By Pam Flaherty and Jennifer Tescher
When you need to borrow money to make a purchase or pay a bill, how do you decide what kind of loan to take? Who do you to turn to? Do you base your decision on the interest rate offered by the lender? Or do you choose based on how much you have to pay back on a monthly basis (i.e., $300 per month)?
Researchers Marianne Bertrand and Adair Morse from the University of Chicago explored this topic with customers, across 10 states- using payday loans – short-term, high-interest loans from cash advance stores. When consumers were shown the APR of a typical payday loan (in many cases 443%) versus that of a credit card (in this case 16%), most consumers continued to make the same borrowing decisions. However, when they were shown examples of how much it would cost to borrow and pay back the same loan in 3 months, expressed in dollars - to the tune of $270 in fees – the number of payday loans taken out by the group fell by 10 percent compared to the control group. These findings demonstrate that it’s not just what you tell consumers at the time of a financial decision, but how that can have the biggest impact.
As millions of Americans struggle to recover from the economic crisis, financial educators and financial services companies are searching for new ways to raise financial awareness. Among the experts, a consensus is emerging that a fundamental change is needed – one that redefines the concept of financial education, from increasing consumers’ knowledge to actually changing their behavior, or developing financial capability.
What is financial capability? While there is no standard definition, the term generally means being able to cover your monthly expenses with your income, select and manage financial products and services, such as a credit card or a checking account, and plan ahead and save for the future.
The Financial Industry Regulatory Authority (FINRA) recently worked with the Treasury Department to conduct the first National Financial Capability Study. Its findings show that many consumers across the country clearly lack these basic financial skills:
- The majority of Americans do not have a “rainy day” fund for unanticipated financial emergencies and are not adequately saving for college and retirement;
- More than one in five respondents use high-cost, alternative borrowing methods, such as payday loans and pawn shops; and
- Fewer than half (46 percent) correctly answered two basic questions about interest rates and inflation.
But improving financial capability is no easy task. Research shows that people make financial decisions not just on their personal knowledge, but also on a host of other factors, including their personal biases and tendencies. These can range from the need for immediate gratification, which can make it very hard to manage a budget, to over-optimism, which can drive some people to keep buying lottery tickets, rather than save.
To identify the best ways to build financial capability, the Center for Financial Services Innovation (CFSI) studied financial education literature, interviewed experts and explored new approaches. The research was sponsored by the Citi Foundation, as part of its 10-year, $200 million commitment to support global financial education. CFSI’s analysis found that to improve financial capability, financial educators and financial services companies must focus on being:
- Relevant to consumers’ lives – addressing consumers’ specific concerns and financial situations in order to capture their attention and motivate change;
- Timely – coinciding with key life events or moments of decision;
- Actionable – enabling consumers to immediately put to use newly gained knowledge to improve their financial situation; and
- Ongoing – fostering long-term relationships with consumers to provide support, instill a sense of accountability and track progress.
The research also examined different ways for service providers to reach the public, from simply sharing information to directly engaging people for in-depth one-on-one coaching or counseling. The research identified ways that technology—text alerts, personal financial management platforms and social media tools—could help to increase the scale, efficiency, and effectiveness of current approaches.
Experts have made a promising start at developing new approaches to improve financial capability and enhance consumers’ day to-day financial habits. But much more needs to be done. The financial services industry, non-profit organizations, funders and policymakers have to work together to move the process forward.
The Obama Administration is helping make that happen. Last December, the Departments of Treasury and Education launched the National Financial Capability Challenge, designed to increase the financial knowledge and capability of high-school students nationwide. The Administration also recently announced plans to create a President’s Advisory Council on Financial Capability.
A concerted effort among government, education and business leaders will be key to making progress. In the wake of the financial crisis, there has never been a greater need – or a greater opportunity – to help consumers develop financial capability, so they can help themselves make better financial choices.
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Jennifer Tescher is the director of the Center for Financial Services Innovation, an affiliate of Shorebank Corp., Chicago. Pam Flaherty is the President and CEO of the Citi Foundation. |
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