I’ve done a good job of sharing my disdain for Dave Ramsey’s popularization of a method of getting out of debt that caters to unmotivated individuals, the “Debt Snowball” method. That doesn’t mean I don’t agree with his principles or his intentions. I just think he, as one of the most popular “gurus” in personal finance, has to cater to the masses. It makes sense for him to profess a methodology that is simple reaches people on an emotional level. Real financial planners who work one-on-one with individuals to get out of debt and formulate a lifetime financial plan would be able to supply better options.

Dave Ramsey does offer something I like, his “Baby Steps.” These are seven suggestions that, when followed sequentially, will do wonders for helping people struggling with their finances to take ownership of the money in their life and start moving towards a more prosperous future.

Here are Dave’s suggestions, verbatim:

• $1,000 to start an emergency fund
• Pay off all debt using the Debt Snowball
• 3 to 6 months of expenses in savings
• Invest 15% of household income in Roth IRAs and pre-tax retirement
• College funding for children
• Pay off home early
• Build wealth and give!

In general, I like this plan of action. These “baby steps” help someone ease into a pattern of new, financially responsible behavior, with small mini-goals which when taken in full view go a long way to help ensure financial stability.

These “baby steps” are designed to appeal to a large mass of people. This is not advice based on any one individual’s real situation, so it’s fair to apply some customization and perhaps even improvements. Here are a few small criticisms.

Is $1,000 enough or too much for an emergency fund base? Dave Ramsey suggests shoring up a $1,000 cash cushion before beginning to pay off debt. Although $1,000 is a finite number of dollars, its value has a different meaning to different people or to different families. A family with an income of $250,000 a year and $1,000,000 in debt may not consider $1,000 to be much of anything, while a family earning $20,000 per year and $100,000 in debt might find the saving of $1,000 to be a struggle. So what’s a better option? I would suggest that this base savings, what is needed to lay the groundwork before embarking on the great debt reduction journey, should be one months’ expenses, whatever they happen to be. That sets a high enough starting goal.

The “Debt Snowball” method is not so great. Despite its popularity and proven track record with a million dollar business marketing this method, I’d like to see more people give a real try to the Debt Avalanche. They’ll save money and time in the long run if they are intrinsically motivated. I’ve discussed this at length before.

Is it too soon to worry about college funding for children? I’ve heard experts suggest that parents should make sure their retirement is fully funded before worrying about funding education for their children. I don’t think saving 15% of household income, unless begun at a young age, will get most parents to a secure retirement, but that depends on the family’s needs at that later date. There are too many variables to predict that with any accuracy. The reason most experts suggest this is because you can borrow money for college, but you can’t borrow money (as easily or inexpensively) for retirement.

I strongly believe that parents have a responsibility to ensure that the best educational opportunities are available to their children, but with the prices of tuition increasingly well beyond the rate of inflation, I’m not sure how well that philosophy will work in the future.

Why pay off the mortgage early? Dave Ramsey is strongly against holding all forms of debt. Mostly, I agree. If the mortgage rate is low enough, and you have the fortitude, risk tolerance, and availability to invest the funds you would otherwise use to accelerate your mortgage payment in an asset allocation designed with a long-term time horizon, it may make more sense to pay just your minimum to the mortgage. But I won’t stop anyone who wants to pay off their mortgage early, even if they might end up with a lower net worth than if they had invested. The market is unreliable, but when paying off a mortgage early, you’re guaranteed to “earn” the rate of interest you’re being charged. It’s not a precise way of figuring the math, but knowing that you don’t have to pay interest that was originally included in your amortization is good.

Thanks go to Dave Ramsey for popularizing good general advice.

General advice for an imaginary average person

Personal finance advice comes in many forms, running the gamut from Dave Ramsey’s philosophies on getting out of debt to Suze Orman’s no-nonsense anti-stupidity spending advice. Opinions vary wildly as you stroll down the promenade from the broker, a salesperson, to the financial planner paid by the hour rather than commission. Mass media, by definition, must appeal to the masses, so unless you’re working individually with a professional, the advice you hear is geared towards the “average” individual.

I don’t know any average individuals. This concept is a fictional statistical human being, an amalgamation of a sample population, with no defining characteristics. Mass advice cannot cater to the most diligent or intelligent of the crowd, because invariably less apt individuals overestimate their abilities, attempt techniques designed for the more able, and fail. Thus, advice is often “dumbed down” or simplified to meet the lower qualifications of a larger group.

Take, for example, the case of the best way to pay off credit card debt. I call it the “Debt Avalanche” but it certainly wasn’t my invention. While there are exceptions, this method of debt repayment calls for credit card debt always being paid off by focusing on the debt with the highest interest rate first. But people don’t always want to take this approach. They may receive more “satisfaction” by paying off the debt with the lowest balance first, which they believe will motivate them to continue paying off debt. Money, after all, is emotional more than it is mathematical.

Unfortunately, it’s this mindset which helps many people fall into debt in the first place (or repeatedly), and it is not correct. The best way of reaching a specific financial goal will always be the mathematical way. If not, your true goal is not purely financial. For example, is your true goal to get out of debt quickly and efficiently or is it to feel good about your debt situation? You will feel better in the end knowing you took less time and spent less money to get out of debt. If not, then perhaps you haven’t learned much from the experience and will find yourself succumbing to the “emotions” of money again and perhaps falling back into debt.

There are legitimate places for emotions when dealing with money, but debt reduction is not one.

Self-limiting philosophies and beliefs

You may hear that “doing what works for you” is the best way to approach a financial situation, but it’s often not a good idea. Doing what works the best mathematically is the ultimate approach. Other approaches may help you reach your goal, but not in the best way possible. “Doing what works for you” is an admission that you feel you have no need to improve yourself. This philosophy tells the world that you’ve learned everything you need to learn and are satisfied with your choice, even though you know it may not be the best. Or worse, if you have not learned all you need to know about your situation, you may not even realize that what you’re doing is in fact “not working.”

“Doing what works for you” is one of a number of self-limiting philosophies, excuses that people will use to convince themselves that they don’t need to strive for excellence. Here are some others:

“Luck and chance affect me more than my effort and skills.” Do you attribute a missed career opportunity to bad luck or not enough hard work? When you received a good grade on a college exam, was it due to the ease of the test or your preparedness? Those who attain their goals are more likely to be those who believe their own decisions and actions affect outcomes, good or bad. Those whose philosophy of outcomes is built around an internal locus of control have been shown to reach their goals more often.

The locus of control is one way psychology pays a significant role in your goals, financial or otherwise.

“Anything is better than nothing.” When it comes to saving, reducing debt, and investing and planning for the future, I agree. You have to start somewhere, but it is only a start. But if you believe that your financial condition in the future is important, the minimum is not enough. Don’t stop at “anything,” even if it is better than “nothing.” This is like saying it’s fine to feed your children one meal a day because one meal is better than no meals. Everyone is busy, but if the minimum is all you have time for, don’t expect results.

“At least I’m better than average.” The New York Times recently cited the Federal Reserve Board with an “average household credit card debt” figure of $8,565. Owe less than that and you’re in good shape, right? It’s unclear how that figure is determined. It may in fact be the average credit card debt of only households that have credit card debt. Include debt-free households in the calculation and the figure will drop. A number this high lulls many people into a false sense of security with the belief that with their balance of $6,000 in credit card debt, they’re “doing better” than most of the country.

This “security” leads to inaction and, in this case, to the glee of credit card providers, merchants, and manufacturers around the world.

Getting over it

The result of a lifetime with these beliefs is guaranteed mediocrity. While removing self-limiting philosophies doesn’t guarantee excellence and the ability to reach every goal, keeping these philosophies guarantees that you will not do your best. I do not know any man or woman with children who is satisfied with being anything but the best father or mother he or she could possibly be, so why are so many people satisfied with being an average personal financial officer?

There is usually a perfect mathematical solution to financial goals, like the Debt Avalanche mentioned above. Although Dave Ramsey says that most people have more success with a different, more expensive and time-consuming technique, that doesn’t mean you shouldn’t strive for the better solution. Just because perfection is not always attainable doesn’t mean that it’s worthwhile to stop striving for that approach and settle for lackluster results, especially if the better approach is not more difficult than the alternatives.

If you’ve found something that “works for you,” don’t assume that there isn’t something else that works better for you. Follow the best examples, not examples set by the fictional average individual. If your financial security is important to you, don’t settle for mediocrity. You won’t always reach your highest goals or always be excellent, but you’ll never be excellent if you limit yourself.

When it comes to mathematics, certain facts are universally agreed-upon. For example, regardless of your culture or educational system, you must agree that one plus one equals two unless you mistakenly fall for an invalid proof. When dealing with money, why are people inclined to believe that one plus one does not equal two?

If you have a certain amount of money available to pay off a portion of your debt each month, even if that certain amount changes, there is a mathematically correct way of paying off that debt. You can call this approach the Debt Avalanche. It is similar to Dave Ramsey’s popular “debt snowball” method, with one small but important detail: With the Debt Avalanche you will pay off your debt faster and pay less total interest to banks and lenders.

The simple calculation for the Debt Avalanche requires only the interest rates for each debt account. This assumes that all debt accounts have the same tax liability, but if that’s not the case, determine your interest rate after taxes for this calculation.

Step 1. Order your debts from highest interest rate to lowest. You may find credit cards at the top of the list. It’s typical to see interest rates from 10% to 20% or more. Credit cards offered by stores often have the highest interest rates, so you might find these at the very top. Watch out for promotional rates ending, which they may do on the date promised when you enrolled, or earlier. Card issuers also re-evaluate their customers every so often, and will not think twice about raising your rates midstream. Note that if your credit improves, they will not magically lower your rates. While lenders will notify you if they intend to raise your rates, you may have missed the notice.

Your mortgage and home equity loan may be the next debts in line. It’s important for your list to capture every debt for which you make a monthly payment. Student loans may be the last on the list, particularly if you qualify for tax credits. The Debt Avalanche formula won’t work properly if it covers only a portion of your debt, so consider all accounts.

Order your list from the highest interest rate (after tax) to the lowest. You may have noticed we didn’t factor in your account balances in the above formula. That is because your individual account balances are irrelevant. The issue solved by the Debt Avalanche is the best way to pay off your total debt with all available funds.

Step 2. Pay the minimum to all debts every month. If you’re writing down your list, or using a spreadsheet like Excel, add a column next to each debt to list its minimum monthly payment. This is the amount you will pay towards each debt, except for the one account listed at the top of the list.

Another column should list the payment due date if it is relatively static from month to month. For example, my credit card payment is due on the last date of almost every month, so I would write “30.” This would indicate to me the last date of every month. Your payments should always arrive before the due date. In fact, in some cases, you can reduce your total interest paid by paying weeks in advance of your due date.

Step 3. To your debt with the highest interest, send all extra available cash. If you have an emergency fund, this step is simple. Since it’s unlikely that you can earn more in savings than you can “earn” (reclaim) by paying off your debt, all your unused income after paying expenses (necessary and discretionary as you see fit) should be dedicated towards the debt account with the highest interest rate.

Step 4. Repeat every month. You cover all your bases by ensuring every creditor receives the minimum payment, but you hone in on only your debt with the highest interest. Once a debt account has been eliminated—and it may not be the account at the top of the list if other balances are smaller—remove it from the list and re-order if interest rates have changed.

It’s that simple. This is mathematically the best method for paying off your personal debt. No other method will get you out of debt faster and save you as much money.

Despite the facts, many people disagree. The primary reason detractors, or supporters of the “debt snowball” method, may argue is that Dave Ramsey’s method will help you pay off your smaller debt faster, providing you with “early success” and possibly the motivation to continue along the path of debt reduction. The Debt Avalanche will also provide early success, but if you need special motivation to continue your monthly payments, consider this: By choosing the Debt Avalanche method, you will pay off your total debt faster, you will pay less interest, and you are mathematically efficient.

That is motivation enough. Or is it?

Dave Ramsey believes his “debt snowball” method, in which debts are paid off in the order of balance from lowest to highest, has shown better results than any other method thanks to “quick wins.” If he were to ask his followers if they want to carry their debt longer and pay more interest throughout before offering the “debt snowball” method, they would choose the faster, cheaper, better option of the Debt Avalanche.

One of the many reasons people can fall into debt is the difficulty of separating emotional thinking from rational thinking. The Debt Avalanche helps separate these two methods of thinking, as the best financial decisions are almost always the rational decisions. But it helps to pay attention to some of the psychology involved, as well.

The possible motivation due to the “early success” aspect of the debt snowball method is cited by many followers to be its strongest point, encouraging debt reducers to continue down the path. Followers of the mathematically and financially superior Debt Avalanche, if they need this sort of motivation, can achieve the same effect by defining milestones.

Rather than “celebrating” when your first full credit card or other debt account is paid off, take note and reward yourself when you’ve paid off your first $1,000 (or $500 or $10,000, whatever is applicable to you). Setting and achieving these short term goals influences the same area of the brain (the mesolimbic system) as the act of paying off the first credit card and are similar enough to provide the same motivational results.

Quick wins may help to motivate debt reducers to continue along the path, but the real win comes in knowing you’ve made the smarter choice.

Updated on July 8, 2008 with more information about redefining milestones to address the psychological effect of “quick wins.”

This article was written for Consumerism Commentary by Adfecto, a mid-20s guy with a masters degree in engineering. He aspires to be wealthy and writes frequently for his own blog, Adfecto Abundantia.

When I purchased a home it was not a lifetime commitment. I view a person’s choice of housing first as a financial decision and second as a lifestyle decision. A house gives you place to live and the added bonus of potential price appreciation and tax deductions. If it is cheaper to rent then by all means that is the way to go. Owning your own home can also give you a tangible increase in your standard of living, but personally that is considered a distant second when compared to the financial benefits. What I find interesting is that so many people tend to make emotional decisions about the home rather than rational ones.

Frequently, when home owners find themselves with a little extra cash at the end of every month, the idea of paying off the mortgage is often brought up. Is early payment the right way to use the money? Should the money be invested instead? Is my real motivation to build wealth or to play it safe?

The first step in analyzing this decision is to compare the interest rate on the mortgage to expected investment returns. Historically the S&P 500 with dividends reinvested has returned 10.43% annualized from January 1926 to December 2007, and the current rate for a fixed 30 year mortgage is about 5.76% according to www.bankrate.com. Based on this simple comparison it is plain to see that in the long run you will build more wealth by investing than by prepaying your mortgage.

If you want to further hone this comparison of rates, next you can consider not just the entire history of the stock market, but also every 30 year rolling period of stock market data. Since 1953 the S&P 500 has returned at least 9.34% over every 30 year period which is again well above the interest rate for a 30 year mortgage. Plowing your money into prepaying your mortgage has a huge opportunity cost that will hurt your ability to build wealth.

Why then would people consider prepaying their mortgage? Most people consider their home as a safe investment, and paying off a mortgage as a guaranteed return. A certain piece of mind comes from owing the bank less money. There is a big problem with this argument; there is still a great deal of risk involved with your primary residence!

Additional risk comes from the fact that until your loan is paid in full, the bank still holds the mortgage on the property. The bank will not give you credit for the extra payments made to pay down the debt if you start to struggle further down the line. Even if you are way ahead on your mortgage, a hardship may cause you to miss payments. The bank can foreclose even if you spent years paying down the mortgage balance early.

Investing your free cash into your mortgage is very similar to investing in a bond. It may seem odd, but you are literally investing in a fixed income asset, the mortgage, lent to yourself. The return you get will be equal to the interest you would otherwise pay on your mortgage. One problem that arises is that the bank has first crack at the collateral; your house. Even worse, your mortgage isn’t even a very good deal when compared to the types of bonds; for example, Toyota AAA rated bonds currently pay as much as 7.652%. I bet your mortgage rate isn’t that high.

Furthermore, understanding the nature of your mortgage as a bond brings to light another risk; improper asset allocation. Mortgage prepayment shifts your asset allocation to rest more heavily in fixed income type investments than you might otherwise consider. A 40 year old person should have at least 60% but more likely 80% percent of his/her portfolio in stocks, but add in all of that mortgage prepayment in the bond category and you may find yourself far out of line from you ideal asset allocation.

Another risk related to mortgage prepayment is a lack of diversification. You may think that your mortgage is not very risky because you believe in your own ability to pay. This personal bias can cloud a person from see the true risk factors such as job loss, poor real estate conditions, natural disaster, and a plethora of others. A single unfortunate event can wipe out a large chunk of the equity. A single job loss may bring about a short sale or foreclosure that could wipe out the value of your home. Would you advise someone in your circumstances to invest in individual mortgages? I sure wouldn’t, and neither should you.

Deciding whether or not to prepay a mortgage is another financial and lifestyle choice which depends on several factors, but most of all it is a choice between building wealth (logical) and piece of mind (emotional). People who focus on paying off their mortgage seem to be more in love with their house and the idea of having it paid off than the goal of building wealth. These people are also blind to the risks that come from investing too much of their finances in a single residential structure. I think that for the majority of people the ‘right’ decision would be to keep the mortgage and invest the extra money.

Image credit: Oracio
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