Most of you have heard of personal finance guru Dave Ramsey, and most of you have heard of his debt snowball tactic. From his website:
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.)
Here’s a link to the first paper, and here’s a link to the second, which says:
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?
The problem with Ramsey is there is no effort to go into detail proper. He says that the benefit of debt snowballing is psychological, but if I was to pay a debt with a lower interest rate first that would do my head in.
Ramsey works the same way a lot of diet companies work, he builds fear around credit rather than trying to educate people who’ve mismanaged credit in the past. He makes a lot of money endorsing products and going to seminars.
For example, he says that you don’t need credit at all. Then his followers starting to get to the stage they wanted home loans, but couldn’t afford to pay a home off in full. Home loans are a very lucrative business to be in, now Dave Ramsey endorses a lender that gives no credit score needed home loans that now completely dominates that space.
It’s genius actually, he effectively created a new market (it did exist before but was tiny) and now controls where that market gets it’s credit from. The whole time he lines his pocket and laughs all the way to the bank whilst rubbing his beard.
The guy is a straight up scum bag.
Looking back at my financial history, I’ve followed similar advice of getting rid of the smaller nuisance debts first – regardless of the relative interest rates – just too much of a PITA to make a slew of payments rather than a few large payments. It relieves the psychological burden if you only have to think about a few payments, rather than a bunch of them.
@ William
A scumbug? That’s harsh even for internet posturing. I don’t agree with everything he says. He’d be appalled at how many credit cards I carry in my wallet, and that last year I bought a new car for five years at 2.9%. But the man is more successful that you and I will ever be, certainly doesn’t have to MS to make ends meet. He’s got a following that we’d covet if it was a fraction of the size. He could have retired at 50 it all he did was write books. No need to be petty. The only people with any credibility to speak to the efficacy of such a debt elimination approach are people who have experienced overwhelming debt. The kind of debt where you just throw your hands up and start believing you will always be in debt. These are the people who need to find a psychological edge to push them in the right direction. Once you actually start believing that you are going to get out of debt no matter what, then sure, start working on the higher interest debt. But Ramsey is reaching out to those who have given up, proven to be successful at helping them, and that success has gotten the attention of many more.
Its the people who don’t care about helping other people that are scumbags. I don’t begrudge him one bit for being successful. When you finally find success in your niche, are you then eligible to be called a scumbag?
The study looks at people who were already in eligible to be contacted by a debt collection agency. That’s an extreme sample, perhaps. Being unable to collect data on subjects such as their gambling habits or income leads to the possibility for omitted variable bias. Being unable to compare them to subjects who weren’t already eligible to be contacted by a debt collection agency opens up the chance of selection bias. Subtle difference.
And, as the kids say these days, LOL at a guy who’s currently aggressively commenting on travel blogs with
links to his affiliate-link-heavy website calling Dave Ramsey a “scum bag.”
I remember with glee tackling one of Dave’s concepts, the Ben and Arthur story of compound interest. From a mathematical perspective I was correct, but from a psychological perspective there were some good things in what he suggested. I see his stuff something like the Grimm fairytales, there are lots of completely ridiculous facets to what he talks about, there are nuggets of wisdom in there too.
The fact of the matter remains – if you are seeking to change a persons approach to spending so that they can get out of debt and improve their life, you have to help them see the change, and perhaps losing something in the optimal mathematics is worth it in exchange for actual progress, even if it is somewhat less efficient.
I feel my post yesterday saying ‘get a Traditional if you haven’t filed yet and get a Roth if you have’ regarding the $1375 rebate is the closest I have come to a Dave Ramsey style post. It had weaknesses that I wouldn’t otherwise have included, but I think in doing so I may have broken through to more people and got more ‘good’ achieved.
Its not a simple conversation, but it is an interesting one, and I too wouldn’t call him a Scumbag based on what I know right now, i’d be happy to hear something that changes that opinion though.
Two application links that are clearly disclosed, oh no! My point is that Dave Ramsey creates hype by putting forward an extreme point of view, personal finance shouldn’t be an “all credit is bad” or “all credit is good” equation.
He is in a position to educate an extremely under educated section of the market and fails to do so.
The issue I’ve had with Dave and will continue to have with him is that there is no wiggle room with his strategies. It’s never phrased as “if you can’t manage debt properly, don’t go into debt” it’s “all debit is evil, if you get into debt you become a slave to it”. His followers have this cult like mentality that I find disturbing and because they’ve been beaten over the head with this ideology it’s almost impossible to get them to even look at any other view.
He’s an extremely intelligent man and an excellent marketer, I just don’t think he’s a very good personal finance coach.
I would mostly agree with that criticism, but I can’t rule out the possibility that in fact his approach may be the right one for some people (though certainly not for readers of this blog). Maybe the people attracted to his message can’t handle nuance? Maybe they’d do worse if they listened to somebody less extreme? I don’t know if that’s true, but I don’t know that it’s not.
“but I can’t rule out the possibility that in fact his approach may be the right one for some people (though certainly not for readers of this blog)”
I totally agree, I probably should’ve make that clearer. I think that’s what I find most frustrating about Dave Ramsey, he presents the other side of the equation which is some people are unable to manage debt properly. This is for a variety of reasons (the most common being that their income is at a level so low that it’s surprising they can make it through day to day live even with large amounts of debt, but that’s a completely separate tangent), the problem with Ramsey is that he thinks this is the solution for EVERYBODY.
Lots of good public financial advisers make this distinction and they don’t get the same attention because Ramey’s message is easier to digest and markets better. That doesn’t mean it’s more valid though.
I guess what I find so frustrating is that he gets so close to being right, yet his readers end up so far off the mark because of it.
Dave is preaching to the religious crowd. He gives them what they want: a way to live debt free because many in the Christian community believe the Bible says that debt is morally wrong. If you understand this basic premise, you’ll understand Dave’s rationale much better.
With that being said, he’s not a “scumbag” or a profit monger by any stretch of the imagination. He’s crafted a message that is highly effective for a certain group of people. It’s true that debt can get you intro trouble, and the people who come to him for help generally aren’t managing debt properly and therefore need some type of solution to their problems. He offers them that solution. If you think about it, their normal way of being was to mismanage credit, so a radical shift is necessary and he provides that. His “shotgun approach” to giving advice, by suggesting to use no debt, isn’t the right advice technically, but it’s effective because it’s so simple that any random person can do it and it’s not the worst advice ever.
Where he goes wrong is when he starts calling people dumb for using debt. I listen to his show often because it’s on while I drive home from work. What Dave doesn’t seem to understand is that debt is simply a tool.
A good analogy is that it’s a power tool. To boil down his argument, he has taken the position that debt is like a chain saw, and because you can cut off your finger with a chain saw you should never use it. But obviously powerful tools can be used to great effect in the proper hands. Dave’s advice, for example, prevents all of his listeners for taking advantage of all the lucrative miles and points offers that they could be using. Why? Because Dave doesn’t understand credit, and credit card companies.
But there’s wisdom too. Anyone who has dug themselves into a massive debt whole probably doesn’t have the discipline to stay on top of the miles and points game the way we do, and thus it’s probably best to take the “nuclear option” and just cut up all their cards. So in a way, Dave’s message is perfect. He’s created a cult where “debt is dumb, cash is king….” etc etc…..
He’s definitely an interesting character. I listen to him because I feel like he acts as a sort of second conscience for me. You can pick up some good stuff.
He’s an entertainer first. And every good radio entertainer needs a “catch”. His is the debt thing. He wouldn’t be nearly as successful if he was the average financial “Bob Brinker” type host.
And his philosophy is Biblical in the sense that he maintains that freedom from financial worries (globally) allows one to devote more resources in a joyful manner to ministry. Prov 22:7: the borrower is slave to the lender. The spirit of the message is that the burden of debt comes between the one’s tithe and worship to God. So no, debt isn’t evil per se, only in the sense that it becomes overpowering in all other relationships. That’s the crux of Ramsey’s message, just distilled to a made-for-radio-show package.