The Verdict Is In: Tackle Smaller Debts First

  • Share
  • Read Later
Derek Cole / Getty Images

Financial experts have long debated the best strategy for paying down debt. Some advise paying off debt in the order of APR, taking on the loan with the highest interest rate first. With this approach, you reduce the amount spent on interest charges every month and free that cash up to chip away at the rest of your debt. Others, including personal finance guru Dave Ramsey, advise tackling your smallest debt first, regardless of the interest rate; when that’s entirely paid off, you move on to the next smallest, and so on. Which approach is better?

Well, Ramsey’s “snowball” method eliminates the total number of different debts faster, but in fact it is also likely to result in paying more in interest over the duration of the debt reduction plan. So the smarter approach, then, is to first pay off the debt with the highest interest rate, right?

Actually, wrong. In light of the results of a new academic study, science has weighed in on the issue, and it turns out Ramsey is right. People who pay off the smallest debt first are more likely to be successful at eliminating all of their outstanding balances.

(MORE: 5 Smart Strategies to Eliminate Your Credit Card Debt)

This isn’t really logical. It make more sense, mathematically, to target your debts in descending APR order. But people aren’t logical. A new paper by two associate marketing professors in Northwestern University’s Kellogg School of Management explores the psychology of motivation that kicks in when we’re working towards a long-term goal like debt elimination.

The two researchers, David Gal and Blake McShane, studied the records of thousands of people who participated in credit-card debt settlement programs and took a look at the results of their efforts to become debt-free. The study compared people who used the “snowball approach” recommended by Ramsey and others with those who took the “rational approach” of first paying off the cards with the highest interest rates. Consumers who utilized the less rational “snowball” method were more likely to actually eliminate credit-card debt.

“You’re seeing the human element in this aspect of personal finance,” says the paper’s lead author, Gal, explaining why a strategy that theoretically should cost more money in the long run due to higher interest payments is more successful. “We conclude that there is evidence that the mere existence of achievable subgoals motivates early goal persistence,” the study says.

(MORE: 10 Things You Should Be Buying Used)

To Ramsey and others, it doesn’t matter if a debt-payment strategy is entirely rational or not. What matters is if it works. “What I have learned is that personal finance is 20% head knowledge and 80% behavior,” Ramsey explains on his website. “You need some quick wins in order to stay pumped enough to get out of debt completely.”

Motivation ebbs and flows throughout the process of striving for any accomplishment. Snagging a “small victory” by completing any distinct portion of your overall goal (in this case, paying off individual debts) acts as a sort of motivational “booster shot.” It gives us proof that our efforts are paying off, and instills confidence that we can accomplish what we’ve set out to do.

(MORE: 12 Things You Should Always Haggle Over)

“There’s a lot of research that suggests perception of progress towards a goal is motivating,” Gal says. “Even if you don’t make absolute progress, that perception of progress is motivating.”

14 comments
MathForTheWin
MathForTheWin

I will never understand the logic of: "Mathematically, it makes no sense to follow the snowball method, but it is what I am going to recommend."  Who in their right mind would want to pay more interest over the life of the loans/debt?  Who the heck cares about small wins -- do what is right LONG TERM!  Short term thinking is what gets people in debt to begin with!  My goodness.  People really just need to think, plan, and sacrifice.  I could develop a plan for paying highest APR first that will work better for people -- and save them money!  They would just have to trust math!

supervelous
supervelous

I pay the highest APR first, and I keep a strict budget with how much I can afford to put towards credit cards each month.  If you can get past the psychological aspect of not falling out of your plan because you're not seeing cards get completely paid off, it is still better to pay highest APR balance first.  I do understand the psychology of this though, it's similar to weight loss, people are more likely to keep working out when they see themselves losing weight in the beginning.  But for someone who sticks to their plan and won't get discouraged, highest APR is better.

DrCabler
DrCabler

I've always been a proponent of paying off debt from smallest to largest.  No, the math doesn't work, but in this case, human behavior is more important.  

If you can get a couple of quick wins under your belt, you are more likely to stick with the plan and see it through to the end.  Yes, it may cost you more in interest, but finishing is more important.  When you can permanently change behavior, you can permanently be successful when it comes to getting out of debt.

I recently wrote a similar article about this same subject that shows how to put together a get out of debt plan, why you should do it from smallest to largest, etc.  I actually like to call it a "Debt Rocket" plan for reasons you'll see in the article.

If you're interested you can find it here:  http://www.cfinancialfreedom.com/CFFwordpress/how-do-you-get-out-of-debt-part-4-the-debt-rocket/

go2mortgageguy
go2mortgageguy

I've read Dave Ramsey, and agree that having a few small victories can provide you with the motivation to finish the race - which is really the important part (eliminating debt).

I paid off my credit cards recently by attacking the highest APR first, then moving down the line until they were all gone.

The method that works...is the best method.  Just be sure that when you have paid down your balances - do not close out your account(s).  I explain why here: http://go2mortgageguy.wordpres...

John | MarriedW/Debt
John | MarriedW/Debt

I advocate the same. Many people are surprised that personal finance has little to do with math. In fact, the entire concept of money is a psychological construct. Those who learn to control themselves can learn to control money.

Queen of Free
Queen of Free

We paid off $127K in 4 years with the snowball.  Absolutely changed our world forever!

glendower
glendower

If I recall, Ramsey came up with the debt snowball method when he realized, "If these people were good at math, they wouldn't be in this mess."

Shavonne Lenahan
Shavonne Lenahan

If you have multiple credit cards with balances and large min payments and then you start paying off the one with the lowest balance, what happens to the other credit cards? Isn't their risk of ruining credit or the companies harrassing you for payment while you are trying to pay the other off? I need to help a family member with credit card debt and any info will be EXTREMELY helpful!

Marcie Meinhart Hatfield
Marcie Meinhart Hatfield

We began Dave's program in  March 2011 with $35,000 of debt.  We will be debt-free (with the exception of our house) by November 2012 through the use of Dave Ramsey's program.  Can't wait for BS3!!!

bebetter19
bebetter19

I'm on the verge of paying off all of my debt by using the debt snowball. It makes perfect sense to have a series of small victories (lower debt amounts) paid off quickly. It signifies progress and provides much motivation. Once this last debt (the largest) is paid off I will have paid of $26,000 worth of debt in under two years. I cannot wait to reach this milestone. Then on I go to baby step 3. Woohoo!

Richard Tesorio
Richard Tesorio

You actually pay all the minimum balances on the cards. You just pay as much as you can on the smallest debt. Once that debt is paid off, you take whatever you were paying on the smallest debt and put that towards the next one, therefore you get that "Debt Snowball" effect. I would recommend checking out Dave Ramsey's stuff or even getting the "Total Money Makeover" book for your family member.

EllenynqLisa
EllenynqLisa

like Alan answered I am amazed that people can earn $6800 in four weeks on the network. did you look at this(Click on menu Home)