America’s Financial Capability Gap

Suppose you put $100 in a savings account with an annual interest rate of 2%. After five years, how much would you have in the account?

  1. More than $102
  2. Exactly $102
  3. Less than $102

This question requires only a basic understanding of the concept of interest. Yet only 61% of Americans selected the right answer in a survey for FINRA’s National Financial Capability Study.

At a recent RAND Behavioral Finance Forum here in DC, Dartmouth Professor and Financial Literacy Center director Annamaria Lusardi presented the study’s key findings and policy implications.

The study found that the majority of Americans are ill-equipped to make financial decisions. The cost of this lack of financial capability can be quite high and poses significant risks for both individuals and the economy.

For instance:

  • 51% of Americans don’t have emergency savings. When asked if they could come up with $2,000 in one month, 46% said no.
  • 23% have taken out a high-cost loan at some point in the last five years.
  • 35% find it difficult to cover bills and basic expenses each month, while 17% find it extremely difficult.
  • 42% have never tried to figure out how much they need to save for retirement.
  • 36% have checked their credit score in the last 12 months.

It seems contradictory, then, that 75% of Americans also consider themselves as being good at dealing with day-to-day financial matters. Even the individuals who gave themselves high “financial knowledge” ratings engaged in behaviors that generated fees and high costs. A large gap clearly exists between self-perception of financial capability and actual behavior.

Financial literacy should be treated as a required skill, much like reading and writing, says Dr. Lusardi. There is an obvious need for drastic improvements in financial education across America. Yet she recognizes the limitations of education by posing the question: can financial education in and of itself really transform behavior?

Given the magnitude of low financial literacy across America, Lusardi argues that this issue is too significant to be addressed with a single solution. In her opinion, financial education must be complemented by market solutions to provide all Americans with the basic tools to make better financial decisions.

Have you ever taken a financial education class?  Who do you go to for help with financial decisions?

Read the full FINRA report or check out Dr. Lusardi’s paper prepared for the Financial Crisis Inquiry Commission (FCIC).

Update 6/29/2010: James Surowiecki wrote a new piece in the New Yorker which addresses the issue of financial illiteracy across America – certainly worth a read as follow up to our short post.