FEEDA few weeks ago I posted an article on debt reduction that generated an interesting conversation. It was a fairly standard article on what I thought was a commonly accepted principle. Here is the scenario:
Joe has two credit card balances. Card A has a balance of $8000 at 19.8% and minimum payments of $160 per month. Card B has a balance of $6000 at 5.9% with minimum payments of $120 per month. Joe has $400 per month to use for repaying his credit cards. How should Joe attack this debt?
The wisest strategy would be to pay the highest interest debt first. Any additional dollars available should be applied to Card A while only paying the minimum payment on Card B. Once the highest interest debt is paid, use the entire $400 to pay on Card B until that debt repayment is completed. I really don’t want to go into the math, but if you are interested take a look at this article. The bottom line is that by paying the highest interest rate debt first; less money is paid in interest resulting in more money in your pocket. That just so happens to be consistent with my objective to “fattening my pockets.”
Well unbeknownst to me, there is a rather famous financial advisor, Dave Ramsey, who promotes a different approach. He recommends that a person pays the smallest debt balance first regardless of the interest rate. Since the smaller debts can be repaid faster, a sense of accomplishment is achieved each time a debt is paid in full. Ramsey believes that from a psychological perspective this increases the likelihood of sticking to the debt reduction plan.
Posting of the article provoked the following exchange:
Reader:
The article is assumes that someone with credit card debt will make a rational, logical, well thought out decision on how to tackle the credit card debt. If the person were this logical to begin with they would never have racked up the debt in the first place. Attacking smallest to largest is a much a psychological win as it is a financial win. By knocking out the small debts first the person in debt gets the much needed feeling of accomplishment and that eliminating debt is achievable.
So the author of the article is wrong and is mostly likely jealous of the “expert” Dave Ramsey.
My Response:
I am sure that Ramsey has worked with thousands of people in debt and has come to the conclusion that paying the smallest debt first may lead to more success. However, I will guarantee that he doesn’t manage his own finances in that manner. Attacking the highest interest debt will put more money in your pocket over the course of the debt reduction process.
I agree that a sense of accomplishment is very important in a debt reduction program. However, compounding mistakes is not necessarily the wisest approach.
Reader:
I agree with the math of attacking highest interest rate first. However the author of the article (which I’ve seen elsewhere a few times) doesn’t acknowledge the psychological aspect of why the person ended up in debt, and the need to crawl before you can run. He ignores the hopelessness many people feel when approaching debt elimination, and the initial baby steps needed to begin the path of debt elimination. He takes a crack at an ultra simplistic method which has helped people at least get on the treadmill, work up a sweat, and eventually get to a point where they can run a mile without stopping. His approach suggests it’s really simple to jump on the treadmill and knock out a 5 mile run, because if you start there in the long run you’ll lose more weight (I jumped into a weight analogy, but you get my drift).
Incidentally part of Dave’s plan includes a 3-6 month emergency fund which he suggests to keep in cash or a savings account initially, others have said to put it in a MMA which check writing privileges. He does suggest that later on in the financial strengthening cycle.
Anyway, you can tell I am a Dave Ramsey fan.
My Response:
Ramsey has apparently done some psychological studies that indicate debt elimination is more probable with small successes by paying smallest debt first. That’s commendable. However, I am most interested in putting the most money in my pocket. That is achieved by paying the highest interest debt first. You could say that I am in the “hard” love camp.
My Response after some additional research:
More rambling on Ramsey: I have not read any of his books, but I did go over to Amazon to look at his reviews. In his latest book, “The Total Money Makeover” where he discusses the concept of paying the smallest debt first, its reviewers gave it 4 1/2 out 5 stars. It was also ranked number 235 on Amazon’s book list. So, apparently many people have read and value his work. While reading the reviews, there was a couple that caught my attention.
“The step by step guide is easy to understand, but hard to apply until you are sick and tired of being sick and tired.”
“His snowball method of paying off debt is not the fastest and least expensive but is probably the most motivating. If you are self motivating you should pay more attention to interest rates and pay the highest one first.”
I majored in engineering and there were “weed-out” courses scattered throughout the program. If you survived one there were many more before graduation. I remember in my Freshman Chemistry class, on the first day, the professor said look to your right and now look to your left. Only one of the three of you will pass my class. Some people just got up and walked out. Debt reduction is just like that class. It is only the beginning of a long path to Financial Freedom.
Ramsey’s approach may help some people get out of debt, but personally I am more interested in financial freedom. That requires taking the most financially prudent paths and leaving the psychological approaches to others.
I agree with paying off highest interest first, but I also have something to add to that method. My wife and I each have a new car, each have student loans, and all the credit card debt rests on my plate. If I were to pay down the highest interest rate first, I would chop away at my student loans.
However, just one of our car loan payments is more than double our combined student loan payments (shorter repayment term causes this). Since one auto loan is about 6% and the other is at 4.5%, I’ll be paying off the 6% loan (only .5% less APR than our highest student loan) first, which will free up a $400+ per month committment off our budget!
Good discussion. Clearly the math says pay off the highest rate debt first. That’s what I did when I had debt. In your example you would be a complete fool to pay the min to the 19.8% card, and load up on payments to the 5.9% card. Most debtors do not have rates as divergent as that. Also, the balances are close. I’m not sure if Dave would make an exception in this case.
I think for most people who have gotten mired in debt, his way works well. My impression is that you have successfully avoided getting in over your head in debt. Great job on that. However, as has been pointed out, getting out of debt is as psychological as it is mathematical.
Losing weight is simple mathematically. Burn more calories than you consume. Someone on a diet plan for three weeks who doesn’t see the type of progress that they hoped for may give up. Likewise for a debt elimination plan. Getting rid of the small one gives you the small victory. Just like losing three pounds after three hard weeks may be somewhat discouraging. But if that dieter tried on a pair of pants that used to be too tight, and suddenly found that they were comfortable, it would be a nice victory.
I’ve critiqued the snowball method before and agree with you entirely about prioritizing according to interest rates, but I think the method also suffers from a lack of imagination. If someone really had two lines of credit with such different rates it would behoove him or her to do one (or both) of the following:
1) Ask the issuer of the 19.8% line of credit to lower the rate, citing the competing card’s rate.
2) Talk to the issuer of the 5.9% line of credit and see about doing a balance transfer from the higher rate card.
Thirty minutes on the phone could significantly reduce the interest paid over the life of the loan.
My husband crunched our numbers and found that we would be out of debt in the same month whether we snow-balled from the smallest debt or we paid the highest interest rate first. We’d pay a small amount of extra interest if we went with the first method.
What did we do? We went with the first method and are eating the small financial loss (of extra interest paid) it will mean when we’re done. Getting money I owed to a friend–at 0 interest–out of the way before moving on to credit cards, and now being done with four of six credit cards, means a lot to me/us. It’s true that it keeps us motivated.
Following the DR strategy doesn’t mean we can’t keep developing greater sense about finances or make hard decisions. We’re not simple-minded people and we’re certainly not undedicated. We just accept that people, including us, have a very emotional reaction to dealing with money (who doesn’t, in all honesty?) and respect money’s effects on us. Given how little difference the method makes in terms of the final sums that we pay, the most important thing is that we stay on the debt reduction.
Taking emotion (how debt makes us feel) and context (such as my relationship with my friend) into an equation is a typically more feminine (less ‘rational’) response to a problem. However, those elements are very important and are often undervalued.
I think the part of your argument that made the most sense was when you admitted, “I have not read any of his books”. Dave’s advice on paying smallest off first is not only to give the person way over their head in debt a feeling of accomplishment but also the funds to start the snowball with. Many people are so heavy in debt that they do not have enough to pay the minimum on all the credit cards, car loans, student loans and other consumer debt they have accumulated over the years. His advice is to get a second job, sell stuff, do anything to get the extra money to pay off the smaller debts; once these are gone, you have extra money from your own income to start paying on the bigger debts. There is nothing wrong with going after the higher interest rate cards or loans next after the smaller ones are gone, now that you have actually have some extra money each month to pay down on the credit cards or loans. I have heard Dave say many times to pay off a higher interest rate loan before a smaller one but only after you have a big enough snowball to do it with.
Looks like I have arrived. I am getting bashed on my own blog. It has been a warm winter in Boston and I haven’t been able to make any snowballs. Good Luck.
In the example you site, Dave Ramsey often suggests that if the balances are close to each other, go after the one with a higher interest rate first. His belief is that until you teach someone to crawl, they can’t walk. You say you doubt he handles his own finances that way….well, you ought to read a little more about him….he did handle his finances that way after recovering from his own bankruptcy…and now, since he lives life without borrowing for ANYTHING, he won’t have to make the choice of paying off one debt over another. But for those he is teaching to crawl, it is important to mix a dose of real human behavior into the some times mystifying world of finance, all for a proven track record of success.
I find it funny how you take the following and try to use it to disparage Dave Ramsey, when it really does the opposite in support of him, “The step by step guide is easy to understand, but hard to apply until you are sick and tired of being sick and tired.”
His point is that until a person is motivated enough, by getting sick and tired of making money, but not having any….or sick of collection calls, or whatever that defining moment is, they will not follow ANY plan; not yours, not his, not anyone’s. For those that are desperate, and in many cases, just average folks….his method is likely to be more successful than a pure numbers approach.
Nothing wrong with looking at the numbers, if your a bean counter, but cut him some slack….he helps people.