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Is ignorance bliss? Consumer accuracy in judgments about credit ratings.

Article Excerpt
There is considerable evidence to suggest that consumers are often misinformed about basic financial and economic principles. The purpose of this study was to examine the accuracy of consumers' self-assessments of their credit ratings. Findings suggest that approximately 32 percent of consumers overestimate their credit ratings, while only 4 percent underestimate their credit ratings. Those who overestimate their credit quality are less knowledgeable about financial matters in general and are more likely to have acquired their financial knowledge from difficult past experiences. In addition, consumers who overestimate their credit ratings are less likely to budget, save, or invest regularly.

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There is considerable evidence to suggest that in general, consumers are unaware or misinformed about basic financial and economic principles--information they need in order to make important decisions such as buying a home and planning for retirement (Chen and Volpe 1998; Hogarth and Hilgert 2002; Lee and Hogarth 1999; Mandell 2006). This issue has gained more attention recently as a result of concerns about borrowers in the subprime market obtaining mortgages that they cannot afford. There is little known about the specific nature of this lack of awareness and misinformation.

Credit scores are designed to measure credit risk at a particular point in time and are based on models that use information in consumer credit reports maintained at the credit reporting agencies to predict future payment behavior (Fair Isaacs 16). Lenders use credit scores to help them make lending decisions, although each lender may differ in terms of the level of risk it finds acceptable, and this may even vary for different types of loans. Higher scores indicate lower credit risks or higher credit quality, although no single cutoff score is used by all lenders.

Previous research on biases in judgment and decision making has shown that individuals tend to display overconfidence about their knowledge and ability (Kahneman and Tversky 1996; Lichtenstein and Fischhoff 1977). Due to overconfidence, people often believe that they know more than they actually do, and this can have negative consequences. For example, previous research has shown that overconfidence affects decision making because it causes individuals to overweight their own judgments relative to other decision inputs. The purpose of this study was to examine overconfidence in consumers' self-assessments of their credit rating. Our research questions ask: How likely are consumers to overestimate their credit ratings? How do consumers who overestimate their credit ratings differ from those who have a more-accurate estimate of their credit quality? Is there a relationship between overestimating one's credit rating and financial behaviors such as budgeting, saving, or investing?

LITERATURE REVIEW

Financial Literacy

Financial literacy has grown in importance to researchers and policy makers in recent years. Much of the policy debate has centered on educating consumers and encouraging legislators to include financial literacy in public school curriculums. Research in this area has focused on measuring the extent to which consumers lack financial knowledge and the resulting consequences (see Braunstein and Welch 2002, for a review). For example, in a nationwide survey of twelfth graders, Mandell (2006) found an average score of 52.4% correct on a test of personal finance basics. In another example, Lee and Hogarth (1999) found that approximately 40% of mortgage borrowers did not understand the interest rates associated with their loans.

Several studies have also linked consumer financial knowledge with responsible financial behavior. For example, Chang and Hanna (1992) found that increased levels of financial information resulted in more-efficient decisions. Hogarth and Hilgert (2002) and Hilgert, Hogarth, and Beverly (2003) found that consumers who are financially knowledgeable are more likely to behave in financially responsible ways. Similarly, Perry and Morris (2005) found that consumers with higher levels of financial knowledge were more likely to budget, save, and plan for the future. The present study examines the relationship between the consumer knowledge of financial and credit principles and the tendency to overestimate one's credit rating.

Previous research has examined self-assessed credit ratings (Ards, Ha, and Myers 2006; Ards and Myers 2001; Betsey 2006; Courchane, Galley, and Zorn 2008). According to Ards and Myers (2001) and Betsey (2006), African American consumers disproportionately underestimate their credit ratings.

Ards, Ha, and Myers (2006) link the tendency to misperceive credit ratings with borrowers' prior experience with loan denials. Courchane, Gailey, and Zorn (2008) examine the relationship between self-assessed credit ratings, actual credit ratings, and loan terms. While these authors found that consumers tend to overestimate their credit rating, this had no significant impact on the interest rates they ultimately paid for mortgage loans. This study builds on these prior studies by examining the relationship between credit rating misperceptions, overall financial knowledge, and financial behaviors.

Overconfidence

This study draws on previous research on overconfidence in decision making. Kahneman and Tversky (1996) conceptualize overconfidence as a judgmental or perceptual bias that may result in errors. This bias leads individuals to overestimate their own knowledge or ability relative to objective assessments of knowledge or ability. Overconfidence is particularly prevalent when tasks are difficult or nearly impossible (Fischhoff, Slovic, and Lichtenstein 1977; Kahneman and Tversky 1996), and overconfidence tends to be less common when tasks are easier. Lichtenstein and Fischhoff (1977) found that the most-knowledgeable subjects were actually underconfident. These findings persist whether difficulty is defined in terms of previous subjects' performance or in terms of independent assessments of correctness (Lichtenstein and Fischhoff 1977; Lichtenstein, Fischhoff, and Phillips 1982).

It is possible that the overconfidence...

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