Suppose you have the following account balances: (1)
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Now assume that for the next 25 years you will receive $5,000 in cash that you can use to pay down your outstanding debt. In addition to this cash infusion, you will hit the lottery several times, winning $20,000 (year No.6), $15,000 (year No.12) and $40,000 (year No.19). You will also apply these winnings against your debt.
In every case, you can apportion your cash any way you like. For simplicity sake, there are no “minimum payments” required. So, how would you pay down your debt? If you’re like most people, the first year you’ll wipe out debt No.1 and put the remaining $2,000 against Debt No.2. In year No. 2, you’d use the entire $5,000 to almost eliminate Debt No.3.
You would follow the same strategy each subsequent year, applying whatever amount of cash you receive to pay off the smallest debts first. After receiving your 25th infusion of cash, you will have cleared out every account except Debt No.6, which would have a balance of $47,861.You’d probably feel relieved. Maybe a bit smug as you’ve eliminated all but one of your debts. But according to Scott Rick, assistant professor of Marketing at the University of Michigan, you made a costly mistake.
Instead of focusing on reducing the number of accounts you have, the smart approach is to pour as much money as possible into paying off the debt with the highest interest rate. After that’s closed, focus on the account with the next-highest interest rate. Based on numerous experiments with real subjects, Rick and four colleagues co-authored a major article on the psychology of debt management.(1)
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They repeatedly found that “people seem to be more sensitive to the absolute number of debts they have versus the total amount of money they owe.” The authors describe this tendency as “debt aversion.”
“Where people really make a mistake,” says Rick, “is when they don’t have enough [money] to come close to closing their big accounts, so there’s an increased temptation to close a small account with a lower interest rate.” He adds, “That might make you feel good today, but you end up paying more in the long run, particularly if you keep up this approach.”
In the example above, for instance, if you paid down your debts according to highest interest rate, you’d end up with three accounts instead of one. However, the amount you’d still owe after 25 years would be $29,428, $18,433 less than if you took the approach of eliminating your smallest balance first, then the second smallest, etc..,and didn’t take into account interest rates.
According to Rick, proponents of this strategy claim that closing a small account gives you a psychological boost that makes you more committed to becoming debt free. “Research on goals indicates just the opposite. You tend to take your foot off the gas and reward yourself for hitting an intermediate goal.” In other words, you feel so good about wiping out one of your debts that you hit the mall. He concedes that while there might be some psychological payoff from seeing an account balance go to zero, the feeling is temporary.
Mathematically you end up “winning the battle, but losing the war.” It’s like trying to lose weight by giving up your daily Oreo cookie, but not reducing the amount of cake, ice cream and sugary soft drinks you consume. You’d lose pounds a lot faster if you gave up the more calorie-laden foods first.
If anything, Rick says the reason most people are debt averse may be emotional: They pay down smaller, lower interest rate debt first “because they’re really stressed out about their debt, and they’re bombarded with bills” and just want to make some of the paperwork go away.
If you’re serious about reducing your debt, Rick suggests that when you sit down to pay your bills, you sort them from highest to lowest interest rate. After paying the minimum amount on each one, apply as much as you can afford to the account with the highest interest rate.
The research by Rick and his colleagues suggests another way to “fool” yourself into paying off your debts the smart way: if possible, consolidate your debt into a single account with the lowest interest rate you can find. Then focus on reducing this single balance. This approach eliminates the temptation to pay off the low-balance/low interest rate accounts first.
1. Amar, Moty, Dan Ariely; Shahar Ayal, Cynthia E. Cryder and Rick, Scott I. “Winning the Battle But Losing the War: The Psychology of Debt Management.” Journal of Marketing Research, Vol. XLVIII (Special Issue 2011), S38-50. Example reproduced with permission.
Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content.
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