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 $500 will be the only money she will have for making debt payments for at least the next year. If she uses the $500 to pay off the credit card, how much interest will accrue on the other loans over the coming year? On the other hand, if she uses the $500 to pay off part of the student loans, how much in combined interest will she owe over the next year on the remaining balances on the two loans? By how many dollars will she be better off if she uses the $500 to completely pay off the credit card that than partly paying down the student loans?
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