It’s unusual for august publications like Scientific American to discuss why people might not manage debts as well as they should, particularly those who are otherwise good with numbers. Nevertheless, that’s exactly the question a guest blog post tackled recently: Debtors with multiple debts tend to focus on paying down the ones with the smallest balances first rather than those with the highest interest rates (if they don’t happen to be the same). Ultimately, this strategy usually results in debtors paying more in interest over the long run. The Scientific American post’s authors, who were funded by Met Life, asked why this is.
The authors created a simple simulation in which 162 people were given fictitious debts with different balances and interest rates and multiple rounds of paychecks to retire them. Only 5 people elected to spend their discretionary income on the highest-interest debts. The majority, which included MBA students, chose to pay the smallest debts first. Clearly there’s more to the problem of clearing multiple debts than just math. It’s psychological.
The human quirk the authors referred to is called, “debt account aversion,” the preference for managing fewer debts irrespective of their characteristics. It’s essentially a type of loss aversion, but there’s also a motivation to receive some kind of mental payoff sooner, even if it costs more. The example the post gives is when stores offer free items after multiple purchases; as consumers close in on the free item, they increase their purchases, whether they really wanted them or not. Finally, many people simply underestimate the effects of compound interest on debts.
The authors offer a handful of suggestions for circumventing the psychological mechanisms that prevent debtors from paying down high-interest debts first. Automatic payments, institutional rules that prioritize debts, and of course, refinancing all debts into one. To encourage refinancing, the authors ran another test of advertisements and determined that charts showing the difference in the total amount of interest paid among refinancing options was twice as effective as just stating the interest rates.
I’ve mentioned before that paying highest interest loans first doesn’t work for everyone, and some people advocate doing exactly what the authors of the Scientific American post discourage: dedicating excess income to the smallest balances first and moving up debts accordingly. Referred to as the “snowball” approach to debt, this method works with debtors’ psychological quirks rather than against them. As debts vanish, debtors become emboldened to clear all of them. In fact, one study from Northwestern University that focused on a debt-settlement company’s records of 6,000 debtors found that those using the snowball method were more likely to close accounts and pay off all their debts irrespective of the total amounts they owed.
The blog post at Scientific American is here; a link to the Northwestern study is here.
It would be ironic for human irrationality to work better than what’s cheapest in the long run, but if you have multiple high-balance debt accounts, then it’s best to know the consequences of all repayment options and choose the one that’s most likely to work for you. If, however, you don’t believe you’ll be able to repay your debts, then you should discuss your situation with an experienced New York bankruptcy lawyer.
For answers to more questions about bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Brooklyn bankruptcy attorney Bruce Weiner for a free initial consultation.
