How financial illiteracy affects mortgage rates, and how we can help

Queen’s PhD candidate and JDI Student Fellow, Jenny Watt, discusses research presented at the Joint Bank of Canada-John Deutsch Institute Workshop on Financial Intermediation and Regulation. 

By Jenny Watt, JDI Fellow

Andrea Pozzi of the Einaudi Institute for Economics and Finance recently presented research on the consequences of financial illiteracy on mortgage rates. Using data containing 90% of Italian mortgages, he and his co-authors show that not only do consumers who are susceptible to bad advice from banks pay higher rates—their presence in the market causes higher rates for all consumers.

The issue arises when the bank a consumer chooses has an incentive to recommend a different mortgage product than the one that would be best for the consumer. For example, the bank may be striving to increase their adjustable-rate to fixed-rate mortgage ratio, but they are faced with a consumer who would be better off with a fixed-rate mortgage. If the consumer is uncertain about which product is better, the bank may be able to use advice to manipulate the consumer into taking an adjustable-rate mortgage.

Indeed, the authors find evidence that banks do not always base their advice on the needs and preferences of consumers. Banks appear to follow different strategies as to which types of mortgages they push, even when their consumers are very similar. Furthermore, banks may restrict their mortgage offerings to manipulate financially illiterate consumers, so that even financially literate consumers are harmed. The average welfare loss is equivalent to paying about $1745 more a year, relative to the situation when banks only give good advice.

Unfortunately, preventing this welfare loss is not straightforward. The authors argue that because advice still conveys some information, consumers do worse on average when banks are banned from giving advice. They advocate increasing financial literacy, but it is not clear how we should do so. Financial literacy campaigns have not been shown to be effective on average, and it is not clear which characteristics make them successful.

That is the idea behind The Financial Consumer Agency of Canada (FCAC)’s new National Research Plan for Financial Literacy—that by designing and monitoring many financial literacy campaigns, we can find out what works and add that to what we already know. For example, because many campaigns only have short-term effects, financial literacy campaigns aimed at high school students are unlikely to protect them from bad financial advice later in life. Successful education programs tend to occur shortly before the decision is made—in this case, the decision to accept a mortgage.

The issue, of course, is that there is not an obvious way to reach people once they are out of high school. Ongoing FCAC research will focus on ways that employers can help workers develop financial literacy. It’s no small task, but as Pozzi and his team have shown, the potential benefits are high.