On Credit Repair and Debt Literacy
What You Know Can Save You Green
Do you consider yourself to be financially literate? How about when it comes to debt – is your level of debt literacy high enough that concepts like credit repair are second nature to you? Chances are your opinion of your debt literacy is higher than the reality. This is much in keeping with a trend numerous studies have observed in Americans: their level of debt literacy is less than adequate to deal with a complex financial market where important decisions – even on the average consumer’s level – can make the difference between a lifetime of saving or an endless cycle of debt. One recent study for the National Bureau of Economic Research by Dartmouth Economics Professor Annamaria Lusardi and Harvard Financial Management Professor Peter Tufano entitled “Debt Literacy, Financial Experiences and Overindebtedness” shows us just how far Americans have to go before debt literacy and credit repair become a part of the everyday financial lexicon.
Saving, investing and being prepared for retirement are vital elements of financial health and well-being. However, runaway personal debt and a widespread lack of basic debt literacy understanding tend to take the place of the more positive aspects for many Americans. What the authors attempt to do with their study is to examine the connection between financial literacy and debt. As the authors see it, debt literacy amounts 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.” To measure debt literacy, the authors worked with a market research company to create and conduct a survey that asks a broad consumer sampling three questions designed to assess their understanding of basic debt literacy concepts like compound interest. The questions were intended to be solved via reasoning alone, so they were simple enough that calculators were not needed. Afterward, participants were asked to rate their own knowledge of debt literacy.
What Did They Expect to Find?
If numerous studies on the financial knowledge of the U.S. consumer were any indication, it wasn’t going to be a fairy tale ending. Douglas Bernheim documented Americans’ lack of financial knowledge as early as 1995. They fail to understand basic financial concepts, “particularly those relating to bonds, stocks, and mutual funds,” and are quite fuzzy on such things as terms and conditions on large-scale loans and mortgages. This trend looks to continue on into the future, as a National Council on Economic Education study of high school students shows “a widespread lack of knowledge.”
Is this a uniquely American phenomenon? Sign point toward “No,” as a survey of Health, Aging and Retirement in Europe (SHARE) indicates poor scores on financial numeracy and literacy scales. Even a member of the U.K. Treasury reported that United Kingdom borrowers have “a poor understanding of mortgages and interest rates.” As a whole, studies in America and Europe show that those with a lower level of debt literacy were less than likely to have a well-developed retirement savings plan, accumulated wealth, stock investments or low-fee mutual funds. They were more likely to have more expensive mortgages, however.
Survey Questions and Analysis
Here are the three debt literacy questions utilized in the authors’ study. The first involves compound interest:
Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20 percent per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?
A) 2 years;
B) less than 5 years;
C) 5 to 10 years;
D) more than 10 years;
E) Do not know;
F) Refuse to answer.
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 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 percent of respondents got this one right. Considering how many people carry revolving balances on credit cards, that’s a troubling statistic, but less than surprising. Many consumers have difficulty grasping percentages and fractions, and compound interest deals with these. The authors found a particular problem in this area for respondents aged 65 and older – many can’t do simple interest calculations.
How Long Will it Take to Pay Off Debt?
That’s something else any consumer with credit card debt should know, so the authors posed this as their second of three questions:
You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an Annual Percentage Rate of 12 percent (or 1 percent per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?
A) Less than 5 year;
B) Between 5 and 10 years;
C) Between 10 and 15 years;
D) Never, you will continue to be in debt;
E) Do not know;
F) Prefer not to answer.
Slightly more than 35 percent of respondents knew that making the minimum payment amounts to an endless cycle (choice D). That’s it. The remainder show a less than solid grasp of debt literacy on this question. Hopefully they’ll do better with the final question.
Interest, Time and Money
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 percent annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?
A) Option (a);
B) Option (b);
C) They are the same;
D) Do not know;
E) Prefer not to answer.
Only seven percent got this question correct. “Most chose a) 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 percent versus the 20 percent in option (b),” write the authors. Personally, this question threw me. As I read it, no interest is implied by choice a). But perhaps I’m missing something.
Demographics of the Debt Illiterate
The study authors found that debt illiteracy is indeed widespread. Respondents 65 and over showed the least debt literacy on the first question, while younger subjects (under 30 years of age) tended to get the first question correct but miss the final two. Gender and race divisions emerged, as did those between married respondents and unmarried. Among the unmarried, it is interesting to note that those who list as being divorced, separated or widowed performed at a lower level than those who had never been married. Surprising no one, respondents with higher income (particularly those earning $75,000 per year or more) scored higher than those in lower income tax brackets.
But Who Thinks They’re Literate?
On a scale from 1 to 7, where 1 means “very low” and 7 means “very high,” the study authors asked respondents to rate their financial knowledge. The average overall score was 4.88, and most considered themselves to be at least above average. Over half of those surveyed marked themselves as a 5 or 6, while only a wink over 10 percent actually chose 4 or lower. Rankings tended to mirror the demographic groups found in the three-question knowledge portion of the survey, but there were two notable differences. In particular, the over 65 age group rated themselves highly but scored lower at an average of 5.3, while the divorced/separated/widowed did the same but clocked in at only 4.79. Again – surprising no one – those who rated themselves high on average had higher incomes and accumulated wealth.
Four Clusters, Four Levels of Debt Literacy
The authors identified four distinct groups among the survey respondents. On one end of the scale are the “in control” group, comprising 26 percent of the sample. They are “firmly engaged in the traditional financial system. These individuals all have credit cards, but do not carry any revolving balances. They have relatively high (but not the highest) levels of experience with mutual funds, stocks, and bonds. They also had the highest incomes. On the other end are “fringe” users who partake of alternative financial services more often, such as payday loans, tax refund loans and pawn shops. Their likelihood of having ever invested in a stock, bond or a mutual fund—or held a mortgage—is about one fifth that of the “in-control” sample.
The middle groups make up what the authors claim to be 43 percent of Americans. The “borrower/saver” group (12 percent) has “the highest level of experience with savings and investments of any of the four clusters, with 98 percent having experience with savings or CD products, 83 percent owning mutual funds, 83 percent owning stocks, and 65 percent owning bonds or savings bonds. They are more extended than the “in control” group in that 95 percent carry revolving credit balances. The final 31 percent are the “overextended” group, who have “less experience with savings and more markers of extended credit.” They typically only pay the minimum on credit cards and have much more experience with penalty fees and much less with stocks and bonds. The authors consider this group to represent the “average American.”
Know Your Debt Level
This is the final question the authors asked participants:
Which of the following best describes your current debt position?
A) I have too much debt right now and I have or may have difficulty paying it off;
B) I have about the right amount of debt right now and I face no problems with it;
C) I have too little debt right now. I wish I could get more;
D) I just don’t know.
In November 2007 when the data was initially collected – barely predating the recession – around 40 percent of respondents had a negative relationship with debt. It seems likely that the numbers would skew even higher.
Lack of Education Will Cost You
That’s exactly what is found with Americans in credit card debt. Those who the authors found to be less financially knowledgeable tended to pay higher fees and finance charges. In fact, the authors estimate that a third of the costs such consumers pay on credit cards are a direct result of a paucity of debt literacy. In total, credit card holders paid $26.8 billion in penalties. Those less educated financially educated make up about 28.7 percent of the cardholder population, but account for a whopping 42 percent of those charges.
Richness of financial experience and a healthy amount of financial and debt literacy are the true recipe for accumulating wealth and approaching credit repair. Considering what Lusardi and Tufano found in their study, this “widespread lack of financial skills” is something America should be concerned about. Making financial education a mandatory part of school curriculums everywhere would be a good start, because what you know is more than worth its weight in gold.
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