Most New Year’s resolutions have a financial element to them. The most popular one? Debt reduction.
If you’ve got one debt your approach to it seems relatively easy; repay as fast and best as you can. For this kind of debt it is important to not leave it dormant in the background. Just because you forgot about it, doesn’t mean it forgot about you. Debt keeps growing if you don’t mind it; your automated minimum repayment doesn’t beat exponentially growing interest (compound interest). And only repaying the minimum is a bad idea regardless. Read your debt statement carefully – it should tell you how long it’s going to take to repay the debt if you only repay the minimum – and it’s going to be a lot longer than you thought it was going to be (this is especially true for high interest products such as credit cards).
Now obviously, repaying debt isn’t exactly the most satisfying thing ever. Research even found that (credit card) debt was being repaid differently pending on the type of consumption it was associated with. People repaid debt associated with durable goods (e.g. sofas, washing machines) much slower and were less likely to stick with repaying this kind of debt, as compared to debt associated with experiential goods (e.g. concert tickets, holidays). The logic here is that the experiential goods have passed, there’s not more future utility (read: joy) to be had for that experience. You’re just stuck with the debt. Which is apparently very motivating for getting rid of that debt. Other research adds to this by showing that credit card debt repayment can be stimulated by allowing people to repay by category, or repay by purchase. This method allows people to ‘demystify’ their debt. Rather than this big blob of money owed, it’s now broken down into the many (many…) reasons you have the debt to begin with. Repaying your ‘brunch with the girls’ feels different to repaying a random amount of money. Because people can recall the utility of the thing they incurred the debt for, they are more likely to repay the debt. Of course, looking at neoclassical economics or traditional finance, all of the aforementioned ‘quirks’ are all nonsense: all debt arises from consumption smoothing and needs to be dealt with by either increased future income or decreased future consumption. There’s the assumption that people don’t take out debt beyond what they can afford, so it should all resolve itself in the end. We all know how this assumptions has panned out for most people…
Now imagine a scenario in which you don’t hold a single debt, you hold multiple. Neoclassical economics and traditional finance have very simple rules for (multiple) debt repayment: the most expensive debt has to go first. This method is also known as ‘avalanching’, which is fitting as I’m writing this article from the snow-covered highlands of Scotland. The reason it’s called avalanching is because you are aiming to start big, so you can end small, sort of like an avalanche. The aim here is to repay as much as you can on the most expensive debt. This is simply the debt that costs the most – so the one with the highest interest rate. So far there’s nothing wild here. Issue is, if this is your biggest debt, and takes forever to get rid of, it can be incredibly demotivating. For clarification: you’d still repay the minimum repayment on the ‘cheaper’ debts, because that’s legally required. The behavioural approach is a tad different, but has an equally charming winter name: snowballing. This is the opposite of avalanching: we now start with the smallest balance and repay as much as we can on that (whilst still repaying the minimum repayments of the other debts, again, legal requirement). The rationale is that as we smash and annihilate debt after debt, we feel a sense of accomplishment, which can motivate, and continue to motivate, the repaying of bigger, more dramatic debts. Of course it’s not the cheapest way of doing debt. Because the higher balances, and potentially higher interest rates, continue to be outstanding, most costs are incurred there. Without giving financial advice (because I shouldn’t), use the approach that fits your situation best. If money is the main constraint, start avalanching like hell. If motivation is your main constraint, start snowballing. Clearly, the latter is a bit of a luxury position, but debt grows quicker than you think. And it can end up with you shifting from the latter to the former, where despite you still having no real motivation for debt repayments, you now also have no choice…
When it comes to motivation, there are other ways of dealing with debt which are a bit more unconscious in nature: meaning you don’t have to struggle every single month to make an appropriate repayment. It helps if you save up, as much as you can per pay cycle, to repay the debt. This can be done through Paying Yourself First, Automatic Saving Apps, SMART goals etc. From that saving account set up automatic debt repayments that crushes as much of the debt as you can afford to. Or, if you want the satisfaction of reducing debt: have a reminder set do you can do the manual repayment. Whatever floats your boat.
Just as much of behavioural science, what works best kind of depends on the individual and their situation. What seems to work more generally, is to make sure you motivate yourself to repay your debt. According to research, this is to figure out what exactly the debt is for. What utility have you incurred from it? Was it a sofa, or brunch, or that daily take-away coffee? Picture it. Then repay it. Don’t repay the minimum unless there’s no other way for you.
The debate on snowballing vs. avalanching hasn’t been scientifically duked out yet. But keep in mind, there’s advantages and drawbacks to both of these methods, so choose wisely.
All in all, if your resolution was to reduce your debt, I hope this article helps. If your resolution was to take on less debt, do read this article on Save Now Buy Later – a more consumption-conscious tool for saving, and spending, money.
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