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Why Don't People Manage Debt Better?

blogs.scientificamerican.com

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Re: Why Don't People Manage Debt Better?

#21

Post by jimbokun »

DannoHung wrote: post #14
pilom wrote: post #8

This is showing that the Dave Ramsey "debt snowball" (pay off smallest debts first to get a psychological win and some breathing room by having fewer minimum payments) is a more effective way to get people to pay off many separate debts than paying off "highest interest rate first" even if it is less optimal for a rational actor. Just another case of people aren't 100% rational that many people have known for a while…

I have literally have people tell me that this is still rationality because it's the rational thing "for them". Like, the weirdest one was a cognitive psychology doctoral student. I mean, okay, if you can redefine rationality to be completely subjective, then sure, rationality is flargikriggendurf.

It is rational to realize human psychology is empirically real and take it into account, including our own. If anything, perhaps we should be even more skeptical of our own reasoning when we believe we are being purely objective and free of bias.

Optimizing the likelihood of consistently following through with a plan is very rational.

Re: Why Don't People Manage Debt Better?

#22

Post by adrianN »

DannoHung wrote: post #14
pilom wrote: post #8

This is showing that the Dave Ramsey "debt snowball" (pay off smallest debts first to get a psychological win and some breathing room by having fewer minimum payments) is a more effective way to get people to pay off many separate debts than paying off "highest interest rate first" even if it is less optimal for a rational actor. Just another case of people aren't 100% rational that many people have known for a while…

I have literally have people tell me that this is still rationality because it's the rational thing "for them". Like, the weirdest one was a cognitive psychology doctoral student. I mean, okay, if you can redefine rationality to be completely subjective, then sure, rationality is flargikriggendurf.

Rationality is about which objective function you want to optimize. If it's money, then the snowball is not rational. If something else bothers you more, it might be.

Re: Why Don't People Manage Debt Better?

#23

Post by jonknee »

imgabe wrote: post #17

Anyone at a point where they are making monthly payments on multiple credit cards has already lost the debt game. People don't manage debt better because they have been marketed to and taught to use debt completely inappropriately. Debt should be used to purchase an asset that will appreciate or otherwise provide an income in excess of the interest payment on the debt. Full stop. That is how businesses use debt and t…

> Debt should be used to purchase an asset that will appreciate or otherwise provide an income in excess of the interest payment on the debt. Full stop. That is how businesses use debt and that is the only sensible strategy.

Businesses use debt in all sorts of ways, they certainly don't limit it to buying assets. A common use recently is to fund share buybacks which is essentially an easy way to engineer higher earnings per share and make investors happy (but not providing any actual income). Another common use is commercial paper markets which corporations use for short term obligations (payroll!) and to smooth out cash flows, this is actually pretty similar to a credit card on a personal scale.

Re: Why Don't People Manage Debt Better?

#24

Post by anon4 »

Don't fall into debt. If you must fall into debt, then do so to a friend at no interest. If you still have to fall into debt, do so to a reputable bank and pay it off as quick as you can - sell whatever assets you have if you must.

This of course applies to private individuals, not companies, banks or other institutions.

Re: Why Don't People Manage Debt Better?

#25

Post by mark_l_watson »

I have so many friends, and some family members, who act as though the optimum life strategy is to buy as much material stuff as they can without getting into a default situation. Given a lifetime exposure to marketing I don't much blaim their attitude.

The thing is: the idea of maximizing material success is so very wrong. A good life is about experiences, not material stuff. Having savings and flexibility that entails makes life more relaxing and pleasure full.

Re: Why Don't People Manage Debt Better?

#26

Post by forgetsusername »

jonknee wrote: post #23
imgabe wrote: post #17

Anyone at a point where they are making monthly payments on multiple credit cards has already lost the debt game. People don't manage debt better because they have been marketed to and taught to use debt completely inappropriately. Debt should be used to purchase an asset that will appreciate or otherwise provide an income in excess of the interest payment on the debt. Full stop. That is how businesses use debt and t…

> Debt should be used to purchase an asset that will appreciate or otherwise provide an income in excess of the interest payment on the debt. Full stop. That is how businesses use debt and that is the only sensible strategy. Businesses use debt in all sorts of ways, they certainly don't limit it to buying assets. A common use recently is to fund share buybacks which is essentially an easy way to engineer higher earni…

>Businesses use debt in all sorts of ways, they certainly don't limit it to buying assets. A common use recently is to fund share buybacks

You don't think buying a stake in a successful company (in this case one that happens to be your own) is buying an asset? The mechanations are slightly different, but you're still buying shares. An effect is rising EPS (due to retired shares), but that isn't the purpose.

Re: Why Don't People Manage Debt Better?

#27

Post by yummyfajitas »

imgabe wrote: post #17

Anyone at a point where they are making monthly payments on multiple credit cards has already lost the debt game. People don't manage debt better because they have been marketed to and taught to use debt completely inappropriately. Debt should be used to purchase an asset that will appreciate or otherwise provide an income in excess of the interest payment on the debt. Full stop. That is how businesses use debt and t…

Consumption smoothing is a perfectly valid use of debt.

Suppose I have utility = log(consumption), but my income is volatile. If I have 1 income in year 1 but 10 income in year 2, and use no credit, my utility is log(1)+log(10) = 2.3.

If I use credit, I can have utility log(5.5 / (1+r)), with r the interest rate. At 10% interest, that's 3.2. At 20% interest that's 3.0. At 50% interest that's 2.6.

So even at 50% interest I'm increasing my utility by 10% due to the use of credit.

Re: Why Don't People Manage Debt Better?

#28

Post by [deleted] »

stevesearer wrote: post #20
kagamine wrote: post #16

Earlier quoted context omitted.

That does sound rational though, by paying off the small debts you reduce the amount of information you have to comprehend. It may not be ideal financial advice, but it will make the remaining debt easier to manage on an emotional level. You also get the peace of mind that those smaller problems will now not spiral into larger problems. You are free to focus on a resolution to the problem.

We had a few small debts (2 student loans, credit card, car payment) and when a friend explained the debt snowball concept it was definitely the key factor in us paying off our debts faster. For me it felt like I was back in control because I actully had a plan that made sense and seemed actually doable.

[deleted]

Re: Why Don't People Manage Debt Better?

#29

Post by kdamken »

pilom wrote: post #8

This is showing that the Dave Ramsey "debt snowball" (pay off smallest debts first to get a psychological win and some breathing room by having fewer minimum payments) is a more effective way to get people to pay off many separate debts than paying off "highest interest rate first" even if it is less optimal for a rational actor. Just another case of people aren't 100% rational that many people have known for a while…

While I agree in that it obviously is not the smartest way of doing that, if it gets people to actually feel like they have a plan for taking care of their debt and to start making progress on doing so, then it's worth it.

Obviously they probably shouldn't have bought a bunch of things they didn't need, but hindsight's always 20/20.

Re: Why Don't People Manage Debt Better?

#30

Post by surfearth »

jonknee wrote: post #23
imgabe wrote: post #17

Anyone at a point where they are making monthly payments on multiple credit cards has already lost the debt game. People don't manage debt better because they have been marketed to and taught to use debt completely inappropriately. Debt should be used to purchase an asset that will appreciate or otherwise provide an income in excess of the interest payment on the debt. Full stop. That is how businesses use debt and t…

> Debt should be used to purchase an asset that will appreciate or otherwise provide an income in excess of the interest payment on the debt. Full stop. That is how businesses use debt and that is the only sensible strategy. Businesses use debt in all sorts of ways, they certainly don't limit it to buying assets. A common use recently is to fund share buybacks which is essentially an easy way to engineer higher earni…

You're correct that there are a multitude of uses for debt (e.g. working capital management). I do think the parent was on to something though - the cornerstone of the private equity/leveraged buyout industry is borrowing debt below your return on equity to amplify returns. This can be a wise strategy for individuals to cautiously replicate.
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