Monday, 20 October 2008

How a psychological bias leads many people to pay more credit card interest

New financial rules in the U.K. and elsewhere mean that credit card companies have to take a monthly minimum payment from card-holders who have an outstanding balance. It's a protective measure that's intended to stop card-holders' debt from spiralling out of control. However, new research by Neil Stewart shows that, thanks to a decision-making bias known as "anchoring", printed information about compulsory minimum payments leads many card-holders to actually pay off less of their balance than they would have done, thus costing them significantly in the long-run.

Stewart first conducted a survey of 248 real-life credit-card users and their statements. This showed that among those card-holders (36 per cent) who paid more than the minimum payment but less than the total outstanding balance, their choice of how much to pay was correlated with the stated size of the minimum compulsory payment. It's as if knowledge of the minimum required payment dragged down their choice of how much to pay off. By contrast, people who paid off the full amount, or only the minimum payment, were unaffected.

Stewart tested this idea further in an experiment. Hundreds of participants were given a credit-card bill with an outstanding balance of £435.76 and asked how much they could afford to pay off, given their real-life finances. Crucially, half the participants were shown what the minimum compulsory payment was and half weren't.

The presence or not of information about a minimum payment didn't affect the proportion of participants who said they'd pay the balance off in full. However, among those 45 per cent of participants who said they'd pay only some of the bill, the presence of information about the minimum required payment had a dramatic effect on how much they said they'd pay.

Among the partial payers, those who saw information on the minimum required payment (which was £5.42) said they'd pay off 70 per cent less than those who didn't see information on the minimum payment. Stewart said that in real life this difference could double the ultimate amount of interest paid by the card-holder over the life of the debt.

He explained: "Although minimum payments are a good idea in principle ― because they protect the small number of people who would otherwise make no repayment at all ― minimum payments do seem to have an adverse effect on those who repay only part of the bill, even those repaying a large fraction of the bill."

Anchoring is a well known psychological bias. It was perhaps most dramatically illustrated by Daniel Kahneman and Amos Tversky in 1974. They asked people to spin a random number wheel before estimating what proportion of United Nations countries were African. People's guesses were strongly influenced by whether the wheel landed on a high or low number, even though they knew the number had no bearing on the question at hand.

In the context of credit-card payments, Stewart says that the effects of anchoring can be countered by providing people with more information. In fact, he's set up a website that helps you calculate what the total costs of a loan will be given how quickly you choose to pay off your debt.

ResearchBlogging.orgStewart, N. (2008). The cost of anchoring on credit card minimum payments Psychological Science. In Press.

Post written by Christian Jarrett (@psych_writer) for the BPS Research Digest.


Anonymous said...

American credit card companies have known and used this technique for ages.

It would be naïve to think that UK politicians who the credit card companies were lobbying to get this passed didn't know that this will only enslave people with more debt and increase credit card companies' profits.

Passageof such laws goes allmost entirely unnoticed.

Very sad.

Unknown said...

I totally agree. The amount of debt students are taking on is absurd. Unfortunately, no school, at any level (be it college or high school) trains kids on increase score. This is something kids are going to have to learn, or they are going to wind up debt-slaves, whether it be college tuition, car debt, credit card debt, home loans, etc. The average American seems not to fear the repercussions of debt enough

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