Knowledge of the Cost and Duration of Credit: Effects on Repayment Decisions Rob Ranyard, Sandie McHugh (University of Bolton, UK) Alan Lewis (University of Bath, UK)

Issues and Research Questions 1 Flexible credit: Duration of credit is not precisely known, especially for longer loans Flexible credit: Duration of credit is not precisely known, especially for longer loans –Does cost information improve estimates of loan duration APR? APR? Total interest charged? Total interest charged? –See: Ranyard & Craig, 1993, Journal of Economic Psychology 14, IAREP/SABE Rome 2008

Issues and Research Questions 2 Instalment credit, fixed and flexible: Instalment credit, fixed and flexible: –(Mis)understanding APR, the Annual Percentage Rate of interest –Does knowledge of APR improve estimates of the total cost of credit? (Study 1 and Study 2, part 1) 3IAREP/SABE Rome 2008

Issues and Research Questions 3 Flexible credit: Long-term consequences of repayment decisions not precisely known Flexible credit: Long-term consequences of repayment decisions not precisely known –Does information concerning the long term consequences change repayment decisions? Loan duration? Loan duration? Total cost? Total cost? (Study 2, part 2) 4IAREP/SABE Rome 2008

Flexible credit: Ranyard & Craig, 1993 Scenario: You want to buy a portable TV and you see the following advert in a store Scenario: You want to buy a portable TV and you see the following advert in a store TV (details here) Price:£119.99(APR 32%) The store offers you a store card.... Minimum repayment £5... Interest rate 2.4% per month... Question: If you repay £5 (£11) per month, how long will it take you to pay it off? Question: If you repay £5 (£11) per month, how long will it take you to pay it off? IAREP/SABE Rome 20085

Flexible credit: Ranyard & Craig, 1993 Results Results IAREP/SABE Rome APR InformationMean Absolute Percentage Error (APE) of loan duration APR Given21% No APR14% Total interest information Mean APE of loan duration TI given 5% No TI 20%

Flexible credit: previous research Conclusions Conclusions –APR information reduces the accuracy of flexible credit duration estimates –Because APR misunderstood: some evidence from estimation strategies –Total interest information improves accuracy –Total interest information (or total cost) supports personal financial budgeting IAREP/SABE Rome 20087

Study 1: Understanding APR Participants and procedure Participants and procedure –Survey with 1023 respondents aged 16 and over –interviewed by trained interviewers in 2004 –a quota sample of the U.K. based on gender, age, social and working status and region, weighted to reflect the national profile The questions form part of a ‘Financial I.Q.’ score designed by the Alan Lewis and collaborators The questions form part of a ‘Financial I.Q.’ score designed by the Alan Lewis and collaborators IAREP/SABE Rome 20088

Study 1: Understanding APR What does A.P.R. stand for? What does A.P.R. stand for? a) Annual Property Revenue b) Annual Perceived Revenues c) Annual Percentage Rate d) April Percentage Rate e) None of the above f) Don't know Main result Main result –Over 85% correct –significant association with education IAREP/SABE Rome 20089

Study 1: Understanding APR Many people borrow money to purchase cars or to make household improvements. Say you were to borrow £5,000 from one of the major banks to be paid back over 12 months, approximately how much do you think you would pay altogether? Many people borrow money to purchase cars or to make household improvements. Say you were to borrow £5,000 from one of the major banks to be paid back over 12 months, approximately how much do you think you would pay altogether?Approximately: £5,000 £5,100 £5,400 £5,700 £6,000don’t know IAREP/SABE Rome

Study 1: Understanding APR I am going to give you some extra information this time (please keep your answer to the previous question the same). The amount of the loan remains at £5000 and the loan repayment period is still 12 months but you now know that the A.P.R. is 8%. How much do you think you would pay back altogether? I am going to give you some extra information this time (please keep your answer to the previous question the same). The amount of the loan remains at £5000 and the loan repayment period is still 12 months but you now know that the A.P.R. is 8%. How much do you think you would pay back altogether?Approximately: £5,000 £5,100 £5,400 £5,700 £6,000don’t know Hypothesis: respondents will over-estimate rather than under-estimate total cost (£5,400 rather than £5,100) Hypothesis: respondents will over-estimate rather than under-estimate total cost (£5,400 rather than £5,100) IAREP/SABE Rome

Study 1 results: Percent responses, no APR information Years educationHighMediumLow Response (total cost) (n = 189)(n = 318)(n = 479) £5, £5, £5, £5, £6, Don’t know IAREP/SABE Rome

Study 1 results: Percent responses, APR given at 8% Years educationHighMediumLow Response (total cost) (n = 189)(n = 318)(n = 479) £5, £5, £5, £5, £6, Don’t know IAREP/SABE Rome

Study 2, part 1: Understanding APR Participants and procedure Participants and procedure –Postal survey of 2000 bank customers aged 18 years and over, 240 responses –a random sample of a U.K. Bank’s customers IAREP/SABE Rome

Study 2, part 1: Understanding APR Many people borrow money to purchase cars or to make household improvements. Say you were to borrow £5,000 from one of the major banks to be paid back over 12 months, approximately how much do you think you would pay altogether? Many people borrow money to purchase cars or to make household improvements. Say you were to borrow £5,000 from one of the major banks to be paid back over 12 months, approximately how much do you think you would pay altogether?Approximately: £5,000 £5,200 £5,400 £5,700 £6,000don’t know IAREP/SABE Rome

Study 2, part 1: Understanding APR I am going to give you some extra information this time (please keep your answer to the previous question the same). The amount of the loan remains at £5000 and the loan repayment period is still 12 months but you now know that the A.P.R. is 8%. How much do you think you would pay back altogether? I am going to give you some extra information this time (please keep your answer to the previous question the same). The amount of the loan remains at £5000 and the loan repayment period is still 12 months but you now know that the A.P.R. is 8%. How much do you think you would pay back altogether?Approximately: £5,000 £5,200 £5,400 £5,700 £6,000don’t know Hypothesis: respondents will over-estimate total cost (£5,400 rather than give the correct response, £5,200) Hypothesis: respondents will over-estimate total cost (£5,400 rather than give the correct response, £5,200) IAREP/SABE Rome

Study 2, part 1 results: response frequencies (n = 234) no APR information IAREP/SABE Rome

Study 2, part 1 results: response frequencies (n = 233) APR given as 8% IAREP/SABE Rome

Study 1 and Study 2, part 1 conclusion Most (85%) UK adults in the sample knew what APR stands for (associated with education) Most (85%) UK adults in the sample knew what APR stands for (associated with education) But most used it incorrectly, and over- estimate the total cost of credit repaid over 12 months But most used it incorrectly, and over- estimate the total cost of credit repaid over 12 months IAREP/SABE Rome

Study 2, part 2: Flexible repayments IAREP/SABE Rome Mortgage scenario: imagine you have renegotiated your mortgage of £40,000 at an interest rate of 5.9%. How much do you want to pay monthly? Amount of monthly repayments Number of years Total cost with the same monthly repayments Please tick your choice √ £7685 years£46,080 £5208 years£ £43910 years£52,680 £38512 years£55,440 £33215 years£59,760 £29718 years£64,152 £28020 years£67,200

Study 2, part 2: Flexible repayments IAREP/SABE Rome How much do you want to pay monthly? Time to clear the loan if same payments made Total cost if the same monthly repayments continue Please tick your choice √ £ months£ £ months£ £ months£ £ months£ £ months£ £ months£ Credit card scenario: imagine you have a £1,500 balance on your credit card at 15.2% APR. How much do you want to pay monthly?

Study 2, part 2: Flexible repayments Independent groups, 2 x 2 factorial design Independent groups, 2 x 2 factorial design –Total Cost information (TC given vs. No TC) – Loan Duration information (Duration give vs. No duration) –Four versions of questionnaire, participants randomly allocated to one condition IAREP/SABE Rome

Study 2, part 2: Results – Credit card Percent responses, all groups IAREP/SABE Rome

Study 2, part 2: Results – Mortgage Percent responses by group

Study 2, part 2: Conclusion In the mortgage scenario In the mortgage scenario –information concerning long-term consequences significantly influenced repayment decisions –Higher repayments were chosen when either total cost or duration information was provided In the credit card scenario In the credit card scenario –information concerning the long-term consequences of repayment decisions had no effect –Participants generally preferred the highest repayment of those available IAREP/SABE Rome

General Conclusions APR provides useful cost information but it can be misleading; Total cost information should be presented in addition APR provides useful cost information but it can be misleading; Total cost information should be presented in addition Both total cost and duration information are important for budgeting with flexible credit and can influence repayment decisions Both total cost and duration information are important for budgeting with flexible credit and can influence repayment decisions IAREP/SABE Rome