Tuesday, July 12, 2011

Day 271 - Smashing Debt With A Snowball

Photo Credit: Wikipedia
Yesterday I discussed paying off debt purely from a numbers perspective. I focused on interest rates, loan balances and the impact on additional interest paid . Today I'm writing about the snowball approach.

Remember those economics courses you took a loooonnng time ago? I did so many supply vs. demand graphs in college that I began to have nightmares.  Neoclassical economics (make sure to point your nose in the air while saying this out loud) is an approach to economics that relates supply and demand to an individual's rationality and ability to maximize utility or profit.*  For example, if demand increases and supply stays the same, the result is a higher equilibrium price and quantity - as explained by the nifty graphic above. Coming back to you yet??? Now stay with me for a minute.

Honey, Milton Friedman thinks I'm Rational - Why Don't You?
When you make purchases, do you consider yourself a rational human being? When you go to Macy's and think about buying a pair of shoes, do you always rationally (and, in a way, selfishly) consider ways to maximize utility and profit? Or do you also consider looks, trends or even social responsibility (think Tom's)? Behavioral economics introduces the theory that people may make decisions based on rules of thumb rather than strict logic. One good example: The phrase 'you get what you pay for' is often followed even when a cheaper version of a product exists that is as good or better than the higher priced version (thanks Wisegeek!). A second theory  relates to the herd mentality - people tend to follow the trend over being rational - like the fact that every outfit Kate Middleton wears is immediately sold out all over the world. Doesn't sound too rational to me. A third theory involved in behavioral economics is framing - mental filters created through their own personal experiences. You have a $10 item that is 75% off!!! Or....Save $7.50. Which sounds like a better deal even though you have the exact same outcome? Even better, are you one of those people that proudly announces 'I got this leopard print tube top on sale!!'? Sometimes that sale price isn't much different than retail, but the store has framed it up in a manner to make you feel like you got a good deal.

The Snowball - Irrationality Rationalized
Sarah, how were you able to mention Milton Friedman and leopard print tube tops in the same blog post? And what about the debt snowball?

I believe that the snowball concept, made popular by Dave Ramsey, is a positive extension of the theories behind behavioral economics. Do your eyes glaze over when people start talking to you about interest rates and loan terms? While these concepts are still important to understand, getting out of debt is about more than just the numbers. Some people need an Excel spreadsheet; others need to simplify and see immediate progress by paying down the smallest debts first. Rationally speaking, it may take you six months less to pay off debt if you start with the highest interest rate loan first, but emotionally this scenario may make you feel like you'll never be able to do it. Is it better to choose the debt payoff plan that is rational and makes more sense? Or choose the plan that makes you feel confident you can pay everything off even if it takes a little more time?

As mentioned in yesterday's post, I chose the snowball method. Lucky for me it didn't matter too much since the difference in interest paid between the two options discussed ended up being less than $100 bucks. I feel way more engaged in paying off my debt and I'm doing a darn good job of it, too! I can't give you a reasonable explanation - I just know that it works for me. And this isn't the first time I have tried to pay off my debt. I also know that this option is not a one size fits all concept and what works for me may sound completely ridiculous to you.

So.......Lowest Balance or Highest Interest Rate?
Have you figured out which method best suits your personality (or even come up with a third option)? A few things to think about:
  • Be informed: model out your options (as discussed yesterday).
  • Don't do something because you should; do it because it fits your lifestyle and works for you.
  • Some people are into the numbers, others are more visual. Think about your style when choosing your plan.
  • Just pick one! Go with your gut and go for it. It's not the end of the world if you decide in a few months to change your strategy. My only advice is to give it at least 4 months before giving up on your strategy - it took me at least 3 months to finally realize our success.
  • You can only listen to other people for so long. Thank them for their opinion and move on. Their lifestyle and formed opinion may not exactly align with yours. You should be the final decision maker!
Stay tuned,

What method do you prefer when it comes to paying off debt? What has worked best for you?

* Definition from www.investopedia.com 


Ken @ Spruce Up Your Finances said... Best Blogger Tips

Snowball is a good approach to cutting down debt. You know what they say about goals, break it down into smaller and more achievable goals. I think this is what makes snowball effective because you can psychologically see progress if you know you have accomplished little goals (paying debts with smaller balance) that will help you pay-off your total debts.

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