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10/10/08

Customer fixation on minimum payments drives up credit card bills

New research by the University of Warwick suggests that for people who do not pay their credit card bill in full each month, the amount of repayment they actually make is directly related to the required minimum monthly payment. The research found that the lower the required minimum payment the lower the actual payment made.

Researcher Dr Neil Stewart, believes the mere presence of a minimum payment is enough to reduce the actual amount many people choose to pay on their bills, meaning they will pay more in interest payments.

The research focuses on the psychological phenomenon of “anchoring” in which arbitrary and irrelevant numbers bias people's judgements. The research reveals that anchoring affects the way people repay their credit card bills. The suggested minimum payment on the credit card statement acts as an anchor and lowers the actual repayments people choose to make.

Dr Stewart said: “These results should be of real concern to credit card companies. Virtually all credit card statements include minimum payments. But this consumer safeguard has an unexpected negative consequence: Minimum payments distort the behaviour of many customers in a way that increases interest charges and increases the duration of their debt. Those paying off the balance in full each month seem to be immune, but anyone repaying only part of the debt is at risk - not just those making only the minimum payment."

To examine whether minimum payments actually cause lower repayments, Dr Stewart conducted an experiment where some people received normal statements and others received statements with no minimum payment information. The experiment recruited 413 volunteers (54% female 46% male, with an age range of 18-68). Half were given mock credit card bills for £435.76 with a suggested minimum payment, and half the same level bill but without a suggested minimum payment. All were asked to imagine that the bill had arrived that morning and to decide, thinking about their current finances, how much they could afford to repay.

The results found that the minimum payment had almost no affect on those who choose to pay their bills in full. 55% of those with minimum payments on their statement paid the bill in full. The same proportion of those without minimum payments on their statement paid the bill in full. However, the presence of a minimum payment had a large effect on those who chose to pay less than the full amount. When a suggested minimum payment was given the average repayment made by those not repaying the full amount plummeted 70% to just £99 on average (23% of the balance). Those not given any required minimum payment paid an average of £175 – 40% of the balance.

What appears to be customer fixation with the minimum payment will inevitably lead to higher credit card bills, as the customer will be paying higher interest charges.

Dr Stewart has calculated that, based on these data, minimum payment information could double the interest charged over the lifetime of the debt. Dr Stewart explained, "It is hard to estimate the cost of minimum payment information. For a particular individual the effect depends on their level of debt and on their repayments, and could be much larger or could be much smaller."Dr Stewart said: "Although minimum payments are a good idea in principle - because they protect the small number of people who would otherwise make no repayment at all - minimum payments do seem to have an adverse effect on those who repay only part of the bill, even those repaying a large fraction of the bill. From the psychology of anchoring, we know that people are less susceptible to its effects when they have greater knowledge. So helping people understand how much different possible repayments will cost them in the long term should help protect them from anchoring on minimum payments."

The publication of the research comes at a time when some credit card companies are changing their miniumum credit card payment rules.

HBOS has announced that customers now have to pay either 1% of the outstanding balance, or monthly interest charges plus insurance premiums, late payment charges (if any) and £5, whichever is the greater.

Previously its four million customers were required to pay a simple minimum of 2% of any outstanding balance over £5. But HBOS argues this disadvantaged those who had used their cards to withdraw cash or gamble online and thereby incurred a much higher interest rate (23.9 per cent APR, compared to 15.9 per cent APR for purchases on its All in One card).

Alex Barnett, a spokesman for the banking group said 'If they were paying the minimum, all their monthly payment might go to paying off the charges, rather than reducing the principal,'.

Although the new rules halve the amount customers who do not incur higher charges and interest will have to pay, Barnett says: 'This is a fairer way of calculating the minimum payment. It ensures that an element of the outstanding balance is always repaid. This is responsible lending.' He adds that, typically, only those on very low APRs have the option of paying the 1 per cent minimum monthly repayment.

The new charging structure could encourage some of those who take out 0% balance-transfer offers to reduce their monthly repayment, enabling HBOS to make more money out of them when the interest rate reverts to its normal levels. However, Barnett adds that HBOS recommends customers pay back more than the minimum each month: 'Our summary boxes clearly state that paying just the minimum means it will take longer to pay off their balance. Under the new rules, customers who typically have higher APR transactions, such as those who make cash withdrawals, will actually pay off their debts in a shorter period of time.'

MBNA, which has seven million customers and provides cards for Virgin, Alliance & Leicester, Manchester United and several charities, as well as those under its own brand name, has also recently changed its charging rules.

Paul Lawler, a spokesman for the bank, says that MBNA used to require customers to pay 3% of the outstanding balance, or interest plus £5 and any fees or charges incurred, but adds: 'We found that hardly anyone was paying the percentage, so we have switched to the greater of £25, or interest plus £5 and fees and charges incurred.' Provided a customer does not incur fees or charges, the minimum of £25 works out lower than 3% for balances of £833 or more, at least until monthly interest charges themselves start to exceed £20.