Guest blogger Rob Berger is the founder of the popular personal finance blog, the Dough Roller.
When it comes to financial decisions, are you more like Captain Kirk or Mr. Spock? If you make decisions based on gut feeling, you and James T. Kirk share a lot in common. On the other hand, if logic powers your financial moves, perhaps you have some Vulcan blood coursing through your veins. And that brings us to “debt account aversion.”
Debt account aversion is best understood through an example. Let’s assume that you have two credit cards. Credit Card A has a balance of $1,000 at 10 percent, while Credit Card B has a balance of $10,000 at the higher interest rate of 15 percent. If you had $1,000 to put toward your debt, which card would you pay? If your goal is to get out of debt as quickly and cheaply as possible, you’d apply the $1,000 to Credit Card B that charges the higher interest rate of 15 percent.
But apparently not all of us want to “live long and prosper.” It turns out that many consumers will pay down a lower interest credit card before a higher rate card if they can reduce the number of credit cards they have with balances. In the above example, many consumers would apply the extra $1,000 to Credit Card A because it would reduce their number of accounts with balances from two to one. Although Credit Card A sports a lower interest rate, many find the satisfaction of paying off a credit card in full to be simply irresistible. And the experts call this phenomenon “debt account aversion.”
In a 2011 study in the Journal of Marketing Research, a group of professors examined the psychology of debt management. Part of the study involved volunteers playing a “Debt Management Game.” The study describes the game as follows:
In the debt management game, participants were saddled with multiple debt accounts that varied in amount [totaling $147,000] and annual interest rate [ranging from 2.50 to 4.00 percent]. The basic game lasted for 25 rounds, and each round represented one year. In each round, participants received a $5,000 cash allotment that they could use to pay down one or more of the open debt accounts. In addition, participants occasionally received cash bonuses that could also be used to pay off their debts ($20,000 in round 6, $15,000 in round 12, and $40,000 in round 19).
The results of the study confirmed the basic theory of debt account aversion. Two findings were particularly troubling:
- First, not a single participant consistently applied the available funds to the debts with the highest interest rates. In one experiment, participants lost on average $12,051 because of nonoptimal debt repayment decisions.
- Second, these costly mistakes occurred even when participants were paid bonuses based on how much they reduced the outstanding debt through the course of the game. Apparently their desire to see a balance paid in full was stronger than walking away from the game with some extra cash.
The study also discussed Dave Ramsey, who is famous for encouraging people to pay off small balance debts first, regardless of interest rates. While the study conceded that in some circumstances such an approach is not always a mistake, it concluded “that debt account aversion can systematically lead consumers astray when larger debts have larger interest rates. Ultimately, debt account aversion might enable consumers to win the battle but lose the war against debt.” Sorry, Dave.
And for those still holding strongly to their debt account aversion, I leave you with this Vulcan proverb: “Challenge your preconceptions, or they will challenge you.”