The study of behavioral finance is a combination of economics and psychology. People who are experts in behavioral finance examine how people’s emotions affect their financial decisions. Last year, behavioral economist Richard Thaler won the Nobel Prize for his work on this topic.
What many behavioral finance experts have found is that people don’t always make rational decisions when it comes to money. In fact, we kind of do the opposite.
That shouldn’t come as a surprise to anyone, though. We all make financial mistakes from time to time. Many of us wish we would have known more about money when we were younger. We have regrets about purchases and get into debt. It’s human nature to have flaws, especially when it comes to handling money.
So, how does behavioral finance affect debt repayment? Below are some ways that our behaviors and emotions can get us into debt, along with some suggestions on how to combat them to improve financial health.
ONLY THINKING OF THE PRESENT
Your future, including your retirement years, seems like it’s a long way away. In fact, according to an episode published on Slate, “One aspect of our nature that’s to blame [for overspending] is called present bias – the human tendency to emphasize now over later.”
For many people, loans don’t seem that bad because they enable us to get the car we want or the education we want right away (and worry about paying it off sometime in the future). Unfortunately, the bills will hit eventually, and what we thought was far away will be here before we know it.
One way to conquer this way of thinking is to know how much you’re paying in interest any time you take on debt. It’s common to think about how much you can afford monthly; instead, think of the total cost of the item you want. Your $20,000 car will actually cost much more over time once you add in interest. The loan you took out to refinish your bathroom means your bathroom might cost much more than that initial $5,000, once you’ve paid for it over time.
Once you know how much interest you’re paying to your financial lenders, you’re less likely to take out loans you don’t need. Save yourself the interest and save up for your purchases ahead of time.
NOT KEEPING EMOTIONS IN CHECK
How many times have you made a purchase because you wanted to celebrate something or make yourself feel better after a bad day?
Research from NerdWallet showed that “nearly half of Americans (49%) say emotions cause them to spend more than they can reasonably afford.” Stress, excitement and sadness were noted as being the top emotions associated with overspending.
I know I’m guilty of this myself. In fact, just recently, my kids did something I was proud of and instead of going home for lunch, I said, “Let’s go out to eat and celebrate!”
My husband and I, caught up in the emotion of the day, ended up getting cocktails at lunch (something we never do) and then had a $70 bill to pay at the end of the meal.
After this meal, my husband and I both felt sheepish. We let our emotions take over when it came to spending decisions and spent a lot on eating out instead of eating at home. This is how many people end up in debt – they spend money after giving way to a strong emotion.
The best way to combat this and to prevent going further into debt is to take a pause before you make a decision or a purchase. Ask yourself, “Am I buying this because I need it or because I feel happy/sad right now?” Sometimes, taking a pause and doing a check of your emotions can prevent you from making a spending misstep.
NOT AUTOMATING YOUR FINANCES
Thaler used his research to encourage companies to automatically enroll their employees in 401(k) plans. The reason is that if left to their own devices, people neglect to enroll in retirement plans and, instead, use their earnings for other things. One article estimates that because of Thaler’s research, he helped add $29.6 billion to retirement accounts.
The same idea applies to debt repayment. I automate every single debt payment that I can. This includes my credit card payment and all of our student loan payments, which are thousands of dollars a month. Automating my payments prevents me from paying them late. This setup also reminds me to watch my spending because everything is auto-deducted, and I don’t want to overdraft.
If you don’t automate your debt payments, you run the risk of spending that money on other things.
Ultimately, learning a little bit about behavioral finance can help us to repay our debt more confidently and quickly. Also, try not to beat yourself up if you’ve spent irrationally in the past. Behavioral finance shows us that humans often spend based on emotions and get into debt because they’re thinking only of the present, not the future. However, by being more aware of this, you can help improve your financial situation, to build a more sound financial future.