Sunday 30 October 2011

Which Loans Should Be Paid Off First?

From an interview with Professor Dan Ariely of Duke:

ARIELY:Imagine you have two credit card debts, one is for $10,000, one is for $4,000. The one that is for $10,00 you're paying 10 percent interest rate, the one that is $4,000 you pay 4 percent interest rate. Which one would you pay first?

Ryssdal: I'm going to pay down the $10,000 one because it's got the higher interest rate, and it's the larger principle.

ARIELY: That's right. And it seems quite trivial that that's what people should do.

Ryssdal: All right, just for the record I think that's the first time in one of your hypothetical studies that I've actually gotten the right answer. I'm just saying. Anyway, go ahead.

ARIELY: So it sounded quite a simple problem to solve. And we assumed initially that people would just get it right, but nevertheless we did an experiment. We gave people six different loans, that's varied on how much money they owed, and how big the loan was, and what was the interest rate. And people played this game over time, with 36 periods. And what we saw was that people overemphasized closing loans. So if you had four loans, and you could put some money into closing one of them, this was too tempting for people, and they did it very often. And they did it instead of putting the money where it could work the best.

Why do you think people don't reduce their high-interest loans first?

15 comments:

  1. The explanation may be quite psychological and behavioral. People are more averse to up-front losses. As mentioned by the professor, they don't really carefully calculate the long-term interest VS short-term interest stuff. Even if they do, they may overestimate their ability to settle down the bigger but more far-way loan in a short time after paying off the loan which is burning. It is just like that students are more likely to do the 5% accounted homework which is due tomorrow, and think they can rush another 20% accounted project in 1 day, though many times they fail to do so...

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  3. I believe the answer may be a combination of (1) lack of information and (2) satisfaction. The example given by Professor Ariely is extremely simple and clear. When concisely presented with the simple facts, the choice seems obvious. I assume that the terms of most loans are a little bit more complicated and not everyone with a loan invests time to fully understand the differences. Secondly, repaying off a loan certainly has an element of satisfaction. An individual may value the intangible of satisfaction greater than the dollar value lost on paying off a lower-interest loan.

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  4. I think that people choose not to pay off the higher loan amount first because they believe that the lower amounts will be able to be paid off easier. They do not look at it as a $10,000 loan vs. a $4,000; but rather look at it as 2 loans that need to be repaid. Once I pay the easier one, I only have 1 left.

    I also think the experiment could yield different results if there were more disparrity in the answers. For example, a $100,000 loan vs. a $10,000 loan.

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  5. I think the key to this is psychological as well. People compartmentalize things, and often have trouble prioritizing. Thus, if a person has four loans, and can close one of them, this reduces their worry by 25% even if the money could have been much more effective if it had been used to reduce the higher interest rate loans.

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  6. I would also suggest that the drastically different financial/credit/debt environment we live in today, compared to the environment from five years ago, also plays a role. Many consumers with credit debt were employed and had always paid 100% of their monthly balance on time. As people began to lose jobs and income, it is not likely that their first action is to analyze what interest rate each of their credit cards is charging.

    Not that this practical is financially rational, but many credit card users might not realize a new account is only charging 5% and another account charges a variable rate that is now closer to 20%.

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  7. I believe people find satisfaction in seeing loans diminish. That makes it more appealing to start off small and begin by paying off the smaller loans, in anticipation that it will take less time. In theory though, people should make sure they are always paying at least the interest on ALL their loans in a timely fashion. It would be better if they could pay the interest and part of the principal for all loans, but for some people that is just unrealistic.

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  8. The more loans you have the more stress you have trying to manage them all. It is perfectly possible that people value peace of mind over the difference of the money. Also, it could be that they are unaware of the extra costs involved in closing an loan as opposed to paying off some of one with higher interest.

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  9. Finishing something outright is, in my opinion, something that is a mental state of mind. When you finish something you don't need to think about it at all, as opposed to having multiple things to worry about concurrently. Does it make sense, no, do a lot of things make sense, no so is it logical.... I guess so

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  10. Maximilian Roedder2 November 2011 at 12:18

    In my opinion, this is a classical example of people behaving irrational because of some perceived effect of their actions. They believe that they are better off having paid back an entire loan. Therefore, they intuitively decide to take the wrong action. In the end, this example only shows that consumer protection is very important in the field a private consumer loans as many consumers do not behave rationally when making private financial decisions.

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  11. I think this is mostly a psychological and behavioral problem. In general people would rather check something off their to-do list than have a bunch of outstanding loans. They do not realize they are misallocating their money. It could be a lack of information as well. People do not calculate the total amount of interest they are paying on each loan.

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  12. I think I can understand why people were thinking like that. If I value more in closing one of the loans I have, I would do so because I will feel like I only have one more loan that I need to pay back. That will make me better to concentrate on paying back the only loan that I have left. I think it's more like self-satisfaction than making a right decision.

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  13. It may also due to the fact that people set up many mental accounts in their mind. So closing one would make them much happier because they can feel the reduction in the number of loans more deeply than the reduction of absolute value of loans. They may overestimated the significance of closing an actual as well as mental account.

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  14. I liked your comments a lot--- I think you've hit on the reason, which is satisfaction at closing a debt of any size and reduction in worry. This satisfaction can also be important in motivating someone to keep up the discipline of restraining spending, since it gives the person a feeling of progress and achievement.

    I liked Linkui's opening analogy to class assignments, which I think is right on the money. It's easier to do a weblog comment than a term paper, even if the term paper is more important!

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  15. I agree with Jordan. Indeed, very seldom do people make pragmatic decisions on what loan to close off first because it is just too satisfying to be able to have less loans on hand at any point in time. If a person has loan A,B and C outstanding, and it would take more money (although it would be the most practical decision) to close off loan C, they may just close off loan A the first chance they get as they might think that it is better to be over with loan A as quickly as possible as it must be a good thing to have two loans outstanding rather than three as soon as possible

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