People Choose Low Loan Repayments and High Interest Rates

Short term thinking leads to longer term, more expensive loans.

Why do consumers not minimize borrowing costs when taking out loans as traditional economic theory says they should? Using data on auto loans, Bronson Argyle and Taylor D. Nadauld of Brigham Young University and Christopher Palmer of MIT find that consumers are disproportionately willing to take on higher interest-rate loans to have lower monthly payments.

Borrowers appear to set targets for their monthly payment on rounded amounts like $200, $300, and $400, rather than choosing the most cost-efficient payments. When borrowers are offered cheaper loan terms, they are more likely to take out larger loans rather than pocket the savings.

The findings the authors observe run contrary to most standard models of consumer behavior and indicate that consumers use simple budgeting rules to choose loan repayments.

Auto debt has grown rapidly since the Great Recession and has surpassed credit cards in total debt outstanding. Auto-loan maturities have also increased such that most auto-loan originations now have a term of over 72 months.