Consumer Credit with Over-Optimistic Borrowers

Over-optimists face worse income risk but incorrectly believe they are rational. Thus, both types behave identically. Lenders price loans forming beliefs — type scores — about borrower types. This gives rise to a tractable theory of type scoring. As lenders cannot screen types, borrowers are partially pooled. Over-optimists face cross-subsidized interest rates but make financial mistakes: borrowing too much and defaulting too late. The induced welfare losses outweigh gains from cross-subsidization. We calibrate the model to the U.S. and quantitatively evaluate policies to address these frictions: financial literacy education, reducing default cost, increasing borrowing costs, and debt limits. While some policies lower debt and filings, only financial literacy education eliminates over-borrowing and improves welfare. Score-dependent borrowing limits can reduce financial mistakes but lower welfare.