Debtor Mindset: Do Interest Rates Affect Financial Literacy?

by JT McGee

How do interest rates affect financial literacyI have long wondered what gets people interested in personal finance.

Over time I have concluded that there are two scenarios:

  1. You go broke then decide to reverse course
  2. You do it right the first time

That’s pretty much it. If my assumptions and observations are correct, I’m guessing that the first entry into the land of personal finance is the most popular. (Am I right so far?)

Making the assumption that most people fall into personal finance after making mistakes with their personal finances—namely, getting into debt—then what role do interest rates play in how Americans take control of their money?

Interest Rates vs. Personal Finance

Unless you have lived until a rock for the past 20 years, you probably know interest rate have been in a long decline. Here’s a chart of the 1-year Treasury yield based on Federal Reserve data:

A chart of interest rates and yields on 1 year treasury bills.

What role does this play in personal finance development?

I mean, if most people go broke before deciding to take control of their finances, wouldn’t it be logical that generations previous to mine would have gone broke earlier in life? It’s a lot easier to go broke with rates at 20% than rates at 2%, right?

And if the power of compounding works best when it can work its magic the longest, wouldn’t generations who had earlier “debt epiphanies” only stand to be better off than those who had them later? How many people would be in an entirely different situation if they had woken up about personal finance 5 years earlier than originally?

Of course we can make the claim that rates were highest when inflation was highest, but inflation rarely benefits the wage worker. The concept of sticky wages is true; wages have typically lagged inflation.

I could also make the claim that people who ignore their finances because high rates haven’t yet forced difficult decisions spend more time developing bad habits. As we all know, the longer you continue a habit, the more you reinforce it.

I’m just rambling, but I really do wonder if there’s a link between interest rates and personal finance literacy. It would seem to me that there is.

Readers,

What do you think?

Is the psychology of the average person affected by interest rates?

Would higher rates force more people to go broke earlier, and thus reverse course in time to make changes that put them on the path to financial independence?

{ 8 comments… read them below or add one }

Jonathan August 24, 2011 at 11:04

That’s a very interesting thought, and I’ll bet there’s some truth to it. I fortunately fall into the “got it right the first time” camp due to having role models who’ve got their heads on straight.

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JT McGee August 24, 2011 at 11:11

It’s nice to be in the “got it right the first time” camp, huh? 😉

My dad beat the game of finance into my head over and over and over again as a child. I couldn’t be happier that he had at least some experience in finance, and that he could answer all my questions. Eventually, I outgrew him, but it was good to have someone there for the days before Google.

Out of curiosity, was it your parents that were the role models for making smart financial decisions?

I guess you’re taking advantage of the low rates with more leveraged rental property?

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Jonathan August 24, 2011 at 11:59

My wife’s parents. And what I learned, largely, was about investing and creative financing and cash flow. While we haven’t done any “creatively financed” investments yet (depending on what you call creative), we have saved like crazy (kept our living costs constant while salaries have risen) and are investing as well as we can and trying to lock up as much low-interest rate debt on property as we can.

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JT McGee August 24, 2011 at 12:09

Ahh, I see. Creative financing and cash flow are the name of the game, for sure. Learning that financing does not need to be compartmentalized is a future post of mine, one which talks about leveraging in ways typically seen as silly.

I had a very similar experience with my girlfriend’s family. They aren’t necessarily super wealthy, nor are my parents super poor, but I have experienced a series of “Rich Dad” like epiphanies about how different people manage their lives and finances. I’ve learned countless lessons from the people her family surrounds themselves with too. Most of the gain was on the softer-side of personal finance, but certainly interesting and definitely enlightening.

If I were in a similar position, I’d have to start thinking long and hard about leveraging up in cash flow positive properties. Alas, I have a relatively good amount of cash flow, and big, long-term wins are my emphasis right now. As I age, and my life trajectory becomes more certain, cash flow will be a very important theme to my investment thesis.

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Craig August 24, 2011 at 11:06

My wife and I have a 30 year mortgage that we got in the 1980s. Falling rates are a blessing to us since we used the money to invest.

Our neighbors refinanced and bought a boat. They probably won’t be retiring any time soon.

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JT McGee August 24, 2011 at 11:14

Do you still have the mortgage? That’s a long time to have one! If you invested the difference, though, you’ve made out like bandits! Especially post-1987.

I envy your situation.

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Funancials August 28, 2011 at 08:46

Interesting thoughts. I was fortunate enough to “get it right the first time.”

Although it should be the opposite, I’m going to say there’s an inverse relationship between interest rates and financial literacy. Over the last several years interest rates have continued to trickle down. I would argue that, while still moronic, the public’s financial literacy is increasing. I believe it’s more ‘economically aware’ instead of ‘financially literate’, but I’ll use the terms interchangeably. Much of it has come from the financial reform laws (ie. being required to highlight on credit card statements the time it would take to payoff a balance).

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Financial Samurai September 3, 2011 at 11:34

Only if you were alive to know 20% rates that are now 2%. Otherwise, not so much.

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