The Psychological Cost of Debt: Evidence from Islamic Housing Mortgages

Abstract

How do borrowers prioritize financial versus psychological costs of holding debt? We explore these trade‐offs using repayment data for 3,705 borrowers with an Islamic housing mortgage in Pakistan. The product allows borrowers to make early payments. Around 40% of borrowers in our sample make early payments, leading to an average cost of PKR 247,707 ($2,890 USD). We develop a new model of consumer hedonics to explain these results, and rule out religion, commitment devices, and cost misunderstanding as complete explanations. These findings suggest that there is a psychological benefit to decreasing debt, even if an account is not closed fully.