How To Deal With Holiday Debt

January can be depressing. You've taken down holiday lights, you're faced with keeping New Year's resolutions, and those holiday bills start to arrive in the mail.

What's the best way to deal with that holiday debt? Most personal finance advisors say you should always pay down the credit card balance with the highest interest rate first. But that's not what consumers seem to do.

“Our research finds that people really like closing accounts,” said Cynthia Cryder, assistant professor of marketing at Olin Business School at Washington University in St. Louis. “They will close a small debt account with a low interest rate at the expense of paying down a larger loan with a higher interest rate.”

Losing the war

Cryder, along with other researchers, designed several studies to examine how consumers manage debt portfolios. She concludes that consumers often win the battle but lose the war.

After examining the psychology of decisions and goal pursuit, the researchers hypothesized that consumers saddled with multiple debts will usually be motivated to reduce their total number of outstanding loans, rather than to reduce their total debt across loans, a phenomenon they refer to as debt account aversion.

Throughout a series of debt-management experiments, the researchers found that participants consistently paid off small debts first, even though the larger debts in the study had higher interest rates. In fact, no participant in their sample consistently used their cash to pay off the loan with the highest interest rate.

Not always wise to close an account

“While it is attractive to close an account, that’s not necessarily the best approach to minimizing your debt burden,” Cryder said.

While consumers should be wary of many commercial debt consolidation services, Cryder says an effort to consolidate several small debt pools into fewer larger ones eliminate tempting small accounts and encourage people to focus on interest rates.

Also, focusing people’s attention on the actual dollars spent on interest payments encouraged people to prioritize interest rates, and helped them reduce overall debt more quickly, Cryder said.

To optimally reduce overall debt, Cryder says, always put extra money toward loans with high interest rates.