Financial literacy and consumer credit portfolios
Highlights
► We analyse financial literacy and consumer credit portfolios. ► We use survey data from a representative sample of UK households. ► Less literate households hold higher shares of higher cost debt. ► This effect is due to consumer behaviour in credit markets. ► Less literate households are also less likely to acquire financial information.
Introduction
Consumers who make use of credit to finance consumption purchases need to understand the financial cost of the credit they use. Mature credit markets offer a broad variety of consumer credit products, including consumer loans, credit cards, hire purchase loans, car loans, catalogue loans, home credit and payday loans. Consumer marketing of these products shares a common set of semantics for expressing the cost of borrowing in terms of interest rates. Regulatory bodies commonly mandate that consumer credit adverts show common interest rate-based measures of the cost of credit to allow life-for-like comparison across heterogeneous products, most commonly using an Annualised Percentage Rate (APR). But do consumers understand these expressions of the cost of credit and, if not, what are the financial costs associated with misunderstanding?
In this paper we measure consumers’ understanding of basic financial calculations relevant to the cost of consumer credit, such as the use of interest rates, Annualised Percentage Rates (APRs), interest compounding over time and also the notion of a minimum payment on a credit contract. Among users of consumer credit, 11% fail to answer correctly any one of three multiple choice questions on simple interest, compound interest or minimum payments. At the other extreme, 30% of respondents answer all three correctly. Wrong answers typically arise because households underestimate the cost of consumer credit when performing the calculations required by the financial literacy questions.
The existing empirical literature on financial literacy finds that individuals who participate in financial markets exhibit, on average, better understanding of core financial concepts relevant to those markets compared to individuals who do not participate. Such studies have been carried out on saving plans for retirement (Bernheim, 1998, Lusardi and Mitchell, 2007, Banks et al., 2010, Clark et al., 2011, Hastings et al., 2011) and stock market participation and portfolio selection (Haliassos and Bertaut, 1995, Guiso and Jappelli, 2009, Van Rooji et al., 2011a, Van Rooji et al., 2011b, Yoong, 2011). Since decisions to invest in financial literacy arise endogenously depending upon individual financial scenarios (Jappelli, 2010, Jappelli and Padula, 2011), some studies use instruments for financial literacy which create variation in levels of literacy within samples uncorrelated with financial market choice. (Lusardi and Mitchell, 2007, Van Rooji et al., 2011a, Van Rooji et al., 2011b). There is also new evidence that since the onset of the financial crisis consumers with more understanding of banking supervision and insurance have more extensively diversified their asset portfolios across banks (Van der Cruijsen et al., 2011).
Consumers who engage in borrowing on the consumer credit market have an obvious incentive to acquire understanding of the terms in which consumer credit is priced in order to make informed decisions about borrowing. However, in contrast to the literature on financial literacy and retirement saving or stock market participation, we show that individuals who participate in consumer credit markets actually display, on average, poorer levels of financial literacy compared to those who do not, even conditioned on characteristics such as income and education. Furthermore, individuals who are deeper into consumer credit markets by holding higher debt-to-income ratios show yet poorer levels of financial literacy. Hence participation does not appear to induce greater knowledge of the workings of the consumer credit market.
We then analyse the relationship between financial literacy and the portfolios of consumer credit held by consumers. We find consumers with poor understanding of the cost of consumer credit products typically hold portfolios with higher weighted average APRs and have larger shares of high cost credit such as home credit and payday loans in their credit portfolios. We also present evidence that consumers with low levels of understanding of consumer credit products self-report being less confident in decisions relating to credit use, are generally more confused about financial products and are less likely to engage in basic behaviours which would improve their search for products and information such as reading the financial pages in newspapers and magazines.
Most consumers with positive consumer credit holdings hold multiple consumer credit products in their portfolio. In our data, we are able to observe, for each household, individual credit holdings across an exhaustive range of consumer credit types, in each case observing the balance outstanding, contractual payment obligation on the product and value of any arrears accrued on the product. We match data on representative APRs on each product using industry-provided figures. Alongside this consumer credit portfolio data, we survey households on their financial literacy using a multiple choice question module inserted into the household survey. We then analyse the relationship between financial literacy scores and consumer credit portfolios, focusing on weighted average APR measures of the cost of the portfolio.
We obtain several new results in the financial literacy literature. We document the notable degree of heterogeneity in financial literacy and in portfolio APRs across households holding consumer credit. Households with poor literacy scores exhibit weighted average portfolio APRs on their consumer credit which are 9 percentage points (64%) higher than households who answer all questions correctly and have portfolio shares of high cost consumer credit which are eight times larger than those who answer all questions correctly. We also show that consumers with poor financial literacy are typically aware of their lack of understanding about finance and typically self-report they are less confident when making borrowing choices which involve calculating the cost of consumer credit. However, despite this evidence of self-awareness of the part of less literate consumers, they are also less likely to engage in the most readily available and straightforward behaviour which might improve their understanding of consumer credit terms, and their understanding of financial markets more generally: they are less likely to read the finance-related pages in the news media.
We show that this variation is not for the most part attributable to related household characteristics that might ration credit supply to the household. Households which perform poorly on the financial literacy questions exhibit on average lower incomes, lower levels of home ownership, less education, lower levels of employment and higher levels of unemployment. These characteristics might imply that they face tighter credit supply constraints compared with households that exhibit higher levels of income, employment and home ownership (which are likely to be correlated with more access to credit). However, conditional upon such covariates, regression estimates show positive and statistically significant effects arising from financial literacy. As a consumer’s financial literacy is not observed by a lender, and hence is not a characteristic on which the lender can discriminate in a credit supply decision, we interpret these estimated effects, conditional on related coefficients on which lenders might discriminate, as arising due to poor consumer understanding of the credit market.
Our results therefore provide a direct measure of the cost of consumer misunderstanding in the consumer credit market, in the form of differences in APRs across households holding other characteristics constant. We contribute to a broader literature on consumer behaviour in credit markets which seeks to understand the drivers of observed consumer behaviour and determinants of effective credit market participation (Agarwal et al., 2006, Campbell, 2006, Gabaix and Laibson, 2006, Lusardi and Tufano, 2009, Tufano, 2009, Meier and Sprenger, 2010, Stango and Zinman, 2009, Stango and Zinman, 2011, Vissing-Jorgensen, 2011).
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Section snippets
Survey data and financial literacy questions
Our dataset is the October 2010 wave of the quarterly Debt Track survey undertaken by the UK market research organisation YouGov, conducted via the internet.1 Each wave surveys a representative sample of approximately 3000 UK households drawn from YouGov’s panel of around 350,000 interviewees. The Debt Track survey is limited to
Consumer credit usage and portfolio characteristics
Summary statistics for our sample of households are shown in Table 1. We distinguish between households with no consumer credit and households with positive consumer credit balances on at least one credit item. Approximately two thirds of our sample holds no consumer credit.2 The summary statistics show that
Econometric analysis of portfolio weighted APRs and high cost credit shares
The previous section suggested that poor levels of financial literacy are associated with higher cost consumer credit portfolios. However, the summary statistics also reveal that households with respondents who typically did better on the financial literacy questions also had different household characteristics from those who fared poorly. Typically, however, household characteristics are likely to be associated with the availability of credit to household. Hence, this finding might suffer from
Financial literacy, self-awareness and behaviour
In this section we investigate whether individuals with poor financial literacy are in general self-aware of the mistakes they make in calculations involving consumer credit terms, and whether they engage in a basic behaviour which would help them to become more aware of financial concepts and generally better informed about financial products and markets. The basic behaviour we consider is reading the financial pages in the news media. Finance sections in newspapers or on news websites are a
Conclusion
This paper has analysed the relationship between financial literacy and consumer credit portfolios. The data source was a representative sample of UK consumer credit users, utilising questions that explore their understanding of basic topics in financial literacy. The questions used might appear simple, even trivial, to an academic audience with a rudimentary understanding of mathematics and basic financial concepts. However, results show that while the large majority of individuals sampled can
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