The Psychology of Debt

Personal debt problems can arise from numerous circumstances, including health crises, theft, property damage, or loss of income. These situations are beyond the debtor’s control and arise through no fault of his or her own. But in other cases, it’s our own purchasing decisions that contribute to amassing a burdensome amount of debt, and it’s entirely avoidable. So why do so many people make this “unforced error” in their financial decision-making?

To better grasp this self-defeating behavior, it helps to understand the psychology of debt.

Why We Accrue Debt

According to Psychology Today, experimental research shows that people tend to spend more when making purchases with credit cards versus cash. One study revealed that people were willing to spend $175 for supplies to throw a party when paying with a credit card, but only $145 when using cash.

One potential reason for this spending difference is the degree of transparency of the payment method — the more transparent, the less we tend to spend. Cash is the most transparent method and therefore is associated with reduced spending, while credit cards and gift cards are less transparent and tend to be associated with greater spending. Other explanations for increased spending when using credit cards relate to the increased delay from the time of a credit purchase to when the bill is due and the fact that individual purchases are less recognizable on a lump sum bill as both reducing the “pain of paying.”

There have even been studies suggesting that the mere presence of credit card branding (i.e. logos) may prime buyers to want to spend more. This could occur much in the same way that the smell of bacon sizzling on the stove can stimulate the appetite. In effect, we become conditioned to associate credit cards with the desire to spend.

The Psychology of Debt Reduction

The avalanche method and the snowball method are two popular debt reduction strategies. According to the avalanche method, debts are ranked in terms of their interest rates from highest to lowest. You start by paying off the debt with the highest interest rate and work your way down the list to the debt with the lowest interest rate. This approach has the potential to save the greatest amount of money over time, yet can be harder psychologically to stick with.

The snowball method, on the other hand, has debtors start by paying off their smallest balance first and gradually working their way up to the largest balance. While this approach will not save the most money, it can often build psychological momentum because you pay off individual balances more quickly and rack up more frequent “wins.” At the end of the day, the debt repayment plan that works best is always the one you’re most likely to stick with over the long haul. And that means it isn’t always all about the numbers — psychology and motivation can also play a big part.

Debt and Stress

Money can be a leading cause of psychological and financial stress for many American families. Among households that comprise the bottom 60% of income (earners with take-home pay of $65,000 or less), about one-third are “stressed,” meaning they have financial obligations in excess of 30% of their income and not enough emergency cash on hand to cover six months of expenses. Among households earning $23,000 or less, nearly half were in this position.

This type of financial stress often leads to psychological stress and can ultimately have negative impacts on physical health. According to WebMD, one study of 8,400 young adults found that a high degree of debt relative to available assets was associated with higher levels of stress and depression, worse self-reported overall health and higher diastolic blood pressure.

Dealing with Debt Distress

There are a number of things you can do to mitigate the negative psychological impact of debt. First and foremost, try to avoid accruing significant debt or adding to the amount of debt you already have if possible. Use cash more often and avoid recreational shopping and the temptation it can bring. Second, work with your financial advisor to come up with a debt reduction plan you can stick with. Simply knowing you have a plan and are working to correct the situation over time can be helpful. Finally, recognize whether your debt is causing you significant psychological distress. Understand that many people feel just like you, and seek out social support and professional help, if necessary, to better manage and cope with this all-too-common stressor.

Sources:

https://www.psychologytoday.com/intl/blog/the-science-behind-behavior/20...

https://www.psychologytoday.com/us/blog/retail-therapy/201306/why-we-ove...

https://www.usatoday.com/story/money/2018/04/18/financial-stress-higher-...

https://www.webmd.com/balance/features/the-debt-stress-connection#1