Winning the Battle But Losing the War: The Psychology of Debt Management

Abstract:     
When consumers carry multiple debts, how do they decide which debt to repay first? Normatively, consumers should repay the debt with the highest interest rate most quickly. However, because people tend to break complicated tasks into more manageable parts, and because losses are most distressing when segregated, we hypothesized that people would pay off the smallest loan first to reduce the total number of outstanding loans and achieve a sense of tangible progress toward debt repayment. To experimentally examine how consumers manage multiple debts, we developed an incentive-compatible debt management game, in which participants were saddled with multiple debts and decided how to repay them over time. Consistent with our hypothesis, four experiments revealed evidence of debt account aversion: Participants consistently paid off small debts first, even though the larger debts had higher interest rates. We also found that restricting participants’ ability to completely pay off small debts, and focusing their attention on the amount of interest each debt has accumulated, helped them reduce overall debt more quickly.

Number of Pages in PDF File: 40

Keywords: Financial Decision Making, Debt Repayment, Debt Consolidation, Subgoals, Credit Cards

JEL Classification: C90, C91, D10

Accepted Paper Series