Leveraging Psychological Insights to Encourage the Responsible Use of Consumer Debt

Abstract

U.S. consumers currently hold 880billioninrevolvingdebt,withameanhouseholdcreditcardbalanceofapproximately880 billion in revolving debt, with a mean household credit card balance of approximately 6,000. Although economic factors play a role in this societal issue, it is clear that psychological forces also affect consumers' decisions to take on and maintain unmanageable debt balances. We examine three psychological barriers to the responsible use of credit and debt. We discuss the tendency for consumers to (a) make erroneous predictions about future spending habits, (b) rely too heavily on values presented on billing statements, and (c) categorize debt and saving into separate mental accounts. To overcome these obstacles, we urge policymakers to implement methods that facilitate better budgeting of future expenses, modify existing credit card statement disclosures, and allow consumers to easily apply government transfers (such as tax credits) to debt repayment. In doing so, we highlight minimal and inexpensive ways to remedy the debt problem.

Full text

For Review Only
Leveraging Psychological Insights to Encourage the
Responsible Use of Consumer Debt
Journal:
Perspectives on Psychological Science
Manuscript ID:
PPS-14-370.R3
Manuscript Type:
Special Issues Article
Date Submitted by the Author:
n/a
Complete List of Authors:
Hershfield, Hal; UCLA, Anderson School of Management
Sussman, Abigail; University of Chicago, Booth School of Business
O'Brien, Rourke; Harvard University,
Bryan, Christopher; UCSD, Psychology
Keywords:
Allied Field: Behavioral Economics, Application: Business, Thinking /
Reasoning / Judgment
User Defined Keywords:
Financial Decision-Making, Debt, Credit Card Use
Perspectives on Psychological Science

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Eliminating Debt 1
Running head: PSYCHOLOGICAL TOOLS AND DEBT ELIMINATION
Leveraging Psychological Insights to Encourage the Responsible Use of Consumer Debt
Hal E. Hershfield
University of California – Los Angeles
Abigail B. Sussman
University of Chicago
Rourke L. O’Brien
Harvard University
Christopher J. Bryan
University of California – San Diego
Author Note
Hal E. Hershfield, Anderson School of Management, University of California, Los
Angeles; Abigail B. Sussman, Booth School of Business, University of Chicago; Rourke L.
O’Brien, Harvard Center for Population & Development Studies, Harvard University;
Christopher J. Bryan, Department of Psychology, University of California, San Diego.
Correspondence concerning this article should be addressed to Hal E. Hershfield, UCLA
Anderson School of Management, 110 Westwood Plaza, B419, Los Angeles, CA 90095. Email:
hal.hershfield@anderson.ucla.edu.
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Abstract
US consumers currently hold $880 billion in revolving debt, with a mean household credit card
balance of approximately $6,000. Although economic factors play a role in this societal issue, it
is clear that psychological forces also affect consumers’ decisions to take on and maintain
unmanageable debt balances. We examine three psychological barriers to the responsible use of
credit and debt. We discuss the tendency for consumers to: 1) make erroneous predictions about
future spending habits, 2) rely too heavily on values presented on billing statements, and 3)
categorize debt and saving into separate mental accounts. To overcome these obstacles, we urge
policy-makers to implement methods that facilitate better budgeting of future expenses, modify
existing credit card statement disclosures, and allow consumers to easily apply government
transfers (such as tax credits) to debt repayment. In doing so, we highlight minimal and
inexpensive ways to remedy the debt problem.
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Leveraging Psychological Insights to Encourage the Responsible Use of Consumer Debt
US consumers currently hold $880 billion in revolving debt, with a mean credit card
balance of nearly $6,000 (Board of Governors of the Federal Reserve System, 2014a,
2014b). The typically high interest rates on such debt can impede productive consumer spending
and investment, such as homeownership. Many intractable factors, both economic (e.g., high
interest rates and low wages; Zafar, Livingston, & VanDerKlaauw, 2014) and psychological in
nature (e.g., scarcity; Shah, Mullainathan, & Shafir, 2012) undoubtedly contribute to this
problem. However, a variety of psychological forces that are amenable to intervention also affect
consumers’ decisions to take on debt. Specifically, people make erroneous predictions about
future spending habits, rely too heavily on values presented on billing statements, and categorize
debt and saving into separate mental accounts. The presence of these context-based
psychological barriers suggests that policies designed to counter them may help ameliorate the
problem.
Although there are many types of debt, we focus on revolving debt (e.g., credit cards).
Given that the evidence for the success of financial education is mixed (e.g., Fernandes, Lynch,
& Netemeyer, 2014), we propose interventions that are psychological, rather than pedagogical in
nature. (See Table 1 for a summary of these interventions as well as the barriers they are meant
to overcome).
Incorporating the Future
People have difficulties thinking about the future: they view their distant selves as
strangers (Bryan & Hershfield, 2012) and fail to consider their changing tastes over time
(Loewenstein, O’Donoghue, & Rabin, 2003). It is perhaps unsurprising, then, that consumers
often act in ways that prioritize the present (e.g., overspend today), leaving negative
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consequences for the future (e.g., large debt burdens). Recent research suggests some factors that
make it difficult to escape this debt cycle: people under-predict their future expenses (Peetz &
Buehler, 2009, 2012) and overspend on unusual items that are often considered in isolation
(Sussman & Alter, 2012). The latter is especially problematic given the large costs associated
with these exceptional purchases over time. The inverse is also true: people have the tendency to
overspend when they receive income that can be considered exceptional (e.g., a tax refund;
Arkes et al., 1994), neglecting to realize that such frivolous spending year after year can have a
significant negative effect on their overall wealth. Interventions that help people accurately
understand future expenses and income may thus minimize current spending and future debt.
Given that hundreds of billions of dollars flow from the government to households
annually, such transfers may be an ideal setting for policy-makers to implement interventions
that help people meet budgeting goals. These interventions should help consumers plan for the
future by 1) incorporating exceptional expenses into budgeting tools and 2) spreading spending
across time.
Our first policy recommendation is to match behaviorally informed budgeting tools with
the receipt of government transfers. First, government should follow the lead of major financial
institutions in using text messages to alert benefit recipients when the account balance associated
with a transfer is low or an unusually large transaction has been made. Second, cash transfers
such as Social Security could be paired with a free app that allows individuals to monitor their
spending. Most important, we suggest that any such budgeting tool (e.g., mint.com) should
include a budget category for expenses that are considered out of the ordinary. Doing so could
promote accurate budgeting for a class of expenses that may be difficult to predict in isolation,
and even lower spending on exceptional items (Sussman & Alter, 2012).
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A second intervention would target the largest lump sum payment most American
households receive each year: the tax refund. People are faster to spend windfall gains than
ordinary income (Arkes et al., 1994), and are more likely to treat a single large annual payment
as a windfall than several smaller repeated payments. Rather than delivering tax refunds in a
lump sum, we recommend breaking up payments into multiple streams; for example, as 12 pre-
paid credit cards
1
. Even if all 12 debt cards were delivered at the same time, dividing the
payment into 12 units could imply that the refund should not be spent at once, but rather, over
the course of a year (Soman & Cheema, 2011). Further, because consumers save more when a
tax refund is framed as a return to the status quo (i.e., “rebate”) rather than a sudden influx of
money (i.e., “bonus”) (Epley & Gneezy, 2007), the cards could be marketed as “rebate cards” in
an effort to encourage saving.
Improving Credit Card Statements
Recent legislation has tried to aid consumers by providing them with more information
on their credit card statements. Namely, the CARD Act of 2009 dictated that credit card
statements include payment warnings detailing not only how long it would take to pay off the
balance if only the minimum payment were made, but also the suggested payoff amount that
would result in the credit card balance being paid off over a period of 3 years. By one estimate,
the CARD Act saved consumers approximately $11.9 billion per year (Agarwal,
Chomsisengphet, Mahoney, & Stroebel, 2014).
However, this additional information has the potential to influence repayment in
unanticipated ways (e.g., through anchoring processes; Stewart, 2009). Indeed, aspects of the
CARD Act can potentially lead customers astray: people unduly gravitate toward paying the “3-
1
If tax refunds were directly deposited into consumers’ bank accounts, an alternative would be to implement an opt-
out system in which consumers receive their tax refund via monthly direct deposits, rather than a single installment.
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year” amount compared to the minimum or the full balance (Agarwal et al., 2014), because they
view this 3-year amount as a strong suggestion for what they should pay (Hershfield & Roese,
2015). This legislation helped consumers who were previously paying less than the 3-year
amount, but caused a reduction in the fraction of account balances that were previously paid in
full (Wang & Keys, 2014). As a result, we recommend that policy-makers instruct credit card
companies to remove the 3-year payment warnings for consumers who regularly pay more than
the 3-year amount, and increase the warning amount (e.g., state a 2-year payment warning) for
those who regularly pay less.
Encouraging Debt Repayment
Prior research has demonstrated that people often create categories for money (i.e.,
mental accounts) and that this categorization constrains its use (e.g., reserving $1 in your right
pocket for certain purchases and $1 in your left pocket for others; Thaler, 1985, 1990). This
process can cause people to treat savings and debt as distinct financial categories rather than to
integrate them into overall wealth (Sussman & Shafir, 2012). In some cases, this categorization
can lead consumers to misguidedly take on high-interest rate debt, while simultaneously holding
money in low-interest bearing savings accounts (Gross & Souleles, 2002; Sussman & O’Brien,
2014). Existing government infrastructure focused on building savings often reinforces this
artificial separation. Policymakers could encourage wealth maximization by broadening the
scope to include debt repayment. We envision at least two ways to achieve this goal.
First, current tax policy actively subsidizes saving behavior (e.g., through a tax-deferred
saving platform). These policies communicate the problematic idea that when it comes to saving
money versus paying off debt, saving is always the right thing to do (i.e., an injunctive norm)
(e.g., Cialdini, 2003). But, many of the credits designed to promote saving could easily be
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expanded to provide similar tax benefits for paying down debt, and could specifically target high
interest consumer debt. Such policies might not only help make debt repayment as salient as
saving money for the future, but could also neutralize the existing norm.
Second, small tweaks to the tax filing process could enable consumers to remit a portion
of their tax refund to repay debt directly, just as U.S. consumers are now able to split their refund
among multiple savings vehicles. More broadly, the recent transition to electronic systems for
making government payments (e.g., direct deposit) provides an opportunity to implement
scalable behavioral interventions to reduce debt and improve financial well-being. Consumers
currently control where these funds are deposited (e.g., a bank account), but they do not have the
option of an automatic payment to a debt account. This structure encourages consumers to
preserve the mental segregation of asset and debt accounts and makes them less likely to direct
the money towards debt repayment once it has been received. We thus recommend that
consumers be given an option to deposit government funds directly towards credit card accounts.
Doing so could help consumers by opening the “channel factor”—making debt repayment easier
by eliminating the seemingly trivial but meaningful barriers that make behavior more difficult
(Lewin, 1951).
Summary of Policy Implications
People have a tendency to under-predict future expenses, rely too heavily on values
presented on billing statements, and fail to take into account overall wealth by categorizing debt
and saving into separate mental accounts. Drawing on insights from recent psychological
research, we make five key policy recommendations to overcome these obstacles: 1) pair
government transfers with budgeting tools that remind consumers when they are overspending
relative to their own guidelines and explicitly incorporate exceptional expenses, 2) split tax
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refunds into separate payments, 3) revise suggested alternative payment warnings on credit card
statements, 4) provide tax credits for debt repayment, and 5) allow consumers to apply
government funds directly toward debt repayment. It is our hope that these suggestions will go a
long way toward encouraging the responsible use of consumer debt.
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Table 1. Psychological barriers undermining successful financial outcomes and suggestions for overcoming them
Problem Solution Example Policy Recommendation
Mispredicting future income and
spending
Highlight recurring nature of one-time events
for consumers
•
Match government transfers with
budgeting tools (e.g., Mint.com)
that explicitly incorporate
exceptional expenses
• Split tax refunds into 12 separate
payments
Relying too heavily on suggested
payment amounts contained in credit
card statements
Modify anchors presented to credit card
customers
•
Remove 3-year payoff amount for
consumers who regularly pay
more than it
• Increase 3-year payoff amount
(e.g., to a 2-year payoff amount)
for consumers who regularly pay
that amount or less
Separating saving and debt into
separate mental accounts, and
prioritizing saving over debt
repayment
Put debt repayment on an even playing field
with building savings
•
Provide tax credits for debt
repayment
• Allow existing government
transfers to be applied to debt
repayment
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