The above graphic is from the facebook page of some “financial guru” named Dave Ramsey. If anyone ever gives you financial advice like this, you should back away from him as quickly as possible and never take advice from him again.
Getting out of debt IS about math. It’s about learning the math and recognizing how much you’re saving by paying off your debts the right way. If you know the math, you will feel good about what you’re doing no matter how long it takes you to pay off an individual debt. Dave Ramsey is basically telling you that you’re too stupid to learn the math so you might as well feel good about yourself even though you’re likely throwing away money by doing so.
What’s the right way to pay off your debts? It’s simple. Which of your debts has the largest interest rate? Pay that one off first. Which of your debts has the second largest interest rate? Pay that one off next. And so on. With very few exceptions, this is the fastest way to pay off your debts while making sure as much of your money stays yours.
Why do it this way? Because it’s the interest that kills you. If you buy a house for $250,000 with a 30 year mortgage at 5%, you will be paying close to $500,000 for that house if you pay off the minimum amount every year. Yes, you pay double for the house because of interest costs. If your loan was at 7%, you’d be paying nearly $600,000 for the house. Interest adds up quickly.
That is an extreme example, though. Most people who are trying to get out of debt aren’t terribly worried about their mortgage and it is likely that the interest rate on the mortgage is the lowest of their debts if they have one. When we’re talking about debts, we’re almost assuredly talking about credit cards. Credit cards commonly have interest rates as high as 30%.
Let’s take a simple example. Say you have two debts. One, a credit card with a $10,000 balance and a 30% interest rate and the other a credit card with a $5,000 balance and a 15% interest rate. Say the minimum payment for each is $50 to avoid paying penalties. Also say that you have $500 a month dedicated to paying off your debts.
Dave Ramsey’s advice is to pay off the $5,000 one first. Let’s see how that goes. We always want to avoid paying penalties (Something Dave Ramsey completely glosses over with his graphic) so we will be paying $450 a month to the 15% card and $50 a month to the 30% card. It will take you 13 months to pay off the 15% card. At that time, the balance on the 30% card will then be $12,200. It will then take another 39 months to pay that off. That’s a total of 52 months.
Now, let’s do things the correct way and pay off the 30% one first. Again, we always want to avoid paying penalties so we will be paying $450 a month to the 30% card and $50 a month to the 15% card. It will take you 33 months to pay off the 30% card. At that time, the balance on the 15% card will be $5,400. It will then take another 13 months to pay that off. That’s a total of 46 months. 6 months sooner than Dave Ramsey’s way. Congratulations! You just saved $3,000 by paying off your debts the right way!