The Effect of Financial Literacy on Student Loan Behavior

Abstract

This paper examines the relationship between financial education mandates at the high school level and the frequency of Free Application for Federal Student Aid (FAFSA) applications across the United States from 2011 to 2019. Against a backdrop of declining FAFSA applications, this paper investigates if a state’s introduction of financial education mandates significantly influences these rates. Given that the student loan crisis has become more severe in the past few years, this research aims to understand if students with greater financial literacy make better decisions over the mix of different student loans. Federal financial aid is generally a better financial decision than private loans, since federal financial aid charges lower interest rates than private student loans and may provide grants that do not need repayment. This phenomenon makes applying for federal aid a desirable financial decision. Yet, many students who might qualify for federal aid do not take the first step to obtain aid—completing the Federal Application for Federal Student Aid. Completing FAFSA is also a requirement for many subsidized student loans provided by state governments and universities. I propose the hypothesis that students with a higher degree of financial literacy are more likely to make optimal financial decisions, namely, by applying for FAFSA. Through rigorous econometric analysis of data that encompasses detailed information on both financial literacy and student loans, this research examines the potential of increased financial literacy as a partial solution to the student loan crisis. The analysis uncovers a positive and statistically significant correlation between the enactment of financial education mandates and the volume of FAFSA applications, thereby suggesting an instrumental policy avenue to combat the declining trend in FAFSA applications.