5.3 Hyperbolic Discounting and Debt Behavior
5.3.2 Swayed by a Teaser Rate But End Up Paying a Higher
Another example that demonstrates hyperbolic credit card usage deals with choices relating to introductory offers. Credit card companies develop a variety of offers, such as waiving the membership fee for a certain period of time at the beginning and issuing additional reward points, in order to promote credit card use. To attract customers, credit cards in the United States usually have a certain length of introductory period with a “teaser rate” that is lower than the market rate. Although an interest rate that is comparable to the market rate for usual credit card loans (probably 10 % or higher), called the “post-introductory rate,” will be applied after the introductory period, consumers could benefit from the offer by paying off the credit card debt before the end of the introductory period.
It is known, however, that many credit card users end up actually paying a higher interest rate because they cannot stop borrowing money after the introductory period. This phenomenon could be explained as an effect of hyperbolic discounting.
Let me explain in greater detail. For a consumer who is thinking about applying for a new credit card, the question is about what type of introductory offer to look for in a credit card. Assuming that the interest rates following the introductory period (post-introductory rate) are the same, one would want to choose a credit card that has a long introductory period and a low interest rate. However, since there is usually a trade-off between the length of introductory period and the interest rate, one would be torn between choosing a credit card that offers a low interest rate for a long introductory period versus a high interest rate for a short introductory period.
For example, many credit card users prefer a card that offers a low interest rate, even if the introductory period is short (like 4.9 % for 6 months) to a card that offers a high interest rate for a long introductory period (like 7.9 % for 12 months).
Experienced users could apply for a series of multiple credit cards in order to take advantage of low interest rates under introductory periods over quite a long period;
they could apply for Card B and use its introductory period as the introductory period of Card A ends, for example. However, tracking credit card use following the opening of an account actually reveals a paradoxical situation: those who chose a lower interest rate were actually paying a higher interest rate than those who chose a longer introductory period. This type of situation occurs because credit card users
continue to borrow money without reducing their debt balance and wind up paying the post-introductory rate of more than 10 %.
It was two researchers, Haiyan Shui and Lawrence Ausubel, who demonstrated this fact by using data on solicitations that a major credit card company sent to 600,000 credit card users and their subsequent credit card usage (Shui and Ausubel 2005). The credit card company created six credit cards with different introductory offers, A through F, and sent a solicitation e-mail to 100,000 credit card users per offer. The terms for each offer are as shown in the second and third columns of Table5.1.
The introductory period of 6 months and the interest rate of 4.9 % were applied to Offer A, while a much longer introductory period of 12 months and a relatively high interest rate of 7.9 % were applied to Offer F. The post-introductory rate was 16 % across the board (see Fig.5.2).
Now, the percentage of customers who actually applied for a new credit card and successfully opened an account in response to the solicitation e-mail they received
Table 5.1 Paying a higher effective interest after being swayed by a teaser rate
Offer
Terms for the introductory offer
Interest rate after the introductory period (post- introductory rate) (%)
Closing rate on the offer (%)
Ex-post effective interest rate (%) Duration Interest (%)
A 6 months 4.9 16 1.07 10.23
B 6 months 5.9 16 0.90 11.35
C 6 months 6.9 16 0.69 11.86
D 6 months 7.9 16 0.64 12.35
E 9 months 6.9 16 0.99 9.23
F 12 months 7.9 16 0.94 8.32
Note: Prepared by the author, based on Shui and Ausubel (2005) Interest rate
Period 4.9%
7.9%
16%
6-month introductory period of Offer A
12-month introductory period of Offer F Introductory rate of Offer A
Introductory rate of Offer F Post-introductory rate
Fig. 5.2 Terms for introductory offers
was less than 1 %. The closing rate of each offer is as shown in the fifth column of Table5.1. In comparing these closing rates, we can see that consumers generally choose Offer A, which provides a low interest rate for a short period of time (1.07 % closing rate), over Offers E and F, which provide a high interest rate for a long period of time (0.99 % and 0.94 % closing rates, respectively). This choice is reasonable if they were only thinking of a loan limited to 6 months.
However, when credit card use following the opening of the account was examined, it was found that users continued to borrow money even after the introductory period ended. Therefore, the effective interest rate calculated based on the amount of interest paid after the fact was higher under Offer A (10.23 %) than under Offers E and F (9.23 % and 8.32 %, respectively), which had higher teaser rates.
The above facts indicate that the behavior of credit card users is irrational in two respects. The first is that they let themselves choose Offer A with a low teaser rate, even though the effective interest rate would be higher. Shui and Ausubel call this phenomenon “rank reversal.”
The second is the fact that they are borrowing money under a high post- introductory rate by using the same credit card to continue to borrow money after the introductory period, even though they could have applied for a new credit card to take advantage of a teaser rate under a new introductory period. A rational credit card user would have obtained a series of new cards to take advantage of teaser rates over an extended period of time. However, it has been reported that more than 35 % of them paid high interest rates without taking such rational actions.
Such baffling behavior can be effectively explained when we suppose that those credit card users are hyperbolic, particularly when we assume them naı¨ve decision- makers who cannot correctly predict their high propensity to consume in the future.
Since they underpredict the debt tendency of their future selves, they chose an introductory period with a lower interest rate at the time of signing up, intending to borrow money only during the introductory period. However, because their dis- count rate suddenly increases when the introductory period ends, they continue to borrow money even at the higher post-introductory rate. We can explain this as how rank reversal occurs.
Nonetheless, Shui and Ausubel argue that rank reversal can be seen even when credit card users possess the sophistication to correctly predict their own self- control problems in the future. The explanation for this is that they are using the high interest rate in the future as a commitment device. It presumes that credit card users with self-control problems chose Offer A as a commitment device in order to make the terms of a future loan as unattractive as possible; they know they will end up with excessive debt in the future if they were left to their own devices. That is, they chose Offer A in order to shorten the opportunity to borrow because they are thinking at the time of signing up for the credit card that, if they choose Offer F with a long introductory period, it would allow them to use the teaser rate for longer than Offer A and lead them to borrow excessively.
However, in such a case, the debt should be smaller when the introductory period ends. In reality, however, it has been reported that many credit card users continue
to borrow at the same pace afterwards and thus maintain a certain level of debt. In view of these things, it is more logical to think of rank reversal as a self-destructive choice made by naı¨ve consumers who, unaware of their own self-control problems, were swayed by the teaser rate.
Irrational behavior wherein one continues to borrow by using the same credit card probably also involves status quo bias. Because behaviors and choices that alter the current condition incur a psychological burden, a bias that tries to maintain the current condition, even if only for a little, would affect our choices. Called status quo bias, this tendency becomes particularly evident among hyperbolic individuals who overrate immediate pain. It is probably reasonable to think that hyperbolic credit card users avoid the pain of applying for a new credit card upon the expiration of the introductory period of the existing card and continue to borrow money by using the same credit card.