Page last updated at 16:51 GMT, Saturday, 31 October 2009

Can credit cards mess with your mind?

By Ruth Alexander
Reporter, Radio 4's Money Box

Selection of credit cards.
Minimum repayments can distort your judgement

The government announced some radical proposals this week to reform the way credit card providers charge customers.

One big idea was that the minimum amount we are asked to pay each month should be raised - from around 2-3% of what we owe to perhaps 5%.

It wants people to be able to pay back their borrowing more quickly and cheaply.

But it is not just the people scraping by on minimum payments the government is thinking about.

A heady mix of maths and psychology

People who pay off more than that - but less than the full balance each month - are also affected by the minimum payment levels.

Tucked inside the consultation paper was a reference to the work of Neil Stewart, a psychology professor from Warwick University, whose research shows that when we see the minimum payment on our credit card statement something strange happens to our brains.

He and his colleagues conducted a survey, which showed that, the smaller the minimum amount asked for, the less above that people chose to pay.

To test this further, they gave about 400 people a mock credit card bill, and asked them how much they could afford to pay.

The anchoring effect

For half the bills, 2% of the balance owed had to be repaid, while the other half made no mention of a minimum payment requirement.

"The credit card statement had a balance of £435," Professor Stewart said. "And what we found was that when we included minimum payment on the statements, people were tending to repay only £99, but when we left off the minimum payment from the statement people were choosing to repay £175, on average.

The minimum payment is a small number, and it drags down the amount people finally choose to repay
Professor Neil Stewart, Warwick University

"So that's quite a big difference - mean repayments rose by about 70% when we left minimum payments off the credit card statements."

What was going on here, Professor Stewart believes, is a psychological phenomenon known as 'the anchoring effect':

"Minimum payments on credit card statements are acting as psychological anchors for those people who have decided not to pay the whole amount, but not just to pay the minimum.

"The minimum payment is a small number, and it drags down the amount they finally choose to repay."

On the high street, this strikes a chord with some people. One woman, with a considerable balance on her credit card, said:

Do you know the true cost of your credit card spending?

"The minimum payment is usually about £35, and I pay about £50 a month.

"I see the minimum payment and I think that's about how much this is costing me - I need to make sure I cover it.

"And I like the idea of paying a little bit more, because it gives me the impression that I might be paying the debt off a little bit."

A debt advice manager at Stoke-on-Trent Citizens Advice Bureau, Jay Lowe, said that sometimes partial repayers are surprised to find themselves in financial trouble:

"We will often see, when they bring their statements in, that what they've really done is look at the bottom line figure in terms of what's owing, and in terms of the minimum payment," she said.

"And they very rarely will actually look at the statement in more detail to actually see each month this is the payment going in, but this is the interest that's being charged.

"We saw somebody recently that owed £8,000 on a credit card. I think the minimum payment was something like £400. He decided to pay £600 a month and thought 'I'm paying an extra £200 - that really should be working to clear the debt', and then was quite surprised to find a year later that he still owed about £7,000."

Compound interest confusion

But why can't we just get it together and do the maths?

Because compound interest confounds most people.

Interest is applied to the cost of your purchases in the first month, and then you are charged interest on that interest as well as your purchases the next month, and so on.

Meanwhile you are making payments which partly pay off interest and partly pay off your purchases. And of course you could also still be spending on the card…

From the Stone Age

"Unfortunately our brains are just not set up to deal with those kinds of calculations," Professor Stewart said.

"If one thinks back a few thousand years, no-one was really worrying about money and so, evolutionarily, we are stuck with stone age brains that are simply not equipped to deal with modern finance."

High-street shoppers when asked how long a debt of £1,000 would last if the APR was about 16.75% and you just made minimum payments at 2.25%, gave answers ranging from one year to ten years.

The correct answer is more than 18 years.

If the minimum payment was raised to 5%, however, that would cut the time taken to repay the debt from 18 years to seven.

But there is another way to pay off the debt even faster.

If you kept the minimum payment at 2.25%, the first actual payment you would need to make is £22.79.

If you cut the card up and stopped using it, and paid that fixed amount every month, the debt would take just five-and-a-half years to clear.

BBC Radio 4's Money Box is broadcast on Saturdays at 12 noon, and repeated on Sundays at 2100 GMT. Download the podcast.

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