Core Insights: Finance

Credit cards are as ubiquitous in our daily lives as children begging to go to McDonalds and there being a Marvel movie on at the cinema.

According to the Reserve Bank of Boston Survey of Consumer Payment Choice approximately 75 per cent of US consumers have a credit card, while in the UK the Office for National Statistics Wealth and Assets Survey found that 60 per cent had the plastic in their wallet.

It is a lucrative business for financial services firms. In the US the credit card industry accrues $600 million a month in late payment fees, according to OCC Credit Card Metrics.

If you have debt on a credit card and have an outstanding balance, you must at least make a minimum payment each month, or you get charged a fee.

The Financial Conduct Authority found that millions of people in the UK do pay the minimum each month. The concern is that repeatedly paying only the minimum is a precursor to joining the millions of people who either had their debt written off or were in arrears.

This is bad, because missing payments and getting into arrears attracts fees and reduces your credit rating. The fees are pretty salient, but worse is the effect on your credit rating because of the knock on effect of an increased future cost of any borrowing.

The good news is that missing payments and attracting fees does not always indicate financial hardship.

We assessed data from 250,000 new card openings across five card issuers in the UK. This large data set allowed us to study human behaviour at scale. The data not only included all transactions people made over approximately 2.6 million card-months, but also particularly valuable insights into how consumers managed their card repayments.

We could see that people were most likely to incur fees just after they had opened their account, with the risk of a fee dropping steeply over the first year or so of a new account. It looked like people new to credit cards were learning to remember to pay their credit card bill each month. But the story is more complicated.

In fact, we found the reduction in fees over time was entirely attributable to people switching to direct debit repayments that automatically pay their bill each month without any need for them to intervene manually.

Fees are almost completely eliminated after people set up a direct debit (as you now only receive a fee if you don’t have enough money in your current account). But if you don’t set up a direct debit, your risk of a fee remains at the same level over subsequent months. Without a direct debit, people don’t appear to have a ready mechanism to avoid incurring fees.

So things are simple, right? You just need to set up a direct debit to avoid forgetting to pay your bill? Unfortunately not.

There is a twist in the tale. Some people who set up a direct debit arrange what is called a minimum payment direct debit. This seems great, because you’ll automatically pay the minimum each month avoiding fees, and can pay more manually whenever you like, just as you did before. You have insured yourself against forgetting, but kept your options open on when you’d like to pay down the debt.

The problem is, because people no longer have to pay their bill when it arrives, they just don’t get round to making these extra manual payments as often any more.

This means they carry more debt from month-to-month and have to pay interest on that debt. And it turns out that the extra interest paid is about 2-3 times more than the fees avoided!

The moral of the tale? Well it’s complicated. Fees don’t mean people are in financial hardship. Some are, but many are just forgetting to pay their bill. If you forgot this month, you are just as likely to forget next month, unless you set up a direct debit.

But if you set up a minimum payment direct debit, you’ll neglect to make larger payments and pay loads of interest.

Perhaps, if you can, set up a direct debit for some fixed amount that is quite a bit larger than the minimum (ideally pay in full, but otherwise try to clear at least 10 per cent  or more of the debt) and you get the best of both worlds.

Further reading:

Gathergood, J., Sakaguchi, H., Stewart, N. and Weber, J. (2020) "How do consumers avoid penalty fees? Evidence from credit cards", Management Science.

Stewart, N. (2009) "The cost of anchoring on credit-card minimum repayments", Psychological Science.

Gathergood, J., Mahoney, N., Stewart, N. and Weber, J. (2019) "How do individuals repay their debt? The balance-matching heuristic", American Economic Review.

Navarro, D. J., Salisbury, L. C., Lemon, K. N. N., Stewart, N., Matthews, W. J. and Harris, A. J. L. (2011) "Minimum required payment and supplemental information disclosure effects on consumer debt repayment decisions", Journal of Marketing Research.

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 Behavioural Finance and Big Data for the MSc Central Banking and Financial Regulation.

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