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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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However, this finding is consistent with the evidence reported by Lusardi and Mitchell (2006) that many older respondents cannot do simple interest rate calculations. It is also consistent with the findings in Lusardi and Mitchell (2007a) that only a small fraction of respondents between the age of 51 and 56 performed a correct interest-compounding calculation when asked to report how the amount in a saving account would grow over a two-year periods at an interest rate of 10%. The larger fraction, 43%, performed only a simple interest rate calculation, without taking into account that interest grows on interest. What we know from psychology and marketing is also confirmed here: many people are not numerate and have difficulties grasping percentages and working with fractions (Peters et al, 2007; Chen and Rao, 2007). Finally, our findings confirm evidence from the health literature that patients have difficulty doing simple calculations (Volk, 2007).

6 In this survey, we were limited to three questions only.

5 The evidence reported in panel A points to two other results. First, a sizable proportion of respondents, close to 20%, reported that they ―do not know‖ the answer to this question. As reported in other papers (Lusardi and Mitchell, 2006, 2007a and van Rooji, Lusardi and Alessie, 2007), ―do not know‖ answers identify respondents with the lowest level of financial knowledge.

Second, more than 30% of respondents over-estimated, sometimes by a wide margin, the number of years it would take for debt to double when borrowing at a high rate. Overall, while many individuals deal frequently with credit cards and credit card debt, there seems to be limited knowledge of interest compounding.

Similar evidence emerges when considering the second literacy question, which asks respondents to calculate how many years it would take to pay off credit card debt when making minimum payments equal to the interest payments on the outstanding debt. Given that one is only paying interest, the principal will never decline. The exact wording of the question is as


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 year;

(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.

Similar to the previous question, this question assesses whether individuals can perform simple interest-rate calculations. Our results illustrate that many respondents don’t understand the working of credit card interest and payments. Table 1, panel b shows that slightly more than 35% of respondents appreciate that making minimum payments equal to the interest payment on the outstanding debt will never eliminate debt. A sizable fraction heavily underestimated the amount of time it would take to eliminate debt; more than 15% of respondents think it will take five to ten years to eliminate debt, and another 20% think that it will take between ten to fifteen years to eliminate debt. Note also that a substantial fraction of respondents, more than 21%, simply do not know the answer to this question.

Not surprisingly, responses to these first two questions are highly correlated. More than half (56%) of those who respond correctly to the first question also respond correctly to the second question. The ―do not know‖ responses exhibit an even higher correlation, with 80% of 6 the ―do not knows‖ from the first question responding similarly to the second question. Mistakes are more scattered, but more than 36% of those who think it will take more than 10 years for credit card debt to double also think it will take from 10 to 15 years to eliminate credit card debt with minimum payments. Individuals who find it difficult to perform these calculations may not appreciate the consequences of borrowing at a high interest rate.

The third question seeks to determine whether people understand the notion of the time

value of money and how skillful they are in comparing methods of payment:

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.

We expected this would be a relatively simple question: by paying $100 a month versus $1200 at the end of the year, one gives money away earlier and foregoes interest that could have accrued by having kept those dollars. As reported in panel C of table 1, a very small proportion of respondents—close to 7%— responded ―correctly‖ to this question. A very high fraction of respondents, 40%, chose option (a)7 even though the stream of payments to finance the purchase of an appliance at $100 per month in (a) has an APR of about 35% versus the 20% in option (b).

About 39% thought that the two payment methods were the same, failing to recognize the time value of money. Overall, these results suggests that individuals may underestimate the interest rate at which they are borrowing, confirming the evidence reported in Stango and Zinman (2008) that individuals are systematically biased toward underestimating the interest rate out of a stream of payments.8 7 This could also reflect their willingness to pay others to enter into a ―self-control‖ contract that did budgeting on their behalf, even at the cost of giving up interest. Our measure of debt literacy in this question reflects this potential feature too.

8 Given the low correct response rate in all questions, one may wonder whether the framing of the question influences the way individuals respond. We are not able to address this issue in this survey. However, the evidence in other modules on financial literacy that one of the authors designed indicates that the framing of the questions matters for questions measuring advanced rather than basic financial knowledge (see Lusardi and Mitchell 2007c, and van Rooij, Lusardi and Alessies, 2007). In this respect, framing may have influenced the responses to the third question, which required some reasoning. When evaluating the empirical work, one has to keep in mind that financial knowledge is measured with error.

7 When considering the relationship between the answers to this question and the other two questions, those who chose option (a) and, in effect, underestimate the interest rate implicit in the stream of payments are more likely to answer the first two questions incorrectly. However, many of those who thought that the payment options are the same are able to answer correctly to the first two questions.

4. Who is More Debt Literate?

Based on our metrics, debt illiteracy is widespread, and as we report here, particularly acute in specific demographic groups. First, we report responses by age, gender, and marital status. Then, we use regression analysis to relate debt literacy to a range of demographic characteristics.

Table 2, panel A, reports the distribution of the responses to the three literacy questions across age groups. The elderly (those older than 65) display the lowest amount of knowledge about interest compounding. Not only are they less likely to answer this question correctly, but also they are also more likely to answer ―do not know.‖ The elderly also display difficulty answering the second question. More than 30% of respondents older than 65 do not know the answer to the second question. On the opposite end of the distribution, young respondents (younger than age 30) do best on the first question, but answer incorrectly on the second and third question. Thus, debt literacy is low among the young too.9 While in a single cross-section we cannot differentiate between age and cohort effects, differences in literacy are sizable across age/generations. Notably, the elderly display very low literacy levels. This is an important finding, as there is some evidence of the prevalence of financial mistakes among the elderly (Agarwal et al., 2007). Lusardi and Mitchell (2006) find that older respondents display difficulty even in answering a simple question about interest rate, with the fraction of correct responses declining sharply with age. While this finding may reflect declines in both knowledge and cognition, it is important because older households have to make important financial decisions until late in life.

Table 2, panel B, reports sharp differences between male and female debt literacy levels.

In each of the three questions on financial literacy, women are much less likely to respond 9 On the other hand, young respondents have less experience in dealing with credit card debt. See also Agarwal et al.


8 correctly than are men, sometimes by as much as 20 percentage points. Furthermore, many women state they do not know the answer to the literacy questions. For example, as many as 25% of women report they do not know the answer to the first question, 28% do not know the answer to the second question, and 13% do not know the answer to the third question. The corresponding fractions among men are much lower. Since our survey covers the entire age group, we also have investigated gender differences among persons younger than 30 and those older older than 65. We find that gender differences are large among the young and continue to be strong among the old, again confirming findings in other papers about the low literacy of women in young and old generations (Lusardi and Mitchell, 2008; Lusardi, Mitchell and Curto, 2008).

Table 2, panel C, reports differences in literacy across marital status. Differences exist not only between the married and the unmarried, but also among the unmarried. For example there are sizable differences between those who never married versus those who are divorced/widowed/separated. This latter group displays the lowest level of literacy, both in terms of the much lower fraction of correct responses in every question and the much higher proportion of ―do not know‖ responses. This is particularly the case for the second question where the fraction of ―do not know‖ responses among the divorced/separated/widowed is as high as 27%.

This finding may be due to the fact that divorced/separated/widower includes a high proportion of female and elderly respondents. The never married group also includes a high proportion of female respondents.

A relatively high fraction of respondents who are divorced/separated/widowed and the never married are African-Americans. Only 14% African-Americans correctly answer the first question, 18% the second question, and 3% the third question. In contrast, these percentages for Hispanics are 26, 27, and 2% respectively, while for Whites they are 37, 38, and 7% respectively (see also Lusardi and Mitchell 2006, 2007a, 2007b).

We also find that financial literacy increases sharply with income (Table 2, panel D).

Given that income (and wealth) are lower among the young and the elderly, female, minorities, and those who are not married, we assess next which demographic characteristics remain significant when we account for all these demographic variables together.

We perform a multionomial logit regression, shown in Table 3, for each of the three debt literacy questions. We include dummies for age groups, being female, African-Americans and Hispanics (the reference group is White respondents), and for marital status (the reference is 9 those who are married). We also add dummies for household income (the reference group is those with income lower than $30,000) and household wealth (the reference group is those with wealth greater than $250,000).10 The table reports the marginal effects. (Rather than reporting the estimates with respect to a specific reference group, we calculate the marginal effects for each set of answers.) Even after accounting for all of these demographic variables simultaneously, both age and gender continue to be statistically significant when considering the responses to the first literacy question. Women and the elderly display less understanding of interest compounding, even after accounting for many demographic characteristics. African-Americans also show lower understanding of this concept. Differences across marital status are no longer significant in a multivariate framework, while differences in literacy across income are large and statistically significant, particularly for those whose income is greater than $75,000.

We find similar results when considering the responses to the second question. Age (being older than 65), gender, race, and income continue to be predictors for differences in literacy. Differences are statistically significant and sizable. For example, differences in male versus female respondents, and differences for those at the top of the income distribution continue to be large even after accounting for many demographic characteristics. When considering the third question, gender and income are predictors. Race and ethnicity is important as well, in this case highlighting Hispanics, who are less likely to respond correctly to this question and are much more likely to report they do not know the answer.

While debt literacy levels are low, the relatively poorer performance by certain groups— women, the elderly, and minorities—is particularly troubling.

5. Who thinks they are financially literate?

In addition to asking questions about some specific concepts related to debt, we have also asked respondents to judge their financial knowledge. The wording of this self-assessment is as


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?

10 Although we do not have information about educational attainment in the survey, income and wealth can also proxy for education.

10 We asked this question for several reasons. First, the questions on debt literacy we have designed cover specific concepts, but they hardly exhaust the list of topics that can affect debt behavior.

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