Reducing debt improves psychological functioning and changes decision-making in the poor

Significance The impact of chronic debt on the poor is psychological, not just financial. We hypothesize that chronic debt impairs psychological functioning and decision-making, contributing to the poverty trap. This is because debt is not considered fungible and is viewed as costly mental accounts that consume cognitive bandwidth. We test this using quasiexperimental evidence from a one-off, unanticipated debt-relief program worth several months’ household income. Comparing the poor before and after debt relief, those with more debt accounts paid off experienced greater improvements in cognitive functioning, reported less anxiety, and became less present-biased. These findings provide actionable evidence for poverty-alleviation policy. We examine how chronic debt affects behavior by studying how a large, unanticipated debt-relief program affected psychological functioning and economic decision-making in beneficiaries. A charity granted low-income households debt relief worth up to Singapore dollars 5,000 (∼3 month’s household income). We exploited quasiexperimental variation in the structure of debt relief: For the same dollar amount of relief, some beneficiaries had more debt accounts eliminated, while others had fewer paid off. Comparing 196 beneficiaries before and after debt relief, and controlling for debt-relief amount, having an additional debt account paid off improves cognitive functioning by about one-quarter of a SD and reduces the likelihood of exhibiting anxiety by 11% and of present bias by 10%. To achieve the same effect on cognitive functioning of eliminating one debt account, a beneficiary must receive debt relief worth ∼1 month’s household income. There is no effect of debt-relief magnitude on anxiety and decision-making. We exclude training and calendar effects, debt-causing behaviors, and liquidity constraints as explanations. Instead, these results support the hypothesis that chronic debt impairs behavior because the mental-accounting costs of owing distinct debt accounts consume mental bandwidth. Poverty-alleviation policies aimed at the indebted poor should consider addressing mental accounting and bandwidth taxes.