Borrowing in the Present Means Payback in Future

The UAE offers economic opportunities to the rich and poor. For those with modest means, trying to move up the ladder often requires incurring substantial debt at the outset. That is why, according to one recent estimate, the average UAE resident owes creditors Dh41,000.

A mixture of poor planning and bad fortune mean that for a subset, the debt becomes unmanageable. The National’s online Debt Panel is replete with letters from distressed borrowers searching for a way out of debt cycles; what is that makes humans so prone to these difficult episodes?

There are two main psychological phenomena that get us into trouble: hyperbolic discounting, and the good news-bad news effect.

It is human nature to exhibit a preference for consuming things in the present rather than the future; this is described as discounting the future. To understand hyperbolic discounting, which is a cognitive bias that is useful to economists trying to understand personal debt problems, we first have to grasp its simpler antecedent, exponential discounting.

When you make a choice that involves a future act, absent the arrival of any new, relevant information, when that future time arrives, you should stick to what you planned to do. This is known as exponential discounting of the future, and someone conforming to it is being dynamically consistent. Thus, if you set your alarm to 6am because you want to get up at 6am, when it rings, you get up.

If that sounds implausible, then that’s because in practice, you are more likely to be a hyperbolic discounter of the future, or a dynamically inconsistent decision-maker. That means that you succumb to an additional dose of discounting when the future time comes around, and critically, it is an additional dose that you can work around only imperfectly. No matter how many times you tell yourself that you will wake up at 6am tomorrow because it is in your interest to rise at that time, when the alarm finally rings, the bed seems extra warm, and your plans for the rest of the day seem less important than you anticipated that they would feel last night.

Understanding this propensity is important for the study of personal debt because borrowing is all about how people value current versus future consumption. Hyperbolic discounting gets us into trouble because it makes us more likely to delay settling debt, thereby incurring high interest charges, as we are unable to stick to the repayment plan that we envision at the point of taking out the loan.

Fortunately for humans in a wide variety of contexts, economists have shown that we possess the capability to diagnose and counteract our cognitive biases, especially under repeated exposure to the decision.

For example, the endowment effect is a cognitive bias that makes us place an irrationally high value on our possessions. Think of how much you would need to be paid to surrender your pen – a figure that typically far exceeds the price of a brand new one. But empirical research shows that professional traders do not suffer from the endowment effect, due to the massive cumulative experience of surrendering their possessions, just as nurses do not grimace at the sight of blood.

Unfortunately for humans, in the personal debt domain, for several reasons we struggle to overcome hyperbolic discounting.

First, in the context of large loans, they are so infrequent that one doesn’t acquire the necessary experience in dealing with one’s cognitive deficiencies. Regular visitors to Las Vegas have often learnt to better control themselves with time, but most people take out at most one mortgage, which is not enough to get good at managing the process.

Second, even with higher frequency loans, such as credit card bills, humans’ efforts at learning from experience are impaired by another cognitive bias, referred to as the “good news-bad news effect”: people are much better at learning from experience which says something good about them than that which casts them in a bad light.

To see this more clearly, returning to the endowment effect example, discovering that you suffer from an irrational attachment to your possessions is not necessarily bad news; in fact, people may even regard you as charming and sentimental. In contrast, learning that you are bad at managing your debt is an unwelcome development, as most would associate it with poor self-control – an unquestionably negative character trait.

To maintain your self-esteem, your brain will often trick you into paying little attention to bad news, or erroneously attribute it to external factors beyond your control; think of athletes blaming a loss on the referee, the weather, the crowd – anything except their lack of preparation and ability. This impairs the improvement process.

To make matters worse, wily companies also take advantage of this; there is an abundance of unscrupulous creditors who excel at exploiting cognitive biases such as hyperbolic discounting. Payday loan sharks are a prominent example.

If you fear that you are prone to such dangers and are searching for tricks that can help you avoid falling into debt traps, then look no further than Odysseus’ 3,000-year-old strategy for resisting the temptation of the sirens: take preemptive actions that prevent you from making a potentially harmful future choice.

The modern analogue to tying yourself to the mast of your ship is subscribing to savings plans that automatically lock off part of your earnings, using credit cards with tight limits and that require full repayment each month, or exclusively using debit cards so that you only spend what you already have.

Whichever steps you take, make room for regular recitation of personal finance guru Nathan Morris’s leading maxim: “Every time you borrow money, you’re robbing your future self.”

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