Two steps forward, one step back? Quantifying the pecuniary costs of debt account aversion and the debt snowball

Abstract

The interest-minimizing strategy to paying multiple debts is to make all minimum payments and allocate remaining funds to the debt with the highest interest rate. However, cognitive biases such as debt account aversion and financial advisors encourage borrowers to instead allocate remaining funds to debts with lower outstanding balances, a strategy known as the Debt Snowball. The author uses the 2016 Survey of Consumer Finances to quantify the pecuniary costs for American households of following the Debt Snowball and finds that the average household pays an additional 1.8%-4.3% in interest, leading to an aggregate transfer of wealth from borrowers to lenders of between $46.2 and $53.9 billion in excess of what would occur if borrowers instead minimized interest accrual. Due to differences in household debt structure, the Debt Snowball strategy imposes greater pecuniary penalties on low-income households, on Black households, and on households with more initial debts.