The Financial Rationality of Consumer Loan Choices: Revealed Preferences concerning Interest Rates, Down Payments, Contract Length, and Rebates

Article excerpt

A choice-based conjoint experiment was employed to identify consumer preferences for automobile loan attributes. Respondents prefer loans with low interest rates and moderate contract lengths. Less important are high rebates and moderate down payments. Rebates are most important to choice when down payment is high. Even when choosing among interest-free loans, respondents do not prefer long terms, conflicting with traditional financial rationality. Respondents appear to focus attention on the first digit of the monthly payment (payment, a function of the other attributes, was provided to respondents). This tendency was stronger among those with less education. Public policy recommendations are discussed.

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   Last year [2005], the Consumer Bankers Association reports, loans
   longer than 60 months accounted for 55.3 percent of its members'
   new-vehicle loans.... The 2005 figure reflects a surge of 10
   percentage points in one year (Allen 2006).

Over 70% of new automobile purchases in the United States are financed in part by vendor loans (Dasgupta, Siddarth, and Silva-Risso 2007), and personal car loans have amounted to 34% of monthly nonmortgage debt in the United States (Heitfield and Sabarwal 2004). The changing array of financing alternatives and rebate offers complicates the process of purchasing a car and may have significant implications for the well-being of buyers. In the summer of 2006, zero-interest loan offers with payment terms as long as seventy-two months presented compelling opportunities to the extent that prices for credit purchases were similar to prices for immediate cash. However, the tone of press coverage concerning long-term loan offers has often been negative. For example, one article suggests that car buyers considering long-term loans should "run from them like the plague" (Bankrate.com 2006). Columnists and some experts have emphasized the likelihood of buyers quickly becoming "upside-down" (when the value of a car is less than the amount owing on the loan). Faced with such issues, consumers may have a difficult time making a financially rational choice in the utility-maximizing sense.

Consumer confusion in the face of complex, multidimensional price information such as auto loan financing offers is indicated by empirical research (Estelami 2001; Herrmann and Wricke 1998; Stango and Zinman 2006; Thaler 1985). For example, Herrmann and Wricke (1998) found that when asked to rate the relative attractiveness of different auto loan financing offers, respondents at best used only linear functions of down payments, monthly payments, and contract lengths, without even calculating the product of monthly payment and number of payments, let alone using discounted values.

Given these indications of financial irrationality and the increasing reliance on credit to finance durable goods purchases, "understanding the psychology of consumer judgments of credit arrangements is ... growing in importance from both a marketing and public policy perspective" (Estelami 2001, p. 63). Accordingly, this study aims to increase our understanding of how consumers choose among auto financing alternatives. More specifically, it attempts to answer the following research questions: (1) What are consumers' preferred levels of loan interest rate, contract length, down payment, and rebate? Do interactions among these attributes matter? And which attributes are weighted most heavily in loan selection? (2) Are the answers to the questions in (1) consistent with rationality? (3) Do the findings for (1) and (2) vary by demographic subgroup? and (4) What implications do the findings have for consumer self-protection and financial literacy education efforts?

To address these questions, a choice-based conjoint (1) experiment was designed to reveal consumer preferences for hypothetical automobile financing offers that varied with respect to interest rate charged, required down payment, contract length in months, and rebate amount. …