Best PhD Student Paper Award at the CEPR Fourth European Workshop on Household Finance
This paper documents new facts and untangles mechanisms regarding the credit card debt puzzle that describes the co-holding of high-cost debt and low-yield assets. First, I capture more accurately the costs of co-holding because I identify households who are on decreasing and increasing paths of co-holding. Second, liquidity-based hypotheses are insufficient to explain co-holding because co-holding occurs even with high liquidity and low credit limit risk, and few co-holding households take up an offer of low-cost liquidity. Third, limited intra-household financial pooling contributes to co-holding because couples are more likely to co-hold than individuals, and the intra-household distribution of assets and liabilities affects household demand for low-cost liquidity. Finally, anchoring to the minimum credit card debt payment contributes to co-holding.
Debt-repayment flexibility should help households with low liquidity smooth consumption, but households with self-control problems may limit flexibility to avoid overconsumption. This paper studies household response to an offer of debt-repayment flexibility with a natural experiment. The experiment provided Finnish mortgage holders a free option to reduce minimum principal payments to zero for 1 to 12 months. Only one in five apply for this flexibility, although all households weakly prefer flexibility in a standard consumption-savings model. I consider three main mechanisms for household behavior: (i) commitment because of self-control problems, (ii) inertia because of time or effort application costs, and (iii) inattention to the offer. Although inertia and inattention can explain part of the behavior, inertia and inattention are inconsistent with two key empirical findings consistent with self-control problems and a desire for commitment. First, many households prefer short to maximum flexibility. Second, consumption drops at the predictable end of flexibility for households who are liquidity constrained before the offer.
Updated draft coming soon
