Video: Minimum payments alter debt repayment strategies across multiple cards

Samuel Hirshman: So thank you for inviting me. And I just want to point out that this is joint work with Abby Sussman, who is brilliant, if you get a chance to look up some of her other work.

So I'm going to talk a lot about debt repayment. And this is an important topic. I don't think I have to convince the audience here of that. Canadians hold about $640 billion in non-mortgage debt. I'm going to be focusing on credit card debt in my talk today. There's been some evidence from Mexico and the UK that people make costly errors in both which cards they buy things on and also which cards they repay on, which, if you take sort of an outside view, is a little bit surprising because, in debt repayment, the cost-minimizing strategy is actually relatively straightforward. First, for credit cards, you want to pay the minimum payment on all of your debts, then you want to pay down your debts in order from highest to lowest interest rate, and, importantly, you want to pay off all of your debts on the highest interest rate card before allocating any money to other debts.

So why might people not be sort of implementing this relatively straightforward– I just summarized it in three steps – policy? One factor might be that they don't know the key information. So if you don't know the interest rates on your cards, then it's going to be hard to implement that policy. There's some evidence to suggest that that's true. That's not going to be our focus today. Another option is that they may not know that optimal strategy, or they might believe that other strategies are better for a variety of reasons. So in a recent paper looking at UK field data, they find that people pay in proportion to their debt amount. So if a person had a thousand dollars on one card and 500 dollars on another, they would repay those debts at a rate of two to one. Another option is that some people pay their smallest debts first. This is a paper I think Scott Rick, who's going to be talking later, is on this paper, and they find that people are more likely to repay their smallest debt first because they don't like having multiple debt accounts open and they get an increase in motivation from closing out debt accounts. And Keri Kettle, who's also talking later, has some follow-up work that suggests that it does in fact increase people's motivation to get out of debt to close out these accounts.

It's also unclear how minimum payments affect these strategies across multiple cards. Almost all cards require minimum payments, so it's difficult to study in the field. And there's evidence that people repay less when there's a minimum payment, both from lab and field data. However, if you were paying attention earlier, you note—you might have noticed that paying the minimum exactly on many of your accounts would be an optimal strategy. So it's not clear how minimums interact with managing debts across multiple cards.

So in our paper, we're going to look at whether people realize interest is an important factor. We're going to find that they do, but maybe not as much as they should. And then, even though people seem to be focusing on their highest interest rate debts, minimum payments are going to lead them to alter their debt repayment strategy and spread their money across more cards.

So in our first study, participants reported the importance of five debt attributes to – in repayment. So first was interest rate, debt amount, the credit capacity, paying something to everything, and splitting evenly across all the cards. They then responded to some subsequent questions to clarify how they would use that information, and, finally, reported some additional demographics and debt experience measures.

So what we find is that a plurality of our participants wanted to focus on their highest interest rate card. That makes sense. That's sort of the right answer in a certain sense. But a large portion of people are sort of spread out across the other heuristics that have been proposed in the literature. So we think that most people do have some idea that this is the right thing to do, but there's a lot of heterogeneity. However, a sizeable proportion of the people, if we look at just the people who wanted to focus on their high interest rate debt, don't have extreme enough allocation intentions. So they only want to repay most of their excess allocations to their highest interest rate debt, not all, as would be suggested by the optimal policy.

So we wanted to follow up this work with some actual sort of field validation. Do people pay attention to their interest rates when they do debt repayment for real? So we got transaction data from a budgeting app, and we looked at the population that carried a balance on all of their cards. They had multiple cards, and they made repayments on all of their cards, but didn't repay all of those debts in full. And we wanted to examine the impact of a card being the highest interest rate debt on repayment value. And this is controlling for the size of the balance. So you can think of that as, if you had two debts of a thousand dollars each, how much more would you repay to the one that was your highest interest rate debt.

So what we find is that there's a small premium put on the highest interest rate debt, about $132 or four percent of the average allocation in a month, for our population. For people with only two cards, so that's – that's for any multiple cards holders, for people with only two cards, the effect is smaller but still marginally significant in the direction of sort of the optimal policy. So overall, we find that most people do intend to repay their highest interest rate debts, and we have some suggestive field evidence to say that they do, but maybe not as much as they should. And some of that might be explained by the fact that some people don't intend to pay off all of their highest interest rate debt. They really are not focusing as much as they should on interest.

So there a whole host of psychological factors that might interfere with people's ability to do this problem right. But prior work in this space has shown that minimum payments do reduce allocations, as I talked about earlier. So we wanted to see what the implications were for multi-card repayment strategies with minimum payments. So we modelled our task, a three-round debt game, on prior work. And participants were randomly assigned to either a control condition or a minimum payment condition, with a budget of $3000 in each round to allocate to various debts. There was a $25 fee in the minimum payment condition for failing to make the minimum payment. And that's important because it makes it optimal to repay the – that – those minimum payments before moving on to any other allocations. And we exclude a small number of our participants who allocated more than their debt amount to any debts, mostly because we think they're not paying very close attention.

So participants saw a screen like this that detailed the terms of their different debts. So you had interest rates, which were drawn from the CFPB database on national APR terms, and then debt amounts that were designed to sum to the average amount of debt for an indebted American household. And then minimum payments were only shown to participants in the minimum payment condition, and were fixed to two percent of the debt amount, rounded up. And participants entered their repayments in this little screen, and we helped them a little bit with the math, in that there was a total box, so anything that they had put in the small boxes to the right was added up over the course of – as they entered.

So first, we find that minimum payments do in fact reduce the likelihood of using the optimal strategy. About 30-some-odd percent of our participants in the control condition are using the cost-minimizing strategy I laid out before, but that goes down by about 11 percent in the minimum payment condition. You might expect, based on prior work, that this would be driven by people paying off their smallest debts first, but that isn't exactly what we see. While some people are using that strategy, it's relatively small, while there's some difference between conditions, that difference is not significant.

Where we do seem to see a large amount of deviation is that people in the minimum payment condition pay to more accounts than people in the control condition. And I want to emphasize that this isn't just paying exactly – just paying their minimum payments; this is paying above the minimum. So what we compare here is the number of accounts paid above zero in the control condition to the number of accounts paid above the minimum in the minimum payment condition. And we find a highly significant increase in the proportion of accounts repaid in our minimum payment condition.

So overall, our conclusions from the study is that participants with minimums do this task less well than they would if they didn't have minimum payments. They pay – and the reason seems to be that they're paying more accounts above their minimum minimum balance. We think that participants may be using a kind of naïve diversification strategy, where they're just more likely to use that split even heuristic when they are faced with a minimum payment. And this is even though 71 percent of our participants made their largest allocation to their highest interest rate debt. So we do find that people are paying attention to interest rates, just maybe not as much as they should.

So sort of in conclusion, in both lab and field we find that people are attentive to their interest rates in debt repayment, but some intentionally and maybe some incidentally allocate less extremely than they should. however, focusing on the highest interest account is our most common strategy in our debt repayment game. That said, minimum payments do increase the tendency to spread out repayments, and we find that they decrease optimal repayments and increase the number of accounts paid. And so minimum payments may be accounting for some of the failures that we're observing in the field, where people are paying excess interest costs on their debts.

We also think that this may be related sort of psychologically to other situations where people should be allocating extremely but don't seem to. So if you have two gambles that – with one has a higher expected value, and you're allocating some lottery tickets to those, you should be putting all of the ones on the higher expected value gamble, and people tend to sort of split based on the probabilities. So we think that these sort of psychological issues might be intertwined. Thank you very much.

(Applause)