Consumers often direct extra money towards their oldest instalment loan, even when paying a newer loan would save more interest, according to research published in the Journal of Marketing Research. The preference appears to be partly driven by the effort borrowers feel they have already invested in the older debt.
The researchers call this a “first-in, first-out,” or FIFO, preference. It describes the tendency to deal with the debt that entered a household’s finances first.
However, the findings do not mean borrowers should automatically pay their newest loan first. Interest rates, outstanding balances, remaining payment schedules and the conditions attached to each loan all affect where an extra payment will produce the greatest saving.
The research involved eight studies by Alicia M. Johnson of the University of Massachusetts Amherst, Daniel Villanova of the University of Arkansas, Julio Sevilla of the University of Georgia, Mathew S. Isaac of Seattle University and Rajesh Bagchi of Virginia Tech.
Older loans attract extra payments
The first study examined data from Bondora, an Estonian peer-to-peer lending platform.
After requiring each borrower’s two loan periods to overlap, the final sample contained 43,456 loans held by 21,728 borrowers. Older loans were recorded as repaid in 20.3% of cases, compared with 16.4% for newer loans.
The Bondora information was a cross-sectional snapshot rather than a complete history of every payment. The authors therefore describe the result as an association and caution that not every recorded repayment can be classified as a voluntary prepayment.
The controlled experiments provided stronger evidence that the age of a loan can directly affect a borrower’s decision.
In one experiment, 200 participants considered two auto loans with the same 4.5% interest rate, $14,331 balance, $626 monthly payment and two years remaining. The only meaningful difference was when the loans had begun.
When participants imagined receiving an unexpected $1,000, 72.5% chose to put it towards the older loan, even though neither option offered a financial advantage over the other.
Past effort pulls borrowers towards old debt
The researchers found that people felt they had invested more mental and physical effort in debts they had been repaying for longer.
An old loan can represent years of checking balances, arranging payments and making sure sufficient money is available. That history can make repaying the loan feel like a job that should be finished.
Johnson explained through a University of Massachusetts Amherst statement: “It can feel counterintuitive to allocate funds to newer instead of older debt, even when it’s financially optimal to do so.”
A separate experiment tested this explanation by telling participants that loan payments were made either manually or automatically.
When the older loan was described as being paid automatically and the newer one manually, participants allocated an average of 41% of their extra money to the older debt. When the payment arrangements were reversed, the share going to the older loan rose to 66%.
This was a hypothetical experiment, not an observation of borrowers changing their real automatic-payment settings. Nevertheless, it supports the researchers’ argument that perceived effort contributes to the FIFO preference.
The cheapest target depends on the loan terms
Another experiment gave participants a $2,500 bonus to divide between two loans.
Both loans had a current balance of $14,331 and a monthly payment of $626. However, the older loan charged 4.5% interest, while the newer loan charged 4.9%.
When participants were not shown the age of the debts, they allocated an average of 32% to the lower-rate older loan. When the ages were disclosed, that proportion increased to 42%, even though directing the money to the higher-rate newer loan would have saved more interest.
The effect of amortisation can also make the remaining repayment schedule relevant. Interest on a conventional amortising loan is calculated using the outstanding principal. An extra principal payment removes money that would otherwise continue accruing interest.
The paper illustrates this with two otherwise identical $100,000 loans carrying a 12% rate and an original 15-year term. One loan was four years old and the other eight years old.
A $5,000 principal payment on the newer loan produced an estimated interest saving of $12,373.51. The same payment on the older loan saved $6,066.52, approximately $6,306 less.
This is a worked example rather than a promise of what any borrower will save. The result depends on the rate, balance, remaining schedule, regular payment and how the lender applies the extra money.
Borrowers should therefore avoid replacing an “oldest first” rule with a “newest first” rule. The Consumer Financial Protection Bureau generally recommends prioritising the highest-rate student loan when making extra payments, while continuing to meet the required payments on every account.
Showing interest savings changed the decision
The researchers tested whether presenting loan information differently could reduce the pull of older debt.
In one experiment, participants directed an average of 65% of a $2,500 payment to the older loan when they were told how many years had elapsed since each debt began.
When the same information was presented as the number of years remaining, the proportion going to the older loan fell to 51%. This was the same result recorded when no age information was provided.
A final experiment gave participants a more direct comparison of the interest savings produced by different allocations.
The financially optimal division of a $2,500 payment in that scenario was $166.02 towards the older student loan and $2,333.98 towards the newer auto loan.
Participants who saw the ages of the loans but did not receive the savings tool allocated an average of 55% to the older debt. Among those shown a dynamic interest-savings graph, the proportion fell to 27%.
The calculator did not eliminate the preference completely. However, it moved participants considerably closer to the allocation that minimised future interest.
For banks and financial applications, the finding suggests that displaying estimated interest savings may be more useful than showing borrowers balances, rates and origination dates alone.
Extra payments may not work as expected
Borrowers should check how a lender will process additional money before making a payment.
Payments may cover fees and accrued interest before reducing principal. A servicer may also place an account into paid-ahead status unless the borrower gives instructions about how the additional amount should be applied.
Some auto loans calculate interest in advance rather than using a conventional simple-interest method. These loans may not produce the same savings from an early payment. Certain contracts may also contain prepayment penalties.
The CFPB advises borrowers to check their agreements, give clear payment-allocation instructions and verify the account statement after the transaction. Its guidance also explains that auto-loan prepayment conditions can depend on the contract and state law.
The research primarily concerns instalment loans with defined repayment periods, including auto, student and personal loans. It does not establish that the same FIFO effect applies to revolving credit-card balances.
Interest savings are not every borrower’s only objective
Minimising total interest is not necessarily a household’s only financial goal.
Completely clearing an account may simplify monthly finances and give a borrower motivation to continue reducing other debts. A partial prepayment that leaves the account open, however, may not remove a monthly bill or deliver that psychological benefit.
The relevant distinction is whether borrowers understand the trade-off. Someone may knowingly accept a higher interest cost in return for eliminating an account. That is different from paying more because the oldest loan simply feels like the natural place to send the money.
All of the interventions were tested in controlled experiments. The next question is whether showing projected interest savings inside real repayment systems would produce the same improvement when borrowers are allocating their own money.
