Why Your Credit-Card Debt Won't Die

We tend to pay off the card with the smallest balance first, regardless of the interest rate.

One reason Americans carry about $800 billion in credit card debt is that we goof up when we try to pay it off.

On average, households with credit cards owe a total of more than $15,000 on five cards, including retail cards. Those accounts have various interest rates and balances. The best strategy for paying down the debt is to make the minimum payment on all the cards except the one that charges the highest interest rate; on that account, you should pay as much as you can afford. When that balance is paid off, concentrate on the card with the next-highest rate. This approach minimizes the amount of interest you pay, which means you’ll pay off the cards as quickly and cheaply as possible.

That’s not the way we usually do things. Instead, we tend to pay off the card with the smallest balance first, regardless of the rate. Studies show that we do this to give ourselves a psychological boost: It feels so good to check one debt off the list, and it’s faster to pay off the card with the lowest balance. Academics refer to this need to cut the number of cards as “debt account aversion.”

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In addition, we don’t properly consider the nasty effects of compound interest. Basically, our brains aren’t adept at quickly calculating its financial impact. Think of $10,000 in credit card debt with an interest rate at the national average of 14.9%. You want to pay off that debt aggressively, so you figure you’ll pay 4% of the balance, or $400, on the card each month. Quick, how long will it take to pay it off? You may think, Twenty-five monthly payments would be $10,000, then add in some interest. The debt will disappear in a couple of years, right?

In fact, you’ll be paying for 31 months and will rack up more than $2,400 in interest. If you bump up your payment to $600 a month—maybe by diverting the money you would have directed to a low-balance, low-rate card—you’ll eliminate the $10,000 debt in just 19 months and save about $1,125 in interest. Yes, you’ll end up paying more on the other card for a longer time, but the net gain of a higher payment on the higher-interest card can be considerable.

Cold reality. Coming to grips with the bottom-line dollars and cents is one good way to motivate yourself to focus on the card with the highest interest rate, says Cynthia Cryder, a marketing professor at Washington University in St. Louis. “If we work out what the actual costs are, it has more meaning to us,” says Cryder, who is one of five authors of a paper titled “Winning the Battle but Losing the War: The Psychology of Debt Management.”

For their paper, Cryder and her coauthors devised a series of experiments on debt-account aversion. Among their findings: Showing subjects the total amount of interest helped spur them to pay off the card with the higher interest rate first, as did consolidating some smaller debts.

I would suggest that debt consolidation is the best first step in attacking multiple accounts. If having many accounts causes us to waste money by paying off smaller ones, get rid of small accounts.

Cryder points to another problem that keeps us from paying off cards: the minimum payment published on every bill. The “anchoring” bias causes us to pay at or near that amount because our brains fixate on it as a point of reference. Worse, says Cryder, some of us see it as a suggestion, “so paying the minimum balance seems like the prudent thing to do.” But keep your focus on the highest-rate debt.

Bob Frick
Senior Editor, Kiplinger's Personal Finance