Where does illiteracy hurt?

While the low levels of financial literacy discussed in my previous blogs are troubling in and of themselves, what is most important are the potential implications of financial illiteracy for economic behavior. One example is offered by an article Hogarth, Anguelov, and Lee published in 2005, that demonstrates that consumers with low levels of education are disproportionately represented amongst the “unbanked,” those lacking any kind of transaction account.

To examine how financial illiteracy is tied to economic behavior, Olivia Mitchell (Wharton School) and I used the questions we have devised for a special module for the 2004 Health and Retirement Study, and linked financial literacy to retirement planning. We found that those who are more financially knowledgeable are also much more likely to plan for retirement. Specifically, planners are most likely to know about interest compounding, which is clearly a critical variable to devise saving plans. Even after accounting for several demographic characteristics, such as education, marital status, number of children, retirement status, race, and sex, we still found that financial literacy plays an independent role: Those who understand compound interest and display basic numeracy are much more likely to have planned for retirement. This is important, since lack of planning is tantamount to lack of saving.

Other authors have also confirmed the positive association between knowledge and financial behavior. For example, in a paper jointly written with Maarten van Rooji and Rob and Alessie, we find that respondents who are more financially sophisticated are more likely to invest in stocks. John Campbell, from Harvard University, in his article published in the Journal of Finance in 2006 has highlighted how household mortgage decisions, particularly the refinancing of fixed-rate mortgages, should be understood in the larger context of ‘investment mistakes’ and their relation to consumers’ financial knowledge. This is a particularly important topic, given that most US families are homeowners and many have mortgages. In fact, many households are confused about the terms of their mortgages. Campbell also finds that younger, better-educated, better-off white consumers with more expensive houses were more likely to refinance their mortgages over the 2001-2003 period when interest rates were falling.

His findings are confirmed by Brian Bucks and Karen Pence, from the Board of Governors, who examine whether homeowners know the value of their home equity and the terms of their home mortgages. They show that many borrowers, especially those with adjustable rate mortgages, underestimate the amount by which their interest rates can change and that low-income, low-educated households are least knowledgeable about the details of their mortgages.

Further evidence of biases is provided by Victor Stango and Jonathan Zinman from Dartmouth College, who thoroughly document the systematic tendency of people to underestimate the interest rate associated with a stream of loan payments. The consequences of this bias are important: Those who underestimate the annual percentage rate (APR) on a loan are more likely to borrow and less likely to save.