Prioritizing which loans to pay off first

Dan Ariely, author of "Predictably Irrational"

TEXT OF INTERVIEW

Kai Ryssdal: Courtesy of the Federal Reserve, here's one of the upsides of a down economy. We are less comfortable spending money we don't have. The Fed says total consumer debt fell by more than $21 billion in July.

But even if we aren't adding to our debt, a good many of us still have a whole lot of bills at the end of each month. There's the mortgage, the car payment, maybe student loans and credit cards. That is a lot of red ink to deal with, which can make the decision of which bill to pay first daunting. Behavioral economist Dan Ariely has some insights. Dan, it's good to talk to you again.

DAN ARIELY: Same here.

Ryssdal: We all have debt, but it turns out you're about to tell us that we handle that debt differently, like from car loan to credit card to mortgage.

ARIELY: That's right. So recently one of the big banks came to have a chat with us. And one of the things they brought up was the question of how people decide what loans to pay back. You know, this is a time when people have lots of loans and different credit cards and so on, and if they try to pay them back what's first on the priority, what's second, and what's third. And of course, the bank really wants to figure this out. But it struck me as an interesting question as well.

So imagine the following. 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.

Ryssdal: But obviously the banks realize this, right? They realize that it's in their interest to have consumers mismanage their debt.

ARIELY: This is actually very tricky whether banks want consumers to mismanage their debt or not. Because banks do want people to be late and make all kinds of mistakes. But they don't want them to declare bankruptcy. It's actually a delicate balance between the fact that banks want people to pay them a very high interest and penalty but not too much so that people have to declare bankruptcy, and your loan goes away.

Ryssdal: All right, so here comes what I imagine is the behavioral economics $64,000 question. Why don't we do the optimal thing when it comes to our debt?

ARIELY: So I think the problem is closing loans is tempting. I think people don't really compute the interest rate. And what they look at is how many loans they have. And because we overestimate this closing loans, we end up misallocating our money.

Ryssdal: Is there any way to fix that, though. What can be done?

ARIELY: So sadly you know from the hundreds of people that we've tested, there wasn't a single individual who knew the right strategy. Everybody made some mistake. One of the things you could suspect is maybe let's just teach people a simple rule about what they should be doing, but education has never really yielded positive result in the domain of financial literacy.

So instead what I think we could do is to think about mechanisms that could fix this problem. So, for example, imagine there was a central mechanism in which you could submit all your bills to, like a Web site, and you say here is what I owe, and here is the interest rate, and so on. You tell me what's the right allocation. Give me a recommendation of what's the right approach. And I think something like this could help.

Ryssdal: Dan Ariely teaches behavioral economics at Duke University. Dan, thanks a lot.

ARIELY: My pleasure.

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