Myth: I should pay off the debt with the highest interest rate first to get out of debt quickly.
Truth: You should pay off the smallest debt first to create the greatest momentum in your debt snowball.
The math seems to lean more toward paying the highest interest debts first, but what I have learned is that personal finance is 20% head knowledge and 80% behavior.You need some quick wins in order to stay pumped enough to get out of debt completely. When you start knocking off the easier debts, you will start to see results and you will start to win in debt reduction.
But the question needs to be asked: how well-founded is Ramsey’s assertion that paying off the smallest debt first is the best way? You can get anecdotes and metaphors to support any point of view, but is there anything more rigorous underlying Ramsey’s marketing pitch?
I’ll quote from page 66 of Helaine Olen’s Pound Foolish:
When a group of researchers studied the issue for the Journal of Marketing Research, they found a majority of people believed this was the best way to pay down their bills, so much so they will even pay down the smallest debt first after being told of the financial error of their way. “Ramsey may be preaching to the choir”, the paper dryly noted, adding he was promoting “non-optimal behavior”. (It’s worth noting other researchers disagree with this analysis, with two professors at Northwestern University publishing a paper in the summer of 2012 showing, at least as far as the debtors they studied, that building up willpower is more important than the actual numbers themselves.)
Our finding that closing off debt accounts–independent of the dollar balances of the closed accounts–is predictive of eliminating debts hints that this intuition [of Ramsey's debt snowball] has a basis in reality. In particular, our findings suggest that, consistent with the recommendations of financial advisors such as Ramsey, maintaining motivation to eliminate debts over a long time horizon might necessitate small wins along the way.
The second paper lends support to Ramsey’s position but is by no means conclusive. Authors David Gal and Blake McShane based their study on “a highly unique data set from a leading consumer debt settlement firm (viz., Freedom Financial Network)”. One subtle problem with this approach is selection bias–the researchers are only able to look at what happened after the fact. The study showed that people who payed smaller debts first did better–but what we don’t know is whether the people who paid smaller debts first are an equivalent population to those who did not.
For example, in theory the population that did not pay the smaller debts first could be a bunch of degenerate gamblers. Or maybe they just had lower income on average.
Or maybe the opposite is true and the debt snowball approach is even better than it appears to be in this study. We simply don’t know that we have an apples to apples comparison.
And to be very clear: this is no knock on the researchers, who in my amateur opinion produced a pretty good paper. Good data is hard to come by for this type of analysis. I can only think of one organization with the resources to do the kind of research that could demonstrate the debt snowball’s effectiveness, and that is the Dave Ramsey marketing machine.
What Dave ought to do is a controlled experiment. This concept is used in medical testing as well as in financial services marketing. He’d want to take a bunch of debtors and divide them into two randomized, equivalent groups. By “equivalent” I mean as equal as possible in terms of demographics, debt, and any factor whatsoever that might influence the outcome. Group A would pursue the Ramsey Debt Snowball while Group B would pursue the high-interest-rate-first approach. At the end of the prescribed period of time, you check to see who’s doing better.
Would such an effort say definitively, once and for all, which approach is better? No. Controlled experiments don’t always give great results. But studying the issue this way works better than more indirect approaches.
Think this is a good idea? Put yourself in Dave Ramsey’s shoes. You run a successful and profitable company, you’ve helped people get out of debt, and you have a great marketing hook with the debt snowball. Would you do an exhaustive and possibly expensive study that risks upsetting your business model, or would you keep doing things the way you’ve always done them?