Consumers' credit card repayment strategies are sub-optimal

Debtors tend to mismanage multiple credit card debts by prioritising debt repayment in a way that ultimately delays their ability to become debt-free, according to new research.

They do this by focusing on paying off individual credit accounts - usually the one that is closest to being paid off - rather than targeting the debt with the highest interest rate and minimising their total interest payments.

They tend to act this way because it makes them feel they have made progress: they owe money on fewer cards. This is called the 'illusion of goal progress'.

"People tend to split large goals into smaller sub-goals. By doing this they garner a strong sense of progress when they attain these sub-goals," said Francois Carrillat, associate professor at the University of Technology Sydney Business School.

Carrillat was one of the authors of "When Motivation is Against Debtors Best Interest: The Illusion of Goal Progress in Credit Card Debt Repayment". The research was undertaken jointly by UTS, the University of Denver and Seton Hall University.

Carrillat said people used this type of goal setting successfully when they were tidying a house or getting fit but it did not translate well to financial management.

He said a rational consumer would pay off credit card debt with the highest interest rate first. However, subjects in a research project only did this when the smallest balance also had the highest rate.

Another effect of the illusion of goal progress is that people pay small card debt balances even when they could afford to pay more.

For many people the goal is to pay off accounts, starting with the smallest, rather than focus on the financial cost of the debt.

"It can actually move the overall goal further away compared with the outcome of a rational financial decision," Carrillat said.

The psychological gain from paying off one credit card account outweighs the psychological loss from repaying the less expensive debt. Consumers have a lack of understanding of compounding interest.

"Policy makers should require credit card issuers to disclose the compound interest in each billing cycle along with the minimum repayment warning," he said.