Monday, September 28, 2009

Minimum Payments and Anchoring

Behavioral finance is absolutely fascinating to me, which is part of the reason I enjoyed Why Smart People Make Big Money Mistakes so much. (Here's my Smart People review, for those who are interested.)

Thanks to Bob Lawless and this Credit Slips article, a previously-unconsidered instance of anchoring just came to my attention:

Research from Professor Neil Stewart (University of Warwick) indicates that the presence of a minimum payment on card statements caused people to pay 43 percent less toward their credit-card debt than they otherwise would. Revolving cardholders see that bold minimum payment number printed on their statements, we surmise, and somehow in their minds the minimum-payment figure takes on importance — when in fact it really should have none (insofar as to what's in the cardholder's best financial interest, anyway).

When they make the decision of how much to pay that month, the cardholder subconsciously "latches" to the minimum-payment amount. It becomes an anchoring point — a low one whose implementation certainly benefits the card company — that has a lowering effect on whatever final decision Joe Cardholder makes.

From a short article at The Economist:

Mr. Stewart was studying a phenomenon known as “anchoring.” Psychologists have found that being exposed to numbers, even irrelevant ones, can affect people’s decisions. For example, diners tend to spend more in a restaurant named “Café 97” than in one named “Café 17." Since minimum payments on credit-card statements are usually small amounts, Mr. Stewart wondered whether seeing an actual amount might make people pay less than they would otherwise have done. That is exactly what he found.

Yet another reason why — despite all the "It's not fair!" debtor outcry — minimum payments ought to be (and have been) raised.

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— Posted by Michael @ 8:15 AM


Heh. I recall a conversation with a friend that demonstrated this clearly. She had been paying $65 a month on a loan, with $60 going to interest, and $5 going to principal. The lender decided that she was a risk of some sort (this was back in 1998 or so), and charged an extra $10 fee. They informed her of the fee, but they never raised the required payment, and she never thought to pay more. Instead of getting out of debt at $5 a month, she was getting further into debt at $5 a month.

It took a fair amount of talking before I was able to convince her that she really NEEDED to send MORE than the minimum payment if she ever wanted to get that loan paid off.

She might have been an extreme case, but yeah, anchoring.

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