Why You Should Ignore Your Instincts When Paying Your Bills

Imagine you're sitting on a park bench one breezy afternoon, minding your own business, when out of nowhere a $100 bill lands in your lap, like a leaf falling off a tree. There's no way to find out who lost the money, so this little treasure is now yours. The only caveat is that you have to use all $100 to pay down some of your debt.

Now imagine you have two credit-card accounts. One has a $100 outstanding balance and a 10% interest rate. The other charges a 15% interest rate on your $1,000 balance. How much do you repay on each account?

This isn't a trick question. If your goal is to get the most bang for your buck, there is a right answer: pay $100 off of the $1,000 balance, as opposed to paying off the smaller, $100 account. Why? Because the higher the interest rate, the more it costs you to carry that debt. This is why financial advisers always suggest paying off our more expensive debt first. Over time, this practice saves us more money.

Why Many Get It Wrong

And yet people often get it wrong, even people who consider themselves financially savvy. At least, that's the conclusion from a recent study in which 171 viewers of "Squawk on the Street," a business news program on CNBC, logged onto the channel's website to answer financial questions like the one above. Roughly one-third of the participants missed the mark, opting to pay off the smaller account, despite its lower interest rate.

"Likely, people feel better [when they close an account]," explains Cynthia Cryder, an assistant professor of marketing at Washington University in St. Louis and one of the study's authors. In other words, watching a $1,000 balance drop to $900 isn't nearly as satisfying as closing a $100 account.

"People like to go for the low-hanging fruit," Cryder says. She's right. When I look at my to-do list, I'm always willing to take out the trash before filing my taxes because running my garbage to the curb gives me a quick and delightful sense of accomplishment, while sorting out my income is a huge hassle.

Turning into the Skid

Choosing to leave open a lower-cost account in order to merely make a dent in the higher-cost one may feel counterintuitive, like turning into the skid when you hit a patch of ice in your car. But it's still the correct way to proceed, and the proof is in the numbers. If you're charged 15% compounding interest per year on $1,000, your balance will be $1,749 after four years. Running those same numbers but with a 10% compounding rate, the balance will be $1,464, saving you almost $300 over the four years.

According to the U.S. Federal Reserve, the country's total outstanding credit card debt is $2.41 trillion and rising. And because consumers who use credit hold an average of four cards, the way we manage our debt payments matters.

However, it can be hard to act against your instincts, which is why Cryder is quick to emphasize the fundamental point that paying off debt is a good thing. "You always want to focus on your debts with the highest interest rates. However, if you're having trouble motivating yourself, it's better to pay down some debt than none. So if you really need to feel great about paying down some debt, go for that small account rather than not paying down any debt at all."

Loren Berlin is a columnist at DailyFinance.com. She can be reached at loren.berlin@teamaol.com. You can follow her on Twitter @LorenBerlin, and become a fan on Facebook.