How to be financially literate

16th November, 2010

Here’s a little test. You buy a new £1,000 computer, but you need to take on some debt to finance it. You have two options: pay in 12 instalments, £100 a month for a year; or borrow at an interest rate of 20 per cent and pay back £1,200 at the end of the year. Which is the better offer?* Or are they both the same?
Take your time. Annamaria Lusardi, an Italian economics professor now based at Dartmouth College in the United States, has been asking a lot of people this question. Only seven per cent of Americans get the answer right. Even simpler multiple choice questions about interest rates and minimum payments on credit cards baffle the majority of people.

Read the whole column here. The answer is below…

Borrowing at 20 per cent is a much better offer. Either way, you pay back £1200 in total, but the monthly instalments require you to start paying back the loan almost immediately. The implicit interest rate of the monthly instalment deal is closer to 30 per cent than 20 per cent. That’s a very large difference.

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