Debt 
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Debt Snowball Is Predictably Irrational

Cats Love Debt SnowballsThis morning I wrote about how Dave Ramsey’s Debt Snowball system works and why it’s an effective way for people to pay off their debts. It might not be the mathematically optimal way to pay off your debt but it’s worked for many people.

My look at the debt snowball was precipitated by an All Things Considered segment I heard on NPR. In it, Dan Ariely, behavioral economist, talks about a study in which he studied the loan payment techniques of over a thousand people. They gave each person five loans they had to pay off, a salary, and then had them start paying off the loans. The amount they received at the end of the study is proportion to how much you had in the study.

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 Debt 
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Dave Ramsey Debt Snowball Payoff Strategy

Snowballs Start SmallDave Ramsey is most well known for an idea known as a “debt snowball” repayment plan. The idea taps into human psychology and our desire to reduce the number of something, even if the sizes of those “somethings” vary (more on this idea this afternoon). While it may not be the mathematically optimal strategy, and everyone agrees on this, it’s one that has seen great success over the years.

The basic premise is that you make minimum payments to all of your debts and put any extra debt repayment dollars towards your smallest debt. As you retire debts, you take those minimum payments and apply them to the next smallest debt. In this manner your small minimum payments “snowball” so that as you near the end, your payments are much larger than the remaining minimums.

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 Debt 
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How Dave Ramsey Helped Me Pay Off My Debt

Dave Ramsey's Total Money MakeoverLate last December I came across a post on Bargaineering about Dave Ramsey’s book, “The Total Money Makeover.” Prior to this, I had never heard of Dave or his somewhat controversial teachings (e.g., he recommends folks pay off their debts from smallest to largest, regardless of interest rates, he quotes Bible verses – though mostly to share common sense financial wisdom, etc.).

Somewhat intrigued, I picked up a copy of the book and read it in about 24 hours. The writing style was engaging and the book really spoke to me. It caused me to sit down and take a long, hard look at where I was financially, a decade plus out of college… The picture wasn’t pretty; a good retirement account, almost no savings, credit card debt, a car loan that was underwater, and incredibly poor spending habits. Today, 11 months later, I am debt free (other than the house) and feel fantastic. If I can change my ways and eliminate more than $25k in debt in less than a year…anyone can.

So how did I do it?

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 Reviews 
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Dave Ramsey’s Total Money Makeover Review

Dave Ramsey's Total Money MakeoverDave Ramsey is a polarizing figure. Some people love him and swear by his advice and others think he’s a hack. Which one is he? Unfortunately that’s a question only you can answer but hopefully I will provide you with enough information about his flagship book to make your own decision.

The problem with personal finance is that there are multiple solutions to any one problem. If you think it’s simply about math, you’re wrong. Someone in credit card debt understands that when you use your credit card and don’t pay your entire bill, you’ll go into debt. They aren’t stupid, they know how interest works, but there is a non-math reason why they’re in debt.

If you had to boil down the book into a single sentence, then I’d say that Dave Ramsey’s Total Money Makeover is a book that gives you a good framework to get yourself out of debt and back on solid financial footing.

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 Your Take 
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Your Take: Your Favorite Personal Finance Book

Every year, hundreds of personal finance books are published. Every year, personal finance bloggers, experts, and columnists always refer back to a handful of books that have stood the test of time. Many bloggers are fans of Your Money or Your Life and the Richest Man in Babylon, many investors call The Intelligent Investor their Bible, and lots of people look up to the books of Suze Orman, Dave Ramsey, and Robert Kiyosaki.

I want to know, what is your favorite personal finance book ever? It can be the book that has had the most impact on your life, the book that you most enjoy reading, or the book you’d most likely recommend to a friend.

I’ve listed my must read personal finance books and even written one sentence summaries of ten personal finance books, but have I ever told you my absolute favorite?

The Motley Fool’s Money Guide by Selena Maranjian. As they say, you never forget your first. This book was the first personal finance book I ever read, back in 2003 when I started my first job, and it gave me all the tools to help me succeed. The best thing about the book was how broad it was. It gave me a sense of the landscape and enough of a vocabulary that I could learn anything Maranjian missed by researching it on my own. Is it the best book? That I can’t say, but I do know it’s my favorite.

So what’s yours?


 Personal Finance 
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Achieving Your Goals Is About You

Football Field GoalIf you talked to me three or four years ago and asked me about my approach to personal finance, I would’ve told you that you should always pick the mathematically optimal path and try to adhere to it as much as possible. I was fortunate enough to have the discipline, a credit to my parents, to almost always be able to follow what I believed was the optimal path. I didn’t have any credit card debt, I contributed as much as I could to my Roth IRA and my 401(k)’s, and I worked hard at my job.

However, in the last few years, I’ve come to recognize that it isn’t the path that you take that’s important, but how quickly you can achieve your goals. The fastest way for you to reach your goals may not come from going the best way. When climbing a mountain, a seasoned climber can scale rock faces while the novice sticks to the paths. The optimal path is by climbing the rocky walls, but a novice might make it up a few handholds before they gave up.

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 Personal Finance 
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BVC #10 – Psychological Money Games [VIDEO]

If there’s nothing else you learn about personal finance, remember that it’s more about psychology than it is about numbers. You don’t go over your credit limit because you don’t know how to add, you go over because you either don’t know you’re that close or you don’t care. You don’t go into debt because you weren’t capable of doing the math that showed that you were spending more than you earned. In the end, it’s mostly psychology and I talk about some different “games” or tricks you can use to help you be more responsible.

I added three markers in the video for the points where I talk about Dave Ramsey’s Debt Snowball, the 100 Boxes, and the Zero Spend Days. It’ll help if you want to skip certain parts.

Finally, my apologies for sounding all stuffed up, the allergy season is in full force in Maryland and the Loratadine I’ve been taking doesn’t seem to be cutting it.


 Debt 
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Dave Ramsey Is Brilliant

Huge Debt SnowballOne of Dave Ramsey’s most popular ideas is that of a debt snowball. The idea is that you pay off your smallest debts first, then roll that debt’s monthly payment into the next smallest. When the next smallest is paid off, you roll the two former payments into the next smallest debt.The snowball grows and grow with each debt that’s repaid.

Here’s a real life example in case that general one was unclear. Here are your three debts and minimum payments:

  • $10,000 @ 20% APY, $500 minimum monthly payment
  • $4,000 @ 10%, $200 minimum monthly payment
  • $1,500 @ 12.5%, $75 minimum monthly payment

The debt snowball method states that you should put all extra debt payments towards the $1,500 balance. When you finally pay off that debt, your new payment schedule should look like this:

  • $10,000 @ 20% APY, $500 minimum monthly payment
  • $4,000 @ 10%, $200 minimum monthly payment + $75
  • $1,500 @ 12.5%, $75 minimum monthly payment

Why is that brilliant? From a strictly mathematical point of view, it’s a bad plan. It’s bad because you’re paying off a 12.5% APY interest debt when you have a 20% APY interest debt staring you in the face. You save more in interest payments if you pay towards the 20% APY debt first.

However, that ignores human psychology. Big mistake.

It’s well known that children aged up to about 7 (the end of Piaget’s pre-operational stage) believe that taller, skinnier objects are “bigger” than shorter, fatter objects (they lack Piaget’s concept of conservation). Ask them to tell you which glass is bigger, a tall skinny glass or a short fat glass, and the taller skinnier one looks larger. It’s not much of a stretch that on an unconscious level this may still apply. The debt snowball method plays on that psychology by making your debt seem shorter and fatter. Two debts may seem less than three, though the two debts are “fatter.”

It also affects your motivation and feelings of success. Drawing a line through one of your debts is a very powerful motivator. It inherently builds on that success by rolling your now unnecessary minimum payment into your next debt. You knock out a few early quicker wins (smaller debts) and that enables you to push onward towards the larger, harder ones. Progress is crucial in motivation, everyone is cognitively aware of that.

Dave Ramsey might not be giving you the mathematically correct plan but he also knows that personal finance is as much about psychology as it is about math.

(Photo: redjar)


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