Wednesday, October 13, 2010

More on the credit card puzzle

Why do people simultaneously hold substantial cash and high interest credit card debt? I previously reported that this could be explained by the demand for liquidity as some goods cannot be purchased on credit. While that explanation seemed to be a good one quantitatively, it does not mean that thtere is no room for other ones as well.

Scott Fulford offers another one: liquidity is necessary for unexpected changes in borrowing limits. Basically, people keep cash or savings so that they have something to live from in case their credit line gets unexpectedly reduced. That seems to be a very poor strategy, though. Given the high interest rate on credit cards, why not lower the credit balance with those savings? You pay less interest, and you end up with exactly the same balance when you are the most constraint. If fact you are even better off in the latter situation, because past interest payments are lower and the balance is thus lower. The reason why household in this model still hold cash is that there is a very peculiar way in which the debt limit is stochastic: it is either zero or some fixed number. Thus it is not some reduction in credit lines, it is a complete cancellation out of the blue. That is important for household choices. In fact, this may give some ideas to credit card companies, because this implies that households will want to have high interest credit card debt while having low interest savings. Crazy.


Kaushik Choudhury said...

Well, this is more westernized view... In country like India credit card is not so popular to en mass, although it is picking up fast .

Also, generally people in India make sure to pay back the money within the stipulated zero credit timeline .

Kansan said...

You hit the nail on the head. A strange result because of a strange assumption that could only be justified by evidence that credit card loans are suddenly canceled in their entirely in significant numbers. I really doubt this is the case.

David Stern said...

1. People may fear that if they don't use more of the credit line available it will get taken away from them, whereas a bank wouldn't reduce the credit limit below the level of an outstanding loan. From what I've seen this could be realistic though more so if the card isn't used at all rather than paid off regularly.

2. They may fear that if they pay off their credit card with their savings they will just end up spending more on their credit card. Whereas the cash might be locked up in a CD or less accessible savings account.

3. People may think that having a balance will help with their credit score.

4. I often read on blogs where people don't think of paying off credit cards as "real saving". So they put money in a savings account. This one is irrational.

taninvest said...

- not everyone is rational
- not everyone understands economics/finance
- people might not know what is the annualized interest rate on their credit card debt
- people might not know that they are paying interest out of after-tax income
- people might not think of interest savings as an investment return.