Credit repair is possible, but only if you increase your debt literacy. (Photo: flickr.com)

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.

Survey Methodology

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.

Despite the claims made by financial advisors and planners, in reality there is no real possibility of having the perfect portfolio that performs to your expectations. Most portfolio planning today uses some variation of the mean-variance optimization process invented by Harry Markowitz, and though this system does make sense, in reality it leaves a lot to be desired. This is because mean-variance based systems are based on one very specific circumstance that is based on the exact volatility, correlation, and returns you stipulate when setting up the calculation.

Since no one can effectively guess at future volatility and performance, these calculations are invariably wrong. The subsequent performance can be well below expectations, or even worse than just taking random guesses at the proper asset allocation.

Stocks versus bonds

Historically speaking, stocks always out perform bonds over a long period of time, but stocks are also more volatile, meaning that there is a greater risk involved. Young investors, people with more fifteen years to go before they intend to retire, need active capital growth in their 401(k) plans and also have enough time that they have the time to recoup any losses from dramatic downturns or crashes.

Although it looked very bad at the time, the stock market crash of September 2008 did not amount to a permanent blow to most young investors because they still have a long time to go before they access their 401(k) funds and much of the value lost has already been regained as of November 2009. Older investors who are planning on retiring within the next fifteen years have much less time to compensate for major losses, so they should probably invest more in bonds than stocks.

What stocks should you invest in?

There are many different types of stocks to choose from, though many 401(k) plans limit their participants to investing in mutual funds holding a basket of stocks. More often than not, these mutual funds are a better idea for people lacking an intimate knowledge of the market because they are managed and operated by professionals who have an intimate understanding of the markets.

Not only do most 401(k) plans limit your stock options to mutual funds, they also tend to limit the number of mutual funds available as well. Assuming this is the case, the best idea is to research those funds that are available and trace their performance over set period of time. Do not just look at individual performance, but look at compared performance. If two or more funds tend to balance each other out – one going up when the other goes down – consider invested in both in equal amounts. Examine your options closely and look for slow, even growth as opposed to the returns made by individual funds by themselves.

What bonds should you purchase?

As is the case with stocks, most 401(k) plans also limit bond holding to funds as opposed to separate issues. Further, many 401(k) plans are tilted in favor of stocks and provide fewer bond options to choose from. By its very nature, the bond market is trickier for non-professionals to understand, so going through a bond fund is probably a better option for most 401(k) holders anyway. That being said, the core of your bond holdings should probably be a total bond market index fund as opposed to many of the more specific bond funds that might be available. One thing that should be taken into consideration in the current climate is the continuing decline of the dollar, which will likely result in increased inflation. Using a mix of foreign and high-yield bonds as well as Treasury Inflation Protected Securities (TIPS), can offset inflation related losses, but should only account for ten to twenty percent of your bond allocation.

How many funds should you hold?

Many people, especially those with a lot of funds to choose from in their 401(k) plans tend to equate holding more funds with better diversification. However, this is not really the case at all; the issue is not how many funds you hold but what those funds invest in and whether or not your funds balance each other. As a general rule of thumb it is better for most people to hold as few funds as possible because the more you hold the more complicated your planning and tracking becomes. While savvy investors with a good understanding of the markets may make more money by using many different funds, for most people using their 401(k) to save for their retirement, holding more funds just complicates the process.

(Photo:fr.wikipedia.org)

This recession has put the proverbial shackles on the aspirations of people both rich and poor. The availability of credit is still moving at the pace of a slow crawl, while consumer spending is still searching for a way to pick itself up off the floor. But of course, it won’t truly be able to do that until the question of job security becomes less a hot button and more background scenery. Until money and credit begin flow as they did 10 years ago, the stock market will continue to show only modest gains at best. People are looking for help, whether it is the temporary assistance of cash advance loans or the more permanent change in which wages actually begin to keep pace with inflation.

Most of know just how the recession has taken a bit out of our finances. But did you know just how much even those who would have been “untouchable” have been hurt by the downturn? A recently New York Times articles takes a look at John McAfee, founder of the software company that produces McAfee Antivirus. His $100 million fortune has dwindled by an astounding 96 percent. Sure, that still means that he’s worth about $4 million and won’t need a cash advance, but what a drop!

“Horrific news”

Yes, Gawker jests when they call this “horrific news,” brought to us by “those tireless chroniclers of the plight of the rich, the New York Times,” but this cautionary tale does give us some idea of just how far America’s economic dealings have run aground. The number of super-rich in the United States may just be at its ebb tide. Yes, there are those who have already recovered to their pre-recession salaries, but there are many more that have not.

John McAfee is certainly not one of those who have recovered. He founded his company in the late 1980, and then sold his stock a couple of years after the antivirus giant had its initial public offering on Wall Street. He made $100 million in the deal, and he went on to invest much of it in real estate and bonds through the Lehman Brothers brokerage. At the time, it seemed like a great way to keep his fortune safe. Everyone in his income tax bracket was doing it.

Then the bubble burst

And John McAfee’s real estate holdings dropped in value like crazy. A 10,000-square-foot home in Colorado with a view of Pike’s Peak cost him $25 million to buy and build. In 2007, it sold for only $5.7 million. Then Lehman Brothers went belly up and his bonds were suddenly worth pennies on the dollar. Other stock investments cost him millions more in lost revenue.

Wait, there’s more. John McAfee has sold his 10-passenger Cessna and now flies like the rest of us. I wonder if he used the JetBlue unlimited pass when he went to visit his Hawaii oceanfront estate for the last time. That estate is gone too. It sold at auction for $1.5 million (much less than he paid for it), and there were only a handful of bidders. Apparently the former antivirus software mogul is going to high-tail it to Belize, where tax laws are more favorable to sinking millionaires like him.

What’s in store for John McAfee?

Let’s be realistic. I’m sure he’s going to land on his feet in Belize just fine. However, he’ll have to make do with much less than before. We who get cash advance loans when we need a cash advance will surely weep for him, particularly after ANOTHER estate (this one in New Mexico) goes up for a no-floor auction. In other words, no matter how low the top bid is, John McAfee has agreed to accept.

(Photo: glyphjockey.com)

I bring all of this to your attention not because John McAfee deserves a pity party. I’m sure he was aware that he was taking some risks with his money, and he certainly isn’t hurting with $4 million left over and likely a nice home in Belize. What I’m saying is that we can no longer allow the game players who manipulated the levers and knobs of the U.S. economy to carelessly speculate with our money. They walk away with something left over, but what of the less sophisticated investors? Like Tommy Wilhelm in Saul Bellow’s “Seize the Day,” they’re left with nothing. Financially, it’s a perpetual funeral.

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