Dave Ramsey the Debt Crusher

This is Dave Ramsey. I call him the debt crusher. You may have heard your co-workers or friends talk about it. Or you may have heard about him at your church. He’s a financial guru, with a nationally syndicated radio show, a series of best-selling books, and a large seminar business. Dave Ramsey is best at motivating and helping people to get out of debt. If you have any amount of debt, you need to check out what Dave has to say. Dave Ramsey the Debt Crusher

I honestly don’t remember where I first heard of Dave, but he has absolutely had an impact on my financial perspective. I listen to Dave’s free podcast on my way to work nearly every morning. You can get the podcast in the iTunes for free by searching for Dave Ramsey. I also recently read one of his books, the Total Money Makeover. When I say that Dave had an impact on my financial perspective, that’s a definite understatement. He literally changed the way I think about debt. I used to think of debt as a tool, but after listening to Dave, I realized that debt was a burden. This includes the normal debt that most people have, such as car loans, credit cards and mortgages. If you’re willing to follow Dave’s plan, he’ll help you eliminate your debt for good. Whether you have $10k in debt, or $500k in debt, this will work for you. It’s not easy, though. Dave will be the first to tell you that becoming debt-free is not easy. There is no magic pill to take here.

First Task: Create a Written Budget

To follow Dave’s plan, the first thing you must do is to create a written budget. Every dollar you are going to receive for the month needs to have a name. You’re going to control your money this next month, rather than letting your money control you. Each dollar must be spent on paper before the month begins. If you’re married, you need to sit down with your spouse and do this together. The budget is going to be a written contract. If, during the month, you or your spouse wants to go over the budget in a category, you must sit down together and re-draft the budget. You must allocate money from one category to another in order to pay for that expense. The goal here is to have a plan. You won’t get it perfect the first month. Dave says that it usually takes families about 3 months to get it right.

A New Promise

Before starting down the path of becoming debt free, you must also make a promise to yourself. You cannot take on any additional debt. It doesn’t make sense to pay off your car loan if you’re adding to your credit card debt. Dave takes a hardline approach and suggests that you cut up your credit cards. I think that if you’re able to control your credit card spending, then it’s fine not to cut them up. If you have credit card debt, though, you really shouldn’t keep them around where you can easily access them. Instead of cutting them up, trying putting them in a safe somewhere that makes it difficult to get to them easily.

Dave Ramsey’s 7 Baby Steps

Once you’ve created a written budget and promised not to take on any additional debt, you can begin Dave’s Baby Steps. These are his bread and butter. After listening to his show for a few months I can tell you most of the time what Dave’s response is going to be to a particular call. He has a set of rules he follows, and he very rarely deviates from this plan.

Baby Step 1: Create a $1,000 emergency fund
Baby Step 2: Pay off all debt except the house, using a debt snowball
Baby Step 3: Finish off your emergency fund with 3 to 6 months of expenses
Baby Step 4: Invest 15% of your income from retirement
Baby Step 5: Save for children’s college
Baby Step 6: Pay off the mortgage
Baby Step 7: Keep investing and give

I’ll be covering Dave’s Baby Steps in more detail soon, so make sure to check back. In the meantime, download his podcast, watch an old episode of his TV show on Hulu, or buy his book, The Total Money Makeover.

Paying Off Debt: Debt Avalanche vs. Debt Snowball

When it comes to paying off debt, there are generally a variety of ways in which you can do so. The one that, unfortunately, too many people opt for, is to simply pay the minimum payments that the lender asks for. If you’re reading this blog, you’ve probably already realized that this is a terrible financial decision. People only choose this option when they’re on auto-pilot, and live in denial of their current financial decision. Many times I’ve had a $10 minimum payment on a $1,000 balance. Paying just $10 would be ridiculous, and would cost you dearly over the next 20 years.

So, assuming you already realize that you want to pay more than the minimum on your debts in order to pay them off, you still have a long way to go. Your approach, in my opinion, should consider both mathematical and psychological aspects of the debt-paying process. Let’s look a little more at the steps that should be taken to pay off your debt in a manner that reaches your financial goals, but also improves your well-being psychologically.

Step 1: Create an Emergency Fund

Similar to what Dave Ramsey proposes, I think that $1,000 is a good emergency fund to start with. Your eventual goal here will be about six months of expenses (the number of months can vary depending on the stability of your income source). The small $1,000 fund allows you to keep on track even when you have small emergencies. You don’t want your progress to being debt free to be halted by a small emergency. It’s recommended that you keep the emergency fund in cash. The reason for keeping it in cash, rather than stocks or bonds, is for liquidity. We don’t want to have to sell an investment to get cash because we could be forced to sell when the investments are down. As a general rule of thumb, you shouldn’t investment any money you’re going to need in the next 5 years. Take this from someone who learned the hard way.

Step 2: Avoid New Debt

If you’re digging yourself out of debt, it makes sense to not throw debt back into the hole, right? To ensure that you’re making the most progress toward your goal of being debt free, you should not take on additional debt when you’re in debt pay-down mode. You’ll need to assess how you can make this happen. If you’re in school and paying for it with student loans you should pay for future school expenses instead of paying off your previous student loan debt. If you’re bad with credit cards, you should lock them away where you can’t access them. Oh, and don’t forget to remove the cards from your Amazon account. If you can truly manage your credit card expenses and pay the balance every month, I’m not going to tell you not to use them. I think the credit cards provide many benefits, particularly for extended warranties, protection from shady merchants, and the ability to easily track expenses through a website such as Mint.com.

Step 3: Paying Your Debts

Now, this is the part where the debate amongst financial planners and gurus begins. Dave Ramsey is a proponent of the Debt Snowball. Under this approach, you list your debts, excluding the house, in order of dollar balance. The debt with the smallest balance should be your number one priority. Don’t worry about interest rates unless two debts have similar balances. If that’s the case, then list the higher interest rate debt first. This ignores the interest rate that your debt is costing you. When you’re paying off the debt with the smallest balance, pay just the minimum payment on the rest. The reason for this method is that, as you pay off one of your debts, you will continue to be motivated. The math involved in personal finance is easy. Controlling your emotions is a completely different story.

A differing method of determining the order to pay your debts is one that uses strictly math, and ignores the emotional and psychological effects. Flexo of Consumerism Commentary coined this the Debt Avalanche. Basically, you pay off your debt with the highest interest rate first. Nobody will argue that this math doesn’t make sense. You’re going to pay less on your debt and you’re going to pay it faster. Just list your debts by interest rate, pay minimums on all your debts, and any extra cash goes to the debt with the highest rate.

I’m going to say that neither of these is the correct approach for all people. You need some type of framework to use in order to make this decision for yourself. In some instances, it will make more sense to use a Debt Avalanche approach. In others, the Debt Snowball may be your best shot. So to determine what the best approach for you is going to be, first head over to this calculator. Select the number of debts you have and input the information for each. I want you to basically run this calculation twice. Once in “Interest Order”, and once in “Balance Order”.

For me personally, I ran my personal student loan of $9,800 and my parent student loan of $33,000. These loans have interest rates of 5.8% and 6.8% respectively. If I were to pay off these debts using the debt snowball, it would take me 49 months and I’d pay $5,943 in interest. If I paid the loans, with the highest interest rate first, I’d pay $5,695 in interest. Basically, if I choose to do the Debt Snowball, it will cost me $248 in interest, but my repayment time will be the same. In this instance, I think it’s more than fair to consider the emotional implications of your repayment order. I know that paying my $10k personal student loan will provide me with much more general happiness and will lighten the psychological burden that this student debt has placed on me.

However, and this is the key point, I can only consider these psychological factors because the difference in total interest paid is not greatly affected by the order in which I pay the debt. This is because the interest rates on the two debts are not very different. If, however, you are contemplating paying a student loan and paying a credit card, you should without a doubt pay the credit card first. Let’s run through a quick scenario here to show the math. Let’s assume I had my $9,800 student loan, but I also had $15,000 in credit card debt. Due to having such a large balance and deteriorating credit score, we’re assuming the credit card company bumped the interest rate up to 23%. Paying $500 toward this debt each month, it would take 80 months to pay off the debt and would result in $15,048 of interest. And that’s if I paid it based on interest rate. Now, what if I decided to pay based on balance, as proposed by Dave Ramsey’s Debt Snowball? I would pay $31,796 in interest and it would take me 114 months. That means, by using the Debt Snowball approach instead of the Debt Avalanche approach, I’d pay an additional $16,748 in interest and it would take me almost three additional years to pay it off.

I think it’s fairly clear here, that determining the order to pay off your debt takes more than just a simple “rule”. If the difference between the two payoff schedules is large, then go with the Debt Avalanche. If the difference is small, and you believe you’ll receive the psychological benefits associate with it, then by all means use the Debt Snowball. If, however, the differences are small, but you don’t think you’ll benefit at all psychologically from kicking out the small debts, then you might as well also follow the Debt Avalanche approach and pay off your interests in the order of highest-interest to lowest.

Debate: Paying Off Debt vs. Investing

Paying interest works against you in the same way the earning interest works for you. Of this, I am certain. However, as you can see in my October 2010 Balance Sheet, I have $10k in my investment account that could be used to pay down some of my student $43k in student debt. Whether you’re carrying credit card debt, student loan debt or a home mortgage, you’ve likely wondered whether you should invest money that you have or pay off your debt. The way I see it, this decision has two aspects: emotional and mathematical.

Emotionally, debt is a drain. It’s constantly on your mind and it impacts your emotional well-being. Many people who become debt-free talk about the burden that was removed once the debt was paid off. Because the decision to pay or not pay off your debt has emotional implications, some of the decision should be based on your personal feelings. If your debt makes you feel trapped, you may opt to pay off the debt even if it’s has a low rate and you can make a better return elsewhere. I think that your emotions should factor into your decision, but you shouldn’t allow them to dictate your selection.

More importantly, though, you should consider the math of paying off your debt. This comes down a comparison between the after-tax interest being paid on the debt and the after-tax rate of return you could expect to earn on that money. Once you have both of these rates calculated, you can make a decision. Basically, you should pay down your debt if the after-tax interest that you pay on the loan is higher than the after-tax rate you can earn on a bond investment with an equal duration. The reason for using a bond investment for this comparison is that when determining whether to invest or pay off your debt, you need to ensure that you’re comparing yields on two investments carrying the same risk. Paying down your debt is the equivalent of a risk-free return equal to the interest rate you’re paying. You can indeed attempt to calculate a risk-adjusted rate, but I personally think that gives you too much room to fudge the numbers.

In my case, the interest rate on my student loans is 5.8% on my $10k and 6.8% on the $33k of parent loans. Since my loans qualify for a tax-deduction, the after-tax rate is about 4.5%. Since I don’t receive the tax benefits of the parent loan, that rate is still 6.8%. Either way, based on current risk-free rates available in the market, the obvious choice appears to be to pay down my debt. However, even though I know where the math points, it’s still something I struggle with. Recently, my investments have been doing well. A simple calculation shows that my investment portfolio is up about 35% over the last 5 months and I don’t want to miss out an any continued recovery in the portfolio. On the other hand, we all know past returns aren’t indicative of future returns. If I do decide to use this $10k to pay down some of my loans now, I need to determine how I want to handle it. Paying down the loan with no tax-benefits makes the most mathematical sense. However, if I factor in the impact on my emotions and personal well-being, I may opt to pay off the loan that it’s in my name completely. I may also opt to do something in-between by splitting the $10k in some form. I’ll keep you posted on what I decide to do.