Op-ed written in Fortune about how our research in the Journal of Consumer Research provided insights into how people should allocate their tax refund dollars.
Tax season is upon us, and this often provides an unusual opportunity for anyone struggling to pay off debts. If you are getting a refund, it’s not very exciting to think about putting it all on your credit card debt. But you should know that psychology plays a big role in our ability to get out of debt; so if you have a chance, apply that refund to cut out a big chunk of a small debt account and jump start your motivation to keep paying off what you owe.
U.S. credit card debt is expected to top $1 trillion in 2017, according to a recent WalletHub report. If you are one of the many Americans who cannot pay credit card balances in full each month and own multiple cards, where should you start first?
First, make sure to cover all minimum payments on all your debt accounts to avoid late fees, which may hurt your credit score with the credit bureau. With the remaining money from your tax refund, you have several options:
Some may decide to sprinkle their refund across all their debt accounts. Others may judiciously pay off debts with the highest interest rates to avoid accumulated interest payments over time, which might make sense but that strategy does little to motivate you to increase your income or save more to repay your debts in the months or years that follow. It also doesn’t help you avoid avoid spending that tax refund on a big flat screen TV or island getaway.
A better way is to apply your tax refund to the credit card with the smallest debt remaining if the interest rate differences between accounts are small. True, it may take several more months (or tax refunds) to clear your debt account, but focusing your repayments on the smallest accounts will make you feel like you’ve made a lot of progress. And that’s important, as a recent study published recently in The Journal of Consumer Research that I co-authored shows, because you’re then more likely to make extra efforts to pay off your debts, such as picking up an extra shift at work; dedicating more of your tax refund to paying off your debt, and even saving a little more. Just as interest compounds, so does motivation.
In one experiment that my team and I conducted, consumers who concentrated their repayments worked harder at getting out of debt and were 15% faster at paying back money owed than those who were spreading payments across all their debt accounts.
Additionally, consumers were demotivated when they were asked to concentrate their repayments into their largest debt account as the dent made into payment due was not as easily seen as when concentrating on the smaller debts.
Many indebted consumers carry multiple credit cards with significant balances and may still be paying off the holiday bills. Unfortunately, those same consumers do not always have the income to pay off these balances in full. It is important to consider concentrated repayment strategies to increase motivation and successfully become debt-free.
Simon Blanchard is an assistant professor of marketing at Georgetown University’s McDonough School of Business.