I recently ran across a stumper of a question and wanted to run it by our blog readers here. So here goes. How would you answer the following question on a test of financial literacy?
Mrs Jones has a loan of 8,000 zeds with FirstZed Finance. The annual interest rate on the loan is 15%. Her repayments each month are 150 zeds. After one year Mrs Jones still owes 7,400 zeds.
Another finance company called Zedbest will give Mrs Jones a loan of 10,000 zeds with an annual interest rate of 13%. Her repayments each month would also be 150 zeds.
If she takes the Zedbest loan, Mrs Jones will immediately pay off her existing loan. What are two other FINANCIAL benefits for Mrs Jones if she takes the Zedbest loan?
If I were taking this test, I would write the following, “It’s not clear there are any (much less two distinct) financial benefits for Mrs Jones to take the loan from Zedbest without further information.”
Then I’d likely memorize the test question and report it* to the test creators and proctors as a faulty question. But that’s not on the list of “correct” answers.
And The “Correct” Answers?
1. She will be paying lower interest
Okay, I’m sorry but this is flat out wrong. I’m going to be a stickler for vocabulary because in this case it matters a lot to Mrs Jones. Mrs Jones might have a lower interest RATE if she took out the new loan with Zedbest, but that’s not REALLY a financial benefit a a lower interest rate is NOT the same thing as paying lower interest.
(For ease of calculation – and since we are given no information on prepayment penalties or amortization schedules I’m just going to assume that interest accrues annually on the yearly starting balance.)
Applying the annual interest rates to the two balances (7,400 and 10,000), shows that Mrs Jones would pay 1,110 in interest in the next year if she kept her original loan, and 1,300 in interest if she switched to the new loan from Zedbest. While her out of pocket expenses on the loans will be the same under both circumstances (150/month, or 1,800 per year), the higher interest costs of the new loan from Zedbest (despite a lower rate) actually means that fewer dollars will be going to decrease her principal balance and she will not only extend the time it takes to payoff that balance, but will also pay significantly more in interest to do so.
I’m just not seeing the financial benefit here.
2. She will have more money available
My jaw dropped when I read this “financial benefit” as a “correct” answer. More money available for *what* precisely? Money is a tool. And right now this tool will be costing Mrs Jones 13% a month to have “available”. Which begets the question…
What on earth is Mrs Jones planning on doing with this tool – the extra 2,600? Because that’s what really matters when calculating its benefit relative to the cost to her? The thing is, I’m having trouble imagining a scenario where paying 13% interest in order to “have money available” is a good thing. If
- she spends it on something she didn’t need simply because she had the credit, then she has done nothing but incur more high interest debt
- she keeps it in savings she’s earning 1% in interest but paying 13%, then she is losing money every month
- she invests it in the stock market she’s earning a bumpy ~7% (based on long term averages) but paying 13%, she is still likely losing money every month and doing it in a much riskier fashion.
Unless Mrs Jones is in a truly dire situation where this 2,600 is keeping her from utter destitution, taking out a loan larger than you need at an interest rate higher than your investments are earning (particularly at a rate as high as 13%!) feels like the equivalent of getting a cash advance on your credit card just to have some walking around money, which is one of the biggest financial mistakes a person can make.
This Is A Bad Question
The oversimplification of this test question encourages students to equate interest rates with total interests costs, a faulty premise that will cost many mortgage holders thousands in interest when they refinance into a lower rate while re-extending the term of their 30-year loan.
It also seems to encourage
- mindlessly increasing consumption: why else would Mrs Jones need money available? There’s nothing to indicate she has a need for an additional loan.
- or overly risky investments: what investments would Mrs Jones be looking into to beat the guaranteed 13% interest expense that she has on that additional 2600 balance?
So Where Does This Question Come From?
Believe it or not, this question actually comes from the first ever financial literacy assessment taken by a cross section of 15-year-olds from 34 different countries but on by the OECD, the Organisation for Economic Cooperation and Development which states as its mission “to promote policies that improve the economic and social well-being of people around the world.” (Though this is where I originally saw commentary on the study and this question in particular. )
The thing is, I think the OECD sadly missed the mark here and that really disappoints me. Financial literacy is important, so it’s great that someone is trying to finally start measuring progress in this area on a vast scale. But with questions like these that miss distinctions between important topics (like interest rates and interest costs) and making positive value judgments on the “availability” of funds regardless to the need for said funds I’m just not seeing how this is really useful. If anything it seems to provide negative reinforcement of all-too-common mistakes and bad social habits.
How would you have answered this question? What are the financial benefits that you see for Mrs Jones taking out this new 10K loan? What would you have proposed as a better follow-up question for the loan offer that Mrs Jones is faced with?
* My teachers always taught me that tests are not infallible and that this is the appropriate response to correct the test for future test takers.