Don't Let the Wording Fool You: Understanding the Effects of Loan Application Formats

Every time I make an online purchase, I am tempted by payment options such as Afterpay and Klarna. I mean, who wants to pay $900 for a new iPhone when you could only pay a small fee of $33! ... per month.... for two years. At first, it sounds like a great idea: making just a few small payments for a few months is much less daunting than paying the full amount upfront.

The seeming convenience of these “buy now, pay later” purchasing options has sparked a fundamental transformation in how individuals approach their spending habits. Individuals are increasingly turning to options such as these to make purchases both large and small, drawn to the allure of spreading out expenses into manageable monthly payments as opposed to one large payment at once. This shift is driven by today's consumers' inclination toward immediate gratification and the desire for financial flexibility, yet it requires careful assessment to avoid potential pitfalls in future budgeting and overall financial health.

This consumer shift also has implications for modern loan acquisitions. Loan application formats, whether the monthly payment or total loan amount is emphasized during the loan application process, significantly influences borrowing decisions, potentially leading individuals to opt for loans that appear more affordable in the short term but may incur higher overall costs in the long run. Without awareness of these nuances, consumers risk making uninformed financial choices that could have lasting consequences.

In the article, “Loan Amount versus Monthly Payments: The Effect of Loan Application Formats on Consumer Borrowing Decisions” authors Daniel Villanova, assistant professor at the University of Arkansas, University of Arkansas alumna Alicia Johnson (University of Massachusetts Amherst), and Ronn Smith (University of Wyoming) examine the influence of loan application formats in financing decisions.

Understanding Personal Loans

Apart from housing debt, consumer debt consists of four major loan types: student loans, auto loans, credit cards, and personal loans. In recent years, consumers have shown that they are . While student, auto, and credit card debt account for about 90% of non-housing loans, personal loan debt was the fastest-growing type of non-housing debt between 2014 and 2020. With this emergence, it is critical for both managers and consumers alike to understand consumer habits when requesting personal loans. 

In 2023, researchers found that the average personal debt per individual in the United States was $21,800. However, this is just the average. Everyone has different experiences with their debt, some with a large sum of debt, and some with none. Those who did have debt reported that, on average, about 30% of their income is allocated to paying it off every month. The impact of personal debt extends beyond financial strain, influencing individuals' mental well-beingand economic mobility.

With so many individuals accruing personal debt, it is essential that people try to understand the intricate details that are often misunderstood with loans. For example, many borrowers underestimate the timelines for repayment, especially if they are only making minimum payments each month. Another common misconception is the total amount repaid. Interest complicates these matters by silently and slowly increasing the amount that will need to be repaid from the original borrowing price. Misconceptions such as these highlight the need for transparency from institutions and financial literacy efforts from consumers.

Monthly Payments versus Loan Amount

When managing a loan request, there are two ways of phrasing that a financial institution can use to understand what loan a consumer wants: loan amount (LA) and monthly payment (MP). When discussing loans in “loan amount” terms, the lender and consumer will speak about how much money the consumer is seeking for the loan. In LA conversations, consumers tend to think about the cost of the purchase they are going to make with the personal loan.

On the other hand, MP discussions involve looking at the loan based on how much consumers are willing to pay monthly. In these types of conversations, consumers often look at their monthly budget and how much they can afford to pay each month. Because consumers prioritize different things depending on the format – the total cost of the purchase in LAs and their monthly budget in MPs – the format of loan application leads to consumers requesting different loans, even for the same purchase!

Villanova’s research finds, however, that customers are generally willing to accept whatever loan results from either loan application format. In the MP format, as long as their monthly payment request is met, consumers are even willing to over-borrow.  

Using an MP format when discussing loans does not always lead to over-borrowing. In fact, Villanova’s research shows that this depends on the size of the purchase they are trying to make. When taking out smaller loans for things such as small home improvements or debt consolidation, customers tend to over-borrow and ask for more money than they need in the MP format, while in larger loans, for things such as major medical bills, customers are more likely to under-borrow in the MP format.

In contrast, LA discussions typically yield a principal request that is more in line with the accurate cost of their purchase. The risk with the LA format, however, is that while it can reduce over-borrowing for lower cost-purchases, it leads to monthly payments that are higher than what consumers would want to pay.

Read the Fine Print

In addition to wording, many financial institutions employ marketing strategies that will appeal to individual budgets and constraints to capitalize on financial flexibility. Easy access to financial profiles allows these institutions to conduct extensive data analysis to gauge budget slack, or how much money individuals feel they can spare each month for the payment. With this information lenders often tailor their marketing to appeal to specific audiences.

For instance, those with a tighter budget might be targeted with offers emphasizing financial relief or consolidation. These frames encourage consumers to see these loans as a way to . At first glance, they might seem simple, with “low” interest rates and manageable monthly payments. However, individuals must approach these loans critically.

What might seem like a lifeline at first can quickly spiral into a cycle of debt, trapping borrowers into limited economic mobility. Financial institutions may capitalize on the vulnerability of individuals with limited budget slack by concealing hidden fees, imposing stringent repayment terms, or large interest rates, all under the guise of a low monthly payment that seemingly “fits in their budget.” Because of this, it is imperative that individuals look closely at their loan agreements and avoid being persuaded by the format of the loan discussions.

Becoming an Informed Consumer

Despite all this information, most consumers will proceed with their loan regardless of the loan application format. Often, if the preferred monthly payment parameter is met, customers will show a substantial willingness to accept debt in excess. Therefore, consumers should try to understand the effects of loan application formats so they can make more informed decisions about borrowing and avoid potential financial pitfalls in the future.

The discussion surrounding consumer financing decisions is crucial for consumers' financial well-being. While things such as personal loans and “buy now, pay later” payments can serve as valuable tools for expanding credit access, they also have the potential to exploit vulnerable consumers. As people explore various loan options, they need to remain vigilant about the regulations and terms associated with borrowing.

While individuals should always be conscious of the fine print, the responsibility of being educated on one’s loan should not fall solely on the customer. Financial institutions and policymakers play a vital role in safeguarding consumers by evaluating the ethical implications of promotional tactics and ensuring transparency in loan agreements. By promoting financial literacy and accountability, these stakeholders can mitigate the risks associated with personal loans and contribute to the overall financial health of individuals and society.