From Scientific American:

Despite its apparent burden on families across the country, many people do not effectively manage their debt. Most individuals juggle multiple kinds of debts, each coming with different terms and interest rates. This diversification of debt requires consumers to make decisions about how to best allocate limited resources to repay them. The most effective way to pay off debt over the long-term is to focus on the loans with the highest interest rates first. Yet evidence has shown time and again that consumers are likely to manage multiple debts in ways that cost them more over time.

The researchers document a phenomena they call “debt account aversion,” when “consumers with multiple debts are motivated to reduce the total number of debts rather than reducing the total of their associated costs.” The researchers list strategies to overcome this and optimally service debt by paying off high-interest loans first:

• Set up automatic payments to pay their high-interest loans first
• Consolidate multiple debts into one loan (e.g., student loans)
• For institutions looking to get debtors to refinance:
  • Graphically show the difference in interest savings from refinancing
  • Ask debtors to contact your institution even if they don’t want to refinance; need to give them a concrete strategy.

——————

Check out NGPF’s latest unit: Types of Credit

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.