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Why Latest Data on Global Financial Literacy Is Alarming

Dec. 10, 2015
Personal Finance
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By Brian Kuhn

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Worldwide financial literacy is hugely important to global prosperity. It’s necessary for people to understand basic concepts — such as saving, borrowing, debt and interest — in order to make the solid financial choices that will improve their situation.

Judging by the results of a recent survey, we have a lot of work to do before that happens.

Standard & Poor’s conducted interviews about financial literacy with 150,000 people from more than 140 countries in their native languages. Researchers interviewed participants in person if they didn’t have phone or Internet access.

The results were alarming. Only 33% of adults who responded were deemed financially literate — meaning that 67% were financially illiterate. The study extrapolated that to estimate that more than 3.4 billion adults worldwide are financially illiterate.

The United States came in 14th globally for financial literacy, with 57% of respondents being classified as financially literate.

These failings are not just academic. Studies have shown that consumers who fail to understand the concept of compounding interest related to debt, for example — in which debt builds upon itself over time to create a heavier burden if it’s not paid down aggressively — spend more on transaction fees, run up bigger debts, incur higher interest rates on loans, borrow more and save less, due in part to a tendency to carry debt balances and pay finance charges and penalty fees.

Women, the poor, and lower-educated respondents are more likely to suffer from gaps in financial knowledge, the report said.

The report also noted that richer countries, judged by GDP per capita, tend to have higher financial literacy rates.

Standard and Poor’s, in conjunction with Gallup, asked the participants five multiple-choice questions in four financial categories: risk diversification, inflation, numeracy and two questions about compound interest. Survey respondents were deemed financially literate if they answered questions correctly in three out of the four categories, meaning they could get either question right in the compound interest category.

Here are the questions:

“Is it safer to put your money into one business or investment, or to put your money into multiple businesses or investments?”

It is safer to diversify your money by putting it in multiple businesses or investments. This is a concept that everyone would benefit from understanding.

“Suppose over the next 10 years the prices of the things you buy double. If your income also doubles, will you be able to buy less than you can buy today, the same as you can buy today, or more than you can buy today?”

Perhaps so few people have experienced a doubling of their income over a 10-year period that this was perceived as a trick question. Or maybe some from countries, like the U.S., with graduated tax schedules argued that a doubling of income doesn’t always result in a doubling of net spendable income.

But apart from those cases, the answer is straightforward: If your income doubles and the cost of the thing you buy with that income doubles, you’re in the exact same place financially. This is why central governments the world over work so hard to fight inflation.

“Suppose you need to borrow $100. Which is the lower amount to pay back: $105 or $100 plus 3%?”

Three percent of 100 is three, which is less than five — so a $100 loan with 3% interest would cost $103, instead of $105.

Here are the questions in the compound interest category:

“Suppose you put money in the bank for two years and the bank agrees to add 15% per year to your account. Will the bank add more money to your account the second year than it did the first year, or will it add the same amount of money both years?”

“Suppose you had 100 dollars in a savings account and the bank adds 10% per year to the account. How much money would you have in the account after five years if you did not remove any money from the account: more than $150, exactly $150 or less than $150?”

There’s an old saying that compound interest is man’s greatest invention. Why is it so great? Because the money you earn earns more money without you having to do anything. In both of these scenarios, and the reason many rich people stay rich, the money earned then earns the same interest rate the original money was earning. Therefore, even if you didn’t deposit more, or take more risk, or achieve a higher interest rate, you would earn more each subsequent period.

>> MORE: Use NerdWallet’s compound interest calculator to see how compounding affects your savings

This survey shows that governments, educational systems, civic institutions and nonprofits need to prioritize financial education. When more people understand these basic financial ideas and apply them to their lives, they can improve their personal financial situations and help raise global standards of living.

Image via iStock.