Article26 July 2018Reading time 4 minutes

Paying on credit when you’ve got the cash? The co-holding puzzle

It makes economic sense to pay off high-interest credit cards before trying to save money in low-yielding accounts. But many people don’t and behavioural science could have the answer

In this article

The credit card balance

Many people use their credit cards for everyday purchases while also having savings in separate accounts. On paper, this seems daft as interest due on borrowing is usually higher than anything you'd get in a savings account. A rational perspective suggests it makes far more sense to minimise higher costs by using the money you've already got to pay for things. 

There are multiple possible reasons for co-holding

So why doesn't everyone do this? Sure, credit cards can be useful financial instruments. Paying for a holiday on the card a week before pay-day can ensure you don't have to move money from a high-interester savings account, for instance. But that sort of behaviour isn't universal and plenty of studies have been carried out to find why 'co-holders', those who hold high-interest debt alongside liquid assets, continue to do so when quite clearly it's costing them more. 

The co-holding puzzle

In a 2017 paper that looked at households with credit card debt, more than 80% also had some form of low-yield, liquid asset. That is, they had access to an asset that could be reused to pay their credit card debt and which wasn’t making them much return from simply holding onto it.  

There are multiple possible reasons for co-holding include a timing mismatch, pre-commitment to forthcoming expenses, self-control problems, or strategic preparation for possible future financial challenges. When it causes unnecessary spending, however, some behavioural insights may help to further explain.

Some find rebuilding their saving's pot more difficult than paying their credit card bill. New York University Professor of Public Policy and Economics, Jonathan Morduch, explains that people who find it difficult to save may also find it hard to use their savings to repay debt because they fear they will not be motivated enough to rebuild those savings.

The penalties for not paying back a debt regularly can also actually function as a type of discipline and commitment device, essentially binding people into regular payments. A high-interest charge may even help as there is then even more incentive to pay back the debt.

That 'losing-out' feeling

Another reason people co-hold is because it can be wise to hold money back for emergencies, especially if there is a risk they would not be able to access money or credit quickly when needed.

It may be that savings have been mentally allocated to a specific purpose, for example, a “rainy day” or emergency fund. Liquid assets like cash in a savings account in theory can be used quite easily. But in practice, people often categorise their savings, mentally filing them separately from their credit card debt. Additionally, not everything can be paid for by credit card, so some people may prefer to keep cash savings on hand for those purchases.

Dipping into savings can feel like losing out

Dipping into savings can feel like losing out, something that loss aversion, the tendency to be influenced by a loss more than a gain, can lead us to avoid. So while some may be aware of their tendency to pay a little more on their credit card, they may choose to do so, in order to maintain their savings progress and to avoid any feeling of loss. It’s worth reviewing your account and understanding the costs of spending any credit you have rather than paying it off with savings. It’s likely there will be clear financial benefits to paying down debt – if you have strong self-control and can easily top up the savings.