Student loans, credit cards, mortgages, car repayment plans, overdrafts. These are just a few of the terms that have become inexorable parts of the fabric of our money language over the last few decades.
With the emergence of consumer credit, the surge in household debt has been nothing short of astonishing. Household debt in the United Kingdom has grown from just above 30% of GDP in the 1970s to consistently above 80% of GDP since the mid-2000s. And the UK is no isolated case. The magnitude of change is equally seismic across most of the developed world.
As interest rates show no sign of a return to the historic levels of 5-6% that we’ve seen in economic good times, lower interest rates have become the new monetary normal. That, of course, is only serving to incentivise higher levels of household debt.
Which leads me nicely to the purpose of this article. How we address our debts is becoming an increasingly important consideration for everybody: from those who are deeply struggling with their escalating debt through to those who are looking to optimise their finances to achieve early financial independence.
But it turns out that reducing our debts is a little more complicated that we’d perhaps first think. First, behavioural science suggests the most mathematically robust method may not be the most effective. And second, sometimes we’d be better off not paying extra towards certain debts at all. Let me explain.
Debt Avalanche vs. Debt Snowball
Let us begin by reviewing the two most common methods for paying down debt: the debt avalanche and the debt snowball method.
Like any other approach to reducing debt, with the debt avalanche we begin by paying the minimum monthly payments on all debts. After we have met our obligations for the month, we then pay more towards the highest interest rate debt first. Only once we have paid off the highest interest rate debt, we move to the next highest, and so on.
Put another way, the debt avalanche prioritises repayment of debts from the most expensive rate down to the least expensive rate.
The debt snowball, on the other hand, takes a different form of prioritisation. After paying the minimum monthly obligation on all debts, this method addresses the debt with the smallest balance first. Once the smallest balance is repaid, we then move onto the next smallest balance, and so on.
This is a method famously championed by Dave Ramsey because of its benefits for motivation and momentum. The truth, however, is that the debt avalanche method can often result in lower payments over time. Based on math alone, then, the debt avalanche tends to be the better approach.
The Psychology of Reducing Debts
But it’s a bit more complicated than that. Just because the debt avalanche method is mathematically superior, it doesn’t mean it’s superior in practice. Out in the real world, our behaviour and psychology affect our decision making.
Small victories help win the war
It turns out that psychologists have a growing body of evidence to suggest the debt snowball method may, on the whole, be more effective in reducing debt. Why? Because small victories matter. As we eliminate one smaller debt, we find ourselves more motivated to persist with an overarching goal.
Two researchers from the Kellogg School of Management demonstrated this point by getting access to the data of 6,000 consumers from a debt settlement company, showing how these individuals eliminated their debt balances. Analysis of their decision making found that consumers who pursued a “small victories” strategy were more likely to eliminate their entire debt balance. In other words, closing debt balances seemed to work more effectively than the optimal approach of paying off higher-interest balances first.
We exhibit ‘debt account aversion’
Not only may the debt snowball method prove more effective, but we exhibit a psychological preference for it. In 2011, Moty Amar, Dan Ariely and a team of researchers published an interesting paper investigating this idea. The premise of their research was to understand how consumers prioritise which debts to pay first. The results were predictably irrational.
The authors developed a debt-management game, in which participants are confronted with multiple debts and must decide how to repay them over time. Their findings were in line with their hypothesis: participants consistently paid off smaller balances first, despite also facing larger debts with higher interest rates.
The authors call this preference for addressing smaller balances first ‘debt account aversion’. It provides some useful context to understanding why the snowball method proved more effective in practice in the Kellogg’s School of Management research.
The power of automation
In 2012, automatic employee enrolment into private pensions was introduced in the UK. In practice, that meant that only by actively opting out could you stop yourself from investing into a private pension (provided you earn above a low salary threshold). At the time, it didn’t seem all that significant. After all, those that weren’t interested would probably just opt out.
Except, that wasn’t quite the case. Automatic enrolment deliberately takes account of an important cognitive bias: our bias for the default. When we default to doing something, we tend to exhibit a preference for the status quo as is becomes established. Such is the power of this effect, 9.9 million workers had been automatically enrolled by 2018. The opt-out rate was just 4.7%.
The case of automatic pension enrolment illustrates an important point. Defaults matter, and this extends to all walks of life, including debt reduction. By automating our finances (a point I’ve written about extensively before) we eliminate incentives to spend impulsively and we establish defaults. By establishing the right defaults, we can make positive leaps towards reducing burdensome debt and better managing our finances.
Before You Take Action
While some of the evidence backs the motivational impact of the debt snowball method, the crucial consideration is context. Circumstances and individual idiosyncrasies are likely to determine the best method.
#1: Do the calculations and understand the differential
The most important thing to consider before you take steps to reduce your debt is the differential cost between the methods. Before taking the road that may bring greater momentum and motivation, consider the additional interest burden, if any. You can make the calculations in a simple spreadsheet or turn to the huge range of debt repayment calculators available online.
#2: Start with the cheapest option
If there is a material difference in the cost between the options, I would always favour the cheaper option first. And if you’re struggling to stay motivated after some months, there’s always the option to switch to the debt snowball method to build some momentum.
#3: Set up automated debt repayments
You may find, however, that once you’ve set up regular automated repayments, the psychological power of defaults does it work. That’s why it’s always worth starting with the cheaper and mathematically more robust option. The default effect really can work quiet magic for our personal finances.
#4: Stick at it
Last but not least, persevere. Reducing expensive debts can have a liberating effect on our mental state, as well as eliminating a huge drag on our net worth. That’s worth remembering when considering returning to our minimum monthly repayments.
Some Leverage Can Be Advantageous
There is one final word of caution to these pointers. Debt reduction is crucially important when it comes to “expensive debt”. Expensive being the operative word. There are circumstances, however, particularly in the current climate of interest rates, where some leverage can be an advantage.
Take the example of paying down a mortgage early. If I have a mortgage at 2% interest, I’m likely to be able to outshoot that percentage over the long term by investing in a diversified portfolio of stocks. Such portfolios typically produce an inflation-adjusted return of 7% annually. Financial logic would therefore suggest a long-term position of investing would be better for my wealth than a long-term position of early mortgage repayment.
Leaving aside the benefits of leverage outside the world of personal finance, this still creates something of a dilemma in the personal finance sphere. Debt reduction can have a powerful psychological effect on our wellbeing, but the trade-off between emotional intuition and financial logic should be carefully considered. This is a trade-off I considered in more detail a few months back.
In summary, the financial maths tends to favour the debt avalanche method for reducing debt. Notwithstanding, the evidence is increasingly suggesting the motivational effects of the debt snowball method make this a preferred approach and even potentially a more effective approach in practice.
How we reduce our debts must take account of our psychology as well as the financial logic. In this respect, automating debt reductions can play a powerful role.
Before we commit to overpaying on our debts, we should run the full calculations. This should not be limited to comparing just the debt avalanche and debt snowball, but should also take into account the potential return if we invested the money elsewhere. While debt reduction can be financially and psychologically powerful, sometimes there is a strong case for the power of leverage.
Ultimately, individual circumstances and context are the defining factors for deciding the best approach to debt reduction. In short, there is no best-case-for-all method. Do your research, do your calculations, make a decision, automate the decision, and then stick at it.