Many people make irrational decisions when paying off their credit card debts.
Rather than paying off the debt attracting the highest interest rate first, card holders tend to pay off the smaller of the debts first, regardless of the interest rate.
Research by UTS Sydney academic, Fran????????????????ois Carrillat, with international collaborators, finds card holders with more than one credit card tend to pay off the debt they can pay off entirely or substantially first, even though they have debts on other credit cards with higher interest rates.
By focusing on smaller debts first, card holders are unwittingly helping to prolong their indebtedness and increase the amount of interest they pay.
To reduce debt overall and reduce interest costs, card holders should pay-off credit card debt with the highest interest rate first, the second-most expensive debt next and so on.
“Paying off big debt seems to be a difficult goal and often it is,” Carrillat says.
“You can understand why it is appealing to pay off a small debt first, even though it is not the rational thing to do,” he says.
He says it is because paying off the smallest credit card debt first gives card holders the “illusion” of making progress towards the goal of reducing total debt.
In a paper published in the Journal of Public Policy & Marketing with two colleagues from American universities, it is shown that people’s approach to debt re-payment also depends on the nature of the debt.
If the debt was for a “want”, such as a holiday, instead of a “need”, the debtor is more likely to pay off that debt first because the benefit of the debt has passed.
The data was collected from an online survey of American adults to find out how they prioritised credit card debt repayment. Carrillat says the results are just as relevant for Australian card holders.
He says the best thing that card holders can do is to consolidate their cards so that they have one card only.
A quick check with one of the financial comparator sites shows there is a wide variation in the interest rates charged on credit card debt, which is why it is worth shopping around.