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Debt Snowball Is Predictably Irrational

This morning I wrote about how Dave Ramsey’s Debt Snowball system works [3] 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 [4]. 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 [5])