The ‘snowball approach’ to debt

8/7/2012 - Which account balances should consumers pay off first to reach their ultimate goal of being debt-free?

A team of Kellogg School researchers has found that people with large credit-card balances are more likely to pay down their entire debt if they focus first on paying off the cards with the smallest balances — even if that approach doesn’t make the best economic sense.

Credit card debt in the U.S. totals about $1 trillion, and U.S. residents, on average, each have five cards. So when cardholders don’t have enough money at bill-paying time to cover their entire debt, they have to choose the best strategy for paying it down over time.

The “rational” strategy is to pay off the cards with the highest rate of interest first, regardless of the amount owed on the card. This is the strategy recommended by the U.S. government, as it ultimately costs consumers less in interest.

However, an alternative approach advocated by some financial advisers is to pay off the small balances first and the big ones later. This “snowball approach” is believed to increase the likelihood of getting out of debt, as it keeps consumers motivated through “small victories.”

How they did it
Assistant professors of marketing David Gal and Blakeley B. McShane got to the heart of the question by obtaining access to a unique data set. Provided by a leading debt settlement company, it gave precise information as to how 6,000 people finally eliminated their credit-card debt. In their analysis, Gal and McShane found that consumers who pursued the “small victories” strategy were more likely to eliminate their entire debt balance.

Their findings appear in the August issue of the American Marketing Association’s Journal of Marketing Research.

“We found that closing debt accounts — Independent of the dollar balances of the closed accounts—predicted successful debt elimination at any point in the debt settlement program,” Gal says.

The authors say their research raises important policy questions. “Perhaps consumers should be told of both the rationally optimal approach to eliminate debt — that is, paying off higher-interest balances first — as well as the possible psychological benefits of closing account balances. Consumers can then make an informed decision,” McShane said.