Paying the price for poor grasp of finances

April 16th, 2012

Consumers with poor financial skills pay over the odds for loans and are eight times more likely to use expensive credit such as payday loans, new research has revealed.

The research from The University of Nottingham on the UK consumer market shows that consumers who have a poorer understanding of key financial concepts such as interest rates and credit terms pay nine percentage points more for loans than those with better numerical skills.

Professor Richard Disney and Dr John Gathergood, of the School of Economics, analysed sample data of 3,000 consumers surveyed by the market research organisation YouGov.

Dr Gathergood said: “Survey results show that poor understanding of loan terms such as APRs is associated with more use of high-cost credit. There is a clear cost of ignorance in the consumer credit market.”

The researchers measured consumers’ understanding using a series of questions about the cost of everyday credit products. For example, one question was:

‘‘Sarah owes £1,000 on her credit card and the interest rate she is charged is 20% per year compounded annually. If she didn’t pay anything off, at this interest rate, how many years would it take for the amount she owes to double?’’ Less than five years / Between five and 10 years / More than 10 years / Do not know.”

Among consumers with outstanding debts, only 52% answered correctly (less than five years), 36% chose a wrong answer and 12% said they did not know. Their answers to a series of questions were analysed alongside information about their outstanding debts and the characteristics of those consumers.

The research found that those with poor understanding of financial terms and concepts were typically aware of their lack of understanding. When asked to evaluate their own understanding of financial terms and calculations, consumers who performed poorly on the questions were more likely to state they were unsure about how to interpret financial information. Yet these consumers also stated they were less likely to read the financial pages in the media in order to improve their understanding.

The UK consumer credit market is the second largest in the world, with approximately £200bn of credit held by UK consumers. National Numeracy recently released results that showed that low financial numeracy imposed economic costs on the economy. The Nottingham research shows that poor financial numeracy imposes direct costs to consumers.

It comes as the Department for Business Innovation and Skills Select Committee published the results of its inquiry into debt in the UK. Dr Gathergood testified before the Committee as an expert witness and argued that consumer misunderstanding of credit products was among the causes of debt problems in the population.

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