Many economists are still trying to figure out who to blame for the housing bubble, and its subsequent bust. Already, a few have given us some answers. One theory links financial literacy to the risk of defaulting on one’s mortgage. In a working paper from the Federal Reserve Bank of Atlanta, three researchers wanted to know why some borrowers stopped making payments on their mortgages, and they found that defaulters didn’t have a facility with numbers.
People who struggle with numbers were about twice as likely to fall behind their mortgage payments as more mathematically inclined people were. A fifth of these people got into foreclosure while only 7% of the financially literate people ended up in foreclosure. These patterns held up across all kinds of data: risk attitude, type of mortgage (30-year fixed versus ARMs, for example), income level, FICO score, debt ratio, etc. They learned that a financially illiterate person gets himself in more trouble than a financially literate person, even if they are in pretty much the same situation.
The authors of the study also found that people with limited numerical abilities make other financial mistakes that get them into trouble with their mortgages. They spend too much, they save too little, and they do not know how to respond correctly to income and/or consumption shocks. When the economic environment changes, those mistakes become visible rather quickly and very suddenly cause financially illiterate people lots of financial and emotional grief.
Two recommendations stood out. First, it makes sense to combine some sort of financial literacy indicator with the FICO score since financially literate people with the same FICO score are less likely to fall behind their payments.
Second, giving young people more intensive financial education could substantially improve the financial decisions they will make later in life. On this one, you can actually do something about it now instead of waiting for the powers that be to take charge.
If you have missed out on getting a solid education in personal finance, you can still catch up. Here’s how:
- Read finance books. Go to a bookstore or your public library and check out what books are available. Select the one that is presented in a way that works for you. There is no need to pick the bestseller or find the best personal finance book. Just start with one or two that work for you.
- Read the top personal finance blogs. Again, check out the range of different blogs available in cyberspace and subscribe to the ones that speak to you.
- Take classes at a school near you or online.
- Talk to financial planners at your bank, or to independent financial planners. Make sure that the initial consultation is free. You will likely benefit from discussing your financial situation with a professional even if you do not hire them.
- Find a trusted person whom you can use as a sounding board. You can discuss your financial plans and other money related ideas with that person, and you may get fairly objective feedback.
This was a guest post by Christian of Money Obedience. A virtual financial coach that offers a free budget planner.
Readers: Do you have any other recommendations to help improve someone’s financial education?