Would you pay $6 upfront to earn $10,000 more over a lifetime?
Since the return is astronomical – better than 30 percent a year – chances are you would cough up the money. But thousands upon thousands of low-income high school seniors in the 1990s did not. As a result, they're earning less money today than they might have.
That's the premise of an intriguing new study by Harvard economist Amanda Pallais looking at high schoolers who took the ACT, a college-entrance exam. It's a useful reminder of how small mistakes in one's financial life can have a big impact.
Prior to 1997, the ACT allowed students to send their test scores to three colleges for free. In the fall of 1997, it expanded that to four colleges for free. Not surprisingly, the share of test-takers sending four reports soared from 3 percent for the class of 1996 to 74 percent for the class of 2000. The intriguing thing is what low-income students (from families with an annual household income of less than $40,000 did with that fourth report).
They widened their college search, according to Dr. Pallais’s study. Some of them sent it to a less competitive school than their other picks, a "safety" school that would improve their chance at admission. More typically, they sent their scores to a more competitive school than their other picks.
Sending scores to an extra school encouraged many to apply and allowed them to get admitted to a more competitive college. Low-income ACT-takers in the high school class of 1998 attended colleges where the average ACT scores of incoming students were 0.26 points higher than the schools attended by the previous year's test-takers, who typically sent out scores to only three schools. For the class of 1999, the advantage was 0.24 ACT points. (Interestingly, middle- and high-income students attended slightly less-competitive colleges after the fourth score report became free.)
Even that small advantage should mean an extra $10,000 in earnings over the low-income student's lifetime, according to previous studies and Pallais's estimates. For the other low-income students who sent the extra score to a safety school, the benefit would be much higher if that school proved to be the difference between attending college and starting a job. Studies suggest that just two years of higher education add an average $173,350 in lifetime earnings.
So why didn't students in 1996 (prior to the change to four free scores) pony up the extra $6 to send out an extra score? The simplest explanation is that they didn't know better, Pallais says. Instead they used the three free reports as a signal that applying to three schools was the recommended number. Small mistake. Big consequences.
Such errors aren't limited to 17-year-olds. Too often in our financial lives, we make small mistakes that cost us thousands of dollars over the long run. We apply for Social Security too early. We invest without a plan. We don't pay $300 for professional advice because, well, it's $300. (Years ago, I visited a financial planner who suggested something that should save me $800 a year in taxes in retirement.)
When it comes to saving and investment, find your optimal solution. If you don't know it, ask. Saving $6 can be a costly mistake.