Wednesday, February 27, 2008

Financial illiteracy and debt

With the November elections rapidly approaching, millions of Americans are examining each candidate’s views on the country’s economic situation. Americans with unmanageable levels of debt, which, according to TNS’ survey, include over one in four Americans, will be particularly interested in candidates’ plans to help alleviate that burden. While strengthening family finances is a complex problem, one key element is financial literacy. The TNS survey, which includes questions that Peter Tufano (Harvard Business School) and I devised, found disturbing patterns of financial illiteracy and indebtedness:

Only 35 percent of respondents were able to correctly estimate how interest compounds over time

More than half of respondents did not understand how minimum payments are calculated and applied to a principal balance

Almost none of the respondents understood the financial difference between paying in monthly installments versus one lump sum at the end of a certain time period

The survey also explored Americans’ comfort with their personal debts. Respondents were asked if they felt they had too little debt, just the right amount, or too much debt. A sizable fraction of respondents (26 percent) report having too much debt and another 11 percent didn’t know if they did. While firms bombard Americans with credit card solicitations, only two percent of American wished they could borrow more. People who felt they had “too much debt” tended to be younger, with lower incomes and larger families. Beyond this, the over indebted did not understand the basic working of interest rates (this line did not read well). There is a strong link between financial illiteracy and excessive debt. Those who severely underestimate the power of interest compounding don’t understand how quickly debts can grow. They end up with more debt than they can handle.

What these findings show us is that financial illiteracy is pervasive. There is a widespread lack of financial know-how in America. This epidemic is not only prevalent in the low-income demographic. Excessive amounts of debt and personal financial worries may make consumers hold back on their spending.

About the Research
The study is based on a representative national sample of 1000 people aged 18+ in the TNS 6th Dimension Access Panel. The internet-based survey was conducted during the week of November 5, 2007.

1 comment:

Anonymous said...

I agree that financial illiteracy is pervasive. The only way to really get ahead of this problem is to begin to teach children the skills of basic personal finance starting from Kindergarten. We'll create a money-savvy generation that way, and the parents just might pick up a thing or two along the way when they see what their kids are learning.