A few weeks ago I posted an article on my website 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.
About the Author
Michael Dawson recently said goodbye to a 20 year career in Engineering, Marketing and Sales to focus on living his dream of financial independence. He has since founded The Time and Money Group as vehicle to encourage others to do the same. The company's mantra is "Why trade time for money ... when you can have both." Sign up for their free weekly newsletter, where he and others discuss the different paths to financial freedom and offer insights for your successful navigation.
http://www.thetimeandmoneygroup.com/
Subscribe to:
Post Comments (Atom)
No comments:
Post a Comment