Knowing What Not to Do: Financial Literacy and Consumer Credit Choices
ZEW Discussion Paper No. 13-027 // 2013Households do not follow the finance industry's model of a homo oeconomicus - a rational planner. To the contrary, their financial decisions are influenced by character traits (e.g. self-control), (a lack of) financial literacy or general mathematical skills. The finance literature finds that financial literacy influences saving and credit decisions.
While the extant literature focuses on the implications of financial literacy for assets and debt of private investors, this study puts particular emphasis on credit decisions and influencing factors. The analysis is carried out using data on overdraft credit on current accounts (Dispositionskredite), since the decision about taking out such a loan is simple and often-repeated. It is taken without advice from banks and is not tied to one method of payment (cash or by card), as opposed to credit card payments. Moreover, current account loans are a popular form of credit whose access is not restricted for certain groups of the population.
In our analysis of the micro-dataset SAVE, we seek to find whether households with greater financial literacy use overdraft credit less often because they are aware of the relatively high costs when controlling for household characteristics. Our results show that more financially literate people use current account loans less often. Surprisingly, the level of income does not play a central role.
However, character traits could be more important than the knowledge about the costs of a loan. Therefore, we extend our analysis by explicitly considering a person's (lack of) self-control when taking credit decisions. We include this non-observable character trait through approximation: We assume that people who spent their pocket money immediately during childhood are impatient in their consumption decisions today and rather use the credit line on their current account more than wait for their next paycheck. Indeed, self-control is an important factor influencing the use of current account loans. However, it does not drive out the effect of financial literacy. Lastly, we verify that mathematical skills alone are not sufficient to know that overdraft credit is expensive by analyzing the survey respondents' mathematical skills. Although mathematical skills are relevant, financial literacy remains an important factor.
Since character traits can hardly be influenced and mathematical affinity can only be changed with great difficulty, we conclude that improving financial literacy is a way to support private households in their credit decisions.
Dick, Christian and Lena Jaroszek (2013), Knowing What Not to Do: Financial Literacy and Consumer Credit Choices, ZEW Discussion Paper No. 13-027, Mannheim.