MarketWatch: This is why people carry credit card balances

By SIMON CONSTABLE

A puzzle that has long vexed personal finance experts may have been solved by an unlikely source: the Federal Reserve.

The problem in question: Why do people so often carry credit-card balances costing 10% to 20% a year, while at the same time keeping money in savings accounts that pay less than half of one percent?

On the face of it, such actions make no sense. And yet two out of three people surveyed by Ohio State University thought it was not a good idea to pay down such debt using savings.

Why is this view so prevalent? People trust that their savings will be there when they need the money more than they trust the banks to lend at such times.

That’s not my view; it’s the Federal Reserve, the banker of last resort to the banking system. It’s an institution that knows only too well how well, or otherwise, banks behave.

The Fed itself sums up the situation facing consumers who might want to borrow.

“There are no guarantees it [credit] will be there when they need it,” states a recent working paper from the Consumer Payments Research Center at the Federal Reserve Bank of Boston. Or put another way, you can’t rely on the bank to lend to you when you need it.

“Savings act as insurance so that even in the worst case when the consumer cannot borrow, she can still consume,” says the report by Scott Fulford, professor of economics at Boston College, and previously a visiting scholar at the Boston Fed. The study analyzed Equifax data from 1999 through 2013, as well as data from the Consumer Finance Monthly survey conducted by Ohio State University.

This lack of trust helps explain why two-thirds (67%) of survey respondents to the Consumer Finance Monthly survey said it was not a good idea to pay off credit card balances with savings.

While this behavior baffled so-called experts, it actually makes sense when you think about it. You have a legal and moral right to access your savings. You can rely on the funds being there. Borrowing, on the other hand, is a privilege that you can’t be sure of especially if you hit a rough patch and become a worse credit risk.

There are other reasons to build up savings even while borrowing.

For people who have racked up substantial debt it can make sense to build savings while they pay down the credit card balances, explains Linda Leitz, a financial planner for Colorado Springs-based financial planning firm, It’s Not Just Money Inc.

The risk of not building savings while paying off a credit card is that once the balance is paid off the same habits that caused the debt will return. “Saving regularly helps them build the emotional muscle,” she says.

See original story here.