Living frugally without financial literacy is like putting a bucket under a leaking roof in an attempt to stop the leaking while you need to repair the roof to stop the leaking.
Many frugal blogs only write about how to spend wisely, how to save money, how to make money on the side, without addressing the most basic issue: financial literacy.
Financial literacy is a must when it comes to dealing with any financial matters. You will understand why it’s a must at the end of this post. Let’s start with its definition.
What is Financial Literacy
The Oxford dictionary defines literacy as:
“Competence or knowledge in a specified area.”
Financial literacy, therefore, is competence or knowledge in financial matters.
At a personal level, someone with financial literacy recognises the differences between an asset and a liability, enabling them to manage personal finance matters efficiently.
What is Asset
In accounting, asset is:
“Things that are resources owned by a company and which have future economic value that can be measured and can be expressed in dollars. Examples include cash, investments, accounts receivable, inventory, supplies, land, buildings, equipment, and vehicles.
At a personal level, Robert T. Kiyosaki in his book, Rich Dad Poor Dad (2001, p. 61) gives a simpler, easier to understand definition about asset is something that puts money in the pocket.”
Examples of assets, as described in Kiyosaki’s book, are: stocks, bonds, notes, real estate, and intellectual property.
The income that derives from assets mentioned above are cash that come in the form of dividends, interest, rental income, and royalties.
What is Liability
While in accounting liabilities in a company are amounts owed to creditors for a past transaction, Robert T. Kiyosaki in his book, Rich Dad Poor Dad (2001, p. 61) has a simpler definition about liability. At a personal level, liability is something that takes money out of the pocket.
Buying a house with a mortgage and then pay it with a salary, for example, is a liability. Many people believe that they’re paying for an asset, but in his book Rich Dad Poor Dad, Kiyosaki argues that if the mortgage is paid out of salary for 30 years, for example, the house is not an asset but a liability as we spend 30 years working just to pay for the house. With the same amount of money that is used to pay for the mortgage, we could have invested it elsewhere that generates enough cash flow to pay for the mortgage.
Getting out of the Rat Race
Wikipedia defines a rat race as:
“…an endless, self-defeating, or pointless pursuit. The phrase equates humans to rats attempting to earn a reward such as cheese, in vain. It may also refer to a competitive struggle to get ahead financially or routinely.”
From the house mortgage example above, if you have to choose between buying a house or learning to develop your skills and talents that can bring assets in the future (from Royalty payment from your creativity), choose learning. Developing your skills and talents is an important part of what life is about. To get more details about this, you can read Robert Greene’s book, Mastery.
If you currently have to work to pay bills, then make it clear to yourself (and your partner/family – if you have any) that you understand the differences between assets and liabilities, and that your end goal is to get out of the rat race so you can have assets that pay all your expenses. To get more ideas how to get out of the rat race, you can read Tim Ferris’ book, The 4-hour Work Week.
The Takeaway
Financial literacy is knowing the difference between assets and liabilities. We should always prioritise buying assets first to generate cash flows so that these assets pay all expenses. In other words, with the example of the house mortgage above, we pay the mortgage from the cash we generate from the assets. The main point is that to be financially healthy, assets should always be larger than liabilities.
