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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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21 We find that self-reported literacy again shows a very strong relationship to debt. Those who report higher levels of literacy are more likely to belong to the group who report having no difficulties paying off debt. The effect is not only sizable but it increases with higher scores for self-assessed literacy. Conversely, those who are less literate are much more likely to report having difficulties with debt and again there is a monotonic (negative) relationship between financial literacy and having too much debt. Although the estimates are less sizable than for those who have or may have difficulties with debt, the unsure also are much less likely to display high levels of literacy. Demographic variables are related to debt loads as well. Those who are employed and have higher income and higher wealth are much more likely to report they have the right amount of debt. Finally, women, African-Americans and those with low income and wealth are more likely to be unable to judge their debt load.

When we consider the other measures of literacy, we find similar results. Most importantly, these results are consistent with the multinomial logit for the experience segments.

Specifically, those who overestimate the number of years it takes for debt to double (recall that these respondents are much more likely to belong to the fringe groups and much less likely to belong to the in-control group) are also more likely to report they have or may have difficulties paying off debt. On the other hand, those who make mistakes in answering this question or do not know the answer to this question are much less likely to report they have the right amount of debt, while they are more likely to belong to the unsure group.

Knowledge about how to eliminate credit card debt by making minimum payments (second literacy question) is also related to self-assessed levels of debt. In this case, those who display the lowest amount of knowledge, i.e., claim not to not know the answer to this question, are less likely to report having the right amount of debt. Those who claim not to know the answer or make large mistakes are more likely to belong to the unsure group. Similar patterns were found for the clusters; for them as well, being unable to answer the question is an important determinant of debt behavior as characterized by the clusters.

Turning to the answer to the question about the more advantageous payment option, we find again that those who are not able to answer this question are less likely to report having the right amount of debt, while they are more likely to belong to the unsure.

For completeness, in Table 12 we report the estimates where we also account for the three dummies characterizing different clusters (the first cluster is the reference group). In this way, we can assess whether financial experiences have a direct effect on the amount of debt that 22 respondents have and whether the effect of financial literacy remains significant after accounting for the debt behavior characterized by the four clusters. As shown in Table 12, the effects of literacy weakens only for the third measure of debt literacy, otherwise there is still an effect even after accounting for the clusters. Thus, financial literacy can affect debt loads above and beyond the effect it has on financial experiences. Moreover, even after accounting for a large set of characteristics, those who report having difficulties with debt are disproportionately likely to belong to the three segments that are not in control. Conversely, members of clusters 2, 3 and 4 are much less likely to report they have the right amount of debt. Note that not just the overextended and the fringe borrowers report having difficulties with debt, but also those in cluster 2, who carry some balances and pay some finance charges, end up with too much debt.

9. The Cost of Ignorance In this section, we offer some partial estimates of what we call ―the cost of ignorance,‖ or the financial transaction costs incurred by less-informed Americans and the component of these costs particularly related to their lack of financial knowledge. For the purpose of our calculations, we focus exclusively on credit card debt (Table 13).

This calculation of expected costs has two components—the likelihood of and costs of various behaviors. First, we calculate the likelihood of engaging in various credit card behaviors that give rise to explicit fees or financing charges: paying bills late, going over limit, using cash advances and paying the minimum amount only. These likelihoods come directly from our empirical work. We compare consumers with higher versus lower financial knowledge, with the least financially savvy in our population defined as those who judge their financial knowledge equal to 4 or less on our seven point scale. Among cardholders this group comprises 28.7% of the population. For the less knowledgeable, we calculate both the average likelihood of engaging in these behaviors as well as the incremental likelihood of engaging in these behaviors as a function solely of having lower financial skills. The latter estimates come directly from estimates analogous to the ones we show in Table 9. For example, the unconditional likelihood that a cardholder reports incurring at least one over-the-limit charge in the prior year was 5.6%. From our dprobits, even after controlling for income, demographics and other factors, the incremental level of incurring an over-the-limit fee is 1.5%. From these two numbers and the fact that 28.7% of the population are less knowledgeable, we can calculate that the average likelihood of a less financially literate individual incurring at least one over-the-limit fee is 7.1%.

23 The second part of the calculation estimates the costs incurred by the cardholder, conditional on engaging in the particular behavior. For late fees, over-the-limit fees and cash advances, we assume that the individual who admits to these activities has only one of these events per year, which is a very conservative assumption. We estimate the cost per incidence from industry data.

For cardholders who pay only the minimum amount, we estimate the finance charges paid for one year assuming that the cardholder’s balance equals the national average balance (about $6000), stated finance charges equal the national average (14.5% in 2007), and the cardholder makes no additional purchases during the year. Again, we select these assumptions to be conservative. We are not attempting to measure all of the costs of transacting, even with a credit card, as we have not included finance charges for revolvers who pay more than the minimum, charges for non-sufficient-funds, annual fees, or other charges.

As the table shows, these four behaviors minimally account for collective fees of $26.8 billion paid by cardholders. While the less informed account for only 28.7% of the cardholder population, they account for 42%% of these charges, because of their higher likelihood of incurring them. They bear a disproportionate share of the fees associated with these behaviors, in particular, their share of fees is 46% higher than their share of the cardholder population.

Perhaps more importantly, of these four charges incurred by less-knowledgeable cardholders, 32% are incremental charges that are empirically linked to low financial literacy after controlling for many variables, including income, age, family structure, wealth ($3.5 billion incremental charges divided by the $11.2 billion total charges incurred by the less knowledgeable).

While we do not make a judgment about whether these fees are appropriate, we note that that they are disproportionately borne by consumers with low levels of financial skills. Furthermore, our empirical results suggest that perhaps a third or more of the fees paid by less knowledgeable consumers might be the result of—or at least linked to—their low level of skills.

10. Implications and Conclusions With this work, we hope to break new ground in a few ways. First, we focus attention on an important component of financial literacy—debt literacy. Secondly, we consider the rich set of financial experiences that individuals have, rather than focus simply on one behavior.

Thirdly, we listen to individuals about their own debt levels. Finally, we designed a collaborative research project that blended scholarly research with timely market research. Our conclusions suggest a complex set of interactions among literacy, experience, demographics and debt loads.

24 While future research must refine some of the findings, there are a few emerging results. Low levels of debt literacy are the norm, and understanding of the basic mechanics of debt is especially limited among certain groups including the elderly, women, certain minorities, and people with lower incomes and wealth. Particularly intriguing—and worthy of additional research—is the notion that certain groups, like the elderly, think they know considerably more than they actually do. This disparity may help explain the incidence of financial frauds perpetrated against the elderly. Moreover, women display substantially lower debt literacy than men and this finding holds true even among the young.

Second, people have rich sets of financial experiences. Our work collapses these experiences into four segments and shows that the segments are closely linked with both demographics and financial knowledge. While it may be reassuring to know that the people who are ―in control‖ of their finances are more financially skilled, it is troubling that people whose financial transaction patterns are characterized by high-cost borrowing are those who come from vulnerable demographic groups and—even after controlling for these factors—are less debt literate. People who are making financial choices that might be considered mistakes (e.g., only paying the minimum balance on their credit cards, incurring late or over-the-limit fees, using alternative financial service credit such as payday loans, tax refund loans, or pawnshops) are those with weaker grasps of debt. While our sample did not specifically study subprime mortgages, it would be useful to know if subprime borrowers were disproportionately drawn from the low literacy groups.

Finally, in November 2007, over a quarter of Americans felt overburdened with respect to their debt loads and another 11% were unable to assess their debt position. Almost no one wished they could get more debt. Given how extensively financial service firms have pushed to make credit available, this is not surprising. Perhaps also not surprising is that those who have or may have difficulties paying off debt were drawn from certain demographic groups, had common financial experiences, and tended to have lower levels of financial literacy.

Our empirical results suggest a sizeable cost of financial ignorance as well. Using credit cards as an example, we find that the less financially knowledgeable pay a disproportionately larger fraction of fees and finance charges than do the more knowledgeable. Our empirical analysis suggests that a large fraction, about a third, of the costs that consumers pay are related to lack of knowledge, after controlling for observable differences in income, wealth, family status and other factors.

25 We think there are a number of implications from our findings. If poor financial decisions partly result from lack of financial knowledge, then in certain circumstances, one may be able to design financial choices to compensate for it. These solutions might be embodied in auto-default mechanisms, such as studied by Choi et al (2003, 2004a, 2004b, among others).

However, once one recognizes the wide range of financial choices that consumers will face, it becomes harder to conceive that all of them can be solved in this fashion. For example, someone who needs additional funds will have to search for and compare alternatives ranging from extending their borrowing on their credit cards, taking out a home equity loan, overdrafting a bank account, taking out a payday loan, or going to a pawn shop. As much as we could try to circumscribe their alternatives, individuals will need to make active choices. Our work suggests that financial literacy is related to the choices that people make, with people with less knowledge making more costly decisions—even after controlling for a host of other factors. We interpret this to mean that additional research on financial literacy—and education to enhance financial literacy—can complement, and not substitute for, auto-default and other comparable approaches.

–  –  –

Agarwal, Sunit, John Driscoll, Xavier Gabaix, and David Laibson, (2007), ―The Age of Reason: Financial Decisions over the Lifecycle,‖ NBER Working Paper n. 13191.

Bernheim, Douglas, 1995, Do households appreciate their financial vulnerabilities? An analysis of actions, perceptions, and public policy, in: Tax Policy and Economic Growth, American Council for Capital Formation, Washington, DC, 1-30.

Bernheim, Douglas, 1998, Financial illiteracy, education and retirement saving, in: O. Mitchell and S. Schieber (eds), Living with Defined Contribution Pensions, University of Pennsylvania Press, Philadelphia, 38-68.

Campbell, John (2006), ―Household Finance,‖ Journal of Finance, 61, pp.1553-1604.

Chen Haipeng and Akshay Rao (2007), ―When Two Plus Two Is Not Equal to Four: Errors in Processing Multiple Percentage Changes,‖ Journal of Consumer Research, 34, pp. 327Choi, James, David Laibson, Brigitte Madrian, and Andrew Metrick (2003) ―Optimal Defaults‖ American Economic Review Papers and Proceedings, 93, May, pp. 180-185.

Choi, Jmes, David Laibson, Brigitte Madrian, and Andrew Metrick (2004a) ―For Better or For Worse: Default Effects and 401(k) Savings Behavior‖ in David Wise editor Perspectives in the Economics of Aging. Chicago, IL: University of Chicago Press, 2004, pp. 81-121.

Choi, James, David Laibson, and Brigitte C. Madrian (2004b) ―Plan Design and 401(k) Savings Outcomes,‖ National Tax Journal, 57(2), pp. 275-98.

Christelis, Dimitris, Tullio Jappelli, and Mario Padula (2008) Cognitive abilities and portfolio choice, mimeo, University of Salerno.

Hastings, Justine and Lydia Tejeda-Ashton (2008), ―Financial Literacy, Information, and Demand Elasticity: Survey and Experimental Evidence from Mexico,‖ NBER Working Paper n. 14538.

Hilgert, Marianne, Jeanne Hogarth, and Sondra Beverly (2003), "Household Financial Managament: The Connection between Knowledge and Behavior,‖ Federal Reserve Bulletin, 309-32.

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