Household financial management: the connection between knowledge and behavior

Federal Reserve Bulletin, July, 2003 by Marianne A. Hilgert, Jeanne M. Hogarth

Across the decade of the 1990s to the present, the issue of financial education has risen on the agendas of educators, community groups, businesses, government agencies, and policymakers. (1) This increased interest in financial education has been prompted by the increasing complexity of financial products and the increasing responsibility on the part of individuals for their own financial security. Well-informed, financially educated consumers are better able to make good decisions for their families and thus are in a position to increase their economic security and well-being. Financially secure families are better able to contribute to vital, thriving communities and thereby further foster community economic development. Thus, financial education is important not only to individual households and families but to their communities as well.

Knowledgeable consumers who make informed choices are essential to an effective and efficient marketplace. In classical economics, informed consumers provide the checks and balances that keep unscrupulous sellers out of the market. For instance, consumers who know the full range of mortgage interest rates and terms in the marketplace, who understand how their credit-risk profile and personal situation fit with those rates and terms, and, consequently, who can determine which mortgage is best for them make it difficult for unfair or deceptive lenders to gain a foothold in the marketplace.

Amid growing concerns about consumers' financial literacy, the number and types of financial education programs have grown dramatically since the mid-1990s. (2) Many of these programs focus on providing information to consumers and operate under the implicit assumption that increases in information and knowledge will lead to changes in financial-management practices and behaviors. Whether that is the case is the province of behavioral economics, which offers its blend of psychological and economic insights into household financial management. Behavioral economics acknowledges the role that psychological characteristics (such as procrastination, regret, risk aversion, compulsiveness, generosity, altruism, and peer pressure) play in household economic decisions. Thus, behavioral economics offers a framework for studying behaviors that seem inconsistent or irrational--for example, consumers who hold money in a savings account earning interest at 2 percent while carrying balances on credit cards and paying 18 percent interest. (3)

This article explores the connection between knowledge and behavior--what consumers know and what they do--focusing on four financial-management activities: cash-flow management, credit management, saving, and investment. Data are from the University of Michigan's monthly Surveys of Consumers conducted in November and December 200l (see Appendix A: Survey Data). Also, data from the Survey of Consumer Finances (SCF) are used for purposes of comparison. (4)

HOUSEHOLD FINANCIAL-MANAGEMENT PRACTICES

Households in the Surveys of Consumers reported on eighteen financial-management behaviors, ranging from very basic money management skills (tracking expenses, paying bills on time) to more sophisticated ones (diversifying investments). They also provided information on their use of thirteen financial products. These ranged from savings and checking accounts to credit cards, mortgages, home equity loans, and investments. To look at the different types of financial practices, measures of financial-management behaviors and financial product ownership were combined. (5) Practices were categorized as cash-flow management, credit management, saving, investment, and other. Table 1 lists the behaviors or products used to analyze each type of practice.

A fairly large percentage of individuals reported what are considered "good" cash-flow management practices: 89 percent of households had a checking account, 88 percent paid all their bills on time, and 75 percent reconciled their checkbook every month. However, fewer than half reported using a spending plan or budget. For the credit management practices, although nearly four-fifths of respondents had a credit card, only one-third compared offers before applying for a card. As to saving practices, the data show that while 80 percent and 63 percent had a savings account and an emergency fund, respectively, only 39 percent were saving for long-term goals, such as for education, a car, or a home. There was also a wide range in the investment practices reported by households. For example, although three-fifths (63 percent) reported having retirement accounts--pensions, 401(k), or IRA plans--and half (52 percent) had investment accounts, less than half (46 percent) said that they had mutual funds, about one-fourth reported holding individual stocks, and about one-fifth said that they put money in other retirement accounts. (6) Of all the behaviors, reading about money management was the least frequently reported (20 percent).

Financial Practices Indexes