From credit cards to home and student loans, debt is big business in America. According to Bloomberg Business Week, student debt has grown by $100 billion per year since 2008. Outstanding consumer debt stands at a record $3.2 trillion. This is the result of new debt being acquired faster than existing debt is paid off.
The specter of incurring interest and obligations for future payments would seem like a strong deterrent against borrowing money. So what is it that drives people to take on debt or delay repaying their existing debt?
It comes down to two primary points: delayed gratification and optimism regarding future earnings.
Optimism for the Future
When a student takes out a loan — most consider it an investment in their future. They assume or hope that future earnings will make those future loan payments affordable or even insignificant. However, as illustrated by the Huffington Post, accumulated student-loan debt has increased dramatically in the past decade while inflation-adjusted wages have decreased.
The same goes for business loans. A study by Na Dai and Vladimir Ivanov reveals interesting facts about optimism in relation to business debt. The authors note that the returns on entrepreneurial ventures are relatively small compared to the inherent risks. Also, optimistic entrepreneurs are more likely to borrow more money; particularly short-term loans with high-interest rates (think credit cards). Credit lenders also tend to grant optimistic business borrowers with larger amounts of money.
In short, debt-acquiring students and business owners put their money where their mouths are: they are confident enough that their future earnings will be much higher than their current earnings, and so are willing to take on substantial debt to finance an uncertain future.
In the 1960s, Walter Mischel, a Stanford professor, came up with a simple test known as the Marshmallow Test. Mischel and his team would give a child a single marshmallow and tell the child that he could eat the marshmallow immediately or wait a few minutes and be rewarded with a second marshmallow. The concept is known as delayed gratification.
The Marshmallow Test helps explain the way people tend to take on and repay their debt. Assume a seventeen percent annual interest rate on a credit card. When a consumer spends $1,000 in credit card purchases for immediate consumption, they are making the choice to have $1,000 now, instead of $1,170 a year from now, ignoring for simplicity the compounding interest.
While this concept doesn’t seem to have much to do with taking out a student loan, it certainly applies to repaying those loans, or any loans for that matter. If a borrower has $30,000 in student debt at a seven percent annual interest rate, and comes into $30,000 of disposable income, she can either pay off that $30,000 now or spend the $30,000 on consumption and be faced with $32,100 in debt in one year.
There are certainly different motivations behind taking on and paying off different types of debt. Putting a leather jacket or a big-screen TV on a credit card isn’t quite the same as taking out a six-figure loan for a PhD; however, the psychology of those decisions is very similar and boils down to a combination of optimism for the future and the concept of delayed gratification.
By Justin Grensing Copyright 2015 brass Media, Inc.