It only seems natural to follow up last month’s post on retail therapy with a discussion of how people manage their debt. In particular, I’d like to consider the psychology of managing multiple debts.
There’s a lot of conflicting advice out there about how to manage multiple debts. Some financial experts (and FICO) suggest focusing your effort on repaying the debt with the highest interest rate first, and then focusing on the debt with the next highest interest rate, and so on. This is the financially optimal repayment strategy. However, other experts (most notably, Dave Ramsey) suggest ignoring interest rates and focusing your effort on repaying the smallest debt first, followed by the next smallest debt, and so on (known as the debt snowball method). The idea is that eliminating debts is exciting, and this excitement will help sustain motivation when tackling larger debts. (Unfortunately, small wins can often generate complacency rather than momentum.)
Even among people who have never heard of Ramsey, there are many cognitive factors that encourage focusing on small debts. People underestimate how quickly interest compounds over time, and people are unlikely to prioritize their debts based on an attribute that they do not fully understand. People also tend to approach complicated tasks (like getting out of debt) by breaking them into more manageable pieces (like paying off individual debts). Effort also tends to accelerate as we approach the finish line, and thus small debts (which are closest to the finish line) may be most tempting. Credit card statements reinforce the focus on debt size by displaying balance information much more prominently than interest rates.
When larger debts have larger interest rates, focusing on small debts likely means that you’re leaving money on the table. And such a situation can easily happen when factors other than interest rates (like available credit or rewards) dictate which credit card gets used most often. Also, a low-interest card can turn into a high-interest card when promotional interest rates expire or when penalty interest rates are imposed for missing payments.
But would people actually focus on repaying small debts when larger debts have larger interest rates? I recently addressed this question with Moty Amar, Dan Ariely, Shahar Ayal, and Cynthia Cryder in a paper published in 2011 in the Journal of Marketing Research. In surveys of multiple-debt-holders and laboratory experiments that saddled participants with multiple debts and paid them based on how well they managed those debts, we documented consistent evidence of debt account aversion: When people must choose between paying off small debts and reducing debts with high interest rates, they tend to pay off the small debts. Participants would have earned more money if they had focused on paying down the high-interest debts.
Now, this should not be interpreted as finger-wagging for people who do not follow basic economic principles (there’s enough of that going around). The psychological benefits of closing debts may be meaningful in and of themselves. For example, the pleasure associated with wiping out a debt might cause people to choose to pay off a small debt instead of buying something new. In addition, the monitoring costs of managing multiple debts are nontrivial, and eliminating a debt reduces the risk of missing a payment and incurring a costly penalty. However, I would argue that strategies that reduce the speed with which debt is repaid are also costly, economically and psychologically. Excessive debt is associated with diminished psychological well-being, diminished physical health, and increased marital conflict.
Ultimately, I think we should look for solutions that make the financially optimal repayment strategy more pleasurable (like an app that tells us how much money we saved by chipping away at a high-interest debt rather than eliminating a small debt). For example, when we present participants with a debt repayment scenario and ask them one of three questions (essentially, What would you do, What should you do, or What would make you happiest), their actual behavior is much more likely to match the behavior that would make them happiest (closing small debts) than to match what they think they should do (chipping away at high-interest debts). Until the financially optimal repayment strategy is pleasurable, the debt snowball method will retain its appeal.