MythTip: Building a Debt Snowball

If you’re looking to get out of debt, then you need a debt snowball. It is, in my opinion, the far and away best way to eliminate your debt.

What is a Debt Snowball?

Have you ever rolled a snowball down a hill? AS the snowball rolls down the hill, it grows larger. AS it grows larger, it rolls faster and faster until it becomes an immense force.

A debt snowball works the same way. You start with a small seed payment (which I call the snowball) that you use to pay off your debts early. The snowball grows and picks up momentum as time goes by until, before you know it, your debts are being paid off faster than you could ever have imagined.

How It Works

  1. List all your debts. Include the balance, interest rate, and minimum payment.
  2. Find some extra money for your snowball. The snowball doesn’t have to be huge to be effective. Even as much as $50 a month can make a huge difference. The larger your seed money, the faster your snowball will grow.
  3. Choose a debt to pay off first. Pay the minimum payment on all the other debts. Use your small snowball money to start paying down that debt until it is paid off completely.
  4. Take the minimum payment for the paid off debt and ADD IT TO YOUR SNOWBALL. Then use the new, improved, snowball as extra payments on the next debt.
  5. Repeat. Every time you pay off a debt, add it’s payment to your snowball, then attack the next debt in line.

Repayment Methods

There are many different ways to decide how to execute your debt snowball plan. The basic techniques are outlined below.

  1. Minimum Balance. In this approach, you pay off your debts in the order of their balance. The smallest debts are paid off first. The advantage here is that you get quick results. The small loans get paid off very quickly, so you get to build your snowball right away. This is the preferred snowball method of financial guru Dave Ramsey.
  2. Highest Interest Rate. This approach pays off debts in order of interest rate. The advantage here is that you get to get rid of the highest interest rate loans fastest. In theory, this would save you more interest in the long run.
  3. Balance/Payment Ratio. This last approach is a bit more complex. The order of repaying your debts under this method requires you to divide the balance of the loan by the minimum payment required. The debts are then repaid from lowest ratio to highest ratio. The logic here is that a low ratio indicates a small loan that is eating up more of your money than others. Therefore, low-ratio loans should both be quick to pay off, and give a big boost to your snowball right away. This is my personal favorite approach.

There is no universally right way to snowball. The best method will depend on your exact situation. These calculations are not particularly easy to perform. But that’s okay, because web developer Randy Merrill has created a powerful new web based snowball calculator that you can use to set up your own debt snowball. It’ll even let you choose your snowball technique and show you which works best. Check it out today!

The Debt Snowball Calculator

Posted on 8 Dec 2011

Myth: Complex Investment Schemes Work Best

The Word on the Street There is a prevailing notion in our society that it is possible to get extraordinary returns out of the stock market by following a particular investment strategy, buying certain sectors of the market, finding stocks with certain characteristics, or in hiring a sharp-dressed, smooth talking account manager.

The Truth While I do not deny that it certainly should be possible to “beat the market”, the simple fact is that, based on historical stock market and mutual fund data, very few account managers or mutual funds have managed to beat the market for more than a few years at a time.

It’s in the Pudding

One of my current favorite finance books is called A Random Walk Down Wall Street, by Dr. Burton G. Malkiel. Dr. Malkiel updates this amazing book every few years with the latest information available in the financial world, and the book is currently in it’s 36th year of publication! The reason that I mention this book here is because one of Dr. Malkiel’s major points is that very few, if any, active investors and fund managers actually beat the market for more than a few consecutive years.

Mutual fund companies have strong motivations to make their funds look really good, so they have a tendency to use a little creativity when it comes to the statistics they report in regards to their funds. A prime tweaking technique involves elimination of underperforming funds from their portfolio of offerings. By closing a “loser” fund, the poor returns it was providing are removed from the pool of statistics used to measure the average return of the funds the company offers.

If you want a prime example of a particular strategy working for a short period of time, then failing, look no further than the dot com boom. For a number of years, the investing mantra was “invest in dot coms, and you can’t go wrong!” Well, history has proven that that strategy was not a long-term success, and most of the fortunes created by that strategy were also lost by that strategy.

Critics of Dr. Malkiel’s premise often will cite the success of a few private investors as proof that high returns can be earned. They cite the success of Peter Lynch (who had excellent returns on his Magellan Fund for a number of years), and Warren Buffett, whose very name is synonymous with investing prowess. But, the reality is, that though there may be a few who can in fact beat the market, they are vastly offset by the numbers of those who not only can’t, but haven’t matched the market. How many successful investors have you ever heard of? One? Two? A dozen? A hundred? A hundred sounds like a lot, but at this very moment there are more than 9000 mutual funds currently available, and many thousands more that have already been closed. The media focuses on the very exceptional few, and tends to ignore the immense mass of investors who have not managed to outperform the market.

Buffett and I

Many of you who frequent the blog know my preferred investment strategy. I am a believer in efficient markets, which basically means that I, like Dr. Malkiel, don’t think you can expect to beat the market. So, if you can’t beat ‘em, join ‘em, right? I think the best approach is to simply purchase an exchange traded fund (commonly referred to as an ETF), or a mutual fund that tracks one of the major indices of the economy. Examples of such indices include the S&P 500, NASDAQ, Dow Jones Industrial Average, Russell 2000, etc. These funds have very low expenses because they are not actively managed, and do not trade stocks around very often. As a result, you manage to efficiently invest your money in the entire market. One great benefit of index investing is that you automatically get access to a phenomenal degree of diversification, which lowers the total risk of your investment.

In a recent interview with PBS’s Nightly Business Report, investing legend Warren Buffett had the following to say in regards to the complexity of the investment world:

You should always stick to what you know. I say the “know-nothing investor” and there’s nothing wrong with being a “know-nothing investor.” I spend 60 hours a week, thinking about investments and most people have got jobs and other things to do. They can buy index funds. And they’re not going to do better then an index fund if they go around and trust some guy who’s promising them very high returns. If you buy a cross section of American business and you don’t buy it during a period when everybody is all enthused about stock, you’re going to do fine over 10 or 20 years. If you buy something with the idea that you’re going to do fine over 10 months, you may or may not. I do not know what stock is going be up 10 months from now, and I never will.

Warren Buffett

If you want to try to play roulette with your money, then go ahead and try to find the >1% of fund managers who will beat the market for more than a few years. For me, I am going to stick with the market, and almost guarantee that I will outperform 99% of all money managers.

Posted on 19 May 2009

Myth: You Need Credit Insurance

The Word on the Street

Whenever someone wishes to make a large purchase on credit (like a house or a car), the lender will often try to sell them an insurance policy. These policies are supposed to protect your family from having to repay the loan in case the buyer dies.

The Truth

This insurance does not truly protect you or your family. Why do you think they press the issue so hard? Is the car salesman or the dealership really out there to do you favors? No. They are out there to make a profit. And there’s nothing wrong with that. But, as a consumer, you ought to be aware that credit insurance really only benefits the lender. When you buy credit insurance, you are in fact guarantying your lender that it’s loan will be repaid. You are paying their insurance premium!

What is Credit Insurance?

The insurance that the salesman/banker will try to sell you is a type of insurance called credit insurance, although they may not call it that. What credit insurance does is pay off the remaining balance of your loan if you should die. If the loan is sufficiently large (like in a mortgage) and you meet certain criteria, a lender may require you to purchase this insurance before they will issue the loan. This is a typical arrangement for mortgages where the buyer has only a small down payment. When it comes to auto loans, these policies are usually discretionary, and will often be paid for with one large premium payment at the time of purchase. This post focuses on discretionary insurance for auto loans, rather than potentially mandatory insurance for mortgages.

How They Sell It

When making a large purchase, people have a tendency to downplay the magnitude of some costs. They figure, “I’m already paying $20,000, what’s another $400 more?” By exploiting this tendency, car salesmen are often able to convince the buyer that the cost of the insurance is a small price to pay. They bury the cost within the larger cost of the car and make it seem as though it is a good deal.

This next tactic is downright cruel. What the salesman will tell you is that this insurance will protect your family from having to pay off the loan should you die. He tries to convince you that your family will be left financially bereft by having to continue to make the car payment. By playing on the emotional bonds within your family, he impairs your rational judgment within a cloud of powerful emotions. This is how they convince you that this insurance is a good deal, and will benefit your family.

Don’t Fall For It

It’s true that your family will receive the money to pay off the loan, and that will benefit them. It’s also true that you ought to use life insurance to help pay off your debts so your family can be free of them should you die. So why shouldn’t you get the credit insurance?

Short Answer

It’s way over priced!

Long Answer

An example. Suppose Herb buys a $20,000 car, taking out a $15,000 loan for 4 years. The dealer offers credit insurance to cover the loan in case he dies. The policy is available for an up-front cost of $500, which they offer to include with his loan. Is this insurance a good deal? Assuming Herb is 35 years old and in good health, for $125 per year over a 4-year period, Herb could purchase a traditional level term life policy for at least $100,000 coverage. So, for $500, he could have $15,000 of declining life insurance (to cover the car loan) for 4 years, or for $500 ($125/year for 4 years) he could have $100,000 of coverage that he could keep that his family could use any way they wish, should he die. Dollar for dollar, the credit life insurance is much more expensive. If you are considering buying a car and wish to cover the loan in case you die, you would be much better off purchasing traditional, term life insurance than you would to buy the credit insurance the dealer may offer you.

Posted on 11 May 2009

My Stance on Renting

Everyone seems to think that I am opposed to buying a home. Almost every fan of the blog that I talk to seems astonished when I tell them that I am very much in favor of people buying homes.

So, let me clarify again my position on renting versus buying.

In my opinion, far too many people (particularly first time home buyers) jump into buying a house because they can’t bear to “waste any more money on rent.” These people have a very valid point. Home ownership provides equity appreciation on the home, which in the large majority of cases will far outstrip any return you could earn in a savings account. This makes buying a home a generally good investment, and certainly can provide much greater long-run results than renting.

I am concerned, however, that first time homebuyers rush to buy before they are financially prepared. Home ownership is much more expensive than renting. You have to pay for hazard insurance, property taxes, repairs, upgrades, and (for first time homebuyers) mortgage insurance. These extra expenses can stretch a family’s budget far beyond what they anticipated when they bought the home. Many of the families who are losing their homes to foreclosure are young couples just starting out. In their desperation to avoid wasting money on rent, they overextended themselves and eventually lost their home.

After losing the home, how much better off are they? They get no equity, pay tons in interest and taxes, and any work they did on the house is pure loss. It’s financially devastating to be foreclosed on. Many families could avoid that if only they would take their time, research the un-told costs of home ownership, and go into the deal with their eyes open. Any financial decision you rush into headlong is susceptible to catastrophe. With a decision this large, potential homebuyers cannot afford to be hasty, because the consequences can be dire.

I think that it is perfectly fine for a family to rent an apartment or small home while they build their financial strength. Once their situation can support the mortgage EASILY, they ought to buy their own place and start up the equity ladder. You must only enter a mortgage if you can have a little extra room in your budget. Don’t stretch to the absolute maximum of your budget to buy the home, because you will find yourself overextended. You have to prepare for unexpected expenses and costs.

Lastly, I am hugely opposed to mortgages. Investment leverage is the only good thing I can think of about a mortgage. Everything else about them is terrible to your finances. A HOME is a great asset: a MORTGAGE is a great burden. Your mortgage is at least DOUBLING the cost of your home over 30 years. Just imagine all that your mortgage is costing you, and how strong your finances could be without that mortgage payment.

Of course, renting does not provide the option of eliminating your housing payment at some point. When you buy a place, you can pay off the mortgage and someday be rid of your housing expense completely. When you rent forever, you pay forever. That’s why I don’t support the idea of long-term renting. If you can pay off your mortgage in less than 30 years (and I can teach you how to get rid of your mortgage AT LEAST 7 years sooner without any extra cost to yourself), then you will have some time to really sock away some money into savings.

I hope that clarifies my thoughts on renting versus buying.

Posted on 20 Apr 2009