Spend or Save? What to Decide When Faced with Financial Emergencies

A phenomenon exists wherein people simultaneously hold low-interest savings and high-interest debt. This can be problematic when people are faced with emergencies that call for essential spending. In emergency situations, many people would rather borrow high-interest debt to preserve savings rather than withdraw money from their low-interest savings accounts. Existing research documents that “earmarking” savings accounts, or dividing and saving money in separate bank accounts with specific purposes, helps accomplish savings objectives. However, when faced with essential spending needs, such as paying for an emergency, having earmarked accounts may encourage people to rely on costly borrowing rather than deplete their savings, which is counterintuitive and potentially costly.

Abigail Sussman and Rourke O’Brien investigate the effects of earmarking savings accounts. In their newest paper, the authors assess the circumstances under which people are more likely to borrow high-interest debt to avoid drawing down their savings. The study examines the psychological mechanisms underlying this counterintuitive spending pattern and whether behavioral interventions can help reduce this costly behavior.

The authors conducted six different experiments to determine how participants decide to finance their emergency spending, by either drawing from savings or increasing debt. In the experiments, participants were randomly assigned to have one savings account, which could be a savings account earmarked for a responsible purpose (e.g., a retirement fund, or an education fund for children), a savings account for a future purchase, or an unspecified savings account. The participants were then asked if they would withdraw from the savings account, or borrow money, in the face of an unspecified financial emergency costing $1,000.

Sussman and O’Brien find that people with earmarked savings accounts would rather incur extra costs to take out high-interest debt and preserve their savings. Research shows that the purpose of a savings account can affect decisions on whether or not to spend it. For example, people were more likely to borrow and increase debt than draw down their savings when the money was set aside for children, relative to unspecified savings, or savings for a future car purchase.

The researchers find that savings earmarked for a responsible purpose, such as child-related savings, education, and retirement are more closely guarded than savings for a neutral purpose (car, vacation, or general savings). In order to keep these funds safe, participants responded that they were willing to pay an interest rate as much as 12 times higher than their savings interest rate to borrow money, rather than dip into funds earmarked for their children. This is more than double that of non-earmarked savings and more than three times that of savings for a future car purchase. In addition, researchers find that participants’ sense of responsibility, specifically guilt, plays a central role in deciding whether to draw down existing savings to pay for an emergency. Having a specific savings goal can accentuate this feeling.

In order to better understand this psychology and encourage financially sound spending, the researchers tested a behavioral intervention aimed at promoting positive savings spending. The intervention presented half of the participants with the option of automatic replenishment of their savings, which automatically deducted money from their future paychecks and returned it to their savings accounts until they repaid themselves. Researchers find that this intervention enabled participants to withdraw funds from savings accounts while maintaining perceptions of responsibility, and consequently reduced costly behavior of borrowing high-interest debt to preserve savings.

Significant public and private resources are expended to nudge people towards responsible levels of savings. Matched retirement savings programs, default savings levels, and “Keep the Change” programs exemplify these efforts. In the public sector, policymakers interested in alleviating poverty often aim to increase savings behavior among low- and moderate-income families. In the private sector, understanding savings behavior informs the way banks attract and retain customers. Although savings promotion is intended to improve individual and household overall and long-term financial stability, Sussman and O’Brien’s study shows that, when a significant sense of responsibility is attached to savings, the psychological factor may prevent consumers from making the less costly decision to finance emergency spending with existing savings. Policies encouraging saving must be coupled with efforts to promote smart saving and spending—for example, guaranteeing auto-replenishment of earmarked savings drawn down in the face of emergencies. While not an easy task, Sussman and O’Brien’s work provides an important backdrop to tackle it.

Article Source: Sussman, Abigail B., and Rourke L. O’Brien, “Knowing When to Spend: Unintended Financial Consequences of Earmarking to Encourage Savings.” Journal of Marketing Research. 2015.

Featured Photo: cc/(Mike Mozart)