A number of studies have pointed to various mistakes that consumers might make in their consumption-saving and financial decisions (e.g., Thaler and Shefrin, 1988). However, it remains unclear how systematic and costly such mistakes are in practice.
Studies of consumer decision-making in actual market environments are rare. Among the few such studies, DellaVigna and Malmendier (2002) find that consumers systematically choose sub-optimal membership plans at health clubs, but Miravete (2003) finds consumers’ choices of telephone billing plans to be closer to optimal.
The quality of consumers’ decision-making might of course vary across different types of decisions. This paper studies a central economic decision, the decision to borrow and choose between different credit contracts. Compared to the assets side of consumers’ balance sheets (e.g., Odean, 1998, and Heaton and Lucas, 2000), there has been much less analysis of the liabilities side, partly for lack of data. We analyze a unique market experiment conducted by a large U.S. bank. Through 1996 all credit card holders at the bank were charged annual fees.
In late 1996, however, in response to industry trends away from using annual fees, the bank started offering new credit card customers a choice between two pre-specified credit card contracts: one with an annual fee but a lower interest rate (APR) and one with no annual fee but a higher interest rate. To minimize their total interest costs net of the fee, consumers expecting to borrow a sufficiently large amount should choose the contract with the annual fee, and vice versa. We utilize an administrative dataset that records the contract choice and subsequent monthly borrowing behavior of over a hundred thousand credit card holders at the bank from 1997-1999. This dataset allows us to determine which account-holders chose the ex post sub-optimal contract, given their subsequent behavior, and if so how costly was their mistake. Further, the account-holders had the option to later switch contracts, so we can also study whether they learned from and corrected their mistakes.
Credit cards play an important role in consumer finances, so they are a good test-case for analyzing the quality of consumers’ financial decision-making. In the mid-to-late 1990s (the start of our sample period), about 20 percent of aggregate personal consumption was being purchased using credit cards (Chimerine, 1997). Moreover, for most households credit cards, in particular bankcards (i.e., Visa, Mastercard, Discover, and Optima cards), represent the leading source of unsecured credit.
About two-thirds of households at the time had at least one bankcard, and of these households at least 56 percent were borrowing on their bankcards, that is paying interest not just transacting (Survey of Consumer Finances (SCF), 1995). Conditional on borrowing, the typical bankcard account was borrowing about $2000, with the account-holder having roughly another $5000 of balances on other cards. These are large magnitudes relative to typical household balance sheets. They are also large in the aggregate: total credit card balances now amount to about $800B (Federal Reserve Board, 2005).
The stakes involved in making optimal consumer-credit decisions are therefore potentially quite large. Also, whether to borrow or not on a credit card is a decision that most households make on a monthly basis, and so is a familiar decision, and the choice between the two credit contracts that we study is relatively simple. Hence the results should be interpreted as a minimal test of the quality of consumers’ financial decision-making.
After rationalizing some salient aspects of consumers’ credit card usage, Gross and Souleles (2002) highlight two more puzzling aspects. First, why does such a large fraction of consumers hold substantial credit card debt? Conventional buffer-stock models calibrated using estimated income processes have difficulty rationalizing so much borrowing at high credit card interest rates (Laibson et al., 2002; Angeletos et al., 2001).
Second, why do many credit card borrowers simultaneously hold low-yielding assets (both illiquid and even liquid)? For example, Gross and Souleles document that about one-third of credit card borrowers have substantial assets in checking and savings (beyond levels reasonably needed for cash transactions), apparently in violation of no-arbitrage conditions.
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