How to Win the War on Credit Card Debt


What’s the best way to pay of multiple credit cards? Research shows it might not be the way you think.

ANN ARBOR, Mich.—When faced with a list of tasks, tackling an easy one first and crossing it off is an effective way to get moving in the right direction. Common wisdom applies this to managing credit card debts.

Even personal finance guru Dave Ramsey advocates consumers pay off the smaller debt, even if it has a lower interest rate, in order to get a quick win. But new research from Ross marketing professor Scott Rick shows that advice actually makes it harder to dig out of debt.

The study, "Winning the Battle but Losing the War: The Psychology of Debt Management," also shows this non-optimal behavior may be such an ingrained human bias that Ramsey probably is preaching to the choir. This is a major issue for U.S. consumers, since the average credit user holds more than five credit cards each with an average balance of more than $1,000.

"It really seems like it makes sense when confronted with multiple debts to eliminate one right away," says Rick, the Arnold M. & Linda T. Jacob assistant professor of marketing. "But there are more obscure attributes with debt, like interest rates, that make it not the right thing to do in some cases. If the smaller debt carries a higher interest rate, it makes sense to follow Ramsey's advice. When it's reversed, when the bigger debt has a higher interest rate, you should stop doing it. But people do it anyway."

The study, published in a special edition of the Journal of Marketing Research, has implications not only for consumers trying to manage debt and policymakers regulating credit, but for banks and credit card issuers. Lenders manage risk by estimating the speed at which their loans will be repaid. The current research suggests that the speed with which a particular debt is repaid depends on whether it is the smallest or largest debt in a consumer's portfolio.

A better understanding of why consumers make these decisions likely will become more important as consumers seek new sources of credit, and accumulate more debt, during times of economic difficulty, not to mention the holidays.

Rick's co-authors for the study were Moty Amar, of the Ono Academic College School of Business in Israel, Dan Ariely of the Fuqua School of Business at Duke University, Shahar Ayal of the New School of Psychology Interdisciplinary Center in Israel, and Cynthia E. Cryder of the Olin Business School at Washington University.

Rick hopes to make consumer debt repayment an ongoing focus of his research.

"There is a lot of research on credit card usage and debt accumulation," he says. "But how do consumers manage the debt once they're saddled with it? I think that question deserves much more attention than it has received."

Math vs. Emotion

When faced with multiple debts, people should use available cash to pay down the loan with the highest interest rate. But consumers often underestimate how interest compounds over time.

Rick and his co-authors devised a series of studies using field surveys and laboratory experiments. Results showed consumers with multiple debts focus on reducing the total number of outstanding loans rather than the total debt across loans. That phenomenon is known as "debt account aversion" and it's a strong bias. It's so strong that experimental participants stuck to it even when they were required to acknowledge how much interest they were accumulating.

"There are a variety of ways to manage debt, many of which are not optimal," Rick says. "One strategy we didn't see a lot of was the rational one, where you pay off the account with the highest interest rate. We tried to be very explicit in the instructions and showed participants what was happening over time with the high-interest account blowing up. But despite this seeming simplicity, emotions drive us to wipe a debt off the books."

One tactic in an experiment did prove somewhat effective. It measured whether participants were focused on the amount of interest that could accumulate in the future, the amount accumulated to date, or neither. Participants were shown various pop-up boxes that reported the interest in different ways. Those shown a "retrospective" pop-up screen, which reported the total amount of interest each debt has accumulated over the course of the game, had a lower total debt at the end of the game.

While that manipulation didn't remove the debt account aversion completely, it did nudge people toward more optimal behavior.

"It was a reminder of their failure so it did get them to behave differently," Rick says. "The interest figures in that particular box were more alarming than the others. So that speaks to how credit card statements could be made more effective. It could report the total lifetime amount of interest accumulated on the current balance, as opposed to just the amount of interest accrued on the previous bill. That's a question for policymakers."

The study also showed that debt consolidation—where consumers bundle several smaller loans into one larger one to simplify payment—can reduce the harmful effects of debt account aversion. Though it can be costly in the short run, the study found debt consolidation to be more beneficial than previously thought. It focuses a consumer's effort on reducing total debt and eliminates the ability to pay off a smaller, low-interest loan first.

Rick hopes to follow up on this study by examining whether debt account aversion influences purchasing. The experiments and games in the study only allowed the participants to repay debt. He wants to run a study more like real life, where people choose between repaying debt and making new purchases.

He also plans to study the emotional side more. Perhaps there are emotional benefits to paying off a debt, even if it wasn't optimal for long-term financial health. The researchers also want to know if banks are aware of this trend. If they are or if they find out, how would they make use of it?

"If you think of the intuitive factors that affect debt payment speed—how much money and debt a person has—we're saying there's another factor," Rick says. "It's also about how this debt is spread out. I would be very interested in whether and how information about the spread of debts is used by financial institutions when determining how much credit to give."


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