Wednesday, March 4, 2015
Who are You? Tell the Truth, at Least to Yourself
There are a number of debates on questions of personal financial that share a common root problem. Are financial questions simple math problems with an obvious solution or are they primarily questions of human behavior and psychology? I try to simultaneously embrace both sides of the argument by asking the question, “Who are you?” If you know the answer to that question, then you will be better able to choose an appropriate path to financial freedom. Consider: Which is a better debt reduction method, the debt snowball or the debt avalanche. They are both proven, effective methods of debt reduction, but authors strongly disagree on the best method. Both camps recommend racking and stacking your debts. They both recommend that the debtor pay the minimum on all but one of these debts. Then every bit of available spare money should be targeted on eliminating the first debt on the list. When that first debt is paid off then all the money going to that debt should be added to minimum payment being made to the second debt until it is eliminated. It is obvious that such a strategy will gain momentum over time until the student is debt free. The problem lies in how to rack and stack the debts. The mathematically correct method is the debt avalanche. List the debts from highest interest rate to lowest interest rate. Pay of the highest interest rate first. This could save the debtor considerable amounts of money over time when compared to the debt snowball. But is that the best path for you? The debt snowball lists the debts from smallest to largest, ignoring the interest rates. In his considerable experience, Dave Ramsey has determined that quick initial victories motivate his students to persevere in their debt reduction efforts. Those who attempt to use the debt avalanche are more likely to give up. I can’t listen to the Dave Ramsey radio show very often. It is just too depressing. People call Dave who have made a complete hash of their financial life by their phenomenally bad decisions. Still, they just don’t get it. They believe that they are not doing anything wrong. Dave screams at them for a few minutes until he has their attention. Then he offers some appropriate counsel from his “seven baby steps” and a free book or a free pass to one of his courses. If you are in serious credit card debt, if you don’t understand compound interest, if you have a track record of unwise financial decisions, you should probably use the debt snowball. If you are a young engineer who, understanding the power of compound interest took on a manageable amount of student debt to get a master’s degree and a better job, the debt avalanche could well be the preferable method. Almost no responsible authors recommend the use of a Home Equity Line of Credit (HELOC) to lower the overall cost of interest on a diverse portfolio of consumer loans. If I can pay off a 15% credit card with 5% money from a HELOC, why shouldn’t I take advantage of the equity in my home to pay off expensive consumer debt? Again answer the question, “Who are you?” Credit card debt is typically unconscious or at best semi-conscious debt accumulated by a consistent pattern of irresponsible impulse purchases over an extended period of time. In some instances people have amassed substantial credit card debt attempting to “live on their credit cards” using them to fund the everyday purchases of life. Their income is less than their actual cost of living. This problem will never be solved by debt—of any kind. Cleaning up consumer debt by placing a lean on your primary residence is almost never a good idea, even though it is the mathematically preferable option. If buying habits and the consistent misuse of consumer credit caused your problems, it is unlikely that you will completely and instantaneously overcome a lifetime of unwise behavior with a consolidation loan. Instead, the data indicates, that carrying a wallet full of credit cards with zero balances; you will resume the habits that led you to the use of a HELOC in the first place. Although it is totally counterintuitive, it is unlikely that a sudden influx of more money will solve your problems with money. A University of California study indicates that winning the lottery will not increase your happiness. There will be a brief spike in happiness, but then the lottery winner tends to revert to his base psychological condition. A study by the state of Florida indicates that lottery winners are twice as likely to go bankrupt when compared to the general population. I guess people who spend significant amounts of money on lottery tickets are demonstrating that they don’t know much about managing their money. The anecdotal evidence is even worse than the controlled studies. A Forbes article tells the story of Jack Whittaker who won a $315 Million Powerball Jackpot. Within five years, he was repeatedly robbed, twice arrested for drunk driving, lost his granddaughter under “suspicious circumstances,” and lost almost all of his money. He told reporters, “I wish I’d torn that ticket up.” First answer the question, “Who are you?” Once you understand yourself, your limitations, the root causes of your behavior, then you can better find your way to financial freedom. This is a never ending, iterative, spiral process. Start where you are. Without guilt, shame, or judgment examine your financial condition. Where do you stand? How did you get there? What can you do to improve your situation? Then day by day take action. Examine the results of your efforts. Repeat endlessly.