In this chapter I look at a series of facts about individual or household financial borrowing behaviour, examine where that behaviour is inconsistent with traditional economic explanations, and examine possible explanations that can account for the observed behaviour.

Under the economic framework we examined earlier, people borrow to smooth consumption. If income is very lumpy and a person has no liquid savings, it is possible to rationalise borrowing at any interest rate, provided there is no alternative product available with a superior rate.

We have already seen that people do not smooth their consumption over their lifetime. So what role does borrowing play?

Below I examine three lending products (credit cards, payday loans and mortgages), the role that these might play in customers’ lives, and some possible rationalisations for the pattern of use that we see.

## 13.1 Credit cards

Credit cards present three puzzles that a traditional economic framework has difficulty resolving.

• People borrow far more on credit cards that you would expect than if they were exponentially discounters
• People fail to choose credit cards with the lowest borrowing costs
• People hold both high-cost credit card debt and liquid assets that earn low rates of return.

I then consider a simple example of how intertemporal discounting might affect credit card debt.

### 13.1.1 Excessive borrowing

Although it is possible to justify borrowing at any interest rate if income is sufficiently lumpy, the levels of observed credit card debt are hard to justify. In particular, the impatience required to justify the high levels of credit card debt does not reconcile with the patience required to justify the savings in illiquid assets such as housing and retirement accounts.

Present bias provides one possible explanation. As noted in the discussion in Section 12.3.1, illiquid savings are hard to access immediately, so the potential consumption of illiquid savings is substantially discounted by someone with high present bias. This enables the saving of illiquid assets. However, consumption using a credit card suffers no such discount. It can occur immediately. Meier and Sprenger (2010) found that more present biased individuals were more likely to have credit card debt and had higher levels of debt.

### 13.1.2 Poor card choices

The explanation of present bias is, however, incomplete, as demonstrated by another puzzle. People don’t choose the credit card with the lowest borrowing costs.

At least a part of this relates to customers being attracted by teaser rates, which they pay more attention to than the long-term rates they will end up paying.

Customers also exhibit poor understanding of exponential growth and how a credit card debt can compound over time. (Recall the compounding question that formed part of the financial literacy test.) Poor understanding of compounding can lead to an underestimation of the cost of high interest rates.

### 13.1.3 Co-holding debt and savings

People often hold both high-cost credit card debt and liquid assets that provide low rates of return. In one UK survey, 12% of households in the sample held an average of £3800 in revolving credit on which they incurred interest charges, while at the same time holding liquid assets that they could use to clear all of this debt (Gathergood and Weber (2014)).

One rational explanation for co-holding is that that some expenses must be paid by cash or direct debit, not credit card. This requirement means that funds must be available in these forms.

An alternative explanation is that co-holding is a self-control strategy. By reducing the amount of unused credit capacity, it may reduce future spending. (Note the use of mental accounts here.)

One shortfall with these explanations is that people who hold multiple cards do not minimise costs when using the cards they have. They pay little attention to relative interest rates when choosing which card to use. They don’t repay the card with highest interest rate first.

### 13.1.4 An example of intertemporal discounting and credit card debt

The following example illustrates how an exponential discounting agent and present-biased agent will consider payment of a credit card debt. Will they pay sooner and avoid interest, or will they delay the payment and incur extra costs? And will their decisions through time be consistent?

Consider an agent with utility function $$u(x_n)=x_n$$ who receives income $$I$$ in each of three periods, $$t=0,1,2$$. They have a credit card with an interest free period and are considering whether to:

1. Not use the credit card, which leads to stream of consumption equalling their income in each period: $$C_1=(0,I;1,I;2,I)$$.

2. Borrow to increase consumption by $$$X$$ at $$t=0$$ and pay the debt$$$X$$ with no interest at $$t=1$$, which leads to stream of consumption: $$C_2=(0,I+X;1,I-X;2,I)$$.

### 13.3.3 Explaining these phenomena

Both rational and psychological arguments can be constructed for the failure of customers to shop around.

On the rational, search takes time and has a cost. The benefits of any improvement in interest rates need to outweigh those costs.

However, the scale of the differences in interest rates makes it hard to justify the failure to search without assuming an unreasonably high cost of search or value of the borrowers time. In particular, most long-term borrowers could likely receive some further discount by sending an email or making a phone call requesting a discount (possibly accompanied by a threat to leave). A minimal cost action can achieve large long-term gain, but is not taken.

Present bias provides one explanation as the costs of search are today, whereas the benefits are distant. The benefits of the search receive unduly low weight to a hyperbolic discounter. This is still somewhat an incomplete explanation, as some of the steps to gain lower rates are of such low cost it requires unrealistic levels of present bias.

Another explanation relates to attention and knowledge. A customer with a long-term mortgage may not have given any attention to their current rate relative to the rates they could achieve in the market. The opacity of advertised rates would further cloud their comparison even if they were to focus attention. They do not take the steps to seek a reduced rate because they do not realise it is an option, not because they have calculated the costs and benefits of their action.