FIRE

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Snowball or Avalanche, Which is Better?

Posted on by David

In our last post we discussed the snowball method of eliminating debt. This method prioritizes paying off your smallest debts first. Then once the smallest debt is eliminated, you take what you were paying on that debt and add it to the payment of your next smallest debt. It is referred to as the snowball method because, like a snowball rolling down a hill becomes bigger, the amount that you pay towards your debts become larger with each eliminated loan.

One of the biggest proponents of the debt snowball is author and financial consultant Dave Ramsey. According to Ramsey, “When you pay off that smallest debt first, you get a taste of victory. And that feeling of success is the momentum you need to tackle the next debt with a vengeance.” The snowball method works because it gives you the hope that paying off debt is possible. And hope is very powerful tool.

Debt Snowball vs. Debt Avalanche

Last post we discussed the criticisms of the snowball method. Because the snowball method has you paying off your smallest debts first regardless of interest rates, you will end up paying more in interest using the snowball method than if you were to use the avalanche method of prioritizing debts by interest rates. Critics will say that the snowball method is fundamentally flawed in this way.

So let’s do an example to see which is better: the debt snowball method or debt avalanche method. Let’s run the numbers to see if (and by how much) the debt avalanche saves you in interest paid and total time to pay back your debt. I’d never seen a breakdown like this before, and I was curious. Let the math begin!

Using Unbury.me I created a debt budget. I decided to simulate a young couple who recently graduated from college (because I have experience with that). The family has two car loans, 2 student loans and some credit card debt. I selected the interest rates and principle amounts specifically so that each method would prioritize paying off the loans in different orders. The calculator has the option to choose between each payment type and also the option to increase your monthly payment. In this case the minimum was $1,775, but you could allocate more money to pay off your debt quicker. I chose to leave it at the minimum because increasing it didn’t affect which option was better.

5 loans total $65,000
Pick your poison: debt snowball or avalanche.

Let’s Crunch Some Numbers

These loans come out be a total of $65,000 worth of debt which is a pretty hefty sum, but even paying the minimum of $1,775/month it can be eliminated in just a few years. So which option is better?

Using the snowball method of paying off the loans with the lowest principle first, this hypothetical couple will have finished paying off their debt within 43 months. The amount of interest paid on this debt will be $11,555.21. Killing $65,000 of debt in under 4 years is pretty impressive. The reason this is so fast is because for each loan that is paid off all of the money you would normally put towards that loan can be lumped into your payments to the next loan. So how does this compare to the avalanche method?

debt snowball works
Using the debt snowball method the debt is paid off in 43 months

If we switch over to the avalanche method of prioritizing the highest interest loans, this hypothetical couple will be able to finish paying off their debt within 43 months. Exactly the same amount of time. Well that’s not exactly shouting a clear winner is it? What about interest paid? The avalanche method does pay less in interest over those 43 months. Using this method the couple pays a total of $10,985.44 in interest which is $569.77 less. That’s about $13 a month less.

While not nothing it’s not a smashing victory for the avalanche method. I’ll be honest, I really expected the difference to be a lot more drastic! After all the hate the snowball method receives for wasting your money, you’d think it would be a runaway victory for the avalanche. Seems less like an avalanche and more like a snowdrift to me.

debt avalanche works too
Using the debt avalanche method the debt is also paid off in 43 months

An Unclear Victory

So which one is better? That’s up to the individual to decide. On a purely math basis the debt avalanche is the option that ends up saving the most money. In this case the debt repayment dates were the same. I tried changing the different loan amounts to see if that would result in different repayment dates. It technically did, but I had to make drastic changes to create any big difference. For example if I up the credit card debt (18% APR) from $9,000 to $40,000 (huge) the avalanche method still only pays off the debt 4 months quicker than the snowball method.

[The Debt avalanche method] might sound like smart math. Here’s why it’s not: Debt isn’t a math problem. It’s a behavior problem.

Dave Ramsey

So if you’re a purely mathematical person who doesn’t insert emotion into their rationale, the debt avalanche may be your better option. But if you operate purely based on math, you probably aren’t in debt. Or at least not that much. That’s probably why Dave Ramsey says that “Debt isn’t a math problem. It’s a behavior problem.” The reason people get into debt they can’t control is because they aren’t being objective and rational.

This is why the snowball method has worked for so many people. Because paying off those small debts first give you that feeling of accomplishment that gives you the motivation to pursue your larger debts and as Dave said, “Motivation is the key to becoming debt-free, not math.”

Conclusion

We have friends who have used the snowball method with a lot of success, and the story is the same every time. “We didn’t think we could do it. Our debt was so daunting! And then bam! First debt completely gone. It was like we could suddenly breathe again.” Don’t underestimate how much of a head game paying off debt can be. You can choose whatever debt repayment method you like, but whatever you choose, start now! The sooner you start, the sooner you can be to a more Financially Independent place. And remember, it’s OK for it to be a slow burn.

What do you think? Were you surprised by my results? Do you see any flaws in my math? Impossible, I know! Let us know in the comments below.

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Dave Ramsey and the Debt Snowball

Posted on by David

When it comes to eliminating debt there is usually one name comes to the forefront of everyone’s minds: Dave Ramsey. Ramsey is a radio host, TV host, author, and champion of the debt snowball. This method prioritizes paying off your debts from smallest to largest. Once the smallest debt is eliminated, you take what you were paying on that debt and add it to the payment of your next smallest debt. This is referred to as the snowball method because, like a snowball rolling down a hill becomes bigger, the amount that you pay towards your debts become larger with each eliminated loan.

Ramsey is no stranger to the kind of debt or financial hardship that he counsels people through. In college he began investing in and selling real estate and by 26 had amassed a $4 million portfolio. However he had become over-leveraged and by the next year he declared bankruptcy. Eventually, after recovering from his bankruptcy he began offering financial advice to couples at his church and that turned into a financial counseling business that has helped 6 million families get out of debt. And one of the biggest things he recommends, like we already mentioned, is the snowball method.

Why the Snowball Method?

Advocates of the snowball method argue that the reason it works is because paying off the smallest (easiest) debt first gives you that first victory quicker. Claiming that first victory quickly is exciting and gives you the motivation to keep working at paying off your debt. After the first debt is payed off, all the money that you were paying towards that debt can be added towards paying off the next smallest debt. That extra amount then helps you pay off the next debt quickly as well, giving you more excitement and motivation to conquer your debt.

Being deep in debt, on top of the financial burden and pressure it puts you under, can lead to a real sense of hopelessness. Oftentimes, paying the minimum towards debt can land you deeper in debt than you were before that monthly payment. The whole situation feels a little like drowning. The snowball method works because it gives you the hope that paying off debt is possible. And that hope can be just as important to conquering debt as reason and logic.

Snowballs eliminate debt... and maybe your friends

Criticisms of the Snowball Method

Critics of the snowball method counter with the fact that prioritizing your debts by principle amount rather than interest rate means that you’ll end up paying more in interest than you would if you tackled the debt with the highest interest rate first. That’s true. This is sometimes referred to as the avalanche method (I think just because it follows the same snow motif). Paying off your debts with the highest interest rates first will minimize the total amount payed in interest.

Since your smallest debts may not have the highest interest rates, you will end up paying more in interest using the snowball method than if you were to use the avalanche method so logically the avalanche method is a better option. Because of this I was firmly in the debt avalanche camp. But remember what I said above: “Hope can be just as important to conquering debt as reason and logic.” Debt is illogical. Most people get into debt by trying to keep up with the Joneses. There are a few good reasons to get into debt, like a buying a house, but most of the time getting into debt is illogical. Because of that it’s very difficult to logic your way out of debt.

Debt isn’t a math problem. It’s a behavior problem.

Dave Ramsey

Debt Snowball vs. Debt Avalanche

So which is better, the snowball or the avalanche method? Well if you like instant gratification and prefer to see results quickly the snowball method may be right for you. It allows you to quickly see initial victories and that momentum helps to motivate you to clinch those next victories. Perhaps a debt-repayment plan with a longer outlook for eliminating the first loan may cause you to lose motivation and give up on getting out of debt.

If you are the kind of person who is able to formulate a plan and stick to that plan for the long run, the avalanche method may be the better option for you. If you’re the kind of person who goes into your undergraduate fully expecting to take 12 years to finally finish your PH.D then you can probably take advantage of the avalanche method and thrive.

The FIRE community has been known for its math-based logical approach to eliminating debt and reaching financial independence so it’s probably safe to say that the debt avalanche approach is a better option for most readers here. But then again the kind of people who create a plan and stick to it unflinchingly for years on end aren’t usually the kind of people who frivolously get into debt. So that may be a moot point.

According to Ramsey’s website:

The debt avalanche and debt snowball have a similar goal: to help you become debt-free. But the debt snowball gives you motivation, and motivation is the secret sauce that gets you debt-free faster! When you pay off that smallest debt first, you get a taste of victory. And that feeling of success is the momentum you need to tackle the next debt with a vengeance. 

With the debt avalanche, you won’t get a feeling of accomplishment for a long time. You could lose steam and give up long before you even pay off the first debt! Sure, it might make sense mathematically to begin with the debt that has the highest interest rate, but—let’s get real—if we were focused on math, we wouldn’t be in debt in the first place.
Most fiscally responsible credit card ever

Conclusion

I went into this study favoring the debt avalanche method of paying off the highest interest loans first. And in my mind I still prefer it. For example the best investment you can make is paying off credit card debt. But I’ve never been in debt (other than a mortgage) so I guess this debate really isn’t for me.

But for people who feel crushed beneath the weight of their debt maybe the snowball method is the best way. I think I’m coming around to this side of the argument. Little victories early on in the process can make a marathon feel more like a sprint. And they can make it feel less daunting. If you are the kind of person who can stick to a plan by looking years into the future, the debt avalanche method is probably better, but for most people in a lot of debt the snowball method has real potential. Because for most people debt isn’t a math problem. It’s a behavior problem.

I our next post we’ll simulate a family’s debt with several different loans at different interest rates and calculate which option is better.

What do you think? Have you worked your way out of debt? How did you tackle it? Let us know in the comments below!

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Who Needs a Financial Advisor?

Posted on by David

Here’s a quote that I found online that really resonated with me. I don’t remember what exactly it was from, but it was a comment that perfectly encapsulated something I’d like to rant about.

This is one of my biggest peeves. That a person would spend a working life accumulating assets only to be totally disinterested in how to manage or even a basic understanding of investing, it’s totally beyond me. Accumulating into the $ix figures+ is a huge big deal! I’ve got friends who have $100K+ in 401Ks/IRAs, and they’re all the same…they all end up offloading it to target funds that operates similarly to these all-in-one’s, or alternatively have a “financial advisor” manage it……a life savings is a heck of a thing to be intentionally ignorant about.

An angry commenter on the internet

Whenever you read the financial news or something about personal finance, it always ends with “consult with your financial advisor”. This is probably for liability reasons so someone doesn’t follow their (usually bad) advice and lose money and then sue them. It’s just a way to cover themselves, but honestly, who has their own financial advisor? Do you even need one?

Who has a Personal Financial Advisor?

MagnifyMoney surveyed more than 1,500 Americans and found that only 30% of those surveyed have ever paid for a financial advisor. And in a recent CNBC survey only 1% of respondents said they currently have a financial advisor managing their money. These surveys pointed to this a fault in Americans. That only those who don’t understand what’s at stake refrain from getting “professional help”.

But what does this “professional help” get you? What will paying a financial advisor $300/hour do for you? That’s right, that’s the kind of money you’d be paying to have a financial advisor. And did you know 10 out of 10 financial advisors recommend you use a financial advisor? Crazy huh? At several hundred dollars an hour it’s not hard to see why. I don’t know about you but I don’t have several hundred dollars to spend on talking to someone about my finances. What could they possibly do to be worth that kind of money?

What does a Financial Advisor do for You?

When meeting with a financial advisor, they will first assess your current financial situation. You’ll list your assets, debts, income, and expenses. Next they’ll identify areas for improvement. They’ll ask you about your plans for the future i.e. buying a house, starting a family, saving for retirement.

Based on your current financial situation and future goals they’ll then recommend paying off debt, growing your emergency fund, or specific investments, for retirement. All of this sounds real great, but it’s 100% a scam. You can do all of it yourself, for basically no charge.

Why you don’t Need a Financial Advisor

A lot of this can seem confusing at first–especially if you haven’t been taught how to manage your own finances. But all it takes is a little research and a desire to learn. And when your future is on the line, you should have a desire to learn! We’re all motivated by different things, but probably everyone is motivated (in part) by money. That’s why we all have jobs. This is your money that you worked really hard for, and if you’re going to spend 40 years working to accumulate money I imagine you care how it’s managed. You want it taken care of properly. At least, I hope you do. As our angry commenter friend said, a life savings is a heck of a thing to be intentionally ignorant about.

A life savings is a heck of a thing to be intentionally ignorant about.

So let’s look at what a financial planner does and how you can do it better, for less money, and actually know what’s going on.

They assess your current financial situation: assets, debts, income, and expenses.

According to common financial terms, assets are anything that increases in value. This means that a house is an asset, and stocks and bonds are assets. Debts are self-explanatory.  They can be seen as negative assets. Net worth is then calculated by subtracting your debts from your assets. For example, a house is an asset and a mortgage is a debt. If your house is valued at $300,000 and you have $200,000 mortgage the net worth is $300,000 – $200,000 = $100,000

Your income is what you bring in and your expenses are what you spend. If your monthly income is $4,000 and your monthly expenses are $5,000, you net income is negative $1,000/month. You don’t need a financial advisor to tell you that’s not good. They’ll then give you advice on what to do to improve your situation like go out to eat less. Again, who needs to pay a “professional” for advice like that?

They ask about your plans for the future. When you plan on retiring, how much you’ll need etc.

Most people plan on retiring at 65 and if you are a younger person, a financial advisor will probably just recommend that. If you are closer to retirement age they will look at your financial situation (as seen above) and try to determine how much you’ll need in retirement and based on that how far away you are for retirement.

If this sounds familiar, good! This is basically what FIRE calculators do. The idea of FIRE is based on using the 4% rule to find out how much you will need in retirement. Greatly simplified, if you spend $4,000/month you will need $1,200,000 in retirement. And based on your net income you can calculate how long it will take to reach that goal.

Using the retirement calculator at networthify.com you can input your annual income and expenses and it will tell you how long it will take you to retire. It will also tell you your required nest egg. If you make $5,000/month and spend $4,000/month. It will take you 31 years to save enough money to retire (assuming you have zero net worth currently). And this tool, unlike a financial advisor, is completely free.

They make recommendations as to what to do to grow your net worth.

After doing this a financial advisor will give you recommendations on how to grow your money. They’ll likely recommend paying off any debts you owe (no-brainer) or growing your emergency fund (literally every financial advice article will tell you that). They’ll also recommend specific investments that will help you grow your nest egg.

This is where the scam really plays out. They’ll almost always recommend you invest in their investment fund or use them as your investment manager. While the hourly rate for a financial advisor is several hundred dollars an hour, the fee to use one to help you invest your retirement savings is usually around 1% of your investments yearly.

If you are saving up to retire with a million dollars, you would eventually be paying this advisor about $10,000/year! That’s a lot of money considering most fund managers actually underperform the general market. So you’re usually paying a financial advisor to perform worse than you would by yourself. All you have to do is buy three index funds and you will outperform any fancy financial manager and do it for free.

So as you can see hiring a financial advisor is rarely worth it because they won’t tell you anything you can’t already easily calculate on your own. And worse, they’ll charge you money to do it worse. More importantly, you should know what is going on when it comes to your life savings. Even if you trust someone else to manage it for you, it’s just good to know how it’s being managed.

An Example

Let’s look at a hypothetical family. And see what we can learn about their finances. And let’s see if they need a financial advisor.

AssetsDebts
House: $300,000Mortgage: $200,000
Savings account: $4,000Car loans: $20,000
Checking account: $1,000Credit card: $2,000
Retirement account: $40,000Student loans: $30,000
Total Assets: $345,000Total Debts: $252,000

This family’s net worth can easily be calculated by subtracting $252,000 from $345,000. This comes out to be $93,000.

IncomeExpenses
$50,000Mortgage: $15,000
 Debt Repayment: $10,000
 Food: $5,000
 Entertainment: $5,000
 Popup Expenses: $5,000
Total Income: $50,000Total Expenses: $40,000

Their income is $50,000 and their expenses are $40,000. Using the 4% rule, that makes their required nest egg to be $40,000/0.04 = $1,000,000. We can see under assets that the retirement account has $40,000 in it. If we plug these numbers into networthify.com we calculate that this family will need $1,000,000 to retire and it will take those 27 years to save up that much.

If you save 20% of your income anyone can retire in less than 30 years.

Super Easy, Barely an Inconvenience

Look at that! We just assessed their financial situation. It looks pretty good with a positive net worth of about $100,000. We also saw that their income exceeded their expenses by $10,000/year. Our advice is to keep saving money for retirement. (They may want to save money for other things too like, say, college for the kids. I’d recommend not putting that into a retirement account so they have access to it before they turn 59 ½.)The amount they’ll need to fund a retirement with current expenses is $1,000,000 and if they do put all their savings into retirement nest egg it will take them 27 years to reach that amount!

If they want to reach $1,000,000 dollars in 27 years they’ll need to invest it in the stock market. Instead of some fancy investment fun with a fancy fund manager, I recommend they put their savings into a three fund portfolio. A good starting point is 30% US Total Stock Market, 30% International Stock Market, and 40% Total Bond Market. That will gain them about 7% gains per year.

There! I just did 90% of what a professional financial advisor would do in less than a page of text! So do you need a financial advisor to manage your money for you? The answer is probably not. Unless you have lots of money from multiple different income sources that are subject to tricky tax codes, you probably can manage all your finances on your own. And if you stick to the tried and true method of investing in index funds (like Warren Buffet advises us all to do) it’s super simple to figure it out yourself.

Super easy barely an inconvenience
Most personal finance is pretty simple.

When Should You Hire a Financial Advisor?

This isn’t to say that you should never hire someone to help you with your finances. There are certain times that it may be prudent to consult with an advisor. Maybe you’ve come into a large inheritance and you want to find the best way to minimize taxes. Or you are about to retire and you want someone to look over your finances and double check that you calculated everything correctly. There are times where it may be wise to consult with a financial advisor, but those are specific events that once are done so is your need for that advisor. Very few people need a personal financial advisor on call.

This is why I’m always annoyed when I read something about finances that ends with, “as always consult with your financial advisor.” Very few people have a financial advisor and even fewer people need one. And if you are taking the initiative to learn and control your finances, you definitely don’t need your own financial advisor!

What do you think? Have you paid someone to help manage your money or do you like to do it all yourself? Let us know in the comments below! And as always consult with your financial advisor… lol

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Roth or Traditional IRA, Which is Better?

Posted on by David
Infinity War IRA Meme

The choice between contributing to a traditional or Roth IRA. It’s been a long-running debate ever since the Roth IRA was created at part of the Taxpayer Relief Act of 1997. As we discussed in the last post, both types of IRAs have valuable tax advantages. Utilizing a traditional IRA allows you to avoid taxes on contributions and gains, but you are taxed on withdrawals. In contrast, with a Roth IRA you are taxed on your contributions, but your gains and withdrawals are tax-free. So which is better? (In this article I’ll be comparing traditional and Roth IRAs, but the principles also apply to traditional and Roth 401(k)’s as well.)

Traditional IRA/401(k)

With a traditional IRA you only pay taxes on withdrawals

Roth IRA/401(k)

With a Roth IRA you only pay taxes on contributions

Why aren’t we discussing taxable brokerage accounts in this argument? I think the decision whether to contribute to an IRA vs a taxable brokerage account should be obvious. Max out your IRA before putting money into a taxable account, since in an IRA you don’t have to pay tax on capital gains. But the choice between a traditional IRA and a Roth IRA is a little harder. Both are good options for investing your savings, and either should be used before contributing to taxable account. For my analysis on which is better for tax avoidance purposes, I assumed:

  • Taxpayers are married filing jointly
  • They are in the second tax bracket ($19,901 to $81,050)
  • They take the standard deduction ($25,100)
  • Inflation affects costs evenly

There is a Definitive Winner

I crunched the numbers and it turns out that the answer is based on your savings rate. If you have a high savings rate, a traditional IRA is better, and if you have a lower savings rate, a Roth IRA is better. The break even point mathematically comes out to be when your IRA contributions can drop your effective tax rate by half. When that happens, you should pick a traditional IRA over a Roth.

If your IRA contributions are less than a certain amount, then it’s better to contribute to a Roth. For example in 2018 the median income for a Midwest family was $64,069/year and their effective tax rate would be 6.6% (after the standard deduction). If this family was regularly contributing $10,000 to a traditional IRA, their effective tax rate would drop to 4.8%, saving them $1,200 in taxes. But when they retire, they would withdraw $54,069/year and incur $3,078 in taxes. This equates to a loss of $1,878 per year due to taxes. So as you can see, we haven’t reached the break even point yet.

If they were contributing $17,900 to a traditional IRA [This is more than the IRA limit, but you could do this with a traditional 401(k) which we already said works in practically the same way], their taxable income drops to $21,069 for an effective tax rate of 3.3%. If they contributed the same amount to a Roth, their taxable income would be $38,969 for an effective tax rate of 6.6%. This is where the break even point is, where contributing to either a traditional or Roth is equally beneficial. If this family were to contribute more than $17,900 they should contribute that money to a traditional IRA, if there were to contribute less, they should opt for a Roth IRA.

What about Inflation?

Again, this is assuming married filing jointly, and taking the standard deduction which is pretty common in the Midwest. This means that all income is taxed in the 10%-12% bracket. The tax code is pretty kind towards Midwest families in that between $19,901 and $81,050 you are only taxed at 12%. And if you include the standard deduction of $25,100 a family can make up to $106,150 before reaching the next tax bracket!

This is also ignoring inflation. Normally I’d get mad at any accountant who ignores inflation, but in this case I think the math works out. The variables that change with inflation are:

  • Income
  • Cost of living
  • 401(k) contributions
  • The standard deduction
  • 401(k) contribution limits
  • Withdrawals (Cost of living in retirement)

Inflation should affect all of these factors evenly (or close enough to be negligible). Below is a table of incomes and which retirement accounts to contribute your savings towards. If a family makes $40,000/year they should contribute up to $5,800 to a Roth 401(k), if they’re saving more than that they should contribute the rest to a traditional.

IncomeRothTraditional
$40,000<$5,800>$5,800
$60,000<$15,800>$15,800
$80,000<$25,800>$25,800
$100,000<$35,800>$35,800

Try it for Yourselves

I uploaded the spreadsheet I created. If you want to test it out with your own income and savings just download it and fill in the two green boxes. The result in the yellow box is how much you’ll save in taxes by choosing a traditional over a Roth IRA. If the result is negative then you’re better off contributing to a Roth IRA.

Roth-Vs-Trad-IRADownload

I have read a few articles stating that a traditional IRA is better, but they are usually assuming dual incomes, large salaries, and high savings rates. However here in the Midwest $80,000/year is considered a high salary and it’s not uncommon to have only one working spouse and the other stays home to take care of the children. So in our case a Roth is almost always a better option.

Tax RateMarried Filing Jointly
10%Up to $19,900
12%$19,901 to $81,050
22%$81,051 to $172,750
24%$172,751 to $329,850
32%$329,851 to $418,850
35%$418,851 to $628,300
37%$628,301 or more
Income tax brackets for married individuals filing joint tax returns

Roth IRA Conversion

There’s also the option of a Roth conversion, which is using a traditional IRA then slowly converting it to a Roth after you retire. If you only convert enough to reach the standard deduction each year, you’ll never have to pay any taxes on it. Of course in 2021 that’s assuming you don’t need more than $25,100/year. Living off that little income is hard, but not impossible, especially if you’ve already paid off your house.

Again this is assuming you have an extremely high savings rate, something that’s hard to do when you only make the median Midwest income of $64,069/year. If you can do it, more power to you! But if you’re closer to the normal end of the savings spectrum, after running the numbers, I’d recommend using a Roth when you can. These principles also apply to 401(k)’s, but as I mentioned in my previous post on what order to contribute to your various retirement accounts, if your company offers a 401(k) match contribute enough to your 401(k) to get the match regardless of whether it’s a traditional or Roth 401(k).

What do you think? Do you agree with my analysis? Do you contribute to a traditional IRA, Roth IRA, or both? Let us know in the comments below!