Financial illiteracy: what's the problem?

Tim Harford worries about financial illiteracy:

You buy a new £1,000 computer and borrow money to pay for it. You have a choice: either (a) pay 12 monthly instalments of £100; or (b) borrow money at an APR of 20 per cent, meaning you pay back £1,200 at the end of the year. Which offer is better – or are they (c) identical?

Only 7% of Americans got this right. This is a remarkably low proportion, given that a very trivial principle would have given you the right answer - hang onto your money for as long as possible.
So low, in fact, that I suspect something else is going on. If we have to pay £1200 in a year’s time, we need to save and we might not trust ourselves to do so. We might therefore prefer answer (a) as a means  of committing ourselves to saving. In effect, we pay to enter a Ulysses pact.
This raises a general problem in establishing how rational people are: what looks like simply wrong behaviour can easily be rationalized. Granted, the paper (pdf) Tim got this from gives other examples of financial illiteracy. But these seem to be cases of simple innumeracy as much as practical ways in which people get into trouble.
This, though, is not my main reason for being sceptical about proposals to improve financial literacy.
For one thing, I fear that the cure here - even if there is one - might be worse than the disease. In some cases, a little learning is indeed a dang’rous thing because our confidence sometimes rises faster than our knowledge. Lessons in financial literacy might therefore increase people’s willingness to take on debt, in the belief that they can handle it.
And for another thing, I’m not sure how far financial illiteracy is a problem. Most people who get into debt trouble do so because they have fallen on hard times, or been overly extravagant or are just desperate - not because their stupidity has caused them to overpay for otherwise manageable debt.
So, what is the answer here? Partly, as Tim says, we need to simplify. Financial products - debt and savings instruments - are vastly more complicated than they need be. How far this is because of providers attempt to bamboozle folk into paying over the odds, and how far to bone-headed regulation is moot. 
Also, though, we need to recognize that financial education is subject to the Pareto principle. A few simple ideas get  you a long way - and these have little to do with maths. Not least of these is that, unless you buy an appreciating asset - which is less likely than you might think - borrowing will make you poorer. Acknowledging this, however, requires both the self-control to lead lifestyles within our means and a lack of illusions about one’s future; as  I’ve said, what matters is not so much financial planning as character planning.
The problem is, though, that it's not obvious that capitalism can thrive if people stick to these principles.

Comments

[Matthew]

I got it right, but it's not a very good example, really. The difference in interest rate - 35% to 20% - is a bit misleading as you're not offered a monthly repayment with 20% interest rate (which would be £111 a month), but pay nothing now then £1200 at the end. You don't tie up the cash, but at current deposit rates it would be much the same deal cash-wise as the first example, wouldn't it?

[Charles Wheeler]

"This is a remarkably low proportion, given that a very trivial principle would have given you the right answer - hang onto your money for as long as possible."

c/w

"unless you buy an appreciating asset - which is less likely than you might think - borrowing will make you poorer."

[Matthew]

Surely you can become richer even without an appeciating asset if the dividends/rent etc is high enough?

[charlieman]

An awful lot of people, including myself, would not instinctively know the answer because we do not borrow money.

The question should have been addressed to people who might borrow $1,000 for an item of short term utility, not to the general population.

[Mark Wadsworth]

?

Nobody anywhere was ever ruined by getting this one wrong, it just does not matter. Get it wrong and you have lost £10 a month or something, which is far less than the extra value you might get from having a computer (compared to not having one at all) or even from having a new computer (which doesn't waste ten minutes a day crashing and being re-booted) compared to an old one.

Where things went wrong was because e.g. British people thought that if buying a house for £100,000 ten years ago was a good deal, then buying the same house in 2010 for £200,000 was a good deal.

"unless you buy an appreciating asset - which is less likely than you might think - borrowing will make you poorer"

Correct. But the poor saps who paid £200,000 for a house last year were duped into genuinely believing that they were buying and 'appreciating asset'.

[Tom Addison]

At least if you're buying a house you're not wasting money on rent. Saying that, I'd rather rent than be crippled by big mortgage payments every month for however many years. Me and my two mates are paying £300 each a month for rent and all bills, boo-yeah, plenty of pub money.

[Straus]

Mortgage companies make their profits off the back of this kind of financial illiteracy or else financial passivity. I suspect that a sizeable majority of people pay off their mortgages according to the schedule prescribed in their mortgage agreements. And I further suspect that quite a few of them do so not because they can’t afford to do otherwise, but because that is how it has been suggested they do so. Few, I imagine, bother to do the sums to discover how much money they will save by paying off their mortgages five of ten years early.

If you haven’t done so already, I suggest you sit down with a calculator and work it out.

[Matthew]

Paying off a mortgage early saves you the difference in interest between the mortgage rate and the savings rate. Because of tax this amounts to something, but it's not as huge as I think you might imagine.

[Alex]

Some would say that the savings interest rate is now so low there's little point hanging on to the money...

[Sofia Britts]

You're right; knowing the rules of debt can lead you to believe that you can handle it even if you can't. But I think that's better than diving in to the obligation by mistake. At least you know your way out, right? But I guess true literacy here lies in your decision whether you'll submit yourself to debt in the first place or not.