Restoring Rational Choice in Repayments

Abstract

Borrowers with revolving debt on multiple accounts often fail to exploit price differences when making their repayments and leave a considerable amount of money on the table. Constructing a simple repayment environment in the laboratory, we test the role of behavioral mechanisms that would directly inform the design of consumer protection policies. We find that anchoring on the irrelevant balance information does not contribute to the choice inefficiencies. Instead, participants with low financial literacy struggle to process interest rate information in percentage format as a price and improve their choices when interest rates are presented in a fee format. Providing an opportunity to purchase financial advice reveals that most participants are somewhat aware of their choice inefficiencies, but the majority of participants underestimate the extent of their mistakes, under-demand, and under-utilize financial advice. Our results underscore the critical role of financial literacy, as it not only directly influences the effectiveness of potential disclosure policies but also shapes individuals' awareness of their mistakes.

Keywords: awareness; anchoring; debt; information processing; financial literacy

JEL Classification: C91, D14, D18, D91