This study explores the varying role of financial literacy in shaping households’ credit and loan choices. It addresses a gap in the literature by examining how financial literacy is prospectively associated with holding credit or loans and transitions between different credit portfolios.
The study utilizes data from three waves of the Panel Study of Income Dynamics (PSID) survey. Household credit portfolios were identified using latent class analysis, followed by the estimation of a latent transition model to evaluate the relationship between financial literacy and transitions among different credit portfolio states. A “what-if” analysis was conducted to illustrate a likely long-term evolution of household credit portfolios under the assumption of a maximum financial literacy score on the financial literacy scale.
Consistent with theoretical predictions, the study finds a positive link between financial literacy and transitioning to a state where credit or loans are present in the household financial portfolio. Credit portfolios exhibit notable persistence over time, with non-indebted households having the highest likelihood of remaining in their state and medical debtors the lowest. Financial literacy significantly influences transitions into multiple and mortgage debtor classes but does not affect transitions related to medical, educational or credit card debt. At maximum financial literacy, the long-term equilibrium of household credit and loan holdings would likely shift toward a larger share of multiple and mortgage debtor households and a decline in non-indebted households.
This research addresses a critical gap in the literature on the relationship between financial literacy and financial inclusion on the borrowing side of the household balance sheet, including the choice of credit product type. It demonstrates that greater financial literacy increases the likelihood of holding multiple credits and loans, challenging the assumption that financial literacy always leads to universally desirable financial decisions. Furthermore, the study highlights the differential impact of financial literacy on credit choices, underscoring the complexity of credit decisions and the practical significance of financial literacy in shaping consumer credit portfolios.
