The Financial Literacy Crisis

Ignorance lands Americans in debt. Is the solution more schooling or a simpler system?

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Updated 5/8/2008

For many Americans, talking about money is at least as uncomfortable as discussing sex. A recent Charles Schwab study found that most parents felt better prepared to give their teens advice on the "birds and the bees" than on investing. That taboo may explain why Americans are so inept when it comes to making some of the most important decisions of their lives.

Millions of Americans accumulate unmanageable debt, fail to save for a rainy day (and retirement), and make countless other poor financial choices that eventually leave them worse off. But before railing against consumer stupidity, consider this: It's not always their fault. Many of those bad decisions are caused or exacerbated by a lack of knowledge. "There are probably millions...of households who have gotten themselves into mortgage [debt] they never should have gotten themselves into. Most of them didn't understand what they were agreeing to do," says Alan Blinder, economics professor at Princeton University and former Federal Reserve vice chairman.

The time for claiming ignorance as an excuse may be coming to an end. Alarmed by the fact that foreclosures are up 57 percent over last year, consumer credit card debt is increasing at an annual rate of 6 percent, and Americans' savings will replace less than 60 percent of their income on average after retirement, public- and private-sector groups have launched a flurry of programs aimed at promoting financial education. But some experts suggest that even such efforts could be fruitless because they might not change consumers' behavior. They say the focus should instead be on making the financial world easier to understand.

"It's naive to think that we could give high school students one financial course and then make them financially literate consumers," says Richard Thaler, economics professor at the University of Chicago's Graduate School of Business and coauthor of Nudge: Improving Decisions About Health, Wealth, and Happiness. "We can make a lot more progress by making the world more benign."

Part of the problem, educators say, is that the financial systems that consumers navigate have become so complex. Easy access to credit, self-directed retirement accounts, and complicated mortgage options all force Americans to make decisions they may not be prepared for. "We don't know any less than our grandparents—we just need to know a lot more now," says Dan Iannicola, deputy assistant secretary at the Treasury Department and executive director of the President's Advisory Council on Financial Literacy, launched by the White House in January.

For Genette Brooks, 30, the ease with which she could take out credit cards as a college student eventually put her $20,000 in debt. "I didn't know what I was getting into," says Brooks, who graduated with a degree in human resources management and lives in Buffalo. A big reason for the debt, she says, was that no one had ever taught her how credit cards work or how to use them. She says she didn't realize that a zero percent introductory rate could later balloon to 30 percent or that making only the minimum payments can lead to a rapid pileup of debt.

Flunking. Most Americans have extremely low levels of financial literacy, research suggests, despite its importance. The Jump$tart Coalition for Personal Financial Literacy tests 12th graders every two years by asking them practical money questions. The students consistently record an average score of 50 to 55 percent, generally considered to be a failing grade. Other research shows that about 3 in 4 workers don't know how much money they need to save for a comfortable retirement. Only about half of respondents in one study were able to correctly answer two simple questions about interest rates and inflation.

Such poor results matter, says Annamaria Lusardi, a professor of economics at Dartmouth College, because research also shows that people who understand basic financial principles are better at retirement planning, accumulating wealth, and avoiding debt. In fact, she found that people who develop financial plans accumulate from 10 to 15 percent more wealth than those who don't, even after taking into consideration income and education levels.