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University of Illinois Extension

Change Your Mind-set when Paying Down Debt

April 6, 2012

Imagine you just received a $100 tax-refund and you've decided to use this money to pay down debt. Now, imagine that you have two credit card accounts, with a total debt of $1,100. On Account A you have a $100 balance and a 10% annual percentage rate (APR). On Account B, you have a $1,000 balance and a 15% APR. Which account will you pay the $100?

According to research done by Moty Amar and associates, most people would choose to pay Account A which has the $100 balance – even though this has the lower interest rate. (Remember, the APR tells you how much interest you are paying annually on the loan; the higher the APR, the more the loan costs you.)

Why would people choose to pay off a loan at 10% APR before paying down a loan at 15% APR? In their article, "Winning the Battle but Losing the War: The Psychology of Debt Management," Amar and associates explain that people tend be "debt-account-adverse." In other words, people choose to pay off small account balances before large balances, without considering the dollar costs of the interest rates.

You too may have done this at some time. And, clearly it is psychologically satisfying to be able to say to yourself, "there, that account is done." "But, it's important to realize that there is a real dollar cost to this choice," says Kathy Sweedler, University of Illinois Extension Educator. "And, while it may not add up significantly for one small debt, there can be a significant cost over a lifetime."

Sometimes when making financial decisions, we need to experience some psychological discomfort to save money. If you're inclined to look at the size of the debt rather than the interest rate when deciding which debt to pay, here are some suggestions on how to change your mind-set.

Make a list of all your credit card accounts with outstanding balances. Add up the balances. What is your total amount owed?

Define your financial goal as "to owe less money." Think about paying down debt in terms of your total debt owed. Don't define your success by how many accounts you have with outstanding balances. This way you won't be as likely to "reward" yourself for paying off one account.

Next, rearrange your list of accounts in order by APRs. List the account with the highest APR at the top of the page. Focus on the APRs; pay off the highest APR first.

Sweedler suggests, "Each month as you pay down your debt, subtract the amount paid from the total amount owed and congratulate yourself!" You are working towards your goal to "owe less money."

Of course, while you're working on paying down the account with the highest APR first, you do need to make the minimum payments due on your other account balances. Paying the minimum due is essential to keep a good credit history and to avoid fees. Whenever you can, though, stretch to pay more than the minimum payment due so that you will not pay large amounts of interest over time. Soon, you'll reach that goal of "owe less money."

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