The overall level of credit debt in the U.S. declined from a peak of $930 billion in the last quarter of 2019 to $810 billion in the third quarter of 2020, according to data from the Federal Reserve Bank of New York. However, 23 percent of credit card debtors added to their balance due to the current pandemic, according to a report from CreditCards.com; millennials have been among the hardest hit, with 34 percent taking on more debt. With more Americans in credit card debt, a clever approach to paying down balances may help consumers get out of debt quicker.
Research by Michael Norton, a professor at Harvard Business School, and his colleagues found that allocating payments toward specific purchases on a credit card bill helps consumers gain a sense of progress and control over their credit card debt. “Instead of a list of purchases that you can do nothing about, and you just feel bad, now you have a list of purchases, and you can decide which ones you want to get rid of,” Norton told Harvard Business School Working Knowledge.
In a recent working paper, Repayment-by-Purchase Helps Consumers to Reduce Credit Card Debt, the researchers tested a repayment-by-purchase strategy that allows consumers to select specific purchases to pay off rather than simply paying an amount towards their overall balance. In a large field experiment, credit card customers of the Commonwealth Bank of Australia who were given the option to allocate payments towards specific purchase categories paid 12.18 percent more toward their debt balance than a control group. “Repayment-by-purchase increases awareness of what is being repaid, which increases perceptions of progress toward reducing debt, which in turn encourages higher repayment,” the authors noted.
“There’s a strong default to making the minimum payment,” Norton argues. “Our goal was not to get people to pay off their debt in full every month because, of course, many people just don't have the money to do that. It was just to see if they would move up a little bit every month off of that minimum payment because over the longer term that can have big implications for your overall wellbeing.” The repayment-by-purchase strategy accomplishes this by bracketing debt into more manageable chunks and providing “visual progress cue, as borrowers see purchases vanish from their statements.”
The notion that seeing progress towards debt repayment is a motivator is not new. In fact, it aligns with previous research, perhaps counterintuitive, suggesting that people are more motivated to get out debt by starting with their smallest balances. “Focusing on paying down the account with the smallest balance tends to have the most powerful effect on people’s sense of progress — and therefore their motivation to continue paying down their debts,” Remi Trudel, one of the authors of the previous research, wrote in the Harvard Business Review.
This approach, often referred to as the “snowball method” prioritizes an individuals smallest debts first, regardless of the interest rate. The other approach, known as the “avalanche method,” focuses on paying off debt with the highest interest rate. The avalanche approach is the most rationale choice because it minimizes the amount of interest that you pay by focusing on the balances with the highest interest rates. However, much of human behavior is not purely rationale and, therefore, the avalanche method may not be the most effective because it doesn’t “generate the motivation needed to make debt elimination a priority.”
The Upshot
The repayment-by-purchase strategy may be a worthwhile approach to try for those struggling with paying off credit card.
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February 01, 2021 at 12:14AM
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Try This New Approach To Pay Off Your Credit Card Debt - Forbes
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