As featured in The Wall Street Journal, Money Magazine, and more!

Search: philosophy

Debt Reduction Methods and Philosophies: Snowball, Avalanche and More

This article was written by in Debt Reduction. 19 comments.


When someone who has accumulated debt across a number of credit cards embarks on the journey to rid himself or herself of this debt, and when that person is generating enough monthly income to cover all expenses and the minimum payments due on all cards with additional funds left over, there are two main philosophies describing the best way to achieve this goal. Although all approaches are good, there is no question where I stand on this issue.

I suggest following the path that affords the opportunity to get rid of debt as quickly and as cheaply as possible. This method has many names, but I’ve called it the Debt Avalanche in the past. The opposing viewpoint is the Debt Snowball, popularized by author and guru Dave Ramsey. This method suggests paying off debt in such a way that it might take more time and be more expensive but offers “quick wins” which help some people gain encouragement and momentum at the earliest stages of the process. And there are, of course, many points of view that present a compromise between these two extremes.

The snowball approach to debt reduction

By ordering your credit card debts from lowest balance to highest balance and paying the minimums to all except the first on the list each month, you will pay off your first debt sooner than by following any other method. If you need encouragement to continue your journey as you pay off debt, you can celebrate after your first credit card has a zero balance.

Not everyone requires this type of extra motivation for paying off debt. Additionally, even those who need extra motivation may not suffer by choosing a cheaper and quicker method of paying off debt. The “quick win” of paying off the first debt could come just as quickly by using the Debt Avalanche. But even if the first payoff doesn’t come as quickly, you can redefine your first milestone to allow yourself helpful celebrations as explained in the next section.

J.D. Roth from Get Rich Slowly has seen success with the Debt Snowball approach, as have many others. It is the most widely marketed philosophy.

For an illustration of the monthly process of sending minimum payments to all credit cards except the one on top, regardless of how the debts are ordered, see this visualization from No Credit Needed.

snowball3

One major problem I have with the above snowball approach is that your largest balance may be significantly more expensive than your smallest balance. Today it is not difficult to find a default interest rate on a credit card north of 30%. There is no way in good conscience I could recommend holding off on eliminating a debt this expensive in favor of paying off a small balance with a 7.9% interest rate. The same goes for payday loans, whose fees can border on usurious if interpreted as interest rates.

The avalanche approach to debt reduction

There is no question that anyone who follows this alternate approach to its conclusion will have emerged from debt sooner and by paying the least amount of interest possible. Some people argue that it is not as likely for someone to follow the Debt Avalanche through, but there are no data to support this. By ordering your credit card debts from the most expensive (highest interest rate) to the least expensive and paying the minimum each month to all cards except the first on the list, you reduce your interest payments quicker.

Since this is a mathematical approach, critics say it doesn’t take into account the emotions that come into play when dealing with money. It is true that emotions — your feelings about money — play an important role in financial decisions, and although this is a mathematical approach, how you feel about money still is represented in this method.

  • If you follow the Debt Avalanche method, you can feel good knowing that you’ve made a sound decision and will spend less money than others who take a different approach.
  • You can motivate yourself throughout by creating your own milestones for achievement, including paying off your first credit card, paying off $1,000 (or some other meaningful amount), or consistently reducing debt for six months (or some other meaningful time frame).
  • Your emotions may be the cause of your debt in the first place. While they obviously cannot be eliminated, learning to focus on the best mathematical approach for certain financial decisions can improve your overall relationship with money.
snowball4

Here I outlined the details of the Debt Avalanche. Trent from The Simple Dollar also likes the Debt Avalanche approach and Five Cent Nickel explains how Dave Ramsey is bad at math.

Other approaches to debt reduction

The hybrid approach. Somewhere between a snowball and an avalanche lives this hybrid. The concept here is simple. Order the credit cards from highest interest rate to lowest, like the Debt Avalanche, but move the card with the lowest balance to the top. This will provide a “quick win” if necessary but could still save significant money and time when compared to the Debt Snowball approach.

Pay the most annoying debts off first. This approach plays directly into the human psyche. The urge to eliminate a persistent itch is strong enough to motivate anyone to scratch, just ask any kid with chicken pox. Stephanie from Poorer Than You is a fan of this approach. This works well when you include debts other than credit cards. If you have a personal loan from a family member, I usually suggest paying that debt off the quickest while paying minimums to your credit card to help retain good will within close relationships.

Baker from Man vs. Debt says the same thing slightly differently: Pay off the debt with the highest emotional impact first. The argument here is simple. For some people the debts with the highest emotional impact are simply the debts with the highest interest rate, while others have a different psychological composition requiring alternate focus. You can’t go wrong by this approach which if continued will help you feel better quicker.

So what is the “right” answer?

It is easy to say, “Do what works for you,” and allow the debtor to come to his or her own conclusions. This can be a dangerous approach as it invites people to skip the consideration of all the options. Many people I’ve talked to who have successfully eliminated debt by using the Debt Snowball method not only found themselves back in debt after some time but did not realize that they could have saved hundreds of dollars and been out of debt sooner just by ranking their credit cards in a different order. They simply followed a guru’s advice without any critical thinking. Not only did they not learn to approach money from a more stable viewpoint but they paid extra money in the form of credit card interest for this “feature.”

Would they have succeeded if they were simply presented the idea that they could save money on their debt reduction journey by following a more mathematical approach? It’s certainly possible.

There is no approach that does not have some sort of merit. Getting out of debt in any way possible is better than not getting out of debt at all. All that I ask is that the details, including the total cost and time differences, are fully explained before a method is prescribed for someone else.

Here’s a calculator that will help inform anyone in debt about the timing and bottom-line differences between the various approaches to eliminating debt. In some cases, the cost of one method over the others will be striking.

An informed decision is the best type of decision. With a full understanding of the differences and is familiar with their own psychological tendencies, someone with debt can make an intelligent choice that is right for the individual or family.

Photos: House of Sims, Joe Shlabotnik

{ 19 comments }

The Cost of Raising a Child With Autism

This article was written by in Health. 11 comments.

A few years ago, I shared a statistic showing that it costs almost $200,000 to raise a child, from birth to age eighteen. If that weren’t enough of a financial burden, consider that one out of 88 children are now diagnosed with autism, according to the Centers for Disease Control and Prevention (source, pdf).

Regardless of whether this significant, 78 percent increase in occurrence since the last study is attributed to broader diagnosis, more families are paying for the services a diagnosis of autism requires. Insurance will not cover all costs for therapies associated with autism or autism spectrum disorders. Families will need to pay out-of-pocket for many medical expenses. While the cost of raising a child to age 18 might average around $200,000, dealing with autism could add another $25,000 a year in medical costs.

The expenses don’t end with therapy and doctor’s visits. Beyond medical expenses, parents with children with autism often need to pay for special education, day care, and a home for an autistic adult who can no longer live with his or her parents.

The emotional burden placed on parents of autistic children adds to the financial burden. Parents of children with autism earn significantly less than parents of children who do not have this condition, presumably because the parents have extra responsibilities in competition with the attention they give to their careers. Mothers of autistic children average earnings that are 56% lower than other mothers. Dealing with autism from a financial perspective is doubly difficult due to the increased cost of care and the parents’ lowered income potential.

As a result of the increased financial burden, many parents of children with autism need to resort to going into debt to cover their costs. Today’s expenses may crush any dreams about retirement, and with a second or third mortgage, the costs of paying for housing may last until death.

It’s all very good for financial gurus, bloggers, and authors of books about money management to extol the virtues of saving money, cutting back expenses, and earning more, but sometimes, some families are faced with realities that place them beyond the sphere of accepting mainstream financial advice to improve their financial conditions. Everyone should be out of debt, but an average family earning average salaries with extraordinary needs like those that arise out of autism can’t be addressed by mainstream financial advice.

Experts write about making sacrifices, like forgoing the $6 daily latte and saving $1,500 or so a year. Experts talk about negotiating a raise from your employer. They argue about the best method for getting out of debt. For families dealing with tough financial issues, these discussions are irrelevant. They need support groups, financial assistance, and specialized advice for making the most out of a difficult situation.

And when the biggest issue a family faces is related to health, financial issues become just a secondary concern.

Have you ever dealt with autism or another health issue in your family that required expensive care? Please feel free to share your experiences, particularly with the effect they had on your finances or your philosophy of money.

CNN

{ 11 comments }

Millennials Want to Be Rich More Than Anything

This article was written by in Wealth and Affluence. 13 comments.

Since 1966, the Higher Education Research Institute has been conducting a study of first-year college students to determine personal goals and values. This collection of data has offered research a chance to see how priorities change over the years, and there are striking generational differences in the results. Recent research at San Diego State University combined the data from this research with additional studies, and the results were published in the Journal of Personality and Social Psychology.

The most striking generational difference is the change of relative importance of “being very well off financially.” 44.6 percent of baby boomers considered this goal essential or very important. Through the period when Generation X entered college, 1979 to 1999, 70.8 percent of college freshmen believed it was essential or very important to be well-off. For millennials, or Generation Y, with students entering college from 2000 to 2009, this rate increased to 74.4 percent. In 1978, being rich ranked 8th among all the goals listed as choices in the survey, and since 1989, this goal has consistently ranked first.

Other goals on the list that lost ground due to the surge in the desire for financial success above all else include developing a meaningful philosophy of life, declining in importance from 73 percent to 44 percent and keeping up with political affairs, declining from 50 percent to 35 percent. At the same time, some goals that may not be directly related to being rich increased. Creating artistic work (painting, sculpting, decorating, etc.) increased from 15.5 percent to 16.0 percent from baby boomers to millennials. Influencing social values increased from 32 percent to 40 percent.

Why are young people significantly more concerned with financial security, and if this concern is so much higher, why is financial literacy in young people lacking to such a degree as reported constantly in the media including financial blogs?

I see two significant influencers of attitudes in college freshmen. The first is a reaction from their parents’ attitudes. Baby boomers’ parents might have lived through the Great Depression, perhaps as kids. The experience of financial difficulty sticks with this generation as they mature and have families of their own. While one reaction to parents whose philosophies of money have been shaped by hardship would be to put an extra emphasis on financial independence within a family, it’s more likely that financial struggle helped people understand that there is more to life than having money, and this is the attitude that was passed down from one generation to the next.

As the baby boomers built their own success as adults and benefited from the clear economic expansion after World War II, financial success was within reach and became a new goal. Suburbs blossomed, and television opened people’s minds to consumer culture. This openness combined with the ability to earn enough money to cover more than just the necessities shifted the culture, and these attitudes weren’t unnoticed by baby boomers’ children, Generation X and millennials.

The second significant influencer is popular media. As mentioned above, the availability of television shaped American attitudes. National programs offered millions of families a glimpse into the best of what the consumer culture had to offer. It wasn’t just Lifestyles of the Rich and Famous, it was the popular sitcoms that projected an idea of what life should be like in the home. I noticed during the recent recession, television programming tended to reflect more financial escapism. People seem to enjoy watching programs featuring rich and upper-middle class lifestyles, and this type of programming has flourished in recent years.

A combination of these influencers likely contributed to Generation X’s and millennials’ stronger focus on their goal of “being well off financially.” There is still a broken connection between this goal and the behaviors that help individuals reach the goal. Consumer debt is still a problem. College graduates lack understanding of basic financial principles, and often make mistakes that may or may not be corrected by the time they start families of their own. Perhaps the real goal is not being well-off, but appearing well-off. When financial independence seems out of reach, young people are willing to settle for looking or feeling rich. This is an approach focused on the surface, just appearances, rather than one based on making the tough adjustments required to fix the fundamental financial issues. It’s faster, more convenient, and outwardly identical to a point.

It’s perhaps why people who play the lottery are more likely to have low incomes, and maybe it contributes to the appearance that people living on welfare might have expensive-looking phones or other accessories; in a world without hope for financial success, the only way to satisfy the need for “being well off financially” is through objects acting as external symbols of wealth.

Photo: chrisdlugosz
American Psychological Association, via MainStreet

{ 13 comments }

Buy-and-Hold: A Losing Strategy for the Future?

This article was written by in Investing. 16 comments.

This isn’t the first time smart professional investors have considered abandoning the buy-and-hold strategy. Most of the controversy has surfaced following the recession. I asked whether buy-and-hold was still a good investing strategy a few years ago. Investors who had been following the buy and hold strategy — forgoing active trading in favor of buying stocks for the long term and sticking with a philosophy of patience — saw the values of their stock-heavy portfolios plummet, following the stock market at large.

This kind of catastrophe shocks investors to the core and gives people a chance to challenge their assumptions and choices. The leading argument against the buy and hold strategy for investors going forward focuses on volatility. Judging from market performance through and after the recession, stocks seem to be riskier than they have been in the past. Some investors believe that the fundamentals that made buying and holding stocks for the long term work in the past, providing an 8% average annual return over 30 year periods, have changed.

DollarsMarkets are more volatile now because the bulk of investing activity isn’t done by humans making purchasing and selling decisions based on available information, most trading is accomplished by computers reacting to market changes in microseconds. Complex investing instruments like derivatives and hedge funds make it possible to take advantage of economic situations generally inaccessible via stocks.

In an interview with CNN Money, economist Andrew Low has this to say about buy-and-hold:

Buy-and-hold doesn’t work anymore. The volatility is too significant. Almost any asset can suddenly become much more risky. Buying into a mutual fund and holding it for 10 years is no longer going to deliver the same kind of expected return that we saw over the course of the last seven decades, simply because of the nature of financial markets and how complex it’s gotten.

Think about how that person earned 4%. He lost 30%, saw a big bounce-back, and so on, and the compound rate of return over the period was 4%. But most investors did not wait for the dust to settle. After the first 25% loss, they probably reduced their holdings, and only got part way back in after the market somewhat recovered.

His argument is that buy-and-hold doesn’t work because investors don’t follow the guidelines of the strategy. Carl Richards pointed out in his recent book, The Behavior Gap, that investor’s actual returns don’t match “investment returns” because people are human and react like humans. When they do react, the often do so improperly, like reacting to a high-flying stock by buying at a high price and selling when the market sinks the stock’s value. If buy-and-hold doesn’t work, it’s not a failure of the strategy, it investors’ failure to properly follow the strategy thanks to their human brains.

Do you plan to use a buy-and-hold strategy for your investments in the future, and do you expect the long-term returns in the stock market we’ve seen over the last century continue in the future?

CNN Money

{ 16 comments }

The Role of Money in Choosing a Relationship

by Flexo
Relationships couple

Do people have any kind of control over whom they fall in love with? Perhaps Cupid’s arrow strikes randomly, and there is no choice but to obey the heart — or chemicals in the brain — or sexual urges. But once that initial response has subsided, if you and your partner are headed for a ... Continue reading this article…

18 comments Read the full article →

The Consumer Financial Protection Bureau’s Director, Richard Cordray

by Flexo
Richard Cordray

As many Presidents of the United States have done, President Obama avoided confrontation with Congress by appointing an individual to direct a government organization while lawmakers were on recess. Yesterday, the President appointed former Ohio attorney general Richard Cordray to the long-delayed position of director of the Consumer Financial Protection Bureau (CFPB). Now that this ... Continue reading this article…

14 comments Read the full article →

You Are In Control

by Flexo
Controller

Many people begin a new year with goals, resolutions and targets that define what they’d like to change within the next 365 days (or 366 days in a leap year). While most people fail to achieve these goals and resolutions, just the process of making resolutions and the self-reflection required can be helpful towards improving ... Continue reading this article…

13 comments Read the full article →

Meeting With a Financial Planner From Vanguard Flagship Services

by Flexo

On Tuesday, I had a phone consultation with a Certified Financial Planner from Vanguard. It was an initial meeting, wherein we talked about each other, focusing on my goals. I tried to take into account many of my own suggestions for working with a financial adviser, but in preparing for the meeting, I realized — ... Continue reading this article…

20 comments Read the full article →
Page 1 of 1612345···Last »