How Credit Card Debt Can Make You Irrational

If you only want to buy what you can afford, then a credit card can be a poor way to do it and can lead to more credit card debt than you can handle.

By the time the bill arrives in the mail, the credit card debt can seem like a long-ago purchase that filled a need at the time, but now you can’t remember what you’re paying for. If you’re not going to pay the bill in full by the time it’s due, a credit card can be an irrational way to pay for something and can lead to high interest payments.

It only gets worse for people who use many credit cards and carry balances, and can affect their credit scores.

Credit card debt can make you more irrational if you have multiple credit cards and are paying off the smallest balances first — even though other card balances have higher interest rates, according to researchers.

Credit card debt is one of the most expensive forms of debt, with the average credit card APR at 15 percent. Most credit cards have high interest rates of 10 percent to 24 percent, and making partial or minimum payments can lead to years of debt.

Studies have found that most credit card customers tend to reduce the number of credit cards rather than decrease the amount of total debt owed across all credit cards, says Ali Besharat, assistant professor of marketing at the Daniels College of Business at the University of Denver. That’s an irrational way to deal with credit card debt, Besharat says.

Debt snowball on credit card debt

The debt snowball method promoted by Dave Ramsey is what many consumers use when carrying balances on many credit cards. This method recommends making the minimum payments on all debts except the smallest one, and then paying that one off quickly. Small debts are paid off as quickly as possible before larger debts are, even if the larger debts have higher interest rates.

Interest rates don’t matter. As long as you’re paying off the smallest debt as quickly as possible, you’re working on eliminating debt and will be more likely to stick to that plan than if you were paying off all debts at the same rate, the thinking goes.

Paying off one of six credit cards gives you the feeling of making progress and is a lot more motivation to tackle your debt than continuing to have six credit card balances.

But that sort of thinking is the “illusion of goal progress,” Besharat says, and is only an emotional coping mechanism.

If the debt snowball is used, it should be used with caution. It has the most success when interest rates among debt accounts don’t vary greatly.

When interest rates on the account vary greatly, then paying off debts from the highest to lowest interest rates has more of a financial savings than the benefits from debt snowballing, according to Besharat and other researchers.

Other irrational behaviors

Researchers have also found that people with a number of debt accounts were more likely to pay off a smaller number of accounts than they were if they had a large number of accounts — such as three credit card accounts versus six. The interest rates they were charged weren’t factored in to eliminating such debt.

To pay off any credit card debt balances, a windfall such as a tax refund or bonus at work was most often used, irrespective of the interest rate, Besharat says, instead of pulling the same amount of money out of a savings account to pay off debt.

Making the minimum credit card payment is also irrational, he says. If you can’t afford to pay the bill, you might ignore the expense of using credit cards.

“A lot of customers look at credit cards as free money,” Besharat says.

What to do?

The average American has five credit cards and the average household has $15,762 in credit card debt. Debt is a problem most people face, but are unclear how to deal with it.

“Many consumers that carry a credit card balance may find it impossible to get out of debt, because they are paying primarily for accumulated interest charges rather than the cost of their purchases,” Besharat says.

Paying off the highest interest rate first is the most rational thing to do, he says, followed by paying off the second most expensive debt and so on so they can lower the total cost of carrying the debt.

To get to that rational point, consumers can start by carefully reading their credit card statements to learn the overall cost of paying interest only, Besharat says. They can also use an online calculator to see how minimum credit card debt payments will affect their balance versus how quickly they can become debt free by first paying off cards with high interest rates.

“Over time we have to increase the financial literacy of consumers,” such as by teaching them how compound interest rates work, he says.

Otherwise, if they’re going to continue paying the minimum balance on multiple credit cards, the irrational behavior and the ensuing debt will only continue. That’s only a snowball toward a lifetime of credit card debt.