20 March, 2012

How Not to Pay Your Debts

An article by Amar et al [1]. showed how irrational people can be when it comes to paying one’s debts. The experiment setting (or one of them) was simple enough:

You have a two debts with different balances and different interest rates. You need to make a decision how do distribute a given amount of cash to pay back some of those debts. 

For example, let’s suppose you have these two debts:
Debt A: Balance 100 €               interest rate 5 %
Debt B: Balance 1000 €             interest rate 10 %

You get 100 € of cash. How do you allocate the money to paying back those debts (assuming you must spend all of it on paying back the debts)?

How would you?

[scroll down for result]

Suprisingly enough, the experiment shows that 29 % of people actually used the 100 € to pay back debt A! Mathematically, this obviously makes no sense. People should pay back debt B. Let’s look at the numbers:

Pay back A
Pay back 100 € of B
Debt Amount left Accrued interest
Debt Amount left Accrued interest
A 0 € 0 €
A 100 € 5 €
B 1 000 € 100 €
B 900 € 90 €
total 1 000 € 100 €

1 000 € 95 €

So here’s yet another example of how we manage to be very irrational even in cases where the numbers are concrete and easy to calculate. But, thankfully this is one of those problems that can be solved: according to the study, whereas a significant majority of normal consumers paid debts in the above situation unoptimally, only 21 % of financial professionals made the same error. They had learnt to obey the heuristic rule “always pay back the debt with the highest interest rate”.

Amar, Moty, Dan Ariely, Shahar Ayal, Cynthia E Cryder, and Scott I Rick. “Winning the Battle but Losing the War: The Psychology of Debt Management.” Journal of Marketing Research (JMR) 48: S38–S50.