Your accountant, your financial planner, your hairdresser, all will most likely say, pay of your home loan first, prior to paying off business loans as the interest on your home loan is not tax deductible, whereas interest on your business loan is. You will therefore save tax by retaining business debt instead of home loan debt.
So what’s the problem with this logical and rational advice? Precisely that, logic and rationality, as humans don’t act logically and framing a solution around logic will often fail.
Studies show that the way we behave to get out of debt fastest is to pay off the smallest debt first, regardless of whether it is business or personal debt.
Remi Trudel, an Assistant Professor of Marketing at Questrom School of Business, Boston University conducted a detailed study in 2016 (summarised here in Harvard Business Review, https://hbr.org/2016/12/research-the-best-strategy-for-paying-off-credit-card-debt) to test what led to the greatest success in paying down debt.
The study clearly showed that participants who focussed on paying off their smallest debt first with one large payment amount, rather than splitting this payment amount equally between each of their debts;
- paid off their total debt significantly faster,
- perceived greater progress toward their goal of becoming debt-free, which in turn led to more motivation to keep going. Perception about progress was based on what portion was paid off, thus paying off the smallest debt first led to the greatest sense of progress.
Researchers including the well-known author and behavioural psychologist Dan Ariely wrote in a 2011 study (summarised here https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1760528) about the psychology of managing multiple debts that participants consistently paid off the smallest debts first, regardless of the different interest rates on the various debts.
Noted US personal finance adviser Dave Ramsey has come to the same conclusion, advising us to “Forget Logic – It Just Works” (https://www.daveramsey.com/blog/scientists-say-the-debt-snowball-method-works) as “quick wins change behavior. When you pay off your smaller, nagging debts, you see the benefits instantly. Those quick wins motivate you to continue the behavior. Your wins keep adding up until you reach your goal of becoming debt-free”.
Many business owners may have a large, personal home loan and smaller business debts with tax deductible interest (eg. business overdraft, business credit card) and are advised to pay off their home loan first, so more interest can be claimed as a tax deduction. The studies show that this will most likely be far less successful in terms of total debt reduction compared with focussing on paying off the business credit and overdraft first in order of smallest size first.
Another implication is that debt consolidation of various small debts into one loan may be counter-productive. Instead, if you have some high-interest credit card debt and other lower interest debt, see if you can refinance the credit card debt into a lower interest loan but keep this as a stand-alone loan, so you can maintain your focus on paying off the smallest debt first.
The research is in and it makes sense when we think about how we are motivated, so if you want to become debt free or next time you’re advised to pay off your home loan first, think about the smallest debt first.