Credit card debt in the United States (U.S.) has steadily grown over the last 13 years because the cost of living has surpassed income growth. While the median household income has increased by 26% since 2003, household expenses have increased at a higher rate (e.g., medical costs grew by 51% and food/beverage prices by 37%). Credit card debt indicates consumers are purchasing goods and services, which fosters economic growth and creates jobs. The concern arises when this debt is not managed properly as it is one of the most expensive types of debt (i.e., the average APR is 15%). Prolonged indebtedness cannot easily be sustained, and it is a symptom of living beyond one’s means.
Credit card issuers divide borrowers into two groups: “transactors/convenience users” who pay the full balance each month and “revolvers” who allow their balance to rollover from one billing cycle to the next, paying interest charges month to month. Many consumers that carry a credit card balance may find it impossible to get out of debt, because they are paying primarily for accumulated interest charges rather than the cost of their purchases. The average American household owes $5,880 in credit card debt. However, this figure surges to $15,762 after eliminating households without credit card debt (61.9% of the population).
How do borrowers manage their credit card debt?
Credit card debt is a financial burden. A rational person should reduce spending and allocate most of his/her discretionary income, if available, toward the debt payment. However, Wilcox, Block, and Eisenstein surprisingly showed that credit card balances could have the opposite effect on spending. The more focused people are to avoid an undesired outcome (e.g., debt), the more likely they are to abandon restraint after failure. More specifically, the authors argue consumers with a high level of self-control avoid credit card debt before incurring a balance. Once they incur a balance, their self-control is decreased, which results in relaxed restraints on spending. Consumers with a high level of self-control reduce spending when their credit card limit is increased; however, among the general population of debt revolvers, a 10% increase in credit card limit translates into a 1.3% increase in debt within one quarter and a 9.9% increase in the long term.
Amar and his colleagues found credit card customers tend to reduce the number of credit cards rather than decreasing the amount of total debt owed across all credit cards. They refer to this phenomenon as “debt account aversion”. When debtors choose to pay the smallest balances with the lowest APR, instead of balances with the highest APR, they pay more interest in the long run. “Debt account aversion” is replicated in a study by Besharat, Carrillat, and Ladik who attribute this effect to “the illusion of goal progress”. That is, a self-endowing progress toward a main goal by attaining an easier sub-goal such as paying off one of the debt balances. This tendency becomes weaker as the number of outstanding balances increases. In contrast, when the income available to pay down the debt is in the form of effortless money (e.g., windfall or reward money), the illusion of goal progress and subsequently debt account aversion is exacerbated. Further, the authors show that debt account aversion is subject to the nature of balances (hedonic vs. utilitarian) and the timing of consumption benefits (past vs. future). The tendency is to quickly pay balances associated with pleasurable expenses, especially if consumption benefits have been realized in the past. If you purchased a necklace and a dishwasher both for $1,000 last year, you are likely to feel more guilt about the fun-oriented purchase and you don’t want that debt to hang around your neck any longer.
Does "snowballing" help consumers become debt free faster?
Knowing that debt account aversion could be an irrational decision is the reason some financial advisors, including Dave Ramsey, advocate “debt snowball”, which is paying small balances ahead of larger balances. Jin, Xu, and Zhang demonstrate that people are more successful when they follow an easy-to-difficult sequence when completing sub-goals. In related research using secondary data from a consumer debt settlement firm, Gal and McShane illustrate that closing individual debt accounts is a significant predictor of overall debt elimination after controlling the dollar balance of the closed accounts. This finding provides evidence that the illusion of goal progress motivates debtors to persist in pursuit of the higher level and long-term goal of being debt free. However, the debt snowball method should be employed with caution, according to Brown and Lahey. This approach is only fruitful in scenarios of debt reduction in which interest rates among debt accounts do not vary greatly. When large differences exist among interest rates of debt accounts, the financial benefits of paying off debts from highest to lowest interest rates outweighs the motivational benefits obtained from debt snowballing.
Could public policy interventions help credit card debt crisis?
In 2009, the U.S. government enacted the Credit Card Accountability Responsibility and Disclosure (CARD) Act. It requires monthly statements to include a table to inform consumers 1) the time required to pay the entire balance if the minimum amount is paid each month and 2) monthly amount that would eliminate the balance in three years. Interestingly, Navarro-Martinez and his colleagues showed that disclosing the minimum required payment has a negative impact on debt repayment, because debtors interpret this amount as sufficient for repaying the debt in a timely manner. The authors found no evidence for including future interest costs and time needed to repay the balance.
Another study by Soll, Keeney, and Larrick shed light on why the supplemental information included in the credit card statement is misleading. First, many debtors do not have the mathematical skills needed to estimate compound interest. Second, consumers are naïve in accumulation problems and assume additional charges will not be added to their existing balance, which results in biased inferences from the supplemental table in their statement. The financial literacy concerns become more prominent when debtors manage multiple balances and receive tempting debt consolidation offers. For example, Bolton, Bloom, and Cohen suggest that effective public policy interventions for debt consolidation loans must focus jointly on loan literacy (i.e., information about how and why a loan works) and lender literacy (i.e., information about how and why particular lenders act as they do).
Credit cards are among the most expensive methods of financing due to the high interest rates on most credit cards (10%–24%). Although credit card companies may provide the option to make partial or minimum payments, it is wise to pay the entire balance monthly. All sources of income, regardless of their origin (e.g., salary, bonus, tax return, etc.) should equally assist in attaining debt reduction goals. To avoid additional spending, borrowers must turn down tempting offers for card line increases, except those with strong self-control. If a balance exists on more than one credit card, debtors should pay the credit card with the highest interest rate first, irrespective of the size of the balance. The debt snowball method could be a feasible solution only if the difference among interest rates of debt accounts is negligible. Finally, all credit card expenses must be viewed the same. Emotional attachment to expenses and postponing payment until the good/service is experienced (e.g., an expense for an upcoming vacation package) must be avoided.
Questions for Academics/Instructors in the Classroom
1. How much do you pay attention to APRs listed for your credit cards? Do you use this information at all when paying off your balances? Have you ever considered or utilized debt snowballing?
2. Do you refer to the supplemental information/table about the interest charges in your statements when paying all or portion of your monthly credit card balances? Please briefly explain your reasons in favor or against this tool.
3. What factors would motivate you to open a new line of credit (e.g., an increase in credit card spending limit, rewards, etc.)?
Amar, M., Ariely, D., Ayal, S., Cryder, C. E., & Rick, S. I. (2011). Winning the battle but losing the war: The psychology of debt management. Journal of Marketing Research, 48(SPL), S38-S50.
Besharat, A., Carrillat, F. A., & Ladik, D. M. (2014). When motivation is against debtors' best interest: The illusion of goal progress in credit card debt repayment. Journal of Public Policy & Marketing, 33(2), 143-158.
Bolton, L. E., Bloom, P. N., & Cohen, J. B. (2011). Using loan plus lender literacy information to combat one-sided marketing of debt consolidation loans. Journal of Marketing Research, 48(SPL), S51-S59.
Brown, A. L., & Lahey, J. N. (2015). Small victories: Creating intrinsic motivation in task completion and debt repayment. Journal of Marketing Research, 52(6), 768-783.
Gal, D., & McShane, B. B. (2012). Can small victories help win the war? Evidence from consumer debt management. Journal of Marketing Research, (0), 487-501.
Jin, L., Xu, Q., & Zhang, Y. (2015). Climbing the wrong ladder: The mismatch between consumers' preference for subgoal sequences and actual goal performance. Journal of Marketing Research, 52(5), 616-628.
Navarro-Martinez, D., Salisbury, L. C., Lemon, K. N., Stewart, N., Matthews, W. J., & Harris, A. J. (2011). Minimum required payment and supplemental information disclosure effects on consumer debt repayment decisions. Journal of Marketing Research, 48(SPL), S60-S77.
Soll, J. B., Keeney, R. L., & Larrick, R. P. (2013). Consumer misunderstanding of credit card use, payments, and debt: causes and solutions. Journal of Public Policy & Marketing, 32(1), 66-81.