The Burden of Household Debt

We propose that holding debt causes worse financial decisions using a novel experimental design where we randomly assign debt. Our design isolates the consequences of holding debt while controlling for potential confounding factors such as initial wealth levels, selection, risk, and time preferences. Our findings show that debt causes behavioral biases detrimental to subjects’ financial payoffs. However, subjects’ strategies are not random but instead debt-biased, consistent with a model of debt aversion. We refer to the financial losses caused by debt as the Burden of Debt and provide evidence that, under certain circumstances, these behavioral biases can compound and lead to substantial losses. Furthermore, we show in additional treatments how these debt-biased behaviors can also deter subjects from borrowing and miss profitable opportunities. Debt is pervasive in the United States. Whether you buy a car or a house, use a credit card, face a surprise medical bill, or attend college, debt is taken as a given for Americans. According to a recent Pew Report, 8 in 10 Americans hold debt, and nearly 70% view debt as necessary even if they prefer not to have it. Recent empirical evidence shows that holding debt is correlated with suboptimal decision-making and worse financial outcomes. Despite this evidence, the mechanisms at play are not clear and under-studied relative to the ubiquity of debt in American life. Clearly, debt should be factored into decision-making as it speaks to commonly understood aspects ∗Mart́ınez-Marquina: Department of Economics, Stanford University, Stanford, CA 94305, (amm15@stanford.edu). Shi: Department of Economics, Stanford University, Stanford, CA 94305, (mikeshi@stanford.edu). We are thankful to Ran Abramitzky, Doug Bernheim, Muriel Niederle, Kirby Nielsen, Luigi Pistaferri, Collin Raymond, Al Roth, Frank Schilbach, Colin Sulivan, Dmitry Taubinsky, and numerous seminar participants for their invaluable comments and feedback. This research is supported by the Stanford Institute of Research in Social Sciences, the Center for Effective Global Action (CEGA), and the Bradley Graduate Fellowship through a grant to the Stanford Institute for Economic Policy Research. The Complex Story of American Debt, Pew (2015). For example, Gathergood et al. (2019) shows how people with several credit cards do not always minimize interests payments. Azmat and Macdonald (2020) finds evidence of sub-optimal house mortgages repayments in Pakistan. 1 like liquidity constraints, wealth effects, or default risk. Yet, could it be that the impact of holding debt goes above and beyond these direct effects? Given the totality of debt among American households, it is essential to understand all of its consequences. In this paper, we show that debt affects decision making through behavioral biases consistent with subjects deriving disutility from holding negative balances. Using a novel experimental design, we are able to show how debt-biased behaviors translate into worse financial outcomes, which we call the Burden of Debt. Even stripped of its direct consequences on credit scores or bankruptcy, debt is more than just negative savings. In a setting with this simplified and stylized version of debt, we find that it still causes significant deviations from typical maximizing behavior. To illustrate how debt can cause biased behavior that negatively impacts financial outcomes consider the following simplified decision where an agent has to allocate some funds. In our experiment a participant has several investment opportunities available, some with substantial upside potential, that she can devote her funds to. Alternatively, she can also use this money to repay her outstanding debt, even if it has lower interest rates. From the perspective of a non-behavioral agent who only focuses on maximizing payoffs, there is no reason to prioritize debt repayments. On the other hand, if the agent is averse to holding debt balances, she might still decide to devote her funds to repaying debt. Our experiments finds causal evidence of these debt-biased behaviors and the financial losses they can cause. In our main treatments, subjects own virtual accounts with different interest rates and balances that generate returns over time. During a week-long experiment, they allocate the returns these accounts generate and make a total of four allocation decisions. To maximize returns, and hence the final payoff from the experiment, subjects should always allocate everything to the highest interest rate account. While accounts differ in their interest rate and initial balances, only interest rates matter when maximizing returns. In our first treatment, subjects can only allocate points to accounts that start with positive balances, providing a baseline for what fraction of participants follows the return-maximizing strategy in the absence of debt. Our main treatment variation changes the accounts’ initial balances, such that two of them now have a negative starting balance. These negative balances are such that subjects can fully repay them during the experiment. We keep the available interest rates constant across these two treatments, and thus the return-maximizing action remains the same regardless of the presence of debt. We quantify deviations from the return-maximizing strategy between treatments to assess the Burden of Debt. We find that subjects with debt are three times less likely to maximize returns across all decisions compared to subjects in our baseline group. This difference is mainly driven by 38 percent of subjects who fully repay at least one outstanding negative balance and miss the opportunity of higher returns from other 2 accounts. Thus subjects with negative balances focus on repaying their outstanding debt at the expense of lower monetary payoffs. Next, we test if the prevalence of this strategy depends on the size, and not just the sign, of the debt balances by running an additional treatment where we increase the initial negative balances. We find a heterogeneous response: more subjects maximize total returns, but those who focus on repaying debt end up with larger financial losses. Altogether, our results indicate that many subjects are attempting to repay their debt as quickly as possible, which in our experimental context is financially sub-optimal. In additional treatments, we increase subjects’ agency by allowing them to redistribute balances across accounts. If redistribution is also debt-biased, we can see if the Burden of Debt compounds and causes larger financial losses. This additional option could benefit subjects as it allows them to further increase their returns by consolidating towards the highest interest account. When subjects can redistribute towards debt accounts, we find that 34 percent of participants partially exhaust their high interest account towards a low interest one, dampening their returns. In contrast, when redistribution towards debt accounts is not possible, only 14 percent of the subjects follow such strategy, and twice as many subjects now increase their payoffs by redistributing towards the highest interest account. By running these additional treatments, we show that redistribution decisions, and not just allocation decisions, are biased towards early debt repayments, which we take as further evidence of the Burden of Debt and its negative financial consequences. After finding that debt distorts allocation and redistribution decisions, we then explore if the Burden of Debt also manifests in borrowing decisions. In two additional treatments, we introduce borrowing opportunities and vary whether they incur debt or not. These borrowing opportunities allow subjects to further benefit from the highest interest rate account. Nevertheless, only 34 percent of subjects borrow the maximum amount when borrowing involves debt compared to 63 percent when borrowing does not incur debt. This stark difference persists even among subjects who otherwise maximize returns. Therefore, we show that debt also hinders borrowing behavior and prevents subjects from undertaking profitable investment opportunities. While debt is pervasive, our understanding of how holding debt affects decisions is still limited. Previous models in the behavioral literature focus on understanding borrowing decisions as opposed to the behaviors of those already in debt. For example present bias (Laibson, 1997; O’Donoghue and Rabin, 1999; Laibson et al., 2007; Meier and Sprenger, 2010; Ikeda and Kang, 2011) or self-control motives (Cadena and Keys, 2013; Allcott et al., 2020) could explain excessive borrowing but they do not imply that debt will cause financial mistakes after it is acquired. Using a model of prospective Other potential drivers of borrowing decisions present in the literature are lack of information (Bertrand and Morse, 2011; Burke et al., 2016) and debt aversion (Callender and Jackson, 2005; Caetano et al., 2011; Meissner, 2016). 3 accounting, Prelec and Loewenstein (1998) rationalizes aversion to financing purchases through credit–i.e., debt aversion–because of the “pain of payment”. Our findings, in line with Prelec and Loewenstein (1998), suggest that subjects perceive negative balances differently and act upon these perceptions, consistent with debt aversion. Previous work in the experimental and psychology literature provides evidence of subjects struggling to make debt repayment decisions that minimize accrued interest. Experimental subjects exhibit a preference for closing out small debt accounts (Amar et al., 2011; Besharat et al., 2014) and concentrating repayments as opposed to spreading them out (Kettle et al., 2016). Furthermore, Besharat et al. (2015) shows how the timing and the type of debt, hedonic vs. utilitarian, can amplify these effects. In recent work, Ozyilmaz and Zhang (2019) documents how subjects struggle to minimize interest payments in an all-debt environment compared to a non-debt