What's the best way to pay off credit card debt?
The traditional formula generally goes something like this: pay down the debt with the highest interest rate first. Once that is paid off, proceed to the debt with the next highest interest rate and so on. However, that's not the way most people go about paying off debt.
According to a recent study headed by Israeli marketing professor Moty Amar and Duke University's Dan Ariely, when it comes to paying down debt, we often don't act logically. If we are saddled with multiple debts, we tend to prioritize paring back the total number of loans, rather than reducing the total debt. In other words, we'll tackle smaller debts first so that we have the peace of mind that comes with checking them off the list — even if it means paying more in interest charges in the long run.
The study's researchers use the term “debt account aversion” to describe the phenomenon of doing what makes the most the most sense emotionally rather than opting for the lowest-cost strategy.
“When it comes to paying off debt, 90 percent of people pay off on emotion,” says Chad Gentry, executive director of the Colorado-based Community Credit Counseling Services. “There are so many emotions to [paying off] that small balance, and it is those emotions that ultimately drive decisions.”
According to Cynthia Cryder, an assistant professor of marketing at Washington University in St. Louis and one of the study's authors, there are likely multiple reasons why we tend to shy away from tackling the largest credit card balances first, even though it would save us money.
“It is extremely satisfying to close a debt account and relatively less satisfying to simply pay one down,” said Cryder in an email. “Another critical factor that we know exists is that people have difficulty understanding interest rates.”
If interest charges are expressed in terms of dollars instead of percentages, Cryder notes, debt account aversion becomes much less prevalent, and people tend to opt for saving money by paring back high-interest debt first.
Not everyone agrees that starting with the debt with the highest interest rate is necessarily the best way to go. Author and financial guru Dave Ramsey advocates a “snowball method.” Focus on paying down the debts with the smallest balance first. Once that debt is paid off, apply the money freed up to concentrate on getting rid of the next (now) smallest debt balance and so on. Only worry about interest rates if two debts are of similar size — then, obviously, tackle the one with the highest interest rate first.
“You need some quick wins in order to stay pumped up about getting out of debt,” Ramsey explains on his website. “Paying off debt is not always about math. It's about motivation.”
Cryder acknowledges that working with debt account aversion rather than denying it might make the most sense in some cases.
“If a consumer feels that paying toward a smaller debt will motivate them to allocate more money from spending toward debt repayment, then, by all means, use the snowball method to keep up motivation,” she notes.
However, if you're already maxing out the amount you can allocate toward debt repayment and don't need the extra boost of motivation, Cryder says that prioritizing accounts with high interest rates will yield the best financial outcome overall.
Paying back debt is not the only area where our feelings might sabotage our financial well-being. When it comes to making purchase decisions and taking on debt in the first place, we may be even more irrational.
“When it comes to making purchase decisions, people go on emotion first and logic second or third — or not at all,” Gentry says.
The same holds true for Americans' long-lived love affair with debt, Gentry says. Consumer credit card debt peaked at $976 billion in 2008, according to the Federal Reserve. In the wake of the financial crisis that ensued, Americans paid down credit card and other debt balances with gusto. Now, however, even as the economy continues to limp along, consumer debt is heading back up.
In November, U.S. consumer borrowing jumped by 10 percent, the largest percentage increase since October of 2001, according to the Wall Street Journal. The surge was driven in part by an increase in credit card borrowing, which was up by 8.5 percent.
“People went right back to their old credit behavior pattern as soon as they got a little more comfortable,” Gentry says. “In fact, 2008 might have been the only year in history that we paid off our credit card debt as a whole. That is kind of scary when you think about it.”