How a Cognitive Bias Shapes Competition: Evidence from Consumer Credit Markets

Abstract

We document evidence suggesting that many U.S. consumers have payment/interest bias: they systematically underestimate the interest rate associated with a loan principal and repayment stream. Biased consumers hold loans with higher interest rates, but only when borrowing from nonbank lenders. This result holds both across and within households, and is robust to controls for income, wealth, default risk and a rich set of other household and loan characteristics. Our findings fit with the stylized fact that nonbank lenders emphasize monthly payments rather than interest rates–often suppressing interest rate information, even when doing so runs afoul of Truth-in-Lending laws. The links between payment/interest bias, actual loan rates, and lender behavior support the emerging view that cognitive biases shape market equilibria, even in highly competitive settings. ∗Stango: Associate Professor of Business Administration, Tuck School of Business, Dartmouth College, Hanover NH 03755. Email: victor.stango@dartmouth.edu. Zinman : Assistant Professor of Economics, Dartmouth College, Hanover NH 03755. Email: jzinman@dartmouth.edu. A previous version of this paper was titled: “What Monthly Payment Gets You in This Car? Payment/Interest Bias and the Market for Consumer Loans.” We are grateful to Andrew Bernard, Doug Staiger, and seminar participants at The Federal Reserve Board of Governors, Dartmouth, the Federal Reserve Banks of Chicago, Philadelphia and Boston, and the Federal Trade Commission for helpful comments. Thanks also to Bob Avery and Arthur Kennickell for helpful discussions regarding the Survey of Consumer Finances. Special thanks to the legal and research staff at the Federal Trade Commission, including Matias Barenstein, Lynn Gottschalk, Jesse Leary, and Carole Reynolds, for pointing us toward legal actions and institutional details.