversely, the rich invest for cash flow. So, for instance, they buy investment real estate with other people’s money, find tenants to pay the expenses, and collect rent each month. It becomes an asset. And if there’s capital gains, that’s a bonus.
By investing for cash flow instead of capital gains, the rich have control over their income and pay the lowest rate in taxes—and sometimes nothing in taxes.
But investing for cash flow, while a simple concept, requires a strong financial education in order to make your own financial decisions.
#3 - Using debt and taxes to get richer
Your financial adviser will tell you that debt is bad and taxes are inevitable. But the rich understand that both debt and taxes can be used to create immense wealth.
When it comes to debt, there are two kinds—bad and good. When your financial adviser tells you to stay out of debt, she means stay out of bad debt.
Bad debt comes in the form of borrowing money for liabilities such as using credit cards to buy TVs and take vacations, borrowing a line of credit on your personal home, and more.
Staying out of bad debt is good advice, but the problem is that your financial adviser won’t tell you about good debt.
Good debt is debt used to purchase assets like rental property.
When you use the bank’s money to purchase cash-flowing real estate, you use less of your own money to secure an asset by paying only a down payment instead of full price, and your tenant’s rent pays off your debt while you own the asset and pocket the profit.
When it comes to taxes, the rich understand that governments write tax codes to encourage specific types of behavior. If governments want you to build affordable housing, they give you a tax cut. If they want to encourage oil exploration, they give you a tax cut. If they want to see higher employment, they give you a tax cut.
The secret is that most tax benefits are made to help entrepreneurs and investors. With the right financial education, you too can utilize the tax code to not only get richer, but also pay nothing in taxes.
Utilizing good debt and getting richer through taxes takes a high level of financial intelligence. But everyone can learn and put these principles into practices.
#4 - Making your own financial decisions
When you’re not confident about your knowledge of money, you let others make your financial decisions for you.
You let your broker decide how your money should be invested. You let your bank tell you what interest rate is worthy of your money. You follow whatever investing trend is popular in the news.
The rich don’t follow the crowds. They set the trends and are gone by the time the trends become mainstream. What’s their secret? They think for themselves about money and make their own financial decisions because they have a high financial intelligence.
The key to building great wealth is having great knowledge to act on and great wisdom to know which course of action is the best.
This kind of knowledge and wisdom only comes through a high financial intelligence gained from applying yourself to financial education.
Are you ready to increase your confidence about money by increasing your financial education? Are you ready to start making your own financial decisions?
Check out our free, financial education community here, and start your journey to financial literacy today.