Precautionary borrowing and the credit card debt puzzle

Abstract

This paper addresses the credit card debt puzzle using a generalization of the buffer‐stock consumption model with long‐term revolving debt contracts. Closely resembling actual US credit card law, we assume that card issuers can always deny their cardholders access to new debt, but that they cannot demand immediate repayment of the outstanding balance. Hereby, current debt can potentially soften a household's borrowing constraint in future periods, and thus provides extra liquidity. We show that for some intermediate values of liquid net worth it is indeed optimal for households to simultaneously hold positive gross debt and positive gross assets even though the interest rate on the debt is much higher than the return rate on the assets. Including a risk of being excluded from new borrowing which is positively correlated with unemployment, we are able to simultaneously explain a substantial share of the observed borrower‐saver group and match a broad range of percentiles from the empirical distributions of credit card debt and liquid assets.

Expectations Uncertainty and Household Economic Behavior

“…Fulford (2015a), Gorbachev and Luengo-Prado (2016), and Druedahl and Jorgensen (2017) 3 A similar tension between theoretical predictions and empirical patterns is also found at the aggregate level. For example, Carroll and Dunn (1997) and Knotek and Khan (2011) find that the response of aggregate consumption to increases in uncertainty regarding income or general business conditions is much less pronounced than predicted by theory.…”

The endogenous grid method for discrete-continuous dynamic choice models with (or without) taste shocks

“…The DC-EGM method has been implemented in several recent empirical applications, where it has proven to be a powerful tool for solving and estimating more complex DC models in various fields: labor supply, human capital accumulation and saving (Iskhakov and Keane (2016)); joint retirement decisions of couples (Jørgensen (2014)); consumption, housing purchases, and housing debt (Yao, Fagereng, and Natvik (2015)); saving decisions and fertility (Ejrnaes and Jørgensen (2016)); precautionary borrowing and credit card debt (Druedahl and Jørgensen (2015)).…”

“…They estimate a model in which households hold debt, financial assets, and illiquid housing, and find that a substantial fraction of households are likely to behave in a "hand-to-mouth" fashion despite having significant wealth holdings. Druedahl and Jørgensen (2015) employ a modified version of DC-EGM to analyze the credit card debt puzzle. They solve a model of optimal consumption and debt holdings, and show how, for some parameterizations of the model, a large group of consumers find it optimal to simultaneously hold positive gross debt and positive gross assets even though the interest rate on the debt is much higher than the rate on the assets.…”

Noncognitive Abilities and Financial Delinquency: The Role of Self‐Efficacy in Avoiding Financial Distress

“…However, many credit applications are submitted for current financing rather than on a precautionary basis. Furthermore, credit lines might be an ineffective form of insurance against future shocks, as borrowing limits can be (and often are) reduced or eliminated at the lender's discretion (see Fulford () and Druedahl and Jorgensen ()).…”