How US Consumers Misdirect Credit-Card Payments

US households piled up $870 billion on credit-card balances in the fourth quarter of 2018, matching the record level reached in the fourth quarter of 2008. But they’re paying more in interest than they were a decade ago: the average interest rate levied in late 2018 was 17 percent, the highest in 25 years.

Unfortunately for any of these households trying to extract themselves from debt, research suggests that consumers exacerbate high-rate credit-card debt by failing to pay it back in a way that would minimize interest costs.

Using data from the TransUnion credit bureau, University of Nottingham’s John Gathergood and Jörg Weber, Chicago Booth’s Neale Mahoney, and University of Warwick’s Neil Stewart tracked the monthly payment habits of consumers with two credit-card balances between 2000 and 2016. They worked with more than 700,000 monthly data points that reflected an aggregate balance of $3.62 billion.

To minimize the high cost of credit-card debt, a consumer should make the minimum payment due on each card, and then direct as much as possible to the lender charging the highest interest rate. But the researchers estimate that a “balance-matching” strategy, where a consumer makes payments matched to the size of each card’s balance, better fits the data—which suggests many consumers were balance matching.

The researchers used various statistical measures to compare the balance-matching approach with five other payment strategies—including an “equal-sum” approach that involves making equal-sized payments on each card—to see which consumers were most likely to use. Across most of the measures, balance matching was the winning explanation for what consumers were doing. The only strategy that came close was the equal-sum approach, which bested balance matching on some measures.

The TransUnion data did not explicitly include the interest rates on individual cards, so the researchers weren’t able to directly analyze how consumers treated cards with different interest rates. However, some of the findings appear to confirm what the researchers established in an earlier study that focused on UK consumers, and which helped establish that balance matching was the most popular repayment strategy—and led consumers to pay more in annual interest charges. (See “Why people mismanage credit-card debt,” published online in September 2017, and “Why ‘balance matching’ in debt management can be costly,” in the December 2018 print issue.)