Does credit card repayment behavior depend on the presentation of - PDF document

Does credit card repayment behavior depend on the presentation of interest payments? The cuckoo fallacy Christina E. Bannier ∗ Florian Gärtner † Darwin Semmler ‡ January 31, 2019 Abstract We study credit card repayment behavior in an experiment with 404 participants run on Amazon’s mTurk platform in 2018. We show that only a small fraction of subjects repays optimally. Instead, a large number of participants focusses on repaying the card that produces more new debts. As this is not nec- essarily also the card with the highest interest rate, we refer to the ensuing allocation error as the cuckoo fallacy. Employing di ff erent treatments that present relevant information in di ff erent ways, we can show that participants can be nudged away from the cuckoo fallacy. Interestingly, while financially literate participants succumb less often to this irrational repayment strategy, the nudging e ff ect of information presentation persists irrespective of financial literacy. JEL Classification: D91, G11, D83, J26 Keywords: Household finance, credit cards, financial literacy, rationality, bias, cuckoo fallacy ∗ Professor of Banking & Finance, Justus-Liebig-University Giessen, Licher Str. 62, 35394 Giessen, Germany, Phone: + 49 641 99 22551, Fax: + 49 641 99 22559, E-mail: Christina.Bannier@wirtschaft.uni-giessen.de † Justus-Liebig-University Giessen, Licher Str. 58, 35394 Giessen, Germany, Phone: + 49 641 99 22595, E-mail: Florian.Gärtner@wirtschaft.uni-giessen.de ‡ Justus-Liebig-University Giessen, Licher Str. 58, 35394 Giessen, Germany, Phone: + 49 641 99 22594, E-mail: Darwin.Semmler@wirtschaft.uni-giessen.de 1

1 Introduction Over the last 20 years, several household finance puzzles, i.e. deviations from optimal behavior as deduced by rational choice, have been identified (Beshears et al. 2018, DellaVigna 2009, Zinman 2015): People hold low-interest assets and high-interest credit card debts at the same time (Gorbachev & Luengo-Prado forthcoming, Gross & Souleles 2002, Laibson et al. 2001), choose more expensive credit cards when they could also choose a cheaper one (Agarwal et al. 2015), fail to refinance their mortgages e ffi ciently (Keys et al. 2016), and are influenced by anchoring (Keys & Wang 2016, Stewart 2009) and simple reminders that could be interpreted as priming (Stango & Zinman 2014). Among more recent studies, the credit card debt puzzle has received particular attention. It posits that, when endowed with several credit cards, a significant fraction of people do not repay their debts in an interest-minimizing way (Gathergood et al. 2018, Ponce et al. 2017). Instead, simpler heuristics like balance matching (Gathergood et al. 2018) or mental accounting (Ponce et al. 2017, Thaler 1985) seem to explain the observed behavior better than rational optimization. Inspired by these results, we reexamine the strategies that people use to repay their debts. To do so, we develop a simple experimental setting where participants hold credit card accounts with negative balances and are provided with an income stream over several rounds, which they can use to repay these debts. We run a pilot study on Amazon mTurk and implement several treatments to elicit di ff erent repayment behaviors. Our pilot study shows one strategy to be particularly pervasive that appears to complement the balance matching and mental accounting strategies derived in earlier work. Based on this pre-finding, we hypothesize that participants focus too strongly on repaying the credit card with the highest current level of interest payment and too little on repaying the card that allows for the strongest reduction of interest payment. The level of interest payment per card hence appears to be the more urgent or more easily processible issue in comparison to a change in the interest payment, thus triggering a repayment decision that is irrational if the card with the highest level of interest payment is not also the card with the highest interest rate. We call this the cuckoo fallacy as it mirrors the behavior of parenting birds feeding first of all the largest and most urgently pleading fledgling in their nest, which might turn out to be a cuckoo. We test our hypothesis with data derived from di ff erent experiments run on mTurk with subjects from the US. In the experiments, participants are endowed with two credit card accounts that show the same initial debt levels but feature di ff erent interest rates: There is a low-interest and a high-interest credit card. Participants receive a constant income stream in every round that they can use to repay the two credit cards 2

in a fully flexible way. In the basic treatment, participants are provided with the necessary information in a very neutral way. I.e., they learn the debt levels and income level per period and the interest rates on each credit card. Two alternative treatments are then designed so as to draw participants’ attention either to the current level of interest payment per card or to the reduction in overall interest payment due to the repayment. We measure the potential amount of misallocation per participant as the deviation from the optimal repayment behavior and study whether it is a ff ected by the two treatments. Interestingly, we find that only 18.32% of all participants in the basic treatment choose the optimal strategy and repay the credit card with the highest interest rate in all experimental rounds. This proportion is much lower (11.11%) in the treatment that focuses attention on the level of interest payments per card, but much higher (26.81%) in the treatment that emphasizes the overall reduction in interest payments. Interestingly, when we test for the treatments’ influence on the allocation error in a multivariate analysis, we find a significant e ff ect only for the treatment that emphasizes the total reduction in interest payments: Here, the allocation error is significantly smaller as compared to the basic treatment. The allocation error does not increase as compared to the basic treatment, however, when the levels of interest payments per credit card are emphasized. We conclude from this observation that participants may be nudged towards more rational behavior by presenting relevant information in an appropriate way, but will succumb to the cuckoo fallacy in a similar fashion in any other case. Our multivariate results are robust against controlling for person specific characteristics such as gender and age, but also characteristics more specific with regard to the decision at hand, such as financial literacy or experience with credit cards. Even though we find that financial literacy correlates negatively with the allocation error, it might be surprising that the nudging e ff ect of the treatment is not a ff ected by the financial literacy of participants. I.e., participants show a significantly lower allocation error in the treatment that emphasizes the overall reduction in interest payments, irrespective of whether their financial literacy is high or low. It should be noted that the cuckoo fallacy becomes relevant only in cases where the credit card with the low interest rate shows a su ffi ciently higher debt level than the credit card with the high rate. This is because the interest payment will then be higher on the low-interest rate card than on the high-interest rate card, so that repaying the former - due to its higher level of interest payment - turns out to be irrational. As our experiments start with an equal debt level on both credit cards in the first round, this situation arises only in later rounds. When we account for this e ff ect and focus only on these later rounds where the irrationality may truly arise, we still find that the treatment that focuses on the overall reductions in interest payments 3