Credit cards can be an expensive way to borrow.
In the UK, for example, the average interest rate on cards in 2017 is 18%.
And curiously, a study has found that the way people tend to pay off their balances means credit cards end up costing even more than they should.
Speaking at the Centre for Economic Policy Research European Conference on Household Finance – sponsored by the Think Forward Initiative – the researchers explained that the best way to repay balances is to minimise interest charges.
So if a person has two cards, they should pay the minimum payment on both cards, and repay as much as possible on the higher interest rate card. They should only make further payments to the lower interest rate card if they can pay off the higher interest card in full.
But instead they found that people tend to match the share of repayments on each card to the share of balances on each card. For example, imagine a person has £2,000 owing on one card and £1,000 on another card. He or she decides to repay £300 that month.
The study found that people would split the repayment, putting £200 on the card with £2,000 of debt and £100 on the card with £1,000 of debt. That is, the ratio of repayments – £200 to £100 – would be the same as the ratio of debt – £2,000 to £1,000.
Anchor for choices
Study author John Gathergood, from the University of Nottingham, says that people tend to focus on balances – which are prominently displayed on credit card statements – rather than interest rates, which are not. This provides an “anchor” for their choices, he says.
“Economic theory would traditionally predict that individuals follow simple price-based rules, such as repaying the most expensive debt first,” said Gathergood.
“Surprisingly, data shows us that consumers appear to use very different rules, maybe based on an alternative intuition about how they should behave.”
But what if you have a number of cards with similar interest rates? What should you do then?
The findings of a study published in 2016 suggest that concentrating on just one account at a time – beginning with the smallest – helps increase the motivation to get out of debt.
After analysing data on 6,000 people with multiple cards the researchers found that those who focused on one card paid off more debt than those who spread their repayments equally.
When the academics then carried out a series of experiments to figure out the psychology behind the results, they found it was not the size of the repayment or how little was left on a card after a payment that had the biggest impact on people’s perception of progress.
Instead, it was the proportion of the balance they succeeded in paying off.
Therefore, focusing on the card with the smallest balance tended to have the most powerful effect on their sense of achievement, spurring them on to continue paying off what they owed.
Breaking down a large problem into small, achievable goals prevents people from becoming disheartened.
Dr Trudel also advised against the temptation to combine debt onto one card.
“Unless it’s possible to consolidate those debts at a substantially lower rate, our findings would argue against pooling debts into a single larger one as this can actually be demotivating and could slow progress in repayment,” he wrote.
And whatever you do, make sure you don’t get into the routine of only paying the minimum repayment each month; borrowing £3,000 at an interest rate of 17.9% would take nearly 30 years to pay off this way.
Another paper presented at the conference investigated the so-called “co-holding puzzle”: when people hold debt on credit cards despite having money in the bank (perhaps earning very little interest) that could be used to pay down the debt.
It seems irrational, but there can be understandable reasons for doing it. Some people use it as a method of self-control by deliberately restricting the money available for impulsive spending, for example.
It’s common too. The 2017 ING International Survey found that 28% of people in Europe and nearly half of those in the USA were co-holding debt and savings.
Now economists from the University of Delaware and the Boston Federal Reserve have found that many saver-borrowers use credit cards as a precautionary measure, to protect against problems accessing credit in the future.
The researchers also examined whether co-holding could predict future financial trouble and compared this group to people who just had savings and no debt.
They found that while co-holders were no more likely than savers to go bankrupt or have their house repossessed in the three years before the financial crisis of 2007-2008, in the three years following the crash they were. Significantly so.
The findings “indicate that the new financial environment that arose from the Great Recession significantly changed the cost of holding credit card debt for precautionary reasons,” the researchers said.