Adverse Selection and Maturity Choice in Consumer Credit Markets: Evidence from an Online Lender

This paper exploits a natural experiment to document adverse selection among prime consumer credit borrowers in the US. In our setting, some borrowers are offered only a short term loan while an observationally equivalent set of borrowers is offered the same short term loan as well as an additional long maturity option. We isolate adverse selection from the causal effect of maturity on repayment by comparing the ex post default behavior of borrowers who took the same short term loan in both settings. We show that when the long term option is available, borrowers who choose the short term loan default less and have higher future FICO scores. Thus, a longer loan maturity induces adverse selection by attracting unobservably less creditworthy borrowers. The difference in the default rate of borrowers who choose the pre-existing short maturity loan and those that self select to the new long maturity option is five percentage points, an economically large effect for prime borrowers whose average default rate is 8.6%. Our results highlight the potential for underprovision of long maturity consumer credit.