How Best to Pay Off Your Debt

There’s no question, the logical way to pay off debt is to go after the debt that you pay the most interest on first, and then work down to the accounts with the lowest interest rate.  In spite of the fact that logically this is the best way to chip away at your debt, financial guru Dave Ramsey has long advocated an approach of going after the accounts with the smallest balances first in order to help develop a little confidence and momentum.  Needless to say, with total credit card debt in the U.S. soaring at around $1 trillion and the average credit card debt, per household with credit card debt, at $15,956 according to CreditCard.com, the time has come to find the way to tackle the debt that works best for you.

A recent study titled “Can Small Victories Help Win the War? Evidence from Consumer Debt Management” in the Journal of Marketing Research based upon data from a leading U.S. debt settlement company shows that “closing debt accounts—independent of the dollar balances of the closed accounts—predicted successful debt elimination at any point in the debt settlement program. Indeed, the fraction of debt accounts paid off appeared to be a more powerful predictor of whether the person eliminated his or her debts than the fraction of the total dollar debt paid off, despite the latter being a relatively more objective measure of progress toward the debt elimination goal.”

The New York Times recently discussed these findings in “To Get Out of Debt, It May Help to Think Small.”  As this article notes, for some consumers there is a “snowball effect” if you go after your debt with the smallest balance first rather than the highest interest rate first.  It’s kind of like having a checklist of chores – knocking a couple of them off your list can inspire you to keep working on your list – after all, success tends to breed success.  In Chapters 6 through 8 of Personal Finance, Turning Money into Wealth, we talk about debt, and in Chapter 8, in the section titled “Successful Debt Management” we discuss six keys to successful debt management – and, logically, you would certainly want to tackle the debt you’re paying the most interest on first.  But this new research shows that for some people there may be an intermediate approach that makes the most sense – a combination of a motivational approach and the logical financial approach.  For those who feel overwhelmed by the amount of debt they are facing it might make more sense to go after the debt with the smallest balances first and gain a little momentum.  Then once you have a little confidence, go after the high interest accounts – in effect, use a combination of the two approaches.

Discussion questions:

  1. Which approach do you think would work better for you if you owed $25,000?  Why?  Be prepared to discuss this in class.
  2. Go to the CreditCards.com website and find 3 facts that you find surprising.  What were they and why did you find them surprising? Be prepared to discuss these in class or write a one page paper on them.
  3. Have you or your parents successfully retired debts? What approach was taken?
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