New research debunks popular method of paying off debt

New research debunks popular method of paying off debt

www.physorg.com

Consumers with multiple debts routinely mismanage them, paying off small debts first even when larger debts have higher interest rates, says a University of Michigan researcher.

Although some personal finance experts advocate eliminating smaller debt first—even if it has a lower interest rate—in order to get a quick win, new research from Scott Rick of U-M's Ross School of Business shows that such advice actually makes it harder to dig out of debt.

(visit the link for the full news article)


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webuser.bus.umich.edu

I found this to be more interesting that I thought it would be....

As a member of the group of Americans who are truly limited to economic survival (rather than prospering) I thought this was going to be another tiresome diatribe about the usual platitudes offered up by those who live in ivory-towers.

At the worst it could have been another banker-sponsored subtle mindwipe piece about our value as people being pegged to their "credit score" scam.

But the research and analysis was very much in tune with something much less expected - how to actually get out of debt. (This is something I think most financial institutions fear since without debt to charge for service they have no negative feedback loop of debt to impose on their clients.)

"It really seems like it makes sense when confronted with multiple debts to eliminate one right away," said Rick, U-M assistant professor of marketing. "But there are more obscure attributes with debt, like interest rates, that make it the wrong thing to do in some cases.

"If the smaller debt carries a higher interest rate, it makes sense to pay it off first. When it's reversed, when the bigger debt has a higher interest rate, you should stop doing it. But people do it anyway."

Interestingly, at least in my case, I found that I too was failing to consider some very real aspects of debt management.

Their results show that consumers with multiple debts focus on reducing the total number of outstanding loans rather than on the total debt across loans. This phenomenon is known as "debt account aversion" and it's a strong bias.

It's so strong that experimental participants stuck to it even when they were required to acknowledge how much interest they were accumulating.

Make sure you click on the additional link above to see the actual study. It's a .pdf file that you may want to study...

www.physorg.com
(visit the link for the full news article)

It always seemed like common sense to me. I guess I can see the psychological attraction in reducing the number of loans by getting rid of the "easy" ones first but the numbers don't lie.

Get rid of the loan you are paying the most for as soon as possible. You'll end up paying less.

I don't subscribe to this. My wife and I did ours like this:

Paid off a small one first, then took that payment and added it to the next one. When that one was paid off, we rolled those two payments to the next one. It's all the same money going out, but it snowballs and before you know it you are paying down some serious debt. In addition, as you pay these off, your credit score goes up. It's simple, and it works. Anyone advocating otherwise is doing nothing but encouraging you to stay in debt longer.

I disagree, based solely on the psychology of getting out of debt.

When a family decides to get out of debt, you have to enforce austerity measures. Spouse and children are more accepting if you can tell them that it will get better in 6 or 9 months, because you'll be paying off a smaller loan--a used car you need for a second job, kitchen appliance, whatever.

Just try telling your spouse and children that you will need to devote all of your disposeable income for the the next FOUR YEARS to paying off a car loan a year early.

Be sure and tell us how that conversation went. Also, tell us how well your family kept to the new budget after 6 months, a year, 3 years, etc.

Family members, just like taxpayers, will put up with hardship for a limited period. But tell them that this is how it will be from now on, and watch them go on strike, refusing to do dishes, refusing to do homework, refusing to go to bed on time. Then they start stealing out of your change tray on the nightstand, because they know that you plan to deny them candy bars for the next four years. Then they start "borrowing" your debit card, and "forgetting to tell you" about the purchase they simply had to make for school, work, etc.

When you try to stop all surreptitious spending, watch them rebel completely, move out of their bedrooms and launch their own "Occupy Living Room" movement.

so much for family leadership.

I consolidated my debts into one payment, worked extra hours for a couple years and paid everything off.

The easiest way I think is refinancing your home mortgage taking out $X amount that covers all other outstanding debts, paying all those creditors off, and having that one payment on the mortgage. We're all going to be threatened with losing our homes at some point eventually in this current economy & real estate market, so why not make it easier and have less paperwork to track?

The United States seems to be the only country on the planet that encourages its citizens to go into debt via credit cards and loans in order to get a decent credit rating.

Credit cards and loans are not just a two-edged sword, they are a trap for the modern American. Who among us has true job security? It makes no sense to take on debt in these crazy economic times.

Although I realize that most Americans are carrying credit card debt, as I have told my children, the best way is not to have any credit cards. Pay for everything in cash. If you don't have the cash, don't buy it. The most anybody should have is one credit card for emergencies such as car repairs, and it should be kept under lock and key at home. Carrying it around is too much of a temptation. The interest rates are nearly always at loan-shark rates, so if you can't pay it all within 30 days, better not do it.

Also, Americans need to change their behavior. Shopping should not be considered entertainment or a hobby. This is the psychology behind malls, and too many people fall into that trap. Yes, let's make a whole day of it....shopping at a bunch of over-priced mall stores, walking around staring at other shoppers, eating at the food court, and buying more than you can afford.

Worse yet is buying meals at restaurants and groceries with credit cards. That is the biggest waste of money I can think of. Within 24 hours, what you bought at a premium price plus outrageous interest will be exiting your system, and when the bill comes due the following month, what do you have to show for it but a bloated waistline? If you have to buy groceries with your card, you will have less money the following month, and then you're stuck on a hamster wheel of ever-increasing debt and less cash.

I got rid of the last of my cards last year. We have plenty of cash to pay our bills, buy groceries, and go out if we want. We get offers in the mail every day for credit cards. I rip them up and throw them in the garbage, which is where they belong.

I'm not being holier-than-thou; I've been through that credit mess, with maxed-out cards, only able to pay the minimum, and noticing that, even if I didn't use the cards, somehow with the minimum payment, you end up owing more each month, not less. The banks love credit cards. That is why I have grown to hate them.

reply to post by JibbyJedi


Using your home as a bank account never works out too well in the end.

reply to post by tovenar

This is not about paying off a loan early. It is about paying off all of your loans with as little interest expense as possible. Bottom line, by concentrating on reducing the principle on higher interest loans first you pay less interest overall.

All your loans must be maintained but any discretionary funds (or funds which result from austerity measures) should be made as additional payments against the highest interest debt. If your car loan is your highest interest debt you either got a rotten deal or you don't have much other debt to deal with.

Originally posted by Skorpiogurl
reply to post by JibbyJedi

 

Using your home as a bank account never works out too well in the end.

No it doesn't, if you abuse it. That happened to many people during the real estate bubble.

Accumulating lots of unnecessary debt is usually the root of the problem one gets into though. Discipline is important when buying with money you don't have yet. I could be in debt, but instead I have what I need that works, it may not be what I want necessarily, but I want debt a lot less than I want a 70" flat screen TV and the latest tech toys.

Take out a HELOC that equals your debt. (Interest rate doesn't matter).

Have a credit card that either earns you points or cash rewards.

Set up your direct deposit so that your weekly or bi-weekly pay-check is deposited directly back to your HELOC (minus a little bit you need for cash on hand (entertainment)).

Meanwhile, use your credit card for all of your monthly expenses i.e., bills, car, food, gas, 1st mortgage, utilities, whatever.... At the end of the month, use a check from your HELOC to pay your credit card bill in full.

Since all of your money (weekly or bi-weekly) is going directly to your HELOC, you won't accrue anymore than maybe two or three days worth of interest per month on that.

Since your paying your credit card off each month (assuming there is an interest rate associated with the card), you are avoiding paying interest there as well, plus you're earning a ton of points.

Since the HELOC was sort of a consodilation loan, you're not paying any other credit cards so... no interest or miscellaneous debt there.

Since you're paying the HELOC in rapid succession with little to no interest attached, the loan will be paid off at a minimum of 10 years earlier than the maturity date.

This method only works if your monthly expenses do not exceed your monthly income.
This method only works if after you consolidate your credit cards and start paying the HELOC, you stop using your credit cards entirely, except for the ONE that you are using monthly. But don't close them out... if you close out your credit cards it will reduce the amount of available credit you have on your credit report which will bump down your credit rating.

Good luck

reply to post by JibbyJedi


Exactly! But everyone wants everything NOW. It doesn't seem like many people are willing to work and save for what they want anymore. Oh well....

Use cash whenever possible

You will also notice that once your credit cards are paid off but retained with zero balance and no activity... you'll get a letter from the creditor telling you that your credit limit is being reduced due to inactivity. Some of them might even cancel your card. First you'll get the paper incentives in the mail, then the phone calls, finally a cancellation notice. Snakes! They're not going to keep you on their books if they're not making money from you

reply to post by Phage


While that seems all well and good, the fact remains that even though you are paying the highest off first, you are still paying interest on the lower one for a longer period. The only way to get it down, and reduce output of cash is to roll payments to the next card.

Example:

1st card is a $35/mo, then $70, $110, and $150.

Pay off $35 and add to $70. Now that card is being paid off at a rate of $105. When it's gone, add that to the $110, and now you are paying $215. By the time you get to the last one, you are paying $365. It doesn't take long at that rate to do some serious damage. Plus you are saving on the interest you would have been otherwise paying for the other three. When those are all paid off, you bank the $365. This becomes your credit card. After 12 months of saving, you now have $4,380 saved for emergencies or other items you want to purchase without having to go into debt for it. Quite simple.

If you fully read the report, it clearly states that their "projection" was that people would not roll the paid off payment into the next card, but instead pocket the cash. That's a big slice of the pie missing for a research paper!

reply to post by haarvik


While you're taking the time to pay off the smallest one first, what do you tell your other creditors?

Good practice: Have at least six months worth of monthly expenses, including mortgage in your savings. Either that or get six months ahead on your important ones i.e., mortgage, car payments, utilities...

reply to post by Skorpiogurl


I didn't say not to pay the others. You direct all disposable income to that bill and get it gone. Then you can roll the payments into the other one. I know, I did this and it works.

Originally posted by Phage
reply to post by tovenar

 

This is not about paying off a loan early. It is about paying off all of your loans with as little interest expense as possible. Bottom line, by concentrating on reducing the principle on higher interest loans first you pay less interest overall.

Yes that is a good outcome - but for some people it is not unreasonable to have a different objective - that of increasing disposable income ASAP. I completely understand this as an objective, and I have used it sometimes too.

Right now I am in the position of having adequate disposable income - so I am paying off my high interest debt....but at times in the past that has not been the case

I do not think there is a "one size fits all" that works here - both objectives have their place, and switching between them as your situation changes is the best idea.

But better still is to not get into problem debt in the first place!!

reply to post by Skorpiogurl

Since you're paying the HELOC in rapid succession with little to no interest attached, the loan will be paid off at a minimum of 10 years earlier than the maturity date.

That's a reasonable plan. Of course, you're going to have to have some equity in order to qualify for the HELOC in the first place. But didn't you leave out the part about using the HELOC to pay off your initial debt at the beginning? Don't forget that you will still be paying paying interest on that.

Even though HELOCs have a variable rate, in this economy it's a pretty good bet that it would stay well below credit card levels (assuming that's the source of your initial debt) for quite a while. And, of course, that debt is now taking a chunk of equity.

Originally posted by Phage
reply to post by Skorpiogurl

 

Since you're paying the HELOC in rapid succession with little to no interest attached, the loan will be paid off at a minimum of 10 years earlier than the maturity date.

That's a reasonable plan. Of course, you're going to have to have some equity in order to qualify for the HELOC in the first place. But didn't you leave out the part about using the HELOC to pay off your initial debt at the beginning? Don't forget that you will be paying still be paying interest on that.

Even though HELOCs have a variable rate, in this economy it's a pretty good bet that it would stay well below credit card levels (assuming that's the source of your initial debt) for quite a while. And, of course, that debt is now taking a chunk of equity.

Yes, I forgot to mention that. Right off the bat you have to qualify for the HELOC, which isn't easy anymore, but not impossible depending on the bank you go to and the loan officer. Yes, you use the HELOC as a consolidation to pay off all credit card debt, that's the main purpose of getting the HELOC and also you'd have to go slightly above the amount you need to make the initial process work.

I say the interest on the HELOC doesn't matter because if you follow the system you'll never pay more than a few a days worth of interest anyway, and you're paying the loan down much faster than normal.

The idea behind this process is to consolidate, pay down and avoid interest. The tricky part is getting the financial institution that services your HELOC to accept mulitple payments. Also, you have to watch them closely, they tend to drag the payment to accumulate the interest... BUT, if you use auto-bill pay through on-line banking you take their choice away. Best scenario would be to have your HELOC with the same bank you use for banking. It's like handing someone cash, same day (transfer), they have to apply it right away minus non-business days, holidays and any system processing times...

Worst case scenario: you begin the process, over-spend and/or start using your credit cards again. Do that and it's bankruptcy for you!

Sorry... I've been in corporate banking for a thousand years

I use a hybrid model, as needed. I typically build a speadsheet and allocate a certain dollar amount towards paying off debt. Then I add each debt owed with latest balance, intereste rate, amount paid per month and then calculate the amortized amount and payoff date. As each row finishes, I roll the amount from that row into the next one to finish and/or reorder the payoff structure as needed.

I admit some of that is done by hand, but usually, loans that have mid-range interest rates, but quick (less than year) pay off time are the first to go. After that, it tends to be a netsum over life of loan kind of thing. The advantage of paying off smaller loans first is being able to roll the money into paying off larger loans.

Your mileage may vary, etc.. A debt payoff plan usually takes some computing to really figure out the best and cheapest approach.