MJTH/ShutterstockMillions of motorists across the UK could be in line for payments of around £700 after car dealers mis-sold finance to earn commission. Finance providers stand to lose billions compensating consumers after the scandal.
The UK regulator, the Financial Conduct Authority (FCA), recently announced that lenders must compensate buyers who took out finance for a new or secondhand car. Millions paid more than they should have because of secret fees paid by lenders to dealerships.
For many, this compensation will be a welcome surprise. For others, it will be hard-won compensation after a complicated legal battle. For others still, £700 may not be enough compensation for the time and stress involved – the sum is lower than the FCA had previously estimated – although the total paid out could top £8 billion.
This settlement begs an interesting question. What should recipients do with this money? This is hardly a trivial question. Organisations such as the National Lottery provide financial advice to big winners, recognising that a windfall involves a lot more than popping the champagne corks.
However, financial advice after winning the lottery – pay off debts, buy a house, invest in long-term assets – does not apply to the relatively small sum of £700. But neither is it smart to write off £700 as if it were only a small win. Economically speaking too, a spending boost of up to £8 billion would show up in UK GDP figures.
Behavioural economists have found that people’s decisions about money depend on their mental frame of reference. If they feel like they’ve lost money, their decisions to save or spend will be quite different to if they feel they’ve gained something. Precisely because many people will have already written off the costs of mis-selling, it is likely that they will choose to spend their compensation.
The psychology of winning can be pernicious because of what economists call “licensing” effects. Licensing happens when a previous event or behaviour influences future actions. If you’ve gone to the gym in the morning, you might choose to have a dessert in the evening – but only because you went to the gym.
Likewise, if you “win” £700 you had mentally written off, you will be more inclined to buy things you would otherwise avoid. In this mental state, small luxuries like eating out or buying designer shoes are likely to feel more tempting. Very quickly, that £700 could disappear.
Spending money is not a bad thing. It is only through spending that the economy grows, which to a lesser or greater extent benefits everyone. And using the money to invest in a new hobby, for instance, is likely to be personally rewarding in ways a cold financial outlook fails to appreciate.
But there is also a more sympathetic, and less explored perspective. Someone might understand what they ought to do financially, but reasonably decide that £700 is not worth the effort. For example, earning 3% on £700 means next year you’d be £21 richer, ignoring inflation. From this perspective, it is reasonable – if not economically rational – to decide spending is preferable to saving.
A growing issue
The question of how to use a windfall is fascinating because it’s an example of something economies like the UK are going to see a lot more of in the coming decades. The movement of wealth from retirees to their adult children (those aged around 30 to 50) has been called the greatest wealth transfer in human history.
It’s not going to be an even transfer. Some millennials will receive enormous sums as their parents pass on houses and savings pots. Others will receive very little. But a large group will receive something in the middle – an unexpected windfall, too large to write off but too small to lay down new financial roots by buying a house, for example.
In the years ahead, what this group does with its slice of a generational inheritance will shape the financial landscape of the UK, and many more countries, too.
Investing in a new hobby could pay dividends that traditional financial metrics can’t measure.
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This £700 settlement is therefore an interesting example. While people may feel they know what they ought to do with unexpected money, behavioural economics can tell us what people probably will do.
The “ought” depends on someone’s financial circumstances. For those set to receive £700, it might be a good idea not to treat it as a windfall. They had probably mentally written it off, so if they avoid seeing it as a gain they are more likely to pay off debts or save it.
Payments could start coming through from early next year. With that in mind, another sensible place for many to “invest” £700 might be in credit with their energy supplier. This could smooth out financial bumps in the road, given rising energy costs.
Many people dislike saving because it can feel like losing money, as they are moving the funds from a “fungible mental account” – where they can do anything with it – to a “non-fungible mental account” (such as a rainy-day fund).
For economists, examples like a £700 compensation are fascinating because they expose elements of human behaviour that we are all guilty of.
But this compensation scheme is also likely to be a precursor to a much bigger economic phenomenon. What will people do when they suddenly receive a sum that’s too big to ignore but too little to change their financial foundations?
Stuart Mills does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.