Debunking Dave Ramsey's Snowball Plan for Debt Reduction

A reader recently commented on my site,  suggesting that I check out Dave Ramsey's website and learn about some of his suggestions for getting out of debt.  This morning, I performed a detailed analysis of his debt reduction plan which he calls the "Snowball Plan."

First accumulate $1,000 cash as an emergency fund. Then begin intensely getting rid of all debt (except the house) using my debt snowball plan. List your debts in order with the smallest payoff or balance first. Do not be concerned with interest rates or terms unless two debts have similar payoffs, then list the higher interest rate debt first. Paying the little debts off first gives you quick feedback, and you are more likely to stay with the plan.

I should mention that Mr. Ramsey is a faith-based financial advisor and regularly takes into account more than just the numbers.  When speaking on personal finace, he focuses on the "personal" just as much as the "finance."  Though his system has proven to be effective for some, it is not my style.

He urges his readers and listeners to build momentum when reducing their debt and try to feel a sense of accomplishment.  But let me warn you: those senses of momentum and accomplishment may not come cheaply.  Essentially, by "feeling good" about paying down debt, you risk taking more time to do it and thus wasting more of your money on interest payments.

Consider this analysis:

Let's say you have two loans: A student loan for $25,000 and an auto loan for $10,000.  The student loan has an interest rate of 8% and regular payments of $227 for 200 months.  The auto loan has an interest rate of 6% and regular monthly payments of $304 for 36 months.  In addition to your regular payments, let's say you have $100/month extra that you can apply to whichever loan you're currently paying and that once it is paid off, you will take the normal payments of it and apply them toward the other loan until it is paid off.  In this scenario, with minimum payments of $227 and $304 and extra cash of $100, you will be paying $631 per month until both loans are paid off.

Because the length of the student loan is much longer than the auto loan, even if you decide to apply the extra money to the student loan first, by the time it's paid off the auto loan will have been long-since paid off.  The total you will have spent on interest over the life of the two loans will be $10,603.  If you had decided to pay off the smaller auto loan first and then send all of your debt-reducing cash to the student loan, you would have saved $2,262 in interest.  In this case, Dave Ramsey's strategy works.

But let's look at another scenario.

Let's say you marry your college sweetheart.  After the wedding, you decide to merge your individual finances and adapt a joint financial strategy that works for both of you.  Let's say that you have a student loan of $30,000 at 9% for ten years.  Your spouse has less: only $15,000 at 6% for the same 10 years.  Like the previous example, you can pay an extra $100 each month toward the principal on whichever loan you're paying down first.

The terms (length) of the two loans are the same, one is twice the size of the other, and the smaller loan carries a smaller interest rate.  Dave Ramsey would tell you to pay off the smaller $15,000 loan first.  By doing that, you're costing yourself $1,534 in unnecessary interest.  If the difference in the interest rates was greater, this wasted amount would be even larger.  Let's say your loan carried 10% interest and your spouse's carried 5%.  You would then waste $2,058 in additional interest by paying the smaller loan first.

Let's tweak the numbers one more time: Assuming the same rates and balances,  a change in terms so that the smaller loan lasted for 15 years instead of ten would result in a waste of $2,656 in unnecessary interest payments; just because you listened to Mr. Ramsey.

As you can see, there is not a definitive high-level strategy that can accurately determine the order in which you should pay off your loans.  Mr. Ramsey tries to justify his financially flawed plan by adding emotion and human perception to the equation.  Here is my solution:  When considering the order in which you pay off your loans, crunch the numbers.  Once you prove which will save you the most money, set up a regular payment with your bank and forget about it.  You should find satisfaction in the fact that you're paying off your loans in the smartest, cheapest way possible.  Maybe it means paying off the smaller loan and maybe it doesn't.