Debt

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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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The Best Investment You Can Make

Posted on by David

People are always looking for that next big investment. Whether it’s the next tech company, cryptocurrency, or real estate, people are always looking for something that will bring home big returns. In the 90’s it was Beanie Babies, then it was Pokémon cards, now it’s Funko Pops. But I’m here to tell you the best way to consistently get returns–at around 20%! Here is the best investment you can make:

Pay off your dang credit card

There it is. That’s all there is to it. It may not be glamorous, but paying off your credit card is the best investment you can make right now. It’s better than Amazon, Apple, Bitcoin, real estate, or government bonds. Why is that? The median interest rate on a credit card right now is 19.96% (source), and that’s historically low. In 2019 the median interest rate was 21.3%, and the average maximum APR was 24.98%. Meaning if you had a $1000 credit card balance, every year you were paying $250 in interest.

As of 2021 Americans owed over $807 billion in credit card debt that comes out to $6,270/family (source). $6,270 on a credit card with a 19.96% interest rate comes out to $1,251.49/year in interest. That’s over $100/month just in interest!

How does this happen?

Most credit cards only require you to make a minimum payment each month. This minimum payment is usually around $30 or 1% of your balance, whichever is greater. In our example of the average family, if they only pay $30/month towards their credit card, they’re actually going $70 more into debt every month. Even if they never use their card again! This is how credit card companies make money. They let you ignore your balance and only charge you a small fee, then charge you interest on that balance.

Bank of America, for example, charges a minimum payment of $35 or 1% whichever is greater. If you have a past due balance on your credit card of $4000, the minimum would be 1% of that or $40. If the interest rate on that card is 20% (the national median) then the APR equates to 1.67%/month. The interest on $4000 would be $66.67/month. $66.67 in interest minus your $40 payment equals $26.67 added to your balance. You paid $40 towards your credit card and instead of going down, your balance went up by $26.67!

Don't pay money to owe more money.
Sonic Sez “that’s no good”

Paying credit card debt is better than playing the stock market

So you can see how making the minimum payments on a credit card is a terrible idea. By keeping a balance on your card you are losing 20% annually. This is the same as making a negative 20% return on investment. So if you have $4000 in credit card debt but also have $4000 in the stock market making a 10% annual return (pretty good for the stock market). Then you are actually making a net 10% loss.


10% + -20% = -10%

In this case it would actually be a better investment (much better) to take all of that money out of the stock market and put it towards eliminating your credit card debt. If having a credit balance is a negative 20% return then any money put towards paying that balance would be like making a 20% annual return on that investment.

A 20% annual return is unheard of in the work of investing. Anything that consistently returns 20% would be the most popular investment ever. Let’s see how other popular investments compare. Between 1985 and 2020 these following assets have returned:

Large cap stocks (S&P 500)9.6%
Real Estate8.5%
United States Bonds 4.1%
Gold3.2%
Source: visualcapitalist.com

Even if you consider Bitcoin’s meteoric rise to nearly $50,000, in the last 6 months it has lost 24.26%. Bitcoin has made some people super rich, but its volatility is so great that no fund manager would choose it over something that consistently returns 20% per year. Remember even during stock market crashes credit card rates stay above 10%. Even at the worst point in the 2008 financial crisis, the average interest rate on credit cards was 12%. Even at its lowest point in the last 30 years, paying off a credit card was a better investment than the average return of the S&P 500.

Credit card debt is an emergency

In a recent survey Bankrate found that that 54% of Americans say that have more emergency savings than credit card debt. 54% of Americans could pay off their credit card debt and make a 20% return on that investment. Even if you don’t pay off the balance in full, everything put towards paying of that balance is the same as making a 20% return on your investment.

More than half of Americans said that increasing their emergency savings was a higher priority than paying down credit card debt. Newsflash: credit card debt is an emergency! Many Americans hold revolving credit card debt while also contributing to a 401(k). Now I’m not one to recommend ignoring your 401(k), but remember if your 401(k) is making a 10% return (above average) then you are making a net loss of 10% by contributing to your 401(k) rather than paying down credit card debt.

Paying off credit card debt can feel like climbing a down escalator, but if your committed, you can accomplish it.
If you’re trying to reach the top you have to be committed.

Unless you can make an investment that returns greater than 20%, your best option is always to pay down credit card debt. Why make a 7% return when you can make a 20% return?

Conclusion

All of this assumes you are going to stay out of credit card debt after paying off your balance. It doesn’t do you any good to divert money from your 401(k) contribution to pay off your credit card just to then max out your card. Then you’re back where you started and you missed out on gains in your 401(k). This requires a changed lifestyle.

Like anything else in life, having a plan is the first step. If you are in credit card debt, make a plan to pay it off as soon as possible. Be committed to that plan even if it means living on less or pausing other investments, because paying down your credit card balance is the best investment you can make.

This advice also applies to other high-interest debt. Most student loans have low interest rates, but some private loans can have up to 13% APR. Paying only the minimum of debt will just leave you further in the hole. Make a plan to tackle high interest debt and commit to that plan.

What do you guys think? Is there a better investment out there that I didn’t think of? What are some good reasons to keep a credit card balance? Let us know in the comments below!

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How to Solve the Student Loan Problem

Posted on by David

Last week we discussed the smart way to do college. The college system isn’t perfect, so it’s up to students to pursue college in an intelligent way: decide on a good career first and then pick a major that will equip you to excel in that career. Then after those decisions are out of the way, choose a college that is well-equipped to teach you that major. But none of this actually solve the root issue. Here’s my proposal for how to solve the student loan problem.

My proposed solution: Just make student loans illegal

It may sound dumb, but I've got a rationale.
Wait, what?

No seriously. It’s illegal to give predatory loans for mortgages or cars, so why is it legal to prey on college students? According to debt.org, Predatory lending can be “any practice that convinces a borrower to accept…a loan that a borrower doesn’t need, doesn’t want or can’t afford.” Based on our imaginary conversation with the loan officer in part 1, it’s hard to deny that the student borrower can’t afford a student loan.

Imagine you’re about to graduate high school and you go to the bank and ask for a $100,000 loan.

Loan Officer: What do you have for collateral?

17 year old: I’ve got an Xbox and that’s about it.

Loan Officer: OK, let me see your bank statement.

17 year old: I’ve got a thousand dollars in my checking account

Loan Officer: Um, do you have two months of pay stubs?

17 year old: Yep, I’ve been working part-time at McDonalds for the past year making about $600/month

Loan Officer: HAHAHAHA good joke. REJECTED.

If we make student loans as difficult to obtain as mortgages, then only those people who are credible will be able to obtain them. It won’t completely eliminate defaulting on student loans but it should decrease it significantly.

I can hear you complaining about it already:

But that would make it harder for poorer families to send their kids to college!

Yes, yes it would. It should be harder for poorer people to buy expensive things. I know that’s not a particularly empathetic position, but that’s just how life is. It’s harder for poorer people to buy houses, cars, and luxury trips to Europe. The reason college is so expensive is because everyone can pay for it whether they can afford it or not. Predatory student loans deceive poorer families into believing they can afford a small private liberal arts college when they can’t.

Now I’m not saying that poor people don’t deserve to go to college. But I am saying that lying to people and telling them that they can have everything they want, all they have to do is take on $50,000 in debt, is not kind. Saddling poor people with student loans that can last multiple decades is not helping them. It’s a hindrance. According to the National Consumer Law Center, over 2 million federal student-loan borrowers have been repaying their debt for at least 20 years.

But college is a means to raise yourself above your current economic condition!

Yes, it is–or at least it’s supposed to be. The problem is that having recurring student loan payments makes it really hard to rise above you current economic condition. According to EducationData.org, 30% of black college graduates with student loans default in the first 12 years of repayment. For 1/3 of black graduates a college degree didn’t even make them enough money to pay their college debt!

College is only useful if it teaches you marketable skills. Otherwise it could bankrupt you for life!

Interest on student loans is a killer
It’s crazy how long it takes to pay off student loans when you pay the minimum payments.

Eliminating student loans will make college cheaper

EducationData.org reports that 30% of college students obtain student loans. So if we outlawed student loans, then college enrollment would drop by 30%. This would put a strain on colleges, pressuring them to lower tuition if they want to attract more students. Remember that at the end of the day colleges are just businesses looking to make money. They’ll follow the laws of economics and set prices at the optimum level to attract buyers (students). The reason tuition keeps outpacing inflation every year is because people keep paying for it (with student loans).

We have seen how the availability of loans increases prices. Until recently car loans were usually 3-5 years in length but within recent years 7 and 8-year car loans have become the norm. This increase in loan availability has causes the automobile market to outpace inflation. Put plainly, the reason cars are so expensive now is because car loans are more easily available. An 84-month car loan will have lower monthly payments than a 60-month loan so consumers then opt for the more expensive car.

The same thing has happened to the housing market. Housing has skyrocketed past inflation because of the relative ease of getting a mortgage. I know we discussed how difficult it was to get a mortgage in part 1 of this series (and it is), but compared to any other type of loan a mortgage is really easy to get. 30-year mortgages were virtually unheard of before the 1950’s. Now nearly every mortgage is a 30-year mortgage. Because of the ease of getting a 30-year mortgage, home buyers often end up buying much more house than they need.

In 1950 the average new house was 983 sqft. (source) as opposed to 2020 where the average new house had 2,333 sqft. People are able to “afford” more house because a 30-year loan has lower monthly payments than a 15 or 20-year loan. But are they really able to afford it? With a 30-year mortgage you will end up paying more interest than the initial value of the house. According to nerdWallet “37.6% of households headed by people age 65 to 74 had a mortgage on their primary residence in 2019.” If you still don’t own your house by the time you’re 70, could you really afford it?

Student loans just allow you pay for that increasing unaffordability for the rest of your life.

Allowing huge loans causes prices to go up, because consumers think they can now magically afford it. But all that does is saddle them with crippling debt. This is the same as college! Student loans don’t make college more affordable, they make it less affordable. Student loans just allow you pay for that increasing unaffordability for the rest of your life.

Eliminating student loans will make college degrees more valuable

Eliminateing student loans would also have the effect of making college degrees more valuable. If fewer people were able to obtain a college degree then it becomes more valuable. In 1950 only 6% of Americans had college degrees, as of 2020 37.5% of Americans have college degrees. You have people going to college who don’t care because “a college degree is required to get ahead”.

The reason that’s true now is not necessarily because a degree helps you get ahead. It’s because not having a degree gets you left behind. College nowadays is like high school was in the 1800’s. Only so many children went to high school so a high school diploma was valuable. Then by the 1900’s when high school became mandated, a high school diploma became less valuable.

The more people who receive a college degree, the less valuable it becomes. That’s why you now need advanced degrees in many fields. If we make college out of reach for a good portion of the population that will increase the value of a college degree. This will also give employers a much-needed kick in the pants to show them that maybe a 4-year degree shouldn’t be required for most jobs. Maybe a B.A. in English doesn’t make you more qualified to be an administrative assistant than anyone else.

Many employers require 4-year degrees for roles that don’t need a 4-year degree. They are still super important for technical positions, but hiring a kid with a bachelor’s degree in psychology over someone with an associate’s degree and 20 years of technical experience for a supervisor position needs to stop. And maybe making college degrees rarer will show employers that they’re often not really necessary.

The Incredibles is always on point.
It’s just basic economics.

A Less Extreme Solution

So I know outlawing student loans entirely is an extreme solution that will probably hurt people, but I think it’s a good starting point for conversation. Maybe don’t outlaw them altogether, but what if we did require the kind of rigor for student loans that we do for mortgages? What if we required a sort of collateral for student loans? High school seniors may not have something valuable enough to ensure a $50,000 loan, but what if we put the student’s decided major down as a way to ensure the loan?

The loan shark (I mean servicer) can check the student’s major against the median salary for recent graduates with that same major and offer a loan accordingly. Students that go into engineering or some field that traditionally pays a lot will be able to qualify for a larger loan amount because the loan servicer has a greater assurance that they will be able to repay the loan. A student who picks a major that traditionally pays less will qualify for a lesser amount because they are more of risk to the loan provider.

Another idea would be to not offer student loans to students. Offer them to the student’s parents who have a job. car loans require a job, mortgages require a job, shouldn’t student loans require a job as well? And this kind of loan already exists; it’s called a parent PLUS Loan. Maybe these should the main type of student loan rather than some fringe option.

Conclusion

Anyway those are some ideas I’ve had to try and tackle our ever-increasing student loan problem. And it is a problem. Student loan debt in the United States totals $1.73 trillion and grows 6 times faster than the nation’s economy. I believe the main culprits behind the student loan problem are the predatory lending practices of the loan servicers and the fact that the federal government guarantees all student loans.

And this isn’t to say that college is stupid and all student debt is bad. I know many people who got student loans to go to college and when they graduated they worked really hard to pay them off. If you pursue college with a solid plan and a clear goal it can be a great tool. The problem is that predatory student lending has made it possible for everyone to go to college whether they can afford it or not. And if someone can’t afford college letting them take on a lifetime of debt won’t help their situation.

What do you think? Is my proposal to outlaw student loans crazy? How would you solve the student loan debt problem? Let us know in the comments below!

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Is it True that 40% of Americans Don’t have $400 in the Bank?

Posted on by David

You’ve all heard the statistic that 40% of Americans don’t have $400 for an emergency. That seems pretty dire! $400 is not that much money in the grand scheme of things. In many cases $400 would not cover rent, a maintenance bill, or even groceries for the month. If this statistic is to be believed, this leaves over 130 million Americans just one step away from financial ruin. So where did this 40% figure come from and is it true?

Page 21 of the Report on the Economic Well-Being of U.S. Households in 2017 starts off by saying “Four in 10 adults in 2017 would either borrow, sell something, or not be able pay if faced with a $400 emergency expense.” News outlets and politicians have run with this to say that 40% of Americans don’t even have $400 in the bank. It makes for a pretty catchy headline and newspapers exist to be sold. But you know what they say, “There are three kinds of lies: lies, d***** lies, and statistics.”

“There are three kinds of lies: lies, d***** lies, and statistics.”

Anonymous

There are problems with all statistics, which is why the methodology must be published alongside the survey. This is also why there are entire classes devoted to statistical bias. In this case, the survey was about how the respondents would choose to pay a $400 emergency expense, and they were allowed to pick more than one answer. The actual responses add up to more than 100%.

The actual data can be seen here.

Question EF3

Suppose that you have an emergency expense that costs $400. Based on your current financial situation, how would you pay for this expense? If you would use more than one method to cover this expense, please select all that apply.

143% answered so it's can't be true that 40% of Americans Don’t have $400 in the bank.

The total adds up to 143% so obviously this data is flawed. The 40% number is taken from the adding all of the responses that weren’t “Put it on my credit card and pay it off in full at the next statement” or “With the money currently in my checking/savings account or with cash”. These answers together comes in at 59%. 59% divided by 143% comes out to about 41%.

So the math works out, but does it make sense? What if one participant surveyed responded with “With the money currently in my checking/savings account or with cash” and another marked all of the responses? They would both be able to pay a $400 bill with cash, but the “percent of respondents who would either borrow, sell something, or not be able pay if faced with a $400 emergency expense” would be 7/10 or 70%. See how disingenuous that is?

A better gauge of the American financial situation might be seen in question EF5.

Question EF5A. Which best describes your ability to pay all of your bills in full this month? 78% responded with “Able to pay all of bills”.

Question EF5B. How would a $400 emergency expense that you had to pay impact your ability to pay your other bills this month? 85% responded with “Would still be able to pay all bills”.

Why would more people be able to pay all of their bills after a $400 emergency than before? This just adds to my suspicion that the 40% number is flawed. It’s possible that Question EF5B is only asked of the 78% who affirmatively in part A, but the report does not say that.

This report was cited later that year in a study by Neil Bhutta and Lisa Dettling, which found that 76% of families have at least $400 in liquid savings, and 40% have at least 3 months of expenses saved up. This directly contradicts the commonly quoted 40% number.

The original question was asking how the respondent would pay a $400 emergency expense, not whether they had the cash to pay it. While the answers are probably correlated with general financial health, there are plenty of reasons why someone who had the money would choose not to pay for an unexpected bill in cash. This survey isn’t saying that 40% of Americans don’t have $400 to pay for an emergency.

How bad are the typical family’s finances?

America’s finances are not great, that’s definitely true. For example the average household has $6,270 in credit card debt. That’s a shocking amount considering the average interest rate on credit cards is 18%. But it’s not all bad news, 47% of respondents in this study said they have never carried an unpaid balance on their credit cards. Almost half of Americans have never had credit card debt!

The FIRE movement has gained considerable traction in the last few years, and between that and the pandemic Americans’ personal savings rates have shot up. The average savings rate for 2020 was 16% and the high in April 2020 was 33.7%! That’s almost 5 times as much as the ~7% it had been at for the previous 5 years.

The highest savings rate in 2020 was 33.7%! Most Americans now have $400 in savings.
Savings rates of Americans since 2015

If the personal savings rate stayed at 16% everyone could afford to retire early assuming they invested those savings. So I think that while Americans in general are bad at delayed gratification and that clearly manifests itself in their financial situation, the actual truth is much brighter than we’re being led to believe.

Furthermore when looking at the Economic Well-Being survey from 2019 (two years later), the percentage of people who could pay cash for a $400 pop-up expense has actually increased by 28% over the last 7 years. That’s good news! Americans are getting better financially! But good news doesn’t sell headlines, so you’re probably going to keep seeing doom and gloom. At least now you’re prepared.

Now you know.
Knowing is half the battle – G. I. JOE

What do you think? Is the typical American drowning in debt or is the mainstream media more interested in clicks than truth? Let us know in the comments below!