Stories | October 31, 2016

Do you hold debt and savings at the same time?

Holding credit card debt and savings at once seems like a paradox, but there may be a rational reason why many people do just that.

It’s not surprising that many people use their credit cards for everyday purchases and have some savings in separate accounts. But the real puzzle is why some people get into the credit card debt spiral in spite of having savings which could pay down their debt.

Interest due on borrowing is usually higher than the interest earned on savings. From a rational perspective, these co-holders (people who are in debt but have savings too, at the same time) could use their savings to make the purchase or pay off their bill and avoid having to pay the often high rates of interest on their borrowing.

The co-holding puzzle
In a 2014 paper, John Gathergood and Jörg Weber at the UK’s University of Nottingham name this the “co-holding puzzle”, finding that 12% of people they observed do this. The consequences of co-holding can be high as on average these households rack up approximately £650 (€729) in unnecessary interest charges every year.

Given how much co-holding can end up costing, why would anyone do it? Yet there may be some method behind this madness: this way of arranging your finances can sometimes help control the spending impulse

Are they dumb?
It might be tempting to think co-holders simply don’t understand they could have a better deal. But that’s actually not always the case. Gathergood and Weber find that people who co-hold tend to be more financially literate than others.

Similarly, a working paper from the Federal Reserve Bank of Boston has found that co-holders have higher financial literacy than borrowers (people who have credit card debt but no savings) or people who have neither debt nor savings. However, it found that these people may have lower financial literacy than savers (people who have savings and no credit card debt).

Nor is the tendency to co-hold necessarily affected by how much you earn. The different studies discovered the problem exists in both low and above-average income families.

Method behind the madness
Given how much co-holding can end up costing, why would anyone do it? Yet there may be some method behind this madness: this way of arranging your finances can sometimes help control the spending impulse. Other research has shown that people who co-hold are more likely than the average person to be impulsive spenders or be impatient and have a high appetite for credit, usually measured by the rate of loan applications someone makes.

Some find rebuilding their savings pot more difficult than paying their credit card bill. New York University professor of public policy and economics Jonathan Morduch explains that people who find it difficult to save may also find it hard to use their savings to repay debt, because they fear they will not be motivated enough to rebuild their savings.

The penalties for not paying back a debt regularly can also actually function as a type of discipline and commitment device, essentially binding people into regular payments. A high interest charge may even help – as there is then even more incentive to pay back the debt.

Emergency fund
Another reason people co-hold is because it can be wise to hold money back for emergencies, especially if there is a risk they would not be able to access money or credit quickly when needed.

It may be that savings have been mentally allocated to a specific purpose, for example a “rainy day”or emergency fund. Liquid assets like cash in a savings account in theory can be used quite easily. But in practice, people often categorise their savings, mentally filing them separately from their credit card debt. 

Additionally, not everything can be paid for by credit card, so some people may prefer to keep cash savings on hand for those purchases. 

What’s best for you?
It’s worth reviewing your account and understanding the costs of spending any credit you have rather than paying it off with savings. It’s likely there will be clear financial benefits to paying down debt – if you have strong self-control and can easily top up the savings.

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eZonomics team
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