Massive declines in investments and housing prices have hit Americans with trillions of dollars in losses over the past 18 months. But there's another financial drain lurking below the surface that's costing consumers hundreds of billions dollars more: financial illiteracy.
Much of it has to do with high credit card fees and loan rates. "We find a strong relationship between debt literacy and both financial experiences and debt loads," says Dartmouth economist Annamaria Lusardi, who champions improved consumer education in her current book, Overcoming the Saving Slump. Consumers short on financial know-how tend to make bad decisions that result in higher fees and loan charges, she says in a recent research paper co-authored with Harvard economist Peter Tufano. "We estimate that as much as one-third of the [credit-card] charges and fees paid by less knowledgeable individuals can be attributed to ignorance," she says. "The less knowledgeable also report that their debt loads are excessive or that they are unable to judge their debt position."
What's more, there's an "alarmingly low" level of financial literacy among older Americans, Lusardi said at a recent Brookings Institution panel. The problem not only leads to higher credit expenses today, she says, but financial burdens in the future. Research has confirmed a brutal three-way relationship: low financial literacy leads to a lack of retirement planning, and people who fail to plan for retirement have half as much retirement wealth as those who do.
Lusardi poses basic questions to consumers in her research studies to gauge relative levels of financial literacy. See how you fare by checking the answers at the end of the story:
1) Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much do you think you would have in the account if you left the money to grow?
a) More than $102
b) Exactly $102
c) Less than $102
d) Do not know
2) Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent per year. After one year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?
a) More than today
b) Exactly the same as today
c) Less than today
d) Do not know
3) Do you think that the following statement is true or false? "Buying a single company stock usually provides a safer return than a stock mutual fund."
c) Do not know
4) Suppose you had $100 in a savings account and the interest rate is 20 percent per year and you never withdraw money or interest payments. After five years, how much would you have on this account in total?
(a) More than $200
(b) Exactly $200
(c) Less than $200
(d) Do not know
5) If the interest rate falls, what should happen to bond prices?
(c) Stay the same
(d) Do not know
Here are the answers to Lusardi's research questions, along with the percentages of correct responses:
1) a; 92 percent
2) c; 87 percent
3) b; 71 percent
4) a; 69 percent
5) a; 32 percent
If you're feeling confident about your financial IQ after these questions, see how you compare with consumers surveyed recently by the Center for Economic and Entrepreneurial Literacy:
- 53 percent did not know what the Dow Jones Industrial Average was.
- 52 percent could not describe the advantages of a Roth IRA.
- 43 percent could not identify a FICO credit score as the most important factor in receiving a loan.
- 76 percent did not know that when in need of short-term emergency cash, bouncing a check costs more than wire transfers and short-term payday loans.
- 71 percent of people severely underestimated the time it would take to pay off a credit card balance making only the minimum payments.