Psychology of Debt

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Psychology of Debt

• Sendhil Mullainathan

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Loan Clients Understanding
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Loan Clients Understanding
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Loan Clients Understanding
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Summary and Questions

• Clients understand some things
• Loan size, repayment
• Fail to understand interest rate
• What should we do?
• Nothing?
• Financial literacy?
• Mandate disclosure?

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Vendors
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Vendors

• Persistent borrowers
• At very high rates
• Stark implication
• One less cup of tea a day.
• In 30 days will have doubled income.
• Significant foregone income
• Is this a rationale for consumer protection?
• Tempted to debt?

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Psychology of Debt

• Confusion
• Temptation

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Ambient Concerns

• Confusion
• May take loans they dont understand
• Temptation
• May take loans they dont want

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Approach

• Confusion and temptation are general
• Occur in many places
• Describe fundamental insights about these
• Apply them to case of microfinance and our two
  examples

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Why Confusion Matters

• People choose badly
• Markets compete on the wrong thing

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Example 1

• Theres a market for rice flour
• Thought experiment
• All firms report in kilograms. People who buy
  flour every day cannot tell you what is the
  weight of their last purchase in pounds.
• Should we conclude that people are choosing
  badly?
• Should we conclude that people need training?
• Should we disclose disclosure in pounds

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Example 2

• Survey purchasers of computers
• Ask them Mhz of just purchased computer
• If they do not know, is that confusion?

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Example 3

• US Market for sub-prime mortgages
• Some mortgages have clauses in which interest
  rates jump at year 3.
• Survey of individuals suggests
• Vast majority do not know their mortgage payment
  is about to jump
• Is this confusion?

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Observations

• Understanding need not be universal
  (pounds/kilograms)
• People need only understand in one frame
• Understanding need not be complete (computers)
• Only need to understand decision relevant
  features
• Confusion about highly hedonically relevant
  features occurs
• Sub-prime mortgages

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Challenge

• How do we know if not knowing interest rates is
  confusion that is causing harm?

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Scenario One

• Customers know monthly payments, loan size,
  tenure
• All other loans they are exposed to (e.g. money
  lender) are quoted in these terms
• This is what matters to them
• Not knowing interest rate is not problematic
• No education needed

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Scenario Two

• Because customers dont know interest rates
• They are making a mistake in comparing it to
  other loans quoted with interest rates
• They are making a mistake in choosing investments

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Some Observations

• We dont know what scenario were in.
• Empirical work is needed to help us understand
  genuine confusion
• Information on knowledge is not enough
• Scenario one versus two is an empirical quesiton
• Disclosure is like language. Must match the local
  language. Not language you think people should
  speak
• Example Force MFIs to quote APR when money
  lenders quote non-declining balance.

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What does this say about financial literacy?

• Clearer choice architecture is a substitute for
  financial literacy
• Example Computer training in unix versus Apple
  operating system

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Psychology of Debt

• Confusion
• Temptation

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Key Lesson About Temptations

• People can have conflicted preferences
• Want to get up early
• Dont want to get up early

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Challenge

• What is a temptation?
• What is a pleasure?
• How can we tell?

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Returning to Vegetable Vendors

• Temptation interpretation feel tempted by the
  debt and fall back in.
• Solution
• Prevent them from borrowing?
• But will that just put them out of business?
• Deeper question
• Why dont they save their way out?

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Problem of Savings
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Important Lesson

• To help people with temptations
• Need not rule out borrowing
• Can help them create savings
• Suggests innovative savings products are
  substitute for regulating debt products

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Broad Lessons

• Both confusion and temptation are inherently
  psychological
• Both require us to violate revealed preference
• But both require we take the perspective of the
  borrower
• What do borrowers think are their temptations?
• When do borrowers feel confused or misunderstand
  for the choices they must make?
• Need empirical tools to take their perspective
• Must avoid imposing our own preferences