This 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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Dave 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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Late 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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Dave 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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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?

If 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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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.

One 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)

The paradox of choice is that the more options we are given for a particular choice, the less likely we are able to make a choice. Penelope Trunk discussed it in her article about taking a job, any job and references Dan Ariely, an MIT behavioral economist, and his book Predictably Irrational. In the book, Ariely discusses a study about how people ended up buying more jam when given six potential samples versus twenty four. Twenty four potential samples was simply too much and people ended up not deciding, even though they had more information.

How does this apply to banks and credit cards? Too much information paralyzes us. It paralyzes me. In the case of jams, there’s no pain in not buying a particular flavor. In the case of credit card debt, there’s a significant pain in not paying down a card. With a bank, there’s a bit of pain in interest not earned and a bit more if you overdraft because you forgot which account held how much (or you forget how much you need to keep in an account to avoid fees because you have too many accounts). Too much information, like juggling many balls, hampers our ability to make good decisions and causes us unnecessary pain.

The solution is the simplify your finances.

If you have credit card debt, pay down the smallest amounts first. This may sound similar to Dave Ramsey’s Snowball technique and that’s because it is. However, rather than focusing on the psychological benefits (yay! another debt conquered! let’s get the next one!), I argue that removing one headache from your life, even if it’s not the most financially distracting one, is beneficial. Next, try to consolidate bigger debts into as few accounts as possible without sacrificing the interest rate. By not sacrificing the interest rate, I mean don’t consolidate lower interest cards to higher interest cards (which sounds obvious but sometimes we make mistakes). The number of credit cards offer zero fee 0% balance transfers are dwindling but they often have a fee transfer cap that could be to your benefit.

With banks, don’t keep accounts you no longer need. I kept an old employer’s credit union account open for a year and a half and it cost me $20. I had transferred money into that account from my Emigrant Direct account and written a check. The check didn’t get cashed for several weeks and before it could be cashed, I went into my account and saw some money sitting around. Not remembering why the funds were there earning a low interest rate, I transferred them back and got dinged with an NSF. While I was able to get the NSF removed, it was entirely my mistake but caused by keeping an account I didn’t need or use anymore. There are no negative credit impacts of closing bank accounts, so close the ones you don’t need anymore and drop juggling that ball.

Simplify your life and reduce the number of things your brain has to manage, you’ll be happier and richer for it.

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On a happier note, my post on the Top 5 Online Banks made it into this week’s Carnival of Personal Finance hosted by Canadian Dream.

“I usually keep my card wrapped in a picture of my children to remind me of why I shouldn’t spend … ”
                                             – Trent of The Simple Dollar

If you think money is about dollar and cents and things you can hold in your house or your hand, you’re wrong. Personal finance may seem like it’s all about the numbers, where you have to spend less than you earn, where you have to save up an emergency fund, where you have to invest in the stock market and get your 10% return; but the truth of the matter is that personal finance is more about psychology than it is about mathematics. Everyone knows that you have to spend less than you earn, no one is so disconnected or so poorly educated that they don’t realize how basic math works. It’s like physical fitness, we all know what we’re supposed to do, we just have difficulty remember to do it.

Trent made the above quoted statement in response to my post about how you should write your goals on your credit cards. My tip was a simple reminder, his was a simple reminder packed with the power of psychology. You can easily write the goal on your credit card and then dismiss it when you need to spend. Dismissing a picture of your children, the reason you live, breathe, and work every single day… dismissing that would take a Herculean effort. But it works. Trent knows he shouldn’t splurge on food or kitchen tools or video games, JD knows he shouldn’t splurge on comic books, and I know I shouldn’t splurge on vacations. Slap a picture on it, of either your kids or your cats, and it drives that point home like a jackhammer.

If you think Dave Ramsey Is Bad At Math, you’re not alone. You’re also right. Dave Ramsey’s Snowball debt busting methodology is mathematically suboptimal. For those unfamiliar with it, you essentially pay off your smaller debt amounts first, then roll those payments into larger and larger debts. The payments “snowball” and you are also rewarded with positive feelings about knocking out the smaller debts. It’s suboptimal because you would save more money by paying off the highest interest rate debts first, but you lose the psychological benefit of kicking one of those debts in the butt. While suboptimal mathematically, for many it is the optimal solution because it helps them overcome their debt. It may not be smart math, but it’s smart psychology.

The next time you have difficulty with something personal finance, be it spending less than you earn or saving towards something, try some psychological tricks and you may find that it works out better in the long run.