Surprise: It may be wiser to pay smaller loans first

It’s almost gospel that if you have a pile of credit-card debt, the rational thing to do is put as much of your income as possible toward paying the biggest balances first.
New research suggests thinking that way might keep you in debt far longer.
A study appearing in a forthcoming issue of the Journal of Marketing Research found that people are more motivated to complete a full series of tasks when they take on the easiest parts first. Applied to debt, that could mean taking on the smallest debts first could generate the greatest motivation to stick with it.
Debt is a big financial obstacle for many Americans, according to financial planners. Thirty-nine percent of Americans have unpaid credit-card balances, according to the Pew Charitable Trusts. Even Wisconsin Gov. Scott Walker, a candidate for the Republican nomination for president, carries credit-card debt. A financial disclosure he filed in July showed one card that charged him a 27.24% interest rate.
“There always was this question of whether it’s better to tackle the difficult tasks first and then move on to the easy ones,” said Michael S. Finke, professor of personal financial planning at Texas Tech University, in Lubbock, Texas. “Many had assumed that it’s better to get the tough one out of the way first, but research seems to indicate that beginning with the easier tasks helps you gain momentum and confidence.”
Some personal-finance pundits already advise people to line up their debts smallest to largest.
Dave Ramsey, who was cited in the new study, has long advocated a similar method, called the Debt Snowball. He said he does so “because we are more concerned with modifying behavior than correct mathematics” and that paying small debts leads to “quick wins,” according to a statement provided by Mr. Ramsey’s spokeswoman, Beth Tallent.
Jeffrey S. Burrow, a financial adviser and managing director with United Capital, said he also often advises clients to pay smaller balances first even if it’s not always the cheapest approach in the long run. He said being trapped in debt can overwhelm his clients.
“In our business as financial planners, being numbers people is very handy, but even more important is being able to motivate others,” said Mr. Burrow, who is based in Modesto, Calif. “Immediate gratification is something you rarely get in financial planning. The closest you can get to that is paying that small balance off first.”
Beyond motivation, Mr. Burrow said clients who pay off credit-card balances also get a positive bump in their credit scores. He said the less outstanding debt you have across many providers, the higher your credit score becomes.
A total of 161 people participated in the study, “Small Victories: Creating Intrinsic Motivation in Task Completion and Debt Repayment.” Those participants had to copy lines of text into Microsoft Excel spreadsheets. Some could choose to take the most difficult tasks first or not. It was a tedious task, meant to imitate the chore-like process of repaying debt but without reminding participants of things they may have been told about the best ways to manage their money. They earned $10 if they could compete the task in 30 minutes, plus a bonus if they finished early. Participants were paid less than $10 if they couldn’t complete the task.
Not only did people who faced easiest tasks first do better. But participants who ranked higher on measures of self-control actually benefitted more from taking on the smaller tasks first. That could mean that the people with the least to gain from debt counseling have the most to gain from adopting this strategy.
The authors of the study — Alexander L. Brown and Joanna N. Lahey, both of Texas A&M University in College Station, Texas — concede their research has limitations. For one, they said it will take a great deal of research to determine just how much of a benefit this provides to people in real-life scenarios.
And, perhaps most importantly, the authors said they believe the impact “will only be useful” to borrowers whose interest rates don’t vary that much.
“In the event of large difference in interest rates on loans, it will be best for consumers to pay off debts from the highest interest rate to lowest, despite the additional motivational benefit of the small-victories approach,” Mr. Brown and Ms. Lahey wrote.
Mr. Finke, a professor who was not involved in this research, said the study does a good job illustrating how people behave when they have to think consciously about how to approach debt. But he said more effective financial planning sometimes involves having certain things done automatically — for instance, setting up a withdrawal from your accounts on payday that goes to paying off high-interest debt.
“I think it’s a much more powerful tool to avoid the thinking entirely,” he said.