What's the best way to pay off debt? After making the required payments to avoid penalties, pay down the loan with the highest interest rate.
This may sound obvious, but most often, people take a different approach, according to Dr. Cynthia Cryder, an expert on consumer behavior and a professor of marketing at the Olin Business School at Washington University in St. Louis, Missouri.
"Our research finds that people really like closing accounts," she says. "They will close a small debt account with a low interest rate at the expense of paying down a larger loan with a higher interest rate."
Cryder, along with co-authors Shahar Ayal, Moty Amar and Dan Ariely of Duke University and Scott Rick of the University of Michigan, designed several studies to examine how consumers manage debt portfolios.
Drawing on prior work about the psychology of decisions and goal pursuit, the researchers hypothesized that consumers saddled with multiple debts will primarily be motivated to reduce their total number of outstanding loans, rather than to reduce their total debt across loans, a phenomenon they refer to as debt account aversion.
Throughout a series of debt-management experiments, the researchers found that participants consistently paid off small debts first, even though the larger debts in the study had higher interest rates. In fact, no participant in their sample consistently used cash to pay off the loan with the highest interest rate.
Because small losses impose a disproportionately heavy psychological burden, eliminating a small debt may offer greater relief than making an equivalent reduction to a larger debt.
Still, "while it is attractive to close an account, that's not necessarily the best approach to minimizing your debt burden," Cryder says.
If you need to pay down debt, follow these three proven strategies:
- Consolidate your debt, combining small debt into one larger debt. This will encourage you to pay down debt by focusing on the interest rate instead of the size of the account.
- Focus your attention on the actual dollars spent on interest payments. This will help you prioritize interest rates so you can reduce your overall debt more quickly.
- Put any extra money toward loans with high interest rates.
The study findings were published in the Journal of Marketing Research.
--From the Editors at Netscape