I have to admit it bums me out when the numbers don’t tell the whole story of how to get out of debt. If one interest rate is lower than another, I want it to be natural that borrowers will trend in that direction. Likewise, if one price is higher than another I want to know that consumers will lean the other way. But I’ve learned I must accept that’s not always the way it works when it comes to figuring out how to pay off debt.
So, what is the best way to get out from under debt? First, assess your situation. When you know what your situation is, particularly when you have a bunch of debts on a bunch of credit cards with various interest rates, I’ve always advocated debt stacking. This is the approach by which you tackle your debts in order of highest interest rate first. That makes economic sense. The highest interest rates cost borrowers the most. So by eliminating them first, you get out of debt faster and more cheaply. The other popular pay down method is called the debt snowball. If you use the debt snowball, you tackle your smallest debts first wiping them from your plate and enjoying the benefit of wins that come at a quicker pace. I get it psychologically, but always thought that the benefit of saving more money ruled.
As anyone who’s had to do it knows, paying down the years of accumulated debt can take years. As far as debt stacking goes, a new study shows I’m not always right when it comes to the best way to pay off debt. As the New York Times Bucks Blog reported: “Researchers at the Kellogg School of Management at Northwestern University have crunched data from a big debt-settlement firm and found people with large amounts of debt are more likely to succeed in paying down their entire debt if they first attack the accounts with the smallest balances — even though that approach might end up costing them extra money in interest over the long haul. That’s because, they say, ‘maintaining motivation to eliminate debts over a long time horizon might necessitate small wins along the way.’
In other words getting out of debt seems to be the operative word. As anyone who’s gone through credit counseling knows, you need a get out of debt plan. Many people quit before they finish. Which of course, can scratch the whole faster/cheaper benefit. “That’s the downside,” said Blake McShane, an assistant professor of marketing at Kellogg and a co-author of the report. “One of the implications of our findings is that there’s no universally optimal solution.”
In light of this, what do the researchers suggest when paying off debt?
“The one thing I would want to note about the so-called rational strategy is that if you’re someone who knows you’re going be able to get out of debt, I don’t think you can argue with [debt stacking]. It’s unassailable,” McShane told me. “If you lack motivation, building up quick wins can be more effective at keeping you motivated and sustaining the process.”
David Gal, who is McShane’s co-author and is also an assistant professor of marketing at Kellogg, also noted that your payment plan can depend on the variety of interest rates you’re looking at. “In many cases [with credit card debt], the interest rates are all pretty similar. In that case, you can focus on paying the smaller accounts first.”
These seem like two good rules of thumb: one, consider your motivation. Two, consider the variation in interest rates. If you need a psychological boost and the rates of your three accounts only vary by a point or two, maybe (just maybe!) starting with the smallest balance is right for you.