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Financial Literacy: An Overview of Practice,Research, and Policy
Sandra Braunstein and Carolyn Welch, of the Board’s Division of Consumer and Community Affairs, pre- pared this article.
In recent years, financial literacy has gained the atten-tion of a wide range of major banking companies,government agencies, grass-roots consumer and com-munity interest groups, and other organizations. Inter-ested groups, including policymakers, are concernedthat consumers lack a working knowledge of finan-cial concepts and do not have the tools they need tomake decisions most advantageous to their economicwell-being. Such financial literacy deficiencies canaffect an individual’s or family’s day-to-day moneymanagement and ability to save for long-term goalssuch as buying a home, seeking higher education, orfinancing retirement. Ineffective money managementcan also result in behaviors that make consumersvulnerable to severe financial crises.From a broader perspective, market operations andcompetitive forces are compromised when consum-ers do not have the skills to manage their financeseffectively. Informed participants help create a morecompetitive, more efficient market. As knowledge-able consumers demand products that meet theirshort- and long-term financial needs, providers com-pete to create products having the characteristics thatbest respond to those demands.As concern about financial literacy has increased,so too have the number and variety of financialliteracy training programs and program providers—some offering comprehensive information on sav-ings, credit, and similar topics for a broad audienceand others tailored to a specific group, such as youthor military personnel, or focused on a specific goal,such as home ownership or savings.The findings of studies of the effectivenessof financial literacy training have been mixed.Although some programs, particularly those havingdiscrete objectives, have succeeded in improvingcertain aspects of consumers’ personal financialmanagement—such as maintaining a mortgage,increasing savings, or participating in employer-sponsored benefit plans—improved financial behav-ior does not necessarily follow from increased finan-cial information. The timing and format of training,as well as human traits such as aversion to change,play a role in whether programs will effect positivechange that contributes to households’ long-termfinancial well-being. Accounting for all the variablesassociated with financial literacy training—when,how, and where it is delivered, who is trained,and what information is presented—poses a greatchallenge for program developers. Given theresources now devoted to financial literacy training,this is an opportune time to evaluate the research,identify best practices, and consider public policyoptions that would further the goal of creating morefinancially savvy consumers.
C 
 HANGES
P
 ROMPTING
I 
 NCREASED
A
TTENTION TO
F 
 INANCIAL
L
 ITERACY 
Numerous factors have led to a complex, specializedfinancial services marketplace that requires consum-ers to be actively engaged if they are to manage theirfinances effectively. The forces of technology andmarket innovation, driven by increased competition,have resulted in a sophisticated industry in whichconsumers are offered a broad spectrum of servicesby a wide array of providers. Compelling consumerissues, such as the very visible issue of predatorylending, high levels of consumer debt, and low sav-ing rates, have also added to the sense of urgencysurrounding financial literacy. Other important demo-graphic and market trends contributing to concernsinclude increased diversity of the population, result-ing in households that may face language, cultural, orother barriers to establishing a banking relationship;expanded access to credit for younger populations;and increased employee responsibility for directingtheir own investments in employer-sponsored retire-ment and pension plans.
Technological Changesand Market Innovation
Over the past decade, technological advances havetransformed nearly every aspect of the marketing,
 
delivery, and processing of 
fi
nancial products andservices. The expansion of the Internet as a meansof communicating and delivering services has alsoenabled
fi
nancial services providers to market
fi
nan-cial products and serve customers more ef 
fi
ciently.Communication and delivery innovations increasethe amount of information available to consumersand allow them to shop for and choose from a widearray of products and services without geographiclimitation. To bene
fi
t from the innovations, however,consumers need a base level of 
fi
nancial knowledge,so that they can identify and access pertinent informa-tion as well as evaluate the credibility of the sourceof the information.Technological advances have also increased thecapacity for targeted marketing to consumers, withrobust databases of consumer information making itpossible to match household characteristics and pref-erences with product offerings. This application of technology can promote competition and improvecustomer service. However, its misuse can increaseconsumer vulnerability to unscrupulous lenders.Questionable marketing and sales tactics may induceconsumers to acquire products that they do not needor that are inappropriate for their circumstances.In addition to broadening the application of data-bases in marketing, technology has enabled the use of databases in loan underwriting. Using statistical mod-eling, sophisticated computer programs produce anumerically based risk pro
fi
le of consumers to estab-lish a range of acceptable risk and to develop guide-lines for pricing credit. While credit-scoring tech-nology has increased loan production and decreasedcreditor costs, it has also diminished lender
–
customerinteraction. With the lack of personal involve-ment, consumers, particularly those unfamiliar withbanking and credit systems, have limited meansfor obtaining insight on the elements in their
fi
nan-cial pro
fi
le that affect decisionmaking and guidanceon the course of action necessary to improve theircreditworthiness.Market innovation and competition within the
fi
nancial services industry can also be seen in theincrease in the variety of products offered by deposi-tory institutions. For example, basic deposit andcredit products have multiplied and become highlyspecialized. In addition, there has been a proliferationof nonbank providers of 
fi
nancial services, such aspayday lenders and check cashers. (The number of check-cashing centers has doubled over the past
fi
veyears, according to Financial Service Centers of America, Inc.) These developments have given con-sumers more options and greater
fl
exibility in creat-ing
fi
nancial arrangements that best suit their needs.However, consumers may have dif 
fi
culty assessingthe options, and a misguided choice can result inhigher costs due to monthly fees, overdrafts, or exces-sive transactions.Market innovation has also prompted deregulationof the banking industry. As competition from non-banking institutions has increased over time, bankshave devised ways to offer products to customersoutside the bank-regulated structure. In response tothese market realities, legislation was passed in 1999to eliminate the regulatory barriers that had prohib-ited banks from engaging in the sale of securitiesand insurance, enabling bank-owned
fi
nancial hold-ing companies to become one-stop
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nancial servicesproviders. This legislation (the Gramm
–
Leach
–
BlileyAct), recognizing the activities already occurringwithin the marketplace, facilitated
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nancial modern-ization and promoted a more ef 
fi
cient
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nancial ser-vices industry. However, the expansion of 
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nancialproducts offered by banking organizations, for exam-ple, securities and insurance, requires consumers tobecome more aware of the distinction between theseproducts and to recognize that they do not convey thesame consumer protections and rights as traditionalbanking products.
 Rise in Questionable Mortgage Lending Practices
An increase in anecdotal reports of unfair anddeceptive home equity lending practices in the late1990s raised concerns about the scope and impactof unscrupulous credit arrangements, commonlyreferred to as predatory lending. Investigations andpublic hearings by federal, state, and local govern-ment agencies to identify possibly unethical or preda-tory mortgage lending practices revealed that in manycases the terms of such contracts are not technicallyillegal but rather are inappropriate for and disadvanta-geous to consumers. An example is a loan structuredwith relatively small
fi
xed payments in the earlyyears but a large
‘‘
balloon
’’
payment at the end of theloan term. Such a structure recognizes that a youngerborrower
’
s future earning potential is generallygreater than his or her current income and assumesthat the borrower will be able to re
fi
nance at the endof the loan term. While the arrangement makes mort-gage payments more affordable for some borrowers,it can be devastating to those living on
fi
xed incomes.Efforts by government agencies to better under-stand predatory lending have generally found that thedistortion or inappropriate use of credit provisions,coupled with the inherent complexity of mortgage
446 Federal Reserve Bulletin November 2002
 
lending, sometimes results in borrowers becomingentangled in a
fi
nancially devastating credit quag-mire. Borrowers who are unfamiliar with credit trans-actions and unaware of the full implications of theloan terms may be vulnerable to unethical lenders
’
sales strategies. Although regulatory protections andlegal remedies are important, consumer education isseen as an essential element for combating and pre-venting predatory lending.
1
Changes in Personal Finances
Other factors prompting increased attention to
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nan-cial literacy include the rise in consumer debt levels,the decline in already-low personal saving rates, andthe increase in non-business bankruptcy
fi
lings.Although the rate of expansion of consumer credit in2001 was well below that in 2000 (6.5 percent com-pared with 10.25 percent), outstanding householddebt increased an estimated 8.75 percent in 2001, arate about 1 percentage point faster than the averagegrowth over the preceding two years. Householdborrowing outstripped the growth of disposable per-sonal income in that year, with the household debt-service burden
—
an estimate of minimum scheduledpayments on mortgage and consumer debt as a shareof disposable income
—
reaching near-record levels.Meanwhile, although the personal saving rate roseon average in 2001, it registered below 1 percentat year-end.
2
In addition, a record number of non-business bankruptcies, approximately 1.5 million,were
fi
led in 2001, an increase of more than 19 per-cent from 2000.
3
Together, these data suggest thatsome consumers may be vulnerable to a
fi
nancialcrisis in the event of an economic shock such as theloss of employment or a protracted illness.
Changes in Demographics
Data from the 2000 census con
fi
rm that the U.S.population has become considerably more diverseand that foreign-born households represent an impor-tant consumer market force. Many in these groups,as is common among underserved populations, maybe unfamiliar with U.S.
fi
nancial practices and (or)lack access to mainstream
fi
nancial systems. Lan-guage, educational, and cultural barriers can discour-age some populations from establishing a bankingrelationship to acquire
fi
nancial services. Instead,they may use alternative providers to conduct basictransactions such as cashing checks, obtaining loans,or wiring funds. Although using alternative providersmay be convenient or comfortable, a report by theFannie Mae Foundation asserts that they generallycharge higher per-transaction fees (table 1). Financialliteracy programs promote participation in the bank-ing system to enable consumers to gain access to a
1. In 1999 and 2000, a variety of efforts were undertaken by fed-eral, state, and local agencies to gain insight into abusive lendingpractices. The Federal Reserve hosted a series of public hearings toobtain comment on proposed revisions to the regulation implementingthe Home Ownership Equity Protection Act, a statute enacted to stemunscrupulous lending by increasing disclosure requirements andconsumer protections for high-cost loans (www.federalreserve.gov/ events/publichearings/default.htm). A joint task force of the Depart-ment of Housing and Urban Development and the Department of theTreasury released a report of 
fi
ndings and policy recommendationsregarding predatory lending (www.huduser.org/publications/hsg
fi
n/ curbing.html). In both cases,
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nancial education was recommendedas a means of helping borrowers better understand the basics of mortgage credit.2. Statistics on debt and savings are from
‘‘
Monetary Policy Reportto the Congress,
’’
Federal Reserve Bulletin
, vol. 88 (March 2002),pp. 141
–
72.3. American Bankruptcy Institute,
‘‘
U.S. Bankruptcy Filings 1980
–
2001
’’
(www.abiworld.org/stats/1980annual.html).
1. Estimated fees for
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nancial services charged by nonbank providers, 2002
ServiceRate per transaction(percent)Number of transactions(millions)Gross revenue(billions of dollars)Total fee revenue(billions of dollars)Check cashing ................... Payroll and government, 2
–
3Personal, can exceed 15180 60 1.5Payday loans .................... 15
–
17 per two weeks400 APR55
–
69 10
–
13.8 1.6
–
2.2Pawnshops ...................... 1.5
–
25 per month30
–
300 APR42 3.3 n.a.Rent-to-own ..................... 2 or 3 times retail 3 4.7 2.35Auto title lenders ................ 1.5
–
25 per month30
–
300 APRn.a. n.a.
Total
...........................
. . . 280 78 5.45
APR Annual percentage rate.n.a. Not available.. . . Not applicable.
Source.
James H. Carr and Jenny Schuetz,
‘‘
Financial Services in DistressedCommunities: Framing the Issue, Finding Solutions
’’
(Fannie Mae Foundation,August 2001).
Financial Literacy: An Overview of Practice, Research, and Policy
447
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