Balance forgiveness programs more effective at reducing credit card debt than lowering monthly minim

October 02, 2017

PRINCETON, N.J. -- According to data recently released by the Federal Reserve, the amount of outstanding debt that Americans hold -- often in the form of credit card debt -- hit a new high at $1.021 trillion in June 2017, topping the previous record set in April 2008 just before the financial crisis.

Even when credit card debt seems manageable, some consumers may only be one emergency away from personal financial crisis. Approximately 25 percent of U.S. households report being unable to come up with $2,000 to cover an unexpected emergency such as job loss or medical issues.

Given these statistics, conventional wisdom among policymakers and borrowers is that a lack of liquidity --how much cash one can currently access -- is the most important driver of financial distress. A common strategy for helping borrowers manage their credit card debt has been for banks to decrease minimum monthly payments so that borrowers have more cash on hand each month after payments are made.

New research from Princeton University, however, counters this widespread view and suggests that relief targeting longer-term debt, such as the partial forgiveness of account balances, has a greater effect on a borrower's overall financial health than strategies concentrating on short-term liquidity issues.

Working with Money Management International, the largest nonprofit credit counseling agency in the United States, researchers Will Dobbie, assistant professor of economics and public affairs at Princeton University's Woodrow Wilson School of Public and International Affairs, and Jae Song of the U.S. Social Security Administration, matched tax, bankruptcy and credit records with data from a large randomized field experiment of various debt relief strategies offered within a credit card repayment program.

Participants in the trial, who were referred to a debt management plan due to their perceived likelihood of default without the program, were offered different strategies to manage their debt. Some focused more on debt write-downs, or partial forgiveness of balances to address long-term debt, while others focused more on reducing minimum payments to address liquidity concerns.

Borrowers in one group were offered the same repayment program that had been offered to all borrowers prior to the trial. Others were offered a more generous repayment program with a greater set of options. Each of the credit card issuers participating in the randomized trial offered a different combination of write-downs and minimum payment reductions. Individual borrowers were able to decide how much to borrow from each of the card issuers, in effect deciding how to balance short- and long-run relief.

Even though the terms for longer-term relief were such that the debt forgiveness would not occur until three to five years after the experiment, the researchers found that concentrating on longer-term balances significantly improved both financial and labor market outcomes for borrowers. Borrowers who took advantage of debt write-downs were 11.89 percent more likely to finish the repayment program, 9.36 percent less likely to file for bankruptcy, and 3.19 percent less likely to face a debt collector. Similarly, this group's likelihood of being employed increased by 2.12 percent. The estimated effects of the debt write-downs for credit scores, earnings, and 401(k) savings contributions were smaller but still found to be significant.

In contrast, the study found no positive effects for borrowers taking greater advantage of minimum debt payment reductions. Their likelihood of filing for bankruptcy and going into collection increased by 6.76 percent and 3.56 percent, respectively. There also were no discernable positive effects on credit scores, employment, earnings, or 401(k) contributions for borrowers in this group.

With the reduction in minimum monthly payments, the number of months a borrower remains in the repayment program increases because the overall debt doesn't decrease; rather the payments are spread over a longer time period with interest accruing each month on the balance. The study suggests that this is a major reason why these short-term liquidity fixes did not improve ultimate debt pay-down and actually increased the probability of debt collections or filing for bankruptcy. During the four additional months in the program, the borrower could be hit by a shock -- such as a medical emergency or job loss -- that could lead to default.

Dobbie said these findings have important implications for financial policymakers when considering changes to current banking regulations.

"Our study results suggest that there may be substantial benefits of considering changes to current banking regulations that would allow greater flexibility in debt forgiveness plans," Dobbie said.
-end-
The working paper, "Targeted Debt Relief and the Origins of Financial Distress: Experimental Evidence from Distressed Credit Card Borrowers," by Will Dobbie and Jae Song, is part of the National Bureau of Economic Research's NBER Working Paper Series. Visit http://www.nber.org/papers/w23545 to read the paper.

Princeton University, Woodrow Wilson School of Public and International Affairs

Related Bankruptcy Articles from Brightsurf:

One in two Americans fear a major health event could lead to bankruptcy
As the COVID-19 pandemic continues to put lives and livelihoods at risk, 1 in 2 Americans say they fear a major health event could lead them to file for bankruptcy, marking a 5% increase since 2019.

Partnerships with bankrupt companies could be double-edged sword for investors
New research from the Indiana University Kelley School of Business found that when a company is in bankruptcy, its advertising and research and development investments can cut both ways.

New study examines impact of major life events on wellbeing
Researchers examined the effect of 18 major life events on wellbeing.

New economic model may prevent stops of capital flow
The 'sudden stops of capital flows' model enables the adequacy of macroeconomic policies, one year in advance, against the risk of a sudden contraction of international. investments.

Financial pressure makes CFOs less likely to blow the whistle
A recent study finds that corporate financial managers do a great job of detecting signs of potential fraud, but are less likely to voice these concerns externally when their company is under pressure to meet a financial target.

Comparing cancer costs is challenging, despite new price transparency rules
A federal rule that requires hospitals to publicly list standard charges for services and procedures -- the foundation of price transparency -- does not facilitate comparison shopping for a standard radiation treatment for prostate cancer at National Cancer Institute-designated cancer centers, according to a study led by University of North Carolina Lineberger Comprehensive Cancer Center researchers.

American cancer survivors face substantial financial hardship and financial sacrifices
American cancer survivors, particularly those 64 years or younger, faced substantial medical financial hardship and sacrifices in spending, savings, or living situation, according to data from a survey.

UBC study finds siblings of problem gamblers also impulsive, prone to risk-taking
Biological siblings of people with gambling disorder also display markers of increased impulsivity and risk-taking, according to a new UBC psychology study.

Inequality gap grew before the Great Recession and after, study finds
The Great Recession hit Americans across the socioeconomic spectrum, but the drivers behind these socioeconomic divides were mounting before the decline even hit, according to a paper published in PLOS ONE.

Experts discover historic roots of Medicare for All, public option and free-market proposals
As political leaders debate the future of the US health care system, a pair of health financing experts discovered that all of the current proposals -- from Medicare for All to 'repeal and replace' -- have been circulating in various forms since the 1940s.

Read More: Bankruptcy News and Bankruptcy Current Events
Brightsurf.com is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.