CHICAGO, Aug. 7, 2012 /PRNewswire-USNewswire/ -- Which account balances should consumers pay off first in order to ultimately get themselves out of debt? A team of researchers at Northwestern University's Kellogg School of Management has found that people with large credit card balances are more likely to pay down their entire debt if they focus on paying off cards with the smallest balances first--even if the approach doesn't make the best economic sense. The research appears in the Journal of Marketing Research.
Credit card debt in the U.S. totals about $1 trillion, and U.S. residents, on average, each have five cards. So when there is not enough money at bill paying time to cover the entire debt, cardholders have to figure out the best strategy for paying it down over time. The 'rational' strategy—because if followed to completion it ultimately costs less in interest payments—is to pay off the cards with the highest rate of interest first, regardless of the amount owed on the card. This is the strategy recommended to consumers by the U.S. government. However, an alternative popular approach advocated by some financial advisors, and sometimes referred to as the "snowball method," is to pay off the small balances first and the big ones later. It is believed that such an approach might increase the likelihood that people get out of debt by keeping them motivated through "small victories."
Kellogg School faculty members David Gal and Blakeley B. McShane, both members of the school's highly regarded marketing department, got to the heart of the question by obtaining access to a unique data set. Provided by a leading debt settlement company, it gave precise information about how nearly 6000 people actually paid down their credit card debt. In their analysis, Gal and McShane found that building up a track record of "small victories" by paying off the cards with smaller balances first and the bigger ones later was more likely to lead to elimination of the entire debt balance.
"We found 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," said Gal. The authors say their research raises important policy questions. "Perhaps consumers should be told of both the rationally optimal approach to eliminate debt--that is, paying off higher interest balances first--as well as the possible psychological benefits of closing account balances. Consumers can then make an informed decision," said McShane.
Nothing triggers more arguments across the kitchen table than money. Now research shows that one way to build the confidence and motivation to pay off a large credit card debt is to pile up the quick wins that come with paying off the easiest ones first and the larger ones later.
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