Allocating Scarce Dollars: Payment Hierachy

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.

Comments

[Constant Diligence]

Paying credit cards before mortgages... Is just one more example of how dysfunctional our financial systems have become. Federal regulations and a handful of banks create debt instruments designed to bleed the Middle-class American homeowner dry... A new approach to debt management should be the personalized debt settlement that many are (as much as I hate the word) entitled to under fair housing, and debt lending laws. http://diligencegroupllc.net/

Good attorneys are beginning to understand the opportunity to negotiate/litigate using basic design flaws in the financial systems created to secure and unsecure asset backed debt. Do the math on every single debt burdened family in America, and the banks will pay one inappropriate debt instrument after the other! With the right leverage in the Debt Negotiation Middle-class America, living in asset poverty, actually has a chance to reach a sustainable settlement without declaring bankruptcy… as any good old American Bank/Company/State does.

The American Middle-class had better wake up and rally against the financial bureaucracy or they will be gone.

American (Middleclass) Homeowner

-AH

[Thomas Wicklund]

I would offer a couple other reasons for "debt account aversion" which are perfectly rational but not included in the study above.

The first is cash flow. If one receives a big chunk of money, it can make more sense to pay off the low interest car loan than a higher rate credit card. For instance, a $2000 windfall could eliminate the $300 per month of a car loan as opposed to $40 per month off a credit card (2% minimum payment). The extra cash per month could make the difference between getting deeper in the hole and breaking even each month.

There are other rational reasons for paying low rate accounts earlier. Paying off a few accounts reduces the number of bills each month, so reduces the chance a bill is forgotten. For "no interest for XX month" offers, it can make sense to pay off more than the minimum to avoid a final unaffordably large payment at the end. Finally, there is a psychological satisfaction to getting an account paid off. It can be worth a few dollars interest rather than the depression of seeing the same unending set of bills each month.

[JC]

Katie.
Researchers tend to have a very narrow view when it comes to their conclusions and commentators like you tend to take the opposite side no matter what or we wouldn't have an article to post, would we?
As usual there are more options in debt reducing other than paying the highest interest debt (other than a Pay Day loan in which case we are not talking about debt management anymore but desperation)

We could for example:
1) Get a consolidation loan,
2) Go bankrupt,
3) Pay highest interest debt first,
4) Reduce accounts.

I looked at 3 and 4, building a spread sheet that took my brother from 4 to 8 years to get out of the hole. Reducing the number of accounts won with a payoff of 4+ years for the simple reason that all accounts have minimum payments regardless of the interest charged. He had 11 accounts for a total of $1200 per month in minimum payments. We allocated $1300 per month. By paying the smaller accounts first we began to apply that minimum payment plus the $100 to the next account and so on. It snowballed where today he is paying $850 to account #3 (4 - 8 are long gone along with the highest interest ones) He will be "clean" by the end of next year. He uses cash and debit cards for day to day and a credit card for travel and internet use for which he carries no balance.
It worked and pretty soon he will be able to stick his middle finger to the banksters or fall in debt again.

[Hangtime79]

Katie,

The inversion of the payment hierarchy you discuss at the beginning of your article is actually a phenomenon that started in early 2008 when cash flow became much more important in the household. Simplistically the hierarchy went from home, car, cards TO car (gotta get to work), cards (gotta eat), home (can't kick me out of my home in any appreciable amount of time). Notice the first two where lenders have immediate recourse (repossession and account closure) saw their position move up while the one with the least recourse fell.

Paying down smaller debts first is perfectly rational as correlates more highly with successful outcomes of debt repayment. While interest may be saved by paying down debt in proportion to the actual interest rate owed, it has a lower probability of success.

You will frequently hear this behavior referred to in the popular consumer finance press (Ramsey, Orman, etc.) as the Debt Snowball.

Example:
Let says say our in-debt family owes 20,000 at a blended 15% rate that they will pay off in 5 years.

Cumulative Interest Over 5 years: $8,548

Now let's say the family's debt is spread over multiple creditors and has the ability to pay down many smaller loans first but doing so will increase their blend to 16%.

20,000 @ 5 yrs - 16%
Cumulative Interest Over 5 years: $9,182

That savings in interest from paying 15 vs 16 is the equivalent of 1 1/2 payments (475 pmt, 634 in interest savings over 5 years).

Knowing this, if you believe by paying down lower rates first will increase your likelihood of success by more then 7.4% ($9,182 / $8,548 - 1) it is altogether more rational to pay down the lower balance first because the average outcome is better.

The reason the debt snowball is so powerful is that it shows immediate results and creates the drive to continue with a plan. Note when you plug in this formula the outcome does not vary if you use equal pay-off times or equal amounts of debt, only the interest rate is a factor. The only reason not to use is when the blended rate ratio (optimal payment blended rate / snowball blended rate) becomes exceptionally pronounced ie (3% vs 4% would need to increase your odds of completing the repayment by a 34%). However, this is also why many say once you get on the plan and have some success you can change to the more optimal pay scenario.

As you pointed out, the next largest factor is the wanting to get rid of creditors from calling. Its easier for people to deal with 2 creditors rather then 10 so this behavior of paying off multiple smaller debts is part for their well-being. While there is a linear relationship between debt and decrease in quality of life for a consumer there is an exponential one between the number of creditors and quality of life. This is why debt management agencies such as Money Management International do a brisk business in that it easier to cut a check to one agency then deal with 10 creditors.

[Leigh Kimmel]

I'll chime in from personal experience on why eliminating small accounts is beneficial psychologically. As a result of a series of expensive misfortunes in the late 1990's and early 2000's, my husband and I got badly debt-locked. Early this year we were able to come into a substantial amount of money which we used to pay off several debts with very large monthly payments, improving our situation enough that we were able to negotiate a consolidation loan at a much lower rate than several other high-interest cards that will also be eliminated.

The savings in mental and emotional energy of not having so many bills to keep track of is a real plus -- I'm still getting used to it, and keep feeling like I must be missing something, until I remember that we've paid off those bills and we don't have them any more. (I'm the person who keeps track of the checkbook and bill-paying).

But the real gain for me is the sense of empowerment -- being debt-locked created a crushing sense of helplessness and hopelessness, that no matter how hard we tried, how busily we worked, how carefully we scrimped, we simply couldn't get ahead. All we could do was franticly tread water, which was mentally and emotionally exhausting. But now that we have concrete progress we can point at, and can see the remaining debts actually shrinking instead of continually bobbing up and down, I find that I have more mental and emotional energy to apply to money-earning tasks.

Barring another series of financial catastrophes beyond our control, we're hoping to be out of debt as soon as we can pay off the consolidation loan.

[Katie Porter]

One comment suggests that the change in payment hierarchy began in early 2008. According to the data that Credit Suisse presented at the Consumer Financial Protection Bureau, that assertion is not correct. The Credit Suisse data show mortgages as #1 in the payment hierarchy in June 2008, with the transformation in hierarchy occurring as of December 2010. It may be that consumers began to think differently in early 2008, but the behavior took much longer to change.

[greentea]

Your entry is very helpful because it has helped me to understand payment heirarchy. There are families who find ways to stretch their scarce dollars to meet their everyday needs. Cutting off their expenses is the first step to budgeting your income.

[CaitlinO]

We were lucky enough to realize that the caca was going to hit the fan in mid-2007 and seriously committed ourselves to getting out of debt, believing that the economy was very close to becoming completely unhinged.

I ran the spreadsheets both ways and the difference between paying highest interest first versus lowest balance first was less than 3 months on a 3.7 year effort.

We initially went with lowest balance first feeling that it would be more motivating to see those bills drop off the plan. When the financial system crashed in late 2008, we shifted our strategy and put our focus on paying off things that could be taken away if we were to lose work - the cars and the house. In that scary time, the security of owning our transportation and shelter outright became top priority. We sent the last check out in February and are now completely debt-free.

I suspect that many people embarking on a multi-year deleveraging effort will find that changing strategies to meet changing conditions may make the most sense. Eliminating home, auto, student and unsecured debt takes years for most people and it may require different strategies at different times. Ultimately, the rational approach is probably the one that keeps families committed and on track as long as is necessary to get the job done.