Unseen Risks Challenge Consumers

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Financial-product complexity isn’t talked about on Capitol Hill, where Congress is arming itself for battle royale over the appointment of Harvard Law School professor Elizabeth Warren to head the new Consumer Financial Protection Bureau.

But some economics and business professors are sticking up for the financial consumer, who they say faces an “ever-widening set of financial options” and “dizzying amount of information.”

“Households are expected to make decisions about pension plan contributions and payouts, to choose from a wide array of credit instruments to fund everything from home purchase to short-term cash needs, and more generally to assume a greater level of responsibility for their financial well-being,” Harvard economists Brigitte Madrian and John Campbell, Harvard Law professor Howell Jackson, and Peter Tufano at the Harvard Business School wrote in a recent paper.

“There is growing evidence that consumers make avoidable financial mistakes” with “nontrivial financial consequences,” they said.

Published in the latest issue of the Journal of Economic Perspectives, the paper used three case studies to support their call for more creative regulation: mortgages, payday loans, and 401(k)s.

Mortgages. Even the answer to a common question – variable or fixed? – is ultimately unknowable for the average consumer.  With refinancing now common, mortgages require complex decisions that George Bailey’s customers never could’ve imagined.  Homebuyers can make even bigger mistakes with adjustable-rate home loans, which can suddenly make their homes unaffordable.  Two words sum that up: subprime mortgage.  But borrowers with more traditional variable-rate loans also “systematically underestimate the degree to which their mortgage interest rates can vary over time,” the authors said.

Payday Loans. This $40-billion-a-year industry isn’t necessarily the villain it’s portrayed to be.  Payday loans may be no more expensive than credit cards with double-digit interest rates linked to overdraft protection and other services that can trigger sky-high fees. 

The problem is that people who use payday loans have low levels of debt literacy and aren’t all equipped to make this calculation.  One study showed that typical payday borrowers interpreted the $15 fee paid for a short-term $100 loan as an annualized interest rate of 15 percent, which is actually much cheaper for a loan that is paid off quickly.

Retirement Products. People who hold 401(k)s make numerous mistakes, the authors report.  Their investment choices are often informed by recent trends.  And many never rebalance their investment portfolio as the value of their asset classes change, or they over-invest in their employer’s own stock — the Enron problem.