By Neil Stewart
One morning when opening my credit card bill and after digesting the bad news, I suddenly thought is the minimum repayment really as helpful as it looks?
An incredibly robust finding from behavioural science, that has been repeated many times in experiments, is ‘anchoring’.
Anchoring happens when the presence of irrelevant information biases people’s decisions or judgements. One experiment by Dan Ariely, Drazen Prelec, and George Loewenstein is typical. It asked students to bid on items in an arbitrary auction using social security numbers as their anchor.
The researchers held up items to be auctioned, like a bottle of wine or book, and then asked each student to write down the last two digits of their social security number. Then they asked for bids on the item.
They found students with high social security numbers bid up to 346 per cent more than those with low numbers and that is all due to the anchoring effect.
It has even been tried with a roulette wheel, where just landing on random numbers influenced people’s subsequent estimate of the percentage number of African countries in the United Nations.
Although social security numbers are arbitrary and have nothing to do with the price of wine, and random roulette wheel outcomes have nothing to with United Nations membership, the numbers get into people’s heads and affect their judgements.
Thus, was it beyond the realms of possibility that the minimum repayment amount on my credit card bill was also producing the same psychological bias? If it was anchoring repayment amounts, it had big implications not just for me but for everyone with a credit card.
In the UK alone, in 2014 credit card debt stood at £70 billion across 30 million card holders, while according to the UK Financial Conduct Authority’s (FCA) latest credit card market study two million people are either in arrears or have had their debt written off, plus another two million have persistently high levels of debt and are at risk of not paying off their debt.
The FCA also estimates that 1.6 million people are making just the minimum repayment and so are taking longer to repay, adding to the overall cost of the debt due to compounding interest rates and having implications for their wider financial situation. Indeed, it found 360,000 people actually paid more in interest than they had borrowed, while another five million credit card holders will take more than 10 years to pay off their balance.
Perhaps some of the slowness in paying down credit card debt is because people simply misunderstand the minimum repayment. The minimum repayment is required by regulation in the UK and US to stop people feeling the full effect of compounding interest rates. It makes sure they pay off at least the interest charged each month, plus a little more. In the UK, minimum repayments must be at least the sum of interest, fees and charges plus one per cent of the outstanding balance.
In a survey of UK credit card holders by consumer campaigner Which?, of those who reported they made the minimum repayment, 48 per cent said that they thought it was an amount recommended by their credit card provider and 50 per cent believed it was the amount most people chose to pay.
And the effects of debt can be devastating. A survey by Step Change, a debt charity, suggests that rising debt can have a negative impact on people’s physical and mental health and badly impacts their relationship with family and friends.
While the Consumer Protection Partnership found debt worries have an impact on people’s ability to work, affecting their attendance or concentration. Plus they might also lose access to cars, telephones or the internet, and so making it doubly difficult to work or seek employment.
Are credit card minimum repayments bad nudges?
It might seem that people taking longer to pay off their debts is good news for credit card companies, but only up to a certain point. After all, they also want the debt paid off. Writing off debts means they are making a big loss and so they want customers who can pay off their debts.
Firms can also earn revenue from the ‘interchange fee’, that is when the credit card is used to purchase goods and the provider takes a small percentage cut of the transaction.
So getting people to pay off their debt quicker is good for everybody.
Thus, we conducted an experiment to test the theory by sending 413 volunteers a mocked-up credit card statement with a balance of £435.76. They were asked to pretend it had arrived that morning with participants either seeing a minimum repayment of £5.42 or a statement without a minimum repayment.
Removing the minimum repayment information had a dramatic effect. The average repayment increased by 70 per cent from £99 to £175 thus providing evidence that the minimum repayment amount was having a strong anchoring effect – that is a bad nudge.
However, warnings about sticking to just the minimum repayment have previously been found to be ineffective in research led by Timothy Wilson, and more research providing alternative options to pay off more had no effect on total payments, while telling people about anchoring in other domains has also failed to alter behaviour.
In collaboration with Benedict Guttman-Kenney and Jesse Leary at the FCA, we put together a survey and a much larger randomised controlled trial to de-anchor repayment choices from the minimum.
Again we used a hypothetical online credit card bill, directing the control group to a standard online bill, where they had to enter how much they were paying back. Meanwhile, another group received the same online bill but with the minimum repayment amount and the button to pay it removed.
In both cases, if somebody entered an amount less than the contractual minimum, a prompt appeared on screen that showed the minimum repayment and asked the consumer to re-enter the quantity.
The experiment was split between groups having a low balance of £532.60 and a minimum repayment of £11.98 and a high debt of £3,217.36 with a minimum repayment of £72.38.
This time the reduction in minimum repayments was even more dramatic. Removing minimum repayment information nearly eliminated people paying at or below the minimum level. Removing the minimum repayment also saw a surprising rise in the number of people paying in full, with between 4.4 per cent and 9.9 per cent more being paid in full as it seemingly became a target for them to aim for.
Taking out the minimum repayment successfully de-anchored repayments, with a 44 per cent rise in the average amount compared to the control group.
This was broadly consistent with a low balance and a high amount to pay back. In monetary terms, there was an average increase in repayments of £60 in the low balance scenario and £355 in the high balance scenario.
Of course this was all a hypothetical situation. Would people react like this with real bills? Working with the FCA we were able to gain access to 1,200 real repayment decisions matching our low balance scenario and 3,218 actual repayment decisions that matched our high balance scenario.
Just like our experiment we found more repayments closer to the minimum in the high than the low balance scenario. Although for those with a real high balance we saw a higher proportion of minimum repayments and fewer paying in full than the experimental version. Whereas in the real low balance world the proportion of consumers choosing full repayments and minimum repayments was very similar to our hypothetical scenario.
Some doing the experiment also gave us consent to check their decisions against their real credit card repayment behaviour. There were 779 matched with the low balance scenario and 774 with the high and we found a reasonably strong correlation with their decisions made in the experiment. Another statistical analysis comparing people’s repayment decisions in real life with their hypothetical ones again found they closely matched.
It shows people were taking the hypothetical bill seriously and acting as they would in real life, which means we can be more confident that de-anchoring bills by not showing the bad nudge - the minimum repayment option - when deciding how much to repay in real life could have a huge impact on consumer debt.
People would be prepared to pay their bills off quicker so reducing the amount of interest they pay and lowering their debt. It would also help firms as people would be less likely to fall behind their payments and fall into financial distress, with their debt eventually being written off, which is expensive for credit card providers.
However, an increasing amount of consumers are using automatic payments or direct debits to handle their credit card bills. This seems the ideal system to avoid late payment charges.
But in research with Hiroaki Sakaguchi and John Gathergood we found that people will often set the default at the minimum repayment level and then ignore their bills. And yet it is the exceptional one-off payments when they are feeling flush that finally pays off the credit card bill.
We have found that people typically pay more in extra interest for taking longer to pay off the bill than they would have done in late payment charges. In fact, we calculated that those setting automatic payments at the minimum level could save one third of the cost of their debt if they paid it off manually.
Once again the minimum repayment has acted as an anchor for people to set their automatic payments too low.
The FCA are now considering consulting on a ‘de-anchoring’ rule that would prevent customers making repayments on-line or by telephone from being automatically told their minimum repayment. Our research indicates that this would increase debt repayments, reducing the total cost and duration of the debt.
Neil Stewart is Professor of Behavioural Science and teaches Behavioural Sciences for the Manager on the Executive MBA and Executive MBA (London). He also lectures on Business Statistics for the MSc Business Analytics and Big Data Analytics for the MSc Central Banking and Financial Regulation.
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