I see a lot of people picking on Dave Ramsey’s less than mathematically ideal debt payoff method, the debt snowball. Interestingly, social science says he’s right.
When it comes to paying off debt, similar to investing, what matters the most is that it gets DONE. Picking the perfect method for paying off debt doesn’t matter nearly as much as making sure you stick to it.
If you haven’t heard of the debt snowball, this is where you pay off debt in order of smallest to largest balance. The main criticism is that it costs you more money to pay off debt this way thank in order of largest to smallest interest rate.
PSST – Interrupting this post for an important announcement! I’m going to be talking LIVE in the #womenrockmoney Facebook group on Tuesday at 8 PM EST all about why women need to be smart about their money. If you’re an interested money-smart woman, be sure to join the group and be hanging out at 8 PM! Hope to see you there.
Here’s a quick illustration:
Say you have three debts – a credit card with a $5,000 balance at 20%, a store card with a $250 balance at 10% interest, and a car loan at 7% interest with $3,000 left.
- The debt snowball method has you pay the store card, then the car loan, and last the credit card.
- The way that will save you the most money is paying the credit card first, then the store card, and last the car loan.
If you’re a human calculator, you know that it’s the second approach that will save you more money. You’ll pay less in total interest this way. But if you’re a human being, the first one likely will.
Let’s explore why.
If You’re A Calculator, Why Do You Have Debt?
Understanding something intellectually isn’t the same as acting on that knowledge. In the Stacking Benjamin’s basement on FaceBook the other day, OG (from the Stacking Benjamins podcast) reminded us of this.
Humans are notoriously bad at certain kinds of math. Even people who are good at math can be bad at personal finance math.
Simple math is easy for us to understand. You have one apple, you’ve added another apple, now you have two apples. Multiplication and division, while harder for kids to grasp, still can use straightforward real life examples. If you have ten cookies, and made two groups, how many cookies would be in each group? Math says five.
Real Answer is -none, because I have three boys in this house and they would eat all the cookies
Complex math is much harder to grasp. Even if you’re “good at math”, you likely don’t do it every day. If you’re like me, you might get good grades in math, and be able to do very complex calculus or statistics when you need to. But really, how often do we need to?
And even if you’re good at math, you likely don’t do those calculations in your head. Instead you use a calculator or a computer. Unless of course you actually can do those calculations in your head. In which case, debt is probably a mathematical decision you’ve strategically employed in order to reach a higher total net worth.
What am I talking about? Well let’s take a look at the calculation for a loan payment.
This is exactly the kind of math most people can’t do in their heads. And that’s a big part of why compound interest is hard to grasp. It’s not intuitive. It goes against your instincts, and what makes sense to you. You need to fight against those instincts and trust in the math.
Don’t Let The Perfect Be The Enemy of The Good
When it comes to paying off debt, deploying a strategy that will be successful beats a “perfect” strategy any day.
Social science tells us that the snowball strategy will be more successful in getting debt ACTUALLY PAID OFF.
Here are five studies from five different institutions that demonstrate this:
- Research from Kellogg shows that people with large balances will be more successful in getting debt paid off if they pay small balances first. Here’s an article from the journal of the American Marketing Association with all the details.
- Research from the University of Michigan tells us that as consumers evaluate how to pay off debt, they gravitate naturally to the debt snowball strategy
- The Boston School of Business, as reported by Harvard Business Review, did a study where they found focusing on one account at a time-and starting with the smallest balance-is most effective
- Research from Texas A&M shows the same, and dives into two different behavioral models that explain why. The full paper can be found here.
- Research published in the Oxford Academic Journal of Consumer Research says something similar, that concentrated payoff of a small number of accounts is most effective.
Let’s Investigate Why
- Credit card – $5,000 balance at 20%, $100 payment
- Store card with a $250 balance at 10% interest, $50 payment
- Car loan at 7% interest with $3,000 balance, $300 payment
You have an extra $200 per month to pay off debt.
If that’s the case, in your first month you’ll pay off that store card. You’ll feel amazing, and celebrate! You can take $250 – your $50 payment from the store card, and the $200 extra you have a month – and put it on that car loan. You’ll get that paid off in just over six more months, and then take an extra $550 and put it on that credit card. About a year later, you’re done! Those payment can go into your emergency fund.
Now, what if you tackle the highest interest rate first – that credit card? You still only have that extra $200 per month, meaning that instead of paying $100 on it, you’ll pay $300. It will be over a year before you get that debt paid off.
Looking at the two methods, you can see how you would get more psychological benefit from the first approach. In the same timeframe – a year – you’ll get two wins and be able to 5X your credit card payment with the first, but with the second you’ll end the year in the same place you started.
Yes, you will have more money at the end by focusing on the mathematical method. You’ll be able to see your lower balance on a paper statement, or online. But you’ll see more tangible results that impact your daily life faster by the first method.
My Story In Brief
I’m a big proponent of doing what works for you. If you have no issues staying focused and paying off debt in a mathematical way, go for it. But don’t dismiss the debt snowball method just because it costs more.
In my own case, after my husband almost died of sepsis, I became determined to eliminate all our debt and reach financial independence once and for all. Not to retire early, but to ensure that no matter what happened, our family would be OK. The first part of that was getting rid of debt, and you can read Part 1 and Part 2 for the full story of how we did it. Now I’m working on the mortgage and college savings, much larger goals that take years to achieve.
Dave Ramsey was a big part of that, although he never made money from me. I got his book from the library, and his podcast was in my rotation to keep me motivated. And sure enough, within a year, all the debt was gone.
I Want To Hear From You!
Have you paid off debt – and if so, which methodology did you use? Anything surprising in those studies? Let me know in the comments!