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.

Keywords: bounded rationality, consumer credit, household finance

JEL Classifications: L5, K2, D1, H3

Working Paper Series