How a Cognitive Bias Shapes Competition

This says it all……..”For example, mortgage holders seem to systematically underestimate the degree to which their variable rates can rise.45 They may also have biased views of how much their monthly payments will change following a change in their APR (Consumer Federation 2004). Our work motivates exploration of the relationship between such biases and the apparent prevalence of costly mistakes in mortgagemarkets.” (via Stango & Zinman SSRN)

Abstract (Via Stango & Zinman  @ SSRN)

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.

Very Important Excerpt!! (via Stango & Zinman @ SSRN)

The cognitive bias we document is payment/interest bias: consumers’ systematic tendency to underestimate the annual percentage rate (APR) associated with a loan principal and stream of repayments. Prior evidence of such bias exists but has been overlooked by researchers and policymakers.3 We provide the most comprehensive evidence of payment/interest bias to date, using the most recent nationally representative survey that asks respondents to calculate an APR from payments (the 1983 Survey of Consumer Finances). The SCF enables us to quantify bias at the household level. Bias is prevalent and economically large: when asked to infer an APR from monthly payments, nearly all households err on the low side by several hundred basis points.

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About Miguel Barbosa

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20. February 2010 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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