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Scientific American: Why Don't People Manage Debt Better?
Monday, May 2, 2016 6:35 AM

Psychology experiments show why even the financially savvy have a hard time following sensible strategies

A recent article in Scientific American spoke to why people don't manage their debt better. Nearly 70 percent of all Americans own at least one credit card and most have multiple. Credit offers an important strategy for families to smooth income, allowing for greater predictability and stability in consumption, the article reads.

Yet, the increasing availability and use of credit also has resulted in indebted households sinking further into debt, ultimately undermining their financial well-being. High-interest, consumer debt makes saving for the future and coping with emergencies when they arise harder. Helping families to better manage and pay down this high-interest debt would significantly improve their financial well-being.

Despite its apparent burden on families across the country, most individuals juggle multiple kinds of debts, each coming with different terms and interest rates. This diversification of debt requires consumers to make decisions about how to best allocate limited resources to repay them. The most effective way to pay off debt over the long-term is to focus on the loans with the highest interest rates first. Yet evidence has shown time and again that consumers are likely to manage multiple debts in ways that cost them more over time.

There are multiple psychological processes that underlie debt account aversion, the article reads. The first of which is prospect theory, which suggests individuals are much more sensitive to a loss than they are to a gain of an equal amount. For example, if you make a bet with someone and lose, you are more willing to enter a second bet at double-or-nothing than if you had won the first bet. What these kinds of results show is that the urge to get back to being in the black is so strong that people are more motivated to pay off small debts and close out accounts without considering how their interest rates differ.

In addition to being disproportionately averse to losses, individuals are also largely motivated by a salient goal. This phenomenon is called Goal-Gradient Theory. For example, when customers are given a loyalty punch-card offering a free coffee after a certain number of purchases, they feel more motivated to buy more coffee as they get closer to the free one. Goal-Gradient Theory suggests that consumers are likely to be much more willing to put out effort (or allocate their scarce resources) towards debts that are smaller just to finish paying them off, even if the interest rate – and thus the total long-term cost – is less than other, larger debts.

There is also a growing body of evidence suggesting that people do not effectively take into account the way interest compounds and grows over time. For example, when making the decision about how much to invest in their retirement, research demonstrates that people discount how much their contributions are worth in the future. In terms of debt, this means that people who choose to utilize their credit cards and to carry a balance are doing so without a full understanding of total cost of that debt in the future.

If we can’t trust our intuitions, how can we reduce our debt?

Read more about this at Scientific American.