Does bad advice like this make you cranky too?

Hi there,

You know, I’m a pretty placid kind of guy but I do get a bit excited about personal finance and budgeting when the topic comes up. I have dedicated over 18 years of my life to creating software and products to help people improve their finances so you would have to agree there is definitely a passion there.

So, I was really interested when one of the TV channel’s supposed money gurus came on the tele the other night and gave his formula for getting out of debt.

Now this is the guy who told me in an e-mail a few years ago that he was not interested in budgeting (which surprised me a lot because a personal budget is the foundation stone that ALL other financial progress sits on).

Anyway as I watched and listened to his formula I just shook my head and wondered why!

He is not the first one I have heard offer the same advice but since he was being beamed out to TV sets all over Australia I was a bit shocked.

I must say he was on the right track like all the others who give the same advice, but the one detail he got wrong could cost anyone who followed the advice thousands of dollars in additional interest.

I was just so so so cranky!!! How could someone come on the TV as the expert and be so wrong??!!

His Formula

His advice was to snowball the repayments so as each debt is paid off the repayment money is then passed on to another debt and so on building up momentum as each debt is paid off. That part was fine! But then he made the classic blunder.

His advice; apply any additional money to the smallest debt first and then when that one is paid off tackle the next smallest and so on, working your way up to the larger debts as each one is paid off.

Below is a list of fake debts I just knocked up to prove how poor this advice is. I arranged these debts from smallest to largest, the order he suggested they should be tackled.

As the first debt is paid off the $125 per month repayment is added to the repayment of the second one making it pay off faster and then repeating the process down the list as debts are paid out.

 

Amount

Repayment

Current

Product

Owing

Amount

Int. Rate

Ready Credit Loan

 $925.28

 $      125.00

12.00%

Family Loan

 $5,000.00

 $        30.00

5.00%

Store Card

 $6,520.44

 $      140.00

16.00%

Visa Card 1

 $7,524.33

 $      150.00

15.25%

Visa Card 2

 $12,000.00

 $      290.00

18.00%

Mastercard

 $15,000.00

 $      270.00

21.00%

 

If you use the advice given by our money expert you will save around $26,000 and 17 years on this list of debts. Not bad you might think.

Except his advice cost the person paying off the debts about $5,200 in additional interest and 6 months of additional repayments!

So how should it be done?

 

You see, he advised that you focus on the size of the debt but that is not the best advice. Interest rates are the all important factor. The higher the interest rate the faster the money bleeds, regardless of the size of the debt!

The absolute fastest way out of debt is to attack the highest interest rate debt first and as debts are paid off add the now spare repayment money to the highest interest rate debt. When it is paid off focus on the next highest interest rate debt and so on.

If you used this strategy with my list above you would save roughly $31,200 and 17 years and 6 months. That’s $5,200 less and 6 months less.

That’s expensive advice wouldn’t you say?!

No doubt you can now see why I got so cranky!

Even Better still

Back when Simply Budgets was quite young I received quite a few e-mails from people asking me how to pay off their debts faster.

I would sit up late at night crunching the numbers so I could send them back a plan (no charge, I was just keen to help people). After a few of these I got smart and created software to do the calculations. When I did that I deliberately built in the ability to compare any order of priority with the method which works best (int rate focus) .

 

I now sell that software so people can crunch the numbers for themselves. It makes it so easy it took me only a few seconds to knock up the list above and generate the report.

I also built into that software a section where you can enter a minimum repayment for each debt. My advice to people is to contact the people you own money to and ask them if you could make smaller repayments for a while. You enter these alternate repayments into the software and it then uses that additional info to focus all spare money onto the highest interest rate debt.

With the list above, I entered that the repayments would be 2% of the outstanding balance, which I think is pretty standard credit card practice. The result was an additional $1,800 saved.

Now I reckon our money guru would probably come back in his own defense and say that he advised tackling the smallest debts first so there was a psychological benefit; one of feeling really good when the smaller debts are paid out quickly, but that was an expensive good feeling don’t you think?

Now it might just happen that the ‘smallest debt to largest debt’ strategy might be the best if it just so happens to be that the interest rates are highest on the smallest debts and lowest on the largest debts. However, you will never do better than tackling your highest interest rate debts first and working your way down the interest rate list!

Have a look at the info at http://www.simplybudgets.com.au/debt-solutions/debtbuster/ if you are interested in finding out more.

There is a DebtBuster demonstration at http://www.simplybudgets.com.au/debtbuster/demo.htm

You can see the DebtBuster report showing how the savings above were achieved at http://www.simplybudgets.com.au/debtbuster/report/

I feel a bit better now I got that off my chest!

Have a great week.

Warm Regards

David Wright
Founder – Simply Budgets