Debt repayment and small victories: When size matters

My first contribution to The Economist’s Free exchange blog is about helping people to pay back their debt:

BENJAMIN Franklin said he would rather go to bed without dinner than to rise in debt. Most of us, however, are in debt at some stage of our lives. If we expect to earn a higher income in the future, we can smooth our consumption over time by borrowing when we are younger. Taking loans to invest in a college education, for example, thus makes sense. Nonetheless, many of those who are at the end of their earning years still have not paid what they owe; more than 65 percent of American families with heads aged 65-74 are in debt. Similarly, estimates by Britain’s Treasury show that up to 40 percent of university graduates may never repay their loans.

So what can be done to reduce the level of personal debt? Standard economic theory suggests that paying back loans based on their interest rates, from highest to lowest, should be preferable since this approach minimizes the total interest paid. However, empirical evidence suggests that this may not always be the case; a study of 6,000 debtors found that, while controlling for debt size, individuals who paid off their debts from smallest to largest were more likely to succeed than those who used other repayment strategies. The authors hypothesize that “[c]onsumers seem to believe that closing off debt accounts, regardless of balance size, is important in motivating them to persist in the goal of eliminating their debts”, which implies that an individual may have a higher probability of repaying loans by focusing on the size of the debts rather than that of the interest rates. The support for this theory is now reinforced in a new behavioural study by Alexander Brown and Joanna Lahey of Texas A&M University.

Read the whole story here.

Simon Hedlin

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