Psychology and Personal Finance Class 4 - Debt

Class 4 Overview Debt Options Debt Behavior Subprime Crisis and Policy Discussion Debt and Entrepreneurship 2

Why Debt? Economics Reasoning –Income smoothing (Permanent Income Hypothesis) –Liquidity Behavioral Reasoning –Immediate gratification –Lack of budgeting –Innumeracy –Mental accounting 3

Debt Options

Federally Subsidized Student Loans Based on need, available to students Interest-free while in school Low 4 - 5% interest rate post-graduation 5

401k Borrowing from yourself (up to $50k) Loan details may vary depending on intent (general purpose vs. housing purchase, etc) Interest is the opportunity cost of your retirement investments 6 Source:

Mortgages Fixed / Adjustable rate mortgages Negative amortization – loan payment is less than interest charged over a period Interest rate after taxes of ~4-5% 7

Home Line of Credit Revolving line of credit in which the home acts as collateral Limited withdrawals Typical interest rate of prime plus 4% - can change over time 8 Source:

Credit Cards Free if you repay regularly Interest rate from 0% (teaser) to 40% with a mode of 25% 9

Pawn Shops Use your possessions as collateral for cash Loan size is ~50% the value of your possession Typical interest rate of % 10 Source: Caskey and Zikmund (1990)

Rent-To-Own Obtain goods via a regular payment plan where the goods and payments are collateral Typically end up paying 2-4 times the cost Typical interest rate of ~230% 11 Source: Zikmund, et. al (1990)

Payday Loans Get a 1 – 2 week advance on your salary Typical interest rate of 391% plus fees 12 Source:

The Mob Use your kneecaps as collateral Everything is done on the mob’s terms Typical interest rate is what they say it is! 13

Sopranos Clip 14

What We’ve Learned (So Far) 15 Do you notice any special ordering of these options? Debt Options Student Loans401kMortgages Home Line of Credit Credit CardsPawn ShopsRent To OwnPayday LoansThe Mob

Debt Behavior

Class Exercise You are about to send $1,000 as credit card payments this month. How much would you pay on each card? 17 Source: Ariely et al (2011) CARD 1 $800 Balance $80 Minimum Payment 12% Interest Rate CARD 2 $2,000 Balance $200 Minimum Payment 18% Interest Rate

Debt Aversion Average 4 yr student loan debt is only $16,700 26% of low income students and 31% of Asians don’t even apply Some people tend to pay off low rate loans faster than required, even when there are better investment opportunities available 18 Sources: Burdman (2005), Cadena, et al (2006)

Excessive Debt Debt / income ratio closely linked with anxiety Average credit card debt increased 300% (in households with at least one card) between 1990 and 2002 WHY? 19 Sources: Dretna (2000), Money Central at

Someone Else Will Do It Myopia & Optimism – –Karyn started a website in 2002 to convince individuals to donate money to help her pay off card debt –She did so in only 20 weeks – chances are you won’t be this lucky! 20

The Wrong Type Of Debt Households who shifted to 401(k) debt would save 15% on annual debt payments Rent-to-own is used as a budgeting mechanism for risk averse consumers Payday loans stem from myopia, innumeracy, self-control and budgeting 21 Sources: Li and Smith (2008), Zikmund, et al (1999)

How Expensive Is The Wrong Debt? 22

Simpsons Clip 23

People Are Clueless! 24

What We’ve Learned (So Far) Debt Options Debt Behavior –Debt aversion –Excessive debt –Wrong type of debt –People are clueless 25

Subprime Crisis and Policy Discussion

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A few weeks later at the bank… 30

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Class Discussion Policy Discussion from Thaler & Sunstein: Is it complexity/cheating on the part of the firm OR Too much hope on the part of the consumer? What should the policy be? 32

What We’ve Learned (So Far) Debt Options Debt Behavior Subprime Crisis and Policy Discussion 33

Debt and Entrepreneurship

Issues With Current Debt Options Borrowing –From banks : high rates, may not qualify, rigid constraints –From friends / family: uncomfortable, risk of damaging the relationship, no regulation –From 3 rd parties: transaction costs 35

Issues With Current Debt Options Lending –To banks: very low rates –To friends / family: damage relationships, collection is unpleasant and not regulated –To 3 rd parties: transaction costs, legal enforcement complexities 36

Virgin Money Mediators for borrowing and lending money between family and friends The company handles legal enforcement Also offers real estate, personal, business and student loans 37

Prosper Matching service, similar to online dating Potential borrowers and lenders post offers Allows for more flexibility and smaller transaction costs 38

Zopa UK based matching service that obviates negotiation You propose a loan, they rate your risk factor –Student loan = A –Business Startup = B –Pay off credit cards = D Zopa sets the rate for grades and acts as the middleman 39

Class Discussion What are the merits and issues with these services / products? Can you think of another service / product that might be useful? 40

What We’ve Learned Debt options Debt Behavior Subprime Crisis and Policy Discussion Debt and Entrepreneurship 41

Assignment 2 Suggest how individuals could practically track their expenses for budgeting purposes. You might find it useful to try and track your own expenses for a week or two. Alternatively, if you feel this is impossible, then explain why. 42