Analysis: the psychology of financial decisions means we often make expensive mistakes when it comes to choosing loans and credit cards
The cost of living crisis is still upon us and winter energy prices are rearing their ugly heads again. Lenders report that more people are applying for personal loans and credit cards to cover costs. These may help in the short term, but many financial products have hidden features that come with a big price tag.
At the Behavioural Research Unit in the ESRI, we study the psychology of financial decisions to try to understand some of the most common traps that people fall into when making financial decisions, such as applying for a loan or credit card. Here are three to avoid:
The minimum repayment on your credit card
Most banks set a minimum amount to be paid off a credit card every month which is usually somewhere around 2 to 5% of the balance. Psychologists have shown that many people get 'anchored' by this amount, which means that they see it as a recommended payment and pay only that amount and no more.
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From RTÉ Radio 1's Today With Claire Byrne, advice from dealing with credit cards from personal finance expert Eoin McGee
This is a big drain on their finances because they get charged interest on the rest of the balance every month and means they are saddled with more expensive debt for longer. When the minimum repayment is removed, people actually pay more off their balance every month, not less, and end up debt-free earlier. Ignoring the suggested minimum repayment and deciding for yourself how much you can afford to pay off every month will cost you a lot less in the long run, if it’s anything more than the minimum.
The "recommended" personal loan term
Many people use online calculators when deciding whether to take out a loan. These calculators often have some settings already on them. For example, the loan amount may be set to €15,000 and the term may be set to five years. The person can then choose to change the amount and the length of the loan to suit them.
We did an experiment to test whether people are influenced by these settings. We showed people an online calculator where the term was either set to one or five years. People could change the number of years to suit them, but the problem was that the first number they saw influenced their final choice.
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From RTÉ Radio 1's Morning Ireland, Pete Lunn from the ESRI on a survey which found that most people do not shop around for bank accounts or financial products like loans and mortgages
When we asked them afterwards what loan they would choose, people who saw the calculator set to one year at the start chose a shorter loan than people who saw the calculator set to five years. That’s not to say they chose an one year loan, but just that they were more likely to choose say three years, rather than five.
Shorter loans cost less than longer loans if the interest rate is the same. In our experiment, just seeing a loan calculator with an initial setting of five years instead of one year would have cost each person €470 more on average if they were taking out a €10,000 loan. That’s a lot of money down the drain because of one setting on a calculator. Using an independent loan calculator that doesn’t come with these settings means your decision won’t be influenced by what someone else thinks is an appropriate loan term.
Overconfidence in our ability to weigh up pros and cons
Many people like to think they are good at weighing up pros and cons and coming to a decision. They are sometimes, but not completely. The human brain has a limited processing capacity which means that people’s attention can be drawn to certain features of products that don’t actually signal good value. People are overly influenced by cashback offers or by introductory offers that offer a cheaper rate for a short period of time.
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From RTÉ Brainstorm, how to save money on your household bills with simple maths
We tested how good people were at judging the value of different products depending on how many different features they had to consider. Everyone was much worse than expected. Even with just three features to weigh up, people couldn’t tell if they were getting a good or a bad deal. This means people can get lured into bad deals because the product is complicated. Finding some way to summarise the value of a product, like the total cost of a personal loan, can help to see through the distractions to find the best deal.
We want to understand how people in Ireland choose products like bank accounts, mortgages, loans and current accounts so that we can find ways to help people get better deals. We are looking for people to take two short, anonymous online surveys. Everyone who takes part will get advanced access to a new webpage that takes a user-friendly and fun way to show you how to get better deals.
Dr. Deirdre Robertson is a senior research officer in the Behavioural Research Unit of the Economic and Social Research Institute. She is an Adjunct Associate Professor in the School of Psychology at TCD and a former Irish Research Council awardee.
The views expressed here are those of the author and do not represent or reflect the views of RTÉ
