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02/11/09

Government planning radical overhaul of credit card terms

The government came out with some radical proposals recently to reform the way credit card providers charge us. One big idea was that the minimum amount we're asked to pay each month should be doubled to perhaps 5%. But tucked inside the consultation paper was a reference to the work of a psychologist whose research shows that when we see that minimum payment on our credit card statement, something strange happens in our brain.

There are 63 million credit cards in the UK and borrowing on them just lately has gone up. The minimum repayment required on these cards tends to be between just 2% and 3% which means that if that's all you're paying you're borrowing will be expensive and your borrowing will last a long time. But in proposing that these levels are raised, the government is not just thinking about people scraping by paying just the minimum. People who pay off more than that but less than the full balance each month are also affected by the minimum payment levels. This is according to findings by researchers at Warwick University. They gave about 400 people a mock credit card bill and asked them how much they could afford to pay. Half of the bills said on them that at least 2% of the balance had to be repaid; the other half had no minimum payment requirement.

Neil Stewart, professor of psychology at Warwick University, told BBC Radio 4 Money Box reporter Ruth Alexander why a phenomenon called 'the anchoring effect' could be costing you money.

Neil Stewart, Professor of Psychology, Warwick University commented: "The credit card statement had a balance of 435 and what we found is that when we included minimum payments on the statements, people were tending to repay only 99 but when we left off the minimum payment from the statement people were choosing to pay 175 on average so that's quite a big difference mean repayments rose by 70% when we left minimum payments off the credit card statements."

What was going on here he says is a phenomenon known as 'the anchoring effect'.

Neil Stewart, Professor of Psychology, Warwick University: "Minimum payments on credit card statements are acting as psychological anchors for those people who have decided not to pay the whole amount and not just to pay the minimum. A minimum payment is a small number and it drags down the amount they finally choose to repay."

On the high street this strikes a chord with some people and Citizens Advice Bureau staff says sometimes partial repayers are surprised to find themselves in financial trouble.

Jay Lowe is a manager at the Stoke on Trent branch.

Jay Lowe: "We will often see when they bring their statements in that what they've really done is look at the bottom line figure in terms of what's owing, in terms of the minimum payment and they very rarely look at the statement in more detail to actually see each month this is the payment that's going in but this is the interest that's being charged. We saw somebody recently that owed 8,000 on a credit card and I think the minimum payment was something like about 400. He decided to pay 600 and thought well he's paying an extra 200 a month, that really should be working to clear the debt. He was quite surprised a year later to find that he still owed about 7,000."

But why can't we just get it together and do the maths? Because compound interest confounds the best of us. Interest is applied to the cost of your purchases in the first month and then you're charged interest on that interest as well as your purchases the next month and so on. Meanwhile you're making payments which partly pay off interest and partly pay off your purchases and, of course, you could also still be spending on your card.

Neil Stewart, Professor of Psychology, Warwick University: "Unfortunately our brains just aren't set up to deal with those kinds of calculations. If one thinks back a few thousand years, nobody was even really worrying about money and so evolutionarily we are stuck with I guess stone age brains that simply aren't equipped to deal with modern finance."

Too difficult to do in your head, but online calculators can do the workings out for you. One of them here in front of me from the UK Cards Association shows that on a credit card with interest charged at 16.75% APR where the minimum payment on the balance each month is 2.25% a 1,000 debt would be paid off in a little over 18 years.

Well Ruth is back from surprising local people in the studio now. Ruth, you used that online calculator and I've got my own spreadsheet here - nothing I like better actually than settling down with a good spreadsheet! Now before the programme we were running some ideas through it. What effect does doubling the minimum payment have?

Ruth Alexander: "Well it certainly does reduce the time taken to clear the debt. In that example I gave, a minimum payment of 5% would cut the time taken to repay the debt from 18 years to 7 years."

But the problem is that would mean a much higher payment from the start wouldn't it and many people couldn't afford that, but the spreadsheet showed us another way didn't it?

Ruth Alexander: "Yes, if you kept the minimum payment at 2.25%, the first actual payment you would need to make is 22.79. Now, if you can afford it that month, perhaps you could afford it every month. So if you cut the card up, stopped using it and paid that fixed amount every month the debt would take just 5 and a half years to clear."