Sometimes people get overwhelmed when they have to think of lots of things. The fact that they have 10 loans may make them feel like it’s hopeless to get caught up. But if 8 of those loans are low-interest loans with low balances, it may overall help that person to pay off those 8 loans so that they only have 2 loans left. It’s much easier to conceptualize how to pay off 2 loans instead of 10, so it may make more financial sense for that kind of person to close out loans quickly rather than pay off loans based on their interest rate.
We see this behavior in all kinds of other areas as well. If someone has 10 assignments to complete, it may help them to be more productive by doing the easiest ones first rather than the most important ones. If they focus on the most important one that may take longer, the mental weight of the other 9 assignments may mean they feel hopeless and like they’ll never get anything done.
This is not an unreasonable conclusion at all. But it’s the conclusion that a confused, overwhelmed person might arrive at without the benefit of better advice.
I’m not a professional financial advisor, but I’ve had people ask for this advice in the past. I see my duty as totally removing any confusion whatsoever as to what to do. Retire the highest-rate debt first, follow this advice to the letter, never question it. Why advise them as if they’re alone and flailing? They’re not alone, they have me. Or you, or some other smart person.
The biggest psychological mistake I see people make when it comes to financing and debt is making the “monthly payment” their measuring stick on if they’ve made a wise decision or not.
The goal of wise borrowing should be “how can I pay the least amount of interest to the lender over the life of the loan making the largest payments that comfortably fit my budget”. Not “What is the smallest monthly payment required to satisfy the lender”.
I’ve know quite a few people that have refinanced loans multiple times and are as pleased as punch to tell me how much their payments have gone down while avoiding to tell me that they’ve been paying on the same house for over 30 years or on the same car for over 8.
We don’t disagree at all about the right thing to do. What a person in this situation who is about to pay off a lower interest loan because it feels good should do is to ask themselves why they want to do this. And then do the thing we both would do.
I’m not saying it is going to work. Not everyone has had the access to behavioral economics research that I’ve had. Lots of people even deny those results. But it might make people do the math.
That’s not a simple calculation, since the utility of a car is more than its mpg. And that’s personal. I bought a car solely on the reviews, and have never been the slightest bit interested in luxury models though I could easily afford them. They don’t offer me any value.
We all have our addictions, and knowledge of psychology doesn’t help. But you can satisfy it in the most efficient way. I’m addicted to jigsaw puzzles and sf books. I buy my puzzles in thrift stores where I can get 6 or 8 for the price of a new one, and I’ve only slowed down book buying when I realized it was becoming iffy that I would live long enough to read the ones I already own.
Heartily agreed. I see this as less psychological than an education issue. They aren’t clear on how their loan works, and how much it will cost them. Just “I want the thing today, can I afford the payments.”
It’s really sad isn’t it? I would classify this as plain ignorance (never bothered to run the numbers and at least consider payoff scenarios), or the psychological issue of learned helplessness (there will always be a monthly payment, my job is to fit it into my cash flow).
And I mean, it could be a value judgment too. After all, debt is for smoothing out big purchases into something manageable. Sometimes when you need a new car, you don’t have 5 years advance notice to save for it! Debt is an invaluable tool when you’re smart about how you use it. But people don’t get great education about it, and we have a predatory lending industry that greases people’s mental skids to only think about getting the thing now, and only worry about whether the payments fit into today’s cash flow.
I think maybe the problem here is that you are reading “people make suboptimal decisions because of psychology, not because they are stupid” as “people’s psychology justifies them making suboptimal decisions.” It doesn’t, it just explains it.
Only when we can accept that the decision we want to make is irrational, and understand that us wanting to make it that way is normal, if not right, can we do better.
Sometimes cash flow is the most important consideration, and the difference between being in the red or in the black (Mr Micawber said something to that effect, I believe). When every penny counts in your monthly budget, the amount of interest paid over the course of several years may be a secondary consideration. I’ve been there.
Well, by that argument, any spending that is strictly pleasurable could be considered wasteful.
As long as such spending is in the context of otherwise careful management, well: that’s what money is FOR: both necessary expenses and for some amount of enjoyment. Hell, we bought a nicer car than strictly necessary last fall - we could get by with a low-end compact car (though there are some logistical issues as we age - I had trouble crawling into and out of our late Civic). Or we could have gotten by with the more basic model of a car in the same class (SUV) - which would have done nearly as well logistically. But we splurged on a higher trim line, both for increased comfort (self-adjusting seats) and some assistive features. Amortizing the extra cost over the 10-15 years we hope to own it, it’s not that much per year.
We do pay a little extra on that loan - just a few bucks a month, not (yet) enough to even shave a single full payment, but it’s a psychological boost for me. Ditto the newly-minted mortgage. But otherwise, extra money will go toward higher-interest debt first.
Another contrarian argument for how to reduce debt: What is the impact of the debt if not paid?
You quit paying the mortgage: you wind up homeless (and losing a fair chunk of equity)
You quit paying the car payment: you get your car repossessed - possibly also losing equity. And you have no transportation, which makes it that much harder to get a job and dig yourself out of a hole.
You quit paying the credit card: You’ll get a lot of hassles from the cc company and your debt snowballs the wrong way - but it won’t immediately render you homeless. And you can get away from (some) cc debt if you ever wind up in bankruptcy.
Which, by the way, is another argument for saving for retirement versus paying down debt. If you go broke or are sued, your retirement savings are largely protected against creditors.
NOT that I recommend using strategic bankruptcy as part of your
financial strategy, of course - I would think doing that would make it more likely for that to actually happen.
Okay. I did some serious number crunching tonight.
Plan A: Apply $700/month extra to husband’s student loan payments
Loans PIF by June 2027
Plan B: Apply $700/month extra to car loan, then roll total payment (about $1100/month extra) to husband’s student loans
Loans PIF by early 2027
The difference in interest is about $5,000. Plan B appears to be the superior choice based on interest saved and payoff date. I don’t fully understand why paying off the car loan first saves more interest, given the car is 5.5% interest and the loan is 6.8%.
I have cross-checked these numbers across multiple debt paydown calculators and while there is slight variation, these are pretty good estimates.
What am I missing? The only thing I can think of is that with Plan B, interest will accrue on the student loans in the two years we’re paying down the car. Oh, and I guess with Plan A, once the car is paid off we’ll have an additional $385 to throw at the student loans instead of $700 - but it’s difficult to calculate that.
My best guess is that it’s a wash, or close enough to be a negligible amount of interest.
And of course this plan doesn’t even touch my student loans. We start where we start.
Oh, I just had a major insight, not sure how it affects this. I mentioned we have negative amortization on the student loan. The statement says the remaining term is 139 months and we will PIF in 2033. How can that be if we’re not even paying interest?
Because 2033 is when we’re eligible for debt forgiveness.
I think the easy way to calculate this is to take the minimum payment necessary each month to stay current, and get debt forgiveness in 2033 on the student loan. So 139 more payments at $350 each, for $48,650. (Pretending $350 is your minimum student loan payment).
If you add $700 to each payment you pay it off in 2027. So 72 payments at $350+700 is $75,600.
An $850 minimum payment is about the break even point where taking 72 months + extra and 139 months doesn’t matter: (850 + 700) * 72 = 104400 ~ 850 * 139 = 104250.
This of course gets into the psychological thing of being out from under the student loans 6 years early, but that piece of mind is costing $25,000 (in my $350/month example).
Hopefully somebody will come along and point out if I’ve made a stupid mistake. Even if I did, the idea is sound: look at the total amount you’ll have paid under the different scenarios.
This is not the problem. If there is a problem to be diagnosed, there are 3.
Based on your above quote, you have not read what I’ve written, or you’ve read it and misapprehended the meaning.
People in this thread are insisting that paying off the lowest debt first is justifiable because something something flawed psychology. They won’t provide a clear theory of how this is supposed to work, and I’m grabbing at straws trying to guess their meaning. I should stop doing that.
People in this thread are so invested in making me understand that humans are irrational, that they utterly miss the fact that I don’t dispute that fact. I’ve conceded it multiple times, I’ll joyfully concede it again.
I mean this is not a particularly strong or novel observation. How do you relate this to the question of consciously choosing to pay more interest? Is this a superior strategy because it helps mitigate the effects of weak or emotional reasoning? If so, how? Or (as I suggest) is this actually an inferior strategy that is actually caused weak or emotional reasoning?
If we’re just waving hands and saying “you must consider psychology”, fine, I’ve conceded it multiple times, I’ll have to do it multiple times more, and I’m happy to do so. There’s no dispute to resolve. Just state that’s your position and move on.
If that’s not your position, then show your work as to how psychology is supposed to save someone money with a non-mathematical strategy, and include what you think the psychology is doing.
Prioritizing lower-rate interest is essentially an impulse purchase that makes you poorer. It seems like we’re saying some people (for whatever reason) ought to do that, because if they don’t, they’ll do nothing. I say that’s an embrace of flawed psychology, not a helpful awareness of it.
This is a great, additional rational point to consider. My mortgage is the only debt I have right now. If I wanted, I could pay a third of it off tomorrow. I’d save a ton of interest and be a few years closer to my payoff date. But they’re not going to reamortize to adjust my monthly payments. So if I paid early and then stopped paying the mortgage, the jerks at the bank would still foreclose on it!
When it comes to paying off the mortgage, my axiom is “if you shoot at the elephant, you shoot the entire elephant and do not leave any monthly payments on the battlefield.” In other words, don’t bleed out your savings to a dangerous level if you can’t kill off the entire mortgage. Obviously there’s a lot of wiggle room in “dangerous level of savings.”
So it’s worth noting that a pure rational calculation isn’t directly math-based, there are also risk contingencies to consider. Also the expectation of future income. All this stuff could be quantified, but I personally don’t need to quantify “I don’t want to get evicted from my house and have my equity extracted at a deep discount.”
OK. In case anyone who is following along is struggling with student loan things too, here’s what I figured out about student loans:
For negatively amortized student loans (REPAYE or other income-based plan in which you’re only paying the interest, or less than the interest)
Compare Option A with Option B
Option A: Continue to pay the minimum as your principal increases over time, until debt forgiveness after 20 years.
Calculate the total amount you will pay over the 20 year term (or however many payments remain)
Now ADD TAXES. Whatever is forgiven at the end of the 20 year term will be taxed as income. To use an example, once my loans are forgiven, I’ll be on the hook for $77,000 in taxes that year. Do not forget to include this in the amount you will pay!
Option B: Rapidly pay down the loans as fast as you can
For Option B, calculate the total amount you will pay to pay down the loans. This varies depending on how much extra you are throwing at it. The more money you pay up front, the less you will pay overall.
Whichever is the lesser amount of money, do that.
For us the calculation is dead even.
Note: If you want debt forgiveness, DO NOT leave the income-based plan. You will no longer be eligible.
Based on threads that have said this over the years, and some articles, I think the theory is that reducing the number of loans outstanding gives them some sort of psychic boost which will motivate them to work on the next loan. If they work at paying off the larger higher interest loan first they don’t see any progress, and, being frustrated at this apparent lack of progress, give up and go back to their spending ways.
You and I would optimize total progress to paying off the loans in dollars, they want to optimize on number of loans outstanding.
I did a quick Google search and this was the first link to pop up:
It turns out that psychologists have a growing body of evidence to suggest the debt snowball method may, on the whole, be more effective in reducing debt. Why? Because small victories matter. As we eliminate one smaller debt, we find ourselves more motivated to persist with an overarching goal.
Two researchers from the Kellogg School of Management demonstrated this point by getting access to the data of 6,000 consumers from a debt settlement company, showing how these individuals eliminated their debt balances. Analysis of their decision making found that consumers who pursued a “small victories” strategy were more likely to eliminate their entire debt balance. In other words, closing debt balances seemed to work more effectively than the optimal approach of paying off higher-interest balances first.
In theory, a bank is supposed to remit you any amount over their costs, when foreclosing on an asset. But in reality, they’re not exactly motivated to try to get top dollar for the place, either.
If your $500,000 house has a mortgage of $200,000, the bank just wants to get their 200K back (plus fees, penalties etc.). If they can sell it quickly for 250,000, why shouldn’t they do that and walk away? (leaving out some less concrete issues like the bank doesn’t want to sell too low, or it will drive down values in the area, and what effect that might have on OTHER loans).
Is that the amount of taxes? or the amount of taxable INCOME? (if the former, YIKES!!).
It will be hard to predict your tax rates in 20 years - as that will vary a lot based on your income, tax law changes, whether it’s taxable in your state, etc, but it’s probably reasonable to use today’s laws at least for estimating purposes.
Okay maybe it is $62,500. This is the estimated income tax we will have to pay upon forgiveness of what is now $125,000 in student loan debt. Basically that $125,000 would be counted as income and would bump us into a higher tax bracket. I need to do some more number crunching tonight. ISTM we either have to set aside a huge amount of money every month to be able to pay those taxes in 2033 or we could just… Put that money toward his debt ($50,000.) I’ve always leaned toward paying off student debt, my husband has always leaned toward investing instead. We have to make a decision together somehow. I think the truth is that we’ll have the same outcome in net assets either way. It’s hard for me to believe we’ll get better returns than 7% average on our investments, and the interest rate on his loans is 6.8%. Probably doesn’t matter what we do.
As for my loans ($75,000) there’s no way we can pay those off before they are forgiven in 2033 so it would be pointless to pay more than the required minimum. So that’s $40,000 in taxes we probably can’t avoid. The federal student loan system is really messed up. If I had truly understood the effect of paying the least amount possible I think I really would have pushed us to keep to the 10 year schedule. But then we’d be even more behind on retirement, maybe we even would have put off having a child, plus I’m not sure my husband would have taken the risk to start his own practice. So I dunno.
This is the dilemma faced by millions of young professionals. Things like homeownership, having children, and saving for retirement must increasingly be pushed further into the future because of student debt obligations. And I feel for those poor souls who won’t see the “tax bomb” coming. They will go from being in debt to the federal government to immediately being in debt to the IRS… So, also the federal government. It’s quite a racket.
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