The Psychology of Debt. A Decision Analytics briefing paper from Experian

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1 The Psychology of Debt A Decision Analytics briefing paper from Experian October 2007

2 Introduction Collecting delinquent debt is fairly well understood as a business process, but little is known about the psychology of indebtedness. Can a greater understanding help improve collections? Professor Alan Lewis Department of Psychology, University of Bath A report issued by the Financial Services Authority in February issued a stark warning about rising debt in the United Kingdom: mortgage repossessions up 65% on the previous year. The Council of Mortgage Lenders has projected that on current trends there may be as many as 20,000 repossessions by Higher interest rates and larger utility bills are likely to be the prime causes. Even at the end of July 2006 the Bank of England reported that consumer borrowing on mortgages and secured loans was 1,025.4 million and million for unsecured credit. From the lenders point of view (or anyone trying to recover unpaid bills) debt collection and debt recovery is becoming increasingly expensive. For those in debt there are significant psychological as well as financial costs incurred. If we were rational economic men and women this is all a bit of a mystery, as one would expect economic actors to adjust appropriately to changing economic conditions. It is clear that mistakes are being made, so how does this happen? The thesis of this white paper is that we need expertise from psychological science (in addition to the usual economic and financial sources) in order to develop a better understanding of what is going on. Whose fault is it? When people get into debt is this the fault of the individual concerned or some aspect of the financial market? In a national survey it has been shown that 90% of respondents agree (64% strongly) that financial companies are too willing to lend money. 2 The sentiment that if I couldn t afford to repay it why did they lend it to me, is often heard. We could take that at face value; alternatively this can be interpreted from a psychological perspective as the self-serving bias i.e. the tendency to blame others when things go wrong, abdicating responsibility 3. Certainly many people in the finance industry would argue that money is lent responsibly and that there is considerable consumer protection legislation already in place, nevertheless 70% of respondents in the same survey feel the Government should do more to protect consumers from getting into debt. It is surely a question of balance as Herbert Spencer so eloquently put it in 1891: the ultimate result of shielding men from the effects of folly is to fill the world with fools. Do the sums! Efforts have been made in recent times (particularly by the FSA) to encourage the provision of financial information that customers use to their advantage, in order to encourage rational decision making. As an example, the calculation of the Annual Percentage Rate (APR) on loans is now more simplified and consistent yet customers frequently misunderstand the information and use it inappropriately. 4 No one is implying that people are stupid or that this, in itself, is the only The Psychology of Debt - 2

3 explanation, but rather, psychologically speaking, some people don t want to think systematically about their finances or when they do, do so in biased ways. Research work on mental accounting, prospect theory, myopic discounting, and financial phobia are all relevant here and will be dealt with in turn. Even people with relatively simple affairs tend to compartmentalise their money into different mental accounts. 5 For example, it is not at all unusual for people to have a savings account geared to paying for a holiday and a loan to pay for a car, where the interest rate on the loan is greater than that for the savings. When loan repayments become difficult many financial actors are unprepared to move money around appropriately or to have an appreciation of their overall financial position. This, along with a tendency to be financially short-sighted (myopic), favouring more immediate rewards rather than financial benefits in the future, leads to poor economic decision making. In addition, work on prospect theory 6 has shown that the majority of people are risk seeking for losses. This means that there is an unwillingness to accept the certainty of a given level of debt and make appropriate arrangements to pay it off, seeking instead riskier solutions which may make matters worse. Furthermore financial decisions, especially when things are not going well can be highly emotional. It has been shown that some 20% of the adult population in the UK are financial phobic, 45% of whom feel anxious, 15% immobilised and 12% physically ill when thinking about their personal finances. 7 Most of the factors that we have talked about so far have concerned errors in the way we think i.e. cognitive factors. A whole new and highly relevant set of factors need to be considered, namely those associated with our contemporary social environment. Social environment and consumer culture For the under 40 s, credit and its use has become a way of life. Older people can remember having to make a case for borrowing money, sometimes with trepidation, face-to-face with a bank manager. Now we are bombarded with loan offers through the letter box, via , and by what seems like every advertisement on day time television. Having things now and paying later is not due to some sort of cognitive malfunctioning, it is the result of the consumer culture in which we live it is expected, even demanded of us. This materialism is prevalent among the young who are particularly discriminating in their knowledge and preferences for cool brands and accessories. The clothes that we buy, the cars that we drive define who we are to the extent that it can be claimed that to have is to be, that consumption has become an essential part of our social identity who we are. 8 It is also predicated on the myth that wealth can bring us happiness in fact much of the literature reveals that, while the association between the two is indeed positive, the relationship is complicated; good health and a happy family life can be as important, if not more so, in the happiness equation. 9 Where do we go from here? There can be little argument that personal debt is rising and that it is caused by changing economic and financial conditions. More contentious is the view that the free-market in the long run will resolve these problems. Lay economic actors feel differently, wanting more help from Government. From a psychological perspective, being in debt incurs (and in some cases very serious) emotional costs. All of us (even financial experts) suffer from cognitive biases (to a greater or lesser degree) which lead us to make sub-optimal financial decisions. We are all influenced (to a greater or lesser degree) by the consumer culture in which we live and the myths associated with wealth and happiness. The Psychology of Debt - 3

4 What is needed is the development of an economic psychology of debt which draws on pertinent factors from both disciplines: economics and psychology. As an example, there is a strong case to be made that the relative ease with which credit has been able to be obtained in recent years has caused people to become more accustomed to its use when making purchases and more complacent about borrowing sometimes quite substantial amounts of money. Nevertheless, not being able to make repayments is highly stressful for all but the most cynical. We are all familiar with some aspects of credit rating assessments based, among other things, on past credit history, income, home ownership, occupation, even postcodes, but who actually are the people who are coping and who are not? Analysis of a baseline survey collected by the Financial Services Authority identified five groups of economic actors. 10 The good news is that some 60% people in the UK appear to be financially sound. These fortunate people tend to be older than average, they are cautious money managers with hardly any unsecured credit. Some 25% of people, many of whom are couples with above average incomes, appear to be managing reasonably well. Of particular interest are the 10% who are showing signs of financial stress. This group comprises the relatively young and well off, yet are excessively funding their sometimes impulsive spending with unsecured credit backed up by inadequate savings and investments. A similar group (2%) are over-indebted: they are the youngest of the five groups identified, with dependent children with credit and mortgage commitments that are not justified by their incomes. Perhaps most worrying of all they continue to be willing to borrow more money rather than to cut back on expenditure. The last group who are struggling financially (6%) are on low incomes with relatively few educational qualifications. They are also more likely to be lone parents living in social housing. There is little evidence however that this group are using credit irresponsibly and a third don t even have a bank account. This evidence suggests that there are relatively simple economic and demographic explanations for financial difficulties: being a lone parent on a low income makes life hard. On the other hand, the typology suggests that young people with reasonable incomes may find themselves with credit or debt difficulties as a result of financial myopia, financial phobia, materialism and a belief that money can buy you happiness. This is indeed a testable proposition and one well-worth undertaking. Government does seem to be taking account of the problems 11 associated with debt and rising credit and one can imagine a number of general policy initiatives that would be of benefit. Among these include improvements in the design and distribution of financial information that consumers can understand and use effectively. Furthermore, it may be possible to inoculate people against errors of financial judgement (including heuristic biases). Individuals, once they have become aware that they are likely to bury their heads in the sand or make risky choices when in financial difficulties or compartmentalise their money inappropriately, may be able to change their ways. Initiatives of this kind are highly relevant to cognitive psychology concerned, as they are, with the presentation and use of information and with decision making. This white paper calls for the inclusion of social psychology which is altogether more fundamental, radical and uncomfortable for policy makers as the analysis leads us to conclude that financial difficulties are a function, not just of economic changes, inequalities and faulty judgements, but also of the nature of contemporary consumer culture, our materialist values and insistence that everincreasing consumption will bring us greater self esteem and happiness. The Psychology of Debt - 4

5 1 The Daily Telegraph, February p.18 2 Nestlé Family Monitor Money in the Contemporary Family. Project Consultant, Professor Alan Lewis 3 Symmetrically we tend to praise ourselves when the sun shines on our financial fortunes 4 See the work of Professor Rob Ranyard at Bolton University 5 Richard Thaler 6 Daniel Kahneman & Amos Tversky 7 Brendon Burchill 8 Helga Dittmar 9 Richard Leyard 10 Elaine Kempson and Adele Atkinson The Government has set up a ministerial group on Over-indebtedness and the Bank of England and the FSA now conduct regular surveys on debt problems. The Psychology of Debt - 5

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