Bookmark this page
Debt is a major issue for many American families.
And when it comes to juggling credit card debt, mortgages, car loans and student loans, many Americans are making the wrong financial moves.
Staring at multiple debts, many consumers pay off smaller debts first even when larger debts have higher interest rates, according to a new study, co-authored by a researcher from the University of Michigan.
This strategy of chipping away at small debt balances with lower interest rates first when larger debts with higher interest rates are looming makes it harder for consumers to dig out of debt, says Scott Rick, an assistant professor of marketing at the University of Michigan.
"If the smaller debt carries a higher interest rate, it makes sense to pay it off first," Rick says. "When it's reversed, when the bigger debt has a higher interest rate, you should stop doing it. But people do it anyway."
Why do people ignore interest rates and focus on balance size instead?
"Emotions drive us to wipe a debt off the books," Rick says.
So it seems when it comes to managing credit cards and other debt, consumers would rather feel the relief of having one less debt to pay, rather than lowering their overall debt total by tackling a larger debt with a higher interest rate.
The study, which used a series of field surveys and laboratory experiments to track how consumers manage multiple debts, calls this phenomenon "debt account aversion."
One way to nudge consumers toward paying off higher balance and higher interest debt was to show them the total amount of interest each debt had accumulated.
Reporting the total lifetime amount of interest accumulated on the current credit card balance, as opposed to just the amount of interest accrued on the previous bill, would make for more effective credit card statements, Rick says.
Fortunately, under Federal Reserve Board regulations that took effect July 2010, credit card statements must show the amount of interest charged on each balance for the period and the year-to-date totals for fees and interest charged.
What do you think? How do you prefer to pay down multiple credit card balances?
Follow @Bankrate
I agree with both comments, if your finances are driven by emotions or minimums are the only amounts that can be met with marginal extra payments.
On the flip side, if you can see past the emotional "win" of a small debt being erased, you'll see the interest rate is always the mathematical winner.
A few hundred extra on a 1.9% car loan will save you just that. A few hundred extra on a mortgage will save thousands (especially in the early years).
I think it makes more sense to pay off the smaller debts first. You get quick wins, which builds up your confidence. You get a sense that you can actually get out of debt. If I had a $5,000 credit card bill with a 15% interest, and few small debts of several hundred dollars apiece on low or no interest, I'd pay the small debts first. I'd feel like it was going to take me forever to pay off the credit card. However, getting those small debts out of the way makes me feel like it's possible.
"Emotions drive us to wipe a debt off the books"
The researcher seems to be imply that customers are being irrational. I couldn't disagree more. Consumers with multiple debts often feel very overwhelmed with their situation. (I speak from experience-- I'm a Certified Consumer Credit Counselor and have counseled over 7000 people over the years.) The emotional boost from knocking out the smallest debt can often propel someone to stick with a debt repayment plan.
One other factor to consider is risk. With fewer debts to worry about, there are fewer late fees and fewer possible lawsuits if someone cannot keep up with the payments in the future.