It makes logical sense to pay off your highest interest rate debts first. Yet research shows that paying off smaller balances is actually more effective. It’s a good reminder that making financial progress isn’t just about logic, it’s also about behaviour.
Photo by John Lodder.
At the Harvard Business Review, researcher Remi Trudel discusses his recent study published in the Journal of Consumer Research. Using anonymous financial data over a period of 36 months, Trudel and his team looked at how 6000 debtors paid off their balances. First, they found that prioritising one debt over another was effective:
We found that consumers who concentrated their repayments on one of their several accounts paid down more of their card debt than those who dispersed their repayments equally across multiple accounts.
Based on this data, they then conducted their own research to study different debt payoff strategies and methods. In one experiment, they had subjects either pay down debt using the equal disbursement method or by focusing on one at a time. Their findings backed up the data:
Participants assigned to the concentrated repayment strategy worked harder than those who dispersed their repayments, producing more words and repaying their debt 15% more quickly.
They ultimately found that the reason this method works so well has to do with the power of small wins. Trudel explained (emphasis ours):
…it is not the size of the repayment or how little is left on a card after a payment that has the biggest impact on people’s perception of progress; rather it’s what portion of the balance they succeed in paying off. Thus focusing on paying down the account with the smallest balance tends to have the most powerful effect on people’s sense of progress — and therefore their motivation to continue paying down their debts.
In the personal finance world, this is called the Snowball Method. Their research supports other data (like this study from Northwestern University’s Kellogg School of Management) that shows the Snowball Method is the most effective debt repayment strategy. Again, personal finance has a lot to do with psychology, so even though it might make more sense mathematically to focus on debts with the highest interest rates, it makes more sense in practice to focus on small wins.
However, even Trudel adds the caveat that this method makes more sense “to the extent that a consumer’s debt accounts have similar interest rates”. If you have a debt with a slightly higher balance but a massively higher interest rate, it probably makes more sense to focus on that instead. You’ll still get the small win, but you’ll save money on interest. And this is an important point — you don’t want to throw all logic out the window, you just want to make sure you’re working with your mindset rather than against it.
For more on the study, head to the links below.
Repayment Concentration and Consumer Motivation to Get Out of Debt [Journal of Consumer Research via HBR]