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Wednesday, 3 March 2010

Putting Down the Credit Cards

Deviant Cards

Credit cards are one of the modern era’s great financial innovations, and have benefited the financial institutions that issue them terrifically. Unfortunately many of the people who use them get rather less rewards, mainly because of the unconscious biases that compel their every conscious move.

One of the few manifest and practical advantages of credit cards, though, is that analysis of their use is a practical primer in many of the behavioural biases which so entrance us on these pages and of the way in which ill-considered legislation magnifies their effects. Credit cards are a marvellous mechanism for a study of our deviant debt-laden ways and the ineptitude of our legislative representatives. However, they’re also the thin end of a very dangerous wedge.

Minimum Payment Palaver

In both the US and the UK credit card providers are legally bound to collect the minimum interest payment outstanding on cards each month, to prevent the issue of compounding interest and evermore spiralling debt. So every month, in nice large and friendly figures, the statement shows the minimum amount that the account holder has to pay. The idea, of course, is to prevent consumers getting themselves into financial difficulties. Which is a nice idea but the law of unintended consequences, allied to the supercharged effect of behavioural biases has other ideas: it turns out that this minimum payment works an anchor, and biases people into only paying the minimum amount outstanding.

We shouldn’t really be surprised by this, because the evidence of people anchoring on completely random numbers in areas of financial uncertainty – which for most of us is anything at all to do with money – is something for which we’ve seen plenty of evidence – see Anchoring, the Mother of Behavioural Biases for example. What’s more interesting, perhaps, is the lack of understanding of regulators who continue to think they can enact laws to protect people from their own stupidity without understanding the underlying, albeit basic, psychology.

Credit Card Anchors

Neil Stewart in The Cost of Anchoring on Credit-Card Minimum Payments has followed up on some ideas of Thaler and Sunstein in 2008 to demonstrate a strong correlation between the minimum payment required and the actual payments made. What the research has shown is that the presence or otherwise of minimum payment targets made no difference to the number of people repaying in full. However, when minimum payment anchors were removed from the statements the average partial payment went up by 70%.

All of which suggests that the inclusion of the minimum payment amount has the effect of reducing the amount paid by the people targeted by the legislation. In fact the research suggests that including these targets roughly doubles the amount paid in interest. The credit card companies will, no doubt, be very grateful for the profit boost enacted by our governments.

Out of Control Consumers

Anchoring isn’t the only effect visible through the use of credit cards, however. Perhaps a more obvious area of study are the issues that surround the inability of many people to avoid acquiring stuff they really want now as long as they can delay until later the pain involved in the outlay of actual money. This issue, the so-called problem of self-control, seems to surface almost anywhere and anytime there’s a significant time delay between acquisition and payment. Credit cards are, obviously, the ideal vehicle for people who must have that must-have item right now.

The traditional way of looking at self control assumed that consumers rationally discount the future – the so-called exponential discounting function. To behave thus is, in the jargon, to be time consistent. However, rumours from the outside world that people don’t actually behave like this keep surfacing in the economic ivory towers, suggesting that humans are time inconsistent and discount hyperbolically not exponentially.

To simplify this drastically, if humans discount hyperbolically they basically disregard future costs entirely, while if they do so exponentially they don’t. Exponential time discounters have a budget while hyperbolic time discounters have a really nice wardrobe, a cool car, all the latest gadgets and some really ugly looking debt collectors banging at the door.

Time Inconsistency

Most hyperbolic discounting studies have been laboratory based which runs the risk of putting people in situations that don’t make human sense. There’s copious evidence that such scenarios produce results that don’t transfer well to real-world scenarios. To get round this problem Shui and Ausubel in Time Inconsistency in the Credit Card Market developed a large-scale real-world experiment. To cut a long story short, the results suggest that consumers have “severe self-control problem” with credit cards. Now, don’t tell me you’re not surprised. Please don’t tell me that.

To simplify the study somewhat, they made two credit card offers, both with low introductory rates. The first offered a very low rate for a short period, then rising rapidly for the rest of the experimental period. The second offered a higher, but still discounted, rate for the whole timescale. Over the entire period the rational discounter with constant debt would have taken the second card, because this produced the lowest total interest payments.

You’re way ahead on this, aren’t you? Yes, the respondents overwhelmingly preferred the first card with its low initial rates. This makes perfect sense, however, if they then switch to another low rate card at the end of the offer. Only they overwhelmingly didn’t and carried on paying higher rates. That consumers don’t always prefer the credit card offer demanding the lowest overall interest is, more or less, evidence that consumers are not rational in their consumption approach. That credit card companies bombard us with low introductory rate offers is, by the same criteria, entirely so, as are the relatively high rates charged for normal credit card rates, a competitive anomaly that this research at least partially explains: consumers don’t select credit cards based on the lowest standard rate.

Behind this is an important differentiator between the exponential and hyperbolic models. The first model would lead us to assume that the consumer is intelligently deciding to use credit card debt to fuel current consumption rather than saving in advance. However, the second model suggests something rather different – it suggests that people don’t have control over their spending and their lack of self-control is what’s leading to racking up the card bills.

What Do We Do About It?

Of course, at one level a simple explanation of these facts is that the spendthrift credit card debt addicts simply aren’t very good at doing sums about compound interest and, moreover, wouldn’t care even if they did as long as they can get their hands on the latest piece of consumer electronics today. While those of us with the self-control to manage our spending impulses may well feel that we can take advantage of the mentally less well endowed there is, unfortunately, a side-effect of this borrowing that affects us all. As Stewart points out:
“About three quarters of credit-card accounts attract interest charges. In the United States, credit-card debt is $951.7 billion of a total of $2,539.7 billion of consumer credit. In the United Kingdom, credit-card debt is £55.1 billion of £174.4 billion of consumer credit.”
That’s one hell of a lot of unsecured credit sitting on already stretched balance sheets much of it weighing on consumers whose job security remains fragile. Expecting the global economy, at least in the West, to charge ahead with this ball shackled to its ankle is to mistake hope for expectation and credit expansion for productivity fuelled growth. That the sheer pressure of uncontrolled self-interest can put the livelihoods of millions of people at risk compels us to look at how we manage this in future.

Protecting the Unwary

Of course, the new US Credit Card Accountability, Responsibility, and Disclosure (CARD) Act is designed to stop some of the more egregious abuses of cardholders. Unfortunately this relies on cardholders behaving with some level of vague rationality. The evidence, such as it is, isn't encouraging.

Credit cards are valuable tools as long as they’re controlled, but the lack of control of many owners puts you in mind of the legislative response to the owners of dangerous dogs: put the dog down and ban the people from owning any more – although responsible dog owners suggest that this is the wrong way around. In our free world that may be a step too far but it’s about time bureaucrats sat down with the people who actually have some understanding of this stuff and started designing proper responses. Demanding that people can actually pass a simple test to calculate, or even understand, the compound interest on their debt would be a good start.

Related Articles: Save More ... Tomorrow, Property Rights and Wrongs, Debt Matters


  1. rumours from the outside world that people don’t actually behave like this keep surfacing in the economic ivory towers, suggesting that humans are time inconsistent and discount hyperbolically not exponentially.

    The people trying to sell us stuff go with what works.

    The people trying to help us understand money matters go with what is most likely to get them tenure.

    If only it were the other way around.


  2. So what changes to credit card rules would you prescribe? Are you just proposing to remove the minimum payment amount from the statement? Somehow, that seems unsatisfying.

    What does behavioral psychology have to say about a schedule that specifies not only payment amounts but consequences? I am thinking of something like this:

    Payment/Time to Repay/Cumulative Interest
    X1 3M Y1
    X2 6M Y2
    X3 1Y Y3
    X4 2Y Y4

    Of course, since CC rates are floating, the times stated would be uncertain - but you get the idea. And obviously there would still be anchoring associated with the given times - perhaps with the middle. That could be turned to the consumer's advantage.

    (I am uncomfortably aware that 2Y is probably an unrealistically short payback cap when considering current minimum payments. But being one of those types who always pays in full, I've never looked into the details.)

  3. Hi Phil

    Yes, the only route I can think of is to provide a set of alternative payment scenarios. As you suggest even that's not entirely satisfying, but the alternative seems to be regulating who can have a credit card which isn't going to happen.

    The problem with credit type financial products is that they assume some level of self-control: not obviously a sensible assumption.

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