By Kelli B. Grant
The recent market machinations are the latest indicators that the economic outlook is anything but rosy. For consumers, it’s not a bad time to reassess your financial picture and make a new commitment to saving and paying down debt — the right way.
A study in a forthcoming Journal of Marketing Research found that consumers often take what can be an expensive approach to paying down debt: They wipe out small balances first rather than focusing on the balance with the highest interest rate. “Our research finds that people really like closing accounts,” says study co-author Cynthia Cryder, an assistant professor of marketing at Washington University in St. Louis, Mo.
In fact, in a series of experiments, none of the participants consistently targeted high-interest debt for early pay-down. But that’s the smarter – and often more cost-effective – thing to do, says certified financial planner Lynn Ballou, a managing partner at Ballou Plum Wealth Advisors in Lafayette, Calif. Ideally, consumers should make the minimum monthly payment on every account, and put any extra toward the debt with the highest interest rate, she says. That can save you hundreds of dollars in interest over the life of the loan, and so help eliminate debts faster.
Study authors suspect that consumers take the other approach because it’s psychologically satisfying to see the number of cards with balances drop, even if your overall debt doesn’t change much in the process. “It’s the difference between what’s mathematically correct and what’s psychologically helpful,” says Ballou. And, she adds, that’s not necessarily terrible: “If that’s what it’s going to take to get you busy, then it’s a good thing.”
There is some wiggle room, too, to take the small-balances-first approach, if they truly are minor debts you can knock out in a month or two. Use our calculators to figure out how much interest you’ll pay in each scenario, and whether you should consolidate any of those balances under a lower rate.
A second mistake people often make when paying off debts is not figuring out how to avoid falling back in. “This whole paying down debt has to start with the notion of, what am I bringing home and what do I need to pay my bills now?” Ballou says. Otherwise, you are likely to keep overspending. After paying monthly bills, put a third of your disposable income into savings. ‘Then if some unexpected expense comes along, you’re more capable of dealing with it,” she says. Use the rest to tackle those debts.