Before I get pitchforked by the cavalry of Dave Ramsey supporters, I want to start off by offering this disclaimer: I actually agree with many of the things that Dave Ramsey says. His ability to motivate people is uncanny and he had inspired thousands, if not millions, of people to take control of their personal finances.
This does not make up for the fact that some of his beliefs are both inefficient and ineffective when trying to build wealth as quickly as possible.
From his “money envelopes” to his blatant disregard of the benefits of leverage, his methods are outdated and are slowing down the wealth building process for millions of people.
With that being said,
Let me begin by introducing the Snowball method as re-imaged by Dave Ramsey:
Dave Ramsey’s Snowball method is fairly simple and easy to understand.
Which is why it is popular with beginners who want to take notice of where they stand financially.
He advises you to lay out all of yours debts, excluding mortgages, from order of smallest to largest, regardless of interest rate. (Spoiler alert: This is where the inefficiency lies.)
Then you make the minimum payments on all except the smallest, once you pay off the smallest balance, use the money to pay off the next smallest, and so on.
So you can see how this makes sense for the most part. However, I am going to use a practice balance sheet to see how effective it is in real life.
For the sake of this example, I want to make one key assumption. Which is:
- Stock Market Return (on average) = 7%
Now that we have that out of the way, let’s build an average balance sheet that a millennial may have coming out of college, or a few years post-college.
|Credit Card Balances||17%||$(10,000)|
Now that we have our balance sheet, let’s take a look at the way Dave Ramsey would have you pay off your debts.
Obviously, you would start off by paying the personal debts of $2,000 (no problem here), as it is the smallest balance and so happens to have the highest interest rate.
But where do you go from there?
According to him, you should then pay off the Auto Loan, and then wait to pay the credit card balances until third, and finally working on paying back the student loans.
And that is completely inefficient.
What I would suggest is paying off your debt like this:
First, start by paying off the personal debt(s) of $2,000.
Not only does this have the highest interest rate, but it is probably for something like a mattress or a refrigerator that is going to lose value over time.
Then, I would pay off the credit card balances of $10,000. This is purely because of the interest rate.
Although, the balance on this is higher than the balance on the Auto Loan, you will actually be saving more money by paying this debt off first rather than the latter because you will be paying less in interest over the life of the loan.
The last two debts are where things get a little fuzzy and also where we start to factor in the historical return of the stock market.
You see the beauty of the stock market is that it involves this wonderful thing called compound interest. Where the money that you place in it today will earn interest, and that interest will earn more interest, and the cycle continues.
So if you have a debt that charges a significantly less percentage than the stock markets average return, then you may be better off putting your money in the market.
The auto loan is a little fuzzier because the return on that is guaranteed, so if it were my personal finances then I would probably pay that off before putting money in the investment account, but I would have no interest whatsoever in paying the student loans back early simply because I could get a better return for my money elsewhere.
I think when reading Dave Ramsey, it is important to understand that..
Debt is not evil.
Yes, being in too much debt is bad.
Yes, it can cause you to go bankrupt, if you don’t handle your finances well.
But, it all boils down to this thing called leverage. Being able to leverage your money so that it is being used in the most efficient way possible is the best way to fast-track yourself along the path to financial freedom.
However, in the end you have to be able to:
Be comfortable with your decision
Maybe you are a person who can’t stand being in a single dollar of debt.
If this is you, and being in debt truly stresses you out, then I advise paying off your debt before beginning investing.
However, there are countless amounts of studies that demonstrate the effects of compounding, and how it can literally double your money every 10 years or so, but more on that in future articles.
- Don’t just look at the balance on a debt when deciding to pay it off. Look at the interest rate. Most hospitals offer 0% interest payment plans that allow you to use that lump sum of money elsewhere to make money for you, while paying the bill back in cheaper dollars in the future. Even if you can’t get 0% interest, as long as it is significantly lower than the stock market average then you will be better of getting the effect of compounding.
- Invest efficiently. If you think you will feel better by paying off a debt before investing then by all means go for it, but if you want to start the effects of compounding on your money then it is best to start investing as early and as often as possible.
- Be comfortable in whatever decision you choose.
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