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How do individuals repay their debt? The balance-matching heuristic

How do individuals repay their debt?

John Gathergood, Neale Mahoney, Neil Stewart, and Joerg Weber

If borrowers aim to minimize their total interest costs, the optimal way to pay down outstanding debt on multiple credit cards is to pay the minimum due on all cards and then to pay as much as possible on the card carrying the highest interest rate. Once a card's balance is fully paid, the borrower should move on to the card with the next highest rate.

In this Nottingham School of Economics working paper, published in the American Economic Review, John Gathergood, Neale Mahoney, Neil Stewart, and Joerg Weber investigate whether borrowers repay their debts in the optimal way. The researchers analyse credit card repayments of 1.4 million individuals over a two-year period. This dataset allows the researchers to link multiple cards to a single user. Gathergood, Weber and co-authors show that credit card borrowers typically do not repay their debts in the optimal way. Instead of first tackling the loan with the highest interest rate, they split repayments to match the ratio of their card payments to the ratio of their card balances. For two-card holders, the interest-minimizing strategy involves making 97.1 percent of "excess" payments on the borrower's highest-interest debt. But the researchers find that borrowers with just two cards only allocate 51.5 percent of their excess payments to the higher rate card, even though the average difference in the cards' annual percentage rates (APRs) is 6.3 percentage points.

Complete NBER Digest article.

American Economic Review, “How Do Individuals Repay Their Debt? The Balance-Matching Heuristic”, by John Gathergood, Neale Mahoney, Neil Stewart, and Joerg Weber.

 

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Posted on Wednesday 13th March 2019

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