Canadians and the psychology of debt

The only wrong way to repay debt is to stick your head in the sand and not pay it

September feels more like the new year than January. Late summer breezes set in, kids flock back to school and summer vacations linger in the rear-view mirror. January may be the official calendar new year, but it feels more like the sleepy leftover of December holidays and just a continuation of cold weather and dark early nights. September is when real change happens in most of our daily lives.

This quasi new year brings with it new starts and opportunities for “resolutions” seen through the stories of Canadians facing very real economic issues. One caught my eye. The Canadian Payroll Association’s annual poll of working Canadians living paycheque-to-paycheque shows despite a strong economy, debt-related stress is on the rise in Canada and four-in-10 working Canadians feel overwhelmed by their level of debt.

This topic is of great interest to Credit Canada, and dovetails with a survey we are releasing this week that takes the pulse of Canadians on the psychology of debt. The Credit Canada Debt Awareness Survey polled 1,517 Canadians and asked, “what freaks you out more: debt or interest?”

Young Canadians (18-34) are much more likely to be “freaked out” by the amount of debt they have (50 per cent) than the amount of interest on that debt (26 per cent), while seniors (65+) are more likely to be “freaked out” by the amount of interest on their debt (42 per cent) than the debt itself (29 per cent).

Truthfully, while millennials ranked the lowest when it came to know how much debt they have and how much interest they’re paying, overall awareness is low across the board among all ages, which is an alarming statistic to say the least.

Canadians generally show a trend toward interest-rate awareness as they age. Millennials are twice as likely to know their total debt than they are to know the interest rate on their debts or their monthly interest payments. Meanwhile, seniors are most likely to know all the numbers — their total debt, the interest rate on their debts and their monthly interest payments.

But overall, a shockingly low number of Canadians know how long it will take to pay off their debts (making either fixed or minimum payments). This brings me to the psychology of debt. Despite traditional economic theory, not all financial decision-making is rational — much is based on behavioural, emotional, cultural and social factors. Take for instance the snowball vs. avalanche approach toward debt repayment.

The snowball method involves paying as much money as possible toward the smallest debt, regardless of interest rate, while maintaining just the minimum payments on other debts. Once the smallest debt is paid off, payments are rolled over into paying down the next smallest debt and so on. This way, a person knocks off debts one by one, and the payments “snowball” into faster debt repayment.

Conversely, paying down debt with the highest interest rate first is known as the avalanche approach — this involves maintaining the minimum on all debts, but paying the most money possible toward the debt with the highest interest rate, regardless of how much money is owed. This in the long-run may save hundreds, if not thousands of dollars in interest charges.

While the avalanche method is likely to save money in the long-run, many prefer the snowball method because paying off the smallest debts first achieves quick upfront wins, which can be a motivating factor for some and helps them stay on track with their debt repayment.

A study from the Journal of Consumer Research suggests the snowball method is more likely to succeed because of the psychological benefits and instant gratification related to paying off a debt balance in full faster.

In the end, it usually comes down to personality. There are free tools such as debt calculators that are available to consumers seeking to determine the best approach. For those looking to pay off debt faster and save on interest, debt consolidation is often a good option.

Whatever method people choose, it’s important to remember, the only wrong way of repaying debt is to stick your head in the sand and avoid paying it altogether.