It should come as no surprise that consumer debt levels are rising. Despite the prevalence of sensible financial advice from top-rated experts, we continue to purchase expensive goods on credit, finance vehicles we can’t afford and mortgage homes that are beyond our budgets. In 2018, the Canadian debt balance increased by 3.3 per cent and now sits at $22,837. According to Statistics Canada, the average Canadian household is now using a record 15 per cent of its disposable income to service debt obligations, with just over 7 per cent going towards paying interest charges. And for those living in the U.S., the figures are equally troubling. The average U.S. household now has $8,284 in credit card debt, a 2% increase from the previous year, and Americans now carry just over $38,000 in personal debt.
Pay Attention to the Ostrich Effect
Rising consumer debt is not limited to Canada and the U.S., it’s a global problem. Many of us might be tempted to ignore our ballooning debt levels and carry on as if everything is fine. Unfortunately, this choice can have disastrous effects on our personal finances as we continue to live a lifestyle we can’t afford. The ostrich effect comes from the legend that ostriches bury their heads in the sand to avoid danger. For many of us, the ostrich effect is most evident when we avoid opening our credit card bills. We ignore high interest rates and bloated balances and pay only the minimum amount due. In effect, we are turning our attention away from our growing debt and convincing ourselves that we’ll deal with it later.
To help combat the ostrich effect, avoid using credit cards altogether. Research shows that you will spend 12-18% more with a credit card than when using cash to pay for a purchase. Credit cards promote impulse buying behaviour because they obscure the costs of your expenditures until your credit card statement arrives. Also, make sure you sign up to get automatic statements from the bank sent directly to your email account and routinely track your credit card purchases using your financial provider’s smartphone app or online account portal. This will help ensure that you become aware of how much you are spending, your interest rate and how fast you are paying down what you owe.
Don’t Focus on the Debt Avalanche
Finance experts often advocate two different debt repayment strategies: the debt avalanche and the debt snowball. The debt avalanche focuses first on repaying the debt with the highest interest rate, while the debt snowball urges you to pay off your debts from smallest to largest. From a financial perspective, the debt avalanche makes the most sense. By tackling debt with the highest interest rate, you will save more money as the amount owing slowly begins to shrink. Behavioural science disagrees.
Numerous studies have shown that the best way to pay off creditors is to start with the smallest loan and concentrate on paying that debt in full. In other words, focus on the debt snowball. But why does this method yield better results? It all comes down to motivation. For debt repayment, our perceptions of progress are impacted by the portion of the balance that remains. So, for example, a $100 payment on a $400 balance pays off 25 per cent of the loan but just 2.5 per cent of a $4,000 balance. It’s easy to see how concentrating on smaller debts generates a greater sense of accomplishment. This in turn prevents you from losing momentum on your journey towards greater financial security.
Plan for the Future
Here’s a thought experiment to help you understand the importance of planning for the future. Imagine that you have an extra $100 in your bank account this month. Would you use that money to pay down your credit card balance or would you plan a night on the town with your friends or spouse? If you’re like most of us, you chose an enjoyable evening of dinner, dancing and fun. This illustrates how the present bias can prevent us from reducing our debt.
The present bias is best understood as a tendency to overvalue immediate rewards at the expense of long-term goals. The present bias is why we lose momentum after starting a new diet or exercise regime. How we feel today overpowers distant goals that we have set for ourselves, no matter how important they are to us. Fortunately, there are two ways you can harness science to combat this behavioural trait.
The first way is to “create a default.” For debt reduction, this would involve making a scheduled automatic payment every month. The second method is to use a behavioural science technique called a “commitment device.” These devices encourage you to follow a desired plan that will yield positive results in the future. For example, you can create a commitment device by reviewing your spending habits and looking for expenditures that are not essential. This could be something as simple as eliminating your morning latte and bringing a lunch to work or as complex as trading in your SUV for a smaller more affordable used sedan. Then, create a contract that stipulates what you will do if you ignore your new habit or chosen course of action. If a month later you are still driving your costly SUV, you could set aside $10 every day to put in a savings account until it is sold. Be sure to share your commitment with friends, family and your spouse, as they can help you achieve your goal and ensure that you follow the penalty established in your contract.
Paying off debt is never easy. But with determination and some helpful tips from behavioural science, you will be much better equipped to realize your financial goals.