Credit cards are ubiquitous in American society – nearly 70% of all Americans own at least one and most have multiple. Credit offers an important strategy for families to smooth income, allowing for greater predictability and stability in consumption. Yet, the increasing availability and use of credit also has resulted in indebted households sinking further into debt, ultimately undermining their financial well-being. High-interest, consumer debt makes saving for the future and coping with emergencies when they arise harder. Helping families to better manage and pay down this high-interest debt would significantly improve their financial well-being.

How do we intuitively manage our debts?

Despite its apparent burden on families across the country, many people do not effectively manage their debt. Most individuals juggle multiple kinds of debts, each coming with different terms and interest rates. This diversification of debt requires consumers to make decisions about how to best allocate limited resources to repay them. The most effective way to pay off debt over the long-term is to focus on the loans with the highest interest rates first. Yet evidence has shown time and again that consumers are likely to manage multiple debts in ways that cost them more over time.

For example, in a series of experiments carried out by our research center, participants played a game that asked them to pay multiple debts of varying amounts and interest rates. They were given a paycheck at the beginning each round, and asked to allocate all or some proportion of that amount to each of their various debts. A financially optimal player would allocate all of the money to the debt with the highest interest rate. Yet, even though participants experienced how interest compounded their debt from one round to the next, only 3% (5 of 162) allocated money in ways that were close to optimal. Instead, an overwhelming majority of participants elected to pay off the smaller debts first.

The sheer number of people using this strategy (including MBA students who took finance classes) suggest that paying off the smaller debts first is not just a mistake, but a planned strategy rooted in our psychology. The research shows that individuals are “debt account adverse,” which means that consumers with multiple debts are motivated to reduce the total number of debts rather than reducing the total of their associated costs.

There are multiple psychological processes that underlie debt account aversion. The first of which is prospect theory, which suggests individuals are much more sensitive to a loss than they are to a gain of an equal amount. For example, if you make a bet with someone and lose, you are more willing to enter a second bet at double-or-nothing than if you had won the first bet. What these kinds of results show is that the urge to get back to being in the black is so strong that people are more motivated to pay off small debts and close out accounts without considering how their interest rates differ.

In addition to being disproportionately averse to losses, individuals are also largely motivated by a salient goal. This phenomenon is called Goal-Gradient Theory. For example, when customers are given a loyalty punch-card offering a free coffee after a certain number of purchases, they feel more motivated to buy more coffee as they get closer to the free one. Goal-Gradient Theory suggests that consumers are likely to be much more willing to put out effort (or allocate their scarce resources) towards debts that are smaller just to finish paying them off, even if the interest rate – and thus the total long-term cost – is less than other, larger debts.

There is also a growing body of evidence suggesting that people do not effectively take into account the way interest compounds and grows over time. For example, when making the decision about how much to invest in their retirement, research demonstrates that people discount how much their contributions are worth in the future. In terms of debt, this means that people who choose to utilize their credit cards and to carry a balance are doing so without a full understanding of total cost of that debt in the future.

If we can’t trust our intuitions, how can we reduce our debt?

There are a number of strategies and interventions that potentially could help minimize the cost of our natural tendency to behave in ways that cost us more in the long run. For example, setting up automatic payments to the debt with the highest interest, regardless of how much you owe on it, eliminates the monthly tension between rationality and intuition. Another strategy would be to structure the environment to ensure consumers allocate money optimally. For example, imagine if a consumer could just tell their bank or credit union (or an application) how much total money they can put toward debt that month and the bank or credit union would, in turn, optimally allocate the money across the multiple debts according to interest rates and possible tax benefits.

However, often one of the most straightforward ways to minimize the cost of debt-account aversion is to consolidate multiple debts into a single loan. For example, if you have five different student loans with varying interest rates, your loan servicer can consolidate each debt into a single payment. Yet, even though refinancing or consolidating debt can save money, many consumers do not choose to do so. Refinancing or consolidating debt requires time and effort to navigate a complex financial system. Refinancing in particular is a complex decision – we must choose which lender we should refinance with, what interest rate should we aim for, how many lenders we should ask before we have too many inquiries on our credit report. Research shows that complex decisions such as this lead to decision paralysis. That means we become unable to make a decision for fear of making the wrong one. So we procrastinate or rely on a default, which can mean doing nothing or going with the first offer that pops up.

To explore ways to increase refinancing rates among people with high-interest loans, we ran a series of experiments. In one experiment, we asked people who had credit card debt to imagine that they had amassed so much credit card debt that they were not able to pay off their balance each month and would likely be making payments on their credit card for the next couple of years. We then presented them with several different advertisements for a refinance loan from a credit union. While the basic information and terms of the loan was the same across all advertisements, we randomly varied the way we described the interest rates. In one ad, we noted that the average credit card interest rate is around 19% and the new loan’s interest rate could be closer to 6%. In another ad, we stated the difference in interest paid over a 3-year term on a $10,000 loan at the different interest rates. And in a third ad, we provided a visual of the interest paid by graphing the difference.

We then asked everyone how useful they thought this loan was and how much effort they would be willing to invest in trying to refinance their debt. While almost everyone thought it would be useful, people who just saw a comparison of interest rates were only willing to invest an average of 4 hours in refinancing. People who were told the numerical difference in interest paid were willing to spend an average of 6 hours to refinance. And people who graphically saw the difference were willing to spend an average of 8 hours; that’s twice as much effort as people who only saw the different interest rates.

In another field experiment with, we targeted people with high-interest personal loans to refinance with a credit union. One-third of the members received a pre-approval offers in a simple, generic letter, telling them about the pre-approval and basic information about the loan product. Another third of the members received the same information but with extra sentences emphasizing that the credit union has their best interest at heart and wants to help them save money. The final third of the members received the second letter but added that members should to call the credit union even if they did not want to refinance their loan. We found that three times as many members refinanced their high-interest personal loans when they received the third letter compared to the first. This is likely because members who received the third version felt that they could not procrastinate. They needed to make a decision, which helped push them toward refinancing to a better loan.

Clearly, high-interest debt continues to significantly contribute to the financial instability of many families across the country. And yet, there are a number of strategies that both individuals and institutions can take to mitigate the burden of this debt, including consolidating and refinancing their existing debts. With a little better understanding of our own psychology, we can change the way people make decisions about their debt and help set them on the path towards greater financial well-being.

Special thanks to Mariel Beasley for her invaluable insights, and to MetLife Foundation for funding this research. The Foundation aspires to help people build a better tomorrow through access to the right financial tools and services.