Financial literacy and high-cost borrowing: Exploring the mechanism

Recent studies have suggested that financial literacy is an important determinant of informed borrowing decisions. Despite the evidence that financially literate consumers are less likely to use alternative financial services, the mechanism through which financial literacy discourages demand for alternative financial services has yet to be fully understood. The previous studies proposed several explanations, such as the ability to undertake complex financial calculations and understand contract terms, to link financial literacy to savvy credit choices. This study evaluates the validity of this argument by examining whether or not financial knowledge plays a greater role in borrowing decisions where consumers are forced to rely on financial knowledge. It is assumed that consumers in an information-sparse environment have a greater incentive to utilize financial knowledge to infer the hidden cost of borrowing contracts. To test this argument, this study examines the extent to which information availability moderates the negative impact of financial knowledge on rent-to-own transactions. Information content is captured by state-level disclosure mandates for rental contracts, given that consumer in a loosely regulated state are exposed to less pricing information. The results illustrate that limited information strengthens the negative association between financial knowledge and rent-to-own transactions. This confirms the previous arguments that consumers are active thinkers who refer to financial knowledge to estimate the overall cost of borrowing.