Debt and Decision-Making: Where Intuition Leads Us Wrong

Personal Finance

In every irrational decision, there is an opportunity for exploitation and an opportunity to steer humans on a better path. Employers make automatic deductions from paychecks into savings accounts to help workers prepare for retirement, but merchants mark up their prices and offer goods “on sale” so that you feel you’re getting a good deal. In the realm of personal finance, where consumers are presented with a lot of choice but precious little clarity, the propensity towards irrational decisions is only exacerbated. Regulators are only now coming around to the idea that consumers need not just more information, but behavioral nudges to move them toward healthier finances.

Take, for example, the evolution of credit card disclosures. A law enacted in 1988 required that issuers disclose their credit cards’ interest rates, grace periods, and other salient information. However, the Schumer box is often buried deep in a credit card’s terms, and even if consumers do manage to find it, few fully understand the concepts behind interest rates.

The Credit CARD Act of 2009 updated disclosures to increase consumers’ understanding, not just knowledge. It requires that credit card statements disclose not just the abstract, sometimes confusing interest rate, but also the interest payments incurred if the customer pays only the minimum, and the monthly payment necessary to be debt-free in three years.

Still, for every nudge we can give toward better financial decision-making, ten other biases exist, ripe for exploitation. Credit card debt, in particular, seems to bring out our irrational side. We spoke with Professor Scott Rick of the University of Michigan about his study detailing human fallacies when paying off credit card debt. His finding: we try to close as many accounts as we can, as fast as we can, even when it’s not in our best interest.

How do we decide to pay off our debts?

Rick, along with four other well-known academics, tried to experimentally determine how consumers pay off their debts and detailed his findings in Winning the Battle but Losing the War: the Psychology of Debt Management. In those experiments, volunteers exhibited debt account aversion: they would try to pay off their smallest debts, prioritizing reducing the number of open accounts rather than minimizing interest payments. From a purely financial standpoint, the best decision is to pay off debts with the highest interest rates first, lowering the amount of interest paid. Instead, people chose the potentially sub-optimal outcome of targeting their smallest debts.

“It’s hard to resist closing your smallest accounts,” says Rick. “There’s the heuristic that you should pay off your smallest debts first in order to build momentum, and that psychological benefit outweighs the higher interest payments.”

“We haven’t found that to be the case. We have found, in more recent work, that the more troubled people were about their debts, the more likely they were to prioritize closing off their small accounts.”

If consumers are making the rational decision to pay their smallest debts, knowing that they will pay (potentially far) more in interest down the line, that would be one thing. But Rick posits that consumers don’t fully understand the implications of interest rates and compounding debt, and so cannot make a fully informed decision. In Winning the Battle, Rick posits that “consumers are likely to manage multiple debts in ways that can ultimately impede their ability to rid themselves of debt” by digging themselves deeper and deeper into a financial hole.

Credit cards represent a particular distortion

In particular, credit cards have the potential to encourage poor decision-making. Mortgages, student loans and other “installment” debts often have, as the name would suggest, fixed payments, and consumers can estimate their total interest paid when they take out the loan. Credit cards are less straightforward for a number of reasons: credit cardholders have on average 5 open cards, each with a different interest rate; people tend to budget for paying off “credit card debt” in general rather than specific cards in particular; and repayment timelines are much more fluid.

Consumers can also take on more credit card debt. In Rick’s experiment, volunteers could only pay off existing debt, and weren’t tempted to make a new purchase. In the real world, you don’t just decide which account to pay down, you also decide whether to pay it down at all. According to Winning the Battle:

That individuals use [sub-optimal] repayment strategies…in our simplified game speaks to the intuitive appeal of debt account aversion and suggests that debt repayment behavior in the more complex world could be even more depressing.

The report also details ways that people make a number of less-than-ideal decisions regarding credit cards: they give outsize importance to the minimum payment, even though that number is designed to reap interest payments for card issuers; they don’t sufficiently weigh interest rates when choosing between loans; and they don’t often transfer balances from high- to low-interest credit card accounts.

All in all, Rick’s research suggests that consumers tend to manage their debts in less than rational ways. “While this might naturally seem like a cause for concern among those interested in protecting consumer welfare, some financial gurus actually endorse debt account aversion,” says Winning the Battle.

The melting debt snowball

Dave Ramsey, a TV personality and radio host who gives practical, easy-to-understand financial advice, introduced the idea of the debt snowball: excluding mortgage payments, pay off the account with the least debt first, building momentum towards paying off your bigger debts. “Getting out of debt is like losing weight,” proclaims his website. “It is an emotional decision. If it takes six months to lose a pound, will you stick to that diet? No way.”

The logic behind this is based on a sensible concept: closing off a small account gives quick, positive feedback, which in turn imparts the will to pay off larger debts. But Rick’s research suggests that “Ramsey may be preaching to the choir, and further encouraging non-optimal behavior driven by some basic human biases.”

Let’s take Ramsey’s diet metaphor one step further, to reflect that consumers decide not just to pay down debt at all, but which account to pay down first. Imagine that you have a number of health problems: you smoke far too much, you’re a little bit overweight, and you attend physical therapy twice a week for a knee injury. Ramsey’s plan would have you continue physical therapy, which like a mortgage requires regular, fixed installments of effort. But then he would have you work on losing five pounds before quitting smoking, arguing that the validation you receive from losing weight will give you the fortitude to quit smoking.

What this fails to account for is the harm of continuing to smoke while losing weight. In terms of lasting damage to your health, smoking is far worse than carrying a few extra pounds around, so you’re doing yourself a disservice by not addressing the most serious problem first.

Similarly, when you’re paying off your debts, by closing a small, low-interest account before, say, a high-interest rewards credit card account, you increase the total amount of money you have to pay. That, in turn, increases the time before you have the relief of being debt-free. Plus, Ramsey’s formula relies partly on the idea that you’re more motivated to finish a task that’s near completion. While this may work for paying off your smaller debts, once you need to tackle the large ones, you’ll find your goal further than it was when you began. From WTB:

While [Ramsey’s] heuristic is not necessarily a mistake, our work reveals that debt account aversion can systematically lead consumers astray when larger debts have larger interest rates. Ultimately, it appears that debt account aversion may enable consumers to win the battle, but lose the war.

So what should be done? And what can be done?

We asked Professor Rick what public-sector, private-sector and personal interventions he thought would be useful. He noted that any policy that ensures optimal debt management – such as, say, routing all debts through a central clearinghouse – would not only be impractical, but would also curtail consumers’ freedoms. Still, he thinks there’s room for nudges in the right direction.

Keeping accounts open. In his research, Rick found that if a consumer was unable to close any of her accounts completely (for example, if the card had an annual fee, or if she didn’t have enough money to pay down his debts altogether) she was more likely to make a rational decision regarding debt management. Annual fees, then, could be a built-in check against our natural biases.

Presenting interest in dollar terms. Research suggests that people understand compounding debt more clearly when it’s put in dollar terms rather than abstract interest rates. This is part of the rationale behind requiring credit card companies to disclose on your statement how much interest you’ll accrue under various scenarios. “It’s only fair to spell out those costs for consumers,” says Rick.

Sending credit card bills all at once. It’s hard enough to find a solid debt management strategy, and the problem is only exacerbated by credit card bills that arrive at different times. Many people pay their bills as they come in, and so may pay off a low interest credit card whose statement arrives on the first of the month rather than a high-APR card whose statement arrives later. An easy fix would be to require that credit card bills be sent at the same time, simplifying the decision-making process.

Challenge the debt snowball. The concept of building momentum on your debts is not all bad, as long as you’re making an informed decision. The concern is that people don’t fully appreciate the downsides of a small-debts-first strategy and unwittingly set themselves up for hardship down the line. Rather than brushing off the logic behind a high-interest-first approach (“mathematics,” Ramsey dismissively calls it), consumers should be made aware of the tradeoffs of both heuristics. “We should make people aware that there is a cost to the debt snowball strategy,” says Rick.

What about balance transfer credit cards?

A balance transfer credit card lets you consolidate all of your debts onto one account, and pay down your debt interest-free for a period of time. Given what we’ve just said about sub-optimal management of multiple debts, it may seem that balance transfers are the best solution: rather than weighing each card individually, consolidate them onto one account. And it does have its merits. If you can pay off your debt during the 0% APR period, you’ll get a reprieve from growing interest. Plus, even if you don’t pay it off in time, you may have a lower ongoing APR than your current credit card.

However, there are a few pitfalls, built into both the credit cards and our psyches. First, after the 0% APR period ends, you might face an APR higher than your original one. Read the terms and conditons carefully, and make an honest assessment of your repayment timeline. Second, the cards often have balance transfer fees of 3-5% of the transfer, which may shrink or negate the benefit of lower interest payments.

The third concern is psychological. Rick notes that debt consolidation has the unfortunate effect of encouraging spending, which the cardholder can ill afford. “People have the illusion that they’ve made progress” because they’ve closed some accounts, even though the amount of debt they hold is unchanged. “That encourages them to spend more.”