Fighting Christmas Debt

This article originally appeared in USA Today on December 28, 2015.

By Aparna A. Labroo

Excessive holiday shopping — and spending — will inevitably lead some consumers into debt. In the meantime, many others are struggling to pay off the debt they have accumulated since last December.

In itself, taking on debt is not necessarily a bad thing. It helps consumers buy homes, cars, appliances, vacations, gifts and investments by borrowing against future earnings. When money is spent well, it can breed money. Indeed, much debt that consumers take on goes toward paying off home mortgages that build consumer wealth. But when debt ends up financing unaffordable lifestyles — attracting penalties, constraining lives and ruining credit histories — it becomes a glaring four-letter word.

If you do accumulate the bad kind of debt, what should you do about it?

Financial advisers overwhelmingly suggest paying off the most costly loans first. They say consumers should consolidate their debt repayments into one low-interest credit card so they pay less money overall. Economically, this approach might make sense. Behaviorally, it doesn’t.

Instead, research on financial decision-making conducted by my colleague Blake McShane at the Kellogg School of Management at Northwestern University finds that consumers should pay off their small accounts first. By comparing consumers with identical debt who make similar payments, he finds that the ones who close more accounts, rather than reduce the size of a single account, are more likely to clear their remaining debt. Surprisingly, after controlling for the number of accounts a consumer pays off, the amount of money a consumer pays off doesn’t matter.

Why is this approach best?

Closing an account feels like a victory. Success is addictive. It makes consumers more committed to closing the next account and then the next one. This extra kick of motivation is especially important for consumers starting out who can be daunted by a mountain of debt. And it strengthens with time as they taste more success.

Focusing on enormous outstanding debts can be discouraging. Thinking about bills piling up can increase anxiety and put anyone in a bad mood. My research shows that when consumers feel these emotions, they tend to care more about the here and now, not about the future. They could become less likely to visualize the future and the long-term goal of eliminating debt, or to value it. Instead, their immediate concern is to feel better, which could cause them to make choices that take them further from their goals.Retail therapy might feel good today, but it only makes things worse.

A focus on the small victories can help people stay on target.

Compared with past views on debt repayment, this advice might seem counterintuitive. But even economically, focusing on smaller debt can make sense. After all, what a consumer pays off depends not only on the cost of her loans, but how quickly she gets rid of her loans. If closing accounts accelerates debt repayment, a consumer could end up paying less overall. That’s especially true if she becomes more likely to pay off her loans following this approach than the other. If the small debts are also high interest, that’s a bonus.

And of course, financial education is important. If consumers do not understand what the costs of debt are and how these costs can escalate over time, then motivation alone might not help. But the point here is that education alone might not be enough, either. Psychological and behavioral insights should direct financial education.

The bottom line is that consumers will not pay off their debts unless they are motivated to do so. Small psychological nudges that increase motivation or make them feel good about paying off their debts can have an unexpectedly big effect on fueling healthy financial choices.

If you are saddled with debt right now, erase the smallest debts first. Savor each success, then repeat.

- Aparna A. Labroo is professor of marketing at the Kellogg School of Management, Northwestern University.