Mathematically correct but psychologically wrong
johndcook.com
johndcook.com
e.g.
1. Charge $100 at the grocery store, 12% APR
2. Pay off $10
3. $200 Cash advance from ATM, 20% APR
4. Pay off $10
As of fairly recently, that's supposed to be illegal here in the US now (supposedly there are loopholes about "accidentally" giving people business instead of individual cards).
"Many things that don’t look optimal are in fact optimal once you take the necessary constraints into account. For example, software that seems poorly designed may in fact have been brilliantly designed when you consider its economic and historical constraints. (This may even be the norm. Nobody complains about how badly obscure software was designed. We complain about software that has been successful enough to criticize.)"
However, the majority of people who are drowning in debt got there because they weren't looking for the optimal solutions to their cash flow problems. Seeing their debt snowball shrink (or grow, I guess) in measurable steps is what provides the motivation to proceed. And in reality, the difference between your highest and lowest interest rate is probably 15-20% or so. Not enough to make or break you (and if it is too much of a difference, you are probably on your way to bankruptcy anyways).
P.S. Think of the variable cost savings of stamps and bill paying time! </sarcasm>
I know, I know. My being a member of HN should make me above psychology. But apparently it affects every human being. Annoying isn't it?
- 4 credit cards - 2 car loans - 2 student loans - 1 mortgage
Individual debts don't follow the same distribution as the categories.
Of course, I was thinking mostly young married couples, so it may not hold outside that demographic.
Thinking of most people I know whose finances I roughly know about... I'd say the average is one credit card (probably just $500-$1000 limit, not neccesarily maxed out, often paid off in full each month), no general loans, and a mortage and/or student loan depending on their need for them.
The snowball strategy could be perfectly rational for people who gain more utility from the small but frequent accomplishments of paying off debt earlier than they do from maximizing their overall lifetime wealth.
It's not what I would do, but as they say, there's no accounting for taste.
It would seem like one would prioritize savings, but due to the variance in interest, the net gain is in favor of paying off high interest loans vs building low interest savings.
Still, from a practical standpoint, you shouldn't put ALL of your disposable income towards debt, as you will want some sort of emergency fund to keep you afloat when your car breaks down. Otherwise, you go rely on more debt. Spending saved money is cheaper than spending borrowed money.
And my car did just break down hard enough for it to be junked.
Sorry, but you're wrong. Your retirement savings should go into relatively high risk investments with good long term average returns, such as the stock market. At this point the average return on investment for retirement savings exceeds the interest rates on your loans, and therefore the net gain is for preparing for retirement. (Unless, of course, you're facing a short term cash crunch where long term returns become irrelevant to your utility.)
Of course, there are lots of complications to this general rule in the real world. The US, at least, taxes the returns on your savings (capital gains and dividends) and gives you tax benefits for your debt. When saving in a 401k, employers often match your contribution, which amounts to a guaranteed 100% return on your investment for the portion that's matched.
Liquidity is also a concern. For example, if you have a 30-year mortgage on your house at 5%, you probably wouldn't want to put all of your savings into paying down that mortgage since you can't get it out again until you sell your house. If you have a sudden need to raise cash, you'd need to get a home equity loan, which can be tricky if your house value has plummeted or if interest rates are high.
Thus the full answer is that, well, it depends on a lot of life factors, and although paying off your debts is generally good advice, especially for very high interest loans like credit cards, there are many factors to consider other than the spread between the return on your savings and the interest rate on your debt.
optimality entirely depends upon your cost function. so pick the right one and optimise. the author clearly has one in mind---paying out the least money to eliminate the debt. but this doesn't seem the right one to me.
for example, i would much rather pay off small debts to friends (which typically have 0% interest) over larger, higher interest rates to banks, simply because there's a social cost owing money to friends, whilst it's kind of the purpose of a bank.
I've heard snowball as a great approach... but without some proof, I wonder if it truly is "...a problem with an obvious but naive solution". Behavioral Economics theorizing aside, even one example from a simple survey or academic study would do much to support his overall point.
Otherwise, his "Many things that don’t look optimal are in fact optimal" comes into question, and I don't want my silly need for proof to get in the way of that essential point, which, come to think of it, I firmly believe even without much proof. But still...
As to the people in debt: if they always consciously made (suboptimal) decisions, most of them wouldn't be in debt.
Jokes aside, you are probably correct, I have always been torn between trying and failing to be perfectly rational versus doing suboptimal emotional things.
It's really not psychologically difficult at all, except it's slightly more effort to pay two bills each month instead of one (since I could have afforded to pay off the smaller but lower interest rate one already had I not put that money into the higher interest rate one.)
However, imo the optimal strategy to pay off debt is to reduce the total amount of payments whenever you have money to pay after the necessities of life are taken care of.
Simple :)
Clearly? This is plainly wrong. Let's say we have two debts: $1000 with 0.7% interest rate and $40 with 0.8% interest rate (these rates are daily). Assuming our daily salary is $19, having payed off $40 debt first, we will never be able to pay off the $1000, as the interest exceeds our salary. The other way around, we pay off $1000 (then $2546.5) debt after 135 days, and then a week later we pay off $40 (then $128) debt.
It is not the sole interest rate, but the ratio between interest rate and debt that matters.
The daily interest on $1000 with 0.7% interest is around $7. Waiting a few days to pay of the smaller debt will not make it exceed $19.
Edit: Were you banning partial repayments? Most debt (I think) is not like that, but maybe it makes your math work
It does make it work assuming that partial repayments are not allowed, and interest is added to the principal (and paid off at the end) instead of being paid as it comes due. I don't think either of these is realistic, especially the second one. Also if I assume a savings account paying even 0.1%, it goes back to being payable in either order.
Yes, I were. If partial repayments are allowed, it is indeed the best approach.
>The daily interest on $1000 with 0.7% interest is around $7. Waiting a few days to pay of the smaller debt will not make it exceed $19.
Of course not, but they will exceed $19 before you will be able to pay it off as a whole -- it will take more than 130 days.
Maybe I should make my statements clearer, so that next time I do not get downvoted for being misunderstood.
Start: $40 @ 0.8% ($0.32 daily) + $1000 @ 0.07% ($7 daily)
day 1: pay $19 on the small debt; $21.32 remain (and $1007 on the other)
day 2: pay $19 on the small debt; $2.49 remain (and $1014.05 on the other)
day 3: pay off the small debt ($2.51) and pay $16.49 on the remaining one ($1004.66 remain)
day 4..n: pay $19 on the remaining debt
balance goes as X=X*1.007 - 19; paid off in 67 more days
Step 0: pay your minimum on all debts.
That prevents your principle amounts from increasing