October 18, 2011
People Make Mistakes When Paying Cards
Myth: I should pay off the debt with the highest interest rate first to get out of debt quickly.
Truth: You should pay off the smallest debt first to create the greatest momentum in your debt snowball.
Behavioral economist Dan Ariely might agree with Dave Ramsey’s second statement: Ariely and fellow researchers for the first time have established that people do, indeed, pay off their small card balances first, because it gives them a feeling of accomplishment.
“We have a desire to close things, to feel we’re making progress,” Ariely said in a recent interview. As each card is knocked off the list, “it’s something you can count.” The strategy also dovetails with people’s natural inclination to break down overwhelming tasks into sub-goals to make the task feel more manageable.
But the mathematical truth remains that holders of multiple cards get out of debt faster and cheaper if they first pay down the cards with the highest interest rates. In other words, it’s not in a card holder’s financial best interest to pay off the small balances first, even if it does make them feel better.
The researchers’ first experiment confirmed this behavioral tendency by testing 162 undergraduates who played a debt-management game, as described in their article, scheduled to appear in next month’s Journal of Marketing Research. First, the students received cash and were shown their dollar balances on six credit cards, with each card’s corresponding interest rate – smaller balances had lower rates. In each of 10 rounds, they were required to pay the minimum balance for each card but then could decide how much of their remaining cash to allocate to each card.
The students were split into two groups: The “No Saving” group was required to allocate all their cash in each round; the “Saving-Allowed” group could hold back some money in a checking account to be used during the next round. The interest rate on the account was set so low – 2 percent – that it did not make financial sense to save it. Yet the “Saving Allowed” treatment was designed to simulate how people behave in real life, juggling whether to hold on to their money or pay off debts.
Their finding: Only five participants took the financially optimal route and used their cash to pay the highest-rate debt in each round. On average, players lost $12,051 by paying additional interest they did not need to pay.
Having established this behavior, Ariely asked, “What do we do about it?”
The paper, “Winning the Battle but Losing the War: The Psychology of Debt Management,” went on to show that people can be nudged into tackling their high-rate cards first. In one experiment, subjects who were not given enough cash to pay off a card with a small balance would divert their money into paying down the high-rate card. This situation “doesn’t give you the full feeling of progress, so now people turn to doing the right thing,” Ariely said.
The researchers in another experiment had reminders pop up on the computer screen to show players how much extra their decision to pay small, low-rate debts would cost them. It was important that the reminders came at the moment that they were relevant, Ariely said, but the strategy worked. Debt consolidation also pushes people toward the financially smart pay-down schedule, because it eliminates options that confuse people and makes doing the right thing easier.
Ariely suggested that financial companies such as Mint.com could introduce products to help people do the right thing. Until then, understanding this behavior may help some people.
“If you understand this is a basic problem, you can think about starting to fight it,” Ariely said.