All other things being equal, if someone offered you the choice between an investment portfolio that was guaranteed to grow like clockwork at 8 per cent a year or one that grew at 2 per cent a year, it seems obvious that you would choose the higher growth rate.
But when it comes to paying off credit-card debt, it turns out we couldn’t care less about the different interest rates we pay on different cards. With the holiday spending spree upon us, this is something Canadians about to go into debt should care about.
The optimal strategy to pay off balances on multiple credit cards is to pay as little as possible in interest charges. In a perfect world, that means paying off your credit-card balance in full each month. Barring that, people should pay the minimum on all cards and then prioritize the highest interest debt before paying any lower interest debt.
"This gives us a clear measure of objective performance to compare people to,” said Neil Stewart, professor of behavioural science at Warwick Business School in England, and one of the authors of a new paper published this year looking into credit-card-payment behaviour. This strategy is sometimes referred to as the “avalanche method.”
An alternative strategy is the “snowball method,” which involves tackling the smallest balance first. The idea is that by achieving the quicker and more salient psychological win of reducing a source of debt, it can serve as encouragement to stay on track with the debt reduction plan.
But for the most part, people ignore both of these strategies.
Instead, the paper’s authors found that people tend to use a suboptimal rule of thumb for determining credit-card payments: balance-matching. In other words, if you owe $7,000 on credit card A and $3,000 on credit card B, people tend to simply allocate 70 per cent of their overall payment to card A and 30 per cent to card B – regardless of the annual percentage rate (APR) of interest. This is close to the worst option. Even a slight difference in interest rates could lead to hundreds of dollars of unnecessary interest costs.
“The most surprising thing is that while the only thing that matters is the APR for a card, the APR predicts absolutely nothing about what people do. So it’s not just that people get it wrong, it is that people don’t appear to pay any attention at all to the only variable that matters,” Dr. Stewart told The Globe and Mail in an e-mail.
If the stakes were low, such that the optimal repayment strategy only yielded a few dollars of saved interest per year, it would make sense that few people would be inclined to sit down and crunch the numbers. But the study found that even when the stakes were high with large balances and high interest rate differentials, for example, one card charging 25-per-cent interest versus one card charging 10 per cent, people still tended to use the balance-matching method.
The authors note that matching behaviour has been observed across species. When pigeons were given a task of pecking keys in order to receive food, they would spend more time pecking the keys that took longer to reset instead of just focusing on the keys with the shortest time to re-arm.
When humans are presented with a game of chance in which one choice has a 70-per-cent chance of winning and a second choice has a 30-per-cent chance of winning, instead of always choosing the higher-probability option, they allocate their choices on a 70-to-30 ratio (thereby decreasing their overall winnings).
There are interesting implications from this research. What incentive does a lender have to compete on non-introductory interest rates for people who are carrying balances on multiple cards if people ignore interest rates when paying off balances? Aggressive balance-transfer promotions may serve to drive up the number of cards people own in exchange for higher profits over the long term as borrowers settle into balance-matching payment behaviours over time.
This suboptimal behaviour provides an example of how “open banking” legislation might be beneficial for consumers. If financial-services companies were required to share customer data upon consent with a third-party company – the premise behind open banking – that company could analyze your multiple debt sources along with the minimum payments and interest rates, and create a prescription to best reduce your debt. For some, that could translate into savings of thousands of dollars a year.
For now, if you carry multiple sources of debt the optimal strategy is to sit down and make a list of your debts, in order of descending interest rates. Pay the minimum required on each, then focus on tackling the highest interest rate first. The snowball method may help those lacking in motivation, but clearly, balance-matching is for the birds.
Preet Banerjee is a management consultant to the financial services industry and founder of MoneyGaps.com.