Naïve Consumers and Financial Mistakes

Abstract: Financial contracts are complicated and consumers often do not grasp them in their entirety. This may lead to financial mistakes when borrowers do fully internalize the costs of credit. We develop a quantitative theory of unsecured credit and equilibrium default where borrowers can sign debt contracts and trade off interest rates for penalty fees. These fees make financial shocks - such as paying late or borrowing over limit - costly. While sophisticated borrowers fully understand the risk of paying penalty fees, naïve borrowers face higher risk without internalizing this fact. Thus, they make financial mistakes by choosing inefficiently high penalty fees. In equilibrium, naïves’ fee payments cross-subsidize interest rates for sophisticates. We use our framework to analyze two unexplored features of the CARD act: transparency requirements and penalty fee limits. More transparency makes financial contracts easier to understand, reducing the financial risk for naïve borrowers. Thus, naïves will pay lower penalty fees in equilibrium. Fee limits directly ban high-fee contracts for everyone. Both policies reduce the expected revenue from naïve fee payments and consequently interest rates rise. In both cases, naïves make fewer financial mistakes and enjoy a welfare gain. Sophisticates, in contrast, suffer: Since naïves pay lower fees, sophisticates lose cross-subsidization and experience welfare
losses.