Insights & News

April 2016

Perspective on Debt: Behavior Matters

The introductory part of this series covered how to determine the most efficient order to pay off loans.  We identified some common reasons why the effective financial cost of a loan may not be accurately captured by its nominal interest rate and how to adjust for them.  This time, we’ll tweak the situation so that we can highlight another important consideration in financial planning: behavior.

We’ll keep the assumption that you have decided to pay down debt.  We determined last time that when making a lump sum payment, you should pay down the highest-rate debt first and keep going in order (some call this the “debt avalanche” strategy).  Does this picture change if you are paying down debt over time rather than all at once?

From a purely financial standpoint, that changes nothing.  It still makes the most financial sense to direct whatever extra payments you can towards the highest-rate debt and work your way down the list.  What changes is that a lump sum payment is a single decision; once you have made the payment, you can go right back to what you were doing before.  Paying down over time is a lifestyle change.  Addressing the issues that arise because of this is important, as a great plan you don’t follow is really no plan at all.

To decide what you might need to do to accommodate this difference, ask yourself this: how often have you made a resolution to eat healthier or exercise more and then discovered that you’re back to your old habits just a few weeks later?  If you’re the type of person who has been able to change lifestyle habits easily, then the “avalanche” is the way to go.  If you’ve struggled with these types of changes or haven’t ever tried to make them, you may want to consider adapting your plans with an eye towards making it easier to stick with your plan over the long haul.

One approach to handling multiple debts attacks this entirely from this behavioral perspective.  Instead of maximizing your financial benefits by paying down the debt with the highest interest rate first, you pay down the debt with the smallest balance first (some call this the “debt snowball” strategy).  The idea is that seeing the small debt disappear quickly provides a sense of accomplishment that keeps you motivated to continue.  To give a sense of scale, if you have a $3,000 debt at 6% interest and a $12,000 debt at 12% interest while paying down $200 extra per month, you might pay about $500 more overall by using this strategy instead of paying down the higher-rate debt first.  If that higher rate debt is 18%, the difference will be closer to $1,000.  Obviously, this will vary heavily depending on the specific debts and minimum payment terms, but there are many tools out there to help you with these calculations if you need to know the exact amount for your specific situation.

If you think staying motivated with the “avalanche” strategy would be difficult, this extra cost may be worth it.  Fortunately, there are other ways of achieving many of the behavioral aims of the “snowball” strategy without needing to accept the extra cost.

One of the easiest and most effective methods to address the behavioral challenges of sticking to an optimal debt payment strategy over time is to put your extra payment plan on auto-pilot.  Many lenders allow you to set up an automatic payment amount above the standard payment without having to do anything more.  Be aware that some lenders may record this as a prepayment of a future payment by default, which would not affect your interest cost!  Therefore, you may need to do a little work up front to ensure that your extra amount goes towards paying down your principal.  Once you’ve done this initial setup, though, you don’t have to do anything until that debt is fully paid off.

Some may feel discouraged because their highest-rate debt is too large, and their smaller debt will keep hanging around.  If this sounds like you, try looking at your debts as smaller increments.  Instead of treating a $3,000 credit card balance as a single loan, think of it as three $1,000 mini-loans.  When that balance drops below $2,000, you can celebrate having knocked off one of your credit card mini-loans; way to go!

Another idea is to share your plans with someone else.  It’s the same principle as having an exercise buddy or personal trainer; having someone else in the loop can help keep you accountable and lessen the emotional burden.  The conversations might even turn out to be a fun thing for you to share!  A financial advisor can be a great resource for keeping you on track, especially if you’re not comfortable talking about money with your friends.  They can also help you make adjustments or consider other options as appropriate.

The key thing to remember with any debt repayment strategy is that what works for one person may not be helpful for another because their situation or temperament is different.  It may take some trial and error to find the strategy that works for you, so don’t get discouraged.  There’s always another strategy to try and something else you can do to help yourself overcome what’s holding you back.  Just like any lifestyle change, deciding to make the attempt and the willingness to keep trying is the biggest part of the journey to a healthier, happier you.

Next time in this series, we’ll consider the question: what about not paying down debt?

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