Stuart Vyse is Professor of Psychology at Connecticut College, in New London. In his new book, Going Broke: Why Americans Can’t Hold On To Their Money, he offers a unique psychological perspective on the financial behavior of the many Americans today who find they cannot make ends meet, illuminating the causes of our wildly self-destructive spending habits. In the excerpt below Vyse looks at the psychology of credit limits. Check out the tips he provided us with this morning or his podcast.
The Magic of Credit Limits
It is a wonderful feeling. You apply for your first MasterCard, hoping to be accepted. Finally it arrives in the mail, and you feel like a million bucks. It is shiny and new, and it comes with a letter that tells you your credit limit. In most cases, this happy event occurs when you are quite young: just after graduation from high school or somewhere in your twenties. As a result, the credit limit often seems like an amazingly large figure. Never before have you experienced this “superior purchasing power,” and you are a bit dizzy thinking about the possibilities that lie before you. If you wanted to, you could buy that new high-end computer that just came out, or you could take a vacation to Australia. Yesterday these were fantasies that you never would have thought possible, but with this little card in your hand, you could have them in an instant.
Most people experience their first credit limit as a kind of affirmation: “Gosh, that’s a big number. They must think I am good for it.” But how do the banks set your credit limit? Ideally the spending limit should be a measure of your future earning potential. Consistent with the life-cycle theory, banks should look at this young person and, based on the information available to them, make an educated judgment about your future income and ability to repay the debt. Large banks have tons of data available to them, including their past experiences with people of your age, education, work status, and other characteristics. They should be able to create a very accurate statistical model that will separate those who are worthy of credit from those who are not.
In fact, there is little evidence that banks engage in such a rational process. Apparently, there are no formal guidelines for banks to use in setting credit limits, and past credit history—not future earning potential—is a much more common factor in setting limits. In addition, credit limits are commonly used as a marketing tool. In an effort to entice you to apply for a new card, letters arrive in the mail saying you have been “preapproved” for an intoxicatingly high credit limit. If at some point down the road, your balance hits the credit limit, banks are very accommodating about raising it for customers who have a good payment record. Thus, the accumulation of debt continues uninterrupted.
But the evidence suggests that some people do see the credit limit as the bank’s prediction of their future earning potential, and as a result, a high credit limit can encourage spending. It is as if the consumer believes that everyone is operating according to the life-cycle theory. The bank has offered a certain amount of credit based on the consumer’s worthiness, and believing this, the new holder of the credit card uses the credit limit as a guide for spending. In our contemporary world, the distinction between borrowing for utilitarian purposes and borrowing for mere hedonic consumption have all but disappeared, resulting in many people finding it easy to see the credit card as a source of alternative income. In some cases, if the credit limit is large, the cardholder feels free to increase spending.
Marketing researchers Dilip Soman and Amar Cheema did a series of studies that demonstrated some of the factors that determine whether your credit limit will fool you into spending. For example, your beliefs about how your credit limit was set appear to matter. In one study, Soman and Cheema stopped people on a university campus and asked them to consider a hypothetical spending scenario in which they were deciding whether or not to purchase an expensive computer. If participants were told their available credit had been determined using a simple and convenient method based on limited information, the size of the credit limit did not affect the likelihood of saying you would spend. In addition, being older and wiser helps. Most people who have been out in the world for a while become skeptical of advertising claims, and a similar distrustfulness seems to apply to the marketing appeals of credit card companies. When you have been around the block a few times, the MasterCard pitch “You work hard for your success—let MasterCard reward you with unparalleled convenience and freedom” is taken with a grain of salt. Soman and Cheema’s older and more experienced participants were not influenced by the size of the credit limit they were given—even when they were told to imagine their credit limit had been decided using a very scientific method that accurately forecasted future earnings potential. But the same description did have a substantial effect on college students who participated in the study. If these relatively naive consumers were told that the credit limit was a credible indicator of the bank’s faith in them, then a higher credit limit made them more likely to say they would purchase the computer.
Normally, of course, credit card companies don’t tell us much about how they set credit limits. For the purposes of their research, Soman and Cheema provided their respondents with descriptions of the process used to determine the credit limit. But in real life, consumers are free to make their own inferences about what is going on behind the walls of the bank, and some give greater meaning to the credit limit than others. In a subsequent study, Soma and Cheema asked credit card users to consider a hypothetical purchase of a $1,200 piece of antique furniture. Participants who said they believed the limits on their credit cards were set based on an accurate prediction of their future earnings were more likely to say they would buy the furniture than those who did not. How these consumers came to this belief is not clear, but this line of research suggests that people who read more significance into their credit limits have a greater tendency to spend.