Numbers don't lie, and statistics state that Americans are drowning in debt. According to NerdWallet, the average household owes credit card companies $16,061. Collectively, American consumers owe around $930 billion. It's at the highest point since the financial crisis.
Consumers need to start paying. One way to start is by paying off accounts that have the highest interest rates. This may be the smartest solution, but it may not be the best in a real-life setting.
According to a research done by the University of Michigan, most people pay accounts with smaller balances rather than the accounts that carry the highest interest. While most financial advisors would view this method as backward thinking, Harvard Business Review is in support for such re-paying strategy.
After analyzing approximately 6,000 HelloWallet users, Harvard researchers determined that the users that are paying off one account, as opposed to paying several accounts at once, paid off more debt in 36 months.
The researchers then tested the strategy with a real-life simulation. The simulation involved giving participants a 'debt' that they need to pay back. For each participant, the debt is divided into five accounts. As a motivation, they told the participants that they could earn money by paying the debt off. Each participant is given a strategy to use. The participants that were assigned to pay off one debt finished 15% faster compared to participants who had to pay off five accounts at equal amounts simultaneously.
Ultimately, Harvard researchers concluded that it's all related to a big psychological factor. It seems that it's all about how much you have paid in relation to the remaining balance that can help with the motivation.
For example, if you have two accounts, one carries $5,000 in debt while the other has $7,000, repaying $2,500 of the $5,000 would make you feel more productive compared to re-paying $1,250 for each account. Even though you essentially paid the same amount, $2,500 is halfway to closing the $5,000 debt. It's a big mental victory.
Dave Ramsey, a best-selling author, also recommends the strategy. He calls it the snowball plan. According to him, when you see it in a mathematical perspective, the better option is to start with the highest interest rate. However, it could be said that if your goal is to pay off your debt completely, then motivation is a much bigger factor compared to sticking to the math.
Research suggests that paying off small accounts first can help you with your motivation. Once you have closed a few smaller debts, you will have the confidence to take on larger accounts. With paying off big accounts first, you may get the feeling of not progressing fast enough. As a result, it's easier to feel overwhelmed and discouraged.
At the end of the day, you need to pay off your debt. Paying off a debt using a "mathematically" inefficient method is a lot better compared to not paying at all. Hence, do what works for you just as long you are making progress.