Angela owes $500 on a credit card and $2,000 on a student loan. The credit card has a 15 percent annual interest rate and the student loan has a 7 percent annual interest rate. Her sense of loss aversion makes her more anxious about the larger loan. As a result, she plans to pay it off first—despite the fact that professional financial advisors always tell people to pay off their highest-interest-rate loans first. Suppose Angela has only $500 at the present time to help pay down her loans and that this $5
By how many dollars will she be better off if she uses the $500 to completely pay off the credit card rather than partly paying down the student loan? 00 will be the only money she will have for making debt payments for at least the next year.
I assume that the interest only accrues once a year.
So we have two scenarios. Angela applies $500 to either the credit card debt, or to the student loan debt.
First scenario the credit card is paid off. The student loan debt increases to (1+0.07) x $2000 = $2140
Second scenario the credit card debt increases to (1+0.15) x $500 = $575
and the loan debt increases to (1+0.07) x $1500 = $1605
for a total debt of $575 + $1605 = $2180
So she is $2180 - $2140 = $40 better off paying the credit card off in full first