People prefer round numbers even though it can cost them money
Study shows people prefer monthly payments in multiples of $ 100, even when it can cost them money.
Do you have a monthly car payment, or a similar loan? Is each payment a nice round number, like $ 300? If so, you are hardly alone. But the allure of that easy-to-remember payout number can cost you money.
This is one of the implications of a new study co-authored by a MIT economist, who shows how much consumers prefer monthly payments that are multiples of $ 100 – indeed, the number of consumers’ monthly payments to dollar digits just above those multiples decreases by 16%. This probably makes monthly budgeting easier for people to calculate. But as the study also shows, people choose potentially unfavorable loan terms accordingly.
“People budget with these round numbers and are trained to think about these monthly payment terms, opting for the smallest monthly payment possible,” says MIT economist Christopher Palmer, co-author of a recently published article detailing the results. “In particular, people are really racking up around $ 200, $ 300, or $ 400 a month in payments, which probably keeps them from overspending month-to-month, but that might not be the best approach if this causes them to pay more interest over the life of the loan.
In fact, after delving into auto loans held by over 2 million people, Palmer and his colleagues found that this was precisely the case: given the multiple financing options, many people read the monthly numbers, often at less money per payment, but with in particular an increase in long-term costs.
And while lower monthly payments are important to many, the study shows that borrowers often take such an approach when they can afford to pay more.
“One thing we did [in this study] is looking at the data for people with high debt capacity, low debt ratio, or high credit scores, and even these people seem to make decisions based on the monthly payment amount, while ignoring the total cost of the loan, ”notes Palmer, Albert and Jeanne Clear career development professor at MIT Sloan School of Management.
The document “Targeting of monthly payments and request for maturity” appears as an online advance in the Review of financial studies. In addition to Palmer, the authors are Bronson Argyle and Taylor Nadauld, finance professors at the Marriott School of Business at Brigham Young University.
The natural experience
To conduct the study, Palmer, Argyle, and Nadauld looked at auto loan contracts held by 2.4 million borrowers, using 319 different lenders. The anonymized information came from a data company that works with loan companies. About 70 percent of the loans were taken out during the period 2012-2015, although some date back to 2005. The researchers also examined 1.3 million additional loan applications to get a better idea of the tax situation of the companies. borrowers.
A key feature of the study – giving the research a quasi-experimental form – involves its use of FICO scores, a basic credit score. FICO scores range from 300 to 850, but at certain thresholds some banks offer very different loans to customers. When you have a FICO score of 700, which is close to the average, you can enjoy much better terms than if your score is slightly lower.
“If you have a FICO score of 701, at some banks you can get a much lower interest rate than someone with a FICO score of 699, even if you ask the company that does the FICO scores, you are basically the same person, ”Palmer says. “But if a bank treats like-minded consumers in a very different way, it becomes this nice lab for a natural experience.”
That is, if borrowers offering a variety of loan terms have the same pattern – like liquidation with round-numbered monthly payments – it suggests how ingrained this pattern is in consumer behavior. The phenomenon of monthly payments in round figures quickly imposed itself on researchers.
“It just came out of the data,” says Palmer. “You plot the data and people cluster at multiples of a hundred dollars. “
So what exactly is the problem?
To understand why this can be a bad personal finance habit – and it clearly is for some people – note that loans with lower monthly payments will have a higher total long-term cost, given the initial purchases of the same amount.
This point applies to a second finding of the study: when consumers are offered loan terms, they react more to changes in maturity – the length of the loan – than to changes in the interest rate.
As Palmer, Argyle, and Nadauld discovered, a bank offer for a 10% increase in loan term increases the odds of a borrower agreeing to the terms by 8.3 percentage points. But a bank offer of a 10 percent cut in the interest rate increases the odds that a borrower will agree to the terms by just 1 percentage point.
Why is it? In this case, changing the loan maturity has a bigger impact on monthly payments, allowing more consumers to take those payments to the magical levels of $ 200, $ 300, and $ 400.
However, changes in loan terms also result in higher long-term costs for consumers. Consider a loan of $ 20,000 with a term of five years and an interest rate of 5%. Increasing the maturity of this loan by one year reduces the monthly payments by $ 55, but increases the total interest paid by $ 546.
In short, by having a nose for the round numbers, consumers in the new study are really paying more for their cars.
Lessons on loans
That said, Palmer recognizes that for different people, there isn’t necessarily a clear answer as to which approach is best: lower monthly payments or lower long-term repayment.
“There isn’t a big theory on what you should be doing,” says Palmer. “What we would say you should do is determine if this tradeoff is worth it for you. If having lower payments today is worth paying more interest over the life of the loan, great. and there could be many reasons for this.But for a lot of people i would expect that it would be better to try to get this loan faster with a shorter term.
Palmer hopes that a practical implication of the study would be to get people to recognize that there is a trade-off in the first place.
“A lot of people think that monthly payments are the responsible way to talk about the cost of a car,” says Palmer. “But if you tell me you’re only going to spend $ 300 a month on a car, I can sell you a Mercedes if I give the car loan long enough.” “
As the study shows, a significant number of people turn to a rule of thumb – round number payments – when it is more useful to do homework and compare loans against loans. Yet it may be the nature of car buying that leads people to underinvest in purchasing loans.
“I can test drive the car,” says Palmer. “I cannot test the loan. “
Reference: “Monthly Payment Targeting and the Demand for Maturity” by Bronson S Argyle, Taylor D Nadauld and Christopher J Palmer, January 22, 2020, Review of financial studies.
DOI: 10.1093 / rfs / hhaa004