What you think you know

Why financial literacy is important.

What you think you know

When I tell people that I am a financial literacy educator and I teach money management classes the response I get is “I don’t need a class like that. I do just fine with my finances.” I find this to be an interesting statement due to the complexity of financial decisions we make today. Forty years ago most people didn’t think about retirement plans or how to set themselves up financially for retirement, when the time came they filed for social security and retired. Today, we now have a greater responsibility to borrow, save, and invest but very few people have the financial knowledge to make and execute complex plans.

In the study “The Economic Importance of Financial Literacy” by Annamaria Lusardi and Olivia S. Mitchell three questions were developed to determine a person’s understanding of the core concepts involving saving and investment decisions. The three questions are:

  • Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow: more than $102; exactly $102; less than $102; do not know; refuse to answer.
  • Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent per year. After 1 year, would you be able to buy: more than, exactly the same as, or less than today with the money in this account; do not know; refuse to answer.
  • 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.” True; false; do not know; refuse to answer.

(Click here for answers see page 10)  

Interestingly enough, although the questions seem basic, very few people across various countries could answer all three correctly. Only 35 percent of participants in the United States answered all three questions correctly. In contrast, people who were asked to self-assess their financial knowledge on a scale of 1 to 7, 1 being low, 7 being high, and 70 percent rated themselves 4 or higher but only 30 percent could correctly answer the questions.

Which leads us to the question, Why is financial literacy education important? According to the study, the less financially literate you are the less likely you are to refinance your mortgage and when you do usually it results in a 0.5 – 1 percent higher interest rate. The study also showed that providing pre-labor market financial knowledge to college individuals improves their wellbeing by roughly 82 percent of their initial wealth, for college graduates the increase is 56 percent. It was also shown, even if a person didn’t make any new investments after receiving financial education they were still inclined to earn higher returns on their savings. In addition, the more financially knowledgeable you are the better informed you are regarding pension rules and the likelihood that you will diversify retirement investments and pay lower investment fees increases. By increasing your financial knowledge you better prepare yourself to execute and make better decisions concerning your financial plans.

Michigan State University Extension has educators on staff to assist with financial literacy. To find an educator near you visit the MI Money Health website or call your county extension office. Michigan State University Extension has released a new toolkit for homeowners who are experiencing or have previously experienced foreclosure. This toolkit will equip these individuals and families with tools to help them recover their financial stability, in the case that a recovery of their home is not possible. The toolkit is available to download free online.

Michigan State University Extension offers financial management and home ownership education classes. For more information of classes in your area, go to either the MSU Extension events page or the MI Money Health webpage.

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