Research shows types of available financial services have major impact on households

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How much should one be saving today for retirement in the future? What do interest rates mean when you borrow money only to be paid later? How do fees compare to interest rates on loans? How does inflation impact your personal spending power over time? Answers to these questions, and more, are valuable to everyone, regardless of income, in making informed financial decisions.

That’s why understanding the terms used in these questions — and why they are important — often go hand-in-hand with one’s financial success. Harbert College of Business finance professors Dr. Jim Barth and Dr. Jitka Hilliard, and doctoral student in finance Nguyen Nguyen, find people who are more financially literate obtain services from more traditional, and less costly, financial institutions. Those who are less financially literate typically rely more heavily on alternative financial service providers such as payday lenders and pawnshops.

Their paper, “Does Financial Literacy Matter for the Type of Financial Services Used by Households?” shows that increased financial literacy is associated with the use of more traditional financial firms like banks instead of alternative financial services, including high-interest payday operations. Importantly, they find that an increase in financial literacy among a greater number of individuals and households contributes to more financial inclusion — it becomes less costly and less difficult for individuals to obtain financial services from banks.

“People sometimes might not know enough, or fully understand the consequences of their financial decisions, because they were not provided with the information they need to make better choices,” said Barth, the Lowder Eminent Scholar in Finance. “People sometimes just aren’t trained in school to make more informed decisions. The need for personal finance courses is becoming increasingly important because more, and more complicated, financial products exist today.”

A proposed solution?

“Start teaching people financial literacy at a much younger age,” Barth suggested. “Yes, it’s taught in some high schools, but there needs to be more done for more people. For example, it could be taught at the community-level, perhaps by universities located within small communities where you have high rates of unemployment or older people who didn’t get the chance to go to college and/or weren’t exposed to personal finance courses.”

“People need to better understand their respective budgetary situations,” Barth added. “What funds are coming into a household? What funds going out for mortgages, rent, utility bills or food? Knowing this, a person is in a better position to make more informed decisions when borrowing money.”

Informed decision-making at the ground level by consumers is ultimately good for the economy, Barth suggested.

“If people make more informed decisions, then we will have a better working financial system,” he said. “In that case, we would expect people not to have borrowed too much and therefore have less trouble repaying it. This means fewer defaults, which makes for stronger financial institutions. Better financial decisions that are made are simply good for the economy — it means that funds are going where they ought to be going rather than going to the wrong place.”