Why do consumers take out car finance rather than save up for the purchase?

Why does a person take a loan out for a holiday rather than put away a portion of their income each month?

The answer, people act irrationally with their money.

Richard Thaler won the Noble prize this year for his work in behavioural economics, which studies the effects of psychological, social and cognitive factors on an individual’s economic decisions, with the main focus on why people act irrationally.

So how should a rational person budget their money?

Well according to economists such as Irving Fisher, a rational individual must decide how much of their income to spend and save in a given time period dependant on their salary. How much a consumer can spend is referred to as a consumer’s intertemporal budget constraint, which stops consumers spending more than their salary. However, consumers can access more than their monthly earnings by taking out loans or credit card, which incur interest and therefore reduce the amount of money available to the consumer next month. As such, Fisher’s model shows that a rational person would be better off saving their money today for a future expense tomorrow. However, most lenders see that this is rarely the case and consumers applying for HCSTC tend to have little to no savings. David Laibson another economist, looks to remedy this insufficiency of saving by relating it to another phenomenon called the pull of instant gratification. Consider the following two questions:

Question 1: Would you prefer (A) a candy today or (B) two candies tomorrow?

Question 2: Would you prefer (A) a candy in 100 days or (B) two candies in 101 days?

Laibson states that many people confronted with such choices will answer A to the first question and B to the second. In a sense, they are more patient in the long run than they are in the short run. Richard Thaler explains this is due to consumer’s having a lack of self-control and trying to plan long-term while doing in the short term. This coincides with Lisbon’s work that consumer preferences may be time inconsistent.

A consumer may decide to splurge out on a new car while promising himself that he will cut back on his spending tomorrow and start saving more. However, when tomorrow arrives the promises are in the past, and a new self takes control of the decision making, with its own desire for instant gratification.

The same principle can be widely applied to the HCSTC market. Consumer A wishes to go on holiday, however, has no savings and as such applies for a short-term loan to cover the expense. The consumer applies for a loan of £1200 (including interest/fees) for 3 months. On the other hand, consumer B has a similar income and plans to go on holiday in 3 months’ time but decides to save the money instead.

most loan providers would not be in business today if all consumers acted rationally

Consumer B is better off as he avoids paying the interest and as such saves a larger portion of his income, while A is now trapped paying £400 per month. However, most loan providers would not be in business today if all consumers acted rationally and as such their main market is the irrational consumer. With all lenders now carrying out affordability checks, this demonstrates that approved consumers can afford the loan and therefore could have saved the money themselves but instead act in the short term and take a loan out in the now.

So why do consumers take loans out rather than save?

Richard Thaler’s theory suggests that people need a “nudge”. A person saving money has no obligation but to themselves to not spend their life savings, however a person with a loan must now pay back the amount or be financially penalised. Therefore, “by knowing how people think, we can make it easier for them to choose what is best for them, their families and society,” wrote Richard Thaler and Cass Sunstein in their book Nudge (2008). This principle was recently undertaken by the UK government where they mandated employers to establish an automatic enrolment scheme in 2012 to increase the amount people were saving for retirement. The results showed that an extra 5 million people had now joined a private sector pension scheme.

To conclude, by better understating how people save, regulators such as the FCA may find a better solution in reducing consumer debts as an alternative to enforcing stricter regulation on payday loan and credit card companies. By “nudging” consumers to save more we may one day see a more dynamic lending sector, with consumers making better financial decisions leading to fewer consumers entering a state of financial distress.