# Financial Literacy And Asking The Wrong Questions

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.

QUESTION
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?

1. _________________
2. _________________

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.

#### 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.

• Weird. That question is way more complicated than the ones researchers (the Financial Literacy Center team lead by Mitchell and Lusardi) use in the US. And people still do badly on the super simple questions. I think the other countries’ versions of the health and retirement survey does use the simple questions, so there are already ways to compare across countries, at least for older people.
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• This was definitely the most complicated question of the bunch, the rest were mostly how to read invoices and pay stubs – fairly straightforward. I get that they’re trying to get students to apply concepts to answer this question, but they seem to have gone about it in a very strange way.

• That really is a bad question with weird “correct” answers. My advice to Mrs. Jones is just to pay loan #1 off and move on with her life!
Holly@ClubThrifty recently posted..One Lifetime Won’t Be Enough For Us

• haha, if I ever meet Mrs Jones I’ll pass on the message. =)

• Debbie M

I would have guessed they wanted:
* more cash on hand
* lower interest rate

* more money is owed
* loan takes longer to pay off

Two better advantages–IF she can pre-pay on the new loan with no penalty AND IF she prepays the extra \$2,000 immediately:
* lower interest (really this time)
* loan paid off earlier

• If this were a test and I took it while I was in college, I would have chosen less interest and moved on. Fast forward to now and I would ask why do we have to take out a loan? Why get 2K more, what do you need that for, just more money to give back. What is the loan for, medical/house/personal emergency? How quickly can I pay back the loan?

So I guess what I’m saying is let’s make this an essay question!
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• Well, it is true that the interest RATE is lower… that is basically the only advantage other than maybe cash flow. But as you stated this is a horrible example. They should have taken out a loan for the amount that was owed. Not some new arbitrary higher amount. Why \$10,000? Why not \$20,000? If they defined this as a purpose to pay off some higher interest debt like a credit card @ 19%, then yea, there is a purpose for this. Otherwise… as you said… money for what?
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• Greg

The reason they chose \$10,000 was because it is the same monthly payment at 13%.

This falls into the typical American thinking “how much per month” instead of “how much” is the total.

• I just had to leave a comment to say that I’m speechless. If that’s what passes for financial literacy I’d rather stay illiterate. I’m all for keeping cash on hand “just in case” but at a rate of 13% that’d be ridiculous.
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• This sounds like tests I took in college! However, my teacher’s were awesome in that they would have accepted an answer such as yours It’s never a question of what the payment will be, and it isn’t always a question of interest rate and total loan……finance is not simple! I agree with Holly, though
Retired by 40 recently posted..The Importance of Budgeting for Fun Money

• Debi

I would have failed the question because I would have said that as the scenario was laid out there was no reason for Mrs Jones to borrow 10,000. I would have suggested that she borrow 7,400 to pay off the other loan. Then she really would have decreased her interest cost and benefited from the new loan.

• OMG. This is horrible. I can’t believe they would administer that question to a bunch of 15 year old kids and want those answers.

I think they need to seriously reassess the questions they’re asking. I would be pissed if they gave that test to my kids and expected those answers.

I think that’s pretty much the opposite of what I try to teach my two daughters.

• Yikes! I think asking better questions really helps get better answers. Unfortunately this test doesn’t seem that great, and the purpose of teaching financial literacy backfires.
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• I honestly had no idea what to put for the two answers given the information they provided. It’s a shame that that’s what constitutes financial literacy. Especially given the one sided nature of the question. At a minimum it should have asked for two financial negatives of taking out that \$10k loan.

We’re all spreading real financial literacy one blog post at a time. Now if only we could figure out how to make those that need the education the most actually read the posts.
JC @ Passive-Income-Pursuit.com recently posted..Income Update – June 2014

• Nikki

Ha! The funny thing is that I look at this and the way my mind works is that I never even considered taking out the full 10,000. It seems like she would obviously take a loan for 7,400 from the second bank with the other 2,600 they were willing to offer never even entering consideration. The only way that other 2,600 the bank was willing to loan would only enter consideration if she had another loan of 2,600 or less at a higher interest rate that she could knock out with that money. Of course if there were prepayment penalties, that might influence whether or not I thought it was a good idea.

However, this would be a really excellent question to pose on a pretest to help guide lesson plans or in order to start discussion.

• Lara

The answer isn’t completely screwy. In certain cases it could make sense. Are you wanting the extra cash to expand a business, take advantage of a super investment deal, advance your education, or just upgrade your lifestyle? There are valid reasons for things like home equity loans. Unfortunately too many people misuse them. Maybe the question should have been “In what scenarios would this be a good decision?”

• Word problems always confused me as a child. However, this reminds me of taking out a low or no interest credit card in order to pay off a loan with higher debt. It makes sense financially but it can just be putting a band-aid on the problem since you still owe the money. It really just depends on what they money is being used for.
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• Disturbing. Very disturbing.

In the first place, the wording is hideously confusing. In the second, the answers the testmakers seem to want to elicit are ambiguous, at best.

In the words of a friend who, as ME of a major metropolitan newspaper, used to stand in the middle of the newsroom waving some suspect piece of copy and yell “WHO WROTE THIS”:

WHO WROTE THIS?????
Funny about Money recently posted..What Would You Do to Realize Your Dream?

• Wow apparently I’m a big amateur. I read that question and thought of course it’s a lower interest rate but I also assumed that she would only take out what she needed. Not what was offered either way definitely a bad question.

Mrs Pop out of curiosity does your family know about your blog? I’d Like to have a graph of net worth but I’d also like to tell my family about some of my posts those 2 don’t seem to mix so I was curious how the Pop’s do?

• Hey Roamer – Here’s what we wrote almost 2 years ago on what our families knew about our financial situations:
http://www.plantingourpennies.com/how-much-does-your-family-know/

Since then, we “came out” with the blog to Mr PoP’s parents when we paid them back a loan around this time last year, and they are avid readers and big supporters. My family is still in the dark, though that’s easier because that relationship is pretty strained without a lot of shared values when it comes to money. They wouldn’t “just happen upon” the personal finance blogosphere.
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• Maybe you’ve answers this in a post ?
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