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«Annamaria Lusardi Dartmouth College and NBER Peter Tufano Harvard Business School and NBER December 22, 2008 We analyze a national sample of ...»

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Debt Literacy, Financial Experiences and Overindebtedness*

Annamaria Lusardi

Dartmouth College and NBER

Peter Tufano

Harvard Business School and NBER

December 22, 2008

We analyze a national sample of Americans with respect to their debt literacy, financial

experiences, and their judgments about the extent of their indebtedness. Debt literacy is

measured by questions testing knowledge of fundamental concepts related to debt and by self-

assessed financial knowledge. Financial experiences are the participants’ reported experiences with traditional borrowing, alternative borrowing, and investing activities. Overindebtedness is a self-reported measure. Overall, we find that debt literacy is low, especially among women, the elderly, minorities and those with low income and wealth. Even after controlling for demographics, we find a strong relationship between debt literacy and both financial experiences and debt loads. Specifically, individuals with lower levels of debt literacy tend to transact in high-cost manners (incurring fees and using high-cost borrowing). In applying our results to credit cards, we estimate that less knowledgeable individuals pay 46 percent more fees than do the more knowledgeable individuals. The less knowledgeable also report that their debt loads are excessive or that they are unable to judge their debt position.

Keywords: Financial literacy, numeracy, debt loads, credit card borrowing JEL: D14, D91.

* Contact information: Annamaria Lusardi, Professor, Dartmouth College. Department of Economics, Hanover, NH 03755-3514 (annamaria.lusardi@dartmouth.edu); and NBER; Peter Tufano, Sylvan C.

Coleman Professor of Financial Management, Harvard Business School, Soldiers Field, Boston MA 02140 (ptufano@hbs.edu); NBER; and D2D Fund. We would like to thank TNS-Global and, in particular George Ravich, Bob Neuhaus, and Ellen Sills-Levy for their willingness to partner with us on this project, and Lauren Cohen, James Feigenbaum, Christopher Malloy, Annette Vissing-Jorgensen, and participants to the Consumer Finance Workshop, the NBER Summer Institute, Williams College, the European Central Bank conference on Household Finances and Consumption, the Federal Reserve Bank of Chicago Symposium on Connecting Financial Education to Consumers, the Herman Colloquium at the University of Michigan, the George Mason School of Public Policy for suggestions and comments. We are grateful to Jan-Emmanuel De Neve who provided excellent research assistance and to Bill Simpson for his useful comments and advice. This paper was written while Lusardi was a Visiting Scholar at Harvard Business School and she would like to thank Harvard Business School for its hospitality. Tufano thanks the HBS Division of Research and Faculty Development for financial support for this work. The views expressed herein do not reflect those of TNS.

Individuals need financial skills—now perhaps more than ever before. Research in the area of financial literacy has typically focused on individuals’ knowledge of economics and finance and its effects on financial decisions, usually related to savings, retirement planning, or portfolio choice. Certainly, it has become all the more important as financial markets become and remain precarious and when decisions about how much to save and how to invest for the future become more complex, such as with the shift from defined-benefit to defined-contribution pension plans. However, little research has been done on the relationship between financial literacy and indebtedness. Rapid growth in household debt and its link to the current financial crisis has highlighted our consumer weaknesses, and raises the question of whether individuals’ lack of financial knowledge led them to take out mortgages and revolving credit they could not afford.

To fill this gap and assess how much knowledge individuals have with respect to debt, we designed and fielded a new survey focused specifically on ―debt literacy,‖ an important component of overall financial literacy. Debt literacy refers to the ability to make simple decisions regarding debt contracts, in particular how one applies basic knowledge about interest compounding, measured in the context of everyday financial choices. We seek to understand the relationship between debt literacy and financial decision-making as well as how they may combine to cause overindebtedness.

This paper contributes to the existing literature in three ways. First, our research questions allow us to measure financial knowledge specifically related to debt, as well as individuals’ overindebtedness. Rather than relying on existing debt indicators, we ask individuals to judge their own debt levels. Second, unlike much of the previous work, we

propose a method to consider the entire set of financial experiences in which individuals engage:

opening a checking account, buying bonds and stocks, and borrowing from traditional and alternative credit providers. Some transactions, such as credit card borrowing, are repeated over time; others are discrete events that take place only once or twice over a lifetime. We translate the rich multi-dimensional set of experiences into more compact consumer segments. Finally, we assess how literacy is linked to both financial experiences and overindebtedness.

We find strikingly low levels of debt literacy across the U.S. population. It is particularly severe among women, the elderly, minorities, and those who are divorced and separated. We identify four different categories of individuals—the ―in control‖, the borrowers/savers, the overextended and the fringe borrowers— and find that debt literacy is related to the financial 1 experiences that people have had. For example, individuals who transact in ways that incur high fees (e.g., only pay minimums on their credit card bills, incur late and overlimit fees) and those who use high-cost alternative financial services are less debt literate, even after controlling for many individual characteristics. Similarly, when we apply our results to credit card behaviors, we find that the less knowledgeable pay a disproportionately high share of fees and financing charges. Specifically, the less knowledgeable pay 46% higher fees than do the more knowledgeable. Debt literacy also is related to the level of overindebtedness. In particular, those who have the highest levels of debt literacy are more likely to report facing no problems with debt, while those with lower levels of debt literacy tend to judge their debt as excessive or report that they are unsure about their debt position. All together, these findings point to the fact that widespread lack of financial skills is a reasonable cause for concern.

1. Review of the literature Over the last decade, several researchers have started to explore whether individuals are well equipped to make financial decisions. Bernheim (1995, 1998) was among the first to document that many U.S. consumers display low levels of financial literacy. More recently, Hilgerth, Hogarth, and Beverly (2003) report that most Americans fail to understand basic financial concepts, particularly those relating to bonds, stocks, and mutual funds.1 Most importantly, in a survey of Washington state residents, Moore (2003) indicates that people frequently fail to understand terms and conditions of consumer loans and mortgages.

Furthermore, we can’t assume that the next generation will do better. The National Council on Economic Education’s (NCEE 2005) study of high school students shows a widespread lack of knowledge regarding fundamental economic concepts, confirming similar findings by the Jump$tart Coalition for Personal Financial Literacy (Mandell, 2009).

This is not only a U.S. problem: The 2005 report on financial literacy by the Organization for Economic Co-operation and Development (OECD) documents low levels of financial illiteracy among several countries. Similarly, the Survey of Health, Aging and Retirement in Europe (SHARE) shows that respondents score poorly on financial numeracy and literacy scales (Christelis, Jappelli, and Padula, 2008). Similar to the findings of Moore (2003), Miles (2004) reports that U.K. borrowers have a poor understanding of mortgages and interest rates.

1 Other surveys on smaller samples find similar results. See Agnew and Szykman, 2005.

2 Lusardi and Mitchell’s (2006, 2008a) module on planning and financial literacy for the 2004 Health and Retirement Study, offers insight as well. They find that many older (50+) individuals cannot do simple interest-rate calculations, such as calculating how money would growth at an interest rate of 2%, and do not know about the working of inflation and risk diversification. Similar results are seen in a sample of early Baby Boomers (ages 51–56): most respondents display low numeracy and a very limited knowledge of the power of interest compounding (Lusardi and Mitchell, 2007a).

Financial literacy has been linked to saving behavior and portfolio choice, often connecting financial knowledge to one specific type of transaction. For example, the less financially literate are less likely to accumulate wealth (Stango and Zinman, 2008), less likely to plan for retirement (Lusardi and Mitchell, 2006, 2008), and less likely to invest in stocks (van Rooij, Lusardi and Alessie, 2007; Yoong 2007; Christelis, Jappelli, and Padula, 2008).

Moreover, less-literate individuals also are less likely to choose mutual funds with lower fees (Hastings and Tejeda-Ashton, 2008). There is also some indication that literacy may affect debt as well. Moore (2003) reports that respondents with lower levels of financial literacy were more likely to have costly mortgages. Similarly, Campbell (2006) reports that individuals with lower incomes and lower education levels—characteristics that are strongly related to financial literacy—are less likely to refinance their mortgages during a period of falling interest rates.

This previous work offers an important staring point. However, unlike these studies, we try to relate financial capability to rich patterns of financial transactions, placing a particular emphasis on its relationship to indebtedness.

2. Methodology and Survey Design

We partnered with the market research firm TNS to develop and administer a survey that reports information on financial knowledge related to debt. In addition to measuring participants’ financial skills, we collected demographic characteristics as well as data on individuals’ financial experiences and their judgments about their indebtedness.

Our approach to measuring financial literacy has two elements. First, we devised questions to assess key debt literacy concepts, such as the power of interest compounding. Our aim is to assess debt literacy among the population, i.e., to measure knowledge and skills closely 3 related to debt. 2 These questions can be solved with simple reasoning and do not require a calculator. Second, we ask participants to judge their knowledge of finance, and can relate this self-assessment to their performance on our questions.

The survey was fielded in November 2007 by the staff of TNS, a leading market research firm.3 The data were collected via a phone interview from a sample of 1,000 U.S. respondents.

Weights were constructed to make the final sample representative of the US population with respect to income, gender, age and other observable traits, such as household size, region, and market size. The survey reports information on several demographic characteristics, such as age, gender, race and ethnicity, marital status, employment, region of residence, family type and family size. In addition, it provides self-reported information on family income and wealth.

Respondents identified their household income category (one of four options) and the category their total investable assets fall into (ten brackets are provided). Total investable assets include any sums in cash, checking or savings accounts, stocks, bonds mutual funds, insurance policies and any money in IRAs.4

3. Measuring Debt Literacy

In partnership with TNS, we designed and tested questions measuring financial knowledge related to debt. While there are a few national surveys that measure financial knowledge in the United States, such as the Health and Retirement Study (HRS), the Rand American Life Panel (ALP), and the Survey of Consumers, few ask questions that focus specifically on borrowing and debt behavior.5 Our survey included three new questions designed to measure debt literacy. Specifically, respondents were asked questions that determined their knowledge about the power of interest compounding, the working of credit card debt as well as 2 Given the information collected in the literacy questions, we are not able to distinguish between pure financial knowledge and ability, including numeracy and cognitive ability—an issue which can be important when considering the elderly and those with low educational attainment. Thus, we use the word ―financial literacy‖ and ―debt literacy‖ to encompass all of these characteristics. However, in our empirical work, we always account for income and wealth. Thus, our measures of literacy will capture knowledge and ability above and beyond what is accounted for by income and wealth.

3 See http://www.tnsglobal.com/ 4 Respondents are asked to exclude primary residence, real estate, closely-held businesses or assets in any employersponsored savings or retirement plans including a 401(k) plan from their measure of investable assets.

5 These surveys cover adults. Surveys of high school students include those by the Jump$tart Coalition for Personal Financial Literacy and the National Council on Economic Education.

–  –  –

Table 1, panel A, reports the responses to this question. Ignoring interest compounding would lead to doubling in 5 years; someone who knew about interest on interest might have selected a number less than 5; someone who knows the ―Rule of 72‖ heuristic would know that it would be about 3.6 years (i.e., correct answer (ii) ―less than 5 years.‖). Answers above five years reflect misunderstanding of the concept of interest accrual.

Fewer than 36% of respondents answer this question correctly. This is a rather low percentage given how many individuals have credit cards and maintain revolving balances.

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