The Debt Argument: What You Should Pay Off First

By on February 4, 2013

Credit DebateThe issue of managing debt has never been more significant to American consumers, but there is still much debate over whether you should pay off certain debts first or you should spread your funds evenly until all debts are paid off around the same time. If you’re in a position to pay more than the minimum balance, where should you be directing your excess funds?

Today, we’ll take a look at what the math says, then at the psychology of the situation to see if we can come to a definitive answer.

Should You Pay Off The Higher Interest or Lowest Balance First?

What the math says:

Many so-called financial gurus advocate paying off the higher balance first. The logic is simple: pay off debts with the highest APR first, so that you don’t incur greater amounts of interest on preexisting debt. After all, once the interest starts to pile up, it may seem like a hopeless cause to ever think of paying off your debt completely. These same experts go on to argue that by paying off the highest interest-incurring credit cards first, you’ll have more money to tackle the next credit card and eventually pay off your debts in a shorter time period than if you had made small, monthly payments across the board.

While this may save you money on interest, studies have shown that following this advice you may lose motivation to pay off your debts before reaching the finish line. When it comes to dollars and statistics, financial gurus generally know their stuff. But often gets forgotten in all those calculations is the humanistic side of personal finance.

What psychology says:

According to a report published by University of Pennsylvania’s Wharton Business School—Winning the Battle but Losing the War: The Psychology of Debt Management—the mathematical logic in paying off the highest interest-accruing credit cards doesn’t apply when we study how human motivation actually works. In a series of four experiments—ranging from surveys to hypothetical situation studies—the hypothesis held true that the average consumer is more motivated to pay off smaller debts first, as opposed to tackling the debts with the most interest.

In one survey, for example, participants were asked how they would pay off their debts, given the following situation: you hold a MasterCard with a $100 balance and 10% APR and a Visa with a $1,000 balance and 15% APR. Next, they were told to imagine that they had $100 and had to decide how to allocate these funds in order to pay off their debts. Approaching the situation with the mathematical logic mentioned previously, the participant would obviously choose to put the money towards Visa payments, yes? In reality however, many of the participants chose to pay off the MasterCard in its entirety, confirming the notion of debt account aversion (whereas, we feel more successful when we finish paying off a card’s debt and have fewer cards to manage).

UPenn’s subsequent studies confirmed that, although we are accruing more interest when we choose to direct our attention to smaller debts, we are more motivated to pay off our debts because we see more progress. Rather than continuously throwing money at our collective debt load, we can cross out the ‘to be paid’ credit cards on out checklist and narrow it down to one card, one bill left to pay off.

The verdict:

It makes more sense, in theory, to pay off the card with the highest APR and highest balance. However, in practice, we are more willing to persist in decreasing our overall debt load when we tackle the smaller debts first (regardless of APR). The concept of “baby steps” works well here—even if we’ll end up paying more in the end—simply because we as humans need to see signs of progress, which act as positive reinforcement to paying off debt.

If the progress isn’t as clear or we feel as though we’re treading water by trying to tackle all debts at the same time, the more discouraged we become (and thus, less likely to pursue debt-free living with the same fervor we once had when we got serious about decreasing our debt). For optimal results, pay off smaller debts as quickly as you can, but don’t ignore your higher APR debts, either. Start small, move up from there, and enjoy your debt-free life when everything’s paid off in full.

In the end, like with most other things, it comes down to what you feel is right for your situation, and what you’re most comfortable with.



Kelly Kehoe

About Kelly Kehoe

Kelly Kehoe is a full time college student and personal finance writer. In her free time she competes in speech and debate and writes fiction. Follow Kelly @kellypkehoe or on Google+.

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