Reviews 
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Debt Free for Life by David Bach

Debt Free for Life by David BachDebt Free for Life is David Bach’s latest personal finance book and the first, as far as I know, that focuses entirely on the subject of debt.

David Bach’s most well known book is The Automatic Millionaire, which pushed the idea that the easiest way to “get rich” was to put it on autopilot. Automatic savings, whether to a bank account or a retirement account, is the key to a prosperous retirement. It’s one of the powerful pieces of personal finance out there. Since then, he’s written Start Over, Finish Rich which has spawned a whole “FinishRich” line of books, live events, and coaching.

In previous books, it was always about putting together a system that sets you up for the rest of your financial life. Set an automatic monthly contribution to your 401(k), check in each year to rebalance, and retire comfortably (that’s the skeleton, you have to put the meat on it by researching investments, etc.). This is one that focuses entirely on debt, how to pay it down faster, how to get out of it (from legally walking away to working with debt settlement companies), and how to stay away from accumulating more debt in the future.

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 Debt 
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How to Pay Off Debt

When the economy is prospering, debt isn’t an issue. You can pay your obligations of today because you know that you’ll be earning more tomorrow and lenders aren’t worried you’ll miss a payment. But as the economy sank last year, you saw a lot of credit card and loan companies scramble to assess the risk of their borrowers. If you had a credit card balance, you might have seen your interest rate go up. If you wanted to buy a house, you may have had to document your income a lot more stringently than you expected. It’s not surprising because the average household credit card debt, based on the Federal Reserve’s Survey of Consumer Finances in 2007, was $3,039.70.

At first glance that may seem a little low, but remember that a lot of people don’t even have access to credit cards. If you only include families with credit card debt, that value goes up to over $7,000. Ultimately, any amount over $0 is too much because credit card companies charge interest rates in the double digits. High yield savings accounts pay out less than 2% these days, so a double digit interest rate on credit cards is far too much. It’s time to pay them down, here’s how.

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 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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 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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 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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