Suppose you have two loans. The first is a student loan of US$40,000 with an interest rate of 6 per cent, and the second is a credit-card balance of $12,000 with an interest rate of 11 per cent. You find that at the end of each month, you have about $1,000 left over, and you want to use it to pay down the principal on your debts. That’s sensible. So how much do you put toward each loan?
The rational thing to do would be to pay off the 11 per cent loan before even starting to repay the 6 per cent loan. This is not a matter of taste, it is just simple maths. After all, every dollar you spend paying down the credit card would otherwise be growing at 11 per cent a year, which is faster than 6 per cent a year. If you can, always pay down your debts starting with the highest interest rate.
But that is not what most people do. According to new research by economists John Gathergood, Neale Mahoney, Neil Stewart and Joerg Weber, they instead tend to split their repayments between higher- and lower-interest debt. Gathergood, and his fellow researchers, looked at consumers in the United Kingdom who had two credit cards, who made their minimum payments on time, and who carried balances on both cards – in other words, people who had enough money to pay down some of their debt at the end of each month.
The difference in interest rates between the two cards tended to be large – 6.3 percentage points on average. This meant there’s a big incentive to pay down the higher-interest one first. But the authors found that on average, after making their minimum payments, borrowers allocated only 51.5 per cent of their extra payments to the higher-interest card. Only 10 per cent of borrowers devoted all of their payment toward eliminating the more expensive debt.