By Ed Emerson
OK, let’s see what the media is trying to sell us today:
- Be afraid, be very afraid – new FIFA president Gianni Infantino has received a worrying endorsement from Sepp Blatter, “he has all the qualities to continue my work”……
- Another day, another UFO sighting. Methinks E.T. is getting very very sloppy…..
- RBS losses top £50 billion since the recession, £5 billion more than we paid to bail it out…..
- Mercedes chooses people over robots in manufacturing plant, as the latter can’t keep up…..
- If you’re retired and living abroad, or planning to, choose your country well if you want your pension…..
Ahhh, yes…here it is…Crap Debt Management Is In Our Genes
Do we have an intuitive path to managing our debts?
We sure do…and it sucks.
In the UK, the average household held credit debt of £6,598 (as at November 2015) went up from a revised £6,562 in October 2015 – that means there’s an extra £353.33 extra that’s been accumulated per household over the course of the year.
Now add in the million or so Brits with interest-only mortgages (read: oh shit, I have to pay off the whole thing because I’m only paying the interest on this mortgage iceberg).
And then, despite the logic of paying off the debts with the highest interest rate first, we tend to try and knock of the small debts first regardless of compound interest (Scientific American, 2016).
Emory Nelms and Dan Ariely write in Scientific American:
“Only 3% (5 of 162) allocated money in ways that were close to optimal. Instead, an overwhelming majority of participants elected to pay off the smaller debts first.
“The sheer number of people using this strategy (including MBA students who took finance classes) suggest that paying off the smaller debts first is not just a mistake, but a planned strategy rooted in our psychology. The research shows that individuals are ‘debt account adverse,’ which means that consumers with multiple debts are motivated to reduce the total number of debts rather than reducing the total of their associated costs.”
The ‘prospect theory’ behind our approach to debt mismanagement – which suggests we’re all much more sensitive to a loss than a gain of the same amount – deserves a bit of a dig around on your own time.
But for our purposes here, let’s suggest a potential fix.
The size of a loan or credit outstanding should come second to the respective interest rate you’re paying. What that means is that instead of listing your debts in order of how much is still due, list them by highest interest rate, and then kill the ones at the top of the list first.
And if you doubt the soundness of that approach you can either Google “Compound Interest” or see Compound Interest? It’s A Wonderful Life! here.
Don’t trust your intuition, or what your friends who are facing the same dilemma as unsuccessfully as you are.
Trust these numbers.
They’ll make sense a long time before your current plan ever will.
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