Dave Ramsey Is Brilliant

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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:

  • $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)

{ 21 comments, please add your thoughts now! }

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21 Responses to “Dave Ramsey Is Brilliant”

  1. Saver says:

    Ramsey’s approach works for emotionally immature people who struggle to make informed decisions for themselves. For most people reading websites like yours, it’s a strategy that could lead to lower net worth over time.

    The debt snowball is for people who have spent years not caring about personal finance and not taking responsibility for their own actions, and then want to do the bare minimum to change their ways.

    There’s a group of people who need Dave Ramsey, and his approach works for them. However, it is fundamentally unsound financially in terms of maximizing net worth.

  2. Adam says:

    Coming from a financial planning program, I cannot agree with you more on the mathematics of it. Most of my academic professors would tell you to pay off the higher interest first. Dave even agrees that the math is wrong. I however, would recommend to do it as Dave tells you to. I have seen many people become frustrated like Dave talks about in his book and then quit the debt plan. If you would do the math on the particular problem that you gave today, you would not be pay that much more in interest by paying the lower balance first. You will however save thousands of dollars because you will stick to the plan and get the debts paid off.

  3. Jesse W says:

    Human psychology will always remain stronger than logical sense; especially with anyone of lower education and knowledge.

    Jesse W.

  4. Cap says:

    I would never suggest someone to pay the lower interest debt first (unless its some miniscule amount that can be quickly wiped). But jim’s point is that dave is trying to motivate a select type of audience.

    I get what you guys are saying but calling that specific type of audience ’emotionally immature’ or lower ed. and knowledge seems to be a bit harsh.

    But then again I wouldn’t go around caling Ramsey brilliant either. damn comment baiting headline. hah.

  5. CUMarketer says:

    Not everyone had a perfect financial literate upbringing. Most people were raised by financially illiterate parents and their first encounter with credit and debt was the high interest rate credit cards that are shoved down students throats in college.

    Yes, Ramsey’s program works. And for “those” people that it works for, they really need the help. To say “those” people are “emotionally immature” or are of “lower education and knowledge” is disrespectful. Just because the program wouldn’t work for you doesn’t mean you have to look down on the people it does work for.

    I am teaching Ramsey’s Financial Peace University to a group of auto workers whose plant is closing. Yes, maybe they aren’t the most formally educated people but these folks deserve the utmost respect because soon they will be out of job and damn it, they are trying to make their lives better.

    People make mistakes, especially with money. At least the people that go through FPU are making a conscience effort to be better. FPU is a huge commitment and I give them credit for taking that step.

  6. Dustin says:

    Anyone who thinks they are above the psychological need for the early successes that the debt-snowball plan provides is either unaware of the science behind cognitive biases or are themselves ’emotionally immature’.

  7. Julie Ali says:

    I like Dave Ramsey’s books. I used them to get out of a glut of debts that we had incurred in doing a life. I don’t think you need to be financially illiterate, “emotionally immature”, “of lower education and knowledge”, belong to a specific “group of people who need Dave Ramsey” (poor, stupid people perchance?) or even a non-financial planner to utilize the information in his books. (Wow, is there that much of a caste system in the minds of the financially adept out there?)

    It is encouraging to pay off any debt when you are buried in debts. We had a student loan, a rental property mortgage, a car loan and we paid them all off using a variant of this system. Mind you, I paid off the highest interest loan off first before tackling the others but I don’t think when you are snowed under that it matters which direction of the submarine of debt, you are eating debt from. Paying off any debt, no matter what the interest rate is – will be productive.

    What Dave Ramsey is offering is a system with built in positive reinforcement so that you, the human rat, will continue to do the debt elimination program. It is perhaps not the most logical way to get out of debt and not be a bank slave but I’m out of debt right now (except for my home mortgage that I’m assiduously paying off) and a debt snowball of sorts got us to this point.

  8. Dave says:

    To the people who say that Dave Ramsey’s method works for uneducated or immature people, I think you do not understand psychology. Just because someone does not act in a purely logical fashion does not make them uneducated or immature. Read some books on Behavioral Finance and you will see that even supposedly “educated” people do not behave like robots. Highly educated mature adults are influenced by many factors which are not purely logical. Because of this, DR’s plan can be a good choice if you have a large number of debts and cash flow problems. Also, the amount of extra interest paid is usually quite small compared to the overall amount of debt. One calculator I tried showed the debts being paid off in 24 months either way, with $2400 in interest for the interest method, or $2650 in interest for the snowball method.

  9. jim says:

    @Dustin: Or they’ve never been in debt!

    @Julie: You make an excellent point about how when you’re under an avalanche of debt, it doesn’t matter which one you pay off first because the psychological factor dominates financial factors.

    @Dave: I agree, Predictably Irrational by Dan Ariely is a great book about how we often don’t behave logically.

  10. Dave says:

    Jim, I’ve read it and it is exactly the kind of research I am talking about. I’ll say it again, people are not robots!!!

  11. ajc says:

    There’s a more important reason why you probably want to go with the ‘highest interest rate’ loans first, then work your way down (a.k.a “The Debt Avalanche’) …

    … when you get down to your lowest interest rate debts, yo STOP an ACQUIRE NEW DEBT!

    Crazy? No. The idea is that when the interest rates on yor remaining existing loans are lower than the prevailing interest rates on home and/or investment loans you should and acquire some of this ‘good debt’ and service those with the $575 that we freed up in the example above (keeping the $200 minimum payment in place.

    This works particularly well with low interest mortgages and student loans.

  12. Flexo says:

    My arguments against Dave Ramsey’s Debt Snowball.

    If emotions helped to contribute to the debt, you don’t want to encourage an emotional solution to getting out of debt, even though that is the most natural answer. Best *financial* decisions are made when emotions are understood and controlled. *Relying* on psychology to get out of debt increases the possibility of getting back into debt due to psychology. Eliminating emotions from reducing debt helps people understand how to work towards eliminating emotions from purchasing decisions as well.

    You can still get “quick wins” with the highest-interest-rate-first method, so for those who want the psychology with better math, it’s there.

    Many people who choose the Debt Snowball method are unaware that there is a different method that will allow them to get out of debt faster and cheaper, even though Dave Ramsey admits this (in small print…).

    Many people who choose the Debt Snowball method do so because Dave Ramsey, a motivational speaker, tells them it has worked for many people (it has) and it will give you the highest possibility of continuing along your progress (debatable).

    Self-motivated people should *never* follow the Debt Snowball, and if you want to get out of debt, gaining self-motivation is one of the *best things* you can do to get and stay out of debt.

    Some people are in debt not because of emotional spending but out of necessity. Otherwise responsible people find themselves saddled with a surprise medical bill, for example. You can’t assume that this person needs hand-holding to get out of debt; they just need the fastest and most efficient way to get back on track. Chances are, this hypoethetical person doesn’t have time or interest in motivational speakers, anyway.

  13. Flexo says:

    Ah, also, Dave Ramsey’s suggestions are targeted to attract the mass population (he has books and seminars to sell — he’s a salesman). To sell the most, he has to appeal to what the media call the “lowest common denominator.”

  14. kitty says:

    I am with Flexo and Saver on this one, but then I’ve never had consumer debt…

    Psychology can work in different ways. Why wouldn’t one consider the reduction in the amount of money owed or an increase in net worth a sufficient motivator? Personally I don’t understand how can one be motivated by removing one debt when it doesn’t make much of a dent in total amount of money owed? Depending on an interest rate on highest interest debt, it is even possible that while one pays the smallest loan, the total amount of debt increased. How could one be motivated in this case?

    I also think Flexo is right about emotions. Learning to think logically about money and learning to count is important. Otherwise, how would this person learn to resist advertising and to think before buying stuff?

    “Otherwise responsible people find themselves saddled with a surprise medical bill, for example. ”
    I agree with that. I do have friends who encountered this situation. One managed eventually to get most of it paid by insurance that initially refused to pay for a specific type of chemo. Another simply used 0% offers and shuffled the balance from one 0% to another until she comfortably repaid everything. It pays to have good credit – you can take advantage of these 0% offers in case of really expensive emergency. And yes, you are right, my friend had no need or time for motivational speakers, she knew exactly what she was doing. She is pretty well off now with no debt and nice savings – she actually made over 100K on a real estate bubble. This is especially impressive considering she came to the US in 1989 from what then was the Soviet Union with nothing and spent first 7 years working as a live-in nanny during the week and cleaning people’s houses on weekends.

    There are also student loans. I heard Ramsey is against those, but without them only kids of rich parents could become doctors.

    “Not everyone had a perfect financial literate upbringing. ”
    I assure you my friend had no “financial literate upbringing” in the Soviet Union. I grew up there as well and so did my parents, although we immigrated in late 70s. We still were able to figure out when we got our first credit card a couple of years later that if you pay your credit card balance in full by the end of the month we don’t have to pay interest; if you don’t – you pay a lot more. And if we had been faced with debt because of really serious emergency, we’d have paid it highest interest first simply because we don’t like to waste money, and a penny in extra interest is wasted money. As to our “financial literate upbringing” – people got paid in cash in the Soviet Union, used cash to pay bills by standing in line in each appropriate office, then stashed whatever little they had left under the mattress since they didn’t trust government bank. As to my parents who were in their 40s when they came to the US without any English, when they grew up, their parents’ salaries didn’t last for the whole month. My mother told me they were eating bread and onions for last week of the month because they run out of money for food. “financial literate upbringing” is just an excuse.

  15. Heather Paige says:

    I am definately paying off my highest interest rate first (IRS).. Dave Ramsey has become so popular.. Whatever happened to David Bach?

  16. Dustin says:

    Dave Ramsey always says to pay off the IRS before anyone else, anyway.

    I think the rest of you are just totally ignoring the science behind cognitive biases. The human brain is broken.

  17. Sheila says:

    I think Bach is hanging out on Oprah’s site. He’s the “stop buying lattes” guy, right? (Not that we all haven’t been ragging on the lattes for this entire century. And not that anybody is listening.)

    Yes, always pay the IRS first. Its penalties and fees are very high and supposedly by law the IRS is not allowed to forgive interest.

    Ramsay’s program has merit because for some people just having multiple debts is a problem. They can’t get organized or keep organized. It’s a major relief to this type of person to reduce the number of creditors. They don’t really care if they waste money in paying off their debts, because they’ve already wasted a ton just by getting into debt in the first place. Can you see how Ramsay’s method would hit the right note with them?

  18. Troy says:

    You are all wrong.

    there is no universal “best” way. Snowball, Avalanche, whatever.

    Paying of the RISKIEST debt is the best approach. Sometimes it is the highest interest, sometimes the lowest balance. Sometimes the highest monthly payment. Sometimes it is your family, or the Government.

    There are many factors. The number of debts. The payments. The interest rate. The default remedies, the tax deductibility, the creditor type.

    For instance, I would always pay the IRS first, because of the default remedies (jail). Same with the Mortgage.

    As well, some debts with high interest rates are tax deductibe, lowering the effective rate.

    some small debts to family members are more uncomfortabe than a debt to a faceless CC company. Makes Holidays uncomfortable.

    A CC with a $100 payment (20% interest) and a $5,000 balance vs. a $650 car payment with a $6,000 balance @ 6%. You can argue all you want about which is “better” For some, it is paying off the CC because of the interest rate. for others, it is the cash flow gained by eliminating the car payment. If freeing up that $650 allows you to accomplish another goal, then that is the correct choice.

    I get the math, and I get the arguments, but you all need to expand your thoughts on this subject. The riskiest debts are the ones that most threaten your ability to complete the payoff. Rank them in that order, and you will ALWAYS be right.

  19. mbhunter says:

    Congratulations on making an Editor’s Pick for this week’s Carnival of Debt Reduction!

  20. Biff Yuppie says:

    If I am broke, buying stuff feels good!

  21. Cynthia C says:

    I cannot believe ANYONE would advocate the “snowball” theory for paying off debt. It is just another way of teaching people how to mishandle money. The analogy was made to children and how they can be tricked by phychology. Well hello, we are not children and should be taught the “right”way, the responsible way. This country would not be in the financial predicament it is in if people would just grow up and be responsible for their finances.

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