We all know people who see their lives upended because of too much borrowing. But how about those who don’t borrow enough and miss out on opportunities? Alejandro Martinez-Marquina investigated how people behave when faced with the opportunity to borrow now to increase their savings later. He found that some people disliked debt so much that they were willing to give up the chance of doubling their savings.
Imagine a prospective student who just got accepted into their dream school. After the initial moments of happiness, they soon realise they did not get financial aid, so they might need a student loan to attend. At this point, many will argue that this student should borrow if the degree will allow them to get a good-paying job and easily repay their loan. Simple enough.
However, we live in a world where debt is ubiquitous. Many of us have heard plenty of horror stories about students unable to repay their loans or people losing their houses due to falling behind on their mortgages. Let us not even talk about credit cards and their hefty interest rates. It might not be surprising, then, that some people develop an aversion to any debt. While this might be beneficial to keep us away from “bad debt” like credit cards, the problem comes when this fear of debt prevents us from making worthwhile investments, like in the case of our prospective students.
In the academic literature, we have many examples of people borrowing too much, often with credit cards or payday loans, but very few on the other side: people not borrowing enough. This is the focus of my research.
Optimal repayment decisions
First, I started by considering whether people already in debt focus too much on repaying their debts while neglecting to build up savings. I presented individuals with a risk-free investment decision in an online study with 638 US participants. They received $5, which they could “invest” across four virtual accounts, each with a different interest rate. These accounts generated considerable returns over a week, sometimes allowing them to more than double their investments.
Some accounts had a positive balance, generating a positive return (savings accounts). In contrast, others had a negative balance that generated negative returns (debt accounts). The main decision participants faced was how to invest $5 across the accounts. For one group of participants, all four available accounts were savings accounts, while in the other group, participants had two savings and two debt accounts.
To maximise returns, participants should have always invested all $5 in the account with the highest interest rate (in this study, this was always a savings account) while disregarding the balances and any debt. Instead, one out of three participants focused on repaying their outstanding debt, missing out on higher returns from savings. Despite correctly identifying which account would provide the greatest return, 25 per cent of participants only maximised returns after repaying their outstanding debt. When asked to describe their strategy in their own words, participants reported wanting to eliminate all debt before maximising returns.
Even in a setting with a simplified version of debt, stripped of all its consequences, I still found that some people disliked debt so much that they were willing to give up the chance of doubling their savings.
Borrowing for a profitable investment
For the second part of the study, I considered how people become indebted in the first place. Participants still had four possible investments to undertake, all without risks. Their choice was whether they were willing to borrow from a low-interest account to take even greater advantage of the investments. Basically, think about borrowing at 5 percent interest to gain a 20 percent return. The key difference now is that in the control group, the account you borrowed from had some funds already, so withdrawals did not cause debt. In the debt group, the borrowing account had no money. Hence, any withdrawals led to debt. While this difference might seem subtle to some, it caused a drastic difference in borrowing behaviour.
When withdrawals cause indebtedness, participants are half as likely to borrow for investment. In the control group, almost 70 per cent of participants borrowed the maximum amount, with nearly everyone using the extra funds to obtain the highest possible return. In contrast, less than 30 per cent of participants did the same in the debt group. Once again, I found a widespread reluctance to borrow, and people missed out on profitable investments because of it.
Lessons and policy implications
The goal of this simple study is to show that while, in some instances, we worry that people might borrow too much, in others, we should worry about the opposite, that they do not borrow enough. How do we reconcile both things?
Using a simple calibration exercise, I showed that in settings where people borrow to consume something immediately, for example, using their credit card for a fancy dinner, they are more likely to ignore the cost of borrowing, as those are paid far in the future. In other words, many people are impatient and consume today without thinking much about the future. The opposite happens in other situations, particularly those where you pay now for a high return far in the future. Consider, for example, borrowing today for college tuition so you can get a better job when you graduate. These are precisely the cases where the reluctance to borrow will appear. Many are unwilling to borrow since you pay now for something that will not give you any benefits until much later.
The lesson here is that access to credit may not be enough to encourage the uptake of good investments, especially among debt-averse individuals. Other funding sources, such as grants, might prove more effective. In addition, debt forgiveness programs or income-based repayment schemes might allow individuals to simultaneously pay down their debt while also making investments that offer a high return.
- This blog post is based on The Opportunity Cost of Debt Aversion, with Mike Shi, in American Economic Review.
- The post represents the views of its author(s), not the position of the institutions where they work, LSE Business Review or the London School of Economics and Political Science.
- Featured image provided by Shutterstock.
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