Suppose you have two loans. The first is a student loan of US$40,000 with an interest rate of 6 per cent, and the second is a credit-card balance of $12,000 with an interest rate of 11 per cent. You find that at the end of each month, you have about $1,000 left over, and you want to use it to pay down the principal on your debts. That’s sensible. So how much do you put toward each loan?
The rational thing to do would be to pay off the 11 per cent loan before even starting to repay the 6 per cent loan. This is not a matter of taste, it is just simple maths. After all, every dollar you spend paying down the credit card would otherwise be growing at 11 per cent a year, which is faster than 6 per cent a year. If you can, always pay down your debts starting with the highest interest rate.
But that is not what most people do. According to new research by economists John Gathergood, Neale Mahoney, Neil Stewart and Joerg Weber, they instead tend to split their repayments between higher- and lower-interest debt. Gathergood, and his fellow researchers, looked at consumers in the United Kingdom who had two credit cards, who made their minimum payments on time, and who carried balances on both cards - in other words, people who had enough money to pay down some of their debt at the end of each month.
The difference in interest rates between the two cards tended to be large - 6.3 percentage points on average. This meant there’s a big incentive to pay down the higher-interest one first. But the authors found that on average, after making their minimum payments, borrowers allocated only 51.5 per cent of their extra payments to the higher-interest card. Only 10 per cent of borrowers devoted all of their payment toward eliminating the more expensive debt.
Instead, the researchers found that many borrowers tended to allocate their extra payments in proportion to how big the balances are on each credit card - if 70 per cent of their debt is on the low-interest card and 30 per cent on the high-interest one, they sent 70 per cent of their repayment cash to the former and 30 per cent to the latter. This behaviour is known as balance matching.
There's really no good way to spin this behaviour as rational. It could be that larger balances create more anxiety in people's minds, causing them to throw more money toward the bigger debt. Or people could be financially unsophisticated, and simply not realise they are leaving money on the table. Either way, the result is that borrowers end up poorer.
This brings us to the topic of the Consumer Financial Protection Bureau in the United States.
Created in 2010 as part of the Dodd-Frank financial reform, the CFPB is supposed to protect financial consumers from predatory lending practices and unsafe financial products. As Elizabeth Warren, now a senator from Massachusetts, put it in 2007: "It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street. ... Why are consumers safe when they purchase tangible consumer products … but when they sign up for routine financial products like mortgages and credit cards they are left at the mercy of their creditors?"
Now, like many other parts of the government, the CFPB is under siege by the administration of president Donald Trump. Mr Trump's method of attack follows a familiar pattern - instead of abolishing the agency, he simply gave the CFPB an interim director who despises the agency's intended mission and purpose. That director is Mick Mulvaney, who has called the agency he now captains "a joke…in a sick, sad way", and "an awful example of a bureaucracy gone wrong". Under Mr Mulvaney, the agency has modified its mission statement to include financial deregulation. It has also implemented a freeze on hiring, rule-making and data collection.
This is a bad time to divert the CFPB from its original mission of protecting consumers. Though households are slightly less indebted than before the financial crisis, they still owe an amount equal to 80 per cent of gross domestic product:
Meanwhile, credit-card debt continues to climb. And although credit-card interest rates have come down, they still average about 13 percent.
Meanwhile, student-loan debt is at record highs, reducing many households’ ability to repay their credit cards, especially if they follow the suboptimal repayment behaviour documented by the researchers mentioned above.
If anything, the latest research - and that of other economists shows that the CFPB’s mission needs to extend beyond merely protecting consumers from the kind of predatory lending practices that were common before the crisis.
Financial literacy in the US is extremely low. Let's hope the public-school curriculum can be modified to teach future generations how to manage money, but in the meantime, the CFPB is the only institution in the country that can help people better understand finance.
With leadership like Mr Mulvaney’s, it seems highly unlikely the agency will take on such a role. Although economists are finding more and more ways that consumers need more financial guidance, the government is moving in the opposite direction.
Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University