Picture this. Your friend has several outstanding loans including credit card payments. He wants you to advise him in managing his mounting debt. What would you advice him?
You will most likely recommend that your friend prepare a monthly schedule and start paying down his costly debt first. This would be, indeed, logical; for paying off costly debt first would reduce the interest cost.
Experiments conducted by researchers in this area, however, suggest individuals behave in a different manner. Suppose there are three loans outstanding- Rs 50,000 at 19 per cent interest, Rs 25,000 at 15 per cent and Rs 75,000 at 18 per cent interest. According to the researchers, individuals are more likely to pay down the Rs 25,000 loan at 15 per cent, even though paying down the 19 per cent loan makes economic sense. Why?
Prioritising payments
When you have multiple loans, you are overwhelmed by the need to prioritise your payments. Neuroscience has shown that our brain typically fails in its logical thinking when it is “overburdened” by complex tasks. We typically overcome this problem by breaking down a complex problem into smaller parts.
In the case of personal debt, breaking-into-smaller-parts could mean reducing the number of loans outstanding. And this prompts individuals to fully pay the smallest loan first, even if that loan carries a lower interest rate! This behaviour is termed debt account aversion, the preference to pay down the smallest loan first and reduce the list of mounting debt, even when there are larger loans with higher interest rate.
But it is not as if we always suffer debt account aversion. What if your friend has only Rs 15,000 to repay a loan? Then, your friend is more likely to repay the costliest loan first, for repaying even the smallest loan will not reduce the list of loans outstanding. Further, debt account aversion can be moderated by nudging people to take an optimal decision, showing them how much they can save by paying the high-cost debt first.