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Allocating Scarce Dollars: Payment Hierachy

By Katie Porter

When Americans have fewer dollars, creditors need to position themselves at the top of the pile to get paid each month. This is called payment hierarchy, and traditionally mortgage creditors have been at the top and unsecured creditors, and perhaps ubiquitous credit card creditors, near the bottom. At the Consumer Financial Protection Bureau conference on the anniversary of the CARD Act, I learned that the payment hierarchy has been upended. In 2010, consumers are paying their credit cards ahead of their mortgages. (Click on CFPB conference link above, then click on "Credit Card Profitability" by Credit Suisse and go to slide 7 to see the full data). Two key explanations for this change: 1) people may be more willing to risk losing their home when its value is plummeting and they are not certain they can hang onto it, and 2) credit card companies reduced the amount of credit lines and closed old accounts, making people more concerned about "preserving" their good standing with their credit card company. Another way to think about this is that homes used to be families' piggy banks, tapped when it is time to send a child off to college or do a home renovation. With no equity, Americans need to rely more on the credit card as their safety net. Unemployment rates are high, the economy remains fragile, medical costs are uncertain. In this economy, it seems entirely rational and reasonable to me for families to highly prize access to unsecured credit from cards.

When there are too many unsecured creditors to go around, however, how do consumers chose who gets their scarce dollars? A new research paper, Winning the Battle but Losing the War: The Psychology of Debt Management, uses a series of experiments to explore this question. The authors find that consumers focus on making payments that reduce the number of open accounts, which the researchers call "debt account aversion," rather than solely on paying off the debt with the highest cost interest rate. The latter would ultimately reduce the total cost of credit, an approach that the researchers term "perfectly rational."  In a series of stylized debt games played by students, not even one student consistently repaid in multiple rounds of the game all of their available cash to the open debt account with the highest interest rate. The pattern of debt account aversion--using some cash to pay off small accounts--held across a variety of conditions, although the researchers find some interventions that reduce the practice, such as prominently highlighting the amount of interest accumulated on each debt between rounds. But is debt account aversion really a "mistake"? Should policymakers be discouraging this behavioral trait?

I think debt account aversion has some virtues, including several that the authors of this research do not seem to consider. The authors mention that debt account aversion is only a mistake if the small accounts have lower interest rates, as in their game, and that this may not be mimicked in life, where large debts like student loans and mortgages may have low/subsidized interest rates. They also suggest that because consumers are particularly satisfied by paying off small accounts entirely, that this behavior may reduce debt in the real world when consumers are chosing whether to pay debt or make new purchases. Put another way, debt account aversion may be more costly than the "perfectly rational" approach but it still reduces costs of borrowing compared to taking one's dollars and buying more stuff, rather than making debt payments.

I would offer two other explanations for debt account aversion, each of which suggests that such behavior--at least in the real world--might be rational. First, credit scores are based in part on the number of open accounts that consumers  have. While the black-box world of credit scoring makes it impossible to say what the optimal number is, there clearly is some tipping point where the score begins to be reduced. Consumers may know this and pay down/close out small accounts first as a way to guard against erosion of their credit scores. Second, and I think even more powerfully,  consumers in the real world do not decide how to allocate their dollars based merely on a list of what they owe. They are motivated by pressure and by creditor leverage. Who is calling me? Who is sending me dunning letters? Which creditors seem forgiving v. menacing? Even among unsecured creditors, these factors can vary dramatically.

These two factors for debt account aversion were not present in the stylized debt games in this research, and yet people still chose to close small accounts. This suggests that there really is a psychological preference for limiting the number of accounts, but of course that preference could in part reflect experiences based on the following factors. People simply cannot check these experiences at the door and turn on a rational switch. 

I think the authors have identified an important consumer behavior and one that we should think about in designing financial education programs for indebted families. But I do caution against characterizing debt account aversion as a mistake or as "irrational." In the real world, it may well be a savvy financial strategy, just like reordering the payment hierarchy to reflect market credit conditions.

Full post as published by Credit Slips on March 28, 2011 (boomark / email).