Credit Cardholders Can’t Seem to Knock Down Balances
After a good Christmas for retailers, the January regrets about overspending are inevitable.
What’s driving that regret was dramatized in a recent experiment to see if consumers could get control of their credit card balances. It was a flop.
This experiment involved U.K. residents applying for credit cards who had selected the automatic payment option, which would withdraw a payment from their bank accounts every month. They were split into two groups, each with different choices. One group had three automated options: a monthly minimum payment, a fixed payment in an amount of their choosing, or paying the balance in full every month.
In the second group, the researchers encouraged the credit card applicants to select a fixed payment every month, which should reduce their balances faster. They were given only two options: choosing the fixed-dollar payment or fully paying the card off every month. If they couldn’t or didn’t want to pay off the card balance, they either could choose a fixed amount to pay monthly or decide against enrolling in the autopayment plan.
A fixed payment, in theory, reduces the debt faster than paying the minimum. Here’s a simple example using a $1,000 one-time charge on a card with an 18.9 percent annual interest rate. Card companies set minimum payments at a percentage of the card balance, so the payments shrink as the balance declines. If the first minimum payment is $25, it would take 18.5 years to pay off that card if nothing is charged after the $1,000 in initial spending.
But if that same consumer had agreed to a fixed $25 payment every month, the payoff time would be slashed to five years, saving $750 in interest on that initial $1,000 shopping spree. A fixed payment knocks down the balance faster, because over time it becomes a larger and larger percentage of the debt as the balance declines.
That’s not what happened in the experiment. The people who chose a fixed payment did not cut down their debt any faster than the people who paid the minimum.
The researchers proposed three reasons based on analyzing the data on the cardholders in their experiment.
First, the fixed amounts the applicants selected were too low. As cardholders continued to spend and increase their balances, their fixed payments were no higher than the minimums they would’ve paid had they been able to select that option.
Second, the researchers found that nudging people to try to get them to accept the fixed payment option reduced the share of cardholders who agreed to pay their bills automatically, making this nudged group more likely to miss a payment.
The third reason has to do with the fact that cardholders always have the option of making extra payments to reduce what they owe. But the people who decided they would automatically pay a fixed monthly amount made smaller extra payments.
The final issue – and perhaps the crux of the problem – was a lack of liquidity generally among all cardholders. Among the subset of cardholders who had accounts at the same bank that issued their credit cards, the researchers found that half of them effectively had no excess cash in their accounts over a period of 90 days.
Nudging people into automatic fixed payments “has no real economic effects on reducing credit card debt,” the researchers concluded. The primary reason consumers use autopay is “as insurance against forgetting to make a payment.”
This experiment nicely demonstrates the problem with credit cards. The consumers who pay them off every month have enough cash in the bank to avoid the exorbitant interest rates.
The shoppers who don’t pay off their balances are probably buying things they can’t afford, piling up interest for months or years.
Preventing January regret requires facing up to this fact.
Squared Away writer Kim Blanton invites you to follow us @SquaredAwayBC on X, formerly known as Twitter. To stay current on our blog, join our free email list. You’ll receive just one email each week – with links to the two new posts for that week – when you sign up here. This blog is supported by the Center for Retirement Research at Boston College.