Tuesday, May 16, 2006

More Debt Reduction Data

Debbie commented, on my last post,

Exactly, it's all about the psychology. It works even better when you just pay off your smallest debt first. You get that feeling of success early on that helps motivate you to continue. Some of us can get a lot of help from weird crutches like this.

and added that I must not need that myself.

The truth is, I am as irrational as the next person, and if I thought this method could help me for a small cost, I would use it. So I just ran the numbers again, this time using my actual debts. I have 5 creditors with a range of APRs - basically, two installment loans and three credit cards with balances. I used the actual total monthly payment that my budget says I can afford.

With the DOLP method (discussed below), the total amount needed to pay off all of my debts was $44,795 and it would take 32 months.

With my APR method, the total amount was $43,571 and it would take 31 months.

That's a difference of $1224, or over $38 per month for those 32 months. (Of course, I wouldn't actually pay an extra $38 every month - that's just an average to put it into perspective.) $38 a month seems like an awfully hefty premium to pay for a psychological trick.


Anonymous said...

(Sally) Does this kind of psychological trick still work even if you know it's a trick? Do you get the same kind of "aha, I'm really making progress now!" satisfaction and motivation if you know it's ultimately costing you more than if you took the obvious approach of paying off your highest interest debt first?

Or is a quick "success" in paying off that one small debt supposed to spur one on to greater effort, so that Tam's equal-money-applied calculations aren't capturing the full benefit of the approach?

Anonymous said...

(Sally) Also, it's kind of interesting that the approach assumes, perhaps entirely correctly, that (at least some) people are really concerned with not just the total amount of their debt, but the number of individual debts. Makes me wonder why debt consolidation isn't more common ... or is it much more common than I think? (OK, I admit I thought of this in the context of "how could person, like me make money off people with this kind of irrational preference?" and debt consolidation services quickly sprang to mind.)

Is there any objective benefit to having fewer debts that could offset the total pay-off costs as Tam has calculated? Saving a few 39c stamps hardly seems worthwhile. Maybe people who have trouble staying out of debt also have trouble being organized enough to keep up with a lot of different debtors? Having one less debt to keep track of/worry about might be worthwhile to some people. You also lower your risk of getting hit with late fees, etc., though again, it seems like you'd have to be kind of a mess for that to make up for something on the order of the $38 per month cost that Tam calculated.

Tam said...

I see one benefit of reducing the number of debts. If you cancel each account once it is paid off, then each paid-off debt represents a diminished capacity for impulsive borrowing. (Of course, installment loans, which tend to be paid off fastest under the DOLP scheme, are usually not re-chargeable anyway, except that you can go buy a new car now that the old one is paid off or something.)

I think people do like to consolidate debts, even when it doesn't make them come out ahead financially, and I think debt consolidation is incredibly common.

rvman said...

One side effect of DOLP is that, once you get loan number one paid off, your total minimum payments is smaller than if you paid off one of the others. This has the good consequence of providing a little extra wiggle room for emergencies - if you leave your job you have a smaller minimum total to cover to maintain current status. It has the bad consequence of, well, giving you a little extra wiggle room to start doing the minimum - only approach while paying less.

The real 'trick' of the DOLP plan is that, under the new Federal rules, high interest credit cards have higher minimums than low interest cards. Why you wouldn't just skip the proxy and pay off the high tax-adjusted interest-rate debt first like Tam says, I don't know. I suppose there could be some comparability issues (APR vs. yield) with interest rates, while every bill contains a minimum due.

Debbie said...

Good point about the wiggle room, rvman.

Some people have the following choice, realistically speaking:

A) Pay an extra pathetic $100 per month to the highest-interest debt. See very little progress. Get depressed. Give up. Run up debt again. Until debt total gets scary. Repeat forever.

B) Pay an extra pathetic $100 to the smallest debt. Five months later it's paid off! Visible success! With $40 extra bucks to apply to the next one, in addition to the $100 already being paid. Feel rich! Feel like you're the type who pays off debt. Pay off debt.

The difference in cost for this person is not really a couple thousand dollars, it's hundreds of thousands, and it's in the other direction.

Sally, I think if one notices the irrational part of the brain insisting on taking over in certain situations, against your rational wishes, then it keeps taking over, even when it's being tricked, because it doesn't feel tricked, it feels excited.

What's really wise is using the rational part of your brain to put yourself in situations where instead of fighting your overpowering irrationalities, you are using them for your benefit. (I'm not sure I've ever done that myself, but I have seen other people do it.)

Debbie said...

I looked into debt consolidation for my student loans and the interest rate was either the same as for my highest loan or higher, I forget which. Ever since then I have never been tempted.

Nor would I have been if I had had more than one debt at any given time. I like having the power to manipulate things. Now that shows up in my wanting several different index funds rather than one all-market one so that I can move shares between them in order to buy low and sell high.

However, there is also a benefit to having only one bill to remember--fewer chances for that payment to slip through the cracks. And credit card debt is extremely unforgiving about late or missed payments.

Tam said...

rvman said:

The real 'trick' of the DOLP plan is that, under the new Federal rules, high interest credit cards have higher minimums than low interest cards.

I don't know how new the new rules are, but my credit cards, which range from about 5% to about 19% APR, all have minimum payments of 2% of the total balance, so their DOLP values would be the same.

When I did my simulation, once I was down to only credit cards (DOLP = 50 for each one), I paid in APR order. Had I been doing this in real life and calculated DOLP based on one month of statements from each, rounding differences might have caused me to pay them off in some other order, costing me even more money.

Good point about reducing the minimums, though.

rvman said...

The new standard is a minimum of all interest and fees plus 1% of principle, rather than just 2% of principle. It is only just kicking in - I don't know if it has started, yet. It requires a Terms of Service change, so it may be that companies will wait and do everyone at once.

At the moment it is voluntary, in that regulator's way of 'we really would like it if you did it this way, we are thinking about making a rule...by the way, have you filed your annual compliance report, yet? I'm looking forward to seeing it'. (I am quite familiar with this particular technique of regulation.)

Tam said...

Hmm. If you work the math on that, it looks like the minimum charge would range from about 1.5% (for 6% APR) to about 3% (for 24% APR). Give or take a bit for my slightly wrong (I think) APR-calculating method.