Paying Off Loans: Strategies Of The 'Irrational' Human

We humans are predictably irrational creatures — so says behavior economist Dan Ariely of Duke University. Ariely weighs in from time to time on how irrational we really are. Today — what strategies people adopt to pay off loans. NPR's Robert Siegel talks to Ariely about the research he has been conducting.

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Imagine, for a moment, that you have several different loans at different interest rates - not a stretch for many of us. Now, what strategy might you adopt to pay off those loans? Do you pay off the small ones first, or do you tackle the ones with the highest interest rates?

Well, Dan Ariely of Duke University studies the predictably irrational behavior of us humans, and he has been researching these very questions.

Professor DAN ARIELY (Behavioral Economics, Duke University): So we started with the study in which we gave people five loans. We said, you have these five loans. They all represent real money, and every month, you'll get some salary and you have to decide which loans you pay off faster and which direction, and so on. And the amount of money you'll get at the end of the experiment is proportional to how much money you have in this pretend life.

So it was for real money that people could make, and they made decision based on their, you know, best interest.

And we tested over a thousand people. And the decision should be very simple. You pay off the loans with the highest interest rate. These are the loans that cost the most amount of money. What we actually found is that nobody, not a single person, has done that. And these include MBA students who took finance classes and undergrads, and people who read Fortune magazine - lots and lots of people.

Now, what do people do instead? They try to get rid of loans. If you have five loans, it makes you really happy to get down to four loans. So you try to get that. And if you have four, you really get happy by getting it to three. So people pay the loans with the lowest amount, and they don't look at the interest rate. And this, of course, is financially very devastating.

SIEGEL: So you mean, if among my five loans, there's a balance of $200 with a 4 percent interest rate on it, but there's also another balance of $2,000 with an 18 percent interest rate, what you find, I'm more likely to pay off the smaller loan with the smaller interest rate than go after the big loan, where I'm really getting hit by the interest rate?

Prof. ARIELY: That's right. That's exactly right. And what we also found is that there are things you can do to fix this. And you can actually -for example, if I tell you, you can never close any loans, it's prohibited.

SIEGEL: Uh-huh.

Prof. ARIELY: No loans can ever be closed...

SIEGEL: I will always have five loans open.

Prof. ARIELY: All of a sudden, this temptation to close loans goes away. You just can't do it. And all of a sudden, people become rational. They actually understand what to do with their money. So this temptation to close loans down actually is very hurting. We also found that we can do loan consolidation.

SIEGEL: Right.

Prof. ARIELY: Right? So what loan consolidation do - I mean, there's lots of terrible things in the market out there. But we should - what if we did loan consolidation in a way that basically prohibited people from doing these mistakes? And it turns out we can do loan consolidation that take more interest rates, but actually help people. In some sense, everybody benefits - the loan consolidator benefits and the people benefits.

SIEGEL: Because our impulse is to want to see that zero balance on some loan, even if it's a relatively cheap loan that is doing us less harm than another loan.

Prof. ARIELY: That's right.

SIEGEL: What did you find about that item, often on a loan statement, which says minimum payment due?

Prof. ARIELY: Yeah, that's actually a very disturbing part because companies are emphasizing it to a great degree. And what people usually do is, they look at it as a recommendation.

(Soundbite of laughter)

SIEGEL: Of how much you should pay?

Prof. ARIELY: That's right. This is the right amount. And, of course, companies are setting it up, so this is incredibly dangerous to follow that recommendation.

SIEGEL: But the suggestions that we see on that bill, even if they're pointing us in a bad direction, they're very meaningful. They condition how we're going to respond.

Prof. ARIELY: That's right. The moment you have suggested the amount, it kind of anchors you. It's a starting point. And you say, hey, I can do that. Let me do that. And that could be a very bad strategy.

SIEGEL: Dan Ariely, thanks for talking with us once again.

Prof. ARIELY: My pleasure.

SIEGEL: Dan Ariely is a professor of psychology and behavioral economics at Duke University, the author of "The Upside of Irrationality." He talks with us, from time to time, on ALL THINGS CONSIDERED.

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