Choosing a mortgage is one of the most important financial decisions made by a household. Financial innovation has given rise to more complex mortgage products with back-loaded payments, known as ‘Alternative Mortgage Products’ (AMPs), or ‘Interest-Only Mortgages’. Using a specially designed question module in a representative survey of UK mortgage holders, we investigate the effect of consumer financial sophistication on the decision to choose an AMP instead of a standard repayment mortgage. We show poor financial literacy and present bias raise the likelihood of choosing an AMP. Financially literate individuals are also more likely to choose an Adjustable Rate Mortgage (ARM), suggesting they avoid paying the term premium of a fixed rate mortgage.

We study how individuals repay their debt using linked data on multiple credit cards. Repayments are not allocated to the higher interest rate card, which would minimize the cost of borrowing. Moreover, the degree of misallocation is invariant to the economic stakes, which is inconsistent with optimization frictions. Instead, we show that repayments are consistent with a balance-matching heuristic under which the share of repayments on each card is matched to the share of balances on each card. Balance matching captures more than half of the predictable variation in repayments and is highly persistent within individuals over time.