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Why the debt snowball works

How to use the 'small wins' strategy to accomplish big goals.

By Karen Datko Dec 7, 2010 10:10AM

This guest post comes from Pop at Pop Economics.


I'm not going to lie: I'm not a huge Dave Ramsey fan.


There have been several times he's spoken on radio or I've seen things he's written in print when I thought he was flat-out wrong or misleading on a point. One of my recurring favorites is how he encourages people to take what they save and put it into a "good growth stock mutual fund that earns 12% on average." Man, if only it were that easy.

Another one of his nonsensical strategies is also one central to the Ramsey philosophy. The "debt snowball" debt payment plan is completely contrary to basic rules of arithmetic. You see, Ramsey says that if you have a bunch of credit card debts, you should line them all up by the size of each debt, and pay the smallest-balance ones off first, regardless of their interest rates.


The rational person in us should cringe at this. The size of individual debts shouldn't be the driving force. If a $20,000 debt has a 15% interest rate and a $3,000 debt has only a 4% interest rate, you're going to be paying more interest if you pay off the smaller debt first.


But Ramsey has a lot of experience talking and working with us humans and knows that's not how we think. We derive pleasure from small wins. So "closing out" a little debt feels like more progress than putting a little dent in a big debt.


I don't think he studied it empirically, but, luckily, we have behavioral economists for that. Post continues after video.

MBA students like the debt snowball, too

Duke University's Dan Ariely actually ran a snowball-like experiment himself. He gave a group of testers a set of five, fictitious loans and a fake salary to pay them off. At the end of the experiment, they got to keep whatever money they had left over.


The "solution" to the experiment -- that is, the method that made the subjects the most money -- was to pay off the loan with the highest interest rate first, followed by the lower-interest-rate loans with no regard to loan size.


Problem is, none of the test subjects did that.


According to Ariely, not one of more than 1,000 people did that, including some testers who were MBA students.


Ariely's takeaway, in his interview about it anyway, was that things can and should be done to take away the incentive to "close out" a loan. If you didn't allow someone to close a loan, for example, people became rational and paid the big one first.


My takeaway, and this is similar to what Ramsey says, is that building those little wins has a psychological benefit that outweighs the extra interest the debtor pays on those loans with higher rates.


If that small win means a debtor keeps paying down debt instead of giving up out of frustration, it's a "win" even if he makes the irrational choice.


The theory of 'small wins'

OK, let's say you're trying to tackle a big problem. No, not patching the hole in your roof. That's too small. Really big, like patching the hole in the ozone layer. How are you going to go about doing that?


Just makes you want to shut down and continue playing Angry Birds, right? For a while, management and psychology gurus have posited that in the face of big challenges with complicated solutions, we tend to shut down and give up.


In a classic 1984 article, Karl Weick proposed that to tackle big social issues, we ought "to recast larger problems into smaller, less arousing problems, (so) people can identify a series of smaller controllable opportunities of modest size that produce visible results."


So telling someone to tackle the ozone problem is pointless. Telling someone to reduce their greenhouse gas emissions by 30 pounds of CO2 is a little better. But telling someone to replace their incandescent lightbulbs with fluorescents -- now we've got something we can wrap our heads around.


The same can be seen in your office or school. A little pat on the back for a new employee -- "Hey, James, nice work on that report. You really sold the plan well." -- builds confidence and increases James' engagement with whatever the next project is.


Applying a small-wins strategy to your finances

Aside from the debt snowball, I can see a number of places where a small-wins strategy could give you the psychological boost needed to get a big goal accomplished.


1. Always break down big goals into concrete outcomes of moderate importance. That's ripped almost straight from Weick's article. But the point is this: Big goals are worthy, but not doable. It's the dozens of small goals that lead up to it that our brains can tackle.


The best goals can be accomplished in a couple hours or even a couple of minutes. For a big goal, try building a work-flow chart that leads from the small goals to the big one.


For example, what if I want to "apply to law school." Big goal, lots of steps. A smaller goal: "Get recommendations from my professors." The best, smallest, and most accomplishable step: "E-mail Professor Thompson to ask for a recommendation letter today."


2. Reward yourself for the small wins. Ariely proposed taking away the reward for paying off a small debt. If you can't close the loan, he said, you won't be misled into paying the small ones off first.


It seems the same thing could be accomplished in a positive way. If you have a big credit card debt, why not break it down into each item that went into it?


For example, within your $5,000 debt, maybe $1,200 was a new computer, $400 was a trip to Macy's, and $600 was an emergency plane ticket home.


Now, when you pay the debt down by $500, you can cross that Macy's trip off the list and feel like you accomplished something, even though the larger debt didn't go down by much.


I have a negative incentive myself to post twice per week. If I don't write two posts, which builds Pop Economics toward a comprehensive behavioral finance blog, I get charged $100 as a penalty. A positive incentive would no doubt make me happier, but I haven't found one as immediate or effective as the financial penalty.


3. Don't let reason get in the way of letting good things happen. Yes, the debt snowball is irrational. However, it's not bad. It works. Consider the money you're losing in higher interest payments to be the fee you pay to actually pay off your debt once and for all, just in the same way it's cheaper to quit smoking cold turkey but nicotine gum might be the more expensive, but better, option.


A lot of very big things can happen if you take the right small steps.


More from Pop Economics and MSN Money:

Jan 3, 2011 10:39PM
It worked for me,2 years ago I had 70,000 in credit card debt,I paid the most I could afford to the highest interest card and so on.I'm down to $4,000 and my credit score is now over 700 due to the fact thatmy payments have been made on time and the difference in my credit limit and what I actually am using decreases every month. 1 more thing,Ive learned my lesson when I think of all those payments that could be in savings and not to the big corp. banks.If I need to use it it gets paid for that month.P.S. some banks will work with you by dramatically lowering your interest rates especially if you let them automatically deduct the money every month.
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