Finance and Investing

A New Way to Cut Credit Card Debt: Pay Off One Purchase at a Time

Letting credit card customers pay back specific purchases encourages borrowers to go beyond the minimum, says research by Michael Norton and colleagues.

A novel approach to repaying debt could help consumers free themselves from crushing credit card balances faster, according to new research.

Rather than asking borrowers to make payments toward their total balances, Harvard Business School Professor Michael I. Norton and colleagues tested a method that lets consumers choose which purchases to pay off each month. Consumers who used this “repayment-by-purchase” method, on average, paid 12 percent more toward their balances.

With COVID-19 restrictions tamping down spending and New Year's resolutions still on the brain, many borrowers are taking aim at their credit card debt, which totaled $825 billion at the end of 2020 in the United States alone. As balances have climbed, the percent of household income allocated to repayment has decreased 17 percent over the last decade, and nearly 30 percent of consumers have reported failing to make a monthly payment, according to the Federal Reserve.

For people struggling to chip away at high balances, targeting specific items on their credit card bills can provide much-needed control and encouragement.

“Instead of a list of purchases that you can do nothing about, and you just feel bad, now you have a list of purchases, and you can decide which ones you want to get rid of,” says Norton, the Harold M. Brierley Professor of Business Administration at HBS, and a member of Harvard’s Behavioral Insights Group.

In their working paper, Repayment-by-Purchase Helps Consumers to Reduce Credit Card Debt, Norton and his fellow researchers argue that separating the purchase from the actual payment demotivates consumers from paying more than the minimum. In contrast, repayment-by-purchase “recouples” the elements of the transaction and “brackets” the debt into smaller, more manageable chunks. It also provides a visual progress cue, as borrowers see purchases vanish from their statements.

Norton worked on the project with Grant E. Donnelly, an assistant professor at Ohio State University; Cait Lamberton, a marketing professor at the Wharton School of the University of Pennsylvania; Stephen Bush, senior manager at the Commonwealth Bank of Australia; and Zoë Chance, assistant professor of marketing at Yale School of Management.

Putting ‘repayment-by-purchase’ to the test

A field experiment conducted with the Commonwealth Bank of Australia, the nation’s largest bank, invited more than 136,000 customers to allocate their credit card payments across 14 spending categories using the company’s mobile app. About 1.5 percent, or 2,157 customers, opted into the feature, which let them pay down categories, such as “home,” “groceries,” and “transportation,” or eliminate them completely.

On average, customers who took advantage of the option to apply their payments to specific spending categories paid 12.18 percent more toward their debt than the control group, the research found.

“There’s a strong default to making the minimum payment,” Norton explains. “Our goal was not to get people to pay off their debt in full every month because, of course, many people just don't have the money to do that. It was just to see if they would move up a little bit every month off of that minimum payment because over the longer term that can have big implications for your overall wellbeing.”

Those who chose to use the novel repayment option tended to be younger, have lower credit card balances, and shorter tenures with the bank than those who did not. Through the field experiment and other lab studies, the researchers also discovered that people prioritized vanquishing purchases that appeared at the top of their bills, as well as the smaller and older expenses.

More work, less spending

Repayment-by-purchase requires more work from consumers, who must spend time examining each statement and deciding which purchases to pay off first. This, it turns out, can be viewed in both positive and negative lights, according to the research.

On one hand, people might be less willing to use a system that requires more time, or they might focus more on small purchases than eliminating their total debt. But on the other hand, the research suggests that the extra time consumers spent scrutinizing their monthly bills—potentially cringing over the many coffee or take-out purchases—also led to a modest decline in monthly spending.

“It was nice to see evidence of that,” says Norton. “It seems like people are a little bit shifting their spending down once they've had the chance to think about their debt and get rid of some of it.”

The prospect of reduced spending might seem like it would deter credit card companies from rolling out the repayment-by-purchase option. But Norton says those companies actually prefer that people spend less and pay more, rather than eventually defaulting on their debt.

Thankfully, borrowers don’t have to wait for lenders to offer a repayment-by-purchase option to begin using this approach, advises Norton. By spending a little extra time scrutinizing monthly credit card or loan statements, consumers can identify spending categories to pay off first, he says. They can also sort their credit card bills by retailer, focusing on those expensive coffees or take-out orders to rein in spending.

“Whatever your weakness is for a retailer, you could look and say, ‘I'm going to pay off that retailer every month,’” Norton suggests. “That could be one quick and easy way to make a little bit more progress and feel like you're having more control.”

About the Author

Kristen Senz is the growth editor of Harvard Business School Working Knowledge.
[Image: iStockphoto/serts]

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