A Better Way To Pay Off Debts

Source :Gary Belsky & Tom Gilovich :Time moneyland : December 8, 2011

‘Tis the season … to accumulate debt, and in that spirit we thought we’d write about a pair of related and timely subjects. The first is a new study, containing findings that could help you pay off loans faster. The second is a new book that may be the most useful and thoughtful gift you can give. Both could make you wealthier and happier.First the study, which comes from a handful of researchers led by Israeli marketing professor Moty Amar and including Duke University’s Dan Ariely, one of the most creative minds in behavioral economics. In a series of surveys and studies, the investigators identified and examined a cognitive bias they call “debt account aversion”: a strong preference of people with multiple loans to pay off smaller debts first, even when it makes more sense to pay down larger balances on loans with higher interest rates.

The flaw in this approach is obvious: Imagine owing a total of $10,000 to four different lenders, with balances of $300, $400, $1,300 and $8,000 and interest rates of 8%, 10%, 12% and 16%, respectively. Imagine further that you have $1,000 to put toward your borrowings. Logic dictates that you devote everything but the required minimum payments to decreasing the $8,000 balance (which costs more to carry) rather than closing out two of the smaller balances. You’ll pay off everything more quickly. On the other hand, going from four outstanding debts to just two sounds very appealing.

The researchers propose various causes, but at their core they combine to highlight a kind of meta-error we might fairly call the “simplification bias.” All things being equal but especially when they’re not—when we’re anxious, frightened or otherwise stressed or confused—people prefer to simplify their world and choices. In fact, it’s not so much of a preference as an elementary feature of how the mind works.

Which brings us to our second topic, what we might fairly call “Tom and Gary’s Holiday Gift Guide!”

Readers of our book and blog surely recognize the name Daniel Kahneman. Along with his partner, the late Amos Tversky, Kahneman is the parent of behavioral economics: Indeed, in 2002 he was awarded a Nobel Prize for Economics (his Nobel lecture is worth the 38-minute listen). Kahneman has been in the news lately because of a book he wrote; not his first, but the first intended for a general audience. It’s called Thinking, Fast And Slow, and we recommend it with the utmost enthusiasm.

In it, Kahneman offers something of a metaphorical view of decision making that he describes as an ongoing interaction between two independent actors within our minds: System 1 is non-conscious, fast-acting and intuitive; System 2 is generally conscious, slower-acting and analytical. Many of our most common judgmental biases and behavioral head-scratchers emerge from System 1 (which, in broad and loose terms, evolved to help our ancient ancestors deal with challenges to survival) and most of the thinking that allows us to consciously understand and sometimes override those instinctive responses emerge from System 2. But, in general, Kahneman writes, System 1 does most of the work: it is the quiet but influential driver of most judgments and choices. Conscious Thought might get top billing, but without Gut Feeling there’s no show.

And so, even though paying down large debts with high interest rates first makes more sense, eliminating small balances first feels right. After all, Gut Feeling whispers to us, going from four debts to two has to be a good thing. And it can be—if, say, a feeling of accomplishment (“Hey, I eliminated two debts!”) motivates borrowers to focus on paying off remaining debt in lieu of spending (and charging) more. At the very least, though, Amar and Ariely’s paper (“Winning The Battle But Losing The Way: The Psychology of Debt Management“) indicates that your feelings about paying down loans might be counter to your financial well-being—and are therefore worthy of some System 2 thought.

Likewise, Thinking, Fast And Slow is a worthy purchase this holiday season. For yourself, certainly, but especially for someone else in your life. Kahneman is skeptical about our ability to notice and correct our own System 1 biases, but he’s more optimistic about our chances for identifying and tweaking those of others. So this bestseller is really a two-for-one special: a good read for someone you care about—and a chance for them to help you improve your decision making!