As a business owner, it can be tempting to extend further credit to struggling customers in order to increase sales and build customer loyalty. The idea is that customers will buy more now, pay later—and love your brand for helping out during tough times. You might even take a lead from the Biden White House and consider pausing interest on overdue accounts until things turn around.
Bold, generous and forward-thinking, right?
But hang on…
Recent research suggests that goodwill gestures like this may not be the best strategy for your business.
A study on debt moratoria and student loans (based on the ongoing federal student-debt pause) found that when borrowers were given a temporary pause on their loan payments, they actually increased their borrowing in other areas such as mortgages, auto loans, and credit cards.
That’s right. They often went and dug themselves a bigger hole. This study, by three University of Chicago economists for the National Bureau of Economic Research, suggests that when individuals (and business customers are operated by individuals) have more liquidity due to debt relief, they are more likely to take on further debt elsewhere rather than pay off existing debts. And the data shows that the more financial trouble a person was in to begin with, the more they leveraged the forgiveness opportunity to borrow harder than ever!
This human behavior relation has important implications for businesses considering extending credit to customers. If a customer is already struggling with debt, granting them more credit may not actually help them pay off their existing debts or improve their financial situation.
Instead, it could well lead them to take on more debt and eventually default on their (now bigger) payments.
What’s more, extending credit, or additional credit, can also create additional administrative costs for your business. You will need to track customer payments and follow up with delinquent accounts, which can be time-consuming and expensive. Then, if a customer defaults on their payments, you may need to write off the debt as a loss.
Overall, while extending credit can be a useful tool for some businesses in certain situations (and is a necessity with many B2B models) it is important to carefully weigh the risks and benefits before making policy changes.
If you do decide to offer or increase credit to customers, make sure you have clear policies in place for managing delinquent accounts and minimizing your risk of losses. In general we’ve found that shorter grace periods (60 days instead of 90 before sending a file to a collection agency, for example) is effective in reducing bad debt write-offs.
In short, think twice before extending further credit to customers who are struggling to pay on time. While it may seem like an easy way to boost sales and build goodwill, it can actually lead customers into deeper debt and create new costs for your business.
One of the kindest things you can do for customers is a little more counter-intuitive. Insist on timely payment, and reinforce win-win business practices. If you offer a reward, make it a small percentage off for customers who pay before an invoice is due. Keeping each other solvent is good for everyone!
Need help collecting on slow-moving accounts? The MetCredit USA team would be happy to offer advice and help you improve your receivables flow.