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 %

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”.

[1]

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.
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