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Just Sign Here: Bottom-Line Personal Finance Myths

Consumers must make many financial decisions, from basic spending and saving to complex investment choices and retirement planning. What does an individual need to do or know to be financially literate? At a minimum, consumers must be able to keep track of their cash resources and all payment obligations, know how to open a savings account and how to apply for a loan, and have a basic understanding of health and life insurance. In addition, a financially savvy consumer knows how to compare competing offers and plan for future financial needs, such as paying for college, buying a car or house, and retiring.

Unfortunately, this type of financial knowledge is in short supply. A survey conducted in 2006 by the Jump$tart Coalition found that 12th-graders could correctly answer only 52 percent of the questions on a basic financial skills quiz. Although adults sometimes do better on tests like these, statistics indicate that U.S. households do not consistently demonstrate the basic skills of financial literacy. (See table below.) This lack of basic financial knowledge often results in poor financial management, including such behaviors as using payday lenders or check-cashing services, incurring late fees on credit cards, or passing up employer-matching contributions to retirement accounts.

Being aware of some common personal finance myths—beliefs, rules of thumb or marketing pitches that are misleading or untrue—may help consumers make better-informed financial decisions.

Myth #1: “All that matters is your monthly payment.”

When a consumer is financing a car or a house, borrowers are often assured that, despite the staggering sum of total interest payments, the only relevant question is, “Can you make the monthly payment?” Your monthly payment is not all you need to know about your loan, of course. The effective annual rate you are paying, the fees, the term to maturity, numerous contract contingencies and other details also matter a great deal. Borrowers who believe this myth may not understand all the costs involved in a loan, or they may not consider the trade-off they are accepting between less-burdensome early payments and more-burdensome later payments.

Myth #2: “Rising house prices make us all richer.”

Over the past several years, house prices in many regions have increased significantly, perpetuating the “housing wealth” myth. To see the fallacy in this myth, imagine a simple economy with exactly two home-owning households. Suppose the “market value” of each house was $200,000 as of yesterday. Today, both households believe their houses have doubled in value. One household sells its house to the other for $400,000, pocketing a $200,000 capital gain—an apparent increase in the economy’s housing wealth.

But the first household needs somewhere to live, and the second household has an extra, empty dwelling. So, household one buys household two’s original house at the inflated price of $400,000, generating a $200,000 gain for household two. Neither household has more cash or other assets than it had before, and each owns one house as before. What has changed? We can say that the housing wealth of the economy has doubled, but it has no economic significance—it is a myth. Compare this concept to automobile price changes. Do we feel richer when automobile prices rise? Probably not; in fact, many of us would feel poorer because we know we’ll have to spend more to buy our next car. The point is that the value of a house or a car is derived solely from the housing or transportation services it provides.

Myth #3: “It’s always better to buy than to rent.”

The renting vs. buying decision is particularly important when households are purchasing housing services. In becoming an owner-occupier, a household effectively is a landlord renting a house to itself. Some of the critical considerations in making this decision include the following:

• A household with a steady income may be more suited to home ownership because it is better able to undertake the fixed financial commitment represented by a mortgage. A household with a highly variable income, on the other hand, may need to reduce housing expenses relatively rapidly if income declines significantly and may, therefore, be better off renting.
• Because the transaction costs involved in selling a house and moving to a new residence are high—probably about 10 percent of the value of the house, including sales commissions, financing-related fees and moving expenses—it may be better for a household that expects to move within a short period of time to rent rather than own.
• Owning a house provides a hedge against unexpected future increases in rent. A household that has a low tolerance for bearing the risk of future “rent shocks” will benefit more from owning a house than a household that is more tolerant of such risk.

Personal finance is becoming more complex every day; yet, the widespread belief in these myths shows that the average level of U.S. households’ financial literacy is low. If consumers want to make informed decisions, they need to arm themselves with knowledge of basic economic and financial principles and to exercise smart spending and saving behaviors.

This article was adapted from “Consumer-Finance Myths and Other Obstacles to Financial Literacy,” written by Senior Economist William R. Emmons and published as a Federal Reserve Bank of St. Louis Supervisory Policy Analysis Working Paper 2005-03 in April 2005.

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