The behavioral barriers to paying off debt

Paying off debt is no easy feat, even for the most disciplined among us. It requires careful planning, forward vision, and financial endurance over long periods of time. Sadly, mishandling debt is becoming an increasingly common reality for many Americans, who have experienced an explosion in household debt over the past three decades. Not surprisingly, low-income families have been hit the hardest, with a quarter of these households spending 40 percent of their take-home pay on debt.

Yet for those whose incomes barely cover basic household needs, how does one pay off debt? Michael Barr, a University of Michigan Law School professor (and former U.S. Assistant Treasury Secretary for Financial Institutions) is seeking to better understand the debt management strategies of low- and moderate-income earners. Barr received one of Equitable Growth’s inaugural grants to identify the behavioral barriers among these households to reducing debt. He plans to use that information to design policies and interventions that help households in similar straits to manage their debt more efficiently.

Barr believes that many of the existing consumer financial products and services do not take into account the conditions of low-income households.  The lives of the poor are unstable, frequently defined by inflexible schedules, low-paying jobs, and meager savings for an emergency. Attempts to reduce the debt loads of these borrowers are further impeded by the fact that people are, well, human. Classical economic theory is based on the premise that we are rational beings, but in reality it is almost impossible for the majority of us to make the most economically optimal decisions, day after day.

For many people, those occasional “irrational” financial lapses (grabbing take-out when you could cook at home, for example) are relatively harmless. But for those with low incomes, such decisions can be a major impediment to achieving financial security. And, as Barr points out, the financial services intended to make savings easier are usually underutilized or unavailable to the poor.

Instead, many of these families “juggle” their debts. They pay the minimum amount necessary to avoid collection agencies or utility shut offs, without making progress toward actually paying the debts off. Furthermore, a study by Laura Tach of Cornell University and Sara Sternberg Green of Harvard University finds that many families view the idea of needing help—especially in the form of government assistance—as shameful.

Instead, these borrowers try to manage their debt in private in order to project a self-sufficient social identity, sometimes cutting themselves off from helpful resources and making their financial woes worse. Tach and Green find that once they framed debt payments in terms of achieving this identity, or as a means to upward mobility, many families were inspired to pay off their debt at all costs, even forgoing basic necessities to do so.

More research needs to be done to understand the full interaction between financial services and how low- and moderate-income families think about and pay off their debt. Barr’s pursuit of making consumer services more sensitive to the nuances of human behavior can help improve the financial stability of low- and moderate-income families, and the economy as a whole.