January 15, 2009
I am a big fan of Dave Ramsey. I listen to his radio program and I’ve read all of Dave’s Books
. His is one of my favorite personal finance books. Dave made famous a specific debt reduction method – The Debt Snowball. From personal experience, I can verify that The Debt Snowball works – and I’ll be eternally grateful for Dave’s enthusiasm about debt reduction.
The Debt Snowball –
- List your debts – from lowest balance to highest balance – and make minimum payments to all accounts.
- Make an extra payment to the first account on your list.
- After paying off the first account, take the combined amount (minimum payment and extra payment) which had been going to the first account, and apply it to the second account.
- Repeat until all of your accounts have been paid off. and your debt has been eliminated.
There is one major issue with The Debt Snowball that cannot be ignored. Dave suggests paying debts off in order of account balances, focusing on the smallest balance first. By ignoring interest rates, Dave’s plan, on paper at least, could actually cost more than alternative methods.
Clearly, the goal of The Debt Snowball is to help us get out of debt. In the long run, this saves money. Dave’s theory – and one that has held up over time, despite criticisms – is that there are emotional and psychological benefits associated with paying off an entire account balance. Once that first account is paid off, the fact that it is paid off motivates us to attack the second account, and so on, until all accounts have been paid off.
Personally, I like Dave’s plan, but I do realize it’s flaw. By not taking into account interest rates, The Debt Snowball could leave you with a big debt, and a higher interest rate, for much longer than necessary. Imagine this scenario.
- Debt A – $900 @ 8.9%
- Debt B – $1,700 @ 3.9%
- Debt C – $5,000 @ 6.9%
- Debt D – $10,000 @ 4.9%
- Debt E – $12,000 @ 19.9%
Under Dave’s plan, you would focus on debts A, B, C, and D, first, even though Debt E has a dramatically higher interest rate. Allowing an account with such a high rate to just hang around, while you focus on the accounts with smaller balances, could get frustrating.
An alternative method of debt reduction,The Debt Avalanche (so coined by my good friend Flexo from Consumerism Commentary), suggests that we ignore account balances, and instead focus on interest rates. The same “snowball” technique applies, paying minimums and rolling old payments into new accounts, but our accounts are listed from highest rate to lowest rate. Our scenario, under The Debt Avalanche would look like this.
- Debt E – $12,000 @ 19.9%
- Debt A – $900 @ 8.9%
- Debt C – $5,000 @ 6.9%
- Debt D – $10,000 @ 4.9%
- Debt B – $1,700 @ 3.9%
Under The Debt Avalanche plan, we’re now focusing on the account with the highest interest rate – and we’re following a mathematically sound approach. There could be, however, for some folks, a problem with this plan –
Watching a $12,000 balance drop to $11,100 just doesn’t feel as good as watching a $900 balance drop to $0.
Face it, we are emotional creatures, and there’s something awesome about destroying an entire debt – even if the process does not add up mathematically. I’m 99% sure that this is why Dave sticks with The Debt Snowball, instead of going with the mathematically-sound Debt Avalanche. He knows that most people, most average people, need to feel the psychological impact of paying off an entire account.
The question is, can we combine the two, The Debt Snowball and The Debt Avalanche, and come up with something else – a Debt Deluge if you will – that will give us both the psychological boost of one and the mathematical advantage of the other? Here’s my attempt.
Debt Deluge –
- List your debts – from lowest balance to highest balance.
- Draw a line at (or near) the midpoint of you list.
- Reorder the debts that are below the line – from highest rate to lowest rate.
- Make minimum payments to all accounts on the list.
- Make an extra payment to the first account on your list.
- After paying off the first account, take the combined amount (minimum payment and extra payment) which had been going to the first account, and apply it to the second account.
- Repeat until all of your accounts have been paid off. and your debt has been eliminated.
The Debt Deluge is really just a combination of the two other methods. When you start your debt reduction journey, you’ll begin by eliminating those small, pesky account balances. As you move forward, and start to get used to the process, you’ll shift away from the Snowball and toward the Avalanche. Our scenario now looks like this.
- Debt A – $900 @ 8.9%
- Debt B – $1,700 @ 3.9%
- —————————–
- Debt E – $12,000 @ 19.9%
- Debt C – $5,000 @ 6.9%
- Debt D – $10,000 @4.9%
Using The Debt Deluge, we can find a good balance. Personally, I think it’s important to get rid of those smaller balances, as quickly as possible, but I don’t like the idea of leaving (too much) money on the table. The Debt Deluge gets us started, and feeling great about eliminating those first few accounts, and then it prepares us for the long-haul, and dealing with those higher interest rates. In the beginning, we sacrifice just a bit, and pay a little more in finance charges, for the psychological impact of paying off an entire account. As we move forward, however, we move away from that technique, and towards a technique that saves more money, albeit at the cost of fewer psychological boosts.
What do you think? Do you need the emotional boost of paying off those smaller balances, or are you content knowing that your plan is mathematically sound? If we combine the two approches, do we get just enough of both worlds to push us forward? I’d love to hear what you think about The Debt Deluge.
