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.