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Debt Snowball Is Predictably Irrational

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Cats Love Debt SnowballsThis morning I wrote about how Dave Ramsey’s Debt Snowball system works and why it’s an effective way for people to pay off their debts. It might not be the mathematically optimal way to pay off your debt but it’s worked for many people.

My look at the debt snowball was precipitated by an All Things Considered segment I heard on NPR. In it, Dan Ariely, behavioral economist, talks about a study in which he studied the loan payment techniques of over a thousand people. They gave each person five loans they had to pay off, a salary, and then had them start paying off the loans. The amount they received at the end of the study is proportion to how much you had in the study.

Snowballing Human Nature

From the transcript:

And the decision should be very simple. You pay off the loans with the highest interest rate. These are the loans that cost the most amount of money. What we actually found is that nobody, not a single person, has done that. And these include MBA students who took finance classes and undergrads and people who read Fortune magazine, lots and lots of people.

Now, what do people do? Instead, they try to get rid of loans. (emphasis mine)

In other words, the debt snowball is predictably irrational and it’s also human nature. We put more value on retiring loans than we do on making the right financial decision (paying off highest interest rate first).

Combating Human Nature

The best part of the discussion comes after this revelation that retiring loans is prized in the human mind – consolidate the loans and you’ll be both rational and mathematically optimal. Overcome this natural human desire to retire individual loans by taking it out of the equation. If you can’t, embrace the mathematically sub-optimal because paying off loans in the wrong order is better than not paying them at all.

It’s discoveries like these that always make me eager to read more in the area of behavioral economics.

(Photo: tjflex)

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31 Responses to “Debt Snowball Is Predictably Irrational”

  1. bRobert says:

    One thing I think the ‘sensible’ approach doesn’t take into account is the relief a heavily indebted person gets from paying off a loan. When you pay off ANY of your loans, you free an amount that can be divided between increasing your snowball and giving yourself a little extra breathing room every month. And the chance to build up savings.

    I tried the ‘sensible’ approach for many years and ended up increasing my debt with every emergency. People are successful with the debt snowball approach because it works. It took me two years using the debt snowball, whereas I spent over 10 years making little progress the other way.

  2. Jil says:

    I am such a huge fan of Dan Ariely!! I have read Predictably Irrational and The Upside of Irrationality, both great books.

  3. Alex says:

    So bizarre. Given how completely irrational it is to pay off lower interest loans first, you’d think that there might be some sort of a market opportunity that takes advantage of that arbitrage.

  4. Nicole says:

    That’s interesting. It shows that in our minds, we value the emotional satisfaction of paying off a loan more (sometimes) than the money we would save in interest by paying off the lower interest first.

    • echidnina says:

      People aren’t logical, so we have to think a little bit illogically to solve some problems. If people were perfectly logical, a lot of them wouldn’t be in debt in the first place – so, you can’t rely on logic to get out of it. The satisfaction of paying off a loan is a powerful motivation to keep on moving forward. :)

  5. Mick says:

    When my To Do list becomes overwhelming and there are tasks that I don’t want to do or don’t know how to start I tend to pick off a few of the easy ones. This gives some feeling of accomplishment and begins to make the list feel more manageable. Same principle here I think. It might not be the best or most efficient way, but some way is better than no way.

    • DIY Investor says:

      This is an interesting comment because what you are doing is perfectly rational. You are taking care of the least costly (to you) tasks first. What the people in the Ariely experiment are doing is irrational.
      In effect they are like people who would pay $3.00/gallon for gasoline when the station next door has the same gasoline for $2.50/gallon.

      • Coyote Lovely says:

        Does the $2.50 station require a left turn against traffic? I’d pay a premium to avoid that, and I have. Not .50/gal. But there are situations where I would go that far.

    • billsnider says:

      I worked in marketing before I retired.

      We use to call this “picking off the low flying fruit”. At least we got something done.

      Bill Snider

  6. Eli says:

    Using the snowball method also reduces your total required minimum payment faster. There’s a real “value” for the cash flow option to pay less if needed. With this added value, the debt snowball may not be mathematically worse off than the rational method of paying off the highest interest rate first.

  7. Gates VP says:

    Perfect convergence :)

  8. live green says:

    I first off want to say, great picture. I could see my cat doing the same thing :)

    It is human nature to want to have fewer debts, even if the that mean paying high interest rates. I still think that we need to overcome this and pay off those higher interest rate loans. Unless you have many smaller loans, we need to readjust our thinking so that it will not take longer to pay off those same debts.

    • Coyote Lovely says:

      You have to run a series of both methods for a given debt scenario. The results may surprise you. Avalanche vs. Snowball is often a difference of a few months or less. It depends on how many small debts you have versus how high the high interest is. It’s also worth noting that highest interest is often a similar order to lowest balance! For me it was nearly the same thing. The high interest loans were also the low-balance dept store cards. So it was a moot point!

  9. zapeta says:

    If I had a lot of debt to pay off, I’d approach it with a hybrid method. Maybe pay off the two smallest balances to get some momentum, and then switch to paying off the highest interest rate balances. That way you get the psychological benefit and don’t lose as much money to interest charges.

    • Shirley says:

      This sounds like the most common-sense method to me. Boost your initiative and then go for it with vigor.

  10. daenyll says:

    Definitely would order by interest rates then pay down smallest of higher rates, combining best of both worlds. Getting the breathing room boost and saving in interest cost. Of course I’m more of the rational OCD kinda person who checks the spreadsheet daily just to see where I’m at and how long until I should have the loans paid off, even if they are all low interest student loans.

  11. Ryan says:

    I’m ignoring student loans and any 0% interest loans currently. My auto loan has lowest balance and highest interest rate, so that will go first. My CC is next in line as far as balance (but has a low interest rate) and will take a few additional months to pay off.

    I like the idea of paying the lowest balance first to free up extra money more quickly.

  12. I think it is hard to put a value on the cash flow that is derived from paying off a lower balance. If the payment that you are making to the lower balance is significant, then in the short run it allows you to weather a “small” storm without taking on more debt, since your safety net is then the Emergency Fund + new cash flow.

  13. kitty says:

    “Using the snowball method also reduces your total required minimum payment faster.” – not true, this really depends on the amounts and minimum payments for each loan.

    Personally, I’d certainly go for the highest interest. For lower interest loans, I’d compare them against – CD rates, term of the loan, future expectation of inflation. In some cases with extremely low interest, I’d just keep the loan around.

    But then I don’t have debts, so I think differently…

    • jimmy says:

      You’re really, really missing the point here.

      People prefer to see tangible results. The odds are, that in a given point of time, debts with lower monthly payments are bound to have lower balances. Of course, the monthly payment depends on starting balance, interest rate, and payment length. But these are rules-of-thumb meant to help people in debt who don’t know the difference between wants and needs, and don’t know what delayed gratification is .

  14. Scott says:

    We should focus on teaching our children the fallacies of CC debt vs. mortgage debt. Teach them what APR really means and behavior that is responsible.

    I realized at 26 (I’m a slow learner) of financial consequences and, quite frankly, I’m still learning at 40. I wish high school would have a mandatory debt consequence class in your senior year as this affects you more than most issues in life.

    Simple, logical decision making or knowing where to find the answer is lacking in our society.

  15. Aaron says:

    Prioritizing based on interest rate is exactly what I did. I put together a simple spread sheet for 3 loans which showed the total principle for each month adjusted by interest and by the amount I planned to pay off that month. With that it was easy for me to see how much I’d end up paying to clear all balances and how much more I’d pay if I tried to clear the smallest first. The difference was in the thousands.

    That sheet also kept me honest about what I was capable of doing with a focused budget. I payed off a little over $20k with an after-taxes salary of $38k.

  16. Aaron says:

    I should add that in my scenario the highest rate loan also had the largest balance and the lowest the smallest balance, so I didn’t have to look at which loan gained the most principle each month. Ultimately I think that that approach makes the most sense. Pay extra towards whichever loan is costing you the most. Eventually they will all cost you the same amount every month. Then you can simply divide the total amount that you can afford to spend on debt equally between the loans until those numbers bump up against minimum monthly payments.

  17. Aaron says:

    I take that back. Even if a low rate loan has a much higher balance gain each month than a high rate loan, you still pay less overall by putting all of your extra payments into the high rate loan and clearing it first.

    • Coyote Lovely says:

      One mistake on a low-balance loan can lead to late fees that undo the progress. Snowball is much better for those who don’t have great discipline. This is just one of the situational aspects of the question. It’s a behavioral concept, not a purely numerical one. If you’re disciplined enough to not need this advice, you are probably not in the same depth of trouble as the people who need it the most.

  18. Coyote Lovely says:

    Late fees and so on make a much bigger impact than interest. The avalanche method assumes that you’ll pay the minimum balance on time on every other small loan, but the problem is that reality gets in the way when you tie up so much cash to keep up with that high-interest debt, miss a department store card, and one late fee sets you back for a month or more.

  19. ryan says:

    While I agree with the theory that the debt snowball is irrational, and Dave Ramsey even points out that its not the best way mathematically, another thing that needs to be looked at is the psychological status of the people doing the snowball. I myself am in the middle of my snowball. When I began I was tired. I was working 60-80 hour weeks just to keep from falling way behind. I was sick and tired of being sick and tired. My first debt snowball payments total 75 dollars. That paid off 2 1/2 debts. The boost I got from making those quick, though admittedly small, victories was amazing. Sometimes the math doesn’t cut it. Sometimes you just need a momentary victory. No matter how small.


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