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That's Fiji Airways.com. You deserve this. Go from here to happiness. Flying direct with Fiji Airways. Radical Personal Finance, Episode 32. What order should I use to pay off my debt? A rational approach to the debt snowball, the debt avalanche, the debt tsunami, and all of the other debt and precipitation terms you can throw in.

Welcome to the Radical Personal Finance podcast for today, Thursday, July 31, 2014. Today we're going to try to stir up the hornet's nest a little bit, try to give a little bit of information and some, what I think, rational ways of thinking and considering the details of how should I go about paying off my debt.

I've decided to pay off my debt, but what order should I use to pay off those debts? This is one of the biggest, I don't know, if you pay attention to the personal finance world, you'll know this is an ongoing debate that everyone likes to argue about. If you don't pay attention to the personal finance world, this may be news to you that this is even a controversy of any sort.

I often talk with people and I mention this controversy and they look at me with a blank stare like, "Why would anybody do that?" That being the other thing that someone else would say, "Why would anybody do this one?" It's rather comical to me just because everyone has this broad range of opinions.

This is one of those things where sorting out right and wrong is challenging because it's personal. I think this is an excellent example to use to show how I think that we who are interested in finance, we who are interested in a rational approach, a rational and radical approach to finance, to personal finance, I think we have a responsibility to up our game in this area because there are literally millions of people that are depending upon us, those of us who are interested in this stuff, whether we're a financial advisor, a financial blogger, just an average person who's interested in finance, all of us are going to have the ability to impact someone else's life when they ask us questions.

I think we have a responsibility to help them and there are millions of people who need our help. It doesn't help to do this infighting, these arguments back and forth about debt snowball versus debt avalanche. If you're not familiar with those terms, give me a moment and I'll explain them to you.

Today, I'd like to just give some thoughts and some ideas for how we could go a little bit deeper than just this back and forth argument. I believe this will be helpful. I wouldn't be doing it if I didn't believe it would be helpful. But I believe there's another layer that we really need to talk about and we really need to understand all of the forces at work in this entire conversation.

We need to go beyond should I pay off my debt in the highest balance first or should I pay off my debt in the highest interest rate first. If we can go beyond this argument, we can stop fighting among each other and start helping more people. Those of us who care about these topics, we're not the enemy.

The debt is the enemy. The consumer debt is the enemy. So let's focus on that and let's clear the way for that. So first I want to lay out the problem and just some of my assumptions for today's show. In today's show, I'm not going to talk much about getting out of debt.

But to be clear, I think getting out of debt is an incredibly important step on the path to financial independence and financial freedom. If I could help any young person avoid going into debt from the beginning, I would. If I could help any person get out of debt, I would.

I don't want to provide any comments today on the topic of getting out of debt versus investing, although I have some pretty strong feelings on that as well. It's not as simple as one or the other. It's a very individualized decision. But today I'm just going to assume we've decided we want to get out of debt and we've decided that this is our number one focus and this is our number one priority.

There may be many reasons why this would be the ideal thing to approach and the ideal thing to do. So let's talk about some different ways to do that. This may sound silly, but there are various debt reduction methodologies that you could use. I've thought of five of them to use in our conversation today.

The first one is what I call the minimum payment methodology. The idea behind a minimum payment methodology is you just simply pay your debts according to how much your creditors are charging you. So you take your statement every month and you take a look at it and whatever the payment, the minimum payment is that it says there on the statement, you pay that amount off.

Now this can work brilliantly for some kinds of debts and this can be a disaster for other kinds of debts. So this can work brilliantly for what are called fully amortizing debts with level payments. So this may work well for a mortgage payment. We all know that if we have a mortgage payment and we have a traditional fixed rate mortgage payment with a level payment, we know that over time if we just pay that level payment that upon the term of the loan maturing, that that payment will be paid off.

So if we took out a 30-year loan and we pay that level payment each month for 30 years, at the end of 360 months that payment will be paid off. Or if we have a car payment, then this car payment will be paid off under the terms of its loan.

So if it's a 60-month loan, we know that 60 months later this car will be paid off and we'll have a level payment over that 60-month period. The minimum payment methodology is a little bit more tricky when you get into the world of student loans and also when you get into the world of credit cards.

The challenge is especially with credit cards of this payment methodology because as you pay the loan balance down, the minimum payment changes. And so with most credit cards, the way that the minimum payment is calculated is that if you start off with a $10,000 balance and that balance declines, then the minimum payment will be recalculated.

So under a credit card minimum payment methodology, you'll wind up paying a substantial amount of interest if you just pay the minimum payments. Student loans vary depending on the nature of the loan and there are some funky things with student loans that I don't want to get into today as far as the various repayment options and various forgiveness options and things like that, various terms where the payments are not due and then the payment calculation being based upon income.

So a little bit funky. Just look and read the terms of your loan for that. So the minimum payment methodology is frankly what many debtors wind up doing. That's what many debtors wind up doing because if you're a debtor and you just pay the minimum amount that you need to do and those minimum amounts can accrue and accumulate over time.

And the challenge is that's usually going to be the slowest way to pay it off. Now many people who are in debt do want to pay off their debt more quickly and get things cleared a little bit faster. And so then that brings us to debt reduction methodology number two, which I call a little extra here and there.

And so this would be I pay a little extra here, I pay a little extra there. I'm putting a little $50 extra on this credit card. I'm putting $50 extra on that student loan and I'm just kind of paying a little bit more as I have the opportunity to pay a little bit more.

This is frankly quite normal. This is what many people do. And this is why those who have ongoing balances of their debt payments, ongoing balances on their debts, they often don't feel like they make much progress because the energy is spread out. And so I agree 100% with the various personal finance gurus and pundits that comment on this topic.

It makes all the sense in the world to me. This is probably the least effective way of paying off debt because $50 here, $200 there, $1,000 on the other debt makes you feel like you're never making measurable progress because you don't have a plan. And so this is probably the least effective.

And I would encourage nobody to follow this one. I would encourage anybody to pick one of the other methodologies. So then we move on to kind of the other methodologies that are more proclaimed. I'm familiar with three or four depending on how you count them. There's two biggies and then there's one or maybe the same thing, two that I've heard of here and there in paying attention to personal finance stuff over the years.

The two biggies are what are called the debt snowball and the debt avalanche. And then the other two is the debt tsunami and the risk reduction method. Those are just some various names that I have heard for paying off debts. And I'll explain them one by one. So the biggie in the personal finance space is the idea of the debt snowball.

All four of these, by the way, are trying to harness the same focus methodology. And so the idea here is that with any one of these payment methodologies, the idea is that you will pay a minimum payment on all of your debts except one. And you will pick one balance, one debt to which you're going to focus all of your extra payments over and above and beyond the minimum payment that's required.

And then by focusing on that payment, on that debt, you will clear that debt and then you'll take the amount of money that you were paying towards that debt and then you'll roll it towards the second debt on your list, whichever that second debt happens to be. And then you'll move on to the third debt, then on to the fourth debt, then on to the fifth debt.

Now this is extremely powerful as a debt payment methodology because instead of just simply paying the minimum payments and then when one debt is cleared, you continue paying minimum payments on the others, by focusing the efforts on one and then rolling the payment that was being paid towards that one once the first one is paid off to the second one, then the amount that you're paying each month towards the debt grows substantially over time.

And so this is really powerful because it focuses your efforts. And then by focusing the efforts onto one specific debt, by focusing on one specific debt, then it concentrates you and gives you the power of, basically the power of focus. I think there was a book written with that name.

It's the power of focus. Basically anything we focus on, we're able to make substantial progress on and it's no different in the area of debt repayment. So I want to walk through these different methods. So the most popular of these four is called the debt snowball. And the reason it's the most popular is because this is the method championed by the big, the big dog in the personal finance space, Dave Ramsey.

And so Dave Ramsey champions a method that he calls the debt snowball. And I assume he didn't make up the name. I assume he just popularized it. But if he did, I give him all the credit. I don't know where these names came from. And the idea behind the debt snowball is to pay minimum payments on all of the debts except the one with the smallest balance.

So if you have a -- you have three loans and one of them has a $1,000 balance, one of them has a $10,000 balance, and one of them has a $5,000 balance, you ignore the interest rates and you focus on the one with the smallest balance. And the idea here is to harness the power of behavioral modification and set yourself up for a feeling of success by getting a win of paying off the debt quickly.

So the analogy that Dave will use and that I think is accurate is anything that you start, for example, dieting, if you focus on what can I do in the first -- what can I do up front and what can I do -- if you go on a diet and you lose five or ten pounds really quickly, your more -- idea is that you're more motivated to stick with your diet.

So the same thing. If you can -- if you have a list of five debts and you have two little ones and you can get that little -- the first little one cleared out in the first month and the second little one cleared out in the second and third month, then this is a really powerful motivating factor to help you stay on the plan.

So now you've gone from five debts to three debts and you get some wins of not having to face those bills and those debt statements in the month -- in the mail every month. The critics of this methodology will quickly complain, well, what about the interest rates? And, you know, if you're paying off the debt that has the smallest balance, it may also have the lowest interest rate, so therefore the interest rate -- the higher interest rates on the other debts are continuing to accrue and you're paying more money.

And I'll go into this in detail because that's the point of today's show. We're going to do some number crunching and show when this matters and when this doesn't matter. So that's what the critics would say is that you're paying more money in interest and then the defense for this method would be, well, yes, you're paying more money in interest, but you're harnessing the power of behavior modification.

So that's the debt snowball. The next method of paying off debt would be what I would call -- or what is commonly called the debt avalanche. And so the debt avalanche is to list all your debts in order of the highest interest rate to the lowest interest rate and put all of your focus onto the payment that has the highest interest rate.

By doing this, you're wiping out the interest payments and this will ultimately be the least expensive way to pay off the debts. Now, the critics of this method will say, well, yeah, it would be the least expensive way if you're able to stay motivated. But if you're not able to stay motivated, then you're not going to pay off your debt.

You're not going to pay off your debt. So you're just going to sit there and be trucking away at this. Maybe you have a big debt with a high interest rate and you're just going to be sitting here trucking away at the amounts and you're not going to make any progress on it.

But the defendants of this methodology would say, well, it's still going to be the cheapest, so it's going to be the fastest and you're going to pay the least money out of pocket. Now, the other two are not -- so those are the two big ones, the debt snowball and the debt avalanche.

And the other two are ones that I've just heard here and there. The debt tsunami, I've only ever heard this written by -- I heard this term, I think it was coined by Adam Baker, who wrote a blog called "Man vs. Debt." And his idea here with his debt tsunami was to focus on the most hated debt.

And his idea was, why don't you harness the power of behavior modification by focusing on the debt that you hate the most? So, for example, if you have -- if you owe a credit card balance that is for an ex-spouse's spending prior to a divorce, and if you hate that balance, get rid of that first.

Or if you owe a credit card balance and you just hate Bank of America for some reason, well, pay off that Bank of America card first. And so, his idea was harness the power of behavior modification by focusing on the most hated debt. And then, the other is similar, and this is the least popular that I've heard, but I've seen it in a couple of articles, basically the risk reduction method, which is the idea is you pick the riskiest debt to you.

And so, this is similar to the most hated debt. And so, the idea is, well, figure out what your riskiest debt is. If it's a debt to your parents or a debt to -- on a mortgage that you want to make sure your house is paid off so you don't lose the house if you face difficult times, things like that.

So, these are the different methodologies. And I'm going to -- we're going to do some math today, and I think I've got it simplified enough to be able to do it on a podcast. We're going to do some math, because here's my issue with all of these things, and I'm going to scream it loud and clear.

This must be an individual discussion, because there are two things that are important. Number one is it's important to look at the individual's makeup of their individual debt. And number two, there's a whole realm that we're not talking about, which is the terms of the debt. And so, most of the time, people are always talking about what debt balance should I pay off and what interest rate balance should I pay off, but they forget about what are the terms of the debt.

And the terms of the debt matter. And so, we're going to talk extensively about the terms towards the end of the show today, because I think we need to factor this in. Now, before we do, many people's -- I want to just give a disclaimer. Many people's debt situations are very simple.

If you listen to Dave Ramsey's show, you listen to his radio show, the people that are calling in, this is the -- this is kind of the average American, low to middle income, struggling with debt, and the debt makeup is fairly simple. So, it's I've got a credit card, I've got a student loan, and I've got a car payment.

And so, if you've got a credit card, a student loan, and a car payment, it may be fairly straightforward as far as which of those you should pay off. And so, I'm not mad about these methodologies, but the problem is that when we fight about them, we're missing the bigger picture, what's actually important.

And so, we need to actually personalize this with people. We need to actually run a personal spreadsheet for each makeup of a debt -- makeup of somebody's balances. This is important. So, I'm going to pass along a tool in a moment, and it's the easiest tool I've found. It's totally free, and I'd encourage you to use it if you're trying to figure out what your -- what plan you should use for your debt, or if you're trying to help somebody else, whether that's a client, if you're a financial planner, or whether it's just a friend or a family member, if you're trying to help somebody else figure out what they should do as far as how they should focus on paying off their debts.

The key thing in all of these plans is to understand basically what's the alternative use of the dollar. And so, the whole concept of paying off the -- of debts is that we're going to transition from consumption of money over to the paying off of debt, which is usually going to be consumer debt, which was previous consumption.

And this is what many people who are deeply in debt or want to get out are going to do. And so, if you're -- if you are -- if you have a lot of debt, and you have a lot of consumer debt, and you're going to transition, and you're going to change dollars that you're currently spending, because you made your cash flow statement, and you're going to move some of the dollars that you're spending on consumption over to paying off your debts, then that's awesome.

That's going to be a good move. But if the majority of your cash flow is going toward investment, and you're carrying debt for -- and you're carrying debt for investment purposes, then this is a very different conversation. And so, that's why in the future we will do some should I pay off debt or invest shows.

But look at your cash flow statement. See where your money's going. Now, again, with the majority of people, at least in my experience, it seems fairly simple. We're going to allocate money over from consumption, from the consumption categories over to the debt repayment categories. And that's definitely going to be a good move.

It's going to be very difficult for that not to be a good move. So, let's assume that's the case. Now, I've run some numbers, and I'm going to walk through those numbers to show you how this does matter. And for the sake of -- I don't -- it's hard to get too numbers intensive in a podcast, but I think I've been able to simplify it enough to make the point.

And so, what I've done -- and you'll see why I've done this in a moment. But I've simplified, and I'm using a spreadsheet here that is a debt reduction calculator. And there will be a link in the show notes. This is the most useful spreadsheet that I have ever found that someone has created.

It's for free. You can buy it. There will be a link in the show -- excuse me. It's for free. You can use it and download it from the link in the show notes. It is published on a website called Vertex 42, where they publish a lot of Excel templates and Excel -- basically Excel templates.

And this is a calculator that someone has created that is a fabulous, fabulous calculator. And you can download it for free, and you can enter up to 10 debts, or you can pay for a version which you can enter more debts. It's 10 bucks if you need to list more than 10 creditors.

So you can list up to -- you can have a list up to 20 creditors, or even as much to -- yeah, as much as 20 creditors. And this is fabulous, because instead of our sitting around arguing about what -- you know, what's right and what's wrong, we can calculate it.

And we can calculate what our cost would be. So if we're going to do the method focusing on behavior modification, the debt snowball, we can calculate what the actual cost of the additional interest that we're paying would be. And I've done these calculations a lot of times with clients.

I've done many of these calculations, and I've found that it's very important to do the individual calculation with a client, because the makeup of the debts and the terms of the debts matters. The interest rates matter and the amounts matter. So just to lay out a very extreme example to make my point, if you have three debts, one of them has a $20,000 balance, one of them has a $300 balance, and one of them has an $800 balance, and you're going to throw an extra $1,000 a month at your debt payments, I think it would be pretty smart to just go ahead and use the debt snowball regardless of the interest rates.

Just ignore the interest rates, because, you know, in a month and a half, you've got your two little debts cleared. But if you have three debts of relatively similar balances, then it's a very different situation. So you can't just say one or the other. You've got to look at what's the actual makeup of your debt, and you need to look at the interest rates and the terms.

So I've got a spreadsheet here, and let me tell you what the debts are that I've entered into it. And again, I'm using this -- I've simplified this to try to get this point across on audio. But I'm using three debts. I'm using credit card debt, a car loan, and student loans.

So I've got credit cards, car loans, and student loans. And for the sake of illustration, I've chosen to make the one with the highest balance have the highest interest rate, and the one with the lowest balance have the lowest interest rate. And I've made these numbers up for the sake of illustration to show that -- first of all, these are reasonable numbers, but to show how this could really make a difference.

And I would encourage you, follow the link in the show notes. Today's show notes are at RadicalPersonalFinance.com/32, and construct this for yourself. But let me use my example to show the difference. So I've got a $20,000 credit card balance with an interest rate of 18% and a monthly payment of $500.

I've got a $15,000 car loan with an interest rate of 8% and a monthly payment of $300. And I've got a student loan balance of $10,000 and an interest rate of 6% and a minimum monthly payment of $100. So my total minimum monthly payments are $900. And the way this spreadsheet works is because I have my minimum payment, it has to be paid of $900.

But then I can choose to put in what is my extra payment. So what additional amount can I pay every month? Now, if I don't pay any additional amount, and I just pay these debts off on their -- and I just pay these debts off, but I pay a level $900, I'm still going to be out of debt faster.

By the way, one disclaimer, I'm going to round some of these numbers to hopefully make them easier to hear on the podcast. So if there's a -- if it's $768, I'll just say $800. So I'm going to round a little bit to make the points. But you can again, you can calculate these out exactly to the dollar if you want to.

So if you just pay the $900 payment every month, then you'll pay that for the first 62 months. And then after 62 months, the first two payments will be paid off. And then the full balance of the $900 will be moved over to the third payment. And it'll take a total of 69 months to pay off these debts under the terms that I have put them in here.

So 69 months to take care of this. So that's just under six years to pay off the debt. Now, if you increase your monthly payment -- and so let's start with the monthly payment of $1,000 a month. If you put $1,000 a month in here, then it shortens things out.

So let's start with an avalanche method. An avalanche of the highest interest rate -- let's start with the snowball method actually, which would be the lowest balance first. So if you're paying a snowball payment of $1,000 a month, so it's an extra $100 on top of the $900 of initial minimum monthly payments, the first debt would be paid off.

That would be the student loan, starting with the $10,000 balance. That would be paid off in 58 months. And you would pay a total of $11,536 of interest. Then the car loan would be paid off at 60 months. So that would be -- you'd pay off the $15,000 balance and pay a total of $3,300 of interest.

And then the credit cards would be paid off in 61 months. And you would pay off the balance of $20,000, and you would pay a total interest of $10,765. So the total interest paid would be $15,604.53. Now if you switch this and you say, "Okay, so I'm paying $15,600 of interest under the snowball method.

What if I take exactly the same terms and I make it -- I'm going to continue to pay $1,000 a month, but I go ahead and put it at the highest interest rate first?" Well now I'm going to pay the credit cards first. And I'm going to have that paid off in 47 months, and then the car loan's in 52, then the student loan's in 59.

My total interest paid would be $13,462. So you would pay a lower interest rate, $13,462. So if you subtract -- I'll just do $13,460 from $15,600, you can see that under the snowball method, you would pay an additional $2,000 of interest. So the snowball method is $2,000 of interest payments, more expensive.

And then the amount of time that it would take to pay off these debts, if you looked at it, it would be a total of 59 months under the snowball method and a total of -- let's see here -- 61 months -- excuse me -- a total of 59 months under the avalanche method, so highest interest rate first, and a total of 61 months under the snowball method.

So under this scenario, if you were working on this plan, you would say, "Well, there's not that -- I mean, to me, when the first debt is paid off in 58 months under the snowball method, and then the avalanche method, the first one has paid off -- the debt has paid off in 47 months, then here the clear winner would be to do the avalanche under this scenario." Now, I want to be fair to Dave Ramsey.

This is not his method. Dave Ramsey's method, if you listen to his show and absorb what he says, his method is you should have a target payoff of being able to pay off your debts in basically around two years -- one year, two years, three years. And his goal for doing that, what he would say is sell the car, get rid of that $15,000.

Now you've dropped your balance from -- total balance is from $45,000 to $30,000, and then sell a bunch of other stuff and just make sure that you're on a plan, get an extra job, make sure you're on a plan to get things paid off in about two to three years.

So that would be his plan. So let's figure out what would be the cost under this scenario if we did it that way. So I'm going to up my monthly payment, and let's just see how -- I'm going to keep my strategy under the snowball, and I'm going to up my monthly payment to $2,000.

Well, now if I up my monthly payment to $2,000, which would be $1,100 higher than my minimum payments of $900, now under the snowball method, I can pay off my debts in 27 months. It would be the longest one paid off, 27 months. So I'm paying them off, and my total interest at $2,000 -- if I can make $2,000 level payments towards my $45,000 debt, in 27 months I will have paid off all of the debts, and I'll pay a total of $7,494.42 of interest under the snowball method.

If I do it under the avalanche method, then my total interest payments would be $4,986.27. So again, that interest savings that I would enjoy by paying this in the highest interest rate first, I would save $2,508 of interest. Well, let's look under this scenario. Let's look and see if I would be able to harness the power of the big wins, the quick wins.

Under the avalanche method, I would have my first debt paid off in 14 months, and under the snowball method, I would have my first debt paid off in 9 months. So I would look at that, and I would say, "Am I going to be extra motivated by having that student loan payment paid off, $10,000, and have that paid off in 9 months, or am I still going to be motivated to do this for 14 months?" But under the avalanche method, I have my full debt paid off in 25 months versus 27 months.

So I got five months. I had my first debt paid off five months sooner, but it took me two months longer under this scenario. So which was better for me? Now again, I want to be fair about this. I have constructed this chart using three loans, and I've made my highest credit card balance have the highest interest rate.

Then my medium-sized car loan, $15,000, have an 8% interest rate, and then my student loans have $10,000 balance, have a 6% interest rate. So I don't think I'm constructing a straw man here. I think this is an accurate analysis, but I have tilted the odds in the favor of this math to illustrate how the math would work.

So this would be the Dave Ramsey plan, because I am paying $2,000, and I have my debts paid off in 27 months. So this would be under the snowball. But to me, this would be a good example. If this were the scenario that someone were facing, this would be a good example where I would say, "Save the $2,500 of interest and make sure that you pay off the credit cards first, because 14 months versus nine months, is that really going to make a difference?" Now, again, if somebody had a $300 debt, well, yeah, get rid of the $300 debt.

That would make a lot of sense to me. But this is why it's so difficult to -- why we have these stupid arguments in the finance world, when they can be quickly -- like, we have these stupid arguments about what's better, and you go and you read these comment threads of thousands of comments.

Well, this method worked for me. It's great that it worked for you, but sit down and calculate it. Use the spreadsheet and calculate your method and figure out what it is for yourself. You're an adult. You can sit down, and you can say, "I think that I need some behavior modification." Let me give an example.

It is not stupid, if you're going to go on a diet, to go around your house and say, "I'm going to throw out all the junk food out of my house, so that I don't have it sitting there and facing me." It's not stupid. You don't have to say, "I'm supposed to be this mature adult who doesn't give into temptation." I think that'd be pretty smart.

Recognize these behavioral cues and recognize your situation. So understand it, and then harness the power of behavior modification. You don't have to go through these things. You can harness the power of behavior modification for yourself. So don't run from it. Don't just say, "I've got to be coldly rational." We're not coldly rational people.

We're human beings. We're emotional human beings. But run the spreadsheet and actually do the math and figure out what your actual better scenario would be. So this would just be an example of snowball versus avalanche. Now, if I change something, I could change any of these variables and adjust the interest rate.

In fact, I thought about doing that, but I think actually it would just be two numbers heavy for me to go through. I thought about making some alternative spreadsheets of different scenarios and showing how these things vary. But the key, I would just say, is do your own math.

And I don't want to belabor the point. I think you get it. Do your own math. Interest rates do matter. Like it or not, interest rates do matter. You can't just say it's all about behavior modification and it's all about--and it's--and ignore the interest rates. Oh, I guess you could say whatever you want.

I think it's dumb to say it's all about behavior modification and interest rates don't matter. And I think it's equally dumb to say it's all about interest rates and behavior modification doesn't matter. Both of these are important. So we've got to integrate these into the plan. And remember, just because something worked for you doesn't mean it's necessarily the same thing that everyone else should do.

It's okay if something worked for you. It's okay for me to say, "I choose to do this because this aligns with my goals." And it's okay for you to say, "I have different goals." So just recognize, you know, we're all adults. We have one life to live. Let's live it and not worry about trying to make everyone else.

Just because something worked for us doesn't mean that's what everyone else should do. If I sound a little bit passionate, it's because I am. Because I labored under this kind of construct for years of just this personal finance dogma, "This is the right way. This is the right way." Someday I'll tell my story on a show.

But I mean, Dave Ramsey was a huge influence in my life. I got out of debt because I read his book, Total Money Makeover. And man, it was a brilliant behavior modification book for me. And I owe him a debt of gratitude for that. I would love to -- I've never met him.

I would love to shake his hand and just say, "Thank you." That's awesome. But the problem is that it was totally destructive for me to take and apply that same thing to everything else, that same thing that worked for me in the financial planning world. And it took me years to learn, "Wait a second.

I've got to be a little bit -- I've got to have a little bit more finesse with this." And then I just -- the dogma is not necessary. We've got to find a way to implement the -- to bring in the reality of behavior modification and inspiration without this like divisive, "This is the only right way." Why don't we teach -- that's what I'm trying to do.

Why don't we teach people to think about it and be adults and think about and create your own plan instead of saying, "This is what you've got to do because this is right." Run the math. We ought to run the math on every single situation. And yes, we are doing math.

And yes, personal finance is about finance. It's also about personal behavior and we -- but we are doing math. This does matter. So I want to go on and hopefully that's not too -- hopefully that's not too -- I'm not bitter. It's just -- the answer is every -- the answer in every situation will reveal itself when you actually sit down and create a spreadsheet or get out a calculator and calculate it.

And this is the weakness is that a lot of times as financial people who are interested in finance, we're not taking the time to learn how to calculate this stuff. And so we spout what we've heard other people say that makes sense without sitting down and saying, "Let me challenge it." And if we would challenge people, you know, don't ever take -- if I do a financial plan for you, don't ever just take it at face value.

Challenge it. You need to understand what's going on in it and I need to be able to defend it. And if we would learn to challenge things instead of just simply saying, "My guru says such and such," we may have a slightly better situation. We may have better teachers because we hold them accountable.

We may hold our politicians accountable instead of lying every day and saying what they're doing and then they just do something else. And we may actually have a better situation if we would increase our knowledge a little bit and increase our capacity and our ability. And in a world where with a quick Google search we can turn up a spreadsheet then we just enter everything in and say, "Let me calculate it," this would be an amazingly -- this is a valuable thing to do.

So let's calculate it. Moving on. Terms. Interest rates matter. Amounts matter. But terms matter. So in my simplified example, I have a credit card, a car loan, and a student loan. But here's where you have to kind of look and say, "What are the actual terms of these debts?" And I cry sometimes when I see people make serious errors in paying off their debts.

Serious errors. So remember, I said that this -- the whole debt conversation is predicated upon the idea of what's the alternative use of the dollar and the alternative use of the dollar being consumption. So yes, if you're going between consumption versus debt payments, you're probably better off paying off the debts.

But what if this is not the question? What if the alternative use of the dollar is not consumption? What if the alternative use of the dollar is investment? Well, now we got to look at the terms of the debts and factor this in and we need to do a slightly more rational analysis.

And so this is where -- I mean, this is what in my experience rich people do. You need to think about this. So let me give you some ideas that generally are not talked about. First of all, don't just look at the interest rate. Look at the fact of is the interest deductible or not?

Deductibility matters. Deductibility matters. Now, you may or may not be deducting it. So for example, home mortgage interest deduction, you may indeed be taking a standard deduction on your taxes and not deducting your home mortgage interest. However, that's not the only thing that's deductible. Are you deducting your student loan interest?

Are you deducting this as a business interest? First of all, don't be dumb and ever borrow money that's not deductible. And I say it again, don't be dumb and ever borrow money that's not deductible. Listen to my show and I'll teach you all the ways to borrow money that's deductible, but don't ever -- this is why the gap between the rich and the poor gets bigger, is that poor people borrow for consumptions.

They borrow on a credit card at a high interest rate and it's non-deductible interest. They borrow on a car and it's a high interest rate and it's non-deductible interest. And they borrow on a house, but their income is such and the house is so low as far as the amount of interest that they're paying on the house payment, that they're better off just taking the standard deduction.

They'd be better off just renting probably, most of the time. And so you're wasting this deduction. So -- but wealthy people would say, well, let me make sure that I'm borrowing and if I'm borrowing it's going to be on a business credit card, so therefore my interest would be deductible.

If I'm borrowing and paying interest on a car loan, let me make sure that at least some portion of that car loan is being paid by business, so that it's deductible. And let me make sure that my home mortgage, if I'm going to go ahead and do that out, let me make sure that I go ahead and maximize that deduction.

So I don't think it's -- I wouldn't -- I don't think it's smart to go into debt for the purpose of deduction, but if you're going to go into debt, make sure that you're going to deduct it. And don't -- and let -- and this stuff matters. And this is a major, major factor in financial planning.

You've got to look at the deductibility of the interest. Now, give me an example, okay? The mortgage is the simple one. If you are deducting your mortgage, you would run the analysis. If you are deducting your mortgage interest, you would run the analysis and see, you know, for example, are you close to the standard deduction line?

If you're close to the standard deduction, you can just use the standard deduction instead of itemizing your deductions, that would be fine. You may choose to go ahead and pay off the mortgage. But you may, if you're in a higher tax bracket, there's no question of the fact that if you can subsidize -- let the tax code subsidize your mortgage interest, that can be a substantial savings.

If you're in a marginal bracket of 25, 28, 30-something percent, then the -- a 30 percent discount on your interest can be a substantial interest deduction. If you go from 4 percent, that drops you down to 3 percent. That's a substantial savings as far as allowing the tax code to subsidize you.

What about something like if you're going to borrow money for a business -- if you're going to borrow money on a car and you do that in your business versus not? Let's say that you're self-employed. Look at the savings that you have with the deductibility of business interest versus not.

Let's say that you have purchased a car and your interest rate is 5 percent on your loan. Hopefully you got good credit and you can get it much lower than that. But let's just say 5 percent for an easy example. If you're in a marginal bracket -- I'm just going to use 28 percent.

Let's say you're in a 28 percent marginal bracket and you're self-employed. So you're also paying -- I'll just use self-employment taxes instead of employment taxes because they're just simpler. So you're paying 15.3 percent of self-employment taxes. So your savings on that loan is 15.3 percent plus 28. So you have a 43 percent discount on that interest rate because of the fact that you are able to deduct the interest.

So if your interest rate were 5 percent, then you would lower that by 43 percent and that's what your effective interest rate is. That's a substantial discount. You've got to factor that in because when you can get a 43 percent savings on your interest rate and if you can borrow money under reasonable terms, you've got to factor that in.

That does matter. So you've got to look at that. And let's say under this scenario -- and here's why I bring it in in the debt scenario. In this scenario, if you're advising a client, if you're a financial planner, or if you're just advising -- you're just coaching yourself, if you have an asset that has a loan on it under the business loan and you have personal debt, then this is going to dramatically affect your specific debt payoff plan.

And you better prioritize that -- I would recommend that you prioritize that personal debt over and above the business debt and continue to enjoy the subsidy on your business debt. It exists for a reason. Remember, Congress -- all this stuff exists for a reason. You're supposed to be being incentivized to go out and borrow money to expand your business.

So why not take advantage of that? Now, you may still want to pay off that debt. If you get to the point where you say -- again, I'm not arguing today what debts you should pay off and shouldn't pay off. I'm just arguing about the order. And that if somebody has -- if you're doing this snowball thing where you've got -- I've got a car loan in my business over here that is a small amount.

I've got to put that first. No. Focus on the deductibility of the debt versus the non-deductibility. Focus on the actual makeup of the interest. So, for example, is this fixed interest or not? So take a look and figure out what you should actually choose to do under the interest.

So is the interest rate fixed or is it not? And depending on what the makeup is of your debt, you may have different options. I would heartily suggest if you can ever refinance, always look to refinance your debt. Now, again, you need to do the math to make sure that it's in your best interest.

So if there's a cost to refinancing the debt at a lower rate -- so, for example, let's say that you're surfing credit card balances and they say we'll allow you to do a balance transfer to a lower interest rate, but we're going to charge you a percentage of the balance.

Because you're actually doing math and not just blindly following someone else's plan, look at your spreadsheet and calculate and see how much is this actually going to be worth it. By the time the debt's paid off, am I actually going to save on interest? So always try to figure out can I surf the interest around?

And sometimes you may choose to refinance variable interest rates over to fixed interest rates, and you may choose to refinance fixed interest rates over to variable interest rates. Sometimes a fixed rate mortgage will make sense. Sometimes a variable rate mortgage will make sense. Sometimes -- just look at this and figure out the interest rates.

Look at the fact of is this a secure debt or not? So if I had two equal debts, let's say that I had a credit card balance of $20,000 and let's say that I had a car balance of $20,000, and if I were sitting there looking at them and if they had equivalent interest rates, which is a big if, because a lot of times a credit card balance, especially if someone has poor credit, will have a much higher interest rate than a car loan.

But let's assume I have good credit and I have a 0% credit card and I have a close to 0% car loan or something like that, then I personally would consider paying off the secured debt first. Because in doing planning for disasters, if I wind up in a situation where I lose my job or if I wind up in a situation where I have a business shortfall for six months or if I wind up in a situation where I get sued or I face financial trouble, I want to make sure that I don't lose my car.

And so I'd rather have a paid-off car and have a credit card balance, and then if I fall behind on my payments, then I just say, "Sorry, I've done my best, but I can't do any better." I'd rather have a paid-off car than a paid-off credit card. So think about that and look at your situation.

Now, if my credit cards are at 18%, variable interest rates, and my car loan is affixed at 3%, I probably would choose not to do that because the cost is much too high as far as the interest, so I'd go ahead and pay off the credit cards first. But this is why you have to look at your actual situation.

I would look at, is this debt bankruptable or not? So if worse came to worse and I were forced to declare bankruptcy, which I think is a very important aspect of financial planning that we don't do, risk management planning, do bankruptcy planning. What if the worst came to worst, my teenage daughter hit somebody and it was her fault and I got sued and I didn't have the proper insurance and I were forced into bankruptcy by my lawsuit?

Well, is my debt bankruptable or not? So here the example would be a student loan is not bankruptable, whereas a credit card balance probably would be, especially if that credit card balance were a business credit card or a car loan would depend. So a personal loan probably would be bankruptable or another loan would be bankruptable.

So if I were looking and let's assume that in my plan I have a student loan balance at an equivalent interest rate of a credit card balance, then I may choose to go ahead and pay off the student loans knowing that, again, same thing, the credit card is unsecured and it's bankruptable, whereas the student loan is also unsecured but it's not bankruptable.

So I guess, I don't know, technically that wouldn't be unsecured, but it is secured in a sense. They can always come after you for that amount of money. Or if I were looking and I was saying I've got a mortgage that I'm interested in paying off and this mortgage has a similar interest rate to a car loan, then I may consider going ahead and choosing to pay off the mortgage more quickly because at least in my state we've got great bankruptcy protection laws because then I wind up in a situation where my house would be debt free and this would be a valuable aspect of my asset protection planning.

So, I mean, does this matter? I think it does. You know, I've worked with various physician clients and I would say if I had – again, depends on the terms. You've got to look at the terms and you've got to run the math. Would I be willing to pay off a 3 percent fixed rate mortgage on a house in a scenario where I were facing 18 percent credit cards – 18 percent interest on my credit cards?

No, I probably wouldn't. And I probably actually wouldn't – and I wouldn't prioritize paying off the house. I'd prioritize fully funding retirement plans which are also credit or protected. So – but you've got to factor this in. Consider it. Consider can I refinance this debt? So again, if you know that you have credit card debt and it has small balances but you know that you're able – because you have a good credit score, you're able to refinance the debt and keep it on zero percent credit cards under the terms and you're expecting that you're going to be able to refinance that, then you may go ahead and prioritize the student loans that you can't easily refinance at the higher rate.

That to me would be an important thing to consider and always be looking to say what can I refinance here, what can I refinance there. What are the – one thing I forgot to mention, I wanted to mention on kind of the – is this debt secured or not.

What about things like 401(k) loans or life insurance loans? I would prioritize repaying a 401(k) loan or I would prioritize repaying a life insurance loan before I would prioritize paying an unsecured credit card because again, same type of thing. My 401(k) loan, if I had a 401(k) loan or if I were working with a client who had a 401(k) loan which they're not a good plan, I would recommend not pursuing that path.

But people pursue it and it's there for a reason. So if you have a 401(k) loan, I would recommend prioritizing the repayment of that so that you can restore the balance of the account to the investment earnings so that you could be protected in case you lose your job and so that you can restore the asset protection nature of the 401(k) and again, look at the terms.

What are the terms of the 401(k) loan versus the credit cards? But I would much rather do that or pay back a life insurance loan that I'm being charged interest on by the life insurance policy. I'd much rather pay that back and restore that balance and restore that in a creditor-protected world than pay back a credit card that I have at 2.99% first.

I mean, I would do that first. So consider that. And then the last thing would be what is the makeup of this debt? Is this consumer debt or is this investment debt? And now again, I recognize that many people who are listening to financial shows or reading financial blogs, kind of at the initial level of financial awareness is get rid of consumer debt.

But consumer debt is not the same thing as investment debt. So look for a way to refinance things and take advantage of investment debt. So if I had consumer debt that I couldn't figure out a way to refinance and keep it as consumer debt, then I would go ahead and I would look at doing a margin loan on a stock account.

And then I could -- or depending on what assets I have and depending on how it's structured and depending on the terms of the loan. But if I can take out a margin loan on a taxable account and use that to pay off my consumer debt, then now I've converted that from a non-deductible consumer debt over to a deductible debt, which is deductible against my growth in my investment account.

So that helps to offset my taxes on any gain in my taxable account. So there's a variety of ways of looking at this. And again, I just would plead that we do a better job of thinking it through. So I think those are the primary things that I wanted to communicate today.

I hope this show is interesting. And I hope that this can provide some ideas. And these are just ideas that I've thought of over the years as I've looked at client situations. And again, my major premise is that we will be far better served by individually looking at client situations or individually looking at our friend's situations or people that we're helping with their money rather than just simply saying, "This is what's always right." It is useful to teach things through.

It is useful to teach, "Here's what a snowball method would be. Here's what an avalanche method is." And sometimes I forget because I have gotten astonished many times in working with clients. And I think, "Why are you doing this?" When I see people doing the little extra here in their method, I just think, "Why are you doing this?" But I can help those people and you can help those people.

Sit down and help build out a spreadsheet. And the last thing I love about this spreadsheet, I encourage you, if you've never done this for yourself or if you've never played with these numbers, go to the link in the show notes and download the spreadsheet and put some numbers in and play with some scenarios because you need to play with the scenarios to see the cases in which a snowball would make sense and an avalanche would make sense.

You want to calculate what is the actual interest that's paid. I've done this sometimes for clients and I've done lots of these spreadsheets. And many times, the makeup of the debts and the amount of interest that is--and the interest rates, you look at it and say, "Look, you've got an extra $332 of interest if you pay the highest interest rate first instead of the lowest balance first." You absolutely, in my opinion, in that scenario, you should go with the lowest balance and you should make sure you harvest this behavioral win.

On the other hand, look at it and say, "How can I harvest the behavioral win? How can I harvest the interest rate savings? And how can I keep these other factors in mind that I've mentioned of the terms of the debt?" And what the thing I like about this spreadsheet, you can put it in as in a custom order.

So you would enter in, "Okay, I'm going to do this one, this one, then this one, then this one," and then you can compare it to your baseline, whatever your baseline is. If your baseline is highest interest rate first, and you can see, "Here's how many months to pay this off.

Here's how this will work. And here's how I can really answer this. I can really--you know, here's what my total cost will be." So play with the numbers. I hope that you enjoy this chart if you've never found one like this. It's the most useful one because it's the most visible.

Quick tip for you, make sure you look at the first page, which is the calculator, and the second page, which is the payment schedule. And the nice thing about the payment schedule is you can add in additional payments using the debt payoff nomenclature. This would be called debt snowflakes.

So you can say, "Okay, let's assume that I have an extra Christmas bonus of a thousand bucks. What if I pay a one-time extra bonus of a thousand bucks on Christmas?" And you can plop that in on the second sheet of this chart, which is the payment schedule. And I find that to be a really useful tool.

And I guess the last thing is--that I have is I find this--I have found this chart to be incredibly motivating for clients and motivating for me as well. And paying off debt can be very motivating for people when they can see how it works. Debt is such a--paying off debt is such a tangible, powerful goal.

This is why it's so actionable, is because it's such a tangible goal. You know there is a clear finish line. Getting wealthy is less of a powerful goal because there's--what's the finish line? What's the number? And that number changes all the time and that's why it's so powerful to harness this behavior modification of paying off debt.

I don't think ultimately paying off debt is necessarily going to make someone happy because you still got to figure out the lifestyle factors. But it certainly can be--is an important step on the road to get there. And I hope you like this--I hope you like this chart. I found that when I've done this for clients and given it to them and allow them to play with the numbers.

And what I do, just a final quick tip is I go through the cash flow statement and I say, "Okay, look." And I use this side by side with the cash flow statement. In many ways, this debt spreadsheet, if someone is in debt, this--I view this as kind of a third statement, a statement of liabilities if you want to be precise.

And what we do is we go through the cash flow statement and we mark some changes. And we say, "Okay, if you were going to adjust this area of your cash flow, okay, you're going to--let's say that, you know, a simple one, you're going to cut your cell phone bill.

Okay, you're going to cut your cell phone bill, then you're going to make this change and so therefore there's an extra 50 bucks. And so now if we go from, you know, $2,000 of payments, we go to--or an extra $100 a month, that would be easier. So now we go to $2,100 of payments.

Then in my little scenario I've got sitting in front of me, at $2,000 a month using the snowball, then this person was out of debt in 27 months. At $2,100 a month, then this is out of debt in 25 months. And so now we can figure out the opportunity cost and we can bring it into an opportunity cost and say, "Would you rather have the fancier cell phone with the--and pay the extra $100?

Would you rather be out of debt two months sooner and save--" Let's see what's the difference, $7,100 of interest versus--let's look here, versus $7,494 of interest and save the $300 of interest and be out of debt with the balance two months sooner. And there's no right or wrong, you know, it's all a matter of choices.

We all have tradeoffs, we all have choices and this is life. We're adults, we can choose for ourselves what we prefer. In one answer, one scenario, the question may be, "Yes, I would prefer that." And the other question may be, "No." And now we have some numbers that we can put behind it.

And these numbers, I think, are valuable. So that's our show for today. I hope you enjoyed it. I hope I didn't come across--I hope I didn't come across as too strong. I really am a nice guy and I'm not--I just--I guess I'm just sharing, you know, some of the things that I have learned and working with clients.

I just--I want to--I want us to raise the level of our advice for ourselves and for others. Let's take it up a notch. Let's get a little more professional. Let's understand a little bit more. And if someone gets motivated just by a debt snowball, that's awesome. But at some point--but I just hate to see people make mistakes that cost them because they don't know how to calculate the impact.

You know, when I see somebody cash out a 401(k), pay the penalty in interest and do this to pay off a debt that's low interest rate, I just look at it and I say, "Arr, did you actually run the cost of that?" If you did and you made that decision, it's your money.

But man, that's an expensive decision sometimes. And look at the lost power of the money that you would have had, the lost compounding that you would have had if you had done it, if you had continued, you know, if you continued on the plan. So, hopefully this is a useful resource for you.

I wanted to create it as something I could point people to so that they're helping--so that you can kind of guide yourself through what order should I pay things off. I hope it's a useful resource for you. That's it for today. Thank you for those of you who are leaving reviews for me.

I would ask you, please, if you haven't done so, I would just solicit--if any of this information has been helpful or if you've enjoyed it, I would solicit a review in iTunes from you or Stitcher or whatever you're listening on. I would just--that would help me so much and I would appreciate that.

So, I just ask you for that and I would say thank you. Also, if you're not subscribed to the show for the show notes, come on by the blog at radicalpersonalfinance.com, enter your email address that I won't spam you. I would just send you the show notes every day so that way you can see the full show notes of the show and you can understand what the show will be out and you can see if it's something that you're interested--see about and you can see if it's something that you're interested in or not.

So, come on by the blog, leave me a comment, shoot me an email, let me know what you thought of the episode. Today was radicalpersonalfinance.com/32 and I am out. Enjoy your Thursday. Peace out, y'all. When you download the Ralphs app, you have easy access to savings every day. Get the most out of weekly sales and receive personalized coupons to save on your favorite items, all while earning one fuel point for every dollar spent.

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