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Tuesday, August 21, 2012

To Get Out of Debt, It May Help to Think Small


Score one for Dave Ramsey, it seems.

Mr. Ramsey, the sometimes controversial personal-finance guru, is known for, among other things, advocating that consumers tackle small credit-card balances first - regardless of the interest rate on the debt - in order to pay down debt in what he calls the “snowball” effect.

Now, researchers at the Kellogg School of Management at Northwestern University have crunched data from a big debt-settlement firm and found evidence that this “intuition has a basis in reality.”

People with large amounts of debt, they found, are more likely to succeed in paying down their entire debt if they first attack the accounts with the smallest balances - even though that approach might end up costing them extra  money in interest over the long haul. That's because, they say, “maintaining motivation to eliminate debts over a long time horizon might necessitate small wins along the way.”

In other words, it feels good to close an account, and that helps you persevere until you can finish the job.

“It's not just how much progress you've made towards the goal in the ‘real' dollars and cents way, but the idea that you're crossing off the list,” said Blakeley McShane, an assistant professor of marketing at the Kellogg School and co-author of the research with David Gal, also an assistant professor of marketing.

Psychology comes into play as much as math, in other words. “Even if we know what the rational thing to do is, we're not cold, calculating machines - we're human beings,” he added.

The findings appear in the August edition of the Journal of Marketing Research.

The rese archers tested whether closing individual accounts affects a consumer's likelihood of eliminating their overall debt, regardless of the absolute amount of debt in the closed accounts. To do so, they examined nearly 6,000 consumers in a debt-settlement program, which is a program designed for borrowers who can't meet the minimum monthly payments on their debt accounts. Participants are required to make a single payment each month to a designated savings account. The debt settlement firm negotiates with the consumer's creditors to reduce the balance due on the consumer's debts and the money saved in the accounts goes to pay off the reduced balances. It typically takes several years to pay down the balances.

The analysis found that “the fraction of debt accounts paid off appears to be a better predictor of whether the consumer eliminates his debts than the fraction of the total dollar debt paid off,” even though the latter criteria is a “relatively more objective” measure of progress toward the goal of erasing debt.

In other words, if there were two hypothetical borrowers with identical amounts of debts and accounts - say, $10,000 total, comprising one $6,000 debt, one $2,000 debt, and two $1,000 debts - the one who, at any given point, closed more accounts (two accounts of $1,000 each, say, rather than one single account with $2,000 in it) would be more likely to eventually eliminate the total debt, even if the closed accounts contained the same amount of money in total.

Prof. Gal said the findings have relevance for pursuing other goals, even if they aren't as weighty as getting out of debt. “If I had a checklist of tasks, I might want to tackle the easiest one first because that would get me motivated to get to the difficult task,” he said.

The researchers say they aren't necessarily recommending such an approach to debt reduction. But it would seem to make sense to inform consumers of both the “rationally optimal” approach, which would involve paying off high-interest balances first, as well as of the potential psychological benefits of closing account balances. Then, they can make an informed decision.

Have you successfully retired debts? What approach did you take?