The Fiendish Genius of Credit-Card Minimum Payments

New research finds that credit-card holders pay down their debts more slowly when their statements suggest a minimum monthly installment. The Economist reports on the study, by University of Warwick psychologist Dr. Neil Stewart:

Mr. Stewart presented 413 people with mock credit-card bills of ?435.76 (about $650) that were identical — except that only half mentioned a minimum payment of ?5.42. Participants were asked how much they would pay.

Among those inclined to pay the bill in full, the presence of the minimum payment hardly made any difference. However, those who wanted to pay just part of it handed over 43 percent less on average when presented with a minimum payment. In the real world, this would roughly double interest charges.

It turns out that, for those inclined to pay their debt bit by bit, the monthly minimum acts as a mental anchor, exerting an enormous amount of influence on how quickly that debt gets paid.

Stewart found that as suggested minimums drop, actual payments fall right along with them, even among people who pay above that bottom limit.

So the minimum payment can be a helpful tool for card holders. It gives them a guide on how much money to pay to keep their debt from exploding under compound interest. But it’s a much better deal for the companies that issue the cards.

Say you’re a credit card company. You make money every time one of your card holders carries a balance at the end of the month, because you charge interest on that debt. A lot of interest. The longer your card holder carries debt, the more money you make.

But if that debt tips out of control, and the card holder defaults, you lose everything.

So you want to find a middle road, a strategy that will keep your card holder’s debt manageable, but that will stretch out repayment as far into the future as possible, maximizing your profits.

Considering Stewart’s findings (paper available here), minimum monthly payments seem like the most surefire way down that middle path.

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  1. Craig says:

    Wouldn’t the best system, from the credit card company’s point of view, be one where they have a MAXIMUM monthly payment — one much lower than your full balance?

    That’s probably not legal (has that stopped them before). But how about this: You owe $100, minimum $5. You get a statement saying if you pay no more than $10 this month, we will give you a credit of 50 cents or a free kazoo or whatever.

    Most people would pay the $10, don’t you think?

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  2. Ashley says:

    I always try to ignore that minimum payment number, it’s so useless! But with some of my store cards, when you get to the online payment screen, it gives you 2 options: pay minimum payment (usually $10 or $20) or “Other Amount”. It won’t even tell you what your bill amount was, you have to go back to the statement and check what the exact number was to pay in full. Very sneaky, but I’m not falling for it!

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  3. Casey says:

    “the minimum payment can be a helpful tool for card holders. It gives them a guide on how much money to pay to keep their debt from exploding under compound interest.”

    On the contrary, the minimum payment is exactly the amount that results in your debt exploding from compound interest. That’s why it’s so low. If you make only the minimum payment every month, it takes upward of 15 years to pay off what you’ve borrowed.

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  4. Ezzie says:

    I find this to be very true. We started paying down debt much faster since we started looking at a target of what we want the balance to be on each card instead of paying the minimum or just more than the minimum.

    Re: Craig’s comment (#1), I think that would not work – people do not trust “gifts” from companies when it comes to paying them back. It’s one thing to say “if you’re going to spend, use our card, we’ll give you miles”; it’s another to say “don’t pay us back, and we’ll give you a gift”. It would make people actually start calculating their interest, which they don’t want.

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  5. Anne says:

    In line with Craig’s comments, I remember that not long ago Discover had a program in effect (not sure if they still do) that offered some sort of reward for paying interest. I don’t remember the exact details, but it was something like, if you paid your bill three months in a row, you got a rebate of the interest paid in the third month. So that was a bit of a sneaky way of encouraging people to accrue interest charges.

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  6. Gary Lambert says:

    Many people make the mistake of thinking that credit-card debt works the same way as a reasonable car loan for example.

    The mistaken notion is that the minimum payment will get your loan paid off in a reasonable amount of time.

    The payoff period should be capped at something like 5 years. Perhaps 3 years would be better.

    Too many people are unknowingly trapped in a life of debt slavery.

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  7. Bryan says:

    I’m skeptical.

    So there is a real world negative correlation between minimum balances and the length of time it takes to repay the balance. But in the real world if the minimum payment goes up, people are forced to repay their balance more quickly. Wouldn’t this cause a selection bias? People who want to pay their bills more slowly (people who don’t care much for the future) choose cards with low minimum payments. Thus explaining the real world correlation without resorting to anchoring affects.

    In the study, the participants face no costs from choosing a bad repayment plan so why wouldn’t they be affected by anchoring? If you’re asked to choose a number hypothetically and without cost for getting it wrong, then why are we surprised that people are affected by irrelevant information?

    All in all, I think that study needs to be redone with a system of financial rewards and budget constraints in order to be convincing.

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  8. Jamie says:

    Credit Card companies are not as inherently evil as the public likes to believe. Many have upped their minimum payments to ensure that negative amortization does not occur. Every credit card company I know will treat you really well if you you pay your bill on time every month (even in full), as they make a lot of money from transactors who don’t charge off… They even go so far as rewarding you with cash, merchandise, air travel, etc. for doing just that. Take advantage of their generosity.

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