The Debt Snowball

Of Dave Ramsey’s Baby Steps, the one most widely discussed in the blogosphere and elsewhere is #2, The Debt Snowball.  This is the step in the program where the participant pays off his non-mortgage debt.  Even I can’t find a reason to say this is a bad idea, at least not in principle.  If you want to improve your net worth, and you owe lots of money, then paying those debts down is almost certainly the place to start.

It is the way that Ramsey advises that you pay your debts down that is controversial.  He instructs that you sort your debts and pay them down in order Snowball attr Kamyar Adl cropof size, smallest to largest.  To his great credit, he concedes that this does not exactly make sense.  It is, according to Ramsey, “more concerned with modifying behavior than correct mathematics.” (Total Money Makeover, p.111.)

Many money gurus give advice that makes sense (if it makes sense at all) only in the context of psychology, but few actually admit it. So Ramsey gets points there.  But saying the math doesn’t quite work is a euphemism.  This isn’t math, it’s money.  If you want to pay off your debt as quickly as possible, or if you want to maximize your net worth, which amounts to the same thing, you should pay off the debts with the highest interest rates first.  Period.

I am hardly the first blogger to point this out.  Nickel at Five Cent Nickel posted the near-legendary Dave Ramsey is Bad at Math way back in May of 2005 at the very start of his blog.  To date it has 381 comments, the last one dated two weeks ago.  Bible Money Matters linked to that post in February of this year and gave the argument in favor of Ramsey.   (And for links to no fewer than 12 other blogs that discuss this issue, see this post.)  But both Five Cent Nickel and Bible Money Matters, and many others who discuss the Debt Snowball, fall into the trap of calling the issue a question of math.  That partially obscures what is at stake. When Ramsey says the math doesn’t work, he means that you’d be financially better off if you successfully followed another scheme.

Of course, his argument is that paying off your debts in interest rate order is only better in theory.  In fact, you are less likely to complete that plan, whereas his way will generate enthusiasm and momentum as you quickly pay off the first few debts.  That may be so for many people, but it seems clear that for many others paying in interest rate rather than size order would be a better choice.  There is no obvious allowance for this possibility in the Baby Steps.

To illustrate the potential impact of size-first rather than interest-rate-first, consider the following simplified case.  A person has only two debts, a student loan for $12,000 at 8% interest with a $100 minimum monthly payment, and a credit card balance of $15,000 at 24% with a $300 payment.  Assume the person has $1000 a month to apply to these debts, i.e. $600 beyond the minimum payments.  Ramsey would have this person apply $700 a month to the student loan and then, when it is paid off, apply $1000 a month to the credit card.  The pro-math camp would have the person pay off the credit card first.

The Ramsey way has both loans paid off in 35 months.  Interest-rate-first takes 31 months.  That’s $4000 in additional payments on what was $27,000 in debt to begin with.  Moreover, in this case the encouraging effect of paying off a loan earlier is marginal.  Ramsey would have the student loan done in month 18.  The other way pays off the credit card in month 19.

Of course, these results are specific to this imaginary case and another set of circumstances might give very different results.  This is my point.  Like much personal finance advice, Ramsey’s is based on a collection of assumptions about his listener/reader.  He assumes that they have many different debts. He assumes these debts are in a variety of sizes.  He assumes that the interest rates on them are not radically different.  He assumes that his listener/reader lacks the willpower to pay off the loans in interest rate order.  And he assumes that completely paying off a debt or two early on will generate enough enthusiasm to overcome the willpower problem and that there exists a debt or two small enough to be paid off in this way.  Each of these assumptions may be reasonable alone, but assuming all of them at once, and failing to acknowledge them as assumptions, borders on irresponsible.

And there are other, lesser problems with Ramsey’s advice on debt, all of it discussed and dissected elsewhere.  He has a zealous hatred of credit cards that reminds me of nothing so much as the anti-alcohol campaigners who cannot distinguish between drinkers and alcoholics.  He advocates paying down debt rather than taking advantage of your employer’s 401k match, which is, frankly, just loopy.  Your employer is willing to pay you to save.  Take them up on that.

But despite much criticism over the years, the Debt Snowball has become part of the cultural background of the personal finance advice world.  It has spawned derivative concepts, such as Snowflaking, the practice of making small savings here and there to apply to debt reduction.  The interest-rate-first method has been called the Debt Avalanche.  Few, if any, other personalities have had Ramsey’s impact on how paying down debt is discussed.

But in those discussions Ramsey himself is a bit of an extremist.  Most observers, myself included, concede he has some generally useful ideas but resist the particulars.  Even his fans tend not to advocate following his advice too strictly.  (See, for example, Frugal Dad’s modified and softened set of steps that might be called Revised Ramsey.)  In the Bible Money Matters post mentioned above the author endorses the Debt Snowball before conceding that the Avalanche might be better for some people.  This, of course, is as it should be.  After all, it’s not merely math.  It’s money.

Next up in this series will be Baby Step #4, saving 15% of income for retirement.

[Read the other posts in this series: Step 4, Step 6, and Step 7.]


[Photo credit Kamyar Adl]

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