• Chart of the Week
  • February 15, 2017

In debt, and in denial

Alex H/Bigstock

Even the simplest financial products are pretty complicated. Credit card customers face a blizzard of numbers on their monthly statements – APRs, minimum payments, late fees – and might not really understand what those numbers mean for them.

In a study appearing in the current issue of the American Economic Journal: Economic Policy, researchers partnered with a bank in Mexico and surveyed some of its customers to see how much they understood about their own credit card debt. They included a question on how many months they thought it would take to pay off their debts if they made only the minimum required payments every month and stopped charging purchases to their cards. This isn’t a matter of opinion – there is one correct answer based on the interest rate, the amount of debt, and the size of the minimum payment.

 

Figure 6 from Seira et al. (2017)

 

As the figure above shows, a good percentage of people believed their debts would be gone in a year or less, even three months or less, if they just made minimum payments (red columns). But the researchers also had access to everyone’s credit card statement from the bank, so they could check the customers’ math and determine the accurate answer. They found that the true time to pay off debts while only making minimum payments averaged 27 months and was very rarely less than a year.

There are a few possible explanations for the disconnect between customers’ responses and the cold mathematical reality: blind optimism, ignorance about debt levels, or even simply misunderstanding what a “minimum payment” is. Regardless, it suggests a huge opening for improving credit card repayment by just giving people simple information to help guide their decisions.

To test this, the researchers sent out informational flyers to some customers with emphatic messages about how long it would actually take to pay down debts and comparisons to other people in similar financial straits. They only found very modest effects on payments rates and defaults, suggesting the denial people have about their debts isn’t something that can be fixed quite so easily.