The problems of financial illiteracy

By Felix Salmon
April 29, 2009

I was keen to go to the panel on financial literacy, which was moderated by John Bryant, the founder of Operation HOPE and a member of the U.S. President’s Advisory Council on Financial Literacy. He’s clearly committed to this cause, and is doing a very good job of picking the low-hanging fruit: in some areas, for instance, only 25% of people eligible for the Earned Income Tax Credit actually claim it. Since it can be claimed going back three years, and since it can amount to $4,000 per year, families earning less than $40,000 a year can end up with a $12,000 windfall just as a result of some simple outreach and basic education. In many cases that’s “more money in many cases than they’ll ever see in their life,” said Bryant; “it’s transformational”.

I was disappointed, however, in the way that Bryant kowtowed to the credit-card representatives on the panel: I think they’re clearly a big part of the problem, but Bryant said that he loves credit cards, on the grounds that they represent the only credit line that most poor families have.

My feeling, by contrast, is that credit cards are a really bad way of structuring an unsecured personal loan from a bank to an individual. Banks have made a concerted effort to make personal loans very difficult and expensive to obtain, complete with prepayment penalties and the like, precisely because they’d much rather their borrowers run a balance on their credit cards. And so I had no sympathy at all for David Simon, of Citicards, when he started moaning about how banks were taking enormous credit losses and how “credit card companies are the people that we love to hate”. Well, yes: because they’re basically evil, with what Elizabeth Warren calls their “tricks and traps”. But no one pushed them on this panel.

While the Obama administration continues to push on credit card regulations, and that’s a very good thing, I’d be much more interested in a parallel push to bring back the old-fashioned personal loan: something which is designed to be paid down over time, and which carries a transparent interest rate. Disappointingly, no one on the panel even mentioned the phrase “credit unions”, despite the fact that credit unions in general, and community development credit unions in particular, are a great way to educate the public on financial matters and to extend good loans rather than bad ones.

Instead, the conversation remained firmly at about 40,000 feet most of the time, with lots of talk about things like the parallels between physical and financial health: in both cases Americans have consistently failed to take responsibility for their own well-being, with disastrous consequences.

The most sanity was injected by Sean Cleary, who did push back a bit against the card issuers, saying that an economy with 8.5 credit cards per person is “a completely dysfunctional institutional context”. He also noted a powerful truism:

If you do not have the quantum of life skills needed to succeed in today’s market-based economy, then you will fail.

There was, unfortunately, very little discussion of how exactly to give Americans those skills. There was a reference to a recent paper by Annamaria Lusardi and Peter Tufano, which sought to measure financial literacy, and found that only 7% of people could answer this question correctly:

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.

Lusardi and Tufano are clear that (ii) is the right answer: a 20% interest rate is much better than the 35% APR on the installment plan, and people who don’t answer (ii) are ignorant, they say, of the time value of money.
But of course there are good reasons to want to pay an affordable repayment every month rather than simply putting off for a year — and exacerbating by $200 — the question of how on earth you’re going to pay for this appliance. If we want financial-literacy classes to be really helpful, I think they should concentrate not on teaching people the “right” answer to a time-value-of-money question, but rather just make people understand that there are fundamental sustainability problems whenever you’re spending more than you’re earning.

Banks are really bad at communicating to their customers that personal loans, including credit cards, should only be used when you are pretty sure that you have a way of paying that loan back in the future. That is real, useful financial literacy, and it requires very little in the way of boring mathematical concepts.

I’m happy however that no one said anything about financial-literacy education involving learning about investments. That’s a fraught area indeed, and it’s far from clear that teaching people about the stock market is ever a good idea. If you want to get rich, there’s really only one way to do it: spend less than you earn. Borrowing money, for most people, is a very bad way of getting wealthier, and investing money, for most people, doesn’t work particularly well either. Don’t count primarily on investment returns: instead, just try to put money away, steadily, month in and month out, until you retire with a decent nest egg.

But pay off those credit cards first.

Update: I’d like to respond to James Shearer, in the comments, who writes this:

Either way you pay $1200. So the second option is clearly better as long as interest rates are greater than 0.

Which is the “right” answer, assuming that a rational person would simply take the $100 a month they’d otherwise spend on the installment plan, and put it in an interest-bearing account: at the end of the year, they can repay the full $1200 in a lump sum, and keep the interest.

But in the real world, people don’t do that. An installment plan is a commitment device, much like a mortgage, and there’s serious value to such a device. Under option (a) you end the year owing nothing; under option (b) you end the year owing $1,200 — and there’s a very good chance that you’ll have no more money then than you do now.

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Comments
18 comments so far

Isn’t the time value of money almost 0 right now?

Posted by crack | Report as abusive

Agree that living beneath one’s means is by far the best path to a healthy financial future. Included in that is the ‘pay yourself first’ mantra.

That is something that cannot be taught to people who have not lived in household in which their parents behaved that way. The real objective is finding a way to teach that spending less that you earn is the ONLY way to go. People believe it and practice it.

I’m financially literate enough to enjoy this blog, but I answered Lusardi and Tufano’s question wrong.

I read “Borrow at a 20% annual interest rate and pay back $1,200 a year from now” to mean I had to pay back $1200 plus make additional (monthly?) interest payments at 20%.

On top of that, “Which is the more advantageous offer?” is a terrible question. Advantageous to whom? It should have been “Which offer requires to you pay less?”

Posted by Pete | Report as abusive

I have always been a HUGE proponent of this type of education in our high schools.
I remember I took a class on how to write checks, but they never taught me what a credit score was, nor how credit cards worked and of course I hit 18 years old and promptly went into debt without a care.
This education is essential for our young folk to understand what they are doing and how they are going to do it after high school.

Posted by Chris | Report as abusive

and exacerbating by $200

Huh? Either way you pay $1200. So the second option is clearly better as long as interest rates are greater than 0.

Felix,

Even though I’m finally literate enough that I got the question right (never mind that [iv] is a better answer since the discount rate could be zero), I cannot for the life of me understand how you came up with a 35% APR on the payment plan. Could you explain?

By a 35% APR, I’m assuming you mean that the FV in 1 year of the installment payments is $1350, as compared to $1200 under the 20% rate alternative. You’d need a really high discount rate for that; something like 28.57% if I did my math correctly.

Posted by Jacob | Report as abusive

Scratch that. I thought about it and realized that you amortized the principal and are using a monthly rate of 2.9%, which is a 35% simple APR, to compute the monthly payment.

Posted by Jacob | Report as abusive

I disagree that ii is the best answer. I say i is.

First, let me note that I understand the time value of money and its use in valuing investments and cash flows and all that stuff.

However.

Those who comment on this blog post likely will overestimate the sophistication of the average person about whom Felix is blogging. These are people for whom the concept of the time value of money is an abstract artifice. If I were financially unsophisticated I would think I’d want to know that I owe $100 every month for 12 months than to ponder the fact that I owe a lump sum of $1200 12 months hence: that is too amorphous and too large a sum to contemplate in the future and so I’d likely default on the loan.

The distinction here is between the theoretical treatment (the time value of money) and the quotidian realities of people’s financial illiteracy.

Felix (and Dave) make well the point that i is the better choice for certain sorts of people. ii is the better choice for me. ii is probably the better choice for almost anyone who is going to answer ii, at least for anyone who is going to answer ii for the correct reason. i is the best option listed for many people who require “outreach”.

As a financial educator working in low and moderate income communities I too am disappointed in the “experts” like John Bryant, Suze Orman, and Jean Chatzky. We must all remember who “sponsors” them and identify the inherent conflicts of interest. People need to seek financial advice from professionals who act as a fiducicary, putting the client’s needs first. This seldom happens with financial institutions. We are fortunate in San Francisco to have a City Treasurer who requires the Bank on SF project partners to develop and offer products that are suited to low and moderate income clients.

Thank you for bring this to the forefront. For more information about financial education that TRULY supports clients seek organizations in your local communities that offer IDA programs (www.idanetwork.org) or visit http://www.sfearn.org to learn more about financial coaching.

Posted by Saundra Davis | Report as abusive

Well, isn’t the real issue here the business model used by the credit card industry – working to develop a group of consumers from whom they can persistently farm income based on high indebtedness, rather than having their customers use the card for convenience and occasional short term loans?

In this respect, greater financial literacy on the part of the consuming public would run counter to the banks’ interests – hence I don’t expect much push on their part to develop it. I concur with the main point that financial literacy means more than present value computation, it means an intuitive understanding of the consequences of financial actions and the potential benefits and risks involved.

But I also concur with William Bernstein, who came to the reluctant conclusion midway through this decade that the general public is too unsophisticated to handle self directed retirement savings. There’s a base level of financial literacy, and an advanced one, and most folks struggle with the basics.

Posted by Andrew | Report as abusive

I paid off my 15 year mortgage in 7 years because I ignored all the people who say option b is better.

The reality is that 95% of people spend everything they have up to some liquidity constraint. If you prepay your debts you feel poorer and spend less.

The extra money that went to the mortgage company while I was still paying off the mortgage was matched almost 1-to-1 by less spending, not by a reduction in other assets.

Most financial advisers would claim I lost a few % points of return because of the tax benefits for mortgages. I think these people are idiots.

I think my net worth is much higher now than it would have been if I had listened to them.

Posted by dk | Report as abusive

We’re all theorising about what “ordinary people” “actually do” and deciding that it probably makes sense for them to pay 35% APR for their finance rather than 20%, but isn’t this just a leetle bit patronising? Is there actual evidence that people who own a load of stuff on installment credit have better financial outcomes than people who have a bunch of debt? Since everyone’s apparently saying “I myself would of course choose option B, but as for the poor little feckless working class, they’re not really to be trusted with money, so they’d better go for option A”, should we not be a bit more diffident?

Posted by dsquared | Report as abusive

Here’s another thought – tail risk. What happens to the person in the example if he suffers some sort of financial or personal catastrophe in the intervening year? In a), he stops making the instalment payments and loses the appliance, which wipes the slate clean. No problem. But in b), he is left with a 20% APR on a loan which will probably now start compounding, and the prospect of trying to sell a second-hand appliance – which won’t leave him enough to pay back the debt. Not a good situation to be in at all.

Posted by ajay | Report as abusive

I think of myself as reasonably sophisticated, but I typically chose option (i). Having a debt that I’m not making regular payments on makes me psychologically uncomfortable, even if I am making regular payments into an interest bearing account. It’s not worth $15 or $20 to experience that discomfort, even if I rationally know that the situation is covered.

Posted by J Mann | Report as abusive

Hello Felix Salmon,

I am John Hope Bryant, the individual you refer to from the panel. Thanks for your passion sir.

Thank you also for coming to the first ever panel hosted by the Milken Global Conference, and frankly, it sounds like maybe you should have been on it, for some lively debate.

Here are a few important clarifications:

1. The panel was 1 hour and 15 minutes total. Very challenging to tailor make the conversation you desire, in a discussion even twice as long. In an hour, in a first ever panel, a thoughtful “40,000 feet” conversation with 5 panelists is unfortunately just about pushing the envelope of the possible. This said, I was surprised we did not hear from you during the Q & A period, given your strong views. Would have been happy to respond there, but nonetheless let me respond here.

2. As a meaningful point of reference, you should know that I am not just an advocate for financial literacy. I am the founder of Operation HOPE, which has reached, teached and empowered more than one million low-wealth individuals in practical, asipirationally relevant financial literacy since the L.A. riots of 1992. Today we are the largest urban delivery system in America, operating in 68 urban communities, and 6 provinces in South Africa. As a nonprofit we have funded more than $300 million in new homeownership from HOPE(loans that did repay), and subsequently have additionally restructured more than $250 million in existing mortgage loans, from other lenders, tied to this subprime mess. Half of the restructures are middle class borrowers and about half are low-wealth. Check out results for yourself at http://www.operationhope.org.

3. The work of HOPE directly inspired our government to make financial literacy federal US policy, which subsequently created the President’s Council, where I serve as vice chairman, and chairman on the Committee on the Under-Served. Mr. Salmon, I had been pushing this issue for 7 years with then President Bush, but it did not actually happen until 2008. That said, our President’s Council annual report has already produced legislative bills from Congress requiring financial literacy in schools, and college (see HR 1325 by Congresswoman Sheila Jackson-Lee, requiring anyone receiving a guaranteed student loan to also be required to take a 4 hour course in financial literacy, and all colleges and universities receiving federal funds would be required to offer a course in financial literacy). The non-partisan Council has enjoyed support from the Obama Administration, and I think President Obama will ultimately make this real in real people’s lives (including his meetings recently with credit card companies at the White House). In other words, progress is a process. A passionate process, but a process nonetheless.

4. Our work at HOPE has increased credit scores from 570 to 670, in our HOPE Centers. That moves someone from predatory lenders to mainstream bankng. That is real.
5. Here is the real point of the last two; we know a thing or two about how this impacts people’s lives on-the-ground and in real time;

5(a). With all the challenges with credit cards, and while there are MANY, they are also not the devil, and a lot better option I might add than what I call “ghettoized financial services”– payday loan lenders, check cashers, rent to own stores, and others in this $10 billion industry. Take away credit cards and the next ladder down is not pretty at all. Credit cards ARE or can be a lifeline for homeowners, and we need to work to make them (credit card providers)work better for people. I might add that I also noted in my remarks that I had personal frustrations with my own credit card providers, and yet we should not throw the baby out with the bathwater.

5(b). My mentor is Andrew Young, and Young and his friend Dr. Martin Luther King, Jr were optimist, and were focused on “what they were for, and not just what they were against.” Young has taught me well that you don’t get very far jamming up people you want to help you, in public no less. There has been more progress through evolution than revolution, and my job is to encourage the “better angels” of leaders within the credit card industry (and their own enlightened self interest), and more so on this panel, to hopefully “ispire” Citi Cards to take a positive lead. Beyond that, and on a personal level, David Simon is just a great American, who has volunteered regularly with me through Banking on Our Future, teaching financial literacy in classrooms throughout NYC, and encouraging his staff and the bank to do the same. Even as he left the panel is was brainstorming ideas of how he and Citi Cards could do more, even changing card terms and promoting incentives to card holders over charges. Isn’t than exactly what we want?

I guarantee you will get more real and sustainable change out of folks through a form of rational inspired leadership, based on enlightened self-interest, than you will through the simple power of coercion, jamming folks up in public forums just because you can (even one who is legally blind can see that the credit card industry is in deep trouble, and need to change. The question is, who is going to help them do precisely that).

Note: at present not one of our funding partners are credit card companies, so my comment(s)come without financial bias, though we are non-profit nonetheless.

In closing, I believe that “every good marriage is made of constructive friction,” so I encourage you to keep pushing me and others to “do more.”

Respectfully —

Felix – Great journalism, as usual. One thing that concerns me though is the way the researchers come to the 35% APR. That may also be the way the U.S. credit card industry publicizes the APR rate in this case, I don’t know. Although I must admit that this is much better than in some other countries where the exact same installment plan could be advertised as having a 20% interest rate, but I digress…

In fact, the internal rate of return of this specific installment plan is found via an iterative process and is a monthly rate of 2.92285% (just to be precise), easily found with any financial calculator.

However I firmly believe that it’s wrong to multiply that number by 12 to come up with a yearly APR that comes to about 35.07%. In fact, if we’re talking about converting monthly rates to an annual rate then we should think about monthly compounding. The mathematics of such compounding will make the annual rate even more than the advertised 35%. It’s obtained by adding 1 to the monthly percentage rate and taking its 12th power.

Which makes the yearly rate worse than the advertised APR: A whooping 41.3%, to be more precise.

It is a profitable business indeed…

There are many others who are misled into believing that they are paying lower interest rates in other countries on installment plans such as those, and the bank in this case will quote a montly rate of 1.67% (20 divided by 12) as opposed to 2.9% that is found via time value of money calculations.

Posted by Suna | Report as abusive

Suna: I too make it 41.3%. But you’ve hit upon a usage difference between the US and the UK.

In the UK, the term “APR” is defined by the Consumer Credit Act 1974 to mean (roughly speaking) the true mathematical (compounded) annual interest rate, rounded to one decimal place.

In the US, “APR” is defined by the Truth in Lending Act 1968 to mean (again, roughly speaking) the periodic interest rate multiplied by the number of periods in a year.

The purpose of each law is to make interest rates easily comparable between financial products, and I suppose this works within each jurisdiction (but in the US it only helps you compare products with the same number of compounding periods in a year). But it makes for a lot of confusion in transatlantic discussions.

Posted by Gareth Rees | Report as abusive
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