MSE’s Academy of Money
MSE’s Academy of Money

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MSE’s Academy of Money

3.2 The preference for simplicity over best value

Do you look closely at the details when comparing the cost of alternative products? Try this activity.

Activity 3 Choosing the low-cost loan

Timing: Allow approximately 5 minutes for this activity

You are buying a vacuum cleaner costing £100. But you need to borrow the money to buy it. You are offered a series of choices to borrow the money. Which loan would you choose?

  • Loan 1: pay back £120 at the end of the year.
  • Loan 2: pay back £115 at the end of the year.
  • Loan 3: pay a £10 arrangement fee and then equal monthly repayments; the interest rate is 5% per annum.
  • Loan 4: pay a £5 arrangement fee and then equal monthly repayments; the interest rate is 8% per annum.
  • Loan 5: pay equal monthly instalments at an interest rate of 7% per annum, plus a final charge of £3.
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Answer

Which loan did you choose? You may be surprised to discover the cheapest loans are Loans 4 and 5. The issue is that people do not like complexity and so often opt for higher-priced products where the pricing is simpler. For comparison, here are the total costs of each loan option:

  • Loan 1 costs £120
  • Loan 2 costs £115
  • Loan 3 costs £112.70
  • Loan 4 costs £109.40
  • Loan 5 costs £106.80

As options become more complex, the reliability of our decision-making quickly deteriorates and we become more inclined to go for the simplest options.

Plus, we also don’t get a lot of practice doing this. Our big financial decisions – like buying a home or car – don’t happen very often. So, there’s not much opportunity for practice, and consequently there’s a lot of scope to forget what we learned the last time we made a big financial decision.

Technical note

To clarify how the answers to Loans 3, 4 and 5 are obtained, a detailed calculation for Loan 3 is shown below.

You can use the same methodology to derive the answers for Loans 4 and 5.

In each case, the £100 loan is repaid in 12 equal instalments, with these being made at the end of each of the twelve months of the year.

The fee needs to be added to the interest costs – with both then added to the original £100 borrowed to get the total repayment.

Note that the process does involve some ‘roundings’, so your answers may be different to those above by a few pence.

Loan 3

Month Loan o/s Monthly interest @ 5%pa
1 £100.00 £0.42
2 £91.67 £0.35
3 £83.34 £0.35
4 £75.01 £0.31
5 £66.68 £0.28
6 £58.35 £0.24
7 £50.02 £0.21
8 £41.69 £0.18
9 £33.36 £0.14
10 £25.03 £0.11
11 £16.70 £0.07
12 £8.37 £0.04
Total Interest £2.70
Upfront fee £10.00
Total repayments (including the original £100 loan) £112.70
AOM_1

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