Prioritizing which loans to pay off first
There are strategies for lowering your debt faster, but most people don't know what they are. Behavioral economist Dan Ariely talks with Kai Ryssdal about the irrational ways people deal with debt.
Dan Ariely, author of "Predictably Irrational" (Dan Ariely)
More on Spending
TEXT OF INTERVIEW
Kai Ryssdal: Courtesy of the Federal Reserve, here's one of the upsides of a down economy. We are less comfortable spending money we don't have. The Fed says total consumer debt fell by more than $21 billion in July.
But even if we aren't adding to our debt, a good many of us still have a whole lot of bills at the end of each month. There's the mortgage, the car payment, maybe student loans and credit cards. That is a lot of red ink to deal with, which can make the decision of which bill to pay first daunting. Behavioral economist Dan Ariely has some insights. Dan, it's good to talk to you again.
DAN ARIELY: Same here.
Ryssdal: We all have debt, but it turns out you're about to tell us that we handle that debt differently, like from car loan to credit card to mortgage.
ARIELY: That's right. So recently one of the big banks came to have a chat with us. And one of the things they brought up was the question of how people decide what loans to pay back. You know, this is a time when people have lots of loans and different credit cards and so on, and if they try to pay them back what's first on the priority, what's second, and what's third. And of course, the bank really wants to figure this out. But it struck me as an interesting question as well.
So imagine the following. Imagine you have two credit card debts, one is for $10,000, one is for $4,000. The one that is for $10,00 you're paying 10 percent interest rate, the one that is $4,000 you pay 4 percent interest rate. Which one would you pay first?
Ryssdal: I'm going to pay down the $10,000 one because it's got the higher interest rate, and it's the larger principle.
ARIELY: That's right. And it seems quite trivial that that's what people should do.
Ryssdal: All right, just for the record I think that's the first time in one of your hypothetical studies that I've actually gotten the right answer. I'm just saying. Anyway, go ahead.
ARIELY: So it sounded quite a simple problem to solve. And we assumed initially that people would just get it right, but nevertheless we did an experiment. We gave people six different loans, that's varied on how much money they owed, and how big the loan was, and what was the interest rate. And people played this game over time, with 36 periods. And what we saw was that people overemphasized closing loans. So if you had four loans, and you could put some money into closing one of them, this was too tempting for people, and they did it very often. And they did it instead of putting the money where it could work the best.
Ryssdal: But obviously the banks realize this, right? They realize that it's in their interest to have consumers mismanage their debt.
ARIELY: This is actually very tricky whether banks want consumers to mismanage their debt or not. Because banks do want people to be late and make all kinds of mistakes. But they don't want them to declare bankruptcy. It's actually a delicate balance between the fact that banks want people to pay them a very high interest and penalty but not too much so that people have to declare bankruptcy, and your loan goes away.
Ryssdal: All right, so here comes what I imagine is the behavioral economics $64,000 question. Why don't we do the optimal thing when it comes to our debt?
ARIELY: So I think the problem is closing loans is tempting. I think people don't really compute the interest rate. And what they look at is how many loans they have. And because we overestimate this closing loans, we end up misallocating our money.
Ryssdal: Is there any way to fix that, though. What can be done?
ARIELY: So sadly you know from the hundreds of people that we've tested, there wasn't a single individual who knew the right strategy. Everybody made some mistake. One of the things you could suspect is maybe let's just teach people a simple rule about what they should be doing, but education has never really yielded positive result in the domain of financial literacy.
So instead what I think we could do is to think about mechanisms that could fix this problem. So, for example, imagine there was a central mechanism in which you could submit all your bills to, like a Web site, and you say here is what I owe, and here is the interest rate, and so on. You tell me what's the right allocation. Give me a recommendation of what's the right approach. And I think something like this could help.
Ryssdal: Dan Ariely teaches behavioral economics at Duke University. Dan, thanks a lot.
ARIELY: My pleasure.
Comments
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From Oregon City, OR, 09/18/2009
I heard Professor Ariely's comment about his wish that there was a tool for consumers to use in making debt reduction decisions, and realized that I had the knowledge and ability to build such a tool.
Available at no cost, it's at www.whichdebtfirst.com. Enjoy!
From Winston-Salem, NC, 09/17/2009
Those who point out important value in paying off any loan, no matter how low the interest rate, are correct. But each individual should make that decision, based on his/her own circumstances, examples of which are provided in some of the responses below.
Here is the extreme comparison, using the example given, assuming all monthly payments are $500. (Ignore any "minimum" payment.)
Alt.1. Assume all payments go to the $10K debt first and to the $4K debt after the former is paid off. Total $ paid is $15,359 over 31 payments.
Alt.2. Assume all payments go to the $4K debt first and to the $10K debt after the former is paid off. Total $ paid is $15,892 over 32 payments.
Alt 1 is "cheaper" than Alt 2 by $533.
09/17/2009
Another useful tool for considering the options: https://powerpay.org/
From Durham, NH, 09/16/2009
The monthly payments on most loans (other than credit cards) won't be reduced by a partial pay off. So anyone who has a cash flow problem that they think (or hope) might improve over time, is acting rationally by paying off small debts. The debt burden won't be optimally reduced, but cash flow will be optimally increased. Penny wise and pound foolish has a certain appeal during a recession.
From spokane, WA, 09/15/2009
People with high debt to income ratios will actually be more likely to survive an "event" that pushes them toward bankrupty or late payments or whatever. It is like insurance, pay a small fee now to be more likely to survive a larger "event". This assumes of course that paying off a card or loan does not then cause a celebration of charging the card back up.
Example: Assume that a person has $3000 a month to pay $2900 in bills $1000 of which is for 4 loans, and (1)can pay down one of four loans (highest interest loan) partially with some free'd up cash or (2)can pay one (lowest interest) off completely. Option 1 leaves the person with $2900 in bills next month and an expected $3000 in income. Option 2 leaves the person with $2750 in bills next month and an expected $3000.
Seems a no brainer to me that the "best insurance" against going bankrupt would be to reduce the monthly bills. That would leave more room for an unexpected event such as a flat tire that was destroyed to be replaced without then having to decide which bills not to pay.
Of course the philosophy of living paycheck to paycheck is not a smart idea, but we cannot ignore the fact that many either choose to or find themselves in this situation when something "unexpected" happens
From Oak Park, IL, 09/15/2009
Dan Ariely's simplified view of this issue has led him to an incorrect conclusion. In a world where the only cost of a loan is interest it may be rational. The problem is that loan servicing companies have lots of interesting ways to add to your costs(unreasonable late fees, etc) A financial strategy that limits your exposure to those risks and their financial consequences can often be the most reasonable course of action. Just ask anyone who has had a credit card interest rate hike because they were late 2 days on a payment.
From Lynn, MA, 09/15/2009
I really think you two missed the point on why people want to pay off a debt, even if it is at a higher rate. If you have no money, or not enough money, or you expect your income to cease or decrease in the near future, you want to pay off one card so as to reduce the number of payments and the total minimum payment amount. Apparently neither of you has ever had to actually deal with more bills than available funds. Not everyone is eligible to be bailed out by the US taxpayers.
From Galveston, TX, 09/15/2009
Jimmy Chooo, you speak like a true Vulcan who has never had substantial debt. Live long and prosper, my friend.
From Towson, MD, 09/15/2009
Prof Ariely is looking for a tool to help rationalize the loan payoff decision. There is a Mac program called "Debtinator" which does that and also helps to track the loans and expenses. http://www.bassetsoftware.com/osx/debtinator/
From Plainview, NY, 09/15/2009
Several comments got it right. It can be just as much about cash flow and liquidity as interest rates. As treasurer of a small commercial bank I listened to the interview kept waiting for the cash flow explanation. I know that people engage in mental accounting, but there are rational reasons to pay down smaller debts first.
09/15/2009
This topic is so dumb i cannot believe it's even a topic.
Of course you pay of the highest interest rate first. no. brainer.
Those that say "success" in spite of being rational (hence irrational economics) makes sense, then how about this scenario. Would you rather pay your high interest loan or pay your lowest but smaller interest loan or buy yourself a nice shiny trophy?
Clearly the trophy would be a mistake, but it does make your feel like a winner.
btw: the logic i've seen here is why we have the financial crisis.
I've even seen a 60minutes interview where the host ask why some teens hold $13,000 debt at 12% interest rate yet have the $13,000 in a bank account earning 3%. They answer "because the $13,000 in the bank is for emergencies. I can pay off the debt anytime, but I don't want to."
From WA, 09/15/2009
Years ago, when applying for a mortgage, the bank required us to pay off the low-dollar & low-interest store brand credit cards (JC Penney, etc) while leaving the higher-dollar & higher-interest bank cards (Visa, Master Card) alone. We wanted to apply the same amount of money against the bank cards instead of the store cards thereby optimizing our pay down of debt. Ultimately we had to chose between doing it their way or no mortgage. I don't know whether the banks viewed a difference between JC Penney debt and Visa debt or they viewed zeroing the owed amount on an account preferable to just reducing the debt load (and interest paid).
09/14/2009
There's one piece of the equation that's missing. Are you adding to the debt as you're paying it down? Are you charging $200 and paying $500 per month? If that is the case then it is best to attack the lower balance card. Once the balance is zero the interest rate effectively drops to 0%.
From Hayti, MO, 09/14/2009
Maybe I missed something. Let's say we have 2 debts of $1000.00 and $10,000.00. And we have $200.00 per month that we can pay. To me paying off the smaller loan gives you the extra money to make a payment on the larger loan that will actually pay off the large loan. A few extra months on the larger loan may add some extra cost but only paying a minimum payment on the larger loan just prolongs the misery.
From CT, 09/14/2009
Prof. Ariely's strategy is correct if the goal is to minimize the total amount of money required to pay off the loans.
However, it would also be perfectly logical to target the smallest-balance loan first - particularly if trying to avoid going bankrupt. That would be the fastest way to lower the total amount owed to lenders each month and thus maximize discretionary income.
From KS, 09/14/2009
I listened with amusement this evening in how irrational I've been behaving in the sequence my wife and I have tackled our debt over the last couple of years. We, too, have followed Dave Ramsey's practices for debt reduction using the "debt snowball" and will have eliminated $61,000 in short term debt by December, a little under 2 1/2 years from when we started. The reward is in paying off the debt, no matter how small. We savored those little victories as we cleaned up after the irrational behaviors that got us there in the first place.
From College Station, TX, 09/14/2009
I think what was overlooked in the study was the personal aspect of how people handle personal finance. Most people are not financial experts and prefer the sense of accomplishment from paying off debts sooner so that more money is available to pay off the next lowest until they are all paid off. A mailbox full of bills will cause stress in anyone who has not learned the steps to prioritize them. The study showed that the sense of accomplishment trumps the savings of a few dollars in interest.
From galveston, TX, 09/14/2009
Dan Ariely completely missed the "emotion factor" in paying off debt. Yes, he is logically correct with his numbers, but if we were purely logical beings none of us would be in debt in the first place. The emotional effect you get from paying off your small loans first and then "snowballing" the amount you paid on that bill into paying off your next smallest bill (ect...) is too large to over look. The feeling of accomplishment grows as each small bill is paid off and as you quickly see tangible results, that great feeling of accomplishment continues to grow and motivates you to start throwing everything at your debts, which I did and I was able to use that emotion to pay off $25,000.00 in credit card debt in one and a half years. Before I always used Dan's purely logical way to try and get out of debt and got so discouraged at not feeling like I was making any headway that I always gave up before making much of a dent. We're emotional beings and I think it's pure folly not to recognize or consider that fact when it comes to debt reduction.
From Baltimore, MD, 09/14/2009
In his study Dan Ariely asked people to come up with a loan repayment strategy and then compared that to the "right" strategy--that is the strategy that costs the least amount of money over the course of all the loans.
It is psychologically rewarding to pay off a loan, but doing so at the expense of another loan with harsher conditions could cost more in the long run.
I agree with Ariely that it would be very nice to have a tool that would help you calculate the repayment strategy that is most efficient. I hope someone is working on that right now!
From Washington, DC, 09/14/2009
The important consideration that Prof. Ariely misses is that debt reduction is an intermediate to long-term process (months to years). As such, the optimal financial behavior is dependent (in part) on the need to form the habit of consistently reducing debt. If this variable is taken into account, then it makes sense that short term successes (i.e. paying off smaller balances with lower rates) will weigh heavily in the calculation that someone makes about which debt to tackle first.
From Schenectady, NY, 09/14/2009
I am always interested in discussions about how to pay off debt -- but I have to say, I found the language of this piece royally annoying: Professor Ariely kept talking about how people in his experiment got the "wrong" answer, made "mistakes," and "misallocated" funds, and that their attitudes have to be "fixed." Even Kai joined in, rejoicing when he came up with the "right" answer. What gives?? As you will hear from countless respondents in these comments, paying off the highest-interest debt first may be logical, but it's unrealistic to expect that people will be logical about paying off debt, which involves some very strong emotions, such as guilt. People need to feel successful. Paying off a small debt gives a psychological boost; that positive energy then goes into paying off the larger debts. If the point of the experiment was to discover how people make decisions about debt repayment, then to judge by the language of this segment, Professor Ariely remains cluelessly mired in his own preconceived notions that all people do and should behave logically when it comes to money. I would not have expected such language from a behavioral economist. Isn't this branch of economics supposed to question such assumptions?
09/14/2009
I beg to disagree with Dan Ariely's argument that paying off smaller debt and wanting to "close" debts is irrational. Irrational from what kind of perspective? From a person who is a human calculator or financial analyst? He fails to consider that people have to also do what works for them, and picking the "financially sensible" option does not necessarily work for people. There are other approaches. Eg. Dave Ramsey's debt snowball method to paying off debt. Actually, what loans one pays off first may have more to do with the size of the loans as well as their interest rates. If the lower interest rate loans are small (in terms of how long it will take to pay off) then paying them off first before higher interest ones does not matter that much.
From Olathe, KS, 09/14/2009
I'm gonna argue that it's better to pay off smaller loans first. That opens up extra money you can apply towards the bigger ones. moreimportantly, it also gives you a sense of accomplishment, makes you feel really good about what you're doing. Maybe that's why people consistantly do it "wrong".
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