You have that big long to-do list, also called your honey-do list. You want to start tackling things, so you go after the easiest ones first. Then you can check them off your list and that gives you a sense of accomplishment. Psychologically, it is very satisfying and it gives you incentive to continue to work on the list.
That philosophy has also been advocated in managing multiple credit card debts by many financial experts, such as personal finance guru Dave Ramsey. If you have numerous credit card balances, the traditional advice is to attack the smallest credit card balances first to get them out of the way, so then you can start working on the larger ones.
However, that traditional thinking may not be the most advantageous economically. A new study by the University of Michigan Ross School of Business professor Scott Rick and others puts that traditional thinking on its head.
If you are in that situation, the study shows that following that traditional advice may make it even harder for you to get out of debt. Professor Rick says that “It really seems like it makes sense when confronted with multiple debts to eliminate one right away. But there are more obscure attributes with debt, like interest rates, that make it not the right thing to do in some cases. If the smaller debt carries a higher interest rate, it makes sense to follow Ramsey’s advice. When it’s reversed, when the bigger debt has a higher interest rate, you should stop doing it. But people do it anyway.”
Professor Rick says “There is a lot of research on credit card usage and debt accumulation. But how do consumers manage the debt once they’re saddled with it? I think that question deserves much more attention than it has received.”
The study shows that when you are working on your credit card debt, the best thing to do is not necessarily to pay off the smallest ones first to take them off your list. It is better to work off the highest interest rate credit cards first, even if they are the largest. It will take some discipline, because it appears that you are not accomplishing much.
However from an economic basis you could be making huge headways. If you attack the most expensive borrowing first, you can pay off the total balances on a more accelerated basis because you would be paying much less interest overall.
With credit card interest accumulating on a monthly basis, you are paying interest on interest. When you have high interest rate credit cards, some credit cards have rates approaching 30%, the interest can rack up astoundingly fast.
But it is not enough to know this, you have to put it into practice. It may be difficult to do. Professor Rick and his colleagues found that even when consumers were shown how much interest was accumulating, they still focused on reducing the number of loans instead of on the total balance of loans outstanding. This behavior is called “debt account aversion”.
This human bias may cause you to make an emotional decision when paying of multiple loans rather than making an unemotional economic one. This debt account aversion may also be at work when you engage the services of a debt consolidation program, in which you combine multiple debts into a single larger debt, even it costs you more overall.
If you have multiple credit card balances or other loans outstanding, it may not be easy to avoid following the advice of many traditional credit counselling services. However, if you are in a bind and you need to get out of debt on a faster basis, run the numbers and follow the money. You will likely find that if you attack the higher percentage rate credit cards first, you will be in much better shape economically, than if you did not.
By: Matthew M. Wallace CPA, JD
Published edited January 29, 2012 in The Times Herald, Port Huron, Michigan as: Buried deep in credit card debt?
Traditional advice may not be the wisest