Here’s how automatic credit card payments could backfire

A popular way to help people with their finances is to gently prompt them to make better decisions.

There are automatic payments on credit cards and automatic enrollment in 401(k) plans. Some companies even automatically increase retirement plan contributions each year for their employees.

These nudges seem to work at first, but a handful of recent studies show that some aren’t nearly as effective as promised in the long run, while others lead to more damaging results.

The findings highlight the limits to changing people’s financial situation one at a time, but also provide a window into how these policies work better over the long term so people can achieve financial security.

“Nudges are not a panacea,” Jialan Wang, an associate professor of finance at the University of Illinois Urbana-Champaign, told Yahoo Finance. “But that doesn’t mean a cleverly designed nudge can’t help people on average.”

“They can absolutely be a very powerful tool in our toolkit.”

“Potential Adverse Effects”

Wang came to this insight after more than a decade of research into how Americans pay off their credit cards. In a recent study of hers focusing on automatic credit card payment, cardholders were given the option to sign up for automatic payment for the minimum amount or the full balance each month when they opened an account.

Autopay more than doubled the share of cardholders making the minimum payment, Wang found, and reduced charge-offs, critical to helping a person’s credit score and avoiding late fees. The automatic minimum payment was also very sticky – people stuck with this option for 10 months after opening the account rather than paying more.

“It has a convenience feature and keeps you from being late,” she said. “But that leads to another stream of potential negative effects, like accumulating more debt, paying higher interest costs, etc.”

Wang theorized that if more automatic payment options were available, it could prevent people from getting stuck in the minimum payment loop.

If only it were that easy. Just ask Benedict Guttman-Kenney, assistant professor of finance at Rice University.

Read more: The best ways to pay off credit card debt

“A disappointing finding”

Guttman-Kenney and colleagues designed a study in the UK that prompted cardholders to choose an automatic payment option other than the minimum.

When cardholders were presented with automatic payment options, a subset could choose from three: the minimum, a fixed amount, or the entire balance. The other subset could only choose between the fixed amount and the total amount.

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At first, the results looked promising. More people signed up for automatic lump sum payment if they weren’t offered a minimum payment option. But after seven months, it became clear that the fixed-sum crowd wasn’t doing much better.

Their debt remained unchanged because they often chose a fixed amount that was so low – just above the minimum payment – ​​that after months of spending on their card and adding to their balance, their fixed amount didn’t even equaled the minimum wage.

“It was a disappointing finding overall,” Guttman-Kenney said.

Read more: What if I only pay the minimum payment on my credit card?

Exchange money, but not models

Of course, not all financial nudges come back. Some turn out to be meh. Let’s look at retirement savings.

In 2006, Congress passed the Pension Protection Act that encouraged companies to automatically enroll workers in 401(k) plans, an effort billed to boost participation and increase savings.

The legislation followed similar research by James Choi, a professor of finance at the Yale School of Management. In 2002, he and his colleagues published one of the first papers showing that self-enrollment had a large effect on participation rates and 401(k) contribution rates. This year, Choi and his coauthors revised those findings.

“Should the spirit of the scholar try to be the harshest critic of your own work, and really try to see what are the limits of that result?” Choi said.

Choi also wanted to examine self-escalation of contribution rates, which the recently passed Secure 2.0 law requires employers to do starting next year.

What Choi and his colleagues found was that, again, over time, the benefits of auto-enrollment and escalation eroded quite a bit, given that people often changed jobs. When they do, many of them cash out some or all of their 401(k), commonly called a drain.

Turnover also leads to less-than-impressive results for self-escalation, as contribution rate increases typically occur once a year. If a worker leaves after a year and a half, the contribution rate does not increase as much. Once they are with a new employer, the automatic contribution rate is likely to be set at a lower starting rate.

“You’re going to start from the back,” Choi said. “It’s a big part of the story of why self-escalation in the work environment Americans live in (isn’t) having as much of an effect as we originally thought.”

And then there’s the stickiness of self-escalations in general. Previous research put the auto-escalation participation rate at 85 percent, Choi said, but his research found that only 40 percent of workers who were defaulted to auto-escalation actually accepted the first escalation. Many quit, followed by more as time went on.

“Many more people are opting out of the auto-escalation default than previously understood,” he said. – So it was a surprise.

Another recent working paper from Taha Choukhmane, an assistant professor of finance at the MIT Sloan School of Management, and his colleague found that with any additional income earmarked for retirement savings, people reduce their spending—a good result. But they also reduced their net bank savings and reduced their credit card payments — not so well.

And among people with substantial savings in a bank account, an increase in pension contributions did not cause them to reduce spending at all and did not lead to a real increase in total savings.

“Any kind of savings exhortations might not have as much of an effect on high-income earners,” Choukhmane said, “because all they’ll be doing is moving money from one account to another, rather rather than actually changing their spending patterns. .”

“A Piece of That Puzzle”

So why aren’t financial nudges working as intended? It’s not like people want to stay in debt or not save for retirement.

In some cases, the nudges don’t take into account people’s real circumstances.

“If they don’t have the money, they don’t have the money,” said Guttman-Kenney, who found that credit card holders with limited money in the bank chose lower payments. “It’s going to be hard to use these soft approaches to get people to pay more.”

These nudges often work in isolation. They don’t take into account what happens to other aspects of a person’s finances. Again, take auto-registration and escalation.

“The goal cannot be just to prepare for retirement. It has to be retirement preparation that is also financial resilience, having money to pay off your car if it breaks down,” Choukhmane said.

“That’s one of the things I think is interesting about these financial nudges, because it’s probably about one piece of the puzzle, but what is the effect on the rest of the puzzle pieces?”

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Moving forward

That doesn’t mean we should throw the nudges out with the bathwater. But we need to be smarter about designing financial measures and be diligent in testing them, especially over the long term.

Otherwise, consumers will face a bunch of inefficient nudges, leading to what Wang called “nudge overload.”

“They want to settle everything.”

The policy is also expensive to implement, so any new dents shouldn’t go awry.

The US CARD Act of 2009 mandated credit card issuers to show the effects of the minimum payment on monthly billing statements to change payment behavior. But studies later showed not, said Guttman-Kenney, who did a similar study on disclosures in Britain that also was unsuccessful.

“In this case, we were able to find that it didn’t work,” he said of his latest study. “So it didn’t make sense for the regulator to make a policy.”

“That was a good political result – at least.”

Janna Herron is a senior columnist at Yahoo Finance. Follow X @JannaHerron.

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