Science of Spending

Impulse buying, ever-increasing credit card balances and other irrational financial behaviours aren’t just driven by greed and short-sightedness. Jonah Lehrer examines the psychology and brain chemistry behind our escalating levels of debt.

Herman Palmer is a financial counsellor in the Bronx, in New York City. He has spent the past nine years working for Greenpath, a non-profit organisation that helps people deal with their debt problems. His small office is a spare affair, with a desk so clean that it looks uninhabited. The only thing on the desk is a large glass jar, but it’s not stuffed with jelly beans or miniature candy bars. Instead, it’s filled with the cut-up shards of hundreds of credit cards. The plastic pieces make for a pretty collage – the iridescent security stickers glittering in the light – but Palmer doesn’t keep the jar around for aesthetic reasons.

"I use it as a kind of shock treatment," he says. 2I’ll ask a client for their cards and just cut them up right in front of them. And then I just add the cards to the jar. I want people to see that they are not alone, that so many people have the exact same problem." That problem is credit card debt.

For the most part, Palmer’s clients are from the neighbourhood, a working-class area of terraced houses that were once single-family dwellings but are now apartment buildings, with numerous buzzers and postboxes grafted onto the front door. Many of the homes have fallen into a state of disrepair, with peeling siding and graffiti that has yet to be painted over. There aren’t any grocery stores nearby, but there are plenty of corner shops and off-licences. A little farther down the block, there are two pawnshops and three cheque-cashing operations. Every few minutes, another number six subway train rumbles directly overhead, shrieking to a stop near the Greenpath office. It’s the last stop on the line.

Most of the people who come to see Palmer tell the same basic story. One day, they get a credit card offer in the mail. (US credit card companies sent out 5.3 billion solicitations in 2007, which means the average adult got 15 offers.) The card seems like such a good deal. In big bold print it advertises a low introductory rate along with something about getting cash back or frequent flier miles or free movie tickets. And so they sign up. 

They fill out the one-page form and then, a few weeks later, get a new credit card in the mail. At first, they don’t use it much. Then one day they forget to get cash, and so they use the new credit card to pay for food at the supermarket. Or maybe the refrigerator breaks, and they need a little help buying a new one. For the first few months, they always manage to pay off the full bill. "Almost nobody gets a credit card and says 'I'm going to use this to buy things I can’t afford,'" Palmer says. "But it rarely stays like that for long."

He believes that the big problem with credit cards – the reason he enjoys cutting them up so much – is that they cause people to make stupid financial choices. They make it harder for us to resist temptation, so that we spend money we don’t have. "I’ve seen it happen to the most intelligent people," he says. "I’ll look at their credit card bill and I’ll see a charge for $50 (£35) at a department store. I’ll ask them what they bought. They’ll say, ‘It was a pair of shoes, Palmer, but it was on sale.' Or they’ll tell me that they bought another pair of jeans but the jeans were 50% off. It was such a good deal that it would have been dumb not to buy it. I always laugh when I hear that one. I then have them add up all the interest they are going to pay on those jeans or that pair of shoes. For a lot of these people, it will be around 25% a month. And you know what? Then it’s not such a good deal any more."

These people aren’t in denial. They know they have serious debt problems and that they’re paying a lot of interest on their debt. That’s why they’re visiting a financial adviser. And yet, they still bought the pair of shoes on sale. Palmer is all too familiar with the problem: "I always ask people, 'Would you have bought the item if you had to pay cash? If you had to go to an ATM and feel the money in your hands and then hand it over?' Most of the time, they think about it for a minute and then they say no."

Palmer’s observations capture an important reality about credit cards. Paying with plastic fundamentally changes the way we spend money, altering the calculus of our financial decisions. When we buy something with cash, the purchase involves an actual loss – our wallet is literally lighter. Credit cards, however, make the transaction abstract, so that we don’t really feel the downside of spending money. Brain imaging experiments suggest that paying with credit cards actually reduces activity in the insula, a brain region associated with negative feelings.

As George Loewenstein, a neuroeconomist at Carnegie Mellon University says: "The nature of credit cards ensures that your brain is anaesthetised against the pain of payment." Spending money doesn’t feel bad, so you spend more money.

Consider this experiment: Drazen Prelec and Duncan Simester, two business professors at MIT, organised a real-life, sealed-bid auction for tickets to a Boston Celtics basketball game. Half the participants in the auction were informed that they had to pay with cash; the other half had to pay with a credit card. Prelec and Simester then averaged the bids for the two different groups. Lo and behold, the average credit card bid was twice as high as the average cash bid. When people used their card, their bids were much more reckless. They could no longer constrain their desire, and so they spent way beyond their means.

This is what’s happened to American and British consumers over the past few decades. The statistics are bleak: the average American household currently owes more than $9,000 in credit card debt – the average Briton owes more than $7,000 – with the average cardholder carrying about 8.5 credit cards. In 2006, American consumers spent more than $17 billion just on credit-card penalty fees.

At first glance, this behaviour makes no sense. Given the exorbitant interest rates charged by most credit card companies – rates of 25% or more are common – a rational consumer would only accumulate credit card debt as a last resort. And yet, the majority of credit card users carry a balance on their cards.

"The people who have credit card debt are the same people who drive an extra mile to save two cents on a gallon of gas," Palmer says. "They are the same people who clip coupons and comparison shop. Many of these people are normally very good with their money. But then they bring me their credit card bill and they say, 'I don’t know what happened. I don’t know how I spent all this money'."

The problem with credit cards is that they take advantage of a dangerous flaw built into our brain. This failing is rooted in our emotions, which tend to overvalue immediate gains (like a new pair of shoes) at the expense of future costs (high interest rates). The emotional brain just doesn’t understand things like interest rates or debt payments or finance charges. As a result, areas like the insula don’t react to transactions involving a Visa or Mastercard. Because our impulsivity encounters little resistance, we swipe our card and buy whatever we want. We’ll figure out how to pay for it later.

This sort of short-sighted decision-making isn’t just dangerous for people with too many credit cards in their wallet. In recent years, Palmer has seen a new financial scourge in the neighbourhood: subprime mortgages.

"I still remember the first subprime mortgage I dealt with," he says. "I remember thinking: 'This is a really bad deal. These people just bought a house that’s way too expensive for them, and they don’t even know it yet.' And that’s when I knew that I’d be seeing a lot of these loans in the future."

The most common type of subprime mortgage that Palmer deals with is the 2/28 loan, which comes with a low, fixed-interest rate for the first two years and a much higher, adjustable rate for the next 28. In other words, the loan works a lot like a credit card: it lets people get a home for virtually nothing up front, but then hits the borrower with high interest payments at some point in the distant future. By the time the housing market went bust in the summer of 2007, subprime loans like the 2/28 accounted for almost 20% of all mortgages. (Poorer neighbourhoods like the Bronx fared much worse, with more than 60% of all mortgages falling into the subprime category.)

Unfortunately, this popularity comes with a steep cost. The structure of the loan ensures that subprime borrowers are five times more likely to default than other borrowers. Once the rates start to rise – and they always do – many people can no longer afford the monthly mortgage payment. By the end of 2007, a whopping 93% of completed foreclosures involved adjustable rate loans that had recently been adjusted. While 2/28 loans tempt consumers with low initial payments, that temptation turns out to be extremely expensive. In fact, subprime loans even proved tempting for people with credit scores that qualified them for conventional loans with far better financial terms. During the peak of the housing boom, 55% of all 2/28 mortgages were sold to homeowners who could have got prime mortgages. Although prime mortgages would have saved them lots of money over the long term, these people just couldn’t resist the allure of those low initial payments. Their feelings tricked them into making a foolish financial decision. The pervasive reach of credit cards and subprime loans reveals our irrationality. Even when we are committed to our long-term goals, like saving for retirement, we are led astray by momentary temptations. Our impulsive emotions make us buy what we can’t afford. As Plato might have put it, the horses are pulling the rider against his will.

Understanding the circuitry of temptation is one of the practical ambitions of scientists studying decision-making. Jonathan Cohen, a neuroscientist at Princeton University, has made some important progress. He’s begun to diagnose the specific brain regions responsible for the allure of credit cards and subprime loans. One of his recent experiments involved putting people in an fMRI machine and making them decide between a small Amazon.com gift card that they could have right away, or a slightly larger gift card that they’d receive in two or four weeks. Cohen discovered that these two options activated very different neural systems. When subjects contemplated gift cards in the distant future, brain areas associated with rational planning, like the prefrontal cortex, were more active. These cortical regions urge us to be patient, to wait a few extra weeks for the bigger gain.

On the other hand, when subjects started thinking about getting a gift card straight away, brain areas associated with emotion – like the midbrain dopamine system and nucleus accumbens – were turned on. These are the cells that tell us to take out a mortgage we can’t afford, or run up credit card debt when we should be saving for retirement. All they want is a reward, and they want it now.

By manipulating the amount of money on offer in each situation, Cohen and his collaborators could watch this neural tug of war unfold. They saw the fierce argument between reason and feeling, as our mind was pulled in contradictory directions. Our ultimate decision – to save for the future or to indulge in the present – was determined by whichever region showed greater activation. The people who couldn’t wait for the bigger gift certificate – and most people couldn’t wait – were led astray by their feelings. More emotions meant more impulsivity. On the other hand, subjects who chose the larger gift card showed increased activity in the prefrontal cortex, which allowed them to do the maths and select the ‘rational’ option.

This discovery has important implications. For starters, it locates the neural source for many of our financial errors. When self-control breaks down and we opt for the reward we can’t afford, it’s because the rational brain has lost the neural tug of war. As David Laibson, an economist at Harvard University and co-author on the paper, notes: “Our emotional brain wants to max out the credit card, order dessert and smoke a cigarette. When it sees something it wants, it has difficulty waiting to get it.”

Corporations have learned to take advantage of this limbic impatience. Consider the teaser rates offered in credit card solicitations. In order to entice new customers, lenders will typically advertise their low introductory charges. These alluring offers expire within a few short months, leaving customers stuck with lots of debt on a credit card with high interest rates. The bad news is that our emotional brain is routinely duped by these tempting (but financially foolish) advertisements. “I always tell people to only read the fine print,” Palmer says. “The bigger the print, the less it matters.”

Unfortunately, most people don’t follow his advice. Lawrence Ausubel, an economist at the University of Maryland, analysed the responses of consumers to two different credit card promotions used by actual credit card companies. The first card offered a six-month teaser rate of 4.9%, followed by a lifetime at 16%. The second card had a slightly higher teaser rate – 6.9% – but a significantly lower lifetime rate (14%).

If consumers were rational, they would almost always choose the card with the lower lifetime rate, since that’s the rate that will be applied to most of their debt. Of course, this isn’t what happens. Ausubel found that the credit offer with the 4.9% teaser rate was almost three times as likely to be chosen by consumers. Over the long term, this impatience leads to significantly higher interest payments.

When we opt for a bad credit card, or choose a 2/28 mortgage, or fail to put money in our 401(k) (US retirement savings plan), we are acting just like experimental subjects choosing the wrong gift card. Because the emotional parts of our brain reliably undervalue the future – life is short and we want pleasure now – we end up spending too much money today and delaying saving until tomorrow (and tomorrow and tomorrow). Loewenstein thinks that understanding the errors of the emotional brain will help policymakers develop plans that encourage us to make better decisions. “Our emotions are like software programs that evolved to solve important and recurring problems in our distant past,” he says. “They are not always well suited to the decisions we make in modern life. It’s important to know how our emotions lead us astray so that we can find ways to compensate for these flaws.” 

Some economists are already doing just that. They are using this brain imaging data in support of a new political philosophy known as ‘asymmetric paternalism’. That’s a fancy name for what’s really a simple idea: creating policies and incentives that make it easier for people to triumph over their irrational impulses, so that we can make better, more prudent decisions.

Shlomo Benartzi and Richard Thaler, for example, designed a 401(k) programme that takes our irrationality into account. Their plan, called ‘Save More Tomorrow’, neatly sidesteps our limbic system. It works like this: instead of asking people whether they want to start saving right away – this is the standard pitch for a 401(k) – companies in the programme ask their employees if they want to opt into a savings plan in a few months. Since this allows people to make decisions about the distant future without contemplating the present, it bypasses their impulsive emotional brain. Trial studies of this program have been a resounding success: after three years, the average savings rate has gone from 3.5% to 13.6%.

Programmes like Save More Tomorrow illuminate the potential applications of this new research. Because we can finally understand why we consistently make bad decisions, we can take steps to prevent these mistakes from occurring in the first place. Sometimes, these cognitive fixes will come in the form of ‘choice architecture’, in which people make better decisions because of how their options are presented. But an even more powerful tool is self-awareness. Once we know that our brain is subject to certain hard-wired flaws, we can learn to outsmart these flaws.

Palmer’s advice is straightforward. “Cut up the damn cards,” he says. “Or put them in a block of ice in the freezer. Learn to pay with cash.” He knows from experience that, unless people get rid of their credit cards, they won’t be able to stay on a fiscally sound spending plan: “I’ve seen people who have more debt than you can believe, and they’ll still make irresponsible shopping decisions if they can charge it.” It’s not easy for our brain to choose the long-term gain over the immediate reward – such a decision takes cognitive effort – which is why getting rid of anything that makes it even harder (like credit cards) is so important.

"Everybody knows about temptation," Palmer says. "Everybody wants that new pair of shoes and the big house. But sometimes you have to say no to yourself." He then quotes a famous song by the Rolling Stones. He can’t quite remember the lyrics, but the message is simple: you can’t always get what you want, but sometimes not getting what you want is just what you need.

Jonah Lehrer’s latest book The Decisive Moment (published by Canongate Books) is available from the RSA Bookshop. Author Jonah Lehrer is also editor-at-large for Seed magazine.