Thursday, June 11, 2009

Are You Debt Literate?

Individuals need financial skills—perhaps more now than ever before. Financial competence has become more essential as financial markets offer more complex choices and as the responsibility for saving and investing for the future has shifted from government and employers to individuals. As the credit crisis shows, borrowing decisions are also critical. Rapid growth in household debt and its link to the current financial crisis raises the question of whether lack of financial knowledge led individuals to take out mortgages and incur credit card debt they could not afford.
To assess how much knowledge individuals have with respect to debt, Peter Tufano of Harvard Business School and I designed and fielded a survey focused specifically on debt literacy, which is an important component of overall financial literacy. (The survey was conducted in partnership with the commercial market research firm Taylor Nelson Sofres [TNS] Global. It was fielded in November 2007, with data collected via phone interviews with a representative sample of 1,000 U.S. residents.) “Debt literacy” refers to the ability to make simple decisions regarding debt contracts, applying basic knowledge about interest compounding to everyday financial choices.
Our approach to measuring debt literacy has two components. First, we asked participants to judge, or “self-report,” their financial knowledge. Second, we devised questions to assess key debt literacy concepts, such as the power of interest compounding. These questions, measuring actual financial knowledge, can be solved with simple reasoning and do not require a calculator. Take a moment to answer the questions below, then compare your results to those we obtained in the survey.

Self-reported financial knowledge:
On a scale from 1 to 7, where 1 means very low and 7 means very high, how would you assess your overall financial knowledge?

Actual financial knowledge:

A) Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?
(i) 2 years;
(ii) Less than 5 years;
(iii) 5 to 10 years;
(iv) More than 10 years;
(v) Do not know.
(vi) Prefer not to answer.

B) You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an annual percentage rate of 12% (or 1% per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?
(i) Less than 5 years;
(ii) Between 5 and 10 years;
(iii) Between 10 and 15 years;
(iv) Never, you will continue to be in debt;
(v) Do not know;
(vi) Prefer not to answer.

C) You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?
(i) Option (a);
(ii) Option (b);
(iii) They are the same;
(iv) Do not know;
(v) Prefer not to answer.

Analysis of responses to these questions is not heartening. We learn that the large majority of Americans do not know about the power of interest compounding, do not realize that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt, and do not understand the time value of money. On question A, only about 36% of respondents knew that it would take less than 5 years for debt to double if one were to borrow at an interest rate of 20%. Even though about 80% of individuals have credit cards (and usually more than one card!) and have to decide frequently whether to pay off the card or carry a balance, only 35% knew the correct answer to question B—that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt. A meager 7% of respondents chose the most advantageous option of those presented in question C: to buy an appliance and pay $1,200 a year from now. Many preferred to give money early to the retailer. Moreover, as many as 40% of respondents indicated that paying in one lump sum or in 12 monthly payments is the same option, thus overlooking the time value of money.

Notwithstanding the poor scores on these questions, when assessing their own financial knowledge, most respondents picked values of 4 or above: in other words, most people thought they were above the mean in their financial knowledge!

This is only part of the research we have been able to do on these data, but the findings are worrisome. We are confronted every day with decisions about how to shop, how to pay for what we buy, how to manage debt. The results of this study show that Americans are not as debt literate as we think we are. Knowing what we do not know can be a first step in acquiring the knowledge we need in order to make better financial decisions.

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